This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Taxable and Business Income Volume Author/Editor: Dan Throop Smith and J. Keith Butters Volume Publisher: NBER Volume ISBN: 0-870-14118-X Volume URL: http://www.nber.org/books/smit49-1 Publication Date: 1949 Chapter Title: Sources of Divergences between Book Profit and Statutory Net Income Chapter Author: Dan Throop Smith, J. Keith Butters Chapter URL: http://www.nber.org/chapters/c3251 Chapter pages in book: (p. 259 - 337)
Transcript
This PDF is a selection from an out-of-print volume from the National Bureauof Economic Research
Volume Title: Taxable and Business Income
Volume Author/Editor: Dan Throop Smith and J. Keith Butters
Volume Publisher: NBER
Volume ISBN: 0-870-14118-X
Volume URL: http://www.nber.org/books/smit49-1
Publication Date: 1949
Chapter Title: Sources of Divergences between Book Profit and StatutoryNet Income
Chapter Author: Dan Throop Smith, J. Keith Butters
Chapter URL: http://www.nber.org/chapters/c3251
Chapter pages in book: (p. 259 - 337)
CHAPTER 13
Sources of Divergences between Book Profit andStatutory Net Income
THE' DATA FOR THE ANALYSIS OF SOURCES OF DIVERGENCEbetween book profit and. statutory income were takenmainly from Sample I. Sample II data are used to supplementSample I in discussing depreciation and depletion and baddebt expenses. Initially it was hoped to make much more ex-tensive use of Sample II but, as explained in Chapter i o, thedata were found to be inadequate for this purpose.
The various sources of divergence were grouped into 15classes, the first five of which affect primarily the amount ofgross income reported, the next eight the amount of deduc-tions claimed, and the last two cover special items (Table 24).
Inasmuch as the findings of this chapter are summarized inChapter g, Section C2, it seems superfluous to repeat them.The reader who is interested only in the broad findings is in-vited to turn to the summary.
Most of the qualifications on the book profit-statutory netincome comparison apply also to the component items affect-ing net income. For instance, whatever errors are in the Treas-ury book profit figure will be reflected in erroneous statementswith respect to some components of net income. As some com-ponents presumably will be affected more than others, therelative importance of the various sources of divergence be-tween book profit and statutory net income will be altered insome degree. However, since the errors in the Treasury book
259
TAB
LE 2
4
Min
ing
quar
ryin
gM
anuf
actu
ring
Food
& k
indr
ed p
rodu
cts
Toba
cco
prod
ucts
Liqu
ors &
bev
erag
esTe
xtile
s, cl
othi
ng, &
app
arel
Pape
r, pr
intin
g, &
pub
lishi
ngC
hem
ical
s & a
llied
pro
duct
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one,
cla
y &
gla
ssIr
on, s
teel
, & n
onfe
rrou
s met
als
Indu
st.,
agr.,
& o
ther
mac
h. &
tool
mfr
.A
utos
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raft,
& sh
ipbu
ildin
gM
isce
llane
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nce
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eM
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llane
ous c
ompa
nies
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ice ut
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13.0
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58.
63.
64.
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5.4
22.8
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61.
137
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8.o
3.4
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4.6
21.3
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711
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0.0
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09.
32.
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39.2
1.5
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0.0
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24.
1.0
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0.0
6.6
8.5
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3.0
100.
03.
7.i
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i8.t
4.3
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0
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0
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910
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2.7
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100.
0
IND
US
TR
IAL
GR
OU
P
Diff
eren
ces i
n Ta
x an
d B
ook
Acc
ount
ing,
Sam
ple
I Cor
pora
tions
, 193
6R
atio
s Exp
ress
ed a
s Per
cent
ages
of I
ndiv
idua
l Sou
rces
of D
iver
genc
e to
Agg
rega
te D
iver
genc
e
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bo —
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. ..V
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52.2
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06
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027
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i.0
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8
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552
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0
.0.0
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0
CHAPTER 13 261
profit figure appear to be relatively minor, the alterations arelikely to be small.
Through auditing adjustments, especially during the, yearscovered, the relationships of some components might be shiftedsignificantly. For instance, as discussed in detail in Section E,
amounts of depreciation were disallowed by theTreasury during 1935-40. Comparisons of audited tax re-turns with book charges would therefore show tax depreciationcharges to be soniewhat smaller than those shown by the un-audited data. No information is available concerning thenature or size of auditing adjustments with respect to othercomponents of income.
A CLASS 1: DIVIDENDS RECEIVED
As statutory net income is defined before the credit for divi-dends received is deducted, divergences reported in Class 1exclude those due to this credit. There are few other sourcesof divergence.
With two or three isolated exceptions, divergences resultingfrom dividends received items are both few and small (Table25). One divergence of over $ ioo,ooo tends to cause book profitto exceed statutory net income: a leather manufacturing com-pany reported "dividends deductible under Section 23 (p) ofthe Revenue Act of 1934" (see below). Two divergences ofmore than $ioo,ooo tend to cause statutory net income to ex-ceed book profit: a clothing manufacturer reported "dividendsfrom X Corporation" (name omitted to conceal identity) ofmore than $400,000. Since the names of the companies payingand receiving the dividends are closely similar, they are proba-bly affiliated in some manner. A machine tool manufacturerreported "divijends received from subsidiaries" of more than$140,000.
In general, divergences in Class i cannot easily be dividedinto subclasses. Nevertheless, several examples are interesting.The following tended to cause book profit to exceed statutorynet income: (a) Dividends in liquidation may have been
Diff
eren
ces i
n Ta
x an
dBoo
k A
ccou
ntin
g, B
asic
Dat
a, S
ampl
e I C
orpo
ratio
ns, 1
936
AM
OU
NT
OF
DIV
ERG
ENC
E ($
)A
NA
LYSI
S Y
RA
TIO
(%)
NU
MB
ER O
F D
IVER
GEN
CES
IND
UST
RIA
L G
RO
UP
Posi
tive'
Neg
ativ
e'Po
sitiv
e'N
egat
ive'
Posi
tive'
Neg
ativ
e'
DIV
IDEN
DS
REC
EIV
EDM
inin
g &
qua
rryi
ngoo
oo.o
o.0
00
o
Man
ufac
turin
gFo
od &
kin
dred
pro
duct
s00
.11
.00
10
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cco
prod
ucts
oooo
.00
.00
oo
Liqu
ors &
bev
erag
es•
oooo
.00
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oo
Text
iles,
clot
hing
, & a
ppar
el1,
809
423,
517
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20.9
41
2
Pape
r, pr
intin
g, &
pub
lishi
ng00
.02
.00
10
Che
mic
als &
alli
ed p
rodu
cts
290
00.0
3.0
01
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one,
cla
y &
gla
ss00
25,2
4600
1.48
01
Iron
, ste
el, &
non
ferr
ous m
etal
s15
,066
3,15
0.6
4.1
33
Indu
st.,
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ther
mac
h. &
tool
mfr
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714
3,34
4.0
12.
354
Aut
os, a
ircra
ft, &
ship
build
ing
oo00
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00
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isce
llane
ous
115,
506
007.
79.0
00
Fina
nce
86,2
7327
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.92
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74
Trad
e63
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00.5
8.0
06
o
Mis
cella
neou
s com
pani
es00
00.0
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00
o
Serv
ice
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.00
.00
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ic u
tiliti
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co.0
0.0
00
o
Man
ufac
turin
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od &
kin
dred
pro
duct
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o pr
oduc
tsLi
quor
s & b
ever
ages
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iles,
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hing
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Pape
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lishi
ngC
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ical
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ther
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build
ing
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cella
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s
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ing
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uarr
ying
255,
051
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21C
API
TAL
GA
INS
OR
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SSES
3.27
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6
50,0
1110
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11,8
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0,29
8
2,79
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179,
778
7,73
716
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2,38
3
4,29
9 0013
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46,4
90
13,1
9912
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134,
702
397,
631
480,
538
61,8
5717
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Fina
nce
Trad
eM
isce
llane
ous c
ompa
nies
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ic u
tiliti
es
7.28
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2.99
...0
01.
281.
475.
952.
30
.21
.98
.00
1.26
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7.90
7.69
17.0
0.1
37.
87
1.40
5.37
.i61.
17
26.5
222
.11
.12
.02
.11
.01
2.47
.00
1.59
.05
23
20
14
103
41
01
24
76
715
511
35
1015
4.3
11 0
2,49
8,04
82,
083,
193
ii,8i
i1,
936
1,12
078
9,78
400
546,
576
16,2
87
TAB
LE 2
5 (c
ont.)
AM
OU
NT
OF
DIV
ERG
ENC
E ($
)A
NA
LYS
ISV
RA
TIO
(%)
NU
MB
ER
OF
DIV
ERG
ENC
ESIN
DU
STR
IAL
GR
OU
PPo
sitiv
e*N
egat
ive
Posi
tive
Neg
ativ
ePo
sitiv
eN
egat
ive
TOTA
L IN
TER
EST
REC
EIV
EDM
inin
gir q
uarr
ying
85,0
6700
1.09
.00
Man
ufac
turin
gFo
od &
kin
dred
pro
duct
s7,
707
001.
12.0
02
Toba
cco
prod
ucts
99,5
5100
27.3
3.0
0o
Liqu
ors &
bev
erag
es17
,203
00i.8
6.0
03
0Te
xtile
s, cl
othi
ng, &
app
arel
12,4
0741
.6i
.00
Pape
r, pr
intin
g, &
pub
lishi
ng19
,498
001.
45.0
06
Che
mic
als &
alli
ed p
rodu
cts
2,53
600
.25
.00
1
Ston
e, c
lay
& g
lass
62,1
4700
3.64
.00
8o
Iron
, ste
el, &
non
ferr
ous m
etal
s22
,083
00.9
4.0
05
0In
dust
., ag
r., &
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er m
ach.
& to
ol m
fr.
2054
235,
160
3.37
.o8
273
Aut
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ircra
ft, &
ship
build
ing
49,7
1131
4.32
.00
6M
isce
llane
ous
1o6,
2o7
485
7.16
.03
7
Fina
nce
106,
648
7,04
66
2
Trad
e15
5,52
200
1.42
.00
210
Mis
cella
neou
s com
pani
es47
,541
004.
58.0
03
0
Serv
ice
15,1
2100
3.82
.00
60.
