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Understanding the P&L Impact of the New Tax Accounting

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April 21, 2016 | Barbara Baksa

Understanding the P&L Impact of the New Tax Accounting

For today's blog entry, I use an example to illustrate the impact the new tax accounting procedures required under the recently issued ASU 2016-09 will have on companies' P&L statements.

A Refresher

Under the old ASC 718, all excess tax benefits and most tax shortfalls for equity awards were recorded to paid-in-capital.  An excess tax benefit occurs when the company’s tax deduction for an award exceeds the expense recognized for it; a tax shortfall is the opposite situation—when the company’s tax deduction is less than the expense recognized for the award. The nice thing about old ASC 718 is that paid-in-capital is a balance sheet account, so these tax effects didn't impact the company's profitability.  Under the amended ASC 718, all excess tax benefits and shortfalls are recorded to tax expense, which ultimately impacts how profitable a company is.

Effective Tax Rates

Not only do changes to tax expense impact a company's profitability, they also impact the company's effective tax rate.  This rate is calculated by dividing the tax expense in a company's P&L by its pre-tax earnings. A company's effective tax rate is generally different from the company’s statutory tax rate because there are all sorts of credits that reduce the tax a corporation pays without reducing income and there are items that can increase a company’s tax expense that don’t increase income.

An effective tax rate that is lower than the statutory tax rate is good; it shows that the company is tax efficient and is keeping its earnings for itself—to use to operate and grow the company or to pay out to shareholders—rather than paying the earnings over to Uncle Sam. Just like you want to minimize the taxes you pay, shareholders want the company to minimize the taxes it pays.

An Example

This example is based on a real-life company that grants stock compensation widely. I’ve rounded the numbers a bit to make it easier to do the math, but my example isn’t that far off from the real-life scenario.

The company reported pre-tax income of $900 million for their most recent fiscal year and tax expense of $250 million.  That’s an effective tax rate of 28%, which is probably less than their statutory tax rate.

The company reported (in their cash flow statement) an excess tax benefit for their stock plans of $70 million. Under the old ASC 718, that tax benefit didn’t impact the company’s earnings. But if it had been recorded to tax expense as is required under the amended ASC 718, it would have reduced the company’s tax expense to just $180 million. That reduces the company’s effective tax rate from 28% to just 20%.

In addition, the company’s basic earnings-per-share is $1.30, with 500 million shares outstanding. The tax benefit would have increased basic earnings per share by 14 cents, which is an increase of just over 10%.

Next week, I'll explain how you can apply this example to your own company.

- Barbara


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