Danielle Green, Ph.D., cannot see into the future.
But give her the right documents, and Green, an assistant professor of accounting and taxation at the Gabelli School of Business since 2015, can do something akin to it.
Green’s expertise is in accounting for income taxes and the lengths that corporations go to reduce the taxes they pay to the government.
In an ongoing research study titled, “Can Financial Statement Information Predict Taxable Income? Evidence from the Valuation Allowance,” Green and her co-authors examine how one can predict a firm’s privately reported taxable income by examining publicly available financial statements.
This is possible because in the United States, all publicly traded companies are required to file a financial statement—specifically Form 10-K—with the Securities and Exchange Commission and share both the current and future tax effects of the economic transactions that they engage in.
Losses as Assets
Those future effects result in either a future expense, which is called a deferred tax liability, or a future benefit, which is called a deferred tax asset. Somewhat counterintuitively, a firm’s net operating loss is classified as a deferred tax asset, because how losses are treated for financial reporting purposes differ from how they’re treated for tax purposes.
“As a business, if I prepare my financial statements and I have a loss, I just report that loss in the financial statements. When I prepare my tax return, my taxable income is bounded at zero. I can’t report negative taxable income on my tax return,” Green said.
“In that scenario, I’ll actually report lower financial statement income compared to my taxable income. What the IRS does is it allows firms to take that loss and either carry it forward or, before the law changed last year, carry it back, and use it to offset taxable income in either of those two periods. It’s reported as an asset on the financial statements, because in the future, I’ll be able to use it to reduce my taxable income.”
When a business reports a deferred tax asset, it is also obligated to report whether it’ll recognize it in the future. The catch? One can only claim it if one has had or expects to have taxable income. If the business does not expect to have taxable income in the future, the value of that asset is worth less, and must be reported as such.
Green’s research shows that the “valuation allowance,” as it’s known, is what allows one to get a glimpse into a firm’s otherwise private financial machinations.
“Say I had a deferred tax asset of $100, but I only think I’ll be able to utilize $30 of it. Then I would record it as a valuation allowance of $70 against the asset. That would reduce the net value of the asset down to $30. In order to determine whether or not I need that valuation allowance, I have to consider sources of future taxable income,” she said.
“As a manager, I have to essentially forecast what I think my taxable income will be into the future. When I put a valuation allowance on this deferred tax asset, I’m essentially saying, ‘I don’t think that I’m going to have sufficient taxable income in the future to offset.’ ”
Changes enacted to the tax code by Congress last year have changed some ways the valuation allowance can be used, but Green said it’s too soon to see the effects of the change because of a lack of available data. The law also addressed tax avoidance, another area that Green has written on, in papers such as “The Influence of a Firm’s Business Strategy on its Tax Aggressiveness,” which she co-wrote in 2016.
Innovative for Business Purposes, Innovative for Tax Purposes
“Tax avoidance is anything that a firm does to reduce its effective tax rate. It’s anything that a firm does, from something as benign as investing in municipal bonds to something more egregious, like participating in tax shelters,” she said.
“What we find is that firms that are innovative for business purposes are also innovative for tax purposes, and as a result they tend to take more risk. Firms that tend to be less risky tend to have higher tax rates, but their rates tend to be more consistent over time.”
Like death, taxes are said to be one of the few things certain in life, and the never-ending areas of life they can affect are a source of fascination for Green.
“I tell my students that the universe of tax is huge, and I only know a small part of it, and when they start my class, they know a tiny dot of it. By the end of it, it’s going to expand a little bit,” she said.
“It’s important to know that they can’t know everything, just like I can’t know everything, but you should always be willing to learn.”
Last fall, she and her valuation paper co-authors attended in a roundtable at Urban-Brookings Tax Policy Center in Washington, D.C., to help develop a business tax model to predict corporate tax revenues using publicly available data.
“The thing I found interesting was that everybody in that room was generally interested in learning about how this information could predict future taxable income. For certain governmental organizations, it may help them determine what revenues are going to be that feed into the budget, or for other organizations or agencies, it can help them determine what the revenue impact of a change in tax law will actually be,” she said.
“That is useful, so I like being able to say what I’m working on matters beyond the ivory towers, if you will.”