How much will firms spend to perpetuate accounting fraud?
Recent research indicates that some firms are willing to burn
through their cash to inflate their financial statements.
Today, accounting fraud remains a topic of concern for businesses,
investors, and the government. However, coverage of massive
accounting frauds in the financial press has largely ignored
the tax consequences of earnings overstatements. Merle Erickson,
a professor at the University of Chicago Graduate School of
Business, along with Michelle Hanlon of the University of
Michigan Business School and Edward Maydew of the University
of North Carolina's Kenan-Flagler Business School, investigates
the tax consequences of accounting fraud in the study, "How
Much Will Firms Pay for Earnings That Do Not Exist? Evidence
of Taxes Paid on Allegedly Fraudulent Earnings."
Erickson, Hanlon, and Maydew studied firms that restated
their financial statements in conjunction with a Securities
and Exchange Commission (SEC) allegation of accounting fraud
during the period 1996 to 2002. For the 27 firms in the study,
the authors estimate that the average firm paid $11.84 million
to the Internal Revenue Service on overstated earnings, which
is the equivalent of $0.11 in additional income taxes per
$1 of inflated pre-tax earnings. This implies that some managers
believe that $1 of overstated accounting earnings is more
valuable than $0.11 of cash. In aggregate, the firms paid
$320 million in taxes on overstated earnings of approximately
$3.36 billion.
The results illustrate the stark trade-off faced by firms
and managers contemplating earnings manipulation: Would managers
rather have a dollar of cash or a dollar of accounting earnings?
"We generally assume-and with good reason-that firms
prefer cash to accounting earnings," says Erickson. "For
firms to literally use up their cash to mask nonexistent accounting
earnings is counterintuitive, to say the least."
The Accused Firms
Erickson, Hanlon, and Maydew used data from SEC Accounting
and Auditing Enforcement Releases, which describe the SEC's
investigations of alleged violations of accounting rules.
For each of the sample firms, they noted the amount of earnings
overstatement as documented by the SEC.
From the larger group of 140 firms accused of fraud by the
SEC, the authors identified a final subset of 27 accused firms
that restated their earnings to the SEC. They compare the
originally reported earnings (including the fraudulently overstated
income) to the restated earnings, and in doing so identify
the amount of income tax paid to the IRS on fraudulently reported
earnings. The firms' restatements to the SEC include footnotes
that disclose the size and source of the overstatement.
One firm in the study, Material Sciences, disclosed that
it overstated its pre-tax income by $5.6 million in 1996.
In its originally filed financial statements (10-K), Material
Sciences indicated that it paid $6 million in income taxes
to the IRS on 1996 earnings. In its restated 1996 10-K, dated
February 28, 1997, Material Sciences reported that income
tax expenses on its restated (corrected) 1996 earnings totaled
$3.8 million. The difference between taxes paid to the IRS
on overstated earnings ($6 million) and the correct amount
of taxes paid after adjusting for the overstatement ($3.8
million) is the estimated amount of income taxes the company
paid on earnings the SEC alleged were fraudulent. Thus, the
authors estimate that Material Sciences paid nearly $2.2 million
of income taxes for its overstated earnings, a staggering
sum in relation to the actual amount of the false earnings.
What mechanisms are used to commit the accounting frauds
in the sample?
Reporting fictitious sales is the most common source of income
inflation for sample firms. For example, one firm created
a fictitious customer and shipped empty boxes to this fictitious
customer at the address of a firm employee. Subsequently,
the firm sent invoices to this fictitious customer, which
made it appear that a sale had taken place, even though nothing
had actually been sold. Ultimately, this transaction increases
the firm's financial statement net income, but not its economic
income. Firms in the sample also understated their costs,
overstated their inventory, or manipulated accounting estimates
associated with mergers and acquisitions.
Who executes the financial statement fraud? For the majority
of the sample firms, the CEO was accused of assisting in the
alleged accounting fraud. In about 50 percent of the cases,
the CFO was accused of perpetrating the fraud. Other corporate
executives accused of fraud by the SEC included the chairman
of the board, president, controller, VP of sales, chief operating
officer, and VP of finance. Overall, the data indicate that
the accounting fraud was committed by the most senior members
of management, though it is reasonable to believe that there
are many more people involved than those accused by the SEC.
