Accounting Tool Keeps Billions in Profits Overseas

As policymakers ponder how to encourage US multinational corporations to bring home more earnings from abroad and help boost a lagging domestic economy, a heretofore rather obscure accounting construct is attracting increased attention. Not only does it greatly reduce earnings repatriation, but it appears to be used extensively to manipulate corporate earnings and thereby mislead investors. A tax director of a Fortune 500 company has compared it to crack cocaine, explaining that "once you start using it, it's hard to stop."

The accounting tool, known as permanently reinvested earnings (PRE), goes one better than IRS rules that each year permit companies to defer paying US taxes on tens of billions of dollars' worth of earnings by their foreign subsidiaries: it gives the multinationals the additional option of omitting from their financial statements entirely, except in footnotes, that any taxes at all are owed to Washington on those profits, something they are able to do by declaring their intention to indefinitely reinvest them abroad. So rapidly have PRE accumulated over time, that by the end of last year they amounted to more than $1.5 trillion, about 42 percent above their level of two years earlier.
Although accounting scholars have for some time agreed that the PRE option lowers repatriation of foreign earnings, it has remained unclear by how much. Now new research has offered an answer: plenty.
A study in the current issue of the American Accounting Association journal, The Accounting Review, concludes that the PRE option reduces multinational firms' repatriation of foreign affiliates' earnings (through dividends paid to US parent firms) by roughly 20 percent a year. While acknowledging that high US corporate tax rates and the ability to defer payment play a major role in keeping earnings abroad, it finds that "repatriation is more sensitive to the repatriation tax rate in the presence of reporting incentives," so much so that "firms with high reporting incentives repatriate, on average, 16.6 percent to 21.4 percent less per year than firms with low reporting incentives."
"Our study suggests that companies would repatriate about 20 percent more than they currently do if they didn't have this accounting tool that enables them to put a gloss on their financial statements," comments Leslie A. Robinson, an accounting professor at Dartmouth College, who carried out the study with professor Linda Krull of the University of Oregon and professor Jennifer Blouin of the University of Pennsylvania.
Even though US tax law permits multinationals to defer payment of US taxes due on earnings abroad, Robinson explains mere deferral does not exempt these firms from recording a tax liability on their financial statements. In contrast, declaring profits to be PRE provides this exemption, which has the effect of enhancing firms' bottom lines.
The accounting standard responsible for PRE, known as APB 23, came under attack last month in a one-day Senate hearing, chaired by Carl Levin of Michigan, which probed offshore corporate profit shifting. Indeed, one expert witness called for abolishing APB 23 entirely, describing it as "provid[ing] enormous potential to call up earnings as needed - or postpone them - in a large multinational operation." Foreign affiliates' permanently invested earnings, he added, can be "sliced as finely as needed to meet earnings estimates with pinpoint precision."
While the authors of the new The Accounting Review paper do not offer specific policy prescriptions, their findings make clear the special appeal PRE have for US parent companies that, in the study's words, "face reporting incentives to consistently report strong earnings numbers." Thus, they find that public firms are likely to declare a considerably greater proportion of their assets as PRE than private firms do, since "capital market pressures vary between public and private firms due to differences in the constituents to which the two types of firms report. . . . Public firm managers typically have a strong focus on reported earnings because of its effect on both firm value and managerial compensation. In contrast, private firms have high levels of insider ownership and encounter . . . less incentive to focus on reported earnings."
Among public multinationals, the study suggests, PRE are especially favored by firms highly sensitive to the capital markets, including those whose stock prices have above-average responsiveness to company earnings, those with a consistent record of matching or narrowly beating earnings forecasts, and those with relatively few dedicated investors - that is, institutional investors whose focus is on companies' long-term performance.
In addition, the more PRE that firms accumulate over time, the lower their repatriation of current foreign earnings. The study explains that, if companies designate high levels of undistributed foreign earnings as PRE, they may find themselves in a bind in repatriating current earnings, since their financial statements will have to recognize both higher tax expense and lower earnings than were recorded for previous periods.
In short, the PRE option becomes a kind of habit. One tax director of a Fortune 500 company, the professors note, has compared PRE to "crack cocaine - once you start using it, it's hard to stop."
The study's findings derive from a sample of 577 US-based multinational corporations, including 479 public companies with 23,669 foreign affiliates and 98 private firms with 1,790 foreign affiliates. The professors combine data from the US Bureau of Economic Analysis with information from other sources to construct measures of tax reporting incentives over a six-year period. To isolate the effect on repatriation of tax reporting incentives, as distinguished from incentives to avoid actual tax payments, the professors "identify and measure firm attributes across which reporting incentives vary while holding the cash payment for repatriation taxes constant." As indicated above, the reporting incentives probed are whether a company is public or private, how sensitive it is to capital markets, and how much PRE it has accumulated.
In conclusion, Robinson notes that most of the discussion on how to encourage repatriation of corporate foreign earnings has focused on Congressional action to lower or even eliminate (whether temporarily or permanently) US tax rates on foreign earnings, now among the highest in the world. "Clearly any such approach has its drawbacks at a time when there is an urgent need for new federal revenues and when it is estimated that the amount of tax liability in S&P-500 earnings parked overseas is in the range of $350 to $400 billion. Changing APB 23 would not require Congressional action, since it is the responsibility of the FASB, the non-government group that oversees accounting standards. The FASB has contemplated revising the standard on several occasions since it was promulgated in 1972, and, given the findings of our study and others, further reconsideration may now be in order."
Entitled "Is US Multinational Dividend Repatriation Policy Influenced by Reporting Incentives?", the study is in the September/October issue of The Accounting Review, published six times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Auditing: A Journal of Practice & Theory, and Journal of the American Taxation Association.
Source: American Accounting Association

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