Bridging the Reporting Gap: A Proposal for More …web.mit.edu/gplesko/www/Mills Plesko NTJ 2003 Bridging...between tax and book income.1 A Wall Street Journal edito-Bridging the Reporting

Forum on Public Disclosure of Corporate Tax Returns

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National Tax JournalVol. LVI, No. 4December 2003

Abstract - In this paper, we review the history and purpose of thecorporation income tax return’s Schedule M–1 in light of recentattention to corporate reporting issues. Although the traditional rolefor the schedule has been to assist the audit process, the reconcilia-tion of book to tax accounting numbers also provides informationuseful to tax analysts. We find the existing tax return ScheduleM–1, largely unchanged since its introduction in 1963, providesinsufficient detail for complex reconciliation issues. We propose re-visions to the M–1 to achieve better reconciliation, and discuss theadvantages and disadvantages of public disclosure of such data.

INTRODUCTION

The usefulness of publicly available data is dependent onits relation to the non–publicly available information it

is intended to convey. Hanlon (2003b) suggests that currentfinancial accounting rules are inadequate to ensure relevantinformation about a firm’s current and future tax liabilities ismade available to financial markets. Lenter, Shackelford andSlemrod (2003) explore the legal foundations of the taxreturn’s confidentiality, as partial or complete disclosure ofthe tax return could help to mitigate the informational defi-ciencies of the current system. However, the benefits of anydisclosure of return information are dependent on the infor-mation provided under the tax reporting systems. In thispaper, we evaluate how well the existing tax return ScheduleM–1 provides needed private data for tax enforcement andgovernment statistics and recommend changes to the cur-rent tax return reconciliation of financial and taxable income.

Recent high–profile cases involving profitable corporationsreporting little or no taxable income, or increasing financialincome without affecting their current tax liabilities, havedrawn attention to the sources and magnitudes of differencesbetween tax and book income.1 A Wall Street Journal edito-

Bridging the Reporting Gap:A Proposal for More Informative

Reconciling of Book and Tax Income

Lillian F. MillsDepartment ofAccounting,University of Arizona,Tuscon, AZ 85721-0108

George A. PleskoSloan School ofManagement,Massachusetts Instituteof Technology,Cambridge, MA 02142-1347

1 See, for example, U.S. Treasury (1999), Plesko (2000b and 2002), Desai (2002),Manzon and Plesko (2002), Mills, Newberry and Trautman (2002). In con-trast to recent popular press view that taxable income is now the new stan-dard for “actual profits,” book–tax differences were previously viewed asindicators of tax aggressiveness. In the mid–1980s, during the development

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rial (January 29, 2003, “The CorporateReform Tax Cut”) critiques current finan-cial reporting disclosures as follows:

Currently it is almost impossible to knowa firm’s tax bill by looking at its financialstatements, and thus it is impossible tofigure out what actual profits are. Profitsreported to the [Internal Revenue Service(IRS)], where firms have less discretion inmaking calculations, are considered to becloser to the truth, but they are confiden-tial and unavailable to investors. Bookprofits and tax profits can be wildly dif-ferent—a divergence, by the way, that in-creased markedly in the 1990s.

The Joint Committee on Taxation’s(2003) report and testimony from expertwitnesses (Outslay, 2003; Plesko, 2003a;and Seida, 2003) discuss how financial in-centives appear to have motivated Enronto structure transactions that reduced theamount of taxes paid without reportingany corresponding decrease in pretaxbook income (see also the Permanent Sub-committee on Investigations, 2003).

On July 8, 2002, Senator CharlesGrassley wrote to Paul O’Neill, Secretaryof Treasury, and Harvey Pitt, Chairmanof the Securities and Exchange Commis-sion (SEC) to “raise the question ofwhether the information contained in thecorporate tax returns of publicly tradedcompanies could be of benefit to govern-ment regulators as well as shareholdersand workers.” On July 24, 2002, the TaxExecutives Institute submitted commentsto the Department of Treasury and theSEC protesting the proposed public dis-closure of tax return information, stating,“public disclosure of corporate tax returns

is not only contrary to the longstandingpolicy of protecting the confidentiality oftaxpayer returns, but is potentially coun-terproductive to the goal of providingshareholders with meaningful informa-tion” (emphasis in original). Canellos andKleinbard (2002) take a middle ground ofrecommending “that a publicly heldcorporation’s Schedules M and L and itsfinancial statement income tax disclosurebe conformed into a single public finan-cial statement–tax reconciliation schedule,filed with the corporation’s tax return inlieu of current Schedule M, and also in-cluded in the corporation’s financial state-ments.” In October, Senator Grassley, in aletter to the President, asked for a reviewof corporate disclosure requirements, in-cluding a review of the Schedule M–1 andfinancial statement disclosures (Lupi–Sher, 2002). Recently, Treasury AssistantSecretary Olson confirmed that Treasuryand the IRS are reconsidering Schedule M(Hamilton and Radziejewska, 2003).

To contribute to a well–informed debateabout public disclosure of Schedule M–1,we evaluate its current usefulness to taxadministrators and government analysts.We begin with a review of accounting con-cepts under both tax and financial report-ing, highlighting situations in which dif-ferences arise. We then examine currentreporting requirements and evaluate theadequacy of the current Schedule M–1.

We conclude that the current M–1 doesnot provide sufficient detail to inform ex-isting users (IRS and other governmentanalysts) about book–tax reconciliationsto effectively evaluate compliance risksand perform other analyses. We recom-mend the M–1 be revised to directly rec-

of the Tax Reform Act of 1986 (TRA86), part of the motivation for the Alternative Minimum Tax was reports oflarge firms paying little or no income taxes regardless of their level of reported income.

In an often–quoted passage, the Joint Committee on Taxation’s staff report on TRA86 states: In particular,Congress concluded that both the perception and the reality of fairness have been harmed by instances inwhich corporations paid little or no tax in years when they reported substantial earnings, and may even havepaid substantial dividends, to shareholders. Even to the extent that these instances may reflect deferral, ratherthan permanent avoidance, of corporate tax liability, Congress concluded that they demonstrated a need forchange. (Joint Committee on Taxation (1987), pp. 432–3)


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oncile public financial statement world-wide net income (from SEC Form 10–K)with taxable income. Providing such aconsistent starting point will, in and of it-self, provide a significant improvementbecause it is difficult to quantify howmuch of the aggregate book–tax differ-ences are due to differing rules for group-ing entities for book and tax purposes. Wealso recommend more uniform detailedcategories of reconciliation to include con-solidation differences, stock options, de-preciation, and other specific items. Fi-nally, we recommend the reconciliationseparately identify the effects of perma-nent and temporary accounting differ-ences, because many tax shelters are de-signed to produce permanent differences.We briefly summarize costs and benefitsof disclosure from the companion paperLenter et al. (2003), concluding with ourown cautious views.

ORIGINS AND TRENDS IN BOOK–TAXDIFFERENCES

Book–tax differences have existed for aslong as the corporate income tax, and arecaused by differences in the reporting rulesunder each system. In the early 1900s, taxreturns were publicly available and wereviewed by many as a more useful sourceof information than company’s financialstatements. The corporate excise tax of1909, although not implemented, requiredthe cash method of accounting for tax re-porting purposes, regardless of thetaxpayer’s usual accounting method (May,1949). Section 212 of the Revenue Act of1918 clarified the link between tax and fi-nancial reporting. It gave the Commis-sioner of Internal Revenue the authority toprovide a separate definition if income wasnot clearly reflected (May, 1949, pp. xviiiand 10). In recounting the period from 1918to 1948, May (1949) observed that manydifferences between tax and financial re-porting income arose, primarily “from theintroduction into law of a constantly in-

creasing number of provisions whichmodify the general concept of income un-derlying the statute, in order to give reliefor for other reasons of a policy character.”(p. xxi) Throughout the 20th century, tax lawand financial accounting standards becamemore complex in response to complicatedtransactions, resulting in more sources ofbook–tax differences.

In what appears to be the first compre-hensive approach to identifying and quan-tifying the various differences in account-ing methods, Smith and Butters (1949)compared the financial and tax reports ofa number of companies for 1929–1936.Overall, they found book income and itstax equivalent, statutory net income, “didnot differ greatly,” especially taking auditadjustments into account (p. 167).

As the tax system developed during thefirst half of the 20th century, so did the sys-tem of financial reporting. Under the Se-curities and Exchange Act of 1934, the SEChas the authority to proscribe accountingand other reporting standards for publiclytraded firms. Although given this author-ity, the SEC has generally cededrulemaking to the private sector. TheAmerican Institute of Certified PublicAccountants (AICPA) has historically re-lied on a series of standard–setting orga-nizations beginning with the Committeeon Accounting Practice (1939 to 1959) andthe Accounting Principles Board (APB)(1959 to 1973). The Financial AccountingStandards Board (FASB) was establishedin 1973 to set standards independent ofthe AICPA (Kieso et al., 2001, Ch.1).

