September 29, 2006 1

Five Things Non-Accountants Should Know about Accounting

Lillian F. Mills

Associate Professor in Accounting, University of Texas

September 29, 2006 2

1: Book income matters

• Public companies prefer to report high net earnings. – Contracts based on book income induce preferences. – Capital markets may also be short-term inefficient.

• Only rate decreases, credits, and permanent deductions increase book income.– Accelerating deductions don’t.

• SO: Doesn’t everyone want a rate cut?

September 29, 2006 3

2. Tax rate changes affect accumulated deferred taxes

• Deferred tax liability = tax owed later.– e.g., Tax effect of accelerated depreciation

• Deferred tax asset = future refund. – e.g., Tax effect of NOL carryforward

• If statutory rate decreases:– Firms with a net liability position have a gain– Firms with a net asset position have a loss

• Thus, firms with net tax assets lobby against rate cuts and prefer permanent deductions (Sec 199)

September 29, 2006 4

3. Tax expense not taxes paid

• Total tax expense = current + deferred• Current tax expense differs from tax paid:

– Stock options– Tax cushion– Prior/future effects of NOLs, etc.

• Media should especially guard against labeling corporations as “high” or “low” taxpayers based on hasty inspection.

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4. Accounting mixes valuation methods and permits discretion

• Accounting concepts attempt to balance: – “relevance” (fair values more informative) VS.– “reliability” (can we audit the number?)– Thus, accounting mixes different valuation

methods.

• Accounting requires estimation; hence permits management discretion– Caution against using book income for tax

base.

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5. Consolidation rules differ book v. tax

• Financial statement = worldwide-controlled corporations (>50 percent)

• U.S. tax return = domestic affiliates (80 percent)

• Cross-border accounting critical for tax, less so for book. – Hence, complex regs needed transfer-pricing.– Schedule M-3 helps IRS see entity

differences.

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Conclusions

• Corporations care about book income and lobby to avoid losses and increase income

– Rate changes affect deferred tax assets and liabilities

• Caveats in using financial statement data to assess tax policy

– Accounting mixes methods and allows discretion– Hard to tell how much U.S. tax is paid– Hard to tell what income is subject to U.S. tax

• Continued cross-education among disciplines improves policy.