Publ
ic u
tiliti
es64
,625
75,7
79.1
9.2
215
INTE
RES
T R
ECEI
VED
FR
OM
TA
X-E
XEM
PT S
ECU
RIT
IES
Min
ing
& q
uarr
ying
85,0
6700
1.09
.00
110
Man
ufac
turin
gFo
od &
kin
dred
pro
duct
s7,
707
001.
52.0
02
0To
bacc
o pr
oduc
ts95
,551
oo27
.33
.00
10
Liqu
ors
& b
ever
ages
17,2
0300
i.86
.00
30
Text
iles,
clot
hing
, & a
ppar
el9,
822
41.4
8.0
04
1
Pape
r, pr
intin
g, &
pub
lishi
ng18
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001.
37.0
05
0C
hem
ical
s & a
llied
pro
duct
s2,
536
00.2
5.0
01
0St
one,
cla
y &
gla
ss00
3.64
.oo
80
Iron
, ste
el, &
non
ferr
ous m
etal
s22
,083
00.9
4.0
05
0In
dust
.,ag
r., &
oth
er m
ach.
& to
ol m
fr.
205,
423
003.
37.0
027
0
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ircra
ft,&
ship
build
ing
49,7
1131
4.32
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61
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cella
neou
s10
6,20
700
7.16
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70
Fina
nce
106,
648
001.
13.0
06
0
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e10
4,27
600
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.00
200
Mis
cella
neou
s com
pani
es47
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004.
58.0
03
0
Serv
ice
15,1
2100
3.82
.00
60
Publ
ic u
tiliti
es24
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00.0
7.0
0-
130
TAB
LE 2
5 (c
ont.)
AM
OU
NT
OF
DIV
ERG
ENC
E ($
)A
NA
LYS
ISY
RA
TIO
(%)
NU
MB
ER
OF
DIV
ER
GE
NC
ES
IND
UST
RIA
L G
RO
UP
Posi
tive'
Neg
ativ
e*Po
sitiv
e'N
egat
ive'
Posi
tive'
Neg
ativ
e'
OTH
ER IN
TER
ES1
RE
CE
IVE
DM
inin
gqu
arry
ing
0000
.00
.00
00
Man
ufac
turin
gFo
od &
kin
dred
pro
duct
s00
00.0
0.0
0o
0To
bacc
o pr
oduc
ts00
00.0
0.0
0Li
quor
s & b
ever
ages
oo00
.00
.00
00
Text
iles,
clot
hing
, & a
ppar
el2,
585
00.1
3-
.00
10
Pape
r, pr
intin
g, &
pub
lishi
ng1,
048
00-.0
5.0
01
0C
hem
ical
s & a
llied
pro
duct
s00
00.0
0.0
00
0St
one,
cla
y &
gla
ss00
00.0
0.0
00
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on, s
teel
, & n
onfe
rrou
s met
als
0000
.00
.00
0o
Indu
st.,
agr.,
& o
ther
mac
h. &
tool
mfr
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5,16
0.0
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8o
Aut
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ircra
ft, &
ship
build
ing
oo.0
0.0
00
0M
isce
llane
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5.0
0.0
30
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nce
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02
Trad
e51
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00.4
7.0
01
o.
Mis
cella
neou
s com
pani
esoo
00.0
0.0
00
(1
Serv
ice
0000
.00
.00
00
Publ
ic u
tiliti
es40
,504
75,7
79.1
2.2
22
3
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ing
& q
uarr
ying
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ufac
turin
gFo
od &
kin
dred
pro
duct
sTo
bacc
o pr
oduc
tsLi
quor
s & b
ever
ages
Text
iles,
clot
hing
, & a
ppar
elPa
per,
prin
ting,
& p
ublis
hing
Che
mic
als &
alli
ed p
rodu
cts
Ston
e, c
lay
& g
lass
Iron
, ste
el, &
non
ferr
ous m
etal
sIn
dust
., ag
r., &
oth
er m
ach.
& to
ol m
fr.
Aut
os, a
ircra
ft, &
ship
build
ing
Mis
cella
neou
s
Fina
nce
Trad
eM
isce
llane
ous c
ompa
nies
Serv
ice
Publ
ic u
tiliti
es-
IN Y
EN
TOR
IE
S12
,912
00.1
7.0
01
0
0000
.00
.00
00
0000
.00
.00
00
0028
,377
•
9,21
0 00.0
01.
40.9
9.0
00 2
1 0
0074
8.0
0.o
60
1
0000
.00
.00
00
7,29
267
,357
.43
3.95
12
1074
2735
0,97
293
,595
22,3
644.
595.
754.
00 .37
2 5
.1 3
58,8
5113
0,07
900 00
5.11
8.77
.00
.00
3 1
0 0
0000
.00
.00
.00
0033
,000
.00
.30
02
7,07
900
.68
.00
20
0000
.00
.00
00
15,0
7114
,975
.04
.04
25
TAB
LE 2
5 (c
ont.)
AM
OU
NT
OF
DIV
ERG
ENC
E ($
)A
NA
LYS
ISV
RA
TIO
(%)
NU
MB
ER
OF
DIV
ERG
ENC
ESIN
DU
STR
IAL
GR
OU
PPo
sitiv
e'N
egat
ive'
Posi
tive'
Neg
ativ
e'Po
sitiv
e' N
egat
ive'
MIS
CEL
LAN
EOU
S IN
CO
ME
ITEM
SM
inin
g &
qua
rryi
ng1,
745,
930
0022
.41
.00
80
Man
ufac
turin
gFo
od &
kin
dred
pro
duct
s44
500
.o6
.00
10
Toba
cco
prod
ucts
0000
.00
.00
00
Liqu
ors &
bev
erag
esoo
3,46
7.0
0.3
7o
Text
iles,
clot
hing
, & a
ppar
el14
,300
541
.71
.03
Pape
r, pr
intin
g, &
pub
lishi
ng00
11.9
7.o
o1
0C
hem
ical
s & a
llied
pro
duct
soo
00.0
0.0
0o
oSt
one,
cla
y &
gla
ss7,
268
00.0
03
0Ir
on, s
teel
, & n
onfe
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AM
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ne,
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& g
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5796
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155,
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247,
583
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& sh
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9
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licut
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L IN
TER
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ts29
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4.o
8.2
71
1
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975
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03
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xtile
s, cl
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190
2,52
8.0
1.1
21
1
Pape
r, pr
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g, &
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1
Che
mië
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rodu
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197,
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5
Aut
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ship
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55
Mis
cella
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s1,
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B.0
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Fina
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3940
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601
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Mis
cella
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s com
pani
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600
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Serv
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0053
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40
Publ
ic u
tiliti
es17
,036
,146
49.5
02.
5230
12
TAB
LE 2
5 (c
ont.)
IND
UST
RIA
L G
RO
UP
AM
OU
NT
OF
DIV
ERG
ENC
E ($
)P
ositi
ve'
Neg
ativ
e'A
NA
LYS
IS Y
RA
TIO
(%
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ve'
Neg
ativ
e'N
UM
BER
OF
DIV
ERG
ENC
ESPo
sitiv
e' N
egat
ive'
FUN
DED
DEB
TEX
PEN
SES
Min
ing&
qua
rryi
ng12
,464
00.iG
.00
20
•
Man
ufac
turin
gFo
od &
kin
dred
pro
duct
sTo
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o pr
oduc
tsLi
quor
s & b
ever
ages
Text
iles,
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hing
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ppar
el
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Pape
r, pr
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pub
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hem
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s & a
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ssIr
on, s
teel
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onfe
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h. &
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Aut
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292
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cella
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600
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es15
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856,
890
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7
INTE
RES
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R Y
EAR
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L IN
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ME
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ESM
inin
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qua
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00
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Man
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kin
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s68
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ts29
800
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905
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20
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679
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cella
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sco
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vice
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licut
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s3,
843
6,53
1.0
1.0
22
2
TAB
LE 2
5 (c
ont.)
IND
UST
RIA
L G
RO
UP
AM
OU
NT
OF
DIV
ERG
ENC
E ($
)P
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ve'
Neg
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NA
LYSI
S Y
RA
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MB
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tive'
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Fina
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00
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00
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cella
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s com
pani
es
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0000
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00
Publ
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tiliti
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RES
TO
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TED
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CU
RR
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Min
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Min
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000
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984
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r, pr
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mic
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004,
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Aut
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13,5
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cella
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290
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8-
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25 (c
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AM
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OF
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NA
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RA
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(%)
NU
MB
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Posi
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7976
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9,77
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322.
16.7
49
6
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r,prin
ting,
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000
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81
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mic
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2,46
76,
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33
Ston
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1715
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315
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26
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9,91
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36
Publ
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304,
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012
14
RE
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S A
ND
RO
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LTIE
S P
AID
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72,2
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774
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07.
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ever
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tiles
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02
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cella
neou
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00
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00
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licut
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s55
000
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10
TAB
LE 2
5 (c
ont.)
IND
UST
RIA
L G
RO
UP
AM
OU
NT
OF
DIV
ERG
ENC
E ($
)P
ositi
ve*
Neg
ativ
e*A
NA
LYSI
S Y
RA
TIO
(%)
PO
sitiv
e*N
egat
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MB
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Pos
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Neg
ativ
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.
42,8
78TO
TAL
239,
825
NO
NA
LLO
WA
BLE
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3.06
RES
ERV
ES 2
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turin
gFo
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kin
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duct
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tsLi
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s & b
ever
ages
Text
iles,
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hing
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.
39,6
5721
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3
11,9
2620
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56,5
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3
5.77
5.95
4.74
4.97
1.74
5.75 6.io
9.02
2 3 5 4
3 4 6 10
Pape
r, pr
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g, &
pub
lishi
ngC
hem
ical
s & a
llied
pro
duct
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cla
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lass
Iron
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l,&no
nfer
rous
met
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2524
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Mis
cella
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pani
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1,82
539
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1I
Publ
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tiliti
es50
9,85
341
0,83
71.
481.
1916
20
NO
NA
LLO
WA
BLE
RES
ERV
ES F
OR
INSU
RA
NC
EA
ND
CO
MPE
NSA
TIO
NM
inin
g &
qua
rryi
ng40
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58,4
53.5
2.7
51
4
Man
ufac
turin
gFo
od &
kin
dred
pro
duct
soo
1.72
9.0
0.2
50
1
Toba
cco
prod
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oo6,
565
.oo
i.8o
01
Liqu
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bev
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13,
718
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.40
12
Text
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eloo
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00
0
Pape
r, pr
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g,&
pub
lishi
ngoo
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13.0
01.
