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Bridging the Reporting Gap: A Proposal for More Informative Reconciling of Book and Tax Income

This paper proposes improvements to the Schedule M-1, aiming to provide more detailed and standardized information on book-tax differences in corporate income reporting.

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Bridging the Reporting Gap: A Proposal for More Informative Reconciling of Book and Tax Income

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  1. Bridging the reporting gap: a proposal for more informative reconciling of book and tax incomeLillian F. MillsUniversity of ArizonaGeorge A. PleskoMassachusetts Institute of Technology April 25, 2003 Brookings Institution/UNC Conference Mills and Plesko

  2. Purpose of paper • 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 Mills and Plesko

  3. Trends in book-tax differences Mills and Plesko

  4. 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. Mills and Plesko

  5. Technical issues – income measurement • Income differs for book and tax due to differences in timing and scope. • Details of income differences: Knott (2003) – accruals, depreciation, many others. • Options are a material item, Hanlon (2003) • 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. Mills and Plesko

  6. Why is consolidation a problem? • Schedule M-1 starts with net book income “according to your books and records” • Financial statements generally consolidate worldwide entities (control/own> 50%) • Tax returnsgenerally consolidate only domestic entities (owned >= 80% ) • Which entities belong in “book income” for M-1? Mills and Plesko

  7. Consolidation starting point affects sign of M-1 difference • 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. Mills and Plesko

  8. Mills/Newberry (2000). Chart displays means, but high variance indicates inconsistent reporting. Evidence of M-1 starting point? Mills and Plesko

  9. 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 Excerpts from Enron’s “true M-1”(per JCT analysis) Mills and Plesko

  10. Limitations in current Schedule M-1 • Ambiguous starting point for net book income. • Scant detail prevents standardized comparisons. • Netting Mills and Plesko

  11. Revised Schedule M-1 (Figure 3) • 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 Mills and Plesko

  12. Benefits to improving M-1 • Improve tax administration • Benefiting compliant taxpayers • Assist tax policy analysis Mills and Plesko

  13. Burden from revised Schedule M-1? • Taxpayers already • prepare supporting schedules. • determine permanent versus temporary for GAAP financial statements • provide reconciliation for IRS exam (large-case). • Small (domestic) firms can ignore most consolidation items. • We welcome audience views. Mills and Plesko

  14. Where does the debate go from here? • 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. Mills and Plesko

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