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

1. 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

2. 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

3. 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.

4. 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.

5. 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  $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.

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

7. Cisco as Compared to Microsoft CSCO - 2002  MSFT - 2002 Allowance for doubtful accounts and returns  $247  x  Lease reserves   281    x  Loan reserves   249    x Inventory allowances and capitalization   340    x  Investment reserves /Impaired investments 476   2,016 In-process R&D, goodwill, purch. intang.    436    x Deferred revenue   968    x  Credits and net operating loss carryforwards   391    x Other  497    x Revenue items x 2,261 Expense items x 945 Total deferred tax assets  3,885  5,222 Purchased 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

8. Cisco’s Rate Reconciliation Years Ended  July 27, 2002  July 28, 2001  July 29, 2000 Federal 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%

9. 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.

10. 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

11. 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 thanthe actual taxes due on the firm’s current period taxable income.

12. 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)

13. 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    24 Comprehensive income      –    –    – 2,141 Issuance 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

14. 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 

15. 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.

16. 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.

17. 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.

18. 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.

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

20. 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.

21. 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

22. 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

23. Example of Potential Reconciliation

24. 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.