Will adjustments in the reporting rules on taxes help to resolve issues concerning the difference between tax- and accounting rules?

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- Will adjustments in the

reporting rules on taxes

help to resolve issues

concerning the difference

between tax- and

accounting rules? -

Bachelor thesis

Written by: Suzanne Hofstee College card number: 10026894

Deadline: July 1st, 2013, FINAL VERSION Supervisor: Conor Clune

Faculty of Economics and Business Direction Accountancy & Control University of Amsterdam

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Abstract

The purpose for writing this paper is (1) to examine the differences and connections between accounting for book and tax purposes, (2) to investigate issues within tax accounting and (3) to outline several proposals for adjusting the rules on reporting for taxes in order to solve these issues. In order to do so I conducted a literature review.

The major findings indicate that financial accounting and taxation have different purposes, which results in different rules. Because these rules are different, the taxable and book income could be different. Notwithstanding the differences between taxation and financial

accounting, they are always in some degree interdependent. Taxable income could also be different because managers, intentionally or unintentionally, use the rules incorrectly. This could be solved (1) by obligating companies to include items in their financial statement notes like the use of tax cushions, non-qualified stock options for employees and Special Purpose Entities (SPEs) or (2) by adjusting a part of the tax schedule.

Although there will probably always be differences between taxable and accounting income, adjustments in the reporting rules on taxes are expected to give more clearness on how these differences arise, and will therewith help to resolve issues concerning the differences between tax- and accounting rules. Possible future research could be done on whether it is possible and desirable to adjust the tax schedule in other countries in order to give investors more

information on how the differences between book income and taxable income arise.

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Samenvatting

De bedoeling van dit paper is om de verschillen en overeenkomsten tussen financieële administratie en boekhouding voor belasting te onderzoeken. Daarbij wordt gekeken naar problemen binnen de tax accounting en bijpassende oplossingen. Om deze problemen op te lossen heb ik een literatuuronderzoek uitgevoerd.

De belangrijkste bevindingen wijzen uit dat financieële administratie en administratie voor belasting verschillende doelen hebben en daardoor zijn er voor beide manieren verschillende regels. Doordat deze regels verschillend zijn, zijn het inkomen voor accounting en belasting vaak verschillend. Ondanks deze verschillen zijn financial accounting en tax accounting onlosmakelijk met elkaar verbonden en zijn ze onderling afhankelijk.

Het kan ook zijn dat de belastbare winst verschilt van het inkomen berekend door accounting, omdat managers, bedoeld of onbedoeld, de regels niet juist toepassen. Dit kan opgelost worden door (1) bedrijven te verplichten om bepaalde onderdelen in de notes toe te voegen, zoals het gebruiken van een belasting “kussen”, niet gekwalificeerde aandelen opties voor medewerkers en eventueel van Special Purpose Entities (SPEs) of (2) een deel van het belasting formulier aan te passen.

Ondanks dat er waarschijnlijk altijd verschillen zullen blijven bestaan tussen winst voor accounting en voor belasting doeleinden verwacht ik dat aanpassing van de regels voor het vaststellen van de verschuldigde belasting meer duidelijkheid zal geven over hoe verschillen ontstaan. Daarmee zullen naar mijn verwachting de problemen die accounting voor belasting met zich meebrengt zoveel mogelijk zijn opgelost.

In de toekomst kan er mogelijk onderzoek gedaan worden naar of het mogelijk en wenselijk is om het belasting formulier voor verschillende landen aan te passen, zodat investeerders meer informatie krijgen over hoe verschillen tussen boekhoudkundige en belastbare winst ontstaan.

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1. Introduction

Mills, Newberry and Trautman (2002) found that academic and government studies report a growing aggregate gap in the 1990s between taxable income and book income (see appendix A). This growing gap may have several sources. Several researchers have come up with possible causes like, for example, the growing use of tax shelters (Desai, 2002), the use of non-qualified stock options (Mills, Newberry, & Trautman, 2002) and methodological issues with the calculation of taxable income (Shackelford & Shevlin, 2001).

The difference between taxable income and the income for book purposes has been an important point of discussion in recent years. Possible causes of this discussion are (1) financial accounting scandals where companies reported high earnings to their shareholders while paying almost no tax (e.g. Enron, WorldCom) as well as (2) the suspected explosion of corporate tax shelters (Hanlon, 2003).

Although there may be differences between taxable income and book income, both systems for income calculation are inextricably connected to each other (Hoogendoorn, 1996; Lamb, Nobes, & Roberts, 1998).

Accounting is an evolving process and accounting standards are subject to change and development. In particular, the trend to the globalization of standards is evident in the European Commission’s acceptance of International Accounting Standards for quoted companies (Macdonald, 2002). Companies face inherently conflicting interests in their reporting for financial and tax purposes. While higher financial reporting earnings are generally viewed as favorable, higher taxable income can result in additional tax liabilities (Plesko, 2007).

Several researchers have conducted research on whether it is desirable to align tax rules and accounting rules. For example, Freedman (2004) believes that alignment between the two will bring simplicity, cut compliance costs, reduce tax avoidance and increase transparancy. Hanlon & Heitzman (2010) add to that that alignment will bring a broader tax base and a lower tax rate and management will be forced to tell the truth. Even though alignment has benefits, all researchers writing about this topic conclude that complete alignment is neither possible, nor desirable (Freedman, 2004; Alley & James, 2005; Hanlon & Heitzman, 2010).

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Alley and James (2005) state that there is a global move towards International Accounting Standards (IAS) and that this could be a reason to review the tenuous relationship between financial accounting and tax accounting. The authors state that they think that this

development could be a step towards harmonization in the tax base. However, they also state that it is suggested that the adoption of International Financial Reporting Standards (IFRS) will itself have tax consequences. This global change and the always tenuous relationship between tax accounting and financial accounting make it interesting and important to research if adjusting rules for reporting on tax would help to resolve issues concerning the differences between tax- and accounting rules. By writing this paper I hope to contribute to solving the discussion on the difference between book and taxable income.

