1. 4/25/03Mills and Plesko1 Bridging the reporting gap: a proposal for more informative reconciling of book and tax income Lillian F. Mills University of Arizona George A. Plesko Massachusetts Institute of Technology April 25, 2003 Brookings Institution/UNC Conference

2. 4/25/03 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

3. 4/25/03 Mills and Plesko 3 Trends in book-tax differences

4. 4/25/03 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.

5. 4/25/03 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.

6. 4/25/03 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 returns generally consolidate only domestic entities (owned >= 80% ) Which entities belong in “book income” for M-1?

7. 4/25/03 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.

8. 4/25/03 Mills and Plesko 8 Evidence of M-1 starting point? Mills/Newberry (2000). Chart displays means, but high variance indicates inconsistent reporting.

9. 4/25/03 Mills and Plesko 9 Excerpts from Enron’s “true M-1” (per JCT analysis) 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

10. 4/25/03 Mills and Plesko 10 Limitations in current Schedule M-1 Ambiguous starting point for net book income. Scant detail prevents standardized comparisons. Netting

11. 4/25/03 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

12. 4/25/03 Mills and Plesko 12 Benefits to improving M-1 Improve tax administration  Benefiting compliant taxpayers Assist tax policy analysis

13. 4/25/03 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.

14. 4/25/03 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.