Conference on Public Disclosure of Corporate Tax Returns: Issues and Options Katherine Schipper

1. Discussion of “What Can We Infer About a Firm’s Taxable Income from its Financial Statements?”by Michele Hanlon Conference on Public Disclosure of Corporate Tax Returns: Issues and Options Katherine Schipper Financial Accounting Standards Board April 2003 The views expressed in this presentation are my own, and do not represent positions of the Financial Accounting Standards Board. Positions of the Financial Accounting Standards Board are arrived at only after extensive due process and deliberation.

2. Overview • Is this a new issue? • Why do we want to estimate taxable income from financial reports? • Is reporting taxable income consistent with the objectives of financial reporting? • Are taxable income and financial statement income reasonable benchmarks for each other? • Where are the opportunities for improvement?

3. Is this a new issue? • No, discussions of taxes (and taxable income) based on financial reports have appeared in the accounting literature for at least 20 years • Example: Stickney et al. (The Accounting Review, 1983) • General Electric used the equity method for GECC for financial reporting, consolidated GECC for taxes • Effects of tax-transfer leases in 1981 => GE paid about $350 million for tax benefits of about $500 million • GE paid about $300 million in foreign taxes, $54 million to state and local governments and received a $104 million U.S. federal tax refund • The financial reporting issue => differences in consolidation policy

4. Intent of financial reporting for income taxes • Intent of financial reporting => focus on long term after tax cash flows of the entity • Current year taxable income is not likely to be useful for this purpose • SFAS 109: As of each balance sheet date, recognize future tax obligations and benefits associated with the entity’s existing assets and liabilities • Composition of deferred tax assets and liabilities • SFAS 95: Cash taxes paid • EITF 00-15: Tax benefit from exercise of employee stock options • SFAS 109: Reconcile reported tax expense to the expense that would have resulted from applying statutory tax rate to pre-tax book income

5. Intent of financial reporting for income taxes • Presumption of financial reporting => governmental and regulatory authorities (e.g., IRS, bank regulators) can compel disclosure of information they need • Intent of financial reporting is unrelated to detection of tax evasion or the use of tax shelters • Focus of financial reporting is on temporary differences not on permanent differences

6. Taxable income and financial statement income as benchmarks for each other • Financial reporting and tax reporting are based on the same general ledger • Calculations and procedures for financial reports and tax returns are very different • Usual benchmarks for assessing earnings quality and earnings management are not derived from tax measures • Financial reporting benchmarks include cash flows and “nondiscretionary” accruals, both of which are financial reporting constructs • Should GAAP require the disclosure of taxable income? • Interest seems to be less in the number itself than in the reconciling line items

7. Where are the financial reporting problems? • Using tax arrangements to obtain financial reporting results • Recognize permanent differences now; tax effect anticipated to occur far in the future • Differences in reporting unit for taxes and financial reporting • Financial reporting consolidation => control • Tax consolidation => an election, after 80% ownership • Descriptions/detail of disaggregations and reconciliations • Management estimates • Deferred tax asset valuation reserves => a management estimate that is readily observed • Additional accrued tax expense to reflect the outcome of possible negotiations with the IRS => a management estimate that is not observed

8. Where are the opportunities for improvement? • Tax payments by jurisdiction not required by GAAP • SEC Regulation S-X rule 4-08(h) => foreign versus domestic taxes; current and deferred tax expense split among US federal, foreign and other (e.g., state and local) • Tax effects of related party transactions • Details/descriptions of disaggregations and reconciliations • Clear descriptions of specific book-tax differences • Permanent differences • Not considered a component of income taxes for financial reporting (because it has no future tax consequences). • Possible change: report financial statement impact in same year as tax effect