Taxable income and analysis

By Suzanne Landry and Nadi Chlala
Illustration: Steve Adams

It can be a useful element to assess the quality of earnings reported by listed entities

The financial scandals of the past few years have underscored how important it is for investors to consider the quality of earnings reported by listed entities. Despite the existence of many benchmarks, the financial market seemed unable to foresee these events. Recently, an attempt was made to assess earnings quality by connecting the dots between pre-tax income (accounting income) and taxable income, the argument being it would be unusual for a company to report high net earnings while showing little or no tax liability. The Enron case was cited as an example because between 1996 and 1999 the company had no taxable income, even though it reported accounting income of US$2.3 billion in the same period. Similarly, the WorldCom affair was evoked, where Andersen was blamed for failing to question the gap between accounting income and taxable income.

There are a number of useful factors to consider if taxable income is to be used as a benchmark to assess the quality of reported earnings, and the appropriateness of such a benchmark and its limitations need to be examined.

Earnings quality assessment factors
Investors use different benchmarks to analyze an enterprise’s earnings. The purpose of these benchmarks is to verify two specific characteristics of reported earnings. The first concerns the relevance of earnings to decision-making. The more net earnings reflect the enterprise’s economic performance, the more they are perceived as being of good quality and the more financial statement users will be able to rely on them for decision-making.

The second characteristic is the absence of management bias. Net earnings are compared to other figures that require fewer estimates and are thus less likely to be biased, such as cash flow from operations. The more net earnings are consistent with cash flow from operations, the more they are deemed to be of good quality. In addition, since management tends to want to increase net earnings, the fact it adopted conservative accounting practices is an indicator of its lack of bias.

Taxable income as benchmark to assess earnings quality
Taxable income could be a valid benchmark, especially as concerns the second characteristic. Management’s judgment and fair value measurement have recently played a major role in determining net earnings, thus increasing the risk of biased information. There are three main advantages to using taxable income as a benchmark. First, taxable income is less subject to falsification than cash flow from operations, which is directly affected by transfers of receivables, accelerated accounts receivable collection, and delays in the settlement of payables. In addition, the taxable income figure reflects management’s optimism because it is lower than accounting income. Management hesitates to artificially inflate taxable income, unlike earnings and cash flow. Finally, the measurement of taxable income is not as flexible as for accounting income. As a result, taxable income is less likely to be manipulated by management and an unusual gap between accounting and taxable income may indicate financial statement manipulation or aggressive tax behaviour.

In the US increasing divergence between accounting income and taxable income in the last few years raises the following question: are enterprises manipulating the financial statements or are they using aggressive financial planning methods, or both? Studies suggest taxable income provides information on earnings quality because US tax law limits the deduct-ibility of certain expenditures such as warranty provisions and restructuring costs, which are generally the vehicle for earnings manipulation. First Baruch Lev and Doron Nissim suggest using taxable income as a reference to ensure the reality and consistency of accounting income. According to them and Michelle Hanlon, financial statement or income tax return manipulation can be detected by analyzing the relationship between taxable income and accounting income.

The significant gaps between accounting and taxable income also lead to questions from tax authorities (Lillian Mills, 1998; US Treasury Department, 1999) and the general public (Gil Manzon, 1992), which can also increase capital cost. For example, a material difference between accounting and taxable income may indicate to investors that the accounting income is not enduring or persistent over the long term and, consequently, of inferior quality.

Management may also want to reduce the gap between accounting income and taxable income. US researchers have noted that management does this to justify aggressive tax behaviour by adopting an accounting policy that will depress accounting income (Bryan Cloyd et al., 1996) or to minimize the risk that aggressive accounting practices will be discovered (Merle Erickson et al., 2004).

Various financial analysis publications have also addressed this issue over the years. For instance, Krishna Papelu, Paul Healy and Victor Bernard (2000) contend that the widening gap between accounting income and taxable income is an indication of aggressive accounting policies. Similarly, Lawrence Revsine, Daniel Collins and Bruce Johnson (2005) submit that it is perhaps a symptom of the deterioration of earnings quality and suggest an earnings conservatism ratio (EC) calculated as accounting income divided by taxable income. In their view, accounting income and taxable income that are close, i.e. where the EC ratio is close to one, result in higher earnings quality. They also highlight the importance of comparing EC ratios between different periods and corporations to identify unusual relationships that require further examination.

Limitations of using taxable income as a benchmark to assess earnings quality
Three factors limit the use of the difference between accounting and taxable income as a benchmark for earnings quality. The first factor concerns the specific objectives sought in establishing these two figures. The purpose of accounting income is to provide useful information for economic decision-making while taxable income is meant, among other things, to obtain funds to pay government expenses. In light of these different objectives, taxable income may not be a valid measurement of earnings quality.

The second factor has to do with the basis of the calculation. Accounting rules are intended to reflect the economic substance of transactions and the relations between various entities. For instance, consolidated financial statements are required under generally accepted accounting principles (GAAP), which is not the case for tax purposes. Also, the impairment of long-lived assets and the setting up of various provisions, which must be accounted for in accordance with GAAP, provide information that is useful for economic decision-making. Such expenses are not tax deductible. Consequently, it can be argued that taxable income is incomplete and as such does not constitute a valid benchmark to assess earnings quality.

