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

45 Pages Posted: 3 Dec 2002

See all articles by Merle Erickson

Merle Erickson

University of Chicago - Booth School of Business

Michelle Hanlon

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Edward L. Maydew

University of North Carolina at Chapel Hill

Multiple version iconThere are 2 versions of this paper

Date Written: October 31, 2002

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.

Keywords: Fraud, taxes, restatement

JEL Classification: M41, M43, H25

Suggested Citation

Erickson, Merle and Hanlon, Michelle and Maydew, Edward L., How Much Will Firms Pay for Earnings that Do Not Exist? Evidence of Taxes Paid on Allegedly Fraudulent Earnings (October 31, 2002). Available at SSRN: https://ssrn.com/abstract=347420 or http://dx.doi.org/10.2139/ssrn.347420

Merle Erickson (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
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Michelle Hanlon

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-668
Cambridge, MA 02142
United States
617-253-9849 (Phone)

Edward L. Maydew

University of North Carolina at Chapel Hill ( email )

McColl Building
Chapel Hill, NC 27599-3490
United States
919-843-9356 (Phone)

HOME PAGE: http://www.kenan-flagler.unc.edu/faculty/directory/accounting/edward-maydew

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