How Much Will Firms Pay for Earnings That Do Not Exist? Evidence of Taxes Paid on Allegedly Fraudulent Earnings

Abstract

We analyze a sample of firms accused of fraudulently overstating their earnings and examine the extent, if any, to which they paid additional income taxes on the allegedly fraudulent earnings. Based on restatements of current tax expense adjusted for the tax benefits of stock options, the evidence indicates that many firms included the overstated financial accounting income on 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.

Inside Agency: The Rise and Fall of Nortel

“…Motivated by executive compensation arrangements and facilitated by earnings management abilities, insider trading is a predictable outcome (Cheng and Warfield, 2005). Some evidence suggests a certain degree of abuse of position is anticipated by these security markets (Liu and Yao, 2003) or, at the autopsy, a pattern of insider trading enforcement (Erickson et al, 2004). Even in a world not requiring absolute trust, markets need the assurance that some insiders will be punished (Beny, 2004).…”

Book-Tax Income Differences and Major Determining Factors

“…Thus, BTDs are created. On the other hand, managers could employ conforming earnings management techniques that affect both book and tax income and thus does not alter BTDs (Erickson et al 2004). Thus, these studies based on BTDs would not be an effective method to evaluate firms that employ conforming earnings management techniques.…”

Book-Tax Conformity Level on the Relationship between Tax Reporting Aggressiveness and Financial Reporting Aggressiveness

“…Lennox et al (2013) also found that the impact of tax reporting aggressiveness on the probability of firm with accounting fraud is negative and significant. This impact is caused by the increasing of opportunity to be monitored by tax authorities (Erickson, et al 2004). Dhaliwal et al (2004) showed that firm will tend to reduce tax avoidance measures to meet or beat analysts' forecasts earnings.…”

“…It is done to avoid the suspicion from savvy investors, capital market authorities, and the tax authorities (Erickson, et al, 2004;Desai, 2005;Desai and Dharmapala, 2006). Erickson et al (2004) describe four potential tax treatment that can be applied by the manager when the company overstated earnings in its financial reporting. First, management may choose not to report the overstated earnings report the company and classifies tax on temporary differences between accounting standards and tax regulations.…”

“…However, managers can also decide to pay taxes based on earnings overstatement that have been reported in the financial statements. It is done to avoid the suspicion from savvy investors, capital market authorities, and the tax authorities (Erickson, et al, 2004;Desai, 2005;Desai and Dharmapala, 2006). However, current research has not considered the endogeneity problem.…”