Do Firms Pay Taxes on Allegedly Fraudulent Earnings?
By Alan Breznick

n many cases the answer is yes, says Edward Maydew, David E. Hoffman Scholar and area chair of accounting at UNC Kenan-Flagler and director of research for the UNC Tax Center. In a new study, Maydew and two colleagues found that while some companies might have overstated their earnings in recent years, most firms surprisingly paid the higher income taxes seemingly due on their inflated earnings, even though their actual tax load was much lower.

Maydew and his two co-authors - Merle Erickson from the University of Chicago and Michelle Hanlon from the University of Michigan - studied 27 undisclosed companies that have been accused by the Securities and Exchange Commission (SEC) of fraudulently overstating their earnings between 1996 and 2002.What they found was that 16 of the 27 firms paid taxes on the inflated earnings.

"A large fraction of the companies in our sample did pay taxes," Maydew says. "Some paid at the top marginal rate, and some paid at less. It's a mixed bag."

The paper is "How much will firms pay for earnings that do not exist? Evidence of taxes paid on allegedly fraudulent earnings." It estimates that the mean firm paid roughly $11.85 million to federal, state and local tax authorities on its overstated earnings. In total, the 27 firms shelled out $320 million to the various tax authorities as a result of inflating earnings by about $3.36 billion.

From this research, the authors conclude that some company executives are willing to trade off the pain of higher taxes for the gain of higher revenues and profits. In other words, they would rather report inflated earnings even if it means that they have to pay heftier tax bills.

"These estimates represent the most direct evidence to date that managers are willing to sacrifice cash in the form of income taxes to increase accounting earnings," the study says. "Although it is difficult to generalize the results from this sample of firms, our analysis indicates that some managers are willing to expend substantial amounts of firm resources to inflate accounting earnings."

Maydew and his co-authors argue that this finding indicates that congressional attempts to prevent aggressive accounting practices by boosting the tax costs of overstating earnings might be doomed to failure. "Further," the study says, "the fact that an increasing number of firms have been required to restate their financial statements suggests that tax costs are not a sufficient deterrent to overstating earnings for these firms."

Why would companies willingly pay higher taxes? The authors speculate that the firms accused by the SEC most likely did so to avoid raising suspicions about their accounting tricks. When companies report big differences between their book and tax earnings, industry watchers take note.

"The risk would be detection, mainly by smart shareholders, analysts and possibly the IRS," Maydew says. "Why else would you pay taxes that you didn't really owe?"

Maydew, a 36-year-old Iowa native, came to UNC Kenan-Flagler in 1999 from the University of Chicago. He has been learning about finance, taxes and economics nearly all his life. His father, now retired, was a tax professor, and his brother is a tax lawyer.

"So we have this genetic defect," he says. "I knew the difference between a marginal tax rate and an average rate at age 11. … It makes for interesting Christmas dinner discussions."

Although he hated his first tax course and only grew to like the subject over time, Maydew has always liked accounting, finance and economics. As a junior high school student, he read several of economist Milton Friedman's books, including the landmark "Free to Choose," and became a convert to the cause of free markets. "The books influenced me in a profound way," he says.

Maydew, an award-winning teacher, is co-author of his own book, "Taxes and Business Strategy," (2nd edition) with Nobel Prize-winning economist Myron Scholes and accounting professors Erickson, Mark Wolfson and Terry Shevlin. Intrigued by their findings in the taxes-on-overstated-earnings paper, Maydew, Erickson and Hanlon are now working on a larger, related study about the "dark side" of stock options. They are examining every firm and manager accused of fraud since the mid-1990s to determine whether the prospect of greater stock options spurred them to cook the books and inflate earnings.

"It could be that some people get over incentivized and become overaggressive," Maydew says, putting it diplomatically. He and his co-authors hope to complete the new study this spring. Contact Maydew at (919) 843-9356, .

The American Taxation Association honored accounting professor Edward Maydew with the Outstanding Tax Manuscript Award for his paper, "Debt-Equity Hybrid Securities." The award recognizes a significant contribution to tax literature published during the prior three years. Maydew's paper, written with Ellen Engel and Merle Erickson of the University of Chicago, was published in the Journal of Accounting Research.