300
2
Che
mic
als &
alli
ed p
rodu
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Ston
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9,58
27.
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, ste
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s29
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27.5
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27,1
331.
42.4
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Aut
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build
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2,75
53,
617
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21
Mis
cella
neou
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00.0
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Fina
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049
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Mis
cella
neou
s com
pani
es31
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10
Serv
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--
1,82
500
.46
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10
Publ
ic u
tiliti
es8g
,688
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6.5
85
11
TAB
LE 2
5 (c
ont.)
IND
UST
RIA
L G
RO
UP
AM
OU
NT
OF
DIV
ERG
ENC
E ($
)P
ositi
ve'
Neg
ativ
e'A
NA
LYSI
S Y
RA
TIO
(%)
Pos
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'N
egat
ive'
NU
MB
ER O
F D
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GEN
CES
Posi
tive'
Neg
ativ
e'
Min
ing
& q
uarr
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Man
ufac
turin
gFo
od &
kin
dred
pro
duct
sTo
bacc
o pr
oduc
tsLi
quor
s & b
ever
ages
Text
iles,
clot
hing
, & a
ppar
elPa
per,
prin
ting,
& p
ublis
hing
Che
mic
als &
alli
ed p
rodu
cts
Ston
e, c
lay
& g
lass
Iron
, ste
el, &
non
ferr
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1,91
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cella
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7,80
0.0
0.7
50
1
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00
Publ
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esg8
889
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11
TAB
LE 2
5 (c
ont.)
AM
OU
NT
OF
DIV
ERG
ENC
E ($
)A
NA
LYS
ISY
RA
TIO
(%)
NU
MB
ER
OF
DIV
ERG
ENC
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DU
STR
IAL
GR
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PPo
sitiv
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egat
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Posi
tive'
Neg
ativ
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sitiv
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egat
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NO
NA
LLO
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BLE
RES
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ES F
OR
SA
LES
EXPE
NSE
SM
inin
g &
qua
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00.0
0.0
00
0
Man
ufac
turin
gFo
od &
kin
dred
pro
duct
soo
6,71
0.0
0.9
80
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bacc
o pr
oduc
ts5,
560
1,36
41.
53.3
72
2Li
quor
s & b
ever
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othi
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747
153,
094
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7.57
17
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r, pr
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pub
lishi
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16,8
9357
1.26
.00
1.
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hem
ical
s & a
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pro
duct
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20
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905
2,74
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ther
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49,4
6126
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5.8
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389
10
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build
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001,
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1
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cella
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283
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92.
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8,24
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cella
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s com
pani
es9,
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01
0
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0000
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Publ
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tiliti
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94.o
6.1
41
3
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ALL
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LER
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VE
S(I
NC
L.C
ON
TIN
GEN
CY
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ES)
Min
ingb
qua
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ng2,
180
181,
372
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11
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kin
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pro
duct
s37
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3,48
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11
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ors
& b
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ages
40,1
6738
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4.33
4.12
31
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tiles
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thin
g, &
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57,9
5625
02.
86.0
12
1
Pape
r, pr
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Publ
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3
25(c
ont.)
AM
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NA
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11
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262,
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724
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742.
533
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oo16
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s37
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28.6
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pani
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423
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13.8
32.
314
8
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18,9
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9,99
44.
8030
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26
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es1,
053,
113
521,
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3.06
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NA
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605
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r, pr
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2,77
6.0
0.2
10
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pro
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(con
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61
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0.
298 PART TWOtreated as income items for book purposes but as a return ofcapital for tax purposes. (b) For the corporations deductingdividends under the Revenue Act of i934, Section 23 (p), statu-tory net income is not defined as it is above.1 (c) Two com-panies reported treasury stock dividends. (d) Nontaxablestock dividends were presumably regarded as increasing bookprofit.
Examples tending to have the opposite effect, namely, tocause statutory net income to exceed book profit, follow:(a) Dividends received from subsidiaries were apparently in-cluded in statutory net income but not in book profit. (b)Dividends from domestic èompanies were reported as "creditedto surplus" on the books of one company but were included instatutory net income. In another and possibly more typicalcase, dividends received were credited to an asset account(probably an investment account) instead of to income or sur-plus. (c) Dividends in arrears were reported as "capitalized"by one company for book purposes, but presumably were tax-able in the year received. The exact nature of this transactionis not clear, since dividends received are not ordinarily capital-ized in the strict accounting sense of the term. Possibly cumu-lative preferred dividends were treated as accrued income inpreceding years even though they had not been received. Inthis event, the current year book credit for income from divi-dends received would include only dividends accrued duringthe current year. But, according to the tax regulations, all divi-dends, both those accruing in the current year and in preced-ing years, would be regarded as current year income. If, on theother hand, the dividends were not accrued in preceding years,they may have been credited to surplus instead of to incomefor boOk purposes, since they may have been regarded as actu-1 Why these companies reported their 1936 incomes under the 1934 Act is notknown. Perhaps fiscal year complications are involved. Section 23 (p), providingthat the amount received as dividends from. a domestic corporation subject totaxation under the 1954 Act may be deducted from gross income in determiningstatutory net income, was replaced by a partial dividend credit in the RevenueAct of 1956.
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ally representing preceding years', rather than current, in.come. (d) One company reported taxable stock dividendswhich were not entered on its books as income.
B CLASS 2 CAPITAL GAINS AND LOSSES
Different amounts of capital gains and losses may be reportedfor tax and book purposes for a wide variety of reasons. Noattempt will be made to explain or to classify these reasonssystematically. An explanation would obviously entail a dis-cussion of the intricate problems of reorganization procedure,basis determination, and depreciation and depletion account-ing, and the considerations involved in deciding whether totreat an item as an income or surplus charge for book purposes.These issues are discussed in detail in Part One.
Unfortunately, the data on capital gains and losses are not• consistently reported in sufficient detail to warrant subdivi-
sion. The unsegregated data are presented in Table 25. Ap-proximately 30 percent of the companies in Sample 1 reportdifferent treatments of capital gains and losses for book andtax purposes. Except for two industrial groups—iron and steeland nonferrous metals companies, and finance companies—theAnalysis Y ratio lies with surprising consistency, in view of thesize of the sample, in the o-8 percent range. In general, devia-tions in Class 2 seem considerably smaller than might havebeen expected. The high ratio for the iron and steel and non-ferrous metals group is attributable to the unusually largedeviations reported by two companies. Consequently, it prob-ably may be regarded as a statistical accident rather than as anindication that Class 2 divergences are especially large in thisparticular group. On the other hand, the high ratio for thefinance group—accounting for nearly half of aggregate diver-gences in this group—is entirely in accord with expectations.While individual divergences vary from negligible amounts tonearly $i,ooo,ooo, there is a liberal sprinkling of large diver-
• gences, including at least a half dozen of more than $ioo,ooo.Even though from the evidence of Sample I, capital gains and
300 PART TWOlosses may seem not to be a major source of divergence exceptamong financial enterprises, Class 2 is important because anextremely large divergence may appear at any time in any in-dustrial group.
Moreover, the importance of divergences in Class 2 mayconceivably be seriously underestimated because items thatproperly belong in it were put in other classes. In some degreethe line between "losses on the abandonment of fixed assets"(Subclass 6d) and "nonallowable reserves for investment andexchange fluctuations" (Subclass 12c) on the one hand, andClass 2 on the other, was difficult to draw. In general, itemsrepresenting merely unrealized adjustments of book valueswere put in Subclass i while Class 2 consists of realized gainsand losses. Moreover, certain Class 2 items may be concealedin the unspecified portions of the two miscellaneous classes, 5and 13, or in Subclass 12C, "other nonallowable reserves". In-deed, the general principle may be laid down that divergencesin all narrowly defined classes, as distinct from the 'miscellane-ous' classes, are likely to be understated because of the diffi-culty of identifying some items not described in detail on taxreturns. Nevertheless, these possible sources of understate-ment probably do not drastically distort the impression Class2 gives.
Despite the lack of detail, a case by case perusal of Class 2divergences reveals certain pervasive causes. At least 20 com-panies reported divergences due to different bases for tax andbook purposes. For example, a textile company reported ahigher tax than book net residual value of fixed assets disposedof during the year. A metal company reported a loss on securi-ties sold which had been written down on its books to nominalvalues in prior years. This write-down was, of course, notrecognized for tax purposes. Divergences of this general naturemay reflect merely a difference in the particular accountingperiods to which income is assigned for the two purposes.
At least ten companies reported taxable capital gains or de-ductible losses that had been credited or charged to surplus on
CHAPTER 13 301
their books. As the above discussion indicates, such divergencesare permanent; they will never be offset.
At least a dozen companies—probably considerably more—reported net capital losses in excess of $2,000 for book pur-poses. Statutory deductions for net capital losses, however,were limited to $2,000 in 1936. Divergences thus caused willnot be offset in subsequent years. The great majority of theremaining ioo cases are not described in sufficient detail towarrant classification; doubtless many fall into the subclassesalready described.
C CLASS INTEREST RECEIVED
Under the definition of statutory net income used in Statisticsof Income for 1936 and here, deviations due to different treat-ments of interest-received items are moderately common butsmalL The definition of statutory net income must, however,be kept carefully in mind (see Ch. 10, Sec. D).
Interest received from tax-exempt securities, Subclassconstitutes the chief source of divergence in Class (Table 25).Consequently, most Class 3 divergences tend to cause bookprofit to exceed statutory net income. But the quantitative im-portance of the class as a whole is small. The Analysis Y ratioexceeds 5 percent for only two industrial groups, and for mostgroups it is less than 2 percent. The high ratios for the tobaccogroup, very poorly represented in Sample I, and for the mis-cellaneous manufacturing group, reflect single divergences;hence, they are not statistically significant. In no industrialgroup is the Subclass 3b ratio, which summarizes 'other inter-est received' divergences, higher than one-half of 1 percent.