The research question of this paper is: “will adjustments in the reporting rules on taxes help to resolve issues concerning the difference between tax- and accounting rules?” The purpose of this study is to examine the major differences between financial accounting rules and tax rules, the causes for these differences and to find out if it is desirable to change reporting rules for taxation in order to get more clearness on how these differences arise. To do so I

conducted a literature review. While conducting this research, I found that the answer to the research question is “yes”. Chapter two will outline the basic accounting rules and the basic rules for taxation. Those two types of rules will be compared in order to analyze differences between them. The third chapter outlines two ways that accounting and taxation could be connected and interdependent. The fourth chapter explains problems within taxation accounting. This chapter will suggest why income for book purposes and tax purposes are different. These differences arise because people, intentionally or unintentionally, misuse the rules. The fifth chapter will introduce some proposition to adjust the rules for taxation in order to get more clearness about book-tax differences. This chapter will be followed by a

discussion chapter and chapter seven will be the conclusion.

2. Analysis of the difference between accounting rules and tax

accounting rules

In order to understand what this paper is about, I will first explain the basics of rules in financial accounting and tax accounting. Some basic rules and settlements will be set out for both types of accounting and those will be compared.

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A. What are accounting rules? What do they measure and on what basis are they formed?

Nobes (1980) describes the history of financial accounting, the purpose of financial

accounting and on what basis accounting rules and principles are formed. The author states that accounting is an ancient art; keeping account has always been part of an ordered society. Therefore the essential purpose is to communicate relevant financial information to interested persons (Nobes, 1980). In her article on tax and accounting rules, Aisbitt (2002) states that the main reason for interest in financial statements is to assess the performance and financial position of an enterprise. The author states that accounting can be helpful in providing information for planning, control, investment appraisal and so on. Financial reporting principles are designed to provide relevant and reliable information to financial statement users, emphasizing consistency over time within a firm (Mills & Plesko, 2003). The main concerns in financial accounting are the measurement of profits and the valuation of assets (Nobes, 1980). Some ways of treating these concerns will be outlined below. The standards set for this are defined by the Accounting Standards Board (ASB) since 1990. The major responsibility the accountant has is to protect interested parties, both internal and external, from being misled (James, 2003).

I. Valuation of assets

The valuation of assets can be done through two different methods: historical cost or current cost (Nobes, 1980). Nobes explains that the first method, historical cost, relies upon

recordable facts, on the evidence of actual external transactions. The second method, the current cost method, addresses many problems which arise by relying on historical cost. The valuation base for this second method could be replacement cost, net realizable value or economic value, depending on the circumstances (Nobes, 1980). Disadvantages of this second method are that with this method it is more complicated to calculate the asset value and that it is highly subjective. The choice between these two valuation methods depends on which stakeholders require the valuation.

II. Measurement of profit

Profit can also be measured using two different methods: (1) comparing the value of the business on two different dates or (2) calculating the difference between revenues and expenses (Nobes, 1980). For the second method revenues and expenses have to be defined using concepts such as assets and liabilities.

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III. Accounting conventions

Nobes (1980) names some conventions which are important for financial accounting. Only the ones that are considered to be the most fundamental by the accounting standard on disclosure of accounting policies (Accounting Standards Committee, 1971) are disclosed in this paper. The prudence convention states that accountants should use the lowest of reasonable values for an asset and for income measurement. It is necessary for an accountant to have prudence as a “state of mind in an uncertain world in order to fulfill his responsibilities to those to whom he is providing information” (Nobes, 1980, p.15).

The objectivity convention states that reliable facts are more valuable than estimates. For stakeholders this is an attractive convention, because it provides a more certain figure which is less manipulable and less likely to suffer from bad judgment (Nobes, 1980)

The consistency convention suggests that businesses should use the same valuation method year on year for the sake of uniformity and comparability (Nobes, 1980).

The going concern convention assumes that the business will continue for the foreseeable future. Therefore the value of fixed assets doesn’t depend on what they are sold for, but on what they can contribute to the profit making of the business (Nobes, 1980).

The accruals convention states that revenues and expenses should be matched to the period they concern. It could, for example, be the case that cash is already received for a job to be done next year, so the revenue should be accounted for next year.

MacDonald (2002) states that information is useful when it has some qualities, like:

• Relevance – information is relevant for decision making, it could influence the decisions taken by decision makers.

• Reliability – information can be presented as free from error or material bias. • Substance of transaction – the substance or commercial effect of transactions

should be represented faithfully.

• Comparability – it is possible to compare information to both different entities and different periods.

• Consistency – consistency in reporting over time facilitates that information is comparable over multiple periods.

MacDonald (2002) believes that:

“The information reported needs to be understandable, so that users can perceive its significance, and finally, even if it meets all the qualitative characteristics outlined, it needs to be material, that is, its omission or misstatement could influence the economic decisions of users” (p.20).

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B. What are tax accounting rules? What do they measure and on what basis are they formed?

Tax accounting has several purposes. The main purpose of taxation is usually to raise revenue (Alley & James, 2005). For a tax system to operate successfully it requires a high degree of certainty of measurement. MacDonald (2002) states that the first criterion of a good tax system is that it achieves its objectives, of which raising revenue is the main one. The author believes that the essence of income as a tax base is that it should be comprehensive. The author states that tax law defines certain sources of income and seeks to tax the income flowing from them. The second purpose of tax accounting is to use tax as an instrument of government economic and social policy (Alley & James, 2005). Hanlon and Heitzman (2010) state that governments use tax policy to provide incentives and disincentives for businesses to engage in certain actions (e.g. investments). James (2003) names another purpose of tax accounting. The author states that the most obvious purpose of tax accounting is to finance public expenditure.

One of the main difficulties for tax law is that economic reality has to be captured (Nobes, 1980). From this I conclude that the objectivity convention is also applicable to tax

accounting.

C. Comparison of accounting rules and tax rules

I. Similarities

Alley and James (2005) state that there are several similarities between tax accounting and financial accounting. The authors mention that both ways of accounting use variables like revenue, expenditure and profit and they report on the same transactions and circumstances. I also concluded that the objectivity convention is applicable to both financial accounting and tax accounting.

