In December 2017, President Trump signed into law the Tax Cuts and Jobs Act. There were significant changes to many parts of the Internal Revenue Code, with one of the the biggest being the lowering of the corporate tax rate to 21%, effective January 1, 2018. This particular change would result in significant one-time gains or write-offs as deferred tax assets and liabilities are adjusted
Will the FHR modelling be changed?
We do not believe any changes are necessary to the modelling at this point in time.
This is a US tax change, and while it will have an effect on US companies and Multinationals with US operations, this is still a small subset of our entire database (40 years of data). Our ratings methodology is unique in the marketplace in that it was designed from the start as a system for rating companies globally. We look to public and private companies globally when calibrating these models, and have generally found that variations across industries are more impactful than variations across regions and countries. We believe that the robust data set used spans a long enough period and a large enough number of private and public companies across different countries to remain as an appropriate benchmarking set
Clients’ diligence and our own research has found that our ratings are robust to different accounting standards and decisions (the most recent example that comes to mind is the implementation of IFRS). While the new tax law is certainly more than an accounting standard change, a significant number of the changes will be effected through accounting policies
We employ a synergistic rather than a reductionist model, employing 68 different ratios in our analysis. Looking at this many ratios ensures we are not disproportionately dependent on a small number of metrics. The nature of double-entry bookkeeping is such that impacts of an accounting standard on a particular ratio are likely to be offset elsewhere in the analysis, so that the net effect is minimal
In addition to new accounting standards and practices, there will also be an effect on the financial statements in the form of one-time gains / losses. Our models were constructed so as to account for the impact of broader monetary policies and regulatory climate via the impact on company’s financial statements (i.e. their response to these policies and regulations)
How will the tax changes be reflected in the FHR?
It follows from the above that the regulatory climate in the US will be reflected with this tax change, causing a change in FHR, the magnitude of which will not only depend on the technical raw numbers but also the profitability, operations and structure of the companies at hand, and how they choose to address the tax changes. In this way, our model is doing exactly what it is designed to do.
The new tax law has some major changes – namely, the decrease in the corporate tax rate will result in a corresponding adjustment to deferred tax assets (or liabilities). Depending on how companies choose to address the corresponding expense (or gain), there will be an income statement change regarding abnormal items (and hence operating profitability), tax expense (and hence net income), or, potentially other comprehensive income (currently being discussed by FASB).
With these options, there’s a varying set of efficiency and resiliency ratios that will be affected and it is impossible to tell the uniform effect of the tax law, nor do we expect there to be a uniform pattern of FHRs up or down based on tax gain / loss. The lack of a pattern or prescription is due to the large number of ratios that go into the FHR and the complexity of the industry models - specifically, the varying importance of balance sheet structure and cash flow (which is not affected by these changes) at different levels of core health.
While it heavily depends on how companies decide to treat these expenses / gains in their statements, we can provide some guidance that the larger FHR changes will be visible at those companies that had poorer core health to begin with, due to the importance of the balance sheet and the additional net profitability (or lack thereof). We believe that the models will still accurately reflect the estimated probability of default and the financial health of companies that you might notice changes for, due to the factors I’ve discussed here, and the robustness of our sample sets.
Also, besides the corporate tax change, there are some other big ticket items (such as changes in repatriation tax regulations, and dividend deductions) that will impact financial statements, and actions that companies might take in light of one time gains / losses that mitigate the fluctuation in financials.
Please contact your Client Services Rep if you have specific ratings-related questions!