Except for the two cases in Subclass tending' to causestatutory net income to exceed book profit, both for "negativeinterest on United Treasury Notes", illustrations are super-fluous. Illustrations of Subclass 3b divergences are interest re-ceived applicable to prior years; interest earnings credited toreserve for contingencies; differences between interest accruedand received; and net interest received on settlement of prior
302 PART TWOyear income taxes. Some will be canceled by offsetting items insubsequent years, while others represent• permanent differ-ences in the amount of income reported for tax and businesspurposes.
D CLASS 4 INVENTORY ACCOUNTING
Until 1938 and 1939 at least, tax requirements for the valua-tion of inventories were rather rigid, barring for tax purposesthe industrial practices of many firms. Most of these industrialpractices are designed to minimize the effect of changes inprices upon profits. The base stock, inventory reserve, and last-in first-out methods all have this effect. In 1936 none of thesemethods was allowed for tax purposes.
Divergences may arise from other less basic causes thandifferent methods of valuing inventories. For instance, obso-lescence reserves may be set up for book purposes before theTreasury is willing to recognize that a portion Of the inventoryhas become obsolete.
Deviations due to different treatments of inventories aresmaller than might have been expected. Only companies—less than 7 percent of the sample—reported Class 4 diver-gences. Moreover, few are large. The ratio for the miscellaneousmanufacturing group is an exception: one company reported$130,000 for a charge to a reserve for its inventory adjustmentaccount. The machinery and other metal products group re-ported 8 divergences; in this group a single large divergenceaccounts for two-thirds of the Analysis Y ratio, which is slightlyover 6 percent.
As in the case of capital gains and losses, the data do notjustify rigid conclusions concerning the importance of diver-gences due to differences in the treatment of inventory. Itemsthat properly belong in Class 4 may be concealed in the mis-cellaneous classes. Moreover, the possibility that large devia-tions may appear at any time renders prediction on the basisof a small sample especially dangerous. A substantial portionof the divergences arose because an 'inventory reserve' account,
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not permitted for tax purposes, was used for book purposes.When credits to an inventory reserve account set up from in-come exceed charges against the account, book profit will tendto be less than statutory net income. Similarly, when charges
• exceed credits, book profit will tend to exceed statutory netincome. Several examples of both cases are included in thesample.
Inventory reserve accounts may apply to the entire inven-tory and be set up to mitigate the effects of fluctuations inprices; or they may apply to specific portions of the inventoryand be set up to absorb losses from obsolescence. Often thepurpose of the reserve account is not specified. Once or twicethe reserve was specifically designated as set up to mitigate theeffects of fluctuations in prices. More frequently it was re-ferred to as a "reserve for defective goods" or a "merchandiseobsolescence reserve". Most of the illustrations involving in-ventory reserve accounts merely state that the deviation re-sulted from a net charge or credit to the account. Such casespresumably would not create permanent differences in thetwo income concepts. A "loss on obsolete inventory charged tosurplus on books", on the contrary, will not be offset in sub-sequent years. Other divergences not obviously related to areserve account include a provision for "the valuation of ac-quired inventory to production costs"; unrealized profits onintercompany inventories; and an item representing thedifference between the lower of cost or market, presumablythe tax value, and the book value of inventories.
E CLASS 5 MISCELLANEOUS INCOME ITEMS -
One of the most difficult tasks encountered in the analysis ofSample I was the proper treatment of divergences too few orsmall or too ambiguously described to warrant inclusion insharply defined classes. Such items were thrown into two 'allother' classes—'miscellaneous income items' (Class 5) and'miscellaneous deduction items' (Class 13). Although itemsallocated to the miscellaneous classes are not always clearly
304 PART TWOdescribed, an attempt was made to place in Class 5 items thataffect the amount of gross income reported. Items representingdeductions from gross income were placed in Class 13.
The items in Class 5 vary widely in nature. Nevertheless,certain well defined causes of divergence are included. One issufficiently important to constitute a major cause of diver-gence in one industrial group. About three-fourths of the 73deviations assigned to Class 5 tend to cause book profit to cx-.ceed statutory net income. In 1 1 of the 17 industrial groups theAnalysis Y ratio is smaller than 5 percent. In 5 of the remain-ing 6 groups no systematic cause of divergence is responsiblefor the substantial Class 5 deviations. A single item of over$i,6oo,00o, "oil revenue from property leased from State of X"(name of state concealed), accounts for almost the entire diver-gence in the mining group. Most of the divergence in thepaper, printing, and publishing group is caused by one com-pany which transferred a reserve for unrealized profits to cur-rent earnings on its books. An item entitled "excess bOok overactual profit" accounts for most of the deviation in the financegroup.
The deviations in these classes are interesting, but they donot represent frequently recurring causes of divergence. In the•trade group, on the other hand, the use of an installment basisof computing sales fbr one purpose but not for the other ac-counts for over half of the total number of divergences and forover 90 percent of the total amount of divergence.
• The nature of Class 5 items has already been indicated, buta few more illustrations may be of interest. Thirteen diver-gences are due to different treatments of deposits in closedbanks. Such divergences may cause a variation in either direc-tion. Book profit tends to exceed statutory net income in one
• case when a recovery was made from a closed bank. The de-posits in the closed banks had been written off on the books inpreceding years, but this deduction was not allowed for taxpurposes. In a second case the situation was reversed: the de-duction had been taken for tax but not for book purposes in
CHAPTER. 13 . 305
preceding years. Thus in the year of recovery an income creditwas recorded only for tax purposes.
Examples such as "1925 income item" and "income taxed inprior year by Revenue Agent" represent divergences arisingfrom the limited period covered by the data. Both of these cx-arn.ples tend to make book profit larger than statutory net in-come in 1936, apparently because the company was morecautious than the tax authorities in recognizing the realizationof income. In several cases adjustments or deferments of rentaland royalty incomes created divergences. Dividends and dis-counts on treasury stock likewise caused several divergences.In the public utility group a half dozen companies reported"contributions from others credited to income" on their books;in these instances, these contributions did not constitute tax-able income. Only a few of the remaining cases are so in-completely described that they may actually belong in otherclasses.
F CLASS 6: DEPRECIABLE AND DEPLETABLE ASSETS
1 Sample IData'Class 6 and the seven classes that follow constitute deductionsfrom gross income. Class 6 is one of the largest sources of diver-gence, both quantitatively, and numerically; for analysis it wasdivided into four subclasses.
Subclass 6a is composed of divergences that arise from differ-ing depreciation allowances for book and tax purposes. Anyone of many causes may bring about different depreciationcharges, but they arise mainly from different bases on whichdepreciation is allowed and different rates at which assets aredepreciated.
Differing depletion allowances are grouped in Subclass 6b.Two causes probably explain the largest items in this subclass.The percentage-of-gross-income and discovery-value methodsof computing depletion deductions, allowable in certain casesfor tax purposes, are exceedingly generous to the taxpayer.Companies that use these methods for tax purposes usually
306 PART TWOtake considerably smaller depletion deductions on their books,if, indeed, they take any book deductions at all. Thus tax de-pletion deductions exceed book depletion deductions bothbecause of the generosity of the former and the absence of thelatter.
The cost of depreciable assets may be either charged di-rectly to current expenses or be set up as an asset subject to de-preciation in subsequent years; divergences due to the adoptionof one of these methods for book purposes and the other fortax purposes were put in Subclass 6c. Subclass 6c divergencesare uniformly small. The largest number of items is reportedby the finance group. Possibly financial companies regard theirwasting physical assets as of such minor importance that theywrite them off as current expenses for book purposes. Themost common source of divergence is reported in the recon-ciliation schedule as "furniture and fixtures, additions orbetterments treated as expenses on books less depreciation onfurniture and fixtures". In subsequent years the tax chargewould Continue to appear as a depreciation deduction, but nooffsetting book deduction would be shown. Other items, suchas tools and dies, have been treated similarly. The procedurewas reversed in the case of repairs, which were charged off im-mediately for tax purposes but deferred for book purposes.Possibly such repairs should not be placed in Subclass 6c.
Subclass 6d comprises divergences arising from the 'retire-ment of fixed assets'. Two obvious reasons probably accountfor most of these divergences. First, the practice of some com-panies of charging losses on such retirements to surplus ontheir books, especially if the losses are unexpected, will usuallycreate a divergence tending to cause book profit to exceedstatutory net income. Secondly, different bases for tax andbook purposes will give rise to different charges at the time ofretirement.
As expected, Subclass 6d divergences are not frequent butthey are often large. Only 39 companies—less than 8 percentof the sample—reported such divergences. In 12 industrial
CHAPTER 13 307
groups the Analysis Y ratio is lower than 2 percent. On theother hand, 3 groups reported ratios ranging—because ofisolated divergences—from over 9 to nearly 36 percent.
Most items in Subclass 6d are described simply as "loss onassets scrapped", "retirement losses", or by some similarphrase without any detailed explanation of the nature of thedivergences arising from these losses. Fora few items, more de-tail was given. For example, one company reported a "loss onabandonment of furniture and fixtures in discontinued dc.partments charged to capital surplus". Another reported thata portion of the losses experienced on the abandonment ofbuildings was deferred on its books but written off for taxpurposes. In contrast to these two instances the book deduc-tion of one company exceeded its tax deduction at the timemachinery and equipment were scrapped, since the appraisedbook value of these assets exceeded their cost.value and wascharged to current income.
These subclasses are by no means unrelated. Different de-preciation policies may be responsible for divergences uponthe retirement of partly depreciated assets. A decision to treatan item as a current expense on one set of accounts and as acapital asset on the other will create divergences in basis andin depreciation charges, in both current and subsequent ac-counting periods.
Table 25 reveals the great importance of divergences in de-preciable and depletable assets. Two hundred ninety-sevendivergences are reported by the 505 corporations comprisingSample I. Some companies reported divergences in more thanone subclass. The total number of Class 6 divergences was cal-culated by adding the number of divergences in each subclassrather than by determining the number of companies report-ing divergences.
Analysis Y ratios vary widely from one industrial group toanother, but in general they are high with sufficient consist-ency to warrant the conclusion that different treatments ofdepreciable and depletable assets are the largest single source
308 PART TWO
of differences between book profit and statutory net income.Moreover, the dispersion among industrial groups appears toreflect actual differences in the importance ofdepreciable anddepletable assets in different industrial groups; at any rate, itaccords with expectations. For instance, depreciation is of rela-tively minor importance in the finance, service, and trade in-dustries. Precisely these groups reported the smallest ratios forClass 6 divergences.