II. Dissimilarities

a. Purpose

The differences between accounting income and book income are driven by a variety of factors. One of the basic ideas is that both systems have different purposes and different purposes lead to different rules (Hanlon & Heitzman, 2010). Hoogendoorn (1996) summarizes that the main purpose of tax accountants is to minimize income in order to minimize or postpone taxes to be paid, while the main accounting purpose is to maximize or

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smooth earnings to satisfy shareholders and to support the share price. Therefore financial accounting rules tend to constrain companies from overstating income. On the other hand tax rules tend to constrain companies from understating income (Mills & Plesko, 2003).

b. Framework

Hanlon and Heitzman (2010) state that financial accounting standards follow from the conceptual framework of Generally Accepted Accounting Principles (GAAP). In this framework the objective is to capture economics of transactions in order to provide useful information for decision makers. On the other hand tax rules are written under a more

political process. This implies that tax accounting rules leave less choice in the application of accounting methods than financial accounting rules (Manzon & Plesko, 2001; Aisbitt, 2002). Tax rules are more focused on the location of earnings so that the appropriate jurisdiction can tax the income (Hanlon & Heitzman, 2010). Alley and James (2005) mention that accounting involves the preparation of information for the purpose of control, stewardship and decision making, which may require recording factual information as well as interpretation of this information. Therefore financial accounting rules are based on accruals while tax accounting relies on rules that are more transactions-based. Tax accounting needs a high degree of certainty of measurement, which may not always be appropriate for financial and commercial accounting (Alley & James, 2005).

c. Concept of income

Alley and James (2005) state that tax rules and financial accounting rules differ, because it is difficult to define the concept of income. Both ways of accounting attempt to measure

income, but there is no accurate and clear definition for it. To illustrate the difference between tax income and accounting income Holmes (1999) introduced the concept of the income pyramid. This pyramid contains four layers as showed in figure 1. Starting at the bottom; the economic concept of income concerns all unrealized value changes, consumption expenditure and physic income. The accounting concept contains market transactions, realized gains and selected unrealized gains. The economists’ deviations include periodicity, productivity and permanence. The legal concept concerns inflow periodicity, product of labor or property realization separate from the source, profit making purpose or motive, ordinary meaning and convertible monetary benefits (Holmes, 1999). As can be seen from the figure and the layers described above, the concept of income becomes narrower when going from the bottom to the top of the pyramid. Holmes (1999) states that the concepts of income for tax purposes and accounting purposes belong in different layers of this pyramid: the tax concept of income

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belongs in the legal concept while the accounting concept of income belongs in the accounting concept. This different approach of income can also be seen as a source of difference between tax rules and financial accounting rules.

Figure 1 Income pyramid

Source: Holmes (1999, p.205)

d. Allowable deductions

MacDonald (2002) explains that a clear distinction should be made between expenditures for the cost of earning income and expenditures that represent consumption. The commonly used criterion to separate the two is that expenditures wholly and exclusively incurred for the purpose of the trade are viewed as the cost of earning income; the rest is viewed as consumption. Some expenditures are tax deductible, others are not, but expenditures are always reported in financial accounting. This could cause a permanent difference between book income and income calculated for tax purposes. In my opinion governments allow for several deductions to stimulate companies in continuing their business.

e. Consolidation issues

Hanlon (2003) points out that the rules for consolidation of entities is different for book purposes than for tax purposes. The author states that for financial accounting purposes an entity is required to be consolidated if an entity controls another entity. For tax purposes, accounting rules for consolidation differ per country. In the USA foreign subsidiaries are not included, but domestic subsidiaries in which an entity has at least eighty percent in terms of voting power and value could be consolidated, but this is not required. These differences in consolidation rules also cause a permanent difference between book income and taxable income.

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f. Other issues

Another source of difference between tax rules and financial accounting rules is that both sets of rules are in continual development, but not at the same time, with the same rate and in the same direction (Alley & James, 2005). Also, there could be a difference in timing of revenue and/or expense recognition, but mostly this will net zero over time (Manzon & Plesko, 2001). This is called a temporary difference. The authors also state that permanent differences can arise because a revenue or expense is recognized under one system but not the other (e.g. amortization of goodwill or loss carry forward).

Conclusion

This chapter outlined some of the differences between income for financial accounting purposes and tax purposes. Differences discussed in this chapter arise because the purposes for both systems are different, which results in different rules. Examples of items that cause differences are: a different framework, a different concept of income, allowable deductions and consolidation issues. Another issue named is that tax rules and financial accounting rules are changing continuously, but not at the same time, with the same rate and in the same direction. Also, permanent differences can arise because a revenue or expense is recognized under one system, but not the other. Other sources of difference will be described in chapter four, those kinds of differences arise due to “aggressive reporting” for book and tax purposes, also called tax avoidance.

3. How are accounting and taxation connected?

This chapter will explain how accounting and taxation are connected. Although there are differences between tax accounting rules and financial accounting rules, several researchers state that the two sets of rules are always in some way connected and have a certain degree of interdependency. These classifications of interdependency will be discussed below.

A. Classification by Hoogendoorn

Hoogendoorn (1996) researched to what degree accounting rules and tax rules are connected. He divided groups of countries on the basis of (1) how mutual dependent financial accounting rules and tax accounting rules are and (2) how specific the rules on deferred taxation are. He states that the relationship between accounting and taxation is sensitive and changing. The author also states that mutual dependence of accounting and taxation makes it difficult or even impossible to achieve both profit maximization and tax minimization at the same time.

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Dependence was often seen as the main obstacle to harmonization in accounting. Because the value of shareholders concepts and corporate governance discussions increased over time, the relationship between accounting and taxation became looser (Hoogendoorn, 1996).

Hoogendoorn (1996) describes two differently structured relationships: “dependence” and “independence”. He states that “independence” means that

…income determination for accounting purposes is independent from income determination for tax purposes.… However, even in an independence structure, there is of course never a complete independence between accounting and taxation. Accounting rules may influence the rules for taxation and the rules for taxation may be applied voluntary for accounting purposes, especially by small companies. (p.785)

Hoogendoorn (1996) states that the main characteristic of an independent structure is the freedom companies have to apply different accounting policies in tax and commercial accounts. The author defines the other structure, “dependence”, as a structure where:

…the commercial accounts follow the tax rules, or that income determination for tax purposes is determined by the choices made in commercial accounts. …. Normally, dependence only exists in individual accounts. Group accounts are formally not (directly) influenced by tax rules, but companies may choose to apply the same accounting policies in individual and in group accounts. (p.785)

During his research in European countries, Hoogendoorn (1996) found out that there is a clear development from dependent to a more independent structure. In his conclusion he divides seven groups of countries with (1) different degrees of dependency between tax accounting rules and financial accounting rules and (2) a different degree of specificity of regulation on deferred taxation. Countries belonging to every group are given in brackets.

