Most companies, like people, are good-natured and well-intentioned. But history is littered with lapses in corporate behavior and financial manipulation ranging from the unethical to the illicit. Sometimes there are just bad eggs.
André Malraux , a French novelist, once said: “Man is not what he thinks he is, he is what he hides.” At CFRA, we believe the same can be said for companies and their financial statements. So we try to find those bad eggs with our Accounting Lens product which provides risk research on an extensive universe of companies believed to have significantly poor quality of reported financial results, operational metrics and corporate governance problems.
Each year we publish a report with the subject line header of this article. In 2018 financial results will include adoption effects of several new accounting standards, including the global revenue recognition guidance. So we discuss major changes and transition requirements that may have one-time effects on key performance metrics. Many of these comparability issues will affect both U.S. companies and IFRS companies. We also discuss the near-term impact of the Tax Cuts and Jobs Act.
Some key areas of focus for CFRA in 2018 and a summary of our report are as follows:
Revenue Recognition. The new revenue recognition guidance became effective in January 2018 for U.S. GAAP and IFRS companies. We discuss transition issues that will likely present significant challenges for investors, particularly under the more popular modified retrospective transition method. These include double counting of previously recognized revenue or loss of revenue, potential cash flow impact due to income taxes, margin distortion as a result of changes in gross vs. net revenue recognition and elimination of certain previously deferred costs.
Tax Reform. Among the major near-term effects of the Tax Cuts and Jobs Act (TCJA) are gains or losses from remeasuring deferred taxes at the new corporate federal tax rate of 21% vs. the previous rate of 35%, and the deemed repatriation tax on unremitted foreign earnings. While the one-off impact should be mostly included in income tax expenses, other income statement line items such as operating expenses can be affected. The SEC’s SAB 118 provides a one-year measurement period for companies to recognize the impact of TCJA. IFRS companies with U.S. tax obligations are subject to similar requirement in accounting for the effect of TCJA.
Pension Expense. The FASB’s new pension expense presentation guidance became effective in January 2018. Only the service cost component of pension expense should be presented above operating income, and only service cost is eligible for capitalization. This change may impact gross margin and operating margin for companies with significant pension obligations.
Financial Instruments. Adoption of new guidance on financial instruments may impact revenue, margins and earnings for some U.S. companies. Among the major changes are 1) equity investments generally must be fair valued through earnings, and 2) the effect of hedging must be presented in the same income statement line item as the hedged transaction. IFRS 9 also became effective in January 2018. The main impact among non-US banks appears to be an increase in provisions and a decline in common equity tier 1 (CET1) ratios due to the new impairment model. This impact tends to be more pronounced at banks with large non-performing loan balances.
Cash flow Classification. Some companies may have to retrospectively change reported operating cash flow and free cash flow due to adoption of a new standard. Possible changes may include contingent acquisition considerations and securitization transactions.
Wishing you investment success in 2018.
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