Income taxes are a constant presence in the financial statements of U.S. corporations. In most years, companies have either tax-related cash outflows or inflows. Tax-related cash outflows normally result when a firm has taxable income in its income tax return. A firm may have tax-related cash inflows when it is able to carry current tax losses back and eliminate previous taxable income. The retroactive elimination of previous taxable income also eliminates previous taxes, resulting in a recovery of taxes previously paid. In other cases, losses are carried forward and used to eliminate what would otherwise be taxable earnings in future years. In these cases, tax-related cash outflows may be eliminated in whole or in part depending on the size of the losses carried forward. Cash flows are benefited, but in the form of a reduced tax cash outflow as opposed to cash inflow.
The Statement of Financial Accounting Standards (SFAS) No. 95, “Statement of Cash Flows,” gives little attention to income taxes and simply calls for their inclusion in the determination of cash flows from operating activities. However, some additional commentary on income taxes in the statement of cash flows is included as part of the section entitled “Basis for Conclusions.”
The limited attention given to income taxes in SFAS No. 95 might suggest that their treatment in the statement of cash flows is without controversy. However, as below quotes to indicates, some contention exists about the classification of income tax cash flows within the statement of cash flows:
Net cash flow from operating activities is contaminated by the income tax effects of investing and financing activities. [H. Nurnberg, “Income Taxes and The Statement of Cash Flows,” CPA Journal, June 2003].
The Bells generated 173% free cash flow growth in 2002, but this does not look sustainable as the temporary benefit from cash taxes deferred could reverse in upcoming periods [S. Flannery, E. Huh, P. Enright, and C. Loh, To Spend or Not to Spend, That Is the Taxing Question (New York: Morgan Stanley & Co., October 16, 2003), p. 1].
The confinement of income tax cash flows to the operating section of the statement of cash flows is seen as improper when these cash flows are the result of investing and financing transactions.
Beyond issues related to the classification of tax cash flows, nonrecurring tax cash flows have the potential to distort cash flow trends. That is, nonrecurring cash flows may either understate or overstate sustainable cash flows. Without adjustment, a cash flow projection based in part on recent historical trends will be either overstated or understated.
An overstatement may result if recent results have included nonrecurring tax cash inflows. Alternatively, an understatement may result if recent results have included nonrecurring tax cash outflows. The second of the opening quotations to this chapter highlights analysts’ concern about the effects of taxes on the sustainability of cash flows.
Tax Reporting Essentials
In attempting to understand tax reporting, it is essential always to bear in mind that there are two different measures of profitability: book or shareholder’s income and tax return income. The income tax provision in the shareholders’ income statement is based on the income reported there. However, taxes are paid or recovered based on income reported in the tax return.
There are many differences between book income and tax return income. All of these differences can be grouped into one of two categories:
- Temporary differences; and
- Permanent differences.
Let’s talk about the both differences. Read on…
Temporary differences result from the recognition or inclusion of revenues, gains, expenses, or losses in the shareholder income statement in periods different from the tax return. A temporary difference is any item of revenue, gain, expense, and loss currently recognized in the book income statement that also will eventually be included in the tax return. A temporary difference also may result from: revenues, gains, expenses, or losses recognized currently in the tax return that will be included in future shareholder income statements.
The reversal of a temporary difference occurs when an item of revenue, gain, expense, or loss that was previously recognized in the shareholder income statement is subsequently included in computing taxable income, or vice versa. For example: the reversal of a temporary difference occurs when revenue recognized earlier on the books is included in the tax return. Also, the reversal of a temporary difference associated with an expense that was recognized earlier in the tax return occurs when the expense is subsequently recorded in the shareholder income statement.
Temporary differences give rise to deferred tax assets and liabilities. Deferred tax as sets represent future tax benefits that will be realized when the associated temporary difference reverses. An example would be an expense that was deducted in one year on the books but in subsequent year in the tax return. When this expense subsequently is deducted in the tax return, it reduces taxable income and with it any cash payment for income taxes. The deferred tax asset recorded represents the future tax savings that will be realized in a future year.
Most temporary differences that give rise to deferred tax assets involve the recognition of expenses in the shareholder income sooner than in the tax return. Expense deductions will be taken in the tax return when these temporary differences reverse in subsequent periods.
These temporary differences typically are referred to as deductible temporary differences. Their reversal results in a reduction in taxable income. Another common source of deferred tax assets is the future tax saving represented by operating loss, capital loss, and tax credit carryforwards.
Unlike carrybacks, the realization of deferred tax assets associated with carryforwards requires income in a future tax return. Moreover, loss or credit carryforward periods are limited. As a result, sufficient income must be produced within the carryforward period or the carryforward will expire and the deferred tax asset will not be realized. The realization of a carryforward reduces tax payments but does not result in a refund of taxes previously paid.
