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

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