1. There is great dependence between tax rules and financial accounting rules and this is not expected to change. There is little or no regulation on accounting for deferred taxation. (Belgium, Italy)

2. There is great dependence between tax rules and financial accounting rules and this is not expected to change. There is some regulation on accounting for deferred taxation. (France, Germany)

3. There is a dependent structure which is clearly developing towards an independent structure. There is no strict regulation on accounting for deferred taxation. (Finland and Sweden)

4. Formally accounting and taxation are independent, but there is still a tight link between the two. There is no strict regulation on accounting for deferred taxation. (Czech Republic, Poland)

5. Accounting and taxation are independent. Regulation on accounting for deferred taxation is stricter, but allows some alternatives. (Denmark)

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6. Accounting and taxation are independent and there is strict regulation on accounting for deferred taxation. (Ireland, United Kingdom)

7. Accounting and taxation are independent and there is strict regulation on accounting for deferred taxation which is very similar to the rules given by the International Accounting Standards Committee (IASC). (the Netherlands, Norway) Hoogendoorn (1996) states that the lack of harmonization between accounting and taxation is surprising. He expects a development towards a more harmonized way of accounting along with the lines of IASC E49, which is a standard about income taxes. This standard requires recognition of all deferred tax liabilities. However, this will be different for all countries in his research. He expects this change to work out in five to ten years from when his article was written, so that must be between 2006 and 2011. There is no new article written yet on the degree of dependency between taxation and accounting.

B. Classification by Lamb et al.

Lamb, Nobes and Roberts (1998) assess the degree of connection between financial reporting rules and practices and taxation rules and practices. They critique the article written by

Hoogendoorn (1996) by stating that his article gives equal weight to two very different issues: accounting for deferred taxation and the connection between financial and tax reporting. In their article Lamb et al. (1998) aim to systematically approach the international variations between tax and financial reporting.

Lamb et al. (1998) distinguish five cases of linkage between tax and financial reporting: I. Disconnection – taxation and reporting rules are independent; they follow their own

different purposes.

II. Identity – there is some accordance between (some) specific tax and financial reporting rules.

III. Accounting leads – financial reporting rules are followed for both financial reporting purposes and tax reporting purposes.

IV. Tax leads – tax rules are followed for both tax reporting purposes and financial reporting purposes.

V. Tax dominates – tax rules are followed for both financial reporting purposes and tax reporting purposes instead of a conflicting financial reporting rule.

These five cases of connection are applied to several so called “arenas of financial reporting” for four different countries: the United Kingdom (UK), the United States of America (USA),

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France and Germany. The original table with arenas and classifications is included in appendix B. From the figure with the results Lamb et al. (1998) it can be concluded that the UK and the USA follow case I and II in most of the arenas. France follows case II, III and IV in a circa equal number of arenas while Germany mostly applies case III and IV.

C. Comparison of the two classifications

A similarity between the two ways of classification is that they try to examine the same issue: the degree of connection between financial and tax reporting, but they use different

approaches. However, there are also differences between the two classifications.

I. Approach

Hoogendoorn (1996) takes a more general approach; he researches thirteen different European countries, while Lamb et al. (1998) take a more specific approach by researching four

different countries all over the world with fifteen different arenas.

Where the research of Hoogendoorn (1996) lacks broadness of the use of arenas, the research of Lamb et al. (1998) lacks the diversity of countries they researched to label their research “international”. Hoogendoorn (1996) used one arena; accounting for deferred taxation while Lamb et al. (1998) used fifteen different arenas. Hoogendoorn (1996) researched most European countries while Lamb at al. researched three countries in Europe and the USA. To make their research more international they should research several countries from all continents, like Oceania, South-America, Africa and Asia.

II. Results

The results found in the research by Lamb et al. (1998) do not differ that much from the results Hoogendoorn (1996) found concerning their opinion on the degree of connection in Germany and France. Lamb et al. (1998) conclude from their research that France and Germany are a bit different; France follows case II, III and IV in an approximately equal amount of arenas, which means that in France sometimes tax leads, sometimes accounting leads and sometimes financial and tax reporting rules are in accordance with each other. Germany mostly follows cases III and IV, which means that sometimes accounting leads and sometimes tax leads. From this I conclude that there is a high degree of dependency in these two countries between tax and financial reporting rules. Hoogendoorn (1996) places Germany and France together in the group where accounting and taxation are dependent and this is not expected to change.

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The reader has to keep in mind that both these articles are more than ten years old. As

Hoogendoorn (1996) states: The relationship between accounting and taxation is sensitive and changing, so since the time the articles were written a lot could have changed in this

relationship. Conclusion

This chapter answered the question how accounting and taxation rules are connected. Concluding from the classifications provided by Hoogendoorn and by Lamb et al. there are different ways how accounting rules and tax rules are connected, but they cannot be seen as completely independent. Alley and James (2005) believe that: “There are different levels of dependency within countries and no country is able to avoid the difficult relationship between accounting and taxation” (p.2).

4. Problems within taxation accounting

The issues with taxation accounting addressed in chapter two have to do with differences because the purposes of tax accounting and financial accounting are different, which causes the rules for both to be different. The issues addressed in this chapter have to do with differences between taxable and book income because of tax avoidance.

A. Tax avoidance

According to Hanlon and Heitzman (2010) there is no generally accepted definition for tax avoidance; it means different things to different people. In their paper Hanlon and Heitzman define tax avoidance as the reduction of explicit taxes. The theory of tax avoidance that Hanlon and Heitzman cite has a lot to do with the agency theory, but is not in and of itself a reflection of agency problems. However, the agency theory is a useful framework for

researching tax avoidance. Hanlon and Heitzman (2010) explain the agency theory as follows: “the separation of ownership and control implies that if tax avoidance is a worthwhile activity, then the owners ought to structure appropriate incentives to ensure that managers make tax-efficient decisions” (p.138). The owners have to do so, because they want the managers of the company to act in their interest. Tax avoidance is usually measured by looking at financial statements, because this is the only publicly available source (Hanlon & Heitzman, 2010).

