Bridging the reporting gap:
a proposal for more informative
reconciling of book and tax income
Lillian F. Mills
University of Arizona
George A. Plesko
Massachusetts Institute of Technology
April 25, 2003
Brookings Institution/UNC Conference
4/25/03
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Purpose of paper

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The conference charge: What do we learn from
the M-1?
Our additional goal: How could the M-1 be
improved?
Goals in conflict?
Improve data versus public disclosure
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Trends in book-tax differences
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Why do book and tax income differ?
Income measurement differences –
how do we measure income under each
system?
 Consolidation differences – financial
statements include different entities
than the tax return.

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Technical issues –
income measurement

Income differs for book and tax due to
differences in timing and scope.

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Details of income differences: Knott (2003) –
accruals, depreciation, many others.
Options are a material item, Hanlon (2003)

4/25/03
Option deduction not disputed on audit, but
hard (for investors or IRS) to identify.
Example: Forbes 4/15 lists Microsoft ‘big tax
bill’ based on current tax expense.
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Why is consolidation a problem?

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Schedule M-1 starts with net book income
“according to your books and records”
Financial statements generally consolidate
worldwide entities (control/own > 50% )
Tax returns generally consolidate only
domestic entities (owned >= 80% )
Which entities belong in “book income” for
M-1?
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Consolidation starting point affects
sign of M-1 difference

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Example 3 facts: $1000 U.S. Parent, $100 U.S.
Sub, $100 foreign sub pays 50% dividend.
Worldwide book income $1,200 MINUS $50
= $1,150
U.S. book income $1,100 PLUS $50 = $1,150
Both starting points end at same place, but
have opposite book-tax differences.
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Evidence of M-1 starting point?

Mills/Newberry (2000). Chart displays means, but high variance
indicates inconsistent reporting.
Mean positive book income large-case manufacturing,
1984-1996
Millions of dollars
600
500
400
300
200
100
0
U.S.
M-1
WW
Compustat (US or WW) versus tax return (M1)
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Excerpts from Enron’s “true M-1”
(per JCT analysis)


See Table 2.
Nearly ½ of the M-1 items that JCT
reconstructed represented differences
between:



Book income per 10-K
Book income per Schedule M-1 Line 1
Remaining ½ of M-1 items were
‘traditional’ book-tax income differences
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Limitations in current Schedule M-1

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Ambiguous starting point for net book
income.
Scant detail prevents standardized
comparisons.
Netting
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Revised Schedule M-1 (Figure 3)

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Reconcile the entity
 10K entity to U.S. tax jurisdiction
Reconcile the income (current M-1++)
 Preserve existing categories
 Provide additional detail
 Partition permanent and temporary
Enumerate the tax
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Benefits to improving M-1

Improve tax administration


Benefiting compliant taxpayers
Assist tax policy analysis
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Burden from revised Schedule M1?
 Taxpayers already

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prepare supporting schedules.
determine permanent versus temporary for
GAAP financial statements
provide reconciliation for IRS exam (largecase).
Small (domestic) firms can ignore most
consolidation items.
We welcome audience views.
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Where does the debate go from here?

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Public attention on disclosure of corporate
tax returns could fade.
Irrespective of disclosure, expanding M-1 is
important for tax administration and
analysis.
The conference authors have suggested a
variety of solutions that improve on current
information.
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