In a new study that examines the negative tax consequences of allegedly fraudulent earnings overstatements, researchers found that, on average, firms sacrifice 11% of inflated earnings to additional tax payments.
‘One might expect that firms willing to engage in earnings manipulation would also be willing to simultaneously avoid reporting the income on their tax returns,’ said Michelle Hanlon, assistant professor of accounting at the University Of Michigan, one of the contributors to the research project.
‘However, firms may willingly pay taxes on bogus earnings to avoid raising the suspicion of savvy investors, the Securities and Exchange Commission or the Internal Revenue Service.’
On a small scale the sacrifice to tax demands does not appear so great. But when considered in the context of the billion-dollar accounting holes at Enron and WorldCom, recently renamed MCI, the sums in tax become huge.
The report signals a clear drive on the part of executives to keep the bottom line looking good for investors and regarding the sacrifice in tax liabilities as worth the deception.
The study is bound to raise questions about the way executives are influenced by having to please investors and the level of pay and bonuses top executives earn.
The paper, produced by the universities of Michigan, Chicago and North Carolina, examined a sample of firms accused of accounting fraud by the SEC from 1996 to 2002, who had refiled their accounts after answering such charges, which enabled the researchers to compare their fake returns with an accurate one.
The study’s report said: ‘In aggregate, (15 of) the firms in our (27 company) sample paid US$320m (£205m) in taxes on overstated earnings of about US$3.36bn. These results illustrate the stark trade-off faced by firms and managers contemplating earnings manipulation – the choice between (non-cash) accounting earnings and (cash) taxes.’
The report said that these 15 firms that actually paid taxes on overstated earnings, incurred substantial immediate additional tax costs on overstated earnings of 20 cents per US dollar.
Half of the companies reported a portion of their inflated earnings as book income, but not current taxable income, enabling them to defer paying taxes on some of the inflated earnings.
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