Corporate tax cuts were supposed to be a boon for company earnings. But, due to U.S. accounting rules, many companies will feel a little pain before the long-term gains kick in.
J.P. Morgan Chase made that clear Friday when it announced that it was taking a $2.4 billion charge against its fourth-quarter 2017 earnings due to the passage of the Tax Cuts and Jobs Act back on Dec. 22. Despite the hit, both CEO Jamie Dimon and the bank's chief financial officer, Marianne Lake, reiterated what pretty much everyone on Wall Street has been saying for weeks if not months: Tax reform is a plus for the country, corporate profits and the economy.
The bank won't be only company that will face a speed-bump along the way.
Why? Accounting rules require companies to reflect the impact of any changes in the tax code in the reporting period they go into effect.
That resulted in a sizable hit to J.P. Morgan's fourth-quarter results, causing the big bank's net income to dip nearly 40% from a year earlier to $4.2 billion. Were it not for the tax code-driven adjustment, its net income would have been $6.7 billion.
But short-term accounting quirks don't mean paying lower corporate taxes in 2018 and beyond won't still be the big positive Wall Street analysts, portfolio managers and investment strategists have been promising.
"It's really kind of an accounting adjustment where companies take the pain up front to realize the gain later on," explains JJ Kinahan, chief market strategist for TD Ameritrade, the Omaha-based online brokerage.
Here's a brief explanation of the pain then gain concept:
The slashing of the corporate tax rate from 35% to 21% is forcing companies like J.P. Morgan to write down the value of "deferred-tax assets." In layman's terms, these are future tax deductions or tax credits that companies can use to reduce their tax bills. Often, these deferred-tax assets build up when companies suffer huge losses -- like banks did in the financial crisis -- that can't be used as a tax deduction all at once.
Write-downs are necessary now, however, because the huge reduction in the tax rate companies pay reduces the value of these deferred-tax assets, explains Charles Webb, tax partner at Aprio, an Atlanta-based accounting and consulting firm.
"The 'asset' is no longer worth 35%, it's only worth 21%," Webb explains.
Adds Ken Leon, director or equity research at CFRA, a Wall Street research firm: "Deferred-tax assets are no longer as useful with the banks effective tax rates becoming lower," he says, noting that J.P. Morgan's new effective tax rate for 2018 will be 19%, down sharply from above 30% in prior years.
The reason why analysts are telling investors to look past the one-time tax-related hit is because lower taxes in the future will open the door to an array of benefits for companies like J.P. Morgan.
Paying the government a lot less in taxes means future earnings streams will rise. And those increased funds can be used for all sorts of purposes that can benefit banks' and other companies' businesses in the future.
"It means more available cash for either investment in the business, higher employee compensation or return of capital to shareholders via dividends or stock buybacks," says Leon.The positive feedback loop of all those good things happening simultaneously has a powerful multiplier effect.
"It will enhance growth in the future," J.P. Morgan's CEO Dimon said in a conference call.