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Why tax cuts are crunching bank earnings - for now

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Shareholders in the region's banks may have noticed a trend in the latest earnings reports.

York Township-based Codorus Valley Bancorp Inc. reported a dip in earnings for the fourth quarter of 2017, with net income falling to $1.5 million from $3.8 million for the last three months of 2016. Codorus Valley is the parent of PeoplesBank.

Fulton Financial Corp. in Lancaster reported a similar hit. Its net income slid to $34 million in the fourth quarter, a drop from $42.2 million in the last three months of 2016.

Orrstown Financial Services Inc. in Shippensburg saw its net income plunge from $1.9 million in the last quarter of 2016 to $6,000 for the same period in 2017.

They and other banks in similar straits are pointing to a common culprit: reductions in the value of what are known as net deferred tax assets in the wake of the Tax Cuts and Jobs Act, the tax bill signed into law late last year by President Donald Trump.

It’s likely the first time many shareholders will have seen such a phenomenon. The tax cuts are the first to the corporate tax rate since 1986, slicing it from 34 percent to 21 percent.

Philmer Rohrbaugh, senior executive vice president and interim CFO at Fulton Financial, said the hit to earnings is a one-time phenomenon.

"Unless they have tax reform again," he quipped.

"Looking forward, though, we will recover that charge through future lower tax expenses. But initially, we have to take the charge," said Rohrbaugh. 

Those paying attention to companies touting bonuses they’re planning for employees under the new tax rate might ask: Why would a tax cut result in lower earnings? 

It has to do with the difference between how a company records assets in its own books and how a company reports assets to the IRS.

On its books, a company can recognize items that will become deductible in the future. The IRS, however, allows companies to recognize deductions only as they actually occur.

So explained Debby Wells, tax services manager at consultant firm RKL LLP.

Banks earn deductions when borrowers default on loans. And banks typically calculate what percentage of loans are going to go bad down the road and set aside money to cover potential losses.

Banks get a tax deduction from the IRS only after a loan actually defaults. However, banks can claim the loans they expect to default as deductions on their books.

"That’s a deduction for financial statement purposes, but that’s not deductible for tax return purposes until there’s a realizable event like when loan actually goes south and they write it off," said Wells.

Once the loan does default, the company can expect a credit from the IRS on the deductible value of the loan loss. But until that happens, the expected credit is recorded in the bank's books as a deferred tax asset.

Banks that are expecting loans to default after the new tax rate takes effect can record an expected credit under the new rate even before they pay taxes under that new rate. 

Because the corporate tax rate is falling to 21 percent, the company owes less to the IRS. But it also gets less back as a credit.

Most companies will charge the dip in the value of the deferred tax asset against their earnings.

"They’ll credit the deferred tax asset as an expense, and that’s why the hit to earnings," said Wells. 

It goes in the other direction, as well. When a company has items that are deductible now but won't be in the future - such as depreciation expenses - it creates a deferred tax liability.

Most companies report the earnings hit as a change in their "net deferred tax asset" - the value of their deferred tax assets measured against their deferred tax liabilities. If their liabilities outweighed their assets, they would report it as a "net deferred tax liability."

"For most of the companies, they’re going to have tax assets that outweigh the deferred liabilities, so they will have a net deferred tax asset," said Wells.  

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