Various authors have provided evi-dence that book–tax differences have dra-matically increased during the 1990s (U.S.Treasury, 1999; Plesko, 2000b; Talisman,2000; Desai, 2002; Manzon and Plesko,2002; Mills, Newberry, and Trautman,2002). However, a lack of data for othertime periods makes it difficult to deter-mine whether the 1990’s increase is onlya recent phenomenon or the continuationof a long–term trend. Data on the amount


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of income reported under each systemhave been published only sporadically,and not necessarily in comparable ways.Nonetheless, some comparisons can bemade. Table 1 provides aggregate data onafter–tax measures of tax and financial re-porting income as reported on the Sched-ule M–1 for selected years from the 1970sand 1990s. From 1972 to 1975, the book–tax gap narrowed due to faster growth in(after–tax) tax net income. By contrast, thebook–tax gap widened from 1996 to 1998due to faster growth in book income(Plesko, 2003a).

TYPES OF DIFFERENCES

Reconciling reported book income totaxable income involves two broad typesof differences: reporting entity and incomemeasurement. Following our discussionof these broad classes we discuss currentrequirements for reconciliation for finan-cial reporting and tax return purposes(found on the Form 1120, Schedule M–1).

Reporting Entity

The challenge of reconciling book in-come with taxable income begins withidentifying “whose book income.” Unfor-

tunately, the current M–1 does not specifi-cally require a consistent starting pointdefinition for book income. Many largecorporations own part or all of other U.S.and foreign corporations. Financial report-ing standards and tax laws provide differ-ent rules for whether and how related cor-porations should be combined. To preparea single consolidated financial report, theindividual lines of income and expense ofrelated entities are combined, eliminatingtransactions between related parties.2

The fact that the consolidation rules dif-fer for book and tax purposes presents aproblem when comparing a financialstatement to a (U.S.) tax return. For ex-ample, assume U.S. parent corporation Aowns some of companies B and C. Sup-pose also that A has $100 of book income,B has $50 of book income, and C has $30of book loss, and that none of the entitieshas transactions with another. If only Aand B are consolidated for financial state-ments under Generally Accepted Ac-counting Principles (GAAP) ($150 of bookincome),3 and if only A and C are consoli-dated under tax law ($70 of book income),then it is difficult to compare the finan-cial statement to the tax return withoutknowing which entities are included ineach report.

TABLE 1AGGREGATE BOOK NET INCOME AND AFTER–TAX TAX NET INCOME, SELECTED YEARS

(IN MILLIONS OF DOLLARS)

After–Tax Tax NIBook Net IncomeRatio of Book Net

Income to After–TaxTax Net Income

56,89779,3811.395

71,77092,865

1.294

84,11493,856

1.116

82,95888,8281.071

1972 1973 1974 1975

404,478553,497

1.368

424,082599,870

1.415

351,969600,319

1.706

1996 1997 1998

Book Net Income is defined on after–tax basis while Tax Net Income is a pre–tax concept. Thus, we must adjustTax Net Income for taxes to derive row 1 above (After–tax Tax NI). See Plesko (2002) for a discussion.

Source: IRS Corporation Income Tax Returns (Publication 16), selected years, and Plesko (2002)

2 This section is paraphrased substantially from Mills, Newberry and Trautman (2002).3 As discussed further below, the consolidated group for financial reporting is typically more inclusive than the

consolidated group for tax. However, special purpose entities (SPEs, now known as Variable Interest Entities,or VIEs) can be structured to avoid consolidation for financial reporting purposes while being consolidatedfor tax purposes. The example we pose in which the profit subsidiary is consolidated for books but the losssubsidiary is consolidated for tax represents an extreme structuring of entities to maximize book income andminimize taxable income.


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As an example of the potential recon-ciliation challenge, consider Enron. Thecompany’s 2000 year consolidated U.S. taxreturn included 713 returns that are partof its tax affiliated group (Joint Commit-tee on Taxation (JCT), 2003, p. 52). Addi-tional returns outside the consolidated taxreturn consisted of 190 returns for domes-tic entities not consolidated with Enron,1,485 foreign branch and subsidiary re-turns, and 98 entities and branches in-cluded in partnership returns. We discussthe detailed rules for book versus tax con-solidation below.

Statement of Financial Accounting Stan-dards (SFAS) No. 94 (FASB, 1987) gener-ally governs financial consolidation. Theconsolidated reporting group includes theparent corporation and all subsidiaries(both domestic and foreign) in which theparent has more than 50 percent owner-ship. If the parent corporation does notown 100 percent of the subsidiary, it sub-tracts from net income the portion of thesubsidiary’s earnings allocable to the mi-nority shareholder interest.

If a corporation owns between 20 and50 percent of another corporation, theparent corporation includes its percent-age interest in the net income of that en-tity as “net equity of unconsolidated sub-sidiaries” (Accounting Principles Board,1971). If the parent owns less than 20 per-cent of a corporation, it includes only thedividends of such corporation in book in-come.4 Special Purpose Entities (SPEs)provide a mechanism to avoid financialconsolidation, even when the parentcompany owns more than 50 percent (Fi-nancial Executives International, 2002).The corporation excludes the assets andthe associated debt and equity of the SPEfrom the consolidated balance sheet.However, if the SPE is treated as a part-nership for tax purposes, SPE lossescould be deductible on the U.S. consoli-

dated tax return. As of recently, FASB In-terpretation 46 (FASB, 2003) providesconsolidation guidance for “variable in-terest entities.”

Tax consolidation is governed by Inter-nal Revenue Code (IRC) §1501, which pro-vides that affiliated groups may elect tofile a single consolidated return. An affili-ated group generally consists of a domes-tic parent corporation and all of its domes-tic subsidiaries in which it has at least an80 percent ownership interest.

The different financial and tax rules forcombined reporting can result in eitherbook or tax income being more inclusive,as discussed by Dworin (1985), Manzonand Plesko (1998), Canellos and Kleinbard(2002) and Mills, Newberry and Trautman(2002). The following chart summarizesthe main consolidation differences be-tween GAAP and tax law, where thebolded blocks show common definitionsof included entities.

Note that for a purely domesticcompany that owns 100 percent of its U.S.subsidiaries and files a consolidated taxreturn, book and tax consolidation are thesame. However, when a company hasforeign subsidiaries or domestic subsid-iaries owned less than 100 percent,the book and tax consolidation rules di-verge.

Researchers cannot easily determine thesources of consolidation differences, evenwhen tax return and financial statementare available (see Mills and Newberry,2000; Boynton et al., 2003; Plesko, 2000aand 2003b). Thus, many of the substan-tial changes we propose to the ScheduleM–1 are intended to help in reconcilingthese consolidation differences.

To illustrate the difficulty for an ex-tremely complex multinational company,we reproduce as our Table 2 “Enron Corp.and Subsidiaries: Reconciliation of Finan-cial Statement Income to Taxable Income

4 If the investor corporation has significant influence on the investee corporation, it can use the equity method(FASB, 1981).


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1996–2000”, which is Table 2 from the JointCommittee on Taxation written testimonyof 2/14/2003.5 The upper half of the tableshows the adjustments to reconcile bookincome as reported on the consolidatedfinancial statement (SEC Form 10–K) tothe book income Enron chose to show asits starting point for Schedule M–1. Laterin the paper we recommend that such rec-onciling items be required in our revisedSchedule M–1.

Income Measurement

The fundamental purposes of financialand tax reporting generate substantial dif-ferences in income measurement. Al-though financial rules tend to constraincompanies from overstating income tofinancial statement users, tax rules con-strain companies from understating in-come to the tax authorities. Other differ-ences between the two systems arise be-

cause the tax system is also used in anattempt to provide incentives or disincen-tives for particular activities (e.g., accel-erated depreciation to encourage invest-ment, limits on deductible compensationto discourage excessive payments).Although IRC §446(a) states, “taxable in-come shall be computed under themethod of accounting on the basis ofwhich the taxpayer regularly computeshis income in keeping his books,” theIRS can disallow accounting methodsthat do not “clearly reflect income.”6 Foran extensive discussion of accountingrules, tax law and judicial precedent thatapply to a variety of book–tax differences,see Knott and Rosenfeld (2003a and2000b).

Temporary Differences

Temporary differences between bookand tax income generally arise from dif-

Parent company

Plus 100% income earned by domestic subsidiar-ies owned >= 80%.