Depreciation temporary differences are the single most common source of deferred tax liabilities. The temporary difference results from the recognition of depreciation on a straight-line basis in the shareholder income statement, while accelerated depreciation is used in the tax return. The temporary difference is originating, and a deferred tax provision and associated deferred tax liability are recorded, as long as depreciation expense in the shareholder income statement is less than that in the tax return. The temporary difference reverses, and the deferred tax liability becomes a current tax obligation, when depreciation in the shareholder income statement exceeds that deducted in the tax return.
A deferred tax liability also would arise if the profit on a sale were recognized in one year on the books and in a subsequent year in the tax return. A tax-deferred tax expense is recorded initially on the books along with an offsetting deferred tax liability. The deferred tax on the gain will not become payable until a subsequent year when the temporary difference reverses and the gain is included in the tax return. Income taxes are paid when earnings are reported in the tax return, not when accrued on the books. In a subsequent year the gain is reported in the tax return and the associated deferred tax liability become payable.
Temporary differences that give rise to deferred tax liabilities are referred to as taxable temporary differences. Their reversal results in an increase in tax return income. Alternatively, temporary differences that give rise to deferred tax assets are referred to as deductible temporary differences. Their reversal results in a decrease in tax return income.
Unlike temporary differences, differences that never reverse are referred to as permanent differences. Permanent differences are revenues, gains, expenses, or losses that appear in the books or the tax return, but never in both. These items do not give rise to deferred tax assets and liabilities. Rather, they cause the expected amounts of income taxes to be either higher or lower than would be expected given the level of shareholder income.
Consider, for example, a company’s receipt of life insurance proceeds upon the death of an officer. The proceeds are income for the company, but they are exempt from taxation. Thus, they are a permanent difference—included in book earnings but never included as income in the tax return. As a result, tax expense computed on book earnings will appear to be somewhat low because the life insurance proceeds are included in earnings but no income tax is accrued on them.
Alternatively, taxes will appear to be higher than expected given the level of shareholder income if a company has paid a fine. The fine is a business expense and is deducted in arriving at pretax book earnings. However, fines are not deductible for tax purposes. Because the fine is deductible on the books but never in the tax return, it represents a permanent difference that lowers book income but not taxable income. Here tax expense computed on book earnings will be higher than expected because the expense associated with the fine did not provide a tax benefit.
Cash Tax Payment
A very direct computation method simply removes the deferred tax provision or benefit from the total tax provision and then adjusts for changes in income taxes payable or receivable. A computation example is provided below:
Computation of Income Tax Payment
Total tax provision $(28,800)
Total net deferred tax provision 4,800
Current tax provision (24,000)
Decrease in income taxes payable (1,000)
Income tax payment $(25,000)
The computation in the exhibit follows the convention of designating tax cash payments with parentheses and tax cash benefits without. Absent any adjustments, the total tax provision would be the tax payment. This explains the parentheses around the initial total tax provision of $28,800. Combining the total tax provision and the net deferred tax provision yields the current tax provision of $24,000. This would be the tax payment for the year if there were no changes in either income taxes payable or receivable. However, the addition of the $1,000 decrease in income taxes payable produces the tax payment of $25,000.
Timing of Tax Payments For most corporations, tax payments are distributed across the year. In general, taxes on U.S. income that are labeled current should be paid by the end of the year for large corporations, defined as those with taxable income of $1 million or more in any of the last three years.
Most corporations must pay their current-year taxes in four installments. For a calendar- year firm, payments must be deposited in a Federal Reserve or authorized commercial bank on or before April 15, June 15, September 15, and December 15. Corporations that do not satisfy the large-corporation test have more favorable payment rules. Small corporations can satisfy the installment payment requirements, and avoid interest or penalties, by paying amounts during the year that are equal to 100 percent of the previous year’s tax. Any additional amounts to discharge the actual total tax obligation for the year must be paid with the filing of the tax return for the year.
Effective Income Tax Rate and Cash Tax Rate
The effective income tax rate normally is defined as the total tax provision, consisting of current and deferred income taxes, divided by pretax book earnings. An effective tax rate assumption is a standard feature of earnings projections.
With their traditional focus on cash flow, lenders often have a much greater interest in the cash tax rate as opposed to the effective tax rate. However, equity analysts have a strong interest in both cash and effective tax rates. They share the lender’s interest in the cash tax rate because of its relevance to their efforts to forecast cash flows. Moreover, their active participation in forecasting earnings means they also must pay attention to the overall effective tax rate.