I. Determinants for tax avoidance

An important issue due to the growing research on tax avoidance is how to measure tax avoidance and how to interpret the results. Hanlon and Heitzman (2010) identify several

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determinants of tax avoidance. The first determinants means that firms are more likely to engage in tax avoidance (1) when tax avoidance activities create value and (2) if

compensation schemes for managers are performance based. The second determinant is ownership structure. For example, small family businesses with concentrated ownership tend to engage more in tax avoidance, they benefit more from the savings, but this is not always the case (Hanlon & Heitzman, 2010).

II. Tax shelters

Desai (2002) believes that firms are faced with greater opportunities for avoiding corporate taxes through less transparent, more sophisticated mechanisms. He also claims that sheltering became less costly through either perceived lower penalties or lower probabilities of

detection, and firms became more aggressive in tax accounting during the 1990s (which can be seen in the graph included in appendix A). One of the sophisticated mechanisms is the use of tax shelters. Tax shelters are single transactions that capture tax avoidance behavior, but may not capture all tax avoidance (Hanlon & Heitzman, 2010). Shackelford and Shevlin (2001) state that “shelters create tax savings by repackaging ownership rights among

investors” (p.340). However, the firms included in tax shelter research only include firms that were caught and charged for tax evasion or firms that disclosed the shelter under recent disclosure rules for certain transactions. Firms accused of using tax shelters have larger book-tax differences, more foreign operations, subsidiaries in book-tax havens, higher prior-year

effective tax rates, greater litigation losses, and less leverage (Wilson, 2009). Typical tax shelters leave average tax rates unaffected, but reduce both income and taxes (Desai, 2002). Manzon and Plesko (2001) state that “a well-designed shelter may well reduce taxable income while leaving income reported for financial purposes undiminished” (p.10). Desai (2002) believes that increased levels of sheltering will be reflected in a flattening relationship between tax income and book income.

III. Over-or underestimation

Hanlon (2003) believes that the most problematic issue within tax accounting is the under-or overestimation of actual tax liabilities. Under-or overestimation can be done by issuing stock options for employees, use of a tax cushion or intraperiod tax allocation, which will be discussed below.

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a. Employee stock options

Accounting for the benefits of employee stock options often result in the tax expense being overstated relative to the actual liability (Hanlon, 2003). This means that more taxes are paid, but probably the received tax deduction in some future year is higher, which is in the benefit of the firm. The firm can obtain a tax deduction in the exercise year, but never recognizes compensation expense for the purpose of financial reporting (Hanlon, 2003). Hanlon and Shevlin (2002) give a clear explanation on how nonqualified stock options (NQOs) for

employees work; little book expense is recorded for stock options, but the company receives a tax deduction once the employee exercises the stock option. The deduction is the same value as the difference between the option price on the date of exercise and the fair market value of the stock. The benefit of the deduction will not be recorded as a tax expense, but will be treated as an counterbalance to the stock transaction in shareholders’ equity (Mills, Newberry, & Trautman, 2002). However, Hanlon (2003) claims, complexity arise when firms have net operating losses. In this case the stock option note is a better source of information to estimate the deduction.

b. Tax cushion

Another way to overestimate the tax liability, defined by Hanlon (2003) is the use of a tax “cushion”. When a firm takes an aggressive position in reporting for taxes and it wants to deduct an amount that it thinks will maybe not stand up to future inspection by the tax authority, it can add an additional amount on its financial statement to reflect this liability (Hanlon, 2003). The author explains that a tax “cushion” serves as a kind of reserve which is booked as a current tax expense because there is no deferred liability or asset to which it relates. So a tax cushion means that you add an additional amount to the current tax liability so that you can deduct a larger amount later, which is in the benefit of the firm.

c. Intraperiod tax allocation

The third and last way Hanlon (2003) defines as a way to overestimate the tax liability is the use of intraperiod tax allocation. She explains that according to the Financial Accounting Standards (FAS) income tax expense should be allocated to three categories; continuing operations, discontinued operations and extraordinary items. This means that the current tax expense is not the expense on all types of earnings, but only on the continuing operations, so discontinued operations and extraordinary items are reported without their tax effects.

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B. Methodological issues

The previous part of this chapter described issues due to the intentional misuse of differences in tax rules and financial accounting rules. This part of the chapter will focus on potential, unintended, mistakes in calculating taxable income. Shackelford and Shevlin (2001) define six methodological issues that tax researchers face. Those will be outlined below.

• Estimating marginal tax rates – tax research requires a marginal tax estimate, but these estimates are not always appropriate, because tax rates that reflect the company’s past tax status are used to anticipate the future tax status.

• Self-selection bias – self-selection becomes a problem when the tax researcher is interested in the effects of this selection on another decision variable.

• Specifying tradeoff models – a researcher may want to find out the tradeoff companies make between taxes and other non-tax costs and benefits. This can only be estimated by regression analysis.

• Changes versus levels approach – the changes approach resolves some issues with the levels approach, because, firstly, levels studies may mistakenly conclude that taxes don’t affect capital structure decisions. Secondly, the changes approach circumvents a downward bias on the regression coefficient, so issues arise when the levels approach is taken.

• Tax burdens and implicit taxes – implicit taxes are said to be pervasive, so it is important that they are merged in measures of the total tax burden.

• Confidential data – this type of data is not always publicly available, so they are hard to obtain.

There also are problems with the grossing up method for calculating taxable income, even when the current tax expense is a reasonable approximation of the actual tax expense (Hanlon, 2003). The first issue Hanlon (2003) describes is that the current tax expense is the expense after tax credits. This means that the computation of taxable income can only be correct if there is a book-tax difference of the same amount. The second issue Hanlon (2003) names is that the gross-up is usually done with the highest tax rate, which is not always the best estimate. The third and final issue Hanlon (2003) addresses is that for firms that have tax losses the taxable income will be truncated at zero.

C. Other issues

Mills and Plesko (2003) state that tax foot notes in financial statements provide insufficient detailed information for (1) precisely determining taxable income or (2) to understand in what

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authority book-tax differences arise. They also believe that vague instructions for filling out tax forms for companies complicate the job of the tax authority, because they have to resolve the beginning point of the tax schedule for entity differences first. After that they can start to consider the differences in income measurement between book and tax.

