Case Study: The JCTs Enron Report Sheds Light on the Book vs. Tax Debate

Editor:
Annette Nellen, CPA, Esq.
Professor, Department of Accounting & Finance
San Jos State University
San Jos, CA

Editors note: If you would like further information about this column or answers to the case studys problems and questions, please contact Dr. Nellen at anellen@email.sjsu.edu, Dr. McGill at mcgill@ufl.edu or Dr. Outslay at outslay@ pilot.msu.edu.

The Joint Committee on Taxations (JCTs) analysis of Enrons 19962000 returns, in Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JCS-3-03, February 2003) (Report), gives educators an opportunity to discuss the debate on tax accounting and financial accounting differences and whether current tax disclosure rules require improvement. The Enron Report, available at the JCTs Website (http://www.house.gov/jct/pubs03.html), is daunting, comprising more than 2,700 pages over three volumes. More accessible is the JCTs testimony, Written Testimony of the Staff of the Joint Committee on Taxation on the Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JCX-10-03, February 2003) (Testimony), which is also available at the JCTs Website.

The Silver Lining

Used as a case study, the Enron Report can stimulate debate over how corporations should report book-tax differences to shareholders. Although it focuses primarily on Enrons tax shelters and compensation arrangements, the Report also provides a reconciliation of the companys financial statement income to taxable income (Table 2 in the Report and the Testimony) and copies of its Schedule M-1 (book-to-tax reconciliation) from its 19962000 returns (Appendix A in the Report, Volume 2).

These two items can form the basis of a case study in an introductory or advanced tax class, consistent with the approach recommended by the AICPA Model Tax Curriculum to integrate tax and financial accounting concepts and promote multidisciplinary skills; see Model Tax Curriculum, p. 3, at www.aicpa.org/members/div/career/edu/introduc.htm. To integrate these two concepts, current teaching methods primarily consist of students transferring appropriate tax-related data from a hypothetical corporations financial accounting statements to Form 1120 and preparing Schedule M-1 to reconcile the differences; see Dennis-Escoffier et al., Tax Education, Experiences with the Model Tax Curriculum, TTA, May 2001.

Depending on students sophistication level, educators can modify the Report to address the many aspects of book-tax issues. For example, in an undergraduate tax class, they can focus on Enrons financial statements (e.g., income, balance sheet, cashflows and shareholders equity) and its Income Taxes Note 5 (see Exhibit 1) and Common Stock Note 11. In a graduate tax course, educators can also fully explore one or more of the companys intricate tax shelters.

Educators can find Enrons annual reports from 19982000 at the companys Website (www.enron.com/corp/investors). These reports provide financial data for the period analyzed by the JCT (19962000). For a more manageable approach, educators can restrict the case study to an analysis of 2000 or the most recent two or three years. They can supplement the financial statements with Table 2 (in the Report or Testimony) and, if intrepid, the Schedule M-1 from Appendix A (in the Report). Educators can also include a summary of Enrons tax footnote information; see Exhibit 1.

The case study approach will help undergraduates to understand just how widely and why taxable income can vary for a multinational corporation. It can also help them to appreciate the current debate over whether the existing disclosure rules under Financial Accounting Statement (FAS) No. 109, Accounting for Income Taxes, are sufficient for shareholders to discern a corporations tax status.

The case study can include recent articles and viewpoints debating book and taxable income conformity and current disclosure rules, which will help in motivating students; see, e.g., Mills and Plesko, Bridging the Reporting Gap: A Proposal for More Informative Reconciling of Book and Tax Income (Brookings Institute working paper, April 2003), available at www.brook.edu/dybdocroot/views/papers/gale/20030425_mills.pdf; Hanlon, What Can We Infer about a Firms Taxable Income from Its Financial Statements?(Brookings Institute working paper, April 2003), available at www.brook.edu/dybdocroot/views/papers/gale/20030425_hanlon.pdf; Knott and Rosenfeld, Book and Tax: A Selective Exploration of Two Parallel Universes (Part One, Tax Notes (5/12/03), p. 865; Part Two, Tax Notes (5/19/03), p. 1043); Lenter, Shackelford and Slemrod, Public Disclosure of Corporate Tax Return Information: Accounting, Economics, and Legal Perspectives (Brookings Institute working paper, April 2003), available at www.brook.edu/dybdocroot/views/papers/gale/20030425_lenter.pdf; and McGill and Outslay, Did Enron Pay Taxes? Using Accounting Information to Decipher Tax Status, Tax Notes (8/19/02), p. 1125.

Case Study Outline

The case study can begin with a preamble explaining the motivation for the analysis to students. For example:

In this case study you will examine Enron Corporations Income Tax Note and related financial disclosures from 19982000. In addition to understanding how Enron computes its book effective tax rate and reconciles its effective tax rate with the statutory Federal tax rate, you will analyze the information that can be gleaned about the companys tax status from its disclosures about its U.S. and international operations.