Managers presumably report false earnings to drive the firm's
stock price up. They may then sell their stock, exercise stock
options, or increase their compensation as a result of the
overstated financial performance. In general, the parties
who benefit from these accounting frauds appear to be managers
and shareholders who sell during the run-up of the stock price
that typically coincides with the overstated earnings.
Making Taxes Match False Earnings
Given some level of overstated accounting earnings, why might
firms pay taxes on overstated earnings? Why don't firms simply
choose not to report the nonexistent accounting earnings to
the IRS? Many firms may willingly pay taxes on the nonexistent
earnings to avoid raising the suspicion of savvy investors,
the SEC, or the IRS. When firms do overstate earnings for
financial reporting purposes, there are typically four ways
of accounting for the income tax effects associated with the
earnings.
1. A firm could choose not to report the overstated earnings
on its tax return and classify the book-tax difference as
temporary (which creates a deferred tax liability).
2. A firm could omit the additional income from its taxable
income and classify the inflated earnings as a permanent book-tax
difference (for example, overstating the income of a foreign
subsidiary in a low-tax country).
3. A firm could choose to pay taxes on the overstated earnings.
Thus, it would not report a book-tax difference in its financial
statements.
4. Firms with tax losses or excess deductions can include
the overstated earnings on their tax returns, but use other
existing tax loss carryforwards or deductions to avoid paying
taxes on the bogus income.
"Suppose a firm overstates its earnings by $100,"
says Erickson. "Management knows that the earnings don't
exist. If they pay the tax on this amount, no one will notice,
because this appears to be the normal course of business.
If the firm reports the extra $100 of earnings and doesn't
pay the tax, the firm will have to make an accounting entry
that shows why they didn't pay taxes on those earnings. At
that point, an analyst may inquire about these additional
earnings and the fraud can unravel."
In addition, if a firm reports higher earnings on its financial
statements to the SEC, but does not report that amount to
the IRS on its tax return, it must file a schedule with its
tax return to explain the difference. If on the other hand,
the firm just pays tax on the false earnings, that item does
not appear on the statements to the IRS, and the IRS is unlikely
to realize that the earnings are not legitimate. Moreover,
the IRS has no reason to investigate overpayment of taxes
on nonexistent earnings.
"Financial reporting fraud is a short-run phenomenon,"
says Erickson. "In general, the longer the fraud persists,
the more likely it is to be detected."
How then do firms restate financial statements in response
to SEC allegations of fraud?
In some cases, firms restate all of their financial statements,
including the income statement, balance sheet, and all associated
footnotes. In other cases, firms will simply provide an abbreviated
restatement that indicates only the effect on income. However,
many firms accused of fraud by the SEC never restate their
financial statements, because they either go bankrupt or are
acquired by another firm.
Possible outcomes of SEC investigations include substantial
fines, and in the worst case, imprisonment for the offending
corporate officers. In the majority of cases though, the company
falls apart because its stock has become devalued.
After such investigations, new management may be installed
that acknowledges taxes paid on earnings that didn't exist.
The IRS may then refund the amount of taxes paid on the nonexistent
earnings, since it was technically an overpayment.
Policy Implications
Recently, some members of Congress have called for tighter
conformity between tax laws and Generally Accepted Accounting
Principles to serve as a check on aggressive accounting and
tax reporting. The logic in part is that such laws would stop
firms from overstating their earnings because they would have
to pay taxes on the overstated earnings.
However, the authors find that some managers will pay substantial
amounts of cash to the IRS on earnings that do not exist.
Thus, their results suggest that mandating public disclosure
of tax return information will not deter financial reporting
fraud because some managers appear to be willing to include
the fraudulent earnings on corporate tax returns as well.
"Managers of some firms will sacrifice substantial amounts
of firm resources to make their financial statements appear
better than they are," says Erickson. "Therefore,
it is doubtful whether new regulations will deter financial
reporting fraud in these situations."