Deferred Tax Valuation Allowance
An important but not well understood feature of tax reporting is the requirement to assess the likelihood that the deferred tax benefits represented by deferred tax assets will be realized. Once recorded, a deferred tax asset continues to be recorded on the balance sheet only if the “likelihood of realizing the future tax benefit is more than 50 percent.” If the likelihood of realization is 50 percent or less, then a valuation allowance is set off against the deferred tax assets failing this likelihood of realization test. Additional deferred tax expense is recorded when the valuation allowance is increased, and a reduction in deferred tax expense is recorded when the valuation allowance is reduced.
Reconciliation of the Effective Tax Rate
Pretax book income of $107,000
at combined 40% rate:
$107,000 × .40 $42,800 40.00
Tax reduction from nontaxable
life insurance proceeds:
40% × $40,000 (16,000) (14.95)
Tax increase from
nondeductible fines: 40% × $5,000 2,000 1.87
Actual income tax provision
and effective tax rate $28,800 26.92%
Summary of Key Features of Income Tax Reporting
Here I summarized a number of important features of income taxes and their reporting.
- There are two taxable income numbers, book income or income reported on the income statement and taxable income or income reported on the tax return.
- Book income and taxable income are virtually always different.
- Taxes are paid or refunded on the basis of taxable income or losses, but accrued in the shareholder income statement on the basis of book income.
- Taxes generally are paid in four installments during the year.
- The divergence between the two taxable incomes is explained by two classes of differences:
- Temporary Differences: Revenues, gains, expenses, or losses that are recognized in different time periods in the books versus the tax return.
- Permanent Differences: Revenues, gains, expenses, or losses that are recognized in either the book or taxreturn profit calculations, but not both.
- Temporary differences give rise to deferred tax assets and liabilities.
- Changes in deferred tax assets and liabilities give rise to associated deferred tax provisions and benefits. In computing cash flows from operating activities, deferred tax provisions are added back to earnings as a noncash expense, but deferred tax benefits are deducted from earnings as a noncash increase in earnings.
- Permanent differences cause effective income tax rates to be either higher or lower than statutory rates.
- The total book tax provision (both current and deferred) is divided by income from continuing operations before taxes to compute the effective tax rate. Dividing just the current provision (an approximation of cash taxes) by income from continuing operations before taxes yields the cash tax rate.
- Temporary differences that upon origination cause book income to exceed tax-return income require the recording of deferred tax liabilities. Temporary differences that upon origination cause book income to be less than tax-return income require the recording of deferred tax assets.
- Temporary differences reverse when the original relationship between book and taxable income is reversed.
- The reversal of a temporary difference that initially caused book income to exceed tax return income calls for the reduction of a deferred tax liability and the recording of a deferred tax benefit.
- The reversal of a temporary difference that initially caused tax-return income to exceed book income calls for the reduction of a deferred tax asset and the recording of a deferred tax provision.
- A valuation allowance must be set off against deferred tax assets that fail a realization test.
- Recall that these two statement formats differ only in terms of the formatting of the calculation of cash flows from operating activities. The presence of tax-related cash flows is clearest when the direct-format statement of cash flows is provided. Their presence is much less apparent when the indirect method is employed.
Classification Of Tax-Related Cash Flow
SFAS No. 95 specifies that all “cash payments to governments for taxes” are to be included in cash outflows from operating activities. Some respondents to an exposure draft of SFAS No. 95 suggested “allocating income taxes paid to investing and financing transactions”. The allocated taxes paid, or recovered, would be only those determined to be associated with investing or financing transactions. The balance of the payments or recoveries would be classified in operations. Taxes paid on gains from the sale of investments are an example of taxes associated with an investment transaction. A financing transaction could produce cash tax savings if a deductible loss were realized on the retirement of debt.
In spite of the conceptual appeal of allocating tax payments or refunds to investing and financing transactions, the FASB decided that all income tax cash flows should be classified in operating activities. This position was based on the FASB’s view that “the allocation of income taxes . . . would be so complex and arbitrary that the benefits, if any, would not justify the costs involved.”
In contrast to U.S. GAAP, International Accounting Standard (IAS) No. 7, the international standard on cash flow reporting, leaves open the possibility of allocating tax payments or recoveries to investing and financing activities. However, international standard setters do recognize the practical difficulties of tracing tax cash flows to investing and financing activities:
While tax expense may be readily identifiable with investing and financing activities, the related tax cash flows are often impracticable to identify and may arise in a different period from the cash flows of the underlying transaction.
Tracing cash tax payments and benefits clearly does represent a challenge. However, in the face of material gains and losses on investing and financing transactions, the cost benefit relationship may make reclassification quite compelling. The alternative is a very poor measure of sustainable cash flow produced from operations.