How Much Are Nonexistent Earnings Worth?

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."