Plus 100% income of all other (domestic or foreign)subsidiaries owned > 50%.

Less % income attributable to minority interest insubsidiaries above.

Plus % income attributable to equity interest incorporations owned >=20% but <=50%.

Exclude income/loss from Special Purpose Entitiesthat meet strict ownership tests above but can beexcluded under special rules.

Less income/expense from intercompanytransactions with entities included above.

= Book income for entities included in theconsolidated financial statements.

Parent company

Plus 100% of income earned by domesticsubsidiaries owned >= 80%.

Include income/loss from Special Purpose Entitiesstructured as partnerships for tax purposes underthe “check the box” regulations.

Less income/expense from intercompanytransactions with entities included above.

Plus [pre–tax] dividends (actual and deemed) fromentities not included above (e.g., dividends fromforeign or <80% domestic subsidiaries).

= Book income for entities included in theconsolidated tax return.

Consolidated for GAAP (books) Consolidated for tax

5 See also Outslay and McGill (2002).6 IRC §446(b). See also Thor Power Tool Co. v. Commissioner, 79–1 USTC 9139 for a detailed discussion by the

Supreme Court of financial accounting not governing tax treatment. Hanlon, Kelley and Shevlin (2003) cau-tion against strictly conforming book and tax reporting so that taxable income is the only information re-ported to shareholders. While they find that both book or an estimate of taxable income provide incrementalinformation in explaining stock returns, using only estimated taxable income would create up to a 50 percentloss in the explanatory power of earnings.


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ferences in when an item constitutes rev-enue or expense, not whether it should berecognized. An understanding of tempo-rary differences, and the length of time thedifference is expected to persist, is impor-tant both to understand the relation of tax-able income to financial reporting income,and to thoroughly audit a firm’s tax fil-ings over time.

Accruals

For financial reporting purposes, rev-enues on the provision of a good or ser-

vice are not recognized until they are both“realized and earned.” This means thefirm must have provided the good or ser-vice and have reasonable assurance pay-ment will be received. As a result, the re-ceipt of cash from a customer may occurbefore, during, or after the period in whichthe goods or services are provided. In thecase of cash payments received in ad-vance, firms will record unearned revenue(a liability) until the contracted goods orservices are delivered. By contrast, theClaim of Right Doctrine allows the taxauthority to claim advance payments as

TABLE 2ENRON CORP. AND SUBSIDIARIES: RECONCILIATION OF FINANCIAL STATEMENT INCOME

TO TAXABLE INCOME 1996–2000TABLE 2 FROM JOINT COMMITTEE ON TAXATION WRITTEN TESTIMONY OF 2/14/2003

Net Income Reported in Consolidated Financial Income Statement1

Less Net Income from Entities Not Included in Consolidated Tax Return

Domestic Corporations2

Foreign Corporations3

Partnerships4

Plus Net Income from:Intercompany Elimination Made for

Books but Not for TaxEntities Not Controlled for Financial

Accounting Included for Tax5

Book Income Reported on Consolidated Tax Return

Significant Book to Tax Adjustments6

Federal Income TaxesNet Partnership AdjustmentsNet Mark to Market AdjustmentsConstructive Sale (section 1259)Structures Treated as Debt for Tax Not for

Book (e.g., equity or minority interest)Company Owned Life Insurance

AdjustmentStock Options DeductionDepreciation DifferencesEquity Earnings Reversal Per Tax ReturnAll Other Book to Tax Differences

Taxable Income Reported on ConsolidatedTax Return

584

–96–232–145

–473

1322

0

1322

1433

159–107–118

0

–2

–19–113–67

–1183–293

–310

105

–189–44

–211

–444

1300

0

1300

961

–35–122

1180

–24

–24–9

–65–1023–281

–504

703

–149–521–319

–989

1884

14

1898

1612

45–109–333

0

–3

–27–92–57

–1688–101

–753

893

–152–1110–638

–1900

3997

122

4119

3112

–128–338–906

0

–12

–35–382–124

–2868223

–1458

979

–345–1722–6899

–8966

13625

258

13883

5896

193–481–5375566

–149

–20–1560–154

–5516–137

3101

Note: (1) As originally reported. (2) Corporations not meeting 80 percent vote and value test (sec. 1504(a)(2)). Thefinancial accounting to tax return reconciliation in Appendix A contains additional details of these amounts. (3)Foreign corporations are not eligible for inclusion in consolidated tax return (sec. 1504(b)(3)). (4) Partnerships arerequired to file separate Federal income tax returns. (5) Disregarded entities for Federal tax purposes (Treas. Reg.sec. 301.7701–3) not included in consolidated financial statements. (6) Amounts as reported in Enron presenta-tion to the Joint Committee staff, June 7, 2002.

1996 1997 1998 1999 2000All amounts in millions of dollars


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revenue when received and under theclear control of the taxpayer, even if thetaxpayer uses the accrual method and willrecognize them as financial reporting in-come at a later time.7

Accrued expenses are recorded for bookpurposes when incurred and matchedwith revenue. Specific rules provide thatcontingent liabilities should be recordedas an expense when they are probable andestimable under SFAS No. 5. However,accrued expenses cannot be deducted fortax purposes unless they are “fixed anddeterminable”—a stricter standard thattypically delays the deduction relative tofinancial reporting. For certain classes ofexpenses, notably tort liabilities and non–recurring services, the deduction mustalso meet an economic performance stan-dard (IRC §461), which often delays thededuction until payment.

A substantial temporary differencearose due to Statement No. 106, “Employ-ers’ Accounting for Postretirement Ben-efits Other Than Pensions,” generally ef-fective for fiscal years beginning afterDecember 15, 1992, but implementedearly in 1992 by many large companies.The required catch–up accrual to changefrom pay–as–you–go to accruing the ex-pense for books resulted in a large expensefor companies that provided retiree medi-cal benefits (e.g., heavily unionized com-panies with generous benefits).8 Becausethe expense is not deductible until paid,the SFAS 106 accrual resulted in a largeone–time and continuing temporary dif-ference.

Other examples of accruals and reservesthat occur frequently in the deferred taxdisclosures of financial statements are in-

ventory write downs and reserves, war-ranty claims, discontinued operations,restructuring reserves, and the valuationallowance account.

Asset Recovery Rules

Asset cost recovery for financial report-ing purposes is guided by the principleof matching production expenses withsales revenues. Thus, book depreciationfor tangible assets (as well as depletion ofnatural resources and the amortization ofintangible assets) reflects estimates of use-ful lives and residual values that reflecttheir economic values (Williams, 2000).Cost recovery for tax purposes followsexplicit asset classifications that specifythe life and method to be used.

For financial reporting, capital invest-ments are generally depreciated using thestraight–line method over an estimate ofeach asset’s expected useful life, to someresidual value. For tax purposes, corpo-rations can use accelerated methods ofdepreciation following procedures givenby the tax code, typically over a shorterlife, with no residual value. These differ-ences in depreciation accounting will gen-erally lead to greater reductions in taxableincome than book income as the tax de-duction for depreciation will be greaterthan the depreciation expense chargedagainst earnings. At some future time, theamount of depreciation allowed for taxpurposes on these assets will be less thanthe amount reported for book purposes,reversing the relation between the twomeasures of income. Such reversals willbe reported as an “expense recorded onbooks this year not deducted on this re-

7 North American Oil Consol. V. Burnet, 286 U.S. 417 (1932). For example, rental payments received in advanceby a company will be recognized for book purposes pro–rata over the period of the lease, although the entireamount is taxable income in the current period. To the extent that a rental period extended over more thanone fiscal year, a temporary difference between book and tax income would arise and reverse in a later year.However, in certain cases, Section 467 and the associated regulations would require spreading the incomeover the rental period.

8 Manzon and Plesko (2002) and Mills, Newberry and Trautman (2002) document a negative book–tax differ-ence in 1992 that coincides with the advent of Other Post–retirement Employment Benefit accruals.


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turn,” on the current M–1 and includedin the itemization for depreciation. Assetrecovery provisions change frequently inresponse to Congress’ use of asset write–offs for economic incentives. For example,recent economic events motivated the cre-ation of a 30 percent first–year bonus de-preciation for certain short–lived tangibleproperty acquired between September 11,2001 and September 10, 2004 (IRC §168).

Intangible Assets

The treatment of intangible assets has avaried history that has affected whethertheir associated book–tax differences aretemporary or permanent. For book pur-poses, intangible assets other than good-will are amortized over their useful lives,consistent with the matching principle.For many years, goodwill was amortizedover a maximum 40 years for book pur-poses (APB, 1970b), a time period oftenused by firms to minimize the effect ofthese charges on reported income. How-ever, under SFAS No. 142, generally effec-tive for fiscal years beginning after De-cember 15, 2001, financial accountingchanged to an impairment method,whereby goodwill is only written downif it is judged by management and audi-tors to be impaired.

