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The Degradation of Reported Corporate Profits

  • Mihir A. Desai
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    Recent corporate scandals have highlighted abuses by firms overstating profits to capital markets. In a related but less noticed vein, the reporting of profits to tax authorities has come under increased scrutiny with heightened concerns over the spread of tax avoidance activities. How could firms simultaneously be inflating profits reported to the capital markets and understating profits reported to tax authorities? The practical answer is that American firms keep two sets of financial statements: a financial statement that reports "book profits" to the capital markets and a separate financial statement that reports "tax profits" to the government. These two profit reports can bear little resemblance to each other and follow distinct rules. This paper argues that the latitude afforded managers by the dual nature of corporate profit reporting has contributed to the simultaneous degradation of profit reporting to capital markets and tax authorities. The distinction between book and tax profits allows managers the ability to mischaracterize tax savings to capital markets and to mischaracterize profits to tax authorities. Examination of three high-profile cases of managerial misreporting of profits and tax avoidance—at Enron, Tyco and Xerox—reveals how the drive to improve reported book profits fosters tax avoidance and how the drive to limit taxes gives rise to the manipulation of accounting profits and managerial malfeasance.

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    File URL: http://www.aeaweb.org/articles.php?doi=10.1257/089533005775196705
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    Article provided by American Economic Association in its journal Journal of Economic Perspectives.

    Volume (Year): 19 (2005)
    Issue (Month): 4 (Fall)
    Pages: 171-192

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    Handle: RePEc:aea:jecper:v:19:y:2005:i:4:p:171-192
    Note: DOI: 10.1257/089533005775196705
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    1. Hanlon, Michelle, 2003. "What Can We Infer about a Firm’s Taxable Income from Its Financial Statements?," National Tax Journal, National Tax Association, vol. 56(4), pages 831-63, December.
    2. Desai, Mihir & Dyck, Alexander & Zingales, Luigi, 2004. "Theft and Taxes," CEPR Discussion Papers 4816, C.E.P.R. Discussion Papers.
    3. Joel B. Slemrod & Marsha Blumenthal, 1996. "The Income Tax Compliance Cost of Big Business," Public Finance Review, , vol. 24(4), pages 411-438, October.
    4. Ball, Ray & Kothari, S. P. & Robin, Ashok, 2000. "The effect of international institutional factors on properties of accounting earnings," Journal of Accounting and Economics, Elsevier, vol. 29(1), pages 1-51, February.
    5. Mihir A. Desai & Alexander Dyck & Luigi Zingales, 2003. "Theft and Taxes," International Tax Program Papers 0501, International Tax Program, Institute for International Business, Joseph L. Rotman School of Management, University of Toronto, revised Dec 2004.
    6. Shackelford, Douglas A. & Shevlin, Terry, 2001. "Empirical tax research in accounting," Journal of Accounting and Economics, Elsevier, vol. 31(1-3), pages 321-387, September.
    7. Bergstresser, Daniel & Philippon, Thomas, 2006. "CEO incentives and earnings management," Journal of Financial Economics, Elsevier, vol. 80(3), pages 511-529, June.
    8. Lenter, David & Slemrod, Joel & Shackelford, Douglas A., 2003. "Public Disclosure of Corporate Tax Return Information: Accounting, Economics, and Legal Perspectives," National Tax Journal, National Tax Association, vol. 56(4), pages 803-30, December.
    9. Ball, Ray & Robin, Ashok & Wu, Joanna Shuang, 2003. "Incentives versus standards: properties of accounting income in four East Asian countries," Journal of Accounting and Economics, Elsevier, vol. 36(1-3), pages 235-270, December.
    10. Michelle Hanlon & Terry Shevlin, 2005. "Book-Tax Conformity for Corporate Income: An Introduction to the Issues," NBER Chapters, in: Tax Policy and the Economy, Volume 19, pages 101-134 National Bureau of Economic Research, Inc.
    11. Mihir A. Desai, 2003. "The Divergence between Book Income and Tax Income," NBER Chapters, in: Tax Policy and the Economy, Volume 17, pages 169-208 National Bureau of Economic Research, Inc.
    12. Mihir A. Desai & James R. Hines Jr., 2002. "Expectations and Expatriations: Tracing the Causes and Consequences of Corporate Inversions," NBER Working Papers 9057, National Bureau of Economic Research, Inc.
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