Saturday, July 14, 2012

Conforming Financial and Tax Accounting in Tax Reform Legislation Receives Cool Reception at Ways and Means Committee Hearing

Hearings conducted by the House Ways and Means Committee on the interaction of tax and financial accounting have revealed a certain coolness towards conforming companies’ financial accounting and tax accounting as part of any tax reform legislation. Committee Chair Dave Camp (R-MI) said Congress must  consider how public companies evaluate tax policy options in light of financial accounting or book considerations. This will allow the Committee to examine whether tax legislation works as intended when Congress does not consider the effects of financial accounting. When companies report profits in SEC-filed financial statements the primary purpose is to convey information about the company’s financial condition to investors and creditors, he noted, but, conversely, the primary purpose of tax accounting is to measure income for the purpose of levying the federal income tax. These two functions are not necessarily consistent, he emphasized, and may even be at odds in some cases.

Rep. Lynn Jenkins (R-KN) askedpanelists to address the issue of moving towards having less differences in book and tax accounting as part of legislation reforming the US Tax Code. While seeing some benefit of simplification to book-tax conformity, Michael Fryt, Vice President, Tax, FedEx Corp., cautioned about putting control of the tax revenues in the hands of FASB. Mark Schichtel, Chief Tax Officer, Time Warner Cable, agreed that ceding control to FASB would not be a good idea, nor would efforts to achieve conformity with GAAP and international accounting standards, because they are not necessarily reflective of real economic lives. When you examine different industries and  classes of assets, he continued,  the lives for tax purposes are much more consistent with reality than what you see from a GAAP perspective.

Noting that she has done a lot of research on book‑tax conformity, Michelle Hanlon, Assoc. Professor of Accounting, MIT Sloan School of Management, said it would be a bad idea.  The first thing is that accounting rules are very conservative, she noted, which means that expenses are accrued very early before they actually happen in cash flow, for example, bad debt expense and so forth, while the federal tax code generally has not favored such treatment. Also, she observed that there is a lot of evidence in the literature that book‑tax conformity would reduce the information that is contained in financial accounting earnings.  The rules are set up for two different purposes, she noted, and basically accounting rules are set in order to inform stakeholders.  Further, evidence based on the 1986 Tax Reform Act, when a certain set of reforms were required to increase their conformity, the international evidence and several other studies basically show that the information that is in accounting earnings will go down if you conform those earnings. 
Professor Hanlon was also concerned about who would make the rules after the book-tax conformity happens, would it be Congress, FASB, or the International Accounting Standards Board. She believes that it would be very hard for the U.S. to handle the International Accounting Standards Board determining the federal tax base. 

In her prepared testimony, Professor Hanlon noted that public companies compute two different measures of income every year: taxable income and financial accounting (book) income. The two measures of income are computed for different purposes. Financial accounting is intended to measure economic performance for external stakeholders. The rules for computing accounting income are conservative in nature, requiring the recognition of expenses and losses earlier than the recognition of income and gains.

Tom Neubig, an Ernst & Young National Director, said that the discussion about moving to IFRS has impacted the discussions about U.S. tax reform.  Because if you move to IFRS, he noted, then LIFO would not be allowed, and so it would automatically eliminate the current ability of some firms to use last‑in, first‑out accounting.  Also there are clearly different goals for the accounting rules as opposed to tax writing committees, who have different goals, including revenue.

Similarly, Timothy Heenan, VP, Treasury and Tax, Praxair, Inc., said that the financial accounting rules are there for something completely different than what the tax accounting rules should be there for. The tax rules are designed to get revenue, he emphasized, but it should be done in a manner that promotes growth, investment, and jobs. Financial reporting and tax accounting rules are just two completely different worlds, he said, and they should be kept separate.