Reconciling corporation book and tax net income, tax years 1996-1998 - Statistical Data Included

Statistics of Income Bulletin, Spring, 2002 by George A. Plesko

Income measurement for tax reporting follows a separate set of rules than that used for financial reporting. The goal of financial reporting, as outlined by the Financial Accounting Standards Board (FASB) in its 1978 Statement of Financial Accounting Concepts No. 1, is to provide external users with "information that is useful in investment and credit decisions [1]." In contrast, tax reporting is intended to facilitate the collection of revenues in an equitable and efficient manner, and tax authorities, while identified by the FASB as potential users, have the authority to require companies to supply the information necessary to administer the tax code. Further, while companies can exercise substantial discretion in applying the financial accounting rules to their businesses, the tax code generally proscribes a fixed set of rules with little room for managerial judgment.

Schedule M-1 of the Form 1120 series of corporation income tax returns requires corporations to reconcile financial reporting of book net income with tax net income. While the sources and magnitudes of the differences between financial and tax measures of income may be useful as part of the Internal Revenue Service (IRS) audit process, the differences between the two measures has also been of interest to those making tax policy. The corporate "alternative minimum tax," enacted as part of the Tax Reform Act of 1986, included as a "tax preference" item subject to that tax one-half of the difference between the amounts of income reported under each system [2]. Recently, increases in the difference between the amount of income reported under each system have raised concern that the corporate tax base may be eroding, and that corporations may have become more aggressive in reducing their tax liabilities [3]. Further, the extent and sources of differences between tax and financial reporting measures of income have been the focus of numerous academic studies evaluating the corporate tax system and corporations' responses to changes in tax rules [4].

This article presents a summary of information tabulated from Schedule M-1 and provides information on the magnitude of the various components of the differences by industrial division. These data, for active corporations other than those filing Forms 1120S, 1120-REIT, and 1120-RIC, supplement annual return data published in the Statistics of Income Bulletin and the Source Book of Statistics of Income--Corporation Income Tax Returns. Specifically, the tabulations presented here match the same group of returns published annually in Statistics of Income--Corporation Income Tax Returns. Tables are provided for 3 return years, 1996 to 1998 [5].

Sources of Book-Tax Differences

The sources of book-tax differences in the amount of income reported as earned by a corporation are based on the differences in the concepts and rules underlying each reporting system. The target audience of financial statements are investors and others who need information in order to make decisions about a company, including whether to invest in the company's equity or debt. Companies that issue publicly-traded equity or debt securities are required by the Securities and Exchange Commission to file audited financial statements. Such statements must follow Generally Accepted Accounting Principles (GAAP), which include an adherence to pronouncements of the Financial Accounting Standards Board (FASB) and other accounting standards.

Tax accounting is designed to administer the U.S. tax laws, with the IRS as the primary audience for tax filings. In contrast to GAAP in a particular area, tax rules can change frequently, depending on legislative initiatives. Further, tax rules are not necessarily designed to present as consistent a definition of income over time as financial accounting rules are, as periodic changes in the tax rules are intended to both change the level of taxes collected and encourage or discourage certain types of activities.

An important element of financial accounting is the amount of discretion left to the corporation in implementing GAAP within its business. For example, in determining the useful life and depreciation pattern of a capital asset, depreciation schedules of the same asset can vary by company, and by usage, and usually follow a straight-line pattern. Tax depreciation is dictated by the Internal Revenue Code and leaves less discretion to the company. The lack of discretion in the tax code is intended to lead to more uniform application of the tax system.

Figure A provides a copy of the Schedule M-1 reconciliation table, the specific sources of differences that are reported, and the steps needed to calculate tax net income from book net income. Differences between tax and financial measures of income can arise from two types of measurement differences in the accounting systems: temporary and permanent [6]. Temporary (timing) differences occur when tax and financial reporting each recognize the same total amount of income or expense, but do so either over different time periods or in different patterns over the same period. These timing differences can arise from the different reporting rules under each system, but also because GAAP allows managers greater discretion in determining the amounts of income and expense in each period than does the tax system.