ANN ARBOR—Companies that commit accounting fraud are willing to pay millions of dollars in additional income taxes on phony earnings to continue the charade, says a University of Michigan Business School researcher. In a new study that examines the tax consequences of allegedly fraudulent earnings overstatements, Michelle Hanlon of the U-M Business School and colleagues Merle Erickson of the University of Chicago and Edward Maydew of the University of North Carolina found that, on average, firms sacrifice 11 cents in additional income taxes per dollar of inflated pre-tax earnings. “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 Hanlon, assistant professor of accounting at the U-M Business School. “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. “If firms expend cash to pay taxes on overstated earnings, that suggests that managers believe that inflated accounting earnings are more valuable than the cash transferred to the government.” The study, which explores tax consequences of Generally Accepted Accounting Principles (GAAP) violations, looks at companies that restated their financial statements in conjunction with SEC allegations of accounting fraud from 1996-2002. It found that the 27 firms in the sample, on average, overstated earnings by $124.5 million and paid $11.84 million in additional taxes. On the whole, these companies paid $320 million in extra taxes as a result of inflating earnings by about $3.36 billion. About 55 percent (15) of the firms in the study actually paid taxes on overstated earnings, incurring substantial immediate tax costs. For these firms, the average amount of taxes paid per dollar of pre-tax overstated earnings was 20 cents. Half of these companies reported at least a portion of their inflated earnings as book income, but not current taxable income. As a result, they were able to defer paying taxes on some of the inflated earnings. Among the 12 firms in the study that paid no current tax on their overstatement, six deferred some taxes on fraudulent earnings, while the other six neither paid current taxes nor showed a restated deferred tax amount. In fact, this latter group incurred tax losses and recorded no net tax provision in any of the years examined. In all, Hanlon and colleagues say that while some members of Congress have called for tighter conformity between tax laws and GAAP to serve as a check on aggressive accounting and tax reporting, such a plan may not work, at least not in the short run. Firms in their sample already acted as if there were some degree of book-tax conformity, paying substantial taxes on the overstated earnings, they say. Further, managers appear willing to include the fraudulent earnings on corporate tax returns. “Overall, our results illustrate the stark trade-off faced by firms and managers contemplating earnings manipulation—the choice between non-cash, accounting earnings and taxes, or cash,” Hanlon said. “It is unclear what real or perceived benefits managers of these firms believed were generated by overstating earnings. Our estimates of taxes paid on overstated earnings suggest that at least some managers believe the value—to the firm or perhaps mainly to them personally—of overstating earnings is substantial.”

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