By the time this column appears, CPAs everywhere are going to be tackling stacks of paperwork for income taxes. This will be true whether they are up to their necks in client returns, or struggling in an audit to reconcile book and tax income in Schedule M.With those pains in mind, it only makes sense that accountants would prefer GAAP accounting for income taxes to be relatively simple.

As for managers, accounting for taxes on the income statement has two goals: to ensure that it looks like they paid their fair share, and that volatile measures and rates of income tax are not revealed. If the management is seen to be tax dodgers, they think that Congress might go after them, and if their reported income is volatile, they think the capital markets might penalize them.

Now add the interests of financial statement users to this mix. Instead of simplicity and cosmetic surgery, they want (and need) to know how much tax has been and will be paid, and when, so they can assess the amount, timing and uncertainty of future cash flows.

BAD TAXES AND POLITICS

Unfortunately for everyone, generally accepted accounting for taxes is bad. Really bad. Its mechanical procedures make life somewhat easier for accountants, but their reports are not informative. As a result, they aren’t adding value to the financial statements, and thus not earning as much money as they could if they were to help the truth be known. Managers mistakenly think artificially smooth numbers project the right financial image, but the resulting scarcity of decision-useful information makes markets skittish and drives their companies’ stock prices down.

And don’t overlook the fact that users have to do extra work to make sense out of what’s reported, with the ultimate outcome being that they have less to invest, further driving down stock prices.

So, just how bad is it? And what might be more useful? Read on.

MISBEGOTTEN DEFERRAL

The acceptable deferral method is based on a couple of questionable decisions. The first is the conclusion that taxes are expenses, not involuntary asset distributions to the government. It’s backwards thinking that deems them expenses. That is, expenses are incurred in order to earn income. Taxes, to the contrary, are incurred because the taxpayer has already earned income. Taxes are the result of income, not its cause. In addition, expenses are incurred to produce some sort of direct benefit. Taxes are paid merely to comply with the law. In short, they’re unlike other costs, and perhaps it is a mistake to account for them as if they’re normal expenses.

The second decision follows from deciding that taxes are expenses. At issue is whether they’re to be allocated. Existing GAAP assigns paid taxes as expenses to the reporting years when the underlying revenues and expenses show up on income statements. There is great reason to doubt that reporting deferred tax assets and liabilities on balance sheets is a good way to unveil the truth, much less the best way. Perhaps it would be more useful to flow through this involuntary distribution, letting the total tax assessment on the return show up on the income statement as tax expense. Of course, disclosures would be essential for helping users understand how things will play out in the future.

If, for example, MACRS accelerates depreciation, the disclosure could describe what’s going to happen in the future when reversal occurs. This makes sense to us when we compare it with the status quo that buries financial statement users under mountains of bogus information about uncertain future tax effects.

MIS-MEASUREMENT

Even if you agree that taxes are expenses and that deferral is useful, you should surely doubt the usefulness of present statement numbers. Why? The answer lies in time value, which makes it advantageous to postpone paying taxes so you can use the cash to earn more income.

But under SFAS 109, which rolled forward the past practice, a dollar of postponed tax produces a dollar of current expense, regardless of how soon it has to be paid. Accountants just debit tax expense, credit deferred tax liability. Unfortunately, that practice doesn’t tell the truth that most of this so-called “liability” won’t be paid for years, if ever.

The awful truth is that not discounting these deferred amounts makes it look like managers are paying higher taxes than they really are. (Here is the paradox that managers want to report more expense, instead of less, giving up the appearance of higher income for the public relations image of good citizenship.)

FASB’s flimsy justification in SFAS 109 is that the issues related to discounting were “numerous and complex,” especially with regard to management effort. Uh, did it ever occur to anyone that the outcome is information that is exceptionally difficult for decisionmakers to analyze and use?

MIS-CLASSIFICATION

Classifying balance sheet items as current or noncurrent is supposed to provide some insight (albeit incomplete) into the timing of future cash flows.

When it comes to deferred taxes, even that limited goal has been sacrificed in the name of “simplification.” Rather than revealing how much must be paid and when, deferred tax accounts are classified according to whether the assets and liabilities that produced temporary differences are current or noncurrent. Users are left scratching their heads in bewilderment, wondering what’s going to happen. All they get is gross amounts of future outflows (or non-outflows) with no information as to when they will occur. If users don’t know, they guess, and then hedge their bets by assuming the worst.

MIS-COMBINATION

As if that isn’t bad enough, SFAS 109 requires management to offset deferred tax assets and liabilities on the balance sheet. Doing so is inconsistent with other generally accepted practices, except for pensions, which is hardly a paragon of good accounting. Offsetting just doesn’t make sense in either situation, because it diminishes the statements’ information content, instead of enhancing it.

MIS-REPRESENTATION

Like an annoying insect, the consequences of taxes on the cash flow statement have been brushed aside with nary a thought. Specifically, all tax payments are included in operating cash flows, even those triggered by financing and investing activities. If, for example, an issuer has a gain from retiring bonds, the resulting tax is included among the operating outflows, which is the wrong place. If there is a gain from selling assets, you guessed it: The tax paid is presented as an operating use, not a reduction of the cash inflow in the investing section.

To comprehend this deficiency, consider the long-established practice of associating taxes on the income statement with the category of earnings that produced them. Continuing operations is charged only with taxes incurred because of their results. The outcome of discontinued operations is reported net of taxes, and the same is true for extraordinary items. The idea is to assign taxes to their source, so users can see the full impact.

Alas, that concept was completely disregarded by FASB in SFAS 95. The justification offered is again simplification of management effort. The consequence is not just misrepresentation, it’s bias that makes companies look less valuable. After all, the whole idea of reporting operating cash flow is to help users predict future flows, or are we missing something? Polluting operating results with non-operating tax outflows cannot be doing anyone any good whatsoever. When will the lesson be learned that cutting corners produces bad results that inescapably produce lower stock prices and higher capital costs?

Fixing it

If it was up to us, we would report the taxes actually paid or payable in a given year on the shareholders’ equity statement as an involuntary dividend to the government.

This practice would cure virtually all the above shortcomings. If standard-setters think it’s worthwhile to disclose pending deferred tax payments or deductions, so be it. Let management bear the burden of clearly explaining volatile results and low tax rates, instead of ducking behind the cover of severely limited GAAP that totally obscures the truth.

The sure outcome would be information flowing to the capital markets that’s better than present GAAP.

We’re heartened that FASB has recently patched up accounting for pensions, fair values and business combinations. Taxes could use some attention, too.

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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