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New tax law will produce unanticipated one-time expense for some banks with Deferred Tax Assets
Jan 27, 2018
By Giuseppe “Joe” Femia, CPA
Vice President & Director
For the most part, corporations – including banks – are applauding the significant reduction in tax rates they will enjoy under the recently-passed Tax Cuts and Jobs Act (TCJA).
However, the new law comes with some unanticipated consequences that result in a one-time expense to write down deferred tax assets, particularly for those banks with capital ratios that are currently tight in accordance with the minimum regulatory standards.
The Financial Accounting Standards Board (FASB) is considering a rule change that will soften the blow for most affected financial institutions.
Description of Deferred Tax Assets (DTA)
Deferred tax assets (DTA) result from expenses incurred for book purposes, for which a tax deduction has not yet been realized, but may be realized in the future. These items have been recorded on the balance sheet as an asset using the current effective tax rate in place. Some examples of items creating DTAs on a bank’s balance sheet include the loan loss allowance, deferred compensation programs, or unrealized losses on AFS (Available for Sale) investments. Under generally accepted accounting principles, banks determine the value of their DTA based on the current enacted federal and state tax rates. So, by the very nature of the federal corporate tax rate decreasing from 35% to 21%, so too will the value of the deferred tax assets, and thus the negative impact to the income statement at December 31, 2017. Despite this one-time large federal tax expense, the majority of banks will recover these costs within two to three years through lower income tax expense and improved cash flow.
DTA write-down Issue regarding AOCI items
The one-time write down of deferred taxes has caused a bit of a stir because it would impact the banks’ regulatory capital ratios and possibly create some regulatory issues with banks that have capital ratios that are currently tight in accordance with the minimum standards.
It boils down to how the adjusted numbers are accounted for. As it currently stands, the entire deferred tax write-down, including any “accumulated other comprehensive income” (or AOCI) deferred taxes, would be counted as expenses in net income. This could significantly reduce the tier 1 capital ratio, a number that regulators watch closely.
Various stakeholders, including the American Bankers Association (ABA), have expressed concern that as a result of the tax law, the tax effects of AOCI items will no longer reflect the appropriate tax rates, known as stranded tax effects. This is because the entire adjustment (including AOCI impacts) of deferred tax rates from 35% to 21% was required to be included in net income from continuing operations under existing GAAP.
FASB proposal for one-time rule change
To address this concern, the Financial Accounting Standards Board (FASB) on January 18 issued a proposed standard which will:
- Allow a one-time reclassification from AOCI to retained earnings for the stranded tax effects caused the by the new corporate tax rates. If this proposal is approved by FASB, the amount of the reclassification would essentially be for the difference in tax rates, which is 14%. If adopted early, this would most likely be recorded in a bank’s financials when the income tax effects of the TCJA are recorded – typically December 31, 2017 audited financial statements.
- It is important to note that the rules regarding the necessary write-down of the operational deferred tax assets would remain unchanged and would still be recorded to federal income tax expense with the appropriate disclosures in the financial statements.
The comment period for this proposed rule change ends February 2, 2018, and the rule could possibly be finalized by FASB by late February. Comments can be submitted online here.
We will keep you informed as to FASB’s progress on this issue. In the meantime, if you have questions about deferred tax assets, please contact Giuseppe “Joe” Femia, CPA.
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