...options, evidence indicates that many firms included the overstated financial accounting income their tax returns, thus overpaying their taxes in the process of inflating their accounting earnings. We estimate that the median firm sacrificed eight cents in additional income taxes per dollar of inflated pretax earnings. In aggregate, we estimate that the firms in our sample paid $320 million in taxes on overstated earnings of about $3.36 billion. These results indicate how far managers of firms are willing to go when allegedly inflating earnings. As outlined in the criminal indictment of Centennial's former Chief Executive Officer, the Company's sales figures were inflated in previous periods. This inflation was achieved by various means, including shipping empty PC card housings; billing customers for nonexistent products; using the delivery of nonproduct materials to generate shipping documents, which were then used to create fictitious invoices; and the payment of these invoices with funds apparently provided by the Company's former Chief Executive Officer.

As a result of the adjustments made to the Company's financial statements in connection with its financial review, previous provisions for income taxes have been reversed and the associated payments of approximately $7.4 million are classified as recoverable income taxes at March 31, 1997. Approximately $6.1 million of these tax refunds were received as of June 30, 1997, and substantially all of the remaining refunds are expected to be received by the end of August 1997.

--excerpt from Centennial Technology's 10-K/A (4/18/1998)

I. INTRODUCTION

Recently, massive overstatements of accounting earnings have captured the attention of the financial press, investors, and prominent government regulators and legislators. To date, the academic literature has for the most part ignored the tax consequences associated with earnings overstatements. This paper examines the tax consequences of allegedly fraudulent earnings overstatements. We investigate two questions: (1) Did firms that overstated their accounting earnings pay income taxes on the earnings overstatements? (2) If firms did pay taxes on overstated earnings, what was the amount of taxes paid by firms on the overstated earnings?

Ex ante, one might expect that firm managers willing to engage in earnings manipulation would also be willing to simultaneously avoid reporting the income on the firm's tax returns. However, managers may willingly have their firms pay taxes on the earnings overstatements to avoid raising the suspicion of savvy investors, the Securities and Exchange Commission (SEC), or the Internal Revenue Service (IRS). Prior research shows that reporting large book-tax differences can signal low earnings quality to investors or other financial statement users (Chaney and Jeter 1994; Joos et al. 2002; Hanlon 2003a). Further, depending on how the managers are compensated, they may not be concerned about the firm paying taxes on the overstated earnings. For whatever reason, if firms pay taxes on overstated earnings, that suggests, at least for this subset of firms, that managers believe that inflated accounting earnings are more valuable than the taxes transferred to the government. The estimate of taxes paid to the government provides a measure of how much managers of these firms were willing to sacrifice to allegedly inflate accounting earnings.

Our sample is designed to produce estimates of taxes paid on earnings overstatements from firm disclosures. Specifically, we examine firms that restated their financial statements in conjunction with SEC allegations of accounting fraud during the years 1996 to 2002. Like Bonner et al. (1998) and others, we use the issuance of an Accounting and Auditing Enforcement Release (AAER) by the SEC as a proxy for fraud. We further restrict the set of AAERs to those in which the SEC actually makes allegations of fraud. These AAERs typically contain allegations of reporting "nonexistent" and "false" revenues, recording "fake" inventory and/or engaging in "fraudulent schemes" to inflate "assets, revenues, and net income." (1)

This sample has three main advantages. First, by focusing on restatements we are able to estimate the incremental taxes that were paid as a result of the earnings overstatement. The incremental taxes are estimated by comparing current tax expense originally reported (i.e., the tax on the originally reported income statement) with the restated current tax expense after the earnings overstatement is removed. Second, by examining restatements that were coupled with allegations of fraud by the SEC, we obtain a sample of earnings overstatements without having to rely on models of earnings management. The ability of accruals-based earnings management models to identify and measure earnings management has been the subject of some controversy (see Healy and Whalen 1999). Restatements that occur in the face of SEC allegations of accounting fraud are the least ambiguous sample of earnings management (albeit quite extreme) available for study. Finally, the size and scope of the earnings overstatements that we examine helps to ensure that the restatements are reasonably detailed, which aids our estimation.

Our estimates are subject to the caveat that computing tax costs from the tax expense reported on firms' financial statements is difficult (Erickson et al. 2003; Hanlon and Shevlin 2002; Gleason and Mills 2002; McGill and Outslay 2002; Hanlon 2003b). In addition, we cannot be completely certain that the original tax expense was not also recorded erroneously, either mistakenly or due to fraud, and then corrected upon restatement. However, a series of robustness tests corroborate our general findings that some firms paid income taxes on the overstated earnings. For example, some firms disclose in their subsequent 10-K filings that tax refunds will be or have been received as a result of the restatements of financial accounting earnings. Further, we called sample firms and in the cases where a firm representative could be reached, obtained additional support for our estimates. Thus, while estimating actual tax liabilities from financial accounting statements can be fraught with error, we support our evidence using other methods of analysis. As a result, we conclude that managers of some firms were willing to pay, and did pay, taxes on the overstated financial accounting earnings they reported.

