Articlegreen2004

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

Merle Erickson · Michelle Hanlon · Edward L. Maydew

396 citations0/0 files storedThe Accounting Review

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Auditing, Earnings Management, Governance Corporate Taxation and Avoidance Corporate Governance and Financial Management

Abstract

This paper examines the extent, if any, to which firms pay additional income taxes on allegedly fraudulent earnings. Our sample consists of firms that restated their financial statements in conjunction with SEC allegations of accounting fraud during the years 1996 to 2002. By examining firms that were accused of fraud by the SEC we obtain a relatively clean sample of earnings overstatements and avoid having to rely on models of earnings management. By further focusing on restatements, we are able to estimate how much income tax was paid on the overstated earnings. The estimates in this paper represent the most direct evidence to date that firms are willing to sacrifice substantial cash to inflate their accounting earnings. Our detailed analysis of a sample of firms admitting to large earnings overstatements indicates that the mean firm sacrificed eleven cents in additional income taxes per dollar of inflated pre-tax earnings. In aggregate, the firms in our sample paid $320 million in taxes on overstated earnings of about $3.36 billion. These results illustrate the stark trade-off faced by firms and managers contemplating earnings manipulation - the choice between (non-cash) accounting earnings and (cash) taxes.

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References

2001The theory and practice of corporate finance: evidence from the field 1996Causes and Consequences of Earnings Manipulation: An Analysis of Firms Subject to Enforcement Actions by the SEC*1997Earnings management to avoid earnings decreases and losses 1985The effect of bonus schemes on accounting decisions 2011The effects of bonus schemes on accounting decisions 1998Earnings management and the underperformance of seasoned equity offerings11We thank Brad Barber (the referee), Randy Beatty, Vic Bernard, K.C. Chan, Kent Daniel, M. DeFond, Laura Field, David Heike, Chuan Yang Hwang, Jonathan Karpoff, S.P. Kothari, Charles Lee, Wayne Mikkelson (the editor), Tim Opler, Krishna Palepu, K. Ramesh, Jay Ritter, Terry Shevlin, Doug Skinner, Sheridan Titman, Ross Watts, Jerry Zimmerman, and seminar participants at the University of California Finance and Accounting Conference (Davis, March 1995), the NBER Corporate Finance Conference (Boston, August 1995), the Center for Research in Security Prices Seminar (Chicago, October 1995), the American Finance Association Conference (San Francisco, 1996), the American Accounting Association Conference (Chicago, August 1996), the University of Michigan, and the University of Rochester for helpful comments and discussions.2003Determinants of market reactions to restatement announcements 2008Financial Accounting Standards Board (FASB)

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2004Taxable Income, Future Earnings, and Equity Values 2012Tax avoidance, tax management and corporate social responsibility

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