Just because a company inflates its earnings by a couple hundred million doesn’t mean it won’t pay the taxes on those bogus earnings. At least that’s what three university researchers discovered when they conducted a study on the tax consequences of allegedly fraudulent earnings.
Michelle Hanlon of the University of Michigan, Merle Erickson of the University of Chicago, and Edward Maydew of the University of North Carolina looked at 27 companies that had restated their financial statements because of Security and Exchange Commission allegations of accounting fraud from 1996 to 2000.
The researchers discovered that as a group, the companies had overstated earnings by $3.4 billion and paid nearly $320 million in additional taxes. The study found that 15 of the companies paid the extra taxes, with about half of those companies deferring the tax payments.
In answer to the question of why an executive would put inflated earnings on a corporate tax return, Ms. Hanlon said, "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".
Ms. Hanlon also said that executives who manipulate earnings have made a trade-off between earnings and noncash versus taxes and cash. The fact that they are willing to pay taxes on inflated earnings suggests that executives place a high value on the results of the earnings manipulation.
Based on their findings, the researchers concluded that stricter controls, as called for by some members of Congress, to have tax laws conform with Generally Accepted Accounting Principles might not be necessary. The large amount of tax paid on overstated earnings indicates that there is conformity at a certain level.