Our results can be summarized as follows. (2) For a sample of 27 firms that were accused by the SEC of fraudulently overstating their earnings by a mean amount of $124.5 million, we estimate that the mean firm paid approximately $11.84 million in taxes on the overstated earnings, an amount equal to 1.3 percent of the market value of the firms (where market value is measured in the year prior to the overstatement of earnings). (3) The mean (median) taxes paid per dollar of earnings overstatement is $0.11 ($0.08). In aggregate, we estimate that these firms paid $320 million to the taxing authorities as a result of overstating earnings by approximately $3.36 billion. (4)

Because we find substantial cross-sectional variation in the taxes paid for our sample of firms, we also calculate our estimates conditional on the firm having paid taxes in order to obtain an estimate of the cost of overstatement when a trade-off is present. (5) We estimate that for the 15 firms that paid taxes on overstated earnings, the taxes paid represent approximately 2.4 percent of their market value and are paid at a mean rate of 20 cents per dollar of pretax earnings overstatement. It is also notable that we find that a substantial number of our firms (48 percent) deferred at least some taxes on the earnings overstatements and that 19 percent of our sample recorded the amount of overstatement as a book-tax difference while recording no current tax on the allegedly fraudulent earnings.

Our study contributes to the line of research that examines the set of firms that have allegedly violated Generally Accepted Accounting Principles (GAAP) (e.g., Dechow et al. 1996; DeFond and Jiambalvo 1991; Palmrose et al. 2002). We are aware of no prior study examining the tax consequences of GAAP violations. Our study also contributes to the literature on tax and financial reporting trade-offs, overcoming many of the obstacles that have plagued that literature such as the unobservability of incremental tax effects. (See Shackelford and Shevlin [2001] for an extensive review of this literature.)

This study also contributes to the long line of earnings management research in accounting (e.g., Healy 1985). Like Dechow et al. (1996), we examine firms accused of the most extreme form of earnings management. Prior earnings management studies investigate managers' motivations to over- or understate earnings. These studies provide evidence that managers manipulate earnings for many reasons, including to increase their compensation (Healy 1995), to avoid debt covenant restrictions (Johnson and Dhaliwal 1988; DeFond and Jiambalvo 1991), and to increase stock price in anticipation of an equity offering (Erickson and Wang 1999; Teoh et al. 1998). While our focus is not on managements' motivations for the alleged accounting fraud, we note that the SEC's allegations imply that the accounting fraud was primarily motivated to increase managers' bonus and option compensation and the value of managers' stock holdings. Specifically, for 14 of the 27 sample firms, the SEC explicitly indicated that managers sought to increase the value of their options, bonuses or stock holdings or actually did so as a result of the alleged accounting fraud.

The remainder of the paper proceeds as follows. In the second section, we review prior related research. The third section contains the sample description and presents the tax data disclosed by sample firms. In the fourth section, we present our results, and the fifth section concludes.

II. THE TAX CONSEQUENCES OF OVERSTATED EARNINGS AND PRIOR RELATED RESEARCH

Tax Consequences of Earnings Overstatements

Why might managers cause their firms to pay taxes on overstatements of financial accounting earnings? One possibility is to reduce the likelihood of detection. When firms overstate earnings for financial reporting purposes, there are four potential tax treatments that will manifest themselves in different ways in the firms' financial statements.

First, management could choose not to report the overstated accounting earnings on the firm's tax return and classify the book-tax difference as temporary. For example, if a firm lengthened the depreciable lives for its fixed assets to an unreasonable (fraudulent) period for financial reporting that would increase book income. However, the change would have no effect on taxable income and income tax payments because depreciable lives are set by statute for tax purposes. This alternative results in no current payment of taxes to the government on overstated earnings but will cause the firm to recognize additional deferred tax expense and a corresponding additional amount of deferred tax liability. This treatment provides temporary relief from the cash flow drain from taxes on the overstatement, but reporting large book-tax differences could attract the scrutiny of shrewd observers, especially for material overstatements. Even if investors did not suspect fraud, there is evidence in prior research consistent with large book-tax differences signaling low earnings quality and/or earnings management (Chaney and Jeter 1994; Mills and Newberry 2001; Joos et al. 2002; Phillips et al. 2003; Hanlon 2003a). (6) Moreover, large book-tax differences could be a red flag for a firm's external auditors. Thus, managers would likely want to avoid raising such a red flag.

Second, the firm could omit the income from its taxable income and classify the inflated earnings as a permanent book-tax difference. For example, the firm might overstate the income of a foreign subsidiary located in a low-tax country. If the firm made the standard assumption that the earnings will be reinvested abroad indefinitely, then under APB No. 23 the firm would not need to recognize deferred taxes for the...

NOTE: All illustrations and photos have been removed from this article.



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