Tax Talk: Does Full Expensing Make Sense?

As you may know, the Republican leadership along with the Trump administration have recently put out the general outlines of their planned tax reform package, which will focus on lowering rates for businesses and individuals, as well as incentivizing business growth and investment through a number of different mechanics, including ‘loophole’ reduction and alteration of some tax treatments. I will have far more to say with respect to this plan as it moves through Congress, but this article is only focused on one specific proposal within the basic GOP plan that is not getting a lot of coverage outside of the business-oriented press (and not even much there). The proposal is known as ‘full expensing’ and allows businesses to treat investments in physical property, intellectual property, and other long-lived assets as expenses that only last one year versus the current treatment which maintains that those expenses must be spread out over multiple years (this is known as ‘depreciation’). Why focus on this seemingly minor proposed change, when there are big rate changes and other important proposals within the plan? As a former auditor and licensed CPA with plenty of experience in reviewing financial statements of large public companies, as well as smaller private firms, I see this proposal, said to boost growth by its backers in the Republican party, as one that will throw the accounting system and financial statements into a world of chaos.

Why don’t we already have full expensing?

Before we go any further, it is important to understand the status quo and why it exists the way it does, as well as to understand the very basics of the accounting system under which American companies operate. The vast majority of American businesses operate under the US Generally Accepted Accounting Principles (GAAP), the financial accounting standards which govern how companies are to treat their transactions and generate their financial statements, so all companies can be compared to each other on a relative basis. For tax purposes, however, the accounting standards are modified to fit within US tax laws; the differences between GAAP and tax accounting are not large, yet the standards are dissimilar enough to make most businesses create two separate sets of books, one for tax purposes and one for accounting purposes. (For future reference, we will mainly be discussing large, mostly publicly-traded, corporations from here on out, although I will briefly touch on small businesses at the end of the piece.)

Both GAAP and tax accounting use depreciation to spread the cost of large assets like vehicles, machinery, buildings, computer equipment, and more across multiple years instead of simply calling it an expense in the year it was initially purchased (items like pens, paper, salaries, repair of buildings, and services are expensed in the year incurred). The reason this depreciation treatment exists is due to an important accounting rule known as the “matching principle“. In brief, this states that the costs, or expenses, that relate to specific revenue being generated should be ‘matched’ to that revenue in the time period in which it was generated. For example, a machine that is bought in 2015 that will produce revenue for the next 5 years should have its cost spread out over those 5 years instead of entirely being parked in 2015, the year of initial purchase. This matching is crucial to better understanding how a business works and how its costs relate to the revenue it is creating, and this is why the current system of depreciation exists the way it does, in both financial and tax accounting.

Who wants full expensing and why?

Currently, full expensing is seen on the right as a good policy tool to significantly boost growth in a multitude of sectors, especially those which are particularly heavy investors in physical property, like mining, transportation, and manufacturing. Many of these sectors have been longtime supporters of the Republican party, and were also supporters of President Trump’s run for high office last year. The current policy proposed by the President’s team allows companies to retroactively expense some depreciable property, as well as allowing full expensing of all investments for at least the next 5 years. The policy’s proponents state that companies are currently dissuaded from investing, as they “do not value deductions far in the future as much as deductions in the present…mean[ing] that the business is less likely to undertake the investment in the first place.” These full expensing advocates believe that allowing businesses to immediately deduct all investments would not only remove the current ‘barrier’ these companies face, but could also help unlock the hundreds of billions of dollars of capital currently sitting idle on balance sheets across the spectrum of large public corporations, as changing tax policy would fundamentally alter the incentive structure these executives use to make decisions. Another argument in favor of full expensing is the simplicity argument; billions are spent each year on compliance with depreciation and tracking of assets to ensure proper tax & accounting treatment, and full expensing would eliminate this need. Some proponents also claim that making the change to expensing would help workers, as increasing asset levels would increase the demand for labor. Finally, advocates for full expensing claim that eliminating depreciation would level the playing field between industries, as some less-investment-centric sectors are favored by depreciation as they do not have as many long-lived assets and can easily expense their salaries and other minor investments.

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Why is full expensing a bad idea?

Oh boy, where do I start here?