Conclusion

The differences between taxable income and accounting income discussed in this chapter arise because people misuse the differences in tax rules and accounting rules, intentionally or unintentionally. Aspects of tax avoidance are discussed like tax shelters and under- or

overestimation of income due to the use of stock options for employees, the use of a tax cushion and intraperiod tax allocation. Other issues discussed in this chapter are issues with calculating taxable income and methodological issues, like estimation of the appropriate tax rate, implicit taxes, the use of confidential data and issues with the grossing-up method of calculating taxable income.

5. How could tax reporting rules be adjusted?

Several researchers have proposed a way to get more clearness on how differences between taxable income and accounting income arise. Hanlon (2003) calls for the inclusion of some items in the notes to financial statements, outlined in part A of this chapter. MacDonald (2002) outlines a new approach to the relationship between taxation and accounting. Mills and Plesko (2003) proposed an adjusted part of the tax schedule used in the USA. The original part of the tax schedule can be found in appendix C and the proposed adjusted part of the tax schedule is included in appendix D.

A. Proposals for tax schedule adjustments

Hanlon (2003) states that there have been several proposals for correcting problems that arise from insufficient tax disclosures and she also believes that there is a simple solution for this. The author believes that that solution may be to provide a settlement of the cash paid for taxes. Now this is often disclosed in the cash flow statements or the notes added to that in order to reflect the current tax expense as conveyed. Hanlon (2003) states this simple solution would “at least provide disclosure of the items that cause the current tax expense to be

different than the cash taxes paid” (p.37). She suggests that the following items should also be included in this reconciliation:

1. Book-tax differences due to stock option deductions

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2. Book-tax differences related to the tax “cushion” 3. The amounts of intraperiod tax allocation 4. Differences due to the timing of tax payments 5. Special Purpose Entity (SPE) issues (if necessary)

While Hanlon (2003) believes that not all firms are willing to provide all this information, she believes that this additional disclosure would be “a useful start to provide financial statement users with more information regarding the tax liabilities and taxable income of the firm” (p.37).

MacDonald (2002) states that: “to align taxation completely with accounting principles and practice would be to require compliance with both accounting principles and accounting standards by all businesses” (p.45). The author believes the rules have to be “robust enough to cover all business situations without detailing every conceivable case” (p.46) in order to be able to legislate accounting principles and practice for tax purposes. This legislation should define the boundaries of what accounting practice is acceptable for tax purposes. MacDonald (2002) sets out a possible future approach for legislative recognition of the relationship between tax and accounting:

• The gains and losses in an accounting period of a firm should be calculated by accounting for past transactions under the historic cost convention in accordance with the transaction consideration, without regard to the date of receipt or

payment.

• Transactions should be recognized in an accounting period under “normal

accounting practice”. MacDonald (2002) defines normal accounting practice as the normal accounting practice in relation to the accounts of incorporated businesses, applied to the consolidated group accounts.

• Transactions should be recognized on the assumption that the business is a going concern.

• Gains from transactions should be recognized in the accounting period when they are regarded as realized in accordance with normal accounting practice.

• Losses from future transactions can only be accounted for if they can be matched with transactions or periods that have already been recognized.

• Adjustments for losses and gains due to accounting policy change should be recognized in the period when the changes are first applied.

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• Adjustments can only be done for corrections of errors, not when “errors” include normal recurring adjustments or corrections of estimates.

• Adjustments of provisions arising from the revaluation of assets and liabilities should not be included as a gain or loss when they are not based on transaction consideration.

• The valuation of work-in-progress and stock should be viewed as a policy of accounting governing the recognition of transactions in an accounting period. Also, where assets have become of negligible value, the loss should be accounted for in the period in which this claim is made.

• Transactions between the business and its owners should be accounted for based on their fair value rather than their transaction value.

• The tax collector may specify which accounting standards should be regarded as normal accounting practice for tax purposes.

By lining this out, MacDonald (2002) has limited the tax base to transactions. He believes that the historic cost measurement and the transaction base provide the objectivity needed for a tax system. This proposed legislation is setting out the accounting policies applicable to tax accounting.

Mills and Plesko (2003) state that the current tax form used in the USA does not provide sufficient detailed information for existing financial statement users about book-tax

atonements to perform analysis and evaluate compliance risks. That is why they introduced an adjusted tax form for the USA which I think could also be used in other counties than the USA. They believe that “increased reporting of book-tax differences within the tax return system would assist current users of tax return information, including tax policy analysts, and other government users …” (p.40). They also believe that investors and the general public will be better assisted in assessing the effects of the corporate tax system and in assessing performance of publicly traded companies, if this additional information is made public. Mills and Plesko (2003) assert that: “making (more detailed) [tax] data public should not impose unreasonable costs on taxpayers. First, tax payers are already computing detailed

reconciliations to complete the current [tax schedule] and tax disclosures required by SFAS No. 109” (p.40). The new tax schedule Mills and Plesko propose is included in appendix D. Mills and Plesko (2003) believe that the additional lines in the tax schedule will not

significantly increase compliance costs related to tax return. They state that “if audited, firms 23

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already provide most, if not all, of the additional detail we recommend in the revised [tax schedule]” (p.37). Notwithstanding, they believe that the new proposed tax schedule will not be applicable for small, domestic companies, because for financial reporting likely the same as for tax reporting. Compliance costs are expected to be highest for medium-sized

companies, because they are expected by Mills and Plesko (2003) to have complex corporate structures that apply sophisticated tax planning. Therefore they think that the revised tax schedule should be most easily to implement publicly traded companies. The authors state that public disclosure of this modified tax schedule is not expected to pose substantial problems from a privacy point of view; from either competitiveness or regulatory perspectives.

B. Consequences of more alignment

Concluding from what Hanlon (2003) wrote, she advocates including several items in the notes to the financial statements. Consequences for this are that companies will have to do more paperwork. Some companies will provide resistance, because there may be information in those items that the company doesn’t want to be public. Hanlon (2003) is not being very specific on how and where she wants companies to include the items she set out, so I think she leaves much room for interpretation. Still I think that she has a point. I think that making items like book-tax differences related to the use of tax cushions and SPEs publicly available will keep companies from misusing the difference between tax rules and accounting rules for the purpose of tax avoidance. As Hanlon (2003) already stated, she believes that this

additional disclosure would be “a useful start to provide financial statement users with more information regarding the tax liabilities and taxable income of the firm” (p.37).