The third factor concerns management’s motivations. It is in management’s interest to maximize accounting income and to minimize taxable income. Accordingly, significant differences between accounting and taxable income may be due to effective tax planning rather than the quality of lower earnings.

It should be noted, however, that the divergence between accounting and taxable income is mitigated by tax laws in Canada. The tax authorities have tended to use accounting information as a basis for calculating taxable income and taxes pay- able. (For federal tax purposes, corporations reconcile their accounting and tax income using Appendix 1 of the T-2 income tax return. The financial statements prepared for investors are the starting point of this reconciliation.) In this way, they reduce the costs of auditing income tax returns and limit opportunities for aggressive tax planning. Without this tie-in, it would be easier for management to both maximize its accounting income to reduce its cost of debt capital and minimize taxable income to lower its tax liability.

Finally, a major constraint in using taxable income as a benchmark to assess earnings quality is its confidential nature. Taxable income need not be disclosed under GAAP. In fact, there is no recommendation in CICA Handbook Section 3465 respecting the presentation of taxable income or its reconciliation with accounting income. The Accounting Standards Board (AcSB) seems to feel this information is only useful to tax authorities.

Consequently, investors can only estimate taxable income based on the income tax expense for the period and the tax rate in effect disclosed in the notes to the financial statements. This estimate may not be suitable in situations where the corporation operates in several jurisdictions, prepares consolidated financial statements or has set up provisions for a potential challenge of its income tax returns by tax authorities.

The difficulty of estimating taxable income has been noted by financial journalists. For example, an article in Business Week (April 26, 2004) indicated that it is very difficult for sophisticated investors to determine the amount of income taxes a particular corporation must pay and the amount that can be deferred indefinitely. Another article from the Wall Street Journal (October 8, 2002) suggested that information included in the tax returns of listed entities be made public.

Conclusion
The gap between accounting and taxable income is a reflection of the choices made at two levels — accounting policies and estimates, and tax planning. Tax authorities can examine the reconciliation between accounting and taxable income to detect any irregularities. As for investors and financial analysts, this examination is impossible since no reconciliation is published in the financial statements. Further analysis of earnings quality is possible with the reconciliation of accounting and taxable income, combined with other methods of analysis such as the relationship between accounting income and cash flow from operations. Specifically, the relationship between accounting and taxable income that would be published in the financial statements would help investors pinpoint certain trends and discrepancies.

Finally, if information about taxable income is useful for the various financial statement users, the AcSB should address this issue. Participants in a recent conference organized by the Tax Center of the University of North Carolina and the Brookings Institution pressed for the implementation of accounting standards to present the reconciliation of accounting and taxable income in the financial statements.

Suzanne Landry, PhD, MFisc, FCA, CMA, and Nadi Chlala, MSc, FCA, FCMA, are professors with the accounting sciences de-partment of the School of Administrative Services at Université du Québec à Montréal

Technical editor: Michel Magnan, PhD, FCA, Associate Dean, External Affairs at the John Molson School of Business at Concordia University in Montreal

References

• CICA Handbook, Section 1000, “Financial Statement Concepts.”
• Cloyd, B., Pratt, J., Stock, T., 1996. “The Use of Financial Accounting Choice to Support Aggressive Tax Position: Public and Private Firms,” Journal of Accounting Research, Vol. 34-1, pp. 23-44.
• Erickson, M., Hanlon, M., Maydew, E., 2004. “How Much Will Firms Pay for Earnings That Do Not Exist? Evidence of Taxes Paid on Allegedly Fraudulent Earnings,” The Accounting Review, Vol. 79-2, pp. 387-408.
• Hanlon, M., 2005. “The Persistence and Pricing of Earnings, Accruals, and Cash Flows when Firms Have Large Book-Tax Differences,” The Accounting Review (January) Vol. 80, No. 1, pp. 137-166.
• Lev, B., Nissim, D., 2002. “Taxable Income As an Indicator of Earnings Quality,” Working paper. NY: New York University, 39 pages.
• Mills, L. 1998. “Book-Tax Differences and Internal Revenue Service Adjustments,” Journal of Accounting Research, Vol. 36-2, pp. 343-356.
• Manzon, G., 1992. “Earning Management of Firms Subject to the Alternative Minimum Tax,” Journal of the American Taxation Association, Vol. 14, pp. 88-111.
• Palepu, K.G., Healy, P.M., Bernard, L.V., 2000. Business Analysis and Valuation: Using Financial Statements. Cincinnati, Ohio: South-Western College Publishing.
• Plesko, G., 2002. “Reconciling Corporation Book and Tax Net Income, Tax Years 1996-1998,” Statistics of Income Bulletin, pp. 111-116.
• Revsine, L., Collins, D.W., Johnson, W.B., 2005. Financial Reporting and An-alysis. Upper Saddle River, NJ: Prentice Hall.
• US Department of the Treasury, 1999. The Problem of Corporate Tax Shelters: Discussion, Analysis, and Legislative Proposals. Washington, DC: GPO.