First, let’s begin with the main argument used by proponents of full expensing: that it will increase growth and investment in the economy. I disagree with this argument. The increased growth rationale is reliant on two main tenets: that companies will increase investment if they are allowed to expense for tax purposes, and that expensing for tax purposes will actually be favorable for companies. Why would companies not increase their investments if they are allowed to write them off immediately, especially since that’s what all the full expensing proponents say will happen? Well, those advocates are missing a critical detail: this proposal only changes the tax accounting rules, not the financial accounting (GAAP) rules. For major US companies, decisions are absolutely not made on the basis of tax accounting, as most of these businesses are able to finagle their way to a ridiculously low tax payment (more on that in a future post), but exclusively on a financial accounting basis, as that is the method by which their financial statements are prepared. And financial statements are what are sent to the SEC, publicly released, and used by investors around the world to judge company performance and thus determine stock price (and stock prices are largely what company executives are graded on these days). If financial accounting rules remain the same, and they most definitely will as the matching principle is not going anywhere, these major companies will make their investment decisions based on GAAP, not tax accounting changes. Expensing a large investment in the year it was made may not be useful for every company either, as each year is different and each company may have varying tax positions. For example, expensing an item fully in one year could make a loss even bigger, while depreciating it could instead spread that loss more evenly across multiple years and reduce one’s tax burden more equally. Not all businesses are in the same situation, and what looks like a simple decision for one could lead to an entirely different outcome for another.

Another issue I have with the current proposal in the tax plan with respect to full expensing is the five year time horizon which has been proposed. This short time span (which I honestly am curious as to its rationale for inclusion [perhaps related to the budget reconciliation process]) could throw financial analysis into a state of chaos, as comparability between financial statements would be massively flawed. Although financial accounting methods would not be affected, the change in tax accounting could allow unscrupulous companies that choose to make investments in this time period to count them as “non-recurring items”, which receive different accounting treatment under GAAP. These items are shifted to the bottom of financial statements and are often overlooked by stock analysts as one-time costs that are somewhat irrelevant to the main business of the corporation. In this case, however, the investments would be directly relevant to the business of the corporation, but could be classified as “non-recurring items” since they would receive special tax treatment under the time-limited full expensing rule. I would hope that my fellow CPAs and auditors would have the ethical backbones to not allow this to happen, but unfortunately this type of sketchy accounting is all too common in practice. The potential for vastly differing treatment of these investments, even in public financial statements, would be a disaster for stock analysts and those who invest in markets, as the ability to compare firms from the same sector or different sectors is the entire point of standardized accounting. Altering that balance at all would cause major issues in the markets that I just don’t think the proponents of full expensing have thought through.

Finally, I’ll address a few of the more minor points that advocates of full expensing bring up. One of these is the argument that the myriad depreciation schedules are too confusing and cost too much in compliance. I don’t disagree with this statement, as I’ve spent countless hours toiling through depreciation spreadsheets (I can almost see the numbers running through my head now…) as an auditor, but the fact is that most large companies have already baked in this compliance into their accounting systems. Depreciation is simply a reality at this point, especially because financial accounting (GAAP) requires it and will continue to do so. Another point is that full expensing will allow easier decision-making for corporate leaders; this is complete bunk and exposes the advocate as one who does not understand corporate decision processes. Major investment decisions, like the ones that are impacted by depreciation, are typically made on a long-term planned basis and are often determined years in advance, making the idea of a relatively short 5 year window for expensing almost laughable. Does anyone really think that Ford or GM would make a factory investment decision on a week or month’s notice? These decisions are planned for years, if not longer, and take immense time to put in place, especially at the largest businesses in America. Lastly, the thought that labor would be helped by full expensing is quite a canard. American businesses are heavily incentivized to increase employment already, as the cost of salaries is fully deductible in both tax accounting and financial accounting, as are subcontractor wages, bonuses and stock options provided to employees.

Depreciation Schedules

A note on small business

As I said earlier, the majority of this article has addressed large corporations, as this tax proposal is mostly geared towards those stakeholders. The effects of full expensing on small businesses is not the same as it would be on larger businesses, as investment decisions are not always made in the same manner in that environment. Small businesses are much more constrained in terms of the cash flow they have on hand and what they need to pay to the government each year, whereas large corporations generally do not have this issue. Therefore, small businesses may be able to benefit from immediately expensing their asset purchases if that lowers their tax liability and thus saves them cash. I fully endorse allowing full expensing for businesses of a smaller size, and think this should be included in a tax proposal, as it allows more flexibility for these critically important drivers of the American economy. These crucial players, however, do not seem to be the major targets of the full expensing proposal laid out by the Republicans in Congress and the Trump administration.

As we see further details come out about this proposed tax plan, I’m sure there will be plenty of focus on the changing rates for businesses and individuals, the alterations in various loopholes, the changes in deductions (including those for state and local taxes), and the Ivanka Trump childcare credit. Still, make sure to think about the smaller provisions that are bound to slip in under the radar for most pundits and columnists who will undoubtedly rail on about the big topics, as they are just as important in the grand scheme of the American economy and can definitely make a major impact.

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