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

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

While the first set of items of Schedule M-1 capture accounting differences that lead to higher levels of tax net income than book income, at least in the near term, other aspects of tax and financial reporting will decrease tax net income. "Income recorded on books this year not included on this return" records items of book income that are not recognized as tax net income in the current year. Examples of such income include tax-exempt interest (which by definition is excluded from the calculation of tax net income, though fully recognized as income for financial accounting purposes) and income recognized as taxable in a prior period that was not considered income under GAAP, such as prepaid rent.

The final set of accounting differences reported on Schedule M-1 is the amount by which tax deductions exceed their respective charges against book income. An important element of these types of expenses is depreciation, which is itemized on Schedule M-1. For financial reporting purposes, property, plant, and equipment are generally depreciated using the straight-line method over an estimate of each asset's expected useful life, to some residual value. In calculating tax net income, corporations can use accelerated methods of depreciation following procedures given by the tax code, typically over a shorter life, and to no residual value [7]. In the near term, other things equal, such differences will lead to taxable income being less than financial accounting income as the tax deduction for depreciation will be greater than the depreciation expense charged against earnings. However, at some point, the amount of depreciation allowed for tax purposes on these assets will fall below that reported for financial accounting purposes, reversing the relation between the two measures of income. Such reversals will be reported as an "expense recorded on books this year not deducted on this return," and included in the itemization for depreciation.

Also included as a deduction not charged as an expense are the effects of the differential treatment of stock-based compensation [8]. When employees exercise non-qualified stock options, the difference between the exercise price and the market price is treated as compensation and is deductible for tax purposes. However, under GAAP, such compensation is treated as a contribution of capital to the corporation, and is not recognized as an expense.

Schedule M-1 reconciliation does not include the net operating loss deduction or other special deductions such as the deduction for dividends received as these two items are subtracted from tax net income in order to determine "income subject to tax," the actual tax base. Unlike pre-tax book income or tax net income, income subject to tax cannot be negative. The effect of these deductions will be to create a larger difference between book income and income subject to tax for companies with positive tax net income. A company's ultimate tax liability is calculated by applying the rate schedule to income subject to tax, with additional taxes potentially levied (for example by the alternative minimum tax) and offset by the use of credits (such as the foreign tax credit).