While the rest of the world argues the pros and cons of the new U.S. tax law, many analysts and investors are concerned that a provision in the tax overhaul could complicate their efforts to compare a company’s earnings to its cash flow. This is important because this is how the traditional way analysts assess earnings quality.
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The provision in question is the one that assesses a one-time tax on companies’ accumulated earnings from outside the U.S. The complication comes from the fact that although the tax would normally be charged against a company’s 2017 earnings, firms have the option to stretch the tax payment over 8 years, interest free.
Companies need to decide how they will handle the repatriating of offshore profits this year, a decision that could throw off comparisons of different companies. This is an issue because investors like to be able to see a company’s earnings backed by cash flow from the same year. Stretching out payments of the “transition tax” on foreign earnings will make that comparison difficult according to accounting experts.
The Nature Of The Problem
Companies that elect to stretch out their tax bill will create a scenario in which 2017 earnings will be reduced but cash flow will not. This will create the appearance that earnings are more fully backed by cash flow than is really the case.
For following years cash flow will take a hit while earnings will not be affected. This creates an opposite scenario in which it appears earnings are less backed by cash flow than they really are.
A Disconnect In The Making
For analysts and investors to compare apples to apples, they will have to reconfigure company numbers. If they fail to do this, could be misled about a company’s true financial standing. The situation could be even worse when analyzing companies whose operating cash flow is below their earnings.
One example given is Mondelez International Inc. (NASDAQ:MDLZD) a company with a $1.3 billion tax bill on accumulated foreign earnings. The company’s highest annual payment, based on the new tax law, would be about $325 million, or 13% of the $2.6 billion in operating cash flow Mondelez posted in 2017. This amount is already less than the $2.9 billion in net income posted in 2017.
More Bad News For Investors
While it will be more difficult to compare earnings results, investors have also noted some additional downsides to the new tax law. Beginning in 2018 (for taxes filed in 2019) you will no longer be able to deduct investment expenses.
Capital gains will also be defined differently than in the past. The rates didn’t change but how they are discussed did. In the past the 0%, 15% and 20% rates applied to specific tax brackets. Now those rates apply to specific income thresholds. These are not huge changes but added to the complications caused in comparing company earnings, they will be a challenge to investors moving forward.