With the exception of the mining group and of one or twoother groups where accidental causes probably predominate,divergences in depreciation charges constitute the dominantreason for Class 6 deviations. In the mining group depletiondifferences are the major cause of divergence. They comprisesubstantially the entire Class 6 divergence and over half of alldivergences in the mining group. A few.dépletion divergencesare scattered among other industrial groups, but they are ofno general importance.
Data on tax returns are not sufficiently detailed to permitallocation into finer subclasses, but enough detail is presentedon some returns to provide interesting illustrations. The fol-lowing instances are typical of divergences arising from differ-ent treatments of depreciation tending to cause book profit toexceed statutory net income. Tax deductions for depreciationwere claimed in 1936 when the book deductions had beentaken earlier. Some of these cases undoubtedly represent cur-rent year depreciation divergences resulting from prior yearSubclass 6d divergences. In other instances book depreciationwas computed on a lower basis than the tax basis. Thus, at thesame rates of depreciation the taxj charge would exceed thebook charge. One company reported a larger tax deduction for.depreciation on a cost basis than on the revalued basis for bookpurposes. Another reported higher depreciation and amor-tization based on cost than on appraised values. Occasionally,a tax. deduction was allowed when no book deduction wastaken in either the current year or prior years. For example,depreciation, was charged to surplus on the books of one corn-
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pany. In other cases book depreciation was charged to obso-lescence reserves, and, therefore, would not constitute an in-come deduction in the current year; moreover, if this reservehad been created from a surplus account, it would at no timehave constituted an income deduction. A public utility com-pany reported excess allowable depreciation over renewals'and replacements taken as book deductions. Doubtless otherexamples are concealed in the many unexplained divergencesreported merely as depreciation divergences.
The divergences tending to cause statutory net income toexceed book profit are considerably less varied in nature. Themost' common source is 'depreciation on appreciation'; that is,the book basis of the assets was written up higher than the taxbasis, and the revaluation results in larger book deductionsfor depreciation in subsequent years. Sometimes such a diver-gence may reflect purely a book revaluation of assets. At othertimes it undoubtedly reflects a difference in basis due to a re-organization or other transfer of assets from one corporationto another. For instance, one company reported a difference.in .the depreciation taken on the appraised book value of assetsas compared with the tax depreciation based on the cost to itspredecessor. Other examples include depreciation accrued onthe books but not deducted on the tax return; depreciation'applicable to prior years taken on the books but not allowedfor tax purposes; depreciation for taxable year on fire loss re-placement not allowed for tax purposes; and many unex-plained items such as "book depreciation in excess of federal"and "excessive
Few depletion divergences are described in much detail;frequently no information is given beyond the brief comment"divergent depletion charges". Several companies reported"excess depletion allowed for tax purposes". Occasionally, de-pletion computed by the percentage method for tax purposesis mentioned as exceeding book depletion. At least one com-pany reported "depletion not recorded on books". The fewcases in which book depletion charges exceeded the tax charges
310 PART TWOinclude such items as "depletion not on return", "depletionnot deductible", and "depletion not claimed". It should beemphasized once again that Sample I does not include oil andgas producing companies. Hence the important deviations inthis industry resulting from different treatments of deductionsfor depletion and of intangible drilling costs are not reflectedin the sample.
2 Sample II DataThe above, measures of the relative importance of differenttreatments of depreciable and depletable assets in terms ofaggregate divergences between book profit and statutory netincome are now supplemented by Analysis X ratios computedfrom Sample II data (Tables 26 and 27).2
From Table 26 the following tendencies may be noticed aspoints worthy of further investigation.3 Tax depreciationcharges for public utilities are apparently consistently largerthan the corresponding book charges. The opposite relation-ship seems to hold, although to a much smaller degree, for thefoods, beverages, and tobacco manufacturing group. On thewhole, with the exception of the public utility group, theaverage differences between book and tax depreciation, byindustrial groups, are remarkably small. This conclusion be-comes more impressive when the relatively small size of thesample is considered. The averages, however, conceal a widedispersion of individual companies. Book deductions are per-haps slightly larger in 1936 and ig37, relative to tax deduc-tions, than in 1934 and 1935, but the evidence is inconclusive.
In connection with the comparison of book and tax deduc-tions for depreciation it is important to recall that the tax2 The Analysis X ratio is computed for Sample H because aggregate deprecia.tion and depletion charges are available; data with respect to the aggregatecauses of divergence between book profit and statutory net income, as used inthe Analysis Y ratio, are not available. For Sample I the situation was the reverse.3 Throughout this section and Section 8 the qualifications made in Chapter io,Section Ci, because of the imperfect comparability of the data should be keptin mind.
e
CHAPTER 13 311.TABLE 26
Ratio of Divergences between Tax and Book Deductions to theirArithmetic Mean, Sample II Corporations, 1934—1937
* This ratio is abnormally large (algebraically) because one, large company re-ported substantial book depreciation atici depletion charges in hut no taxdepreciation and depletion charges whatsoever. This probably represents anerror in reporting rather than a significant difference. The ratio under 'Depre-ciation' above, —15.3, is undoubtedly more representative of the sample.
data are taken from unaudited tax returns. Under Congres-sional pressure the Treasury inaugurated in 1934 a campaignto increase tax revenues by disallowing unduly large claimsby taxpayers for depreciation deductions (Ch.3, Sec. A3). Theannual reports of the Commissioner of Internal Revenue in-dicate that during the five years ending June 30, 1940, approx-imately $i billion, or an annual average of $200 million, ofclaims for depreciation were disallowed by the Treasury. The
TABLE 27: Tax and Book Deductions, Sample II Corporations, 1934—1937(dollar figures in millions)
MANUFACTURINGFood, hey.
MINING Total & tobacco Metals Misc. TRADE PUB. UT. MISC. CO.
Tax ded. .11 5.24 .96 2.83 1.45 2.57 2.20 1.01Book ded. .o6 4.72 .93 2.12 1.67 2.45 2.36 .62* The tax depreciation and depletion deduction for the public utilities group in 1934 exceedsthe book deduction by only a small amount because one large company took substantial de-
ductions on its books but did not claim any deduction on its tax return. The depreciation datafor the public utilities group in 1934 are undoubtedly more representative of the sample.
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amounts disallowed were approximately 6 percent of totalannual deductions for depreciation claimed by corporate tax-payers.
In interpreting these auditing adjustments several pointsshould be noted. First, the $i billion figure is for total disal-lowances of depreciation claims; some part—though presum-ably a small part—is for disallowances of deductions for depre-ciation claimed by unincorporated enterprises. Secondly,there is no way of distributing these amounts to the tax yearsto which they apply. Thirdly, it seems reasonable to believethat the amounts disallowed in 1935-40 were abnormally largebecause of the special pressure applied to the Bureau of Inter-nal Revenue by Congress.4
The important difference between the 'Depreciation' and'Depreciation and Depletion' sections of Table 26 lies, ofcourse, in the mining group, where tax charges for depletionfar exceed book charges. In the first sectiOn mining corpora-tions were included among 'miscellaneous companies' sinceonly a few mining companies reported no or negligible chargesfor depletion. Moreover, the mining companies reporting nodepletion charges for book or tax purposes may be assumed tobe atypical. The favorable tax treatment accorded depletioncompanies is a matter of general knowledge; the extent of theadvantage is illustrated by the ratios of the second section.
Table 28 expresses the sum of the deductions for deprecia-tion and depletion taken by the Sample II corporations in1937 as a percentage of the deductions for depreciation anddepletion taken by all corporations in the comparable indus-trial groups of Statistics of Income for 1937, thereby indicatingthe coverage of the sample.
Frequency distributions of the Analysis X ratio for deprecia-tion and depletion charges of the Sample II corporations for4 Indeed, it is presumably only because of this pressure that published informa-tion is available for 1935-40 concerning the amounts of depreciation disallowedby the Treasury. Such data are not available for other disallowances or for de-preciation deductions since 1940.
314 PART TWOTABLE 28
Deductions Reported on Tax Returns by Sample II Corporationsand in Statistics of Income, 1937 (dollar figures in millions)
MANUFACTURINGFood,bev. PUB. MiSC.
MINING Total & tob. Metals Misc. TRADE UT. CO.
DEPRECIATION AND DEPLETION1 Amt. report. by
Sample II corp. 20.52 70.54 8.64 39.00 22.90 9.03 6.47..2 Amt. report, in
Stat, of Income 446.41 1,592.49 187.44 469.60 935.45 276.12 926.20 585.95% line 1 is of 2 4.6 4.4 4.6 8.3 2.4 1.1
5 Amt. report. inStat, of Income 10.79 185.65 27.11 53.81 104.73 183.44 28.95 342.56f
6 % line 4 is of 5 1.0 2.8 8.5 1.4 1.4 7.6 0.5* Because of rounding, the manufacturing groups do not add precisely to the total manu-facturing figure in Statistics of Income.1- Agriculture is excluded from the miscellaneous companies for purposes of comparability.
1937, classified by industrial groups, are presented in Chart5.5 If we omit, for the moment, the mining and public utilitygroups, the following generalizations may be made. There is amarked concentration of Analysis X ratios about a zero value.On the other hand, a small minority of corporations have largedivergences; for instance, approximately 14 percent of allmanufacturing corporations have ratios numerically greaterthan 50 percent.
For the food, beverage, and tobacco industries, taken as aunit, book depreciation and depletion charges systematicallyexceeded the tax charges; 6 the aggregate Analysis X ratio for5 Detailed worksheets were constructed for much finer industrial groups foreach year 1934-37. The charts presented are typical of these worksheets. InChart 5, and also Chart 6, the dotted area in the zero column represents com-panies that report equal amounts of depreciation and depletion (or in Chart 6bad debt expenses) for tax and book purposes. The cross-hatched area repre-sents companies that do not report such charges [or either purpose.6 While the data presented in Chart 5 include both depreciation and depletioncharges, for all industrial groups except mining depletion charges are negligible..Thus, no significant error will be introduced if the charts for the nonmininggroups are interpreted simply as frequency distributions of depreciation charges.
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this industrial group was 7.5-10 percent in each year 1934-37.The beverage group is almost entirely responsible for thetendency of book charges to exceed tax charges. The concentra-don to the right is marked in each year 1934-37. For example,in 1937, 28 percent of the beverage group has Analysis X ratiosalgebraically in excess of +50 percent, while fewer than iopercent of the entire manufacturing group, exclusive of bev-erages, have ratios exceeding +50 percent.