By contrast, through 1993, intangibleassets other than goodwill were amortizedstraight–line over their useful lives for fi-nancial reporting purposes, but goodwillwas not tax deductible. The adoption ofIRC §197, effective for intangible assetsacquired after August 9, 1993, requiresmost intangibles, including goodwill, to beamortized over 15 years for tax purposes.

Thus, for assets acquired prior to 1993,goodwill amortization generated a perma-nent book–tax difference. For assets ac-quired between 1994 and 2001, goodwill

amortization generates a temporary differ-ence. Subsequent to 2001, whether good-will amortization generates a permanentor temporary difference depends on theinterpretation of the SFAS 142 (FASB, 2001)impairment method. McGill (2003) de-scribes post–2001 tax goodwill amortiza-tion as a temporary difference rather thana rate–favorable permanent difference. Hisdiscussions with managers and partners atthree of the Big–Four accounting firms con-firmed they treat the tax goodwill as tem-porary even though the company hopesnever to record an impairment charge.

Other examples of temporary differ-ences are mark–to–market accountingmethod differences and capital losses inexcess of capital gains, which reverse ifcapital losses are used before they expire.The only temporary differences explicitlydetailed on the current Schedule M–1 aredepreciation and the excess of capitallosses over capital gains.

Permanent Differences

Permanent differences arise from fun-damental differences in the scope of ac-tivities considered to be income or ex-penses under each reporting system.9 Inthis section we provide examples of per-manent differences that have recently gen-erated attention.

Stock Options

The financial accounting debate aboutwhether employee stock options shouldcreate an expense is complex and beyondthe scope of this manuscript. In brief, theissue contrasts the principle that transac-tions of a firm in its own stock do not (gen-erally) affect income with the argumentthat compensation for employee servicesshould be recorded as expense. Although

9 Because SFAS 109, unlike APB 11, does not use the term “permanent difference,” we use the term broadly toinclude any book–tax difference that is not temporary. A more narrow use of “permanent difference” wouldlimit its use to items that appear in the effective tax rate reconciliation.


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SFAS No. 123 (FASB, 1995) appears to re-quire corporations to record the imputedvalue of options granted to employees(using a modified Black–Scholes optionpricing formula), it is not mandatory be-cause it leaves open an election to con-tinue to use the old accounting standardthat does not require an expense be re-corded. If companies choose not to adopt,they must still make a pro forma footnotedisclosure of earnings as if SFAS 123 wereadopted. SFAS 148 (FASB, 2002) amendsSFAS 123 to require more prominent dis-closure and provide transition rules forvoluntary recognition. Further, in March2003 the FASB announced the opening ofa project on stock options. Several com-panies have said they will begin to vol-untarily record an expense for stock op-tion compensation, including GeneralElectric and Coca–Cola.10

Under existing standards, stock optionsgenerate an unusual form of ‘permanent’difference. The book–tax difference due tostock options is not revealed in the finan-cial statement income tax footnote becausethe tax benefit (if material) is generallydisclosed in the stockholders’ equity recon-ciliation (see Hanlon and Shevlin, 2002;Manzon and Plesko, 2002; Outslay andMcGill, 2002; Shevlin, 2002; and Graham,et al. 2003). As a result, a casual reader ofthe financial statements might think com-panies like Microsoft and Cisco pay sub-stantial amounts of federal income tax(based upon a reported large positive cur-rent tax expense) when their actual tax li-abilities are substantially smaller, or nega-tive (Hanlon and Shevlin, 2002). Becauseit is not a temporary difference, we de-scribe it as permanent, even though it doesnot appear in the effective tax rate recon-ciliation. If companies record a book ex-

pense for the value of the stock option,however, that amount of expense will gen-erate a temporary difference.

For tax purposes, Regulation 1.83–6specifies the tax deduction occurs at thedate the employee exercises the option,with the employee recognizing an equiva-lent amount as salary income. After thatpoint, the employee is merely a stock-holder (although he or she may be sub-ject to insider trading restrictions). Whenthe employee sells the stock, any increasein value from the exercise date generatesa capital gain, and any decrease in valuefrom the exercise date generates a capitalloss.11

Example 1 illustrates the above treat-ment. We assume the following: the stockis worth $10 per share at the grant date(1997), $40 at the exercise date (2000) and$60 when the employee sells the stock(2002). The company records a financialstatement expense of $25 in the grant year(1997). Example 1 shows the amount ofexpense on the financial statements ($25)generates a temporary difference that re-verses in the year the company claims atax deduction. The remaining book–taxdifference ($5), although not reported inthe effective tax rate reconciliation, is es-sentially a permanent difference.

The current M–1 does not specificallydetail the stock option difference, but wewill recommend specific disclosure be-cause this is both a material difference formany firms and the financial accountingtreatment across firms may vary.12

Intangible Assets

As described above, cost recovery forintangible assets can generate either per-manent or temporary differences depend-

10 Http://www.usatoday.com/money/companies/regulation/2002–08–08–options–pit_x.htm.11 Many employees, sell at the same time as exercise, although this is less true of top executives. We show the

sale date subsequent to the exercise to illustrate the capital gain (or potential loss) treatment.12 Jaquette et al. (2003) conclude their study of recent trends in stock options by stating, “given the relative

magnitude of the spread income deduction in recent tax years, this deduction may warrant separate itemiza-tion on Schedule M–1.”


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ing on the financial or tax reporting re-gime.

Merger and Acquisition Valuation Issues—The Inside/Outside Basis Problem

Mergers and acquisitions can generatebook–tax differences beyond the goodwilldifferences discussed above. In general,differences arise because the rules differconcerning when acquired assets shouldbe restated to fair market values. If, for ex-

ample, book asset values are restated to fairmarket value but tax assets are not, thenbook–tax differences will arise through theremaining lives of such assets, as inventoryis sold, property is depreciated, etc.13 Onesuch setting arose during the late 1990swhen high–tech companies wrote–off thevalue of purchased in–process researchand development costs. This write–offtypically generated a permanent differ-ence, because the assets were not restatedto fair market value for tax purposes.14 For

EXAMPLE 1NONQUALIFIED STOCK OPTION

BOOK EXPENSE IN YEAR OF GRANTBASED ON MODIFIED BLACK–SCHOLES OPTION PRICING FORMULA

TAX DEDUCTION IN YEAR OF EXERCISE

Assume that the exercise price is equal to the stock’s fair market value at the Grant Date.

Fair market value of stockEMPLOYERFinancial statementexpenseTax deductionBook–tax difference(temporary)

Book–tax difference(“permanent”=credit toadditional paid in capital)

EMPLOYEESalary income

Capital gain income

$10

$25

$0$25; taxable income

> financialstatement income

$0

$40

$0

($30) {= –($40 – $10)}($25); taxable income< financial statement

income($5); taxable income

< financial statementincome

$30 {= $40 – $10}

$60

$0

$0$0

$20 {= $60 – $40}

Grant Date3/15/1997

Exercise Date3/15/2000

Sale Date3/15/2002

13 Under SFAS Nos. 141 and 142 (effective for acquisitions after June 30, 2001), acquisition of more than 50percent of another corporation is treated as a purchase and the target’s assets are restated to their fair marketvalues. The excess of the purchase price over the fair market values of the tangible assets less liabilities isrecorded as goodwill. Until June 30, 2001, Accounting Principles Board Opinion No. 16 (1970a) provided analternative called Pooling of Interests, allowing a merger of equals through an exchange of common stock.Under pooling, the assets and liabilities of the target corporation remained at their original net book valuesand were combined with the acquirer in consolidation.

14 In a taxable transaction, if the acquirer purchases assets, they are restated to fair market values; if the acquirerpurchases stock, the target stock has a new basis equal to the acquisition price (the “outside basis”), but theassets of the target corporation (the “inside basis”) are not restated barring an election under IRC ◊338. Thiselection causes the target corporation to immediately recognize any built–in gains and losses so only firmswith sufficient favorable tax attributes to offset the potential tax liability typically make this election. Thetypical taxable structure used to acquire a freestanding C corporation is a taxable stock purchase in which theinside basis of the target’s assets are not stepped–up (i.e., no §338 election).

In tax–free acquisitions, the inside basis of the target’s assets cannot be stepped up to fair market value.Erickson (1998) indicates that almost all acquisitions of freestanding C corporations result in a carryover basisfor tax. As a result, we should see large differences for companies that engage in substantial M&A activity,and such differences are frequently treated as permanent differences.


