VideoIf investors had seen WorldCom's tax return the year before the telecom giant collapsed, would it have told them there was trouble brewing? You bet, say some tax experts. "WorldCom's [incorrect] capitalization of expenses would have jumped out at everybody in the difference between financial and tax numbers," argues Edward D. Kleinbard, a tax partner with Cleary, Gottleib, Steen, & Hamilton in New York.
Kleinbard is one of a growing number of tax experts who suggest that more disclosure of tax figures — and specifically the way companies reconcile those numbers with their financial statements — would help reassure investors skeptical about the accuracy of those statements.
Fueling the sense that something is amiss is the growing gap between the two sets of numbers. In 1992, there was no significant difference between pretax book income and taxable net income reported to the Internal Revenue Service, notes George Plesko, an accounting professor at the Massachusetts Institute of Technology. By 1996, according to IRS data, a $92.5 billion gap had appeared. By 1998, the gap was $159 billion — a fourth of the total taxable income reported. Couple that with revelations about differences between Enron's tax and financial reporting, and you have a strong argument for increased disclosure of book-tax discrepancies. "If people had seen numbers showing very significant differences between [Enron's] book numbers for trading and tax numbers, they would have wondered if those numbers were completely real," says Kleinbard.
That's not to say any discrepancy is a red flag. Accounting treatment under the tax code is different — often dramatically so — from that under the U.S. financial reporting regime's generally accepted accounting principles. For example, depreciation is accelerated for tax reporting, so it is higher in the early years of an asset's life than it is under U.S. generally accepted accounting principles. Even trickier, the threshold for consolidating subsidiaries under GAAP is a 50 percent equity stake — for tax purposes, it's a minimum of 80 percent. Thus, aligning the two accounting systems would not only be difficult, it may not even be desirable. But improved disclosure of the differences might shed light on problem areas. And that, proponents contend, could go a long way toward restoring confidence in the U.S. capital markets.
Consolidation of subsidiaries and stock options were the "thorniest" issues in a study of the gap between book and tax reporting that was undertaken by University of Arizona professors Lillian Mills and Kaye Newberry and IRS senior economist William B. Trautman, says Mills. Using confidential IRS tax data, the study revealed a widening gap in both income and balance-sheet reporting. In 1998, the 1,579 companies studied reported a total of almost a trillion dollars more in liabilities to the IRS than they did to the investing public. Meanwhile, tax-return assets exceeded book assets by more than $1.9 trillion.
Minding the Gap
Scrutiny of book-tax differences is nothing new. Indeed, says former IRS commissioner Margaret Milner Richardson, IRS form M-1, which requires companies to explain such differences, is usually the starting point of an audit. "Revenue agents are instructed to start with the M-1 and look at all the reconciliations when they begin an examination," she says.
Wider public interest in the gap was first piqued in July 1999, when a Treasury Department White Paper cited the growing discrepancy as possible evidence of increased tax-shelter activity.
The Enron scandal, says Kleinbard, shifted the focus of the tax-book reconciliation discussion from rooting out tax shelters to rooting out financial fraud. In an August issue of Tax Notes newsletter, he and fellow tax lawyer Peter C. Canellos, of Wachtell, Lipton, Rosen & Katz in New York, urged Congress, the Securities and Exchange Commission, and the IRS to consider requiring companies to reconcile their book and tax-income statements and balance sheets in a detailed schedule — a sort of enhanced M-1 — that would be publicly disclosed.
Efforts to calculate Enron's taxes underscore how difficult it is to determine from financial statements alone what any company has actually paid to the IRS. "It's not clear how effective current accounting rules are at providing information that allows me to really understand the tax status of a firm," says MIT's Plesko.
That challenge has given rise to a variety of proposed reforms designed to address financial-statement accuracy, tax compliance, or both. At the extreme end are suggestions that financial-statement numbers should be used for tax-return purposes, or that tax returns should be disclosed in their entirety.
Overload?
Many observers react in horror to the idea of publicly disclosing tax returns. "Some tax returns are literally six feet tall," notes University of Florida accounting professor Gary McGill. "You could have nondisclosure by information overload."
Timothy McCormally, executive director of the Tax Executives Institute, (TEI) in Washington, D.C., agrees, adding, "There are things in tax returns that competitors would love to have." Taxpayer privacy, he notes, has been a carefully protected modern right.
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