Since 1 beverages, including alcoholic liquors, havebeen a rapidly growing and presumably highly profitable in-dustry. Most of the beverage companies in our sample have re-ported much larger charges for depreciation on their publicstatements than they have claimed for tax purposes. A possibleexplanation is that they may have deliberately attempted tominimize their apparent profitability. Such a policy mighthave been followed for several reasons. Companies could with-hold a larger proportion of their true earnings without arous-ing protest from their stockholders. In addition mightsafeguard themselves from public or political criticism as prof-iteers or from increased competition from new investmentattracted to the industry by its unusual profitability.
The data do not demonstrate the validity of this hypothesis,but they do suggest that more extensive study of depreciationpolicies of companies classified by their rate of profitabilitymight be illuminating. Unfortunately, the present sample isnot adequate for such a study.
The mining and public utility groups have patterns strik-ingly different from the other groups: tax deductions typicallyexceed book deductions, often by large amounts. None of the
corporations in the public utility group, for instance, hasa positive Analysis X ratio exceeding 4 percent. In certainfields of utility operations, the discrepancy between theamounts of depreciation and related expenses taken for thetwo purposes is attributable largely to retirement accounting.
The explanation for the marked tendency of tax deductionsfor depreciation and depletion to exceed book deductions in
A. Mining
8. Food, Beverage, and Tobacco Manufacturing
C. Metal
0. Miscellaneous Manufacturing
E. All
F. Trade
G. Public Utilities
H.
I. Breweries, Distilleries, andOther Beveruge Manufacturing
3i8 PART TWOthe mining group is simple: deductions were computed bythe percentage-of-gross-income or discovery-value methods fortax purposes but not for book purposes.
G CLASS INTANGIBLE ASSETS
The nature of Class 7 divergences varies with the particularintangible asset involved. Differences in the treatment of or-ganization and reorganization expenditures, Subclass forexample, systematically tend to cause statutory net income toexceed book profit. Such expenditures are never allowed asdeductions for tax purposes. For book purposes, however, theyare usually treated as current expenses or as assets subject toamortization.
Patent expenses constitute a second general source of Class7 divergences. Some part of expenditures on patents are or-dinarily regarded as assets subject to amortization for tax pur-poses, but the entire amounts are often charged off as currentexpenses for book purposes. Thus, in the year in which a newpatent is purchased or developed, the book charge is likely tobe larger than the tax charge. In subsequent years, however,when the patent is amortized for tax purposes, the tax chargewill exceed the book charge. The cost of additional patentsin later years may, of course, conceal this relationship.
Other sources of Class 7 divergences were grouped in Sub-class which includes divergences resulting from differenttreatments of all intangible assets except patents and organiza-tion and reorganization expenses. Different treatments of de-velopment expenses are responsible for many deviations. Forexample, one company reports development expenses amor-tized for tax purposes but previously charged to surplus on itsbooks. The different treatments of mining leases are not ex-plained. A large source of divergence in the trade and publicutility groups is the treatment of leaseholds. One com-pany reports the "amortization of cost of leaseholds notcharged off on books"; others report apparently similar itemsin less detail. Most cases mentioned tended to cause book profit
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to exceed statutory net income. The most, frequent source ofdivergence operating in the opposite direction is the treatmentof the cost of issuing new securities or registering securities onstock exchanges. In a sense some of these divergences areclosely similar to reorganization expenses.
A striking fact about the analysis of Classes i -6 is that, ex-cept for isolated items and predictable variations, the relativeimportance of each is surprisingly consistent among industrialgroups. Class 7 divergences, in contrast, vary greatly fromgroup to group and are apparently not explained by specialcauses operating in specific industrial groups. Hence, an eval-uatipn of their probable importance in a larger sample is dif-ficult.
In 9 of the 17 industrial groups the Analysis Y ratio is lowerthan 2 percent. On the other hand, in '?' groups it exceeds 5percent and in 4 groups 10 percent. Class 7 divergences aremoderately common: i i8 are reported by Sample I corpora-tions.
None of the subclasses dominates this class. Twenty com-panies reported different treatments of assets representing or-ganization and reorganization expenditures. Eighteen of theseconform to expectations, showing larger book than tax deduc-tions; in two, unexplained instances the tax exceeds the bookdeduction. Only twice do these divergences exceed $50,000.Fifty companies reported different treatments of patent ex-penses, but the differences are uniformly small; the highestAnalysis Y ratio for Subclass 7b is smaller than 5 percent. Sub-class c has about the same number of divergences as b, butthey run to considerably largcr amounts. In the mining group,for example, two items of over $300,000 are reported, one de-scribed as development costs capitalized and another as astatutory loss on leases written off. A miscellaneous manufac-turing company reported over $400,000 for development ex-penses charged off on its books in 1935 but not claimed as atax deduction until 1936. One retail tradecompany reported
320 PART TWOa special statutory amortization of leasehold improvements ofover $900,000, while only $8o,ooo was taken as book amortiza-tion.
H CLASS 8: BAD DEBT EXPENSES
1 Sample I DataDifferences in bad debt accounting are frequent and occasion-ally of moderate size. Their nature is discussed in detail inChapter 5 and need not be repeated here.
Over one-third of the companies in Sample I report baddebt divergences, but most are small (Table 25). The largestdivergence occurs in the retail trade i.ndustry where .one com-pany reported nearly $700,000 for "addition to bad debts re-serve". The Analysis Y ratio does not reach i i percent in anyindustrial group. But it exceeds 5 percent in 8 groups and in
other groupsit is between and 5 percent.The data are not sufficiently detailed to warrant a division
of bad debts divergences into subclasses. Nevertheless, almostevery kind of divergence mentioned in Chapter 5 could beillustrated. The broader scope of. the tax classification is illus-trated by one case where the tax deduction exceeds the bookdeduction by the amount of second mortgage notes ascer-tained to be uncollectible and therefore charged off. Otherrepresentative instances apparently not due to differences inscope include bad debts accrued in excess of the actual writeoff; reserve for bad debts in excess of the actual loss; and excessbook provision for bad Several companies reported dif-ferent treatments of bad debt recoveries; one reads "recoveryof bad debts previously disallowed". Presumably, this recov-ery was reported as book income, since the debt had previouslybeen charged against income on the company's books, but notas taxable income.
2 Sample II DataAs in the analysis of depreciation and depletion deductions,Sample II may be used to supplement the information on bad
CHAPTER 13 321
debt divergences revealed by Sample I. Conclusions based onthe bad debt section of Table 26 must be even more tentativethan those drawn from the depreciation section of Table 26,for the bad debt ratios are much more subject to distortion bysingle, large divergences.7 With the exception of the publicutility group, and to a lesser degree the foods and miscellane-ous manufacturing groups, the tax deductions are consistentlylarger than the book deductions. Excluding public utilities,ig of the remaining 24 ratios are negative. Thus, the expecta-tion that bad debt deductions claimed for tax purposes exceedbook deductions because of the more inclusive character of thetax concept is confirmed.
On the average, manufacturing companies show moderatelysmall divergences. The ratios for the food, beverage, and to-bacco group are within 6 percent of zero in all four years. Intwo years they are negative and in the other two years, positive.Likewise, the miscellaneous manufacturing group ratios aretwice negative and twice positive. The ratios in this subgroupbecome progressively larger, algebraically, during the fouryears. Probably, however, this variation is not significant.Three large divergences account for the size of the negativeratio in 1934. Nevertheless, the ratio would be negative evenif these three cases were eliminated. A single, large divergenceis responsible for the size of the 1937 ratio also, but not for itsalgebraic sign, which is positive. The metals group, on thecontrary, has a negative ratio in all four years; in three yearsthe numerical ratio exceeds i 8 percent. Though several sub—stantial divergences are reported, their direction is such thatthey largely offset one another. On the whole, the eliminationof the largest half-dozen individual divergences would bringthe ratios closer to zero, but they would remain negative.
The ratios for the trade group are negative in three yearsand positive in the fourth. The large negative ratio in 1934can be attributed to three companies which report much larger7 Throughout this section the qualifications mentioned in Chapter io, SectionCi, because of the imperfect comparability of the data should be kept in mind.
322 PART TWOtax than book deductions. The mining group shows unusuallylarge negative ratios in every year because several companiesreported moderately'large bad debt deductions for income taxpurposes but no deductions for book purposes. No one com-pany dominates the group.
Since financial companies are included in the miscellaneousgroup, it too shows large negative ratios in all four years inaccordance with expectations. In 1935 and 1936 several largedivergences are responsible for the size, but not the sign, of theratios. One extremely large divergence accounts for the excep-tionally large 1934 ratio.
In sharp contrast to all the other groups, public utilitieshave positive ratios in each year. In three years the ratios arelarge. While several substantial divergences account for thesize of the ratios in the first three years, the ratios bepositive even if these cases were ignored. Why the public utilitygroup is different is not clear. It may be simply a statisticalaccident, but that seems somewhat unlikely, since the ratio isconsistent from year to year. Moreover, as Table 28 indicates,bad debt deductions by the public utility companies in thesample represent nearly 8 percent of the total bad debt deduc-tions reported by all public utility corporations in Statistics ofIncome for i Indeed, the sample contains approximately i -8percent of the bad debt deductions claimed by the entire corpo-rate economy in 1937 in most of the broad industrial groups.
Chart 6, which shows frequency distributions of theX ratio for bad debt deductions by industrial groups, is identi-cal technically with those in the book profit-statutory netincome comparison. Data are for 1937 except for the 'miscella-neous corporations' group which presents the frequency distri-bution for i 936, a more typical year for this group. Preliminarycharts were made for all four years and for narrower industrialclassifications, but the charts here presented are adequate torepresent the nature of the distribution of bad debt diver-gences.