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a striking example, see IBM’s 1995 annualreport, showing a nine percentage pointincrease in its effective tax rate due to thewrite–off of purchased in–process re-search and development related to its ac-quisition of Lotus. Because GAAP nolonger requires goodwill amortization, theincentive for immediate write–off has dis-appeared, and we no longer observe largedifferences for this item.

As previously noted, the current Sched-ule M–1 provides little specific detail. Werecommend that the revised Schedule M–1 include a specific line item for book–taxbasis differences in addition to the depre-ciation differences already reported.

How Differing Reporting IncentivesMotivate Interest in Book–taxReconciliation15

Financial statement users (especiallyrecently) and tax return users (tradition-ally) view book–tax differences as impor-tant because such differences, to the ex-tent not mechanistically determined bystandards and laws, could indicate ag-gressive reporting in one direction or theother.

Financial reporting principles are de-signed to provide relevant and reliableinformation to financial statement users,emphasizing consistency over time within

a firm. However, they also permit consid-erable flexibility in the choice of methodsand discretion in estimation, particularlywhen the information is not deemed to beof sufficient magnitude to affect a user’sdecision (i.e., material).16 Independent au-ditors are necessary to constrain manag-ers’ opportunistic use of the discretiongranted by financial accounting principlesto overstate income and assets, smoothincome or to take a “big bath” in lossyears. By contrast, because the IRS is thenation’s tax collection agency and admin-isters the IRC, it uses audits of tax returnsto detect and deter underreporting.17

Shackelford and Shevlin (2001) reviewan extensive empirical literature on howconflicting incentives affect tax, financial,and regulatory reporting. Some studiesemphasize one system as the economicbenchmark to evaluate manipulation inthe other system. Mills and Newberry(2001), Joos et al. (2002), Phillips et al.(2003) and Hanlon (2003a) imply that (es-timates of) taxable income provides abenchmark for high–quality earnings,whereas Cloyd (1995), Cloyd et al. (1996),Mills (1998), and Mills and Sansing (2000)imply that book–tax differences could beinterpreted as signals of aggressive taxavoidance. Finally, Plesko (2000a and2003b) questions the extent each report-ing system constrains the other because

The exception to this rule occurs if the target is a subsidiary of a C corporation or a conduit entity (e.g.,S corporation). In these transactions, it is not uncommon for the deal to be structured to include a §338(h)(10)election, resulting in a step–up in the tax basis of the acquired entity’s assets (see Erickson and Wang, 2000;Ayers, Lefanowitz and Robinson, 2000; and Erickson and Wang, 2003). Thus, in acquisitions of subsidiariesand conduit entities, the tax bases of the target’s assets are often recorded at fair market value. When an R&Dwrite–off occurs for such an acquisition, the tax basis of the assets is not written down for tax purposes at thesame time that the book write–down occurs. Therefore, the write–down will frequently generate a book/taxtemporary difference. We appreciate conversations with Merle Erickson on these transactions.

Determining whether the transactions above generate a temporary or permanent difference is not unam-biguous, with some transactions resulting in the booking of a deferred tax asset or liability even though thereis no foreseeable income statement effect. See Center for International Tax Education (2002).

15 Paraphrased from Mills, Newberry and Trautman (2002). See also Manzon and Plesko (1998) and Plesko(2002) for discussions.

16 Manzon and Plesko (2002) provide an extended discussion of the application of the Statements of FinancialAccounting Concepts Nos. 1 and 2.

17 The IRS stated mission is service oriented: “to provide America’s taxpayers with top quality service by help-ing them understand and meet their tax responsibilities and by applying the tax law with integrity and fair-ness to all.” http://www.irs.gov/irs/index.html


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of the difficulties to infer taxable incomefrom financial statement data (see alsoHanlon, 2003b).

TAX RETURN REQUIREMENTS FORRECONCILIATION BETWEEN BOOKAND TAXABLE INCOME (SCHEDULEM–1)

To understand better why the currentreconciliation is inadequate, we beginwith a description of the current tax re-turn reconciliation schedule. Prior to 1964,the Form 1120 Corporation Income TaxReturn included a Schedule M, “Recon-ciliation of Taxable Income and Analysisof Earned Surplus and Undivided Prof-its.” In this schedule, firms were requiredto reconcile the change in earned surplusfrom the end of the prior tax year to theend of the current year. Beginning in 1964,the M–1 appeared on the 1120, in essen-tially the same form as it appears today.Figure 1 shows the current fourth pageof the Form 1120, which contains theSchedule L, Balance Sheet per Books, theSchedule M–1, Reconciliation of Income(Loss) per Books with Income per Return,and the Schedule M–2, Analysis of Un-appropriated Retained Earnings perBooks.

The Schedule M–1 begins with acompany’s “net income (loss) per books,”which is intended to be the after–tax in-come reported to shareholders. We sayintended, rather than actual, because cur-rent instructions to Form 1120 SchedulesL and M–1 are sufficiently imprecise as topermit substantial reporting flexibilityregarding the book accounting numbersdisclosed on the tax return, especiallywhen the company has different report-ing entities for book and tax purposes.18

Consistent with consolidation differ-ences existing for foreign subsidiaries,Mills and Newberry (2000) show that av-erage pretax book income (Schedule M–1, Lines 1 plus 2) reported on the tax re-turn ($427 million), falls between world-wide consolidated pretax income ($483million) and U.S. pretax income ($306million), based on a joint data set of IRStax return and Compustat financial state-ment data (Table 2, p.169). Their findingfor 2,833 firm–year (1984–1996) observa-tions of manufacturing firms in the large–case audit program is consistent withsome, but not all, foreign income beingincluded in taxable income when it is re-patriated as a dividend. We recommendthat the M–1 be revised to explicitly iden-tify the starting point of the reconciliationas the worldwide–consolidated book in-come reported to shareholders on SECForm 10–K.

A brief example will illustrate the prob-lem the imprecise instructions can create.Suppose that U.S. Parent (USParent) earns$1,000 and has two 100–percent–ownedsubsidiaries: a U.S. subsidiary (USSub1)that earns $100 and a foreign subsidiary(ForSub2) that earns $100. Assume thatnone of the companies has transactionswith another. If the foreign subsidiarypays all of its profits to the U.S. parent asa dividend, there are no differences in thepretax income reported for financial state-ments versus the tax return.

Absent any dividend payments, theconsolidated financial statement wouldshow $1,200 of pretax earnings, but theU.S. tax return would include only $1,100of pretax earnings before any book–taxdifferences due to income measurement,as shown in the following example. Fi-nally, if the foreign subsidiary pays 50

18 Mills, Newberry and Trautman (2002) found that for many large multinationals, the balance sheet on the taxreturn substantially differed from the tax return on the published financial statements. Reports from auditteams to IRS Research suggest some companies do not carefully post elimination entries when compiling thetax return balance sheet. Although balance sheet reporting is not the focus of this paper, we recommend thatthe IRS consider making its Schedule L instructions more specific to require reconciliation of entities in thepublished financial statements to the entities included in the tax return balance sheet.


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Figure 1. Current Schedule L, M–1 and M–2


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percent of its profits as a dividend, the U.S.tax return would include $1,150 of pretaxearnings. Example 2 illustrates these re-sults.

Large book–tax differences arise in ei-ther direction depending on which“book” number is used as a starting ref-erence point. The Schedule M–1 requirestaxpayers to begin with their net incomeaccording to their books and records. Thiscould reasonably be interpreted as world-wide net book income or U.S. net bookincome reported on the public financialstatements, or a newly constructed bookincome for only those entities included inthe U.S. tax return. To make this point, weuse the last column (50 percent dividend)to extend Example 2.

Example 3 illustrates how the book–taxdifference could be negative, positive, orzero depending on whether the corpora-tion starts its Schedule M–1 (Lines 1 plus2) with book income on a worldwide, U.S.,or intermediate basis.

This example illustrates that the sameset of facts can result in either a positivebook–tax difference, a negative book–taxdifference, or no difference, all depend-ing on the reporting choice the firm makesin completing the Schedule M–1. Thevague Schedule M–1 instructions compli-cate the IRS’s job in having to reconcilethe beginning point of the Schedule M–1for entity differences before they can be-gin to consider the differences in incomemeasurement between book and tax.

The second line of the M–1 is theamount of Federal income tax, which isadded back to book net income to deter-mine pre–tax book income. Because tax-payers could have reported U.S. or world-wide net income (or some other amount)on Line 1, it is not clear that the federaltax expense on Line 2 will always repre-sent U.S. tax expense.