MacDonald (2002) has lined out a way so that the tax base is limited to transactions. By doing so he applies accounting policies to tax accounting. It synthesizes the way of thinking about accounting rules and tax rules in a way, but MacDonald is not being very specific on how he wants this new way of thinking to come into practice. Therefore I can’t include anything about the consequences of this adjustment.

Mills and Plesko (2003) are being much more specific in how they think firms should provide more information the government and tax policy analysts. Their part of the original tax

schedule is included in appendix C while the proposed new tax schedule is included in

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appendix D. Compliance costs, privacy issues and data consistency are not expected to be a problem (Mills & Plesko, 2003).

The old tax schedule part that Mills and Plesko want to change consists of ten lines. Their new proposed part of the tax schedule consists of thirty lines and shows little strict overlap with the current schedule. The proposed schedule is split up in two parts: asset reconciliation and reconciling book income to tax income. It is a major difference that the second part of the proposed schedule is starting from book income and then adjusts that to obtain taxable

income. In my opinion the original tax schedule uses vague terms while the new proposed schedule is much more specific, it provides much more detail. Some items from the original schedule are split in the new proposed schedule. For example “expenses recorded on books this year not deducted on this return” is split out in permanent differences and temporary differences. Permanent differences is itemized in travel and entertainment, goodwill and/or intangible amortization and stock option expense. Temporary differences are also itemized. The original tax schedule didn’t split these items out that specific, only travel and

entertainment was named for this part. This example shows that the new proposed tax

schedule gives much more information on which amounts are and included in taxable income and which are not. Thus the new proposed tax schedule gives much more information on how differences between book income and taxable income arise. Mills and Plesko (2003) state that this new proposed schedule will not give companies more work, because all the amounts that have to be filled in are already available. Taxable income has to be calculated anyway, but these amounts are not explicit in the original tax schedule, so this proposal for adjustment is not expected to have significant consequences.

Conclusion

In this chapter three kinds of adjustments of tax reporting have been outlined in order to give more clearness on how differences between taxable income and book income arise. Hanlon (2003) proposes to include some additional items in the notes to financial statements, MacDonald (2002) proposes a new way of looking at accounting for taxes, he wants to limit reporting for taxes to transactions, and Mills and Plesko (2003) introduce an adjusted part of the USA tax schedule. I think that MacDonald’s proposal is not very useful, because it is vague. I think that Hanlon’s proposal could be useful, but maybe some stricter guidelines are needed. Mills and Plesko leave no further room for interpretation and I think that this is just what tax schedules need.

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6. Discussion

The main question to be answered in this thesis is: “will adjustments in the reporting rules on taxes help to resolve issues concerning the differences between tax rules and accounting rules?” I conclude that the answer to main question is “yes”. In order to come to that conclusion I conducted a literature review. While doing so I explained how differences between tax income and book income arise, how taxation and accounting are connected, what the problems within taxation accounting are and I outlined proposals for adjustments on the rules for reporting on taxes.

Both Hoogendoorn and Lamb, Nobes and Roberts have found that accounting and taxation are always connected in some way. As Alley & James state: both ways of accounting use variables like revenue, expenditure and profit. Also they are reporting on the same transactions and circumstances. The authors believe that: “There are different levels of

dependency within countries and no country is able to avoid the difficult relationship between accounting and taxation” (p.2). Therefore this relationship has to be taken into account always when considering either of these two ways of accounting.

I found that reporting rules for taxes can be adjusted in several ways. The new tax schedule that Mills and Plesko (2003) introduced provides more detail than the original part of the tax schedule they want to adjust. It gives more clearness on what causes differences between taxable and accounting income, it leaves no room for interpretation. Besides that, with a detailed tax schedule like this, I think that a “vague instruction” for filling out the tax form is no longer needed, because the lines will probably speak for themselves. This will also

facilitate calculation issues identified by Hanlon. Also, an estimation of the appropriate tax rate will not be necessary. Likewise, footnotes will not be as important as they are now, because much more detail is provided in the statements itself, if made publicly available. The tax authority will also have a less complicated job, because they can see straight away if taxable income is calculated correctly. Also the costs associated with this proposal are

expected to be low. Companies will have to fill in more numbers, but the numbers are already available because these numbers are needed to calculate taxable income. As Nobes (1980) states: certainty of measurement is very important for taxation; taxation relies on transaction based accounting rules, on precise, verifiable transactions. From this I conclude that the

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adjustment of the tax schedule could help to resolve issues concerning the differences between accounting income and taxable income.

Hanlon (2003) calls for the inclusion of several items in the notes to financial statements, like book-tax differences due to stock option deductions, tax cushions and intraperiod tax

allocation. Hanlon (2003) claims that this would be “a useful start to provide financial statement users with more information regarding the tax liabilities and taxable income of the firm” (p.2), but I couldn’t find other articles confirming or denying that. By making it obligatory to include these items in the notes to financial statements, I think this will bring more clearness on what companies do and keep them from engaging in fraudulent activities like avoiding taxes. At least companies will have to insert more effort to hide fraudulent activities. I expect Hanlon’s proposal to solve issues concerning tax shelters, non-qualified stock options and tax cushions. Her proposal will bring more clearness, under the condition that these notes are made publicly available.

Because MacDonald is not being very specific on how he wants the tax reporting rules to change, so his contribution to a solution to the issues concerning book-tax differences is not very significant. I can’t really match specific issues I identified in chapter four to his solution. I think that MacDonald’s proposal relates more to the differences identified in chapter two. His proposal is more in favor of alignment of taxation and accounting rules, which is already said to be unfavorable in the introduction.

7. Conclusion

The growing gap between taxable income and book income is found to be increased in the 1990s and last few years. This growing gap has been an important point of discussion, possibly due to financial accounting scandals. Therefore there is a call for more clearness on the differences between book income and taxable income. In this thesis I tried to answer the question: “will adjustments in the reporting rules on taxes help to resolve issues concerning the differences between tax rules and accounting rules?” I found that the answer to this

question is “yes”. I conducted a literature review in order to come to this conclusion. In order to understand what this research is about I first examined what the taxation rules and

accounting rules are. I compared those two in order to identify how differences between book and taxable income could arise and I figured out how the two ways of accounting are

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connected. Then I identified the problems within taxation accounting and I outlined proposals for adjustments on the rules for reporting on taxes and their consequences.

