Financial Statements Analysis 63

FINANCIAL STATEMENTS ANALYSIS

The Degradation of Reported Corporate Profits

Mihir A. Desai
Journal of Economic Perspectives
vol. 19, no. 4 (Fall 2005):171192
The author argues that the dual nature of corporate profit
reporting has given managers the ability to mischaracterize tax
savings to capital markets and profits to tax authorities, thereby
contributing to the degradation of reported corporate profits in
general. Examination of the cases of Enron, Tyco International,
and Xerox Corporation as well as of more systematic measures
of the quality of corporate profits provides support for the
authors proposition, which calls into question the confidential
character of corporate tax returns.

American companies keep two sets of financial statements: one that

reports book profits to the capital markets and another that reports
tax profits to the government. The author argues that this dual
corporate reporting system has led to deteriorating quality of reported
profits by giving managers the ability to mischaracterize tax savings
to capital markets and profits to tax authorities.
The author examines the cases of Enron, Tyco International, and
Xerox Corporation to illustrate how the drive to improve reported
profits fosters tax avoidance and how the drive to limit taxes gives rise
to the manipulation of accounting profits and managerial misconduct. At Enron, accounting profits were generated by liberal characterizations of the timing of reduced projected tax payments. At Tyco
International, active tax management strategies enhanced the ability
of managers to divert funds and to obscure their dealings from
shareholders. At Xerox Corporation, the efforts to meet earnings
targets led to manipulations of book profits and to aggressive measures
to reduce the companys effective tax rate. The author also examines
Mihir A. Desai is at Har vard Business School. The summar y was prepared by Luis
Garcia-Feijoo, CFA, Creighton University.

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64 CFA Digest May 2006

more systematic measures of the quality of corporate profits to

conclude that these high-profile cases are representative of a larger
phenomenon. In particular, the author observes that the difference
between profits reported to tax authorities and those reported to
capital markets over the last 15 years has widened; that the evolution
of forecasts of aggregate profits relative to initial estimates indicates
growing measurement error in forecasting corporate profits; and that
evidence exists that investors find earnings decreasingly relevant for
assessing value.
Differences between book and tax profits typically stem from the
differing treatment of the timing and location of income. With
respect to timing, for example, accountants measure income when
accrued whereas tax authorities emphasize the actual receipt of proceeds. With respect to location, book profits measure the worldwide
income of companies whereas tax authorities consider the repatriation
of earnings to the United States to be the recognition event. The
author notes that a variety of tools is available for managers to exploit
the distinction between book and tax profits. Specifically, the author
notes the following as contributors to the increasingly discretionary
nature of corporate profits: financial engineering that transforms the
nature and timing of receipts; the growing importance of multiyear
contracts and the accompanying ambiguity over the timing of
receipts; the increased likelihood that company activities are spread
across countries; and the increased accessibility of offshore tax havens.
The author calls into question several features of the current corporate
tax system. First, the confidential nature of corporate tax returns may
deprive investors of an alternative picture of corporate profitability.
Given the other means available to preserve the integrity of ideas from
abuse by competitors (e.g., patents), it is unclear why confidential tax
returns are required for this purpose. Second, greater conformity in
the measurement of book and tax profits could provide companies
with some automatic incentives to reduce tax avoidance and earnings
manipulation. Finally, the degree to which a dual reporting system
enables managerial misconduct provides yet another argument
against the current corporate tax system.
Keywords: Financial Statement Analysis: accounting and financial reporting
issues; Corporate Governance

2006, CFA Institute