The remainder of the M–1 either addsor subtracts specific types of items de-pending on the differential treatment for

EXAMPLE 2ILLUSTRATION OF U.S. JURISDICTION TO TAX FOREIGN INCOME OF FOREIGN SUBSIDIARIES

U.S. Parent companyU.S. subsidiaryForeign subsidiaryPretax book income

taxed in the U.S.

$1,000$100$100

$1,200

$1,000$100$100

$1,200

$1,000$100

$0$1,100

$1,000$100$50

$1,150

FinancialStatements

U.S. Tax Return(100% dividend

from foreignsubsidiary)

U.S. Tax Return(no dividendfrom foreignsubsidiary)

U.S. Tax Return(50% dividend

from foreignsubsidiary)Pretax income of:

EXAMPLE 3BOOK–TAX DIFFERENCES ARISING FROM FOREIGN INCOME

DUE TO ALTERNATIVE BOOK INCOME REPORTING ON SCHEDULE M–1

Pretax book income usedfor M–1

Plus (minus) foreignincome=Pretax book income taxedin the U.S.

Public financialstatement

worldwide pretaxincome$1,200

(= 1,000 + 100+ 100)

($50)

$1,150

Public financialstatement U.S.pretax income

$1,100(= 1,000 + 100)

$50

$1,150

Pretax income plusdividends of entitiesincluded in U.S. tax

return$1,150

(= 1,000 + 100 +1/2 × 100)

$0

$1,150

Book–Tax Entity Difference will be: NEGATIVE POSITIVE ZERO


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financial and tax purposes. Line 3 specifi-cally itemizes “excess of capital losses overcapital gains,” which represent losses onthe sale of capital assets (such as securi-ties) not deducted in the current tax year.

Line 4 reports “income subject to tax notrecorded on books this year,” such as ad-vance cash payments discussed previ-ously. Line 5 reports “expenses recordedon books not deducted on the return” andseparately identifies two items: the ex-pense for travel and entertainment in ex-cess of deductible limits (typically 50 per-cent), and any excesses of book deprecia-tion over tax depreciation, which typicallyoccurs due to reversal of previous excesstax depreciation. Lines 1 through 5 aresubtotaled on Line 6.

Line 7, “income recorded on books thisyear not included on this return,” sepa-rately details tax–exempt interest. Thisline would also include life insurance pro-ceeds, and reversals of income previouslyrecognized as taxable that was not con-sidered income under GAAP.

Line 8, “deductions on this return notcharged against book income,” separatelydetails the excess of tax depreciation overbook depreciation and the utilization ofcharitable contribution carryovers. Line 8would also include the stock option de-duction discussed above. Line 9 subtotalslines 7 and 8.

Line 10, calculated as Line 6 less Line 9,equals tax net income (tax return Form1120, page 1, Line 28), not taxable income(Line 30). Taxable income (Line 30) equalstax net income (Line 28) less the net oper-ating loss deduction and other specialdeductions (e.g., the deduction for divi-dends received). Unlike book income ortax net income (Line 28), taxable income(Line 30) cannot be negative in the Statis-tics of Income data.

How Does the IRS Use the Schedule M–1?

The ways in which the IRS uses theSchedule M–1 highlight the need for bet-

ter information. The IRS’ Internal RevenueManual (IRM) describes the role of theSchedule M–1 in the audit process. Thefirst task in using the Schedule M–1 is tounderstand the starting book income onLine 1 and reconcile it to the taxpayer’sbooks (IRM § 4.10.3.5.6). IRM § 4.10.3.6.1outlines procedures for analyzing thebook–tax differences in the Schedule M–1, noting, “Schedule M–1 is a criticalschedule for identifying potential tax is-sues resulting from both temporary andpermanent differences between financialand tax accounting.” Audit techniquesinclude verifying “large Schedule M–1 ad-justments going in opposite directions . . .were not netted to arrive at what appearsto be an immaterial amount that wouldnot be reviewed.”

The audit procedures are consistentwith the discussion above about reservesresulting in book expenses being accruedbefore they are tax–deductible. As an ex-ample of an audit procedure using theSchedule M–1, the IRS recommendsagents prepare a schedule showing begin-ning and ending balances in accrued ex-penses. “If the reserve increases during theyear, a Schedule M–1 adjustment shouldhave been made [by the taxpayer] to in-crease taxable income” (IRM § 4.10.3.5.6).If the taxpayer did not post an adjustment,the agent asks further questions.

FINER DETAIL NEEDED FORACCURATE RECONCILIATION

Our premise for a revised M–1 is thatinformation provided in such reconcilia-tion could greatly improve the ability ofthose who use the form to better under-stand the financial position of a company,and provide a mechanism to link firms’tax reports to their financial filings. Bet-ter linkage could lead to improvementsin both tax and, if made public, financialreporting, as similar information will berequired on both sets of reports. As partof the audit process, and to understand


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the effects of differential consolidation, webelieve all tax reports of a public corpora-tion should be matched to their financialreporting numbers. Figure 2 presents ourproposal for an expanded Schedule M–1.

Part 1 newly requires that publiclytraded firms report the parent companynames and identification numbers forboth tax (employer identification number,or EIN) and book (CUSIP) associated withthe entity that files the 10–K.19 Part 1 ad-ditionally requires an asset reconciliationof consolidated book assets on the 10–K(Compustat data item 6) with consoli-dated book assets for entities included inthe consolidated tax return.

Because of the previously outlined dif-ferences in consolidation between tax andfinancial entities, Part 2 begins with theinformation needed to link the return toits related consolidated financial reportingentities. Line 1 is a specifically defined andindependently identifiable measure ofbook income equal to worldwide net in-come from the SEC Form 10–K for publiclytraded companies, or certified financial

statements issued for other purposes, ifavailable, for non–public firms. We recom-mend that the instructions that accompanythe revised M–1 reference the regulationscreated for the Alternative Minimum Taxbook income adjustment (1.56–1(c)(1)).These regulations provide a hierarchy asfollows: (i) Statement required to be filedwith the SEC, (ii) Certified audited finan-cial statement, (iii) Financial statement pro-vided to a government regulator, (iv) Otherfinancial statement.

Line 2 displays the components of taxexpense presently recorded in financialstatement tax footnotes. GAAP requiresseparate disclosure of current and de-ferred components of U.S., foreign, andstate (with other) income tax expenses. Webelieve separately detailing these compo-nents (in place of the current Line 2) willbe informative. The U.S. current tax ex-pense is an estimate of the taxpayer’s U.S.tax obligation for the current year, withnotable exceptions for stock option ac-counting and “tax cushion”, which is theaccrued expense for probable and esti-

19 The provision of such data is not new; Form 5500, “Annual Return/Report of Employee Benefit Plan,” al-ready requires a firm to provide the Committee on Uniform Security Identification Procedures number (CUSIP)of a plan sponsor. We recommend the full 9–digit identifier used on Compustat be reported: the 6–digitCUSIP, plus the issue number and check digit. In any case, instructions should be clear to the taxpayer.

Figure 2. Proposed M–1 (Strict overlap with current M–1 is indicated in italics)


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Figure 2. Proposed M–1 (Strict overlap with current M–1 is indicated in italics) (continued)

20 Extraordinary income and discontinued operations will cause Line 3 to differ from pretax income reported onthe 10–K because these items are reported net of tax.


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mable contingent tax liability (Gleasonand Mills, 2002). The foreign current taxexpense indicates the potential availabil-ity of foreign tax credits to reduce domes-tic taxes owed. The taxpayer adds theseexpenses back to net income to deriveworldwide pretax book income (Line 3).

Lines 4 through 9 reconcile the bookincome of entities included in the consoli-dated financial statement with book in-come included in the consolidated tax re-turn. Line 4 subtracts from financial state-ment income the book income of thoseU.S.–owned entities that are not consoli-dated for tax purposes. Typically, thesewould be entities for which the parentowned between 50 and 80 percent, as wellas income accounted for on the ‘equity’basis. Line 5 subtracts book income of allforeign subsidiaries included in the con-solidated financial statement because for-eign subsidiaries are not eligible for inclu-sion in a consolidated tax return.

Line 6 adds back book income from do-mestic and foreign entities excluded fromfinancial reporting but included for tax,such as dividends from non–tax–consoli-dated entities, e.g., dividends from 60 per-cent owned domestic corporations. Line 6also includes income or losses from Spe-cial Purpose Entities that are treated aspartnerships or branches for tax purposes.

