Inflated Profits In Corporate Books Is Half the Story

By Alan Murray
886 words
2 July 2002
The Wall Street Journal
A4
English
(Copyright (c) 2002, Dow Jones & Company, Inc.)

SO NOW WE KNOW: In the last decade, leading American corporations have teamed up with unscrupulous (or incompetent) accountants to mislead shareholders about how much money they make. But that is only half the story.

At the same time, many of those same companies have teamed up with the same accountants to mislead the Internal Revenue Service about how little money they make. The result is a huge and growing gap -- call it the credibility gap -- between book income and taxable income. If the efforts at accounting overhaul now under way are to be successful, they will need to close that yawning gap . . . from both ends.

Consider the case of WorldCom. Between 1996 and 2000, the company reported $16 billion in earnings to its shareholders. But to the tax man, it reported less than a billion dollars of taxable income. The truth undoubtedly lies somewhere in between. Enron has a similar story. To its shareholders, it reported profit of $1.8 billion between 1996 and 2000. But it told the IRS that it lost a billion dollars during the same period, according to calculations by Robert McIntyre of the labor-backed group, Citizens for Tax Justice. A study of more than 17,000 publicly traded firms by Gil Manzon of Boston College and George Plesko of MIT confirms that the gap widened for all of corporate America through the 1990s.

The games that allow companies to achieve such anomalous results are often the brainchildren of clever accountants and investment bankers. One particularly egregious tactic used by Enron was the now infamous "MIPS" -- a security invented by Goldman Sachs that counted as debt on the company's tax return, but equity on its public books. Regardless of whether MIPS technically complied with the law, it was a sham. And any honest accountant or tax lawyer who works at one of the big accounting firms will tell you such tactics have become increasingly common, and increasingly outrageous, in the last decade. Indeed, fierce arguments have occasionally broken out at those firms between publicly minded tax experts who still feel some obligation to abide by the spirit of the tax laws, and profit-minded partners eager to find clever new ways to exploit every loophole in the law.

Lying to the IRS doesn't generate the same public outrage as lying to shareholders. In some quarters of the country, it is almost seen as a patriotic act. Americans have a peculiar ability to view the public's finances as separate from their own. During the savings and loan crisis a decade ago, for instance, a talk show host asked a guest whether taxpayers should foot the bill for the savings and loan mess. "No, no, no," the guest replied without hesitation. "The government should pay."

BUT IT'S INCREASINGLY clear that lying to shareholders and lying to the IRS are just opposite sides of the same coin. Accounting is no longer a way to provide an accurate and unified view of a company's finances. Instead, it has become a means to an end. For the public books, the goal is to achieve smooth and steady earnings growth that will lift the value of the company's stock (and the value of executives' stock options.) For the IRS, the goal is the exact opposite -- keeping income, and thus taxes, to a minimum. The fact that accountants have become so good at serving both ends is the clearest evidence of the corruption of their profession.

So what's to be done? Well, for starters, publicly traded companies should be required to make tax returns public. That kind of information may not be much use to the average investor. But conscientious stock analysts -- surely there are some out there? -- could spend their time analyzing the gaps between book and tax income, attempting to find truth in between. Some critics will complain that publicizing tax returns violates the privacy of corporations. But just how much privacy are public companies entitled to? At the moment, it seems they have too much.

And over time, Congress and the Securities and Exchange Commission should work to bring the two measures of income into closer alignment. That won't be easy, and it goes against congressional instincts. Congress shares much of the blame for the existing credibility gap, having adopted tax loopholes over the years in response to lobbying from accountants, investment banks and corporations.

But a unified definition of income for both book and tax purposes would go a long way toward alleviating the current problems. No matter how much money Congress pours into the SEC, or how strong an accounting oversight board it creates, corporations will always have the resources and ability to outwit regulators . . . as long as they have the incentive. Reuniting book and tax income would take away some of that incentive. If a company wants to overstate its income, it would have to pay more taxes as a result. And if it wanted to reduce taxes, it would have to moderate its income claims.

The result could be more honest accounting.

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Alan Murray is Washington Bureau Chief of CNBC and co-host of Capital Report, which airs Tuesday through Friday at 7 p.m.

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