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I CLASS 9 INTEREST PAID
With one major exception, divergences due to the treatmentof interest expenses are not large. But this exception, differenttreatments of funded debt expenses by public utility com-panies, ranks with depletion in the mining group and depre-ciation in the public utility group as among the most dramaticcases revealed in this study. Indeed, divergences in interestexpenses, primarily in funded debt expenses, account for overhalf of the aggregate divergences reported by the 29 publicutility companies in Sample I, aggregating nearly $i8 million.Moreover, go percent tend tO cause book profit to exceedstatutory net income. Scattered instances of different treat-ments of funded debt expenses are reported in other industrialgroups, but most lead to relatively small divergences. A hold-ing company, however, reported $350,000 for a credit to adebenture retirement fund reserve, an unallowable book de-duction, and a bridge company reported a tax deduction of$250,000 representing the cost of retiring bonds but did nottake a book deduction. Because the miscellaneous group, inwhich the latter company is classified, is poorly represented inthe sample the Analysis Y ratio reflecting this divergence is24.3 percent. Qf 51 Subclass ga divergences 40 percent occurin the public utility group.
Funded debt expenses may be treated in a considerablevariety of ways. Regulations 94, Article 22(a)-18, stipulated thetreatment to be followed for tax purposes in accounting forthe sale and purchase by a corporation of its bonds under theRevenue Act of 1936. Broadly speaking, income or expensefrom bonds issued after February 28, 1913 at a premium or dis-count is amortized over the life of the bonds. On the otherhand, if a corporation purchases or redeems its bonds, incomeor loss on the transaction is taxable or deductible in the yearof purchase. The amount is determined by the excess of theissuance price, adjusted for premiums or discounts alreadyamortized, over the purchase price.
A.
B. Food, Beverage, and Tobacco Manufacturing
C. Metal Manufacturing
D. Manufacturing
E. Trade
F. Public Utilities
G. Miscellaneous, 1936
PART TWOThe tax regulations obviously prescribe only one of many
ways in which these transactions may be recorded. A differentrate of amortization may be used for book purposes. Indeed,the entire premium or discount may be credited or charged toincome at the time of issuance. The book charge may be car-
'ned directly to surplus. A surplus credit or charge is especiallylikely if bonds are called for redemption when a large unamor-tized premium or discount remains outstanding.
Most of these treatments are represented, although oftenwithout complete details. Many divergences are reported withuninformative explanatory comments such as "amortizationof bond discount on bonds charged to surplus". One companyreported a larger tax than book deduction for "unamortizeddebt discount and expense and premium and redemption ex-pehse on bonds called for redemption in 1936". Possibly theseexpenses were charged to surplus on the books. In a similarcase, however, such charges were reported as deferred on thebooks. Occasionally, the divergence consists only of year-to-year variations. For example, one company reported "discounton bonds purchased during 1936 not on books until '937".
Subclass 9b divergences—interest paid or received on prior-year federal income taxes paid or refunded in the current year—are uniformly small; indeed, in no case does the Analysis Yratio reach even i percent. When, as is often the case, paymentsor refunds of prior-year taxes are charged or credited to sur-plus rather than to income accounts, the interest is usuallycharged or credited to surplus. But the interest on such taxes,in contrast to the taxes themselves, constitutes an allowabletax deduction. Divergences arise, therefore, when such inter-est expenses or receipts are charged or credited to surplus forbook purposes.8 Twenty-one such cases, scattered through thevarious industrial groups, are reported. Eighteen represent in-8 Some of the items classified in both Subclasses ga and b are gross incomeitems. While the practice of regarding them as part of interest expenses islogically inconsistent, it afforded the most convenient basis of classification forour purposes.
CHAPTER 13 327
terest payments that had been charged to surplus for bookpurposes.
The often referred to but unimportant provision that inter-est on indebtedness incurred to purchase tax exempt securitiesshall not be considered an allowable deduction gives rise tosmall divergences. They were put in Subclass 9C. Only fourcompanies—less than i percent of the sample—report suchdivergences.
The other interest paid subclass, 9d, consists of severalmiscellaneous items of which the most important is interestcharged to surplus or deferred until future accounting periods.Thirty-five divergences, amounting to $1.4 million, are re-ported, over half of them in the public utility group. In thisgroup they are overshadowed by Subclass divergences, andthey are unimportant elsewhere. Subclass 9d offers a consider-able variety of cases, At least io public utilities—more thanone-third of the companies in the sample—reported interest onfunds advanced for construction work as a tax deduction butnot as a book deduction. One or two reported an item of thisnature along with different amounts of funded debt expenses.Companies outside the public utility group also reported in-terest set up in an asset account for book purposes without ex-plaining the nature of the assets. Other companies reportedinterest charged to surplus. Divergences reported as causingbook deductions to exceed tax deductions include "interestcredited to asset account" and "interest expense not applicableto 1936". Presumably the book deduction was taken in 1936while the tax deduction was taken in another year.
J CLASS 10: TAXES PAID (EXCLUSIVE OF FEDERAL INCOMEAND UNDISTRIBUTED PROFITS TAXES)
Differences in taxes paid are by far the most frequent sourceof divergences between book profit and statutory net income.Three hundred and four companies—over 6o percent of thesample—reported different figures for• taxes. Many report sev-era! items on their tax returns causing divergences. By a
328 PART TWOstrange coincidence, exactly half of the companies reportingdivergences show larger book deductions while the other halfshow larger tax deductions.
Despite the great frequency of divergences in taxes paid,their average size is so small that, quantitatively, they are onlymoderately important (Table 25). In no case does the AnalysisY ratio exceed io percent. Five industrial groups, however,have ratios of 5-10 percent, and in only one group is the ratioless than 1 percent.
No attempt was made to compute an elaborate set of tablesfor Class io. But a rough count of the divergences attributableto different taxes was made in order to indicate, even thoughcrudely, the principal sources. Approximately 165 companies—one-third of the sample—report divergences in accountingfor the federal capital stock tax. Most of these divergences re-flect the fact that the tax was assessed for a period that ordi-narily did not coincide with the accounting period used forbook or tax purposes. For example, one company reported thata portion of the federal capital stock tax for the year endedJune 30, 1936 was deferred on its books and charged as an ex-pense for the calendar year 1936. But the entire amount of the.tax through June 30, 1936 was deducted on the 1935 incometax return filed for the perIod ended December 31, 1935. Like-wise, a portion of the tax assessed for the year ended June 30,1937 was deferred to the calendar year 1937 for book purposes,although it was deducted in full on the tax return for the calen-dar year 1936. Other companies reported substantially similartreatments. Many merely reported divergences without ex-plaining their causes.
About 85 companies reported different amounts of statetaxes. The New York state franchise tax—and less commonlyfranchise taxes of other states—was reported with considerablefrequency as a source of divergence. State income, excise, andcapital stock taxes are well represented. To some extent the ex-planation is the same as that suggested as the principal causeof differences in federal capital stock taxes. In other cases an
CHAPTER 13 329
unallowable reserve for payment of the tax in question was setup on the books, while for tax purposes the deduction wasclaimed as it accrued in the tax sense or was paid. In still othercases the accounting procedures were identical but differentamounts were charged for the two purposes.
About 50 companies reported current year payments or re-funds of prior year taxes as creating divergences. Probablymore than two-thirds involved the federal income tax. Suchpayments or refunds may be charged or credited to either netincome or surplus accounts on the company's books. Whenthey are carried through the income account a divergence iscreated, since they do not constitute current year expenses orincome for tax purposes.
About 40 companies, many in the public utility group, re-ported deducting federal income taxes on tax free covenantbonds for book but not for tax purposes. About io companiesreported nondeductible special assessments against propertyfor local improvements enhancing the value of the property.The treatment of various local taxes caused 20 divergences.Unemployment insurance taxes were charged to surplus or setup in asset accounts by a handful of companies. 'Organizationtaxes', such as document stamps, were charged to surplus in adozen cases. Processing tax refunds and windfall taxes on'unjust enrichments' received a smattering representation.Several divergences in the amount of foreign taxes reportedwere recorded. One company reported a reversal of a reservefor taxes on unrealized appreciation of securities held. Severalcompanies reported different treatments of excess profits taxes.Finally, perhaps 50 divergences were reported without anyexplanatory detail.
K CLASS ii: RENTS AND ROYALTIESStatistically, divergences between rents and royalties arewholly unimportant, as Table 25 indicates. Of the 13 reported,all are small. Indeed, in only one industrial group does theAnalysis Y ratio exceed i percent: an item of $50,000 in the
330 PART TWOfoods group, 'deferred rents', causes statutory net income toexceed book profit. Other examples operating in the samedirection include overaccruals of rent expense and differenttreatments of royalties.
Divergences tending to cause book profit to exceed statutorynet income include such items as rent paid to X (name with-held) Telephone Company for use of poles charged to surplus;royalty payments not deducted on books; minimum royaltieson non-operating reserves; pro rata portion of lease revision;and amortization of cost of lease previously written off.°
L CLASS 12: NONALLOWABLE RESERVES
Except in isolated instances—such as the reserve for bad debtsprovision—the tax law does not permit a deduction for reservesagainst possible subsequent but unascertained expenses orlosses. At one extreme are items analogous to the reserve forbad debts, representing necessary exclusions from gross in-come in order to obtain a proper accounting definition of in-come. Tax practice, however, ordinarily disallows their deduc-tion; the practice with reference to reserves for bad debts is astatutory exception to the general rule. At the other extremeare purely precautionary reserves.
Business corporations have set up a wide variety of reserveaccounts for book purposes. To facilitate tabulation, the nu-merous specific reserve accounts were divided into 5 subclasses:reserves for insurance and compensation, repairs and replace-ments, investment and• exchange fluctuations, sales expenses,and for contingency and other unallowable items.
The importance of Class i 2 divergences is manifest fromTable 25. Indeed, nonallowable reserve accounts for bookpurposes are perhaps second only to differences in the treat-ment of depreciable and depletable assets as a cause of diver-gence. Moreover, Class i 2 divefgences include only items that9 When leases were reported in the mining group they were regarded as in-tangible assets on the theory that they probably resemble development expendi-tures. In all other groups, however, such divergences were included in Class ii.
CHAPTER 13 331
cannot conveniently be allocated to other classes; for example,a divergence between a book reserve for taxes and statutorytaxes paid or accrued would be assigned to Class io. Class 12has 273 divergences, divided rather evenly between the twodirections.
Subclass i 2 a—unallowable reserves for insurance and com-pensation—constitutes a relatively frequent but not especiallylarge source of divergence. Seventy-three companies reportsuch divergences as reserves for workmen's compensation, pen-sions, employees' welfare, employees' injury, vacation payroll,plate glass insurance, and employee retirement. The AnalysisY ratio exceeds 2 percent in only two industrial groups.