Line 7 provides a subtotal that shouldequal the book income of U.S. entities in-cluded in the U.S. consolidated tax return,but before deemed or actual dividend re-patriations of foreign source income. Be-cause U.S. entities receive flow–throughincome from foreign branches and partner-ships, Line 7 already includes foreign in-come from such sources, as well as any in-come such as interest, rents, royalties andmanagement fees from foreign subsidiaries.

Lines 8 and 9 report taxable income dueto actual or deemed dividends from for-eign subsidiaries. Line 8 reports dividendrepatriations of foreign source incomefrom foreign corporations. In Line 8a, thetaxpayer reports the gross (before reduc-

tion for any withholding tax) dividend,and in Line 8b, the taxpayer reports the(IRC §78) gross–up, if applicable. Line 9reports taxable income, including gross–up, from controlled foreign corporationsunder Subpart F (IRC §956, etc.) and otherincome under anti–deferral rules.

Line 10 equals pretax book income ofthe U.S. consolidated tax group plus tax-able deemed or actual foreign repatria-tions. Finally, Line 11 subtracts actual de-ductible state (and other) income taxes.Line 11 may not equal Line 2e, which wasan estimate for the financial statements.

The subtotal on Line 12 is pretax bookincome of the U.S. consolidated tax groupplus repatriations of foreign income, butafter the deduction for state income taxexpense. This subtotal represents whatwas probably reported on the combina-tion of Lines 1 and 2 of the existing Sched-ule M–1 when companies started with abook income other than consolidatedworldwide income or strictly U.S. entities’book income.

Lines 13 through 17 are taken from thecurrent M–1, and serve to identify differ-ences in the reporting of income and ex-pense between the two systems. Our goalin this section is twofold. First, the revisedM–1 provides more detailed itemizationof particular items than does the currentM–1. Second, the revised M–1 separatesthe differences in income and expense thatare temporary (due to timing differences)from those that are permanent. As a re-sult, we add lines for pension income,stock options, and the amortization ofgoodwill. In some cases, the accountingfor these items will have both temporaryand permanent effects that should beseparately listed.

In addition, though we do not addressthe issues specifically here, we suggeststrict rules be implemented to ensure that“other” reconciliation items that fall intothese categories but are not specificallyitemized on the form are reported consis-tently across all firms. Such consistency


885

will require that the netting of temporarydifferences not be allowed and that a ma-teriality rule be established so that anytransaction above a specified thresholdwill be separately identified.21 Informalconversations with revenue agents sug-gest that combining large offsetting entriesinto smaller net Schedule M–1 entries pre-sents a significant challenge to agentsduring audit.

Enforcement

Increased reporting requirements maynot result in improved information absentpenalties for incomplete or misleadingreports. For example, we speculate thatfirms that prepare the Schedule L BalanceSheet without carefully posting elimina-tion entries for entities in the consolidatedtax return do so because casual or sloppycompliance carries no implicit or explicitpenalty. If taxable income is computedcorrectly (or at least any disputedamounts are not deemed negligent orfraudulent), there is no explicit motivationto use care in completing the remainingline entries on the schedule. However, wealso believe the request for specific infor-mation carries the presumption that it isimportant to tax administration.

POTENTIAL BENEFITS OF REVISEDM–1

Potential Benefits to Tax Administratorsand Policymakers

If the M–1 is an audit tool, the primarybeneficiaries of a revised M–1 should beauditors. We recognize that IRS examin-

ers already have the authority to requiretaxpayers to provide additional detail asneeded, but we believe that standardiz-ing additional detail on the face of theSchedule M–1 will improve audit effi-ciency. 22 For example, auditors couldmore quickly identify the magnitude of(multinational) consolidation issues anddetermine whether an International Spe-cialist is needed. Standardization of addi-tional detail will also facilitate compari-sons across firms. Finally, the introductionof detail concerning temporary and per-manent differences will permit the IRS toconsider whether these categories shouldreceive equal attention for tax enforce-ment. U.S. Treasury (1999) described theperfect tax shelter as one that reduces tax-able income without affecting book in-come. To gain a financial statement ben-efit through a reduced effective tax rate,such differences must be considered per-manent. Thus, additional disclosure con-cerning permanent differences shouldhelp identify potential tax shelter trans-actions. Recent regulations concerningcorporate tax shelter disclosures (TreasuryRegulations §1.6011–4) require companiesto disclose certain transactions with book–tax differences exceeding $10 million.

The IRS, in its efforts to improve effi-ciency and reduce taxpayer audit–relatedburden, has implemented Limited IssueField Exams (LIFE audits). Under theseaudits, the exam manager or team mustquickly identify the audit issues and limitthe audit’s scope to a handful of issues.More detailed and standardized ScheduleM–1 reconciliation should assist in LIFEaudits. While improvements in audit effi-

21 See, for example, Treasury Regulations §1.6011–4(b)6 requiring disclosures of tax shelter transactions: “Trans-actions with a significant book–tax difference — (i) In general. A transaction with a significant book–tax differenceis a transaction where the amount for tax purposes of any item or items of income, gain, expense, or loss fromthe transaction differs by more than $10 million on a gross basis from the amount of the item or items for bookpurposes in any taxable year. For purposes of this determination, offsetting items shall not be netted for eithertax or book purposes.”

22 The tax return as filed typically includes supplemental schedules that provide additional detail supportingthe Schedule M–1 line items. For example, the longest of the more detailed Enron Schedule M–1s took fivepages for 1998, (JCT, 2003, Volume II, pages A-29 through A-50).


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ciency clearly benefit the IRS, they alsoreduce the audit–related costs of other-wise compliant firms.

An additional beneficiary of an im-proved M–1 will be IRS Research. The Re-search division uses large–sample tax re-turn data for audit selection, classificationand issue identification. Our recommen-dations for changes to the Schedule M–1preserve the existing category subtotals,so the time series of Statistics of Incomedata will be uninterrupted. Standardizingthe detail for material book–tax differ-ences will permit IRS Research to evalu-ate better whether book–tax differences ofvarious types relate to compliance risk,potentially increasing audit efficiency. Forexample, because stock option deductionsare permitted by legislative grace, thebook–tax difference for stock optionsshould not by itself represent a compli-ance risk, even if it generates a large ag-gregate spread between book income andtaxable income. Finally, any improve-ments in IRS audits and tax complianceresearch apply to state tax administrationas well, because state governments haveaccess to federal tax return data and per-form similar enforcement functions.

Beyond the administration of the taxcode, additional M–1 detail will provideother users of tax return information amore complete picture of tax returns’ re-lation to publicly available financial state-ments. Such a link between the tax returnand publicly available data should allowfor better understanding of the economicand financial behavior of firms in responseto tax changes. The 1999 Treasury reporton tax shelters and Treasury testimony(Talisman, 2000), for example, pointed tothe disparity in book–tax income as po-tential evidence of increasingly aggressivetax positions being taken by firms. A more

detailed M–1 would provide additionalinformation to those studying these is-sues.

Finally, book–tax differences affect fed-eral budget forecasting and economists’estimates of the national accounts. Be-cause tax return data become availableapproximately two years later than pub-lic financial statement data, economicforecasters use public financial statementdata to predict corporate profits and taxcollections adjusting financial statementincome for expected book–tax differences(Petrick, 2001). Better data on the relationbetween taxable and financial reportingincome could make extant financial datamore useful to policy analysts.

Potential Benefits to Financial StatementUsers Were Tax Return Data MadePublic

Although the provision of additionaldetail in the M–1 would benefit currentlyauthorized users—tax administrators,policymakers, and other internal govern-ment users—the same information couldalso be useful to other external partieswere it to be made public. GAAP requiresvarious disclosures and reconciliation ofa firm’s financial statements with its ulti-mate tax liability. However, this informa-tion appears to be incomplete, as the evi-dence seems to indicate it is unreliable indetermining the amount of income re-ported for tax purposes (Plesko, 2000a).Hanlon (2003b) summarizes research thatindicates current disclosures under FAS109 (FASB, 1992) are not sufficiently com-plete to allow inferences of taxable incomeor taxpaying status.23

Because the revised Schedule M–1serves as a tax–reporting analog to a firm’stax footnote, were it to be publicly avail-

23 Greater financial disclosure was suggested more than 20 years ago in an SEC petition by Tax Analysts (Field,1982). Marovelli (1986) used both 10–K information and additional information provided by companies toprovide common formatted measures of effective tax rates. Outslay (2003), Outslay and McGill (2002) andSeida (2003) discuss that the substantial tax net operating losses disclosed in Enron’s financial statement taxfootnotes made it easier to estimate taxable income than is typically the case.