Differences between income for tax purposes and for accounting purposes can arise in two ways. The first way is because taxation and accounting serve different purposes resulting in different rules. The second way is that people, intentionally or unintentionally, misuse these differences in rules. In general managers will try to minimize tax income in order to avoid or postpone taxes. On the other hand managers will try to increase or smooth accounting income. However, the link between taxation and accounting cannot be denied, they are always in some way interdependent.

Managers could misuse the differences between financial accounting rules and taxation rules, for example, to avoid taxes. This can be done through several ways. Firstly, managers could use tax shelters, where tax savings are created by repacking ownership rights among

investors. Secondly, managers could overestimate accounting income while underestimating income for tax purposes. This can be done (1) through the use of non-qualified stock options for employees (when the company gets a tax deduction once the option is exercised), (2) through the use of a tax cushion (a tax expense that serves as a kind of reserve), or (3) through intraperiod tax allocation (when discontinued operations and extraordinary items are reported without their tax effects). Thirdly, there are some difficulties in calculating taxable income, like the estimation of the appropriate interest rate and implementing book-tax differences in these estimations. Fourthly some other methodological issues are identified, like implicit taxes, the use of confidential data and tradeoff model specification. A fifth issue is that notes to financial statements provide insufficient detail to understand book-tax differences and sixth, the instructions for filling out the tax form are said to be vague.

Several solutions are provided in literature that could help resolving the issues named above. Hanlon proposed that companies should compulsory include items in the notes to their financial statements like book-tax differences due to stock option deductions, the tax

“cushion”, the amounts of intraperiod tax allocation and differences due to the timing of tax payments. If necessary, information can also be included on issues related to the use of Special Purpose Entities (SPEs). By obliging companies to include this kind of information, I think companies will keep away from using stock options and SPEs in order to avoid taxes, because it will be noticed. Another proposal, the adjusted part of the tax schedule, could give

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more clearness on how the differences between book and taxable income arise. By introducing the more detailed tax schedule, it will be clear what numbers are required to calculate taxable income and a vague instruction on how to fill out the tax form will probably become superfluous. Because this tax schedule starts with book income and adjusts this to get taxable income, I don’t think it is necessary to work with an estimated tax rate, because this tax schedule relies on verifiable facts.

Possible future research could be done on whether it is possible and desirable to adjust the tax schedule in other countries in order to give investors more information on how the differences between book income and taxable income arise.

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8. Bibliography

Accounting Standards Committee (ASC) (1971). Accounting Standard on Disclosure of Accounting Policies. London: Accountancy Bodies.

Aisbitt, S. (2002). Tax and Accounting Rules: Some Recent Developments. European Business Review, 14(2), 92-97.

Alley, C., & James, S. (2005). The Interface Between Financial Accounting and Tax

Accounting: A Summary of Current Research. University of Waikoto, Department of Accounting. Hamilton: University of Waikoto.

Desai, M. (2002). The Corporate Profit Base, Tax Sheltering Activity, and the Changing Nature of Employee Compensation. Boston: Harvard University.

Freedman, J. (2004). Aligning Taxable Profits and Accounting Profits: Accounting Standards, Legislators and Judges. eJournal of Tax Research, 2(1), 71-99.

Hanlon, M. (2003). What Can We Infer About a Firm's Taxable Income from its Financial Statements. Michigan: University of Michigan Business School.

Hanlon, M., & Heitzman, S. (2010). A Review of Tax Research. Journal of Accounting and Economics, 50, 127-178.

Hanlon, M., & Shevlin, T. (2002). Accounting for Tax Benefits of Employee Stock Options and Implications for Research. Accounting Horizons 16, 1-16.

Holmes, K. (1999). The Concept of Income - A New Zealand Analysis. Wellington: Victoria University .

Hoogendoorn, M. (1996). Accounting and taxation in Europe - a comparative overview. Accounting review, 5, Supplement, 783-94.

James, S. (2003). The Relationship Between Accounting and Taxation. Exeter: University of Exeter.

Lamb, M., Nobes, C., & Roberts, A. (1998). International Variations in the Connections Between Tax and Financial Reporting. Accounting and Business Research, 28(3), 173-188.

Macdonald, G. (2002). The Taxation of Business Income: Aligning Taxable Income with Accounting Income. The Institution for Fiscal Studies. London: Tax Law Review Committee.

Manzon, G., & Plesko, G. (2001). The Relationship Between Financial and Tax Reporting Measures of Income. Cambridge: MIT Sloan School of Management.

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Mills, L., & Plesko, G. (2003). Bridging the Reporting Gap: A Proposal for More Informative Reconciling of Book and Tax Income. Massachusetts: MIT Sloan School of

Management.

Mills, L., Newberry, K., & Trautman, W. (2002). Trends in Book-Tax Income and Balance Sheet Differences. Tucson: University of Arizona.

Nobes, C. (1980). Introduction to Financial Accounting. London: George Allen & Unwin. Plesko, G. (2007). Estimates of the Magnitude of Financial and Tax Reporting Conflicts.

Cambridge: National Bureau of Economic Research.

Shackelford, D., & Shevlin, T. (2001). Emperical Tax Research in Accounting. Journal of Accounting and Economics, 31, 321-387.

Wilson, R. (2009). An examination of corporate tax shelter participants. The accounting review 84, 195-231.

APPENDIX A – Growing gap between book income and taxable income

Source: Manzon and Plesko (2001)

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APPENDIX B – Lamb et al. research connection between financial and tax

accounting

Source: Lamb, Nobes, & Roberts, 1998

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APPENDIX C - Original M-1 (tax) schedule

1. Net income (loss) per books

7. Income recorded on books this year not

included on this return

2. Federal income tax per books Tax-exempt interest 3. Excess of capital losses over capital

gains

8. Deductions on this return not charged against book income this year 4. Income subject to tax not recorded on

books this year a. Depreciation

5. Expenses recorded on books this year

not deducted on this return b. Charitable contributions

a. Depreciation 9. Add lines 7 and 8

b. Charitable contributions 10. Income: add line 6 and 9

c. Travel and entertainment

6. Add lines 1 through 5

Adapted from Mills and Plesko (2003)

APPENDIX D - Mills and Plesko: proposed new tax schedule

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Source: Mills and Plesko (2003)

Will adjustments in the reporting rules on taxes help to resolve issues concerning the difference between tax- and accounting rules?