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What Can We Infer About a Firm’s Taxable Income from its Financial Statements?

Michelle HanlonUniversity of Michigan Business School

Prepared for the conference Public Disclosure of Corporate Tax Returns:

Issues and OptionsSponsored by the UNC Tax Center,

Brookings-Urban Institute Tax Policy Center, and The National Tax Association

April 25, 2003

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Outline Statement of Financial Accounting Standards No.

109 (FAS 109) required recognition and disclosures How tax liabilities and taxable income are estimated

using FAS 109 disclosures. Why these estimates can be erroneous.

Reasons why the current tax expense may not be equal to the actual tax liability of the firm.

Reasons why the estimate of taxable income can be wrong even in cases where the current tax expense is equal to the actual tax liability.

Consolidation issues Conclusions

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FAS 109 Required Recognition, Disclosures, and Limitations

Objectives of FAS 109: Recognize the amount of taxes payable or

refundable for the current year.

Recognize deferred tax liabilities and assets for future tax consequences of events that have been recognized in an enterprise’s financial statements or tax returns.

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FAS 109 Required Recognition, Disclosures, and Limitations Firms are required to recognize an income tax

expense on the income statement. Total income tax expense or benefit for the year is the

sum of the current tax expense (benefit) and the deferred tax expense (benefit).

Income tax expense is a financial accounting expense. Accrual accounting method

Deferred tax expense (benefit) reflects the changes in the deferred tax assets and liabilities—future deductible and taxable amounts.

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Tax Note: Cisco’s Tax Expense11. Income Taxes The provision for income taxes consisted of the following (in millions):     Years Ended  July 27, 2002  July 28, 2001  July 29, 2000

Federal:      Current  $929   $581   $1,843   Deferred   (480) (697)   (652)   

449    (116)   1,191 State:         Current   117   157   282   Deferred   (68)   (199)   (118)    49   (42)   164 Foreign:      Current  344    326    332   Deferred   (25)  (28)   (12)    319    298    320  Total  $817   $140   $1,675 

The Company paid income taxes of $909 million, $48 million, and $327 million in fiscal 2002, 2001, and 2000, respectively.

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Cisco’s Deferred Tax Assets and Liabilities        July 27, 2002  July 28, 2001ASSETS        

Allowance for doubtful accounts and returns  $247   $466 Lease reserves   281    325 Loan reserves   249    284 Inventory allowances and capitalization   340    706 Investment reserves   476    274 In-process R&D, goodwill, and purchased intangible assets   436    400 Deferred revenue   968    478 Credits and net operating loss carryforwards   391    414 Other   497    230 Total deferred tax assets   3,885    3,577 LIABILITIES        

Purchased intangible assets   (192)   (266)Unrealized gains on investments   –    (1)Other –   (187)Total deferred tax liabilities   (192) (454)Total  $3,693   $3,123 

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Cisco as Compared to Microsoft       CSCO - 2002  MSFT - 2002

Allowance for doubtful accounts and returns  $247  x Lease reserves   281    x Loan reserves   249    xInventory allowances and capitalization   340    x Investment reserves /Impaired investments 476   2,016In-process R&D, goodwill, purch. intang.    436    xDeferred revenue   968    x Credits and net operating loss carryforwards   391    xOther  497    xRevenue items x 2,261Expense items x 945Total deferred tax assets  3,885  5,222Purchased intangible assets   (192)   (x)Unrealized gains on investments   –   (887)International earnings x

(1,818)Other   –   (803)Total deferred tax liabilities  (192) (3,508)Total  $3,693  $1,714  

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Cisco’s Rate ReconciliationYears Ended  July 27, 2002  July 28, 2001  July 29, 2000Federal statutory rate   35.0%  (35.0)%  35.0%Effect of:             State taxes, net of federal tax benefit   1.8    (2.4)   1.9  Foreign sales corporation  (1.5)   (1.8)   (1.9) Foreign income at other than U.S. rates   (4.9)   (1.7)   (1.6) Nondeductible in-process R&D   0.9    30.3    7.6  Nondeductible goodwill  –    20.9    0.5  Nondeductible deferred stock-based comp.   1.9    8.0  –  Tax-exempt interest   –    (1.0)   (1.8) Tax credits   (3.4)   (2.5)  (1.6) Other, net   0.3    1.2   0.5   Total   30.1%   16.0%   38.6%

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How Financial Statement Users Estimate a

Firm’s Tax Liability and Taxable Income Gross-up current tax expense by the statutory

tax rate to get taxable income. The current tax expense is thought to be

approximately equal to the tax liability from the tax return(s) of the firm.

Example: Cisco U.S. current tax expense = $929 M Using this as an estimate of the tax liability from the US Form

1120, the estimate of U.S. taxable income = $929 M / 0.35 =$2,654 M

Gross-up the deferred tax expense (benefit) and subtract/add from pre-tax accounting earnings.

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Why the Current Tax Expense May Not be Equal to the Actual Tax Liability of the Firm

The accounting for the tax benefits of stock options

Tax cushion Intraperiod tax allocation Timing of tax return filing with the IRS and

the 10-k filing with the SEC

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The Stock Option Deduction Stock options are not treated symmetrically for

book and tax purposes. A tax deduction but no book expense. However, this is not treated as a permanent

book-tax difference which would be a direct reduction in current tax expense.

APB 25 requires that the tax benefits related to this difference be accounted for as a credit to Additional Paid-In Capital.

As a result, the current tax expense is greater than the actual taxes due on the firm’s current period taxable income.