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able it could address many of the short-comings of current financial reporting andallow investors to utilize both sets of re-ports in evaluating a company’s perfor-mance. Alan Murray (2002) reasoned thattax return information “may not be ofmuch use to the average investor. But con-scientious stock analysts—surely there aresome out there?—could spend their timeanalyzing the gaps between book and taxincome, attempting to find truth in be-tween.” In addition to those who are mak-ing investing decisions, other potentialbeneficiaries include the business andgeneral press and other financial andpolicy analysts.

POTENTIAL COSTS OF ADDITIONALDISCLOSURE

Regardless of the audience, the supplyof additional information raises questionsas to the costs of supplying the informa-tion. Information should be required onlyif the benefits of reporting the informationoutweigh the costs. In the case of tax re-turn information, a difficult trade–off isthat the costs are borne by groups distinctfrom those that receive the potential ben-efits. Such a trade–off frequently occurs forfinancial reporting disclosures as well. Wenote that any costs of corporate disclosureare ultimately borne by shareholders, cus-tomers, employees or other stakeholders.

Compliance Costs

We do not believe requiring additionalline–item detail on the Schedule M–1 willsubstantially increase the tax return com-pliance costs. Although the revised M–1totals 25 lines, merely counting entries ismisleading. The first eleven lines, all newto the M–1, are used to reconcile net in-come from the 10–K to the current first lineof the M–1, and are necessary to controlfor consolidation differences. Of theseeleven, the first three would be taken di-rectly from the 10–K filing. The reconcil-

ing items of the current M–1 are left es-sentially unchanged in new Lines 13 to 19,but with supplemental detail that wouldalready be part of current record keepingand reported in attachments or used toprepare the deferred tax assets and liabil-ity reconciliation for the financial state-ment tax footnotes. The six remaining newlines (20 to 25) summarize informationreported elsewhere on the return.

If audited, firms already provide most,if not all, of the additional detail we rec-ommend in the revised Schedule M–1.Thus, for the large–case audit firms that arecontinually audited (more than one thou-sand companies), the new M–1 only accel-erates the provision of such informationfrom the audit process to the return filing.For the smallest companies, much of therevised M–1 will be inapplicable becausethey are domestic companies whose con-solidated group for financial reporting islikely the same as for tax reporting. Thecompliance costs are probably highest formedium–sized corporations with complexcorporate structures that conduct sophis-ticated tax planning. However, we assertthat firms already compute the informa-tion on the revised M–1 to prepare the in-come tax footnote or to determine taxableincome on the tax return.

As a point of comparison, Australia re-quires 28 lines in its book–tax reconcilia-tion (Company Tax Return 2002, Schedule7). Canada recently expanded its book–taxreconciliation schedule to include morethan 100 specific reconciling items (Sched-ule 1, for taxation years 2000 and later).Requiring companies to classify their de-tailed book–tax differences into approxi-mately 20 categories instead of four maincategories is not unreasonable.

To Whom Should Revised M–1Reporting Apply?

Our proposal to begin M–1 reconcilia-tion with a standard starting point is mosteasily implemented for publicly–traded


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companies: net income reported on SECForm 10–K. Our initial thinking regard-ing privately–held companies is that theyshould report net income as reported onaudited GAAP financial statements pro-vided to outside stakeholders such ascreditors. If a company does not file withthe SEC, the priority of alternative state-ments to be used should be explicitly es-tablished. Such a list could mimic the setof financial statements used to determinebook income for the book income adjust-ment of the alternative minimum tax, asenacted in 1986. Such prior regulationsalso provide guidance for differences be-tween book and tax year–ends.

Another consideration is whether thereshould be a size threshold for the moredetailed reporting. The argument for asize threshold is to limit compliance coststo those firms with the size and sophisti-cation to bear them. Given the nature ofthe information requested, a size thresh-old may not be necessary, as much of theadditional detail will not apply to smallfirms. Alternatively, if a size threshold isnecessary, the definition of small firmscurrently in place for the corporate alter-native minimum tax (§55(e)) may well beadequate, as it was motivated by a simi-lar concern.

Privacy Issues Related to PublicDisclosure of Tax Return Information

We do not think that public disclosureof a modified Schedule M–1 would posesignificant problems to firms from eithera regulatory burden or competitivenessstandpoint. From a burden view, the de-tails provided in a modified M–1 are in-formation a corporation should alreadyhave available as part of its normal fil-ing. From a competitiveness perspective,any concern that these additional disclo-sures would harm a company must be

viewed in the context of the extent towhich this information goes beyond theinformation a firm should be providingunder GAAP.

A companion paper (Lenter,Shackelford and Slemrod, 2003) discussesthe privacy issues in greater detail. Strauss(1993 and 1995) and Pomp (1994 and 1995)discuss objections to greater disclosure inother contexts. Gleason (2003) fails to findthe claimed competitive costs from man-dated segment disclosures. Such informa-tion does not appear to be derivable fromthe Schedule M–1.

Our primary recommendations concernimproved data for the government’s ef-forts in tax enforcement and economicanalysis, rather than the public as a whole.Given the differences in consolidation andthe lack of uniformity in reporting, pub-lic disclosure of the existing summarySchedule M–1 would not, by itself, pro-vide much useful information, althoughcorporations’ subsequent voluntary dis-closures to provide additional detail couldbe informative. While public disclosure ofa revised M–1 should provide betterbook–tax reconciliation than either thecurrent M–1 or existing financial state-ments, the demonstrated need for an im-proved M–1 is an independent issue, andshould be viewed separately from anydiscussion of disclosure.

DISCLOSURE OF OTHER TAXRETURN DATA

We have limited our scope to recom-mendations for expanded book to tax in-come reconciliation. A partial approach tofull disclosure could involve the disclo-sure of the revised M–1 along with otherselected items of taxable income and ex-pense.27 As a starting point, we suggest theentire M–1 of each tax return could bemade publicly available because it con-

27 Outslay (2003) suggests the first four pages of the Form 1120 (which includes the M–1) could be made public.


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tains information that others, such asFASB, have already deemed as importantto the general public. Like Lenter,Shackelford and Slemrod (2003), we cau-tion against full public release of corpo-rate tax returns.

SUMMARY RECOMMENDATIONS

Shortcomings in the current state of fi-nancial and tax information suggest a fail-ure of both sets of regulatory guidelines.Increased reporting of book–tax differ-ences within the tax return system wouldassist current users of tax return informa-tion, including tax administrators, taxpolicy analysts, and other governmentusers. Although the detailed reconciliationdata we recommend are already availableto tax examiners on request during audit,such data are not reported in useable formto facilitate aggregation and comparisonsamong taxpayers.

Like Lenter, Shackelford and Slemrod(2003), we believe the benefits of greaterdisclosure appear to outweigh the costs.Such disclosure would provide an impor-tant source of supplemental informationfor investors and creditors to assess boththe performance of publicly–traded cor-porations, and the tax system underwhich they operate. For such a disclosureto be effective would not necessarily re-quire firms to release all M–1s from all ofthe tax returns associated with the con-solidated financial statements. Instead,an aggregation of the M–1s associatedwith the consolidated financial state-ments, reconciling worldwide book in-come to domestic taxable income, inclu-sive of the reconciliation suggested byHanlon (2003), would augment currentfinancial reporting information. Such anaggregation has the advantage of provid-ing more detailed tax information on theexact entity observed by investors andother users of financial statement infor-mation.

We assert that making (more detailed)M–1 data public will not impose unrea-sonable costs on taxpayers. First, taxpay-ers are already computing detailed recon-ciliations to complete the current M–1 andtax disclosures required by SFAS No. 109.Second, we feel potential privacy concernsare disingenuous considering that SFAS109 already requires firms to disclose ma-terial book–tax reconciling items, al-though Hanlon (2003) points out the limi-tations of current financial disclosure inadequately providing transparency onbook–tax differences. Lenter, Shackelford,and Slemrod (2003) provide a thoroughdiscussion of the pros and cons of disclo-sure, and we look forward to additionalpublic debate on this issue.

Acknowledgments

We have benefited from comments fromRosanne Altshuler (editor), CharlesBoynton, Merle Erickson, Tom Field, JeffGramlich, Michelle Hanlon, Alvin Knott,Jay Levinsohn, Gil Manzon, Gary McGill,Kaye Newberry, Ed Outslay, John Phillips,Sonja Rego, Richard Sansing, DougShackelford, Terry Shevlin, Joel Slemrodand Connie Weaver, and our conferencediscussants, Mihir Desai and RichardTeed. All opinions and errors are our own.

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Documents

Bridging the Reporting Gap: A Proposal for More …web.mit.edu/gplesko/www/Mills Plesko NTJ 2003 Bridging...between tax and book income.1 A Wall Street Journal edito-Bridging the Reporting