Reserves for unallowable repairs and replacements are in-frequent. Examples include reserves for dock repairs, paint-ing, maintenance of general structures, extraordinary mainte-nance, and for relining furnaces. Only 23 cases, rather evenlydivided between the two directions of divergence, are re-ported. The Analysis Y ratios are uniformly small.
Forty-five companies report different amounts of reservesfor investment and exchange fluctuations; these too are almostequally divided between the two directions. While they areless frequent than those in Subclass isa, they are considerablylarger. Four industrial groups report Analysis Y ratios in ex-cess of 3 percent. The line between Subclass 12C and diver-gences in capital gains and losses (Class 2) is rather fine. Ingeneral, items representing merely unrealized adjustments ofbook values were included in Subclass i while Class 2 con-sists of realized gains and losses. This distinction is perhaps ofdoubtful validity, and Subclass 12C should be kept in mindwhen Class 2 is appraised. Examples of Subclass includeproperty valuation reserves, reduction in reserves for securi-ties, appreciation of securities, provision for loss on invest-ment, excess of charges over credits to exchange reserves,foreign exchange adjustment, and depreciation of sterling ac-count.
Divergences due to unallowable reserves for sales expenses
332 PART TWOnumber 56 but the Analysis Y ratio exceeds 3 percent in onlytwo industrial groups. Examples of Subclass 1 2d are reservesfor discounts, customer allowances, dealers' commission, andfor advertising expenses, sales discount not charged to currentearnings, prepaid foreign commissions, noncollectible ac-counts of agent, provision for returns and allowances, and un-allowable increases in reserves for participation certificates.'°
Subclass c—other nonallowable reserves—are by far the larg-est source of Class 12 divergences, reported by 75 companies.While the highest Analysis Y ratio is 1 1.0 percent, io industrialgroups report ratios of over 4 percent. Thus, other nonallow-able reserves are consistently of moderate importance al-though nowhere of dominant importance. As contingencyreserves constitute the vast majority of cases, most of thedivergences probably represent nonallowable precautionaryreserves. Other scattered divergences include reserves for legalexpenses, closed banks, and for farm lands. Subclass likeClasses 5 and 13, may conceal items which, if described moreexplicitly, would significantly alter the reported ratios forother classes.
M ClAss 13: MISCELLANEOUS DEDUCTIONSThree subclasses not considered sufficiently important to de-serve separate listing were grouped as miscellaneous deduc-tions. This decision was made although two of these subclassesare among the most common causes of divergence. Subclass
comprises unallowable donations and contributions. Di-vergences may result from either the character or the amountof corporate donations and contributions. In Subclass i 3b arelisted insurance premiums paid on the life of any officer or em-ployee when the corporation is directly or indirectly a bene-10 The last item is explained as follows: dealers take in merchandise intrade, we participate and accept participation certificates in partial settlementof outstanding accounts. On receipt of these participation certificates, we chargeoff to profi.t and loss a portion of their face and carry the balance as an asset.This anticipated loss is not claimed for federal income tax purposes until actu-ally realized."
CHAPTER 13 333ficiary. Subclass i contains other miscellaneous deductions.
A glance at Table 25 suffices to indicate that a sizeable frac-tion of aggregate divergences is included in Class 13. BothSubclasses and b show an overwhelming portion of casesthat tend to cause statutory net income to exceed book profit.In g8 of 102 companies with unallowable donations and con-tributions, the divergence reported tends to cause statutorynet income to exceed book profit. The surprising fact is notthat 98 cases have this tendency, but that 4 have the opposite.tendency. These 4 cases reflect the fact that the definition ofthe subclass was not applied rigidly. Accordingly, one caseentitled "contributions to X University (name withheld) notcharged off on books" was assigned to Subclass i even thoughit was not strictly an unallowable deduction. Quantitatively,this subclass is negligible. In all industrial groups the AnalysisY ratio is less than 2 percent and only one group reports a ratioas high as i percent.
The distribution of cases in Subclass 1 3b is very similar. Of144 divergences, 129 tend to cause statutory net income to ex-ceed book profit. The payment of an unallowable premium—if not offset by proceeds from the policy upon the death of theinsured person—will cause divergences in this direction.
Divergences tending to cause book profit to exceed statutorynet income occur for several reasons. A few companies reportthat the cash surrender value of life insurance policies whichthey hold has increased by a larger amount than the premiumdue on the insurance. In other cases dividends on a paid-uplife insurance policy augmented book profit but not statutorynet income. Proceeds from life insurance upon the death ofthe insured person were reported by only two companies. One,a receipt of $140,000 of nontaxable income, accounts for thesingle Analysis Y ratio higher than 10 percent. All other Sub-class 13b ratios are small; indeed, in 14 of the 17 industrialgroups they are less than 3 percent.
Subclass c accounts for the vast majority of Class 13 diver-gences. Indeed, in 8 industrial groups it accounts for over io
334 PART TWOpercent of aggregate divergences. Divergences tending to causebook profit to exceed statutory net income are much largerthan those operating in the reverse direction, and are dividedrather evenly between the two directions. Because of theheterogeneous nature of Subclass i important cases of di-vergence are discussed in considerable detail.
In the food group two items—expenses charged to surplusand loss on judgment—account for the greater part of the di-vergence. One tobacco company reported "radio and news-paper advertising deferred on books". Several companiesproducing beverages reported items such as discarded labels,losses on containers and on cartons in the hands of customers.All were presumably charged to surplus for book purposes.
Most of the divergence in the textiles group is accounted forby a single large item, $140,000, entitled "allowable deduc-tions not taken on books". Unfortunately, a considerablenumber of divergences in Subclass i 3C are described in thisunsatisfactory manner. Consequently, some cases assigned toit may be misclassified. Other divergences in the textiles groupare due to idle mill expenses and legal and professional serv-ices. Presumably they were charged to surplus or set up as de-ferred charges for book purposes. In the paper, publishing,and printing group the major source of divergence is entitled"deductible portion of items deferred on books".
The machinery and equipment manufacturers group re-ports such items as adjustment to cost of sales, law suits andstamps charged to surplus. breakage on boat shipments, and,surprisingly, "ordinary and necessary expenses capitalized".Not to treat ordinary and necessary expenses as a deductionfrom income is indeed peculiart In the iron and steel and non-ferrous metals group, both strike expenses and flood losseswere deducted for statutory but not for book purposes.
Divergences in the finance group are very inadequately de-scribed. Four large items, amounting to nearly a million dol-lars, bear such ambiguous titles as "deductions debited todeferred charges on books", "not shown per books", "unex-
CHAPTER 13 335plained and miscellaneous deductions". In the trade group, onthe other hand, an excellent degree of detail is given. Onelarge item, $2.6 million for "amortization in settlement oflandlord's claims", was taken as a statutory but not as a bookdeduction. One company described a statutory deduction ofnearly $400,oQo as "administrative expenses of trustee". Nocorresponding book deduction was taken.
Two interesting cases occur in the public utility group. Inone, costs in connection with the establishment of a uniformaccounting system were not taken as book deductions. Simi-larly, book profit tended to exceed statutory net income by$500,000 in another case because of different treatments of"amortization of 30/60 cycle change-over expenses in 1936";details were not given.
All the illustrations cited so far tended to cause book profitto exceed statutory net income. Divergences operating in thereverse direction are generally not large, but are significant intwo or three industrial groups. One company in the machineryand equipment manufacturers group, for example, reported adivergence amounting to nearly $400,000 for "adjustment ofSouth American Branch income per tax schedule". An auto-mobile parts and accessories company reported a substantialitem for "advertising expense" without any details. In theservices group two large divergences are for "prior year's ex-pense" and "miscellaneous". Finally, several interesting casesappear in the public utilities group. One company reported a"credit to surplus on books from the sale of securities trans-ferred to the company by trustees of the service annuity fund".Presumably the sale of these securities involved a realized capi-tal gain. Perhaps this item should have been assigned to Class2. Another item is reported merely as "indirect charges to con-struction in excess of io percent of general expense".
4
336 PART TWO
'N CLASS 14: DIVERGENCES IN SCOPE OF ACCOUNTING UNITWHEN UNCONSOLIDATED RETURNS ARE SUBMITTED
In some cases, even when unconsolidated returns are sub-mitted, transactions of subsidiary or affiliated companies areincluded on the books of the parent company." Such transac-tions do not affect statutory net income. Seventeen such diver-gences are reported, of which two or three are of moderate size.Examples of Class 14 divergences include adjustment of sub-sidiary profit on sale of equipment, net income of subsidiarynot consolidated, net profit from operation of X company forportion of taxable year prior to merger, reduction in reservefor affiliated company, reserve for inter-company profits, ex-cess losses over profits of wholly owned subsidiaries, loss onstock of subsidiary, proportion of cost of investment in subsidi-ary company written off, and additional reserve for deficit ofsubsidiary company. Perhaps one or two of these really belongin Class 2. Most, however, clearly illustrate differences in thescope of the accounting unit adopted for book and tax pur-poses.
0 CLASS DIFFERENCES DUE TO REORGANIZATIONS,MERGERS, AND DISSOLUTIONS
To differentiate Class 15 divergences from Class 14 and Sub-class 7a divergences is difficult, and probably not entirely suc-cessful. Class 15 is designed to include divergences due tocurrent year reorganizations, mergers, and dissolutions of afar-reaching character. Accordingly, the amortization of prioryear organization expenses and even of current year issues ofnew securities was relegated to Class 7, divergences in the treat-ment of intangible assets. Likewise, divergences resulting from11 reporting on a consolidated basis for book purposes were de-liherately excluded from Sample I. Consequently, no divergences are reportedas due to the use of consolidated reports for book purposes and unconsolidatedreports for tax purposes. Had the sample not been selected so as to avoid thisproblem such divergences might have assumed significant proportions.
CHAPTER 13 337profits or losses of subsidiary companies taken up on the booksof the parent company were assigned to Class 14.
Class 15 contains only 6 divergences. Fortunately, for pur-poses of illustration, one represents a loss of nearly $700,000upon the liquidation of a wholly owned subsidiary. It accountsfOr 68 percent of aggregate divergences in the rather poorlyrepresented chemicals group. The other cases also represent
• divergences growing out of liquidation procedures. As theseinstances dramatically illustrate, Class 15 divergences are ex-ceedingly rare, but they may be huge.