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The Stock Option Deduction

Example entries:

Current tax expense

Taxes payable(amount=tax not considering deduction for option exercises)

Taxes payable

Additional paid-in capital(amount = the tax benefits recognized from the stock option deduction)

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Cisco’s Statement of Shareholders’ Equity

Common Stock Retained Accumulated Total and Additional Earnings Comprehensive 

Shareholders‘ Paid in Capital Income (Loss)  Equity

BALANCE AT JULY 28, 2001     20,051    7,344    (275)   27,120 Net income     –    1,893    –    1,893 Change in net unrealized gains and losses on investments      –    –    224    224 Other      –    –    24    24Comprehensive income      –    –    – 2,141Issuance of common stock      655    –    –    655 Repurchase of common stock    (350)   (1,504)   –    (1,854)Tax benefits from employee stock           option plans      61    –    –    61 Purchase acquisitions   346    –    –    346 Amortization of deferred                      stock-based compensation   187    –    –    187 BALANCE AT JULY 27, 2002    $20,950   $7,733   $(27)  $28,656 

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Cisco’s Cash Flow Statement (excerpt)

Cash flows from operating activities:     July 27, 2002  July 28, 2001 July 29, 2000  Net income (loss)  $1,893   $(1,014)  $2,668  Adjustments to reconcile net income (loss) to               net cash provided by operating activities:               Depreciation and amortization   1,957    2,236    863   Deferred income taxes   (573)   (924)   (782)   Tax benefits from employee stock option plans   61    1,397    2,495    In-process research and development   53    739    1,279    Change in operating assets and liabilities:                Accounts receivable   270    569    (1,043)    Inventories   673    (1,644)   (887)    Prepaid expenses and other current assets   (28)   (25)   (249)    Accounts payable   (174)   (105)   286     Income taxes payable   389    (434)   (365)   Other   … … …Net cash provided by operating activities   6,587    6,392    6,141 

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Summary-- Stock Option

Results in the current tax expense overstating the actual tax liability of the firm.

The amount of the deduction and tax benefits can, in general, be estimated.

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Tax Cushion The tax cushion is a reserve (accrual) of

tax expense for future tax authority assessments against tax positions taken.

There is very little disclosure by firms of the existence or amount of this reserve.

Results in a higher reported current tax expense relative to the tax liability on the tax return.

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Tax Cushion Cisco: Management believes that adequate amounts

have been reserved for any adjustments that may ultimately result from these examinations.

Microsoft: The IRS is examining the Company’s 1997 through 1999 U.S. income tax returns. Management believes any adjustments which may be required will not be material to the financial statements.

GM: Annual tax provisions include amounts considered sufficient to pay assessments that may result from examination of prior year tax returns; however, the amount ultimately paid upon resolution of issues raised may differ materially from the amount accrued.

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Intraperiod Tax Allocation Tax expense is to be allocated to continuing

operations, discontinued operations, extraordinary items, and, for some specific items, directly to shareholders’ equity.

This allocation results in the current tax expense reflecting only the tax on continuing operations.

Disclosure of tax allocated to the other items is aggregated and somewhat limited.

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Intraperiod Tax Allocation-GMFor the year ended, December 31 1999Total net sales and revenues $176,558Cost of sales and other expenses 140,708Selling, general, and administrative 19,053Interest expense (Note 13) 7,750Total costs and expenses 167,511Income from continuing operations before income taxes and minority interests 9,047Income tax expense (Note 8) 3,118Equity income (loss) and minority interests (353)Income from continuing operations 5,576Income from discontinued operations (Note 1) 426Net income 6,002

Note 1: Income from Delphi discontinued operations of $426 million for the year ended December 31, 1999, is reported net of income tax expense of $314 million.

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Summary

Items that can cause the current tax expense to differ from the actual tax liability of the firm:

The accounting for the stock option deduction The tax cushion Intraperiod tax allocation Timing of filing – IRS vs SEC

Important for both those interested in tax status of the firm (the tax liability for the period) and those interested in estimating taxable income.

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Problems with Estimating Taxable Income

Gross-up of current tax expense can lead to erroneous estimates of taxable income even when the current tax expense is an accurate representation of the firm’s tax liability.

Tax credits are included in the rate reconciliation The gross-up rate—what rate to use? Problems with tax loss firms

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Possible Additional Disclosures

A new M-1 schedule as proposed by Mills and Plesko (2003)Possibly make this publicly available with the

financial statements

A reconciliation of current tax expense to the cash taxes paid amount

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Example of Potential ReconciliationCisco Systems, Inc.

Reconciliation between current tax expense and cash taxes paid For the year ended July 28, 2001

In millions

Federal Foreign State Total

Current tax expense $581 $326 $157 $1,064

Add/Less: Tax allocated to items below the tax expense on the income statement

xxx

xxx

xxx

xxx

Less: Tax benefits of stock option deductions (xxx) (xxx) (1,397)

Less: Current year tax cushion reserved (xxx) (xxx) (xxx) (xxx)

Less: Payments related to this year not made (or planned to be made) until next year

(xxx) (xxx) (xxx) (xxx)

Add: Payments related to prior years’ taxes but paid this year

xxx xxx xxx xxx

Less: Reduction in cash taxes due to consolidation with loss entities

(xxx) (xxx) (xxx) (xxx)

Add/Less: Other xxx

Cash Taxes Paid xxx xxx xxx $48

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Conclusions What can we infer from financial statements about

taxable income? Usually, not much. Problems arise because of:

Accounting for the stock option deduction Tax cushion Intraperiod tax allocation Other unknown reasons?

FAS 109 was not intended to provide disclosure of taxable income but rather to provide a fair recognition of the tax assets and tax liabilities (and thus the tax

expense) for financial accounting purposes. If we want to know taxable income, additional

disclosures are required.