What Can We Infer About a Firm’s Taxable
Income from its Financial Statements?
Michelle Hanlon
University of Michigan Business School
Prepared for the conference
Public Disclosure of Corporate Tax Returns:
Issues and Options
Sponsored by the UNC Tax Center,
Brookings-Urban Institute Tax Policy Center, and
The National Tax Association
April 25, 2003
1
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
2
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.
3
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.
4
Tax Note: Cisco’s Tax Expense
11. 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
Deferred
State:
Current
Deferred
Foreign:
Current
Deferred
Total
$929
(480)
449
117
(68)
49
344
(25)
319
$817
$581
(697)
(116)
157
(199)
(42)
326
(28)
298
$140
$1,843
(652)
1,191
282
(118)
164
332
(12)
320
$1,675
The Company paid income taxes of $909 million, $48 million, and
$327 million in fiscal 2002, 2001, and 2000, respectively.
5
Cisco’s Deferred Tax Assets and Liabilities
July 27, 2002
July 28, 2001
Allowance for doubtful accounts and returns
$247
Lease reserves
281
Loan reserves
249
Inventory allowances and capitalization
340
Investment reserves
476
In-process R&D, goodwill, and purchased intangible assets 436
Deferred revenue
968
Credits and net operating loss carryforwards
391
Other
497
Total deferred tax assets
3,885
$466
325
284
706
274
400
478
414
230
3,577
ASSETS
LIABILITIES
Purchased intangible assets
Unrealized gains on investments
Other
Total deferred tax liabilities
Total
(192)
–
–
(192)
$3,693
(266)
(1)
(187)
(454)
$3,123
6
Cisco as Compared to Microsoft
CSCO - 2002
Allowance for doubtful accounts and returns
Lease reserves
Loan reserves
Inventory allowances and capitalization
Investment reserves /Impaired investments
In-process R&D, goodwill, purch. intang.
Deferred revenue
Credits and net operating loss carryforwards
Other
Revenue items
Expense items
Total deferred tax assets
Purchased intangible assets
Unrealized gains on investments
International earnings
Other
Total deferred tax liabilities
Total
$247
281
249
340
476
436
968
391
497
x
x
3,885
(192)
–
x
–
(192)
$3,693
MSFT - 2002
x
x
x
x
2,016
x
x
x
x
2,261
945
5,222
(x)
(887)
(1,818)
(803)
(3,508)
$1,714
7
Cisco’s Rate Reconciliation
Years Ended
July 27, 2002
Federal statutory rate
35.0%
Effect of:
State taxes, net of
federal tax benefit
1.8
Foreign sales corporation
(1.5)
Foreign income at other
than U.S. rates
(4.9)
Nondeductible in-process
R&D
0.9
Nondeductible goodwill
–
Nondeductible deferred
stock-based comp.
1.9
Tax-exempt interest
–
Tax credits
(3.4)
Other, net
0.3
Total
30.1%
July 28, 2001
(35.0)%
July 29, 2000
35.0%
(2.4)
(1.8)
1.9
(1.9)
(1.7)
(1.6)
30.3
20.9
8.0
(1.0)
(2.5)
1.2
16.0%
7.6
0.5
–
(1.8)
(1.6)
0.5
38.6%
8
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.
9
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

10
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.
11
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)
12
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
Net income
–
Change in net unrealized gains
and losses on investments
–
Other
–
Comprehensive income
–
Issuance of common stock
655
Repurchase of common stock
(350)
Tax benefits from employee stock
option plans
61
Purchase acquisitions
346
Amortization of deferred
stock-based compensation
187
BALANCE AT JULY 27, 2002 $20,950
7,344
1,893
–
–
–
–
(1,504)
(275)
–
27,120
1,893
224
24
–
–
–
224
24
2,141
655
(1,854)
–
–
–
–
61
346
–
$7,733
–
$(27)
187
$28,656
13
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.
15
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.
16
Tax Cushion

Cisco: Management believes that adequate amounts
have been reserved for any adjustments that may
ultimately result from these examinations.

Microsoft:

GM:
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.
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.
17
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.
18
Intraperiod Tax Allocation-GM
For the year ended, December 31
Total net sales and revenues
Cost of sales and other expenses
Selling, general, and administrative
Interest expense (Note 13)
Total costs and expenses
Income from continuing operations before
income taxes and minority interests
Income tax expense (Note 8)
Equity income (loss) and minority interests
Income from continuing operations
Income from discontinued operations (Note 1)
Net income
1999
$176,558
140,708
19,053
7,750
167,511
9,047
3,118
(353)
5,576
426
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.
20
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
21
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
22
Example of Potential Reconciliation
Cisco Systems, Inc.
Reconciliation between current tax expense and cash taxes paid
For the year ended July 28, 2001
In millions
Current tax expense
Add/Less:
Tax allocated to items below the tax expense on
the income statement
Federal
Foreign
State
Total
$581
$326
$157
$1,064
xxx
xxx
xxx
xxx
(xxx)
(1,397)
Less: Tax benefits of stock option deductions
(xxx)
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)
xxx
xxx
xxx
xxx
(xxx)
(xxx)
(xxx)
(xxx)
Add: Payments related to prior years’ taxes but paid
this year
Less: Reduction in cash taxes due to consolidation
with loss entities
Add/Less: Other
Cash Taxes Paid
xxx
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.
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