The case study can also include a short discussion of accounting pronouncements  that govern accounting for income taxes (e.g., FAS Nos. 109 and 5, Accounting for Contingencies; Auditing Practices Board, Opinion Nos. 18, The Equity Method of Accounting for Investments in Common Stock; 23, Accounting for Income TaxesSpecial Areas; and 25,Accounting for Stock Issued to Employees; and SEC Regulation S-X, Rule 4-08(h)). (The papers cited above concisely summarize these pronouncements. In addition, a preamble the authors used in a similar case study is available on request.)

Besides examining Enrons financial statements (along with Income Taxes Note 5 and Common Stock Note 11), students can ponder the following problems and questions:

1. In 2000, Enron reported $1.413 billion pre-tax net income and $3.101 billion taxable income on its U.S. return (before any net operating loss (NOL) carryforwards). For 1999, the company reported $1.128 billion net income before tax and a $1.458 billion NOL on its U.S. return. Using Report Table 2 as a guide, list four general reasons why the companys pre-tax net income and U.S. taxable income differed so widely.

2. Enron reported in its Income Taxes Note 5 that at the end of 2000, it had approximately a $65 million NOL carryforward applicable to U.S. subsidiaries. In its 1999 annual report, the company reported that the corresponding NOL was approximately $2.9 billion. Based on the change in the companys NOL carryforward from 1999 to 2000, estimate Enrons taxable income reported on its U.S. 2000 return.

3. Enron reported a current $112 million Federal income tax expense for 2000 in its Income Taxes Note 5. According to the Report, Enron paid $63.2 million of Federal income taxes in 2000. FAS No. 109, 8 states, a current tax liability or asset is recognized for the estimated taxes payable or refundable on tax returns for the current year. List some general reasons why Enrons reported financial accounting current Federal tax liability differs from the amount reported on the companys U.S. return.

4. How much of Enrons actual $63.2 million U.S. tax liability in 2000 was due to the imposition of the alternative minimum tax?

5. Enron reported in its Common Stock Note 11 that in 2000, it recorded tax benefits related to stock options exercised by employees of approximately $390 million. Where are these tax benefits reported in Enrons financial statements? How might one estimate the tax deduction from stock option exercises in 1999 using only the information contained in Note 11? How does the estimate compare to the $382 million stock option deduction shown in the Report (see Report Table 2)?

6. Enron reported a 30.7% effective tax rate in 2000 and 9.2% in 1999 (Note 5). Show how the company computed these rates. What caused the effective tax rate to increase so significantly from 1999 to 2000? Are such causes manageable by a companys tax department?

7. Enron reported very different tax numbers in its financial statements and Federal income tax returns. From 19962000, it reported cumulative book income reported on [a] Consolidated Tax Return that exceeded cumulative taxable income before NOL carryforwards by a staggering $12.628 billion. Some commentators believe that these differences are a natural and appropriate outcome of tax and book accounting systems having different rules and objectives. Others propose that there should be much more conformity between book and tax numbers, as the differences can hide aggressive tax shelter schemes. Some on either side of this debate contend that taxing authorities should require corporations to disclose their returns to the public, a major change to the longstanding policy of strictly protecting a taxpayers privacy. What are your opinions on the conformity between reported book and return numbers and possible return disclosure? Your answer should address the potential costs and benefits of your positions.

Besides asking students to address the above issues, educators can use Appendix A of the Report to emphasize the complexity and magnitude of the book-tax differences on the Schedule M-1 of a large publicly traded corporation. Also, Appendix A illustrates how corporations can interpret line 1 of the schedule differently. The first number on Line 1 is net income per books, but the forms instructions do not define that term. Although that number supposedly comes directly from the income statement (for 2000, Enron reported $979 million net income), Enron used book income reported on [a] consolidated tax return (Report Table 2). This shows why any plans to change Schedule M-1 should begin with a uniform definition of net income per books.

Advanced students can examine Enrons Schedules M-1 and list which items may be indicative of aggressive tax shelter behavior, to either confirm or call into doubt the contention that the public disclosure of Schedule M-1 would be the key for identifying abusive tax shelter behavior.

Conclusion

The wealth of return data and analysis available on Enron and the broad discussions in Congress and in the press about the companys aggressive accounting and tax strategies provide educators with an invaluable teaching opportunity.

From Gary A. McGill, Ph.D., CPA, PricewaterhouseCoopers Term Professor of Accounting, Fisher School of Accounting, University of Florida, Gainsville, FL, and Edmund Outslay, Ph.D., CPA, Professor of Accounting and Deloitte & Touche/Michael Licata Teaching Fellow, Eli Broad Graduate School of Management, Michigan State University, East Lansing, MI