The Degradation of Reported Corporate Profits

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.