The Aggressive Sweet Spot: Income Up; Taxes Down

Two Darden professors peeked into the murky world of aggressive tax and financial reporting to discover a remarkable fact. Firms that push the limit in reporting higher book income to shareholders also report lower taxable income to the government.

Professors Mary Margaret Frank, an expert in tax accounting, and Luann Lynch, an expert in financial accounting, found in their pioneering research that firms that are aggressive in one type of reporting are usually aggressive in the other. These firms seek the sweet spot of reporting book income up and taxable income down.

The professors said they were motivated to examine the relation between the two types of aggressive reporting by “the recent spate of accounting scandals, widespread tax shelter activity and the growing book-tax gap.” That connection was a relatively unexplored area of accounting research

“It was our academic expertise, in combination with our knowledge of real-world issues such as the growing book-tax gap and accounting scandals, that led us to dip our toe in the water,” says Lynch.

“I’ve seen a lot of research on managers misreporting earnings, and a lot of literature on how managers make choices to engage in tax planning,” says Frank. “What you began to see at the time of Enron was that the same companies were being discussed in these separate contexts. Enron is the poster child for this because it was engaging in very aggressive tax shelters and propping up earnings through financial manipulation.”

Lynch describes the traditional trade-off — and the inconsistencies in regulations — in simple terms. “It helps to think of firms keeping two sets of books but for all the right reasons. The financial reporting books are those books that companies use to capture their economic performance and communicate that to investors, the SEC and creditors. And then there are the tax books that companies complete to file tax returns and pay taxes.

“Those two sets of books are prepared under two different sets of guidelines,” says Lynch. “The financial books are prepared under GAAP and are regulated by the SEC. The tax books are prepared according to tax laws.”

“But there are some places where the rules for each of these sets of books aren’t connected to each other and so the managers can be aggressive on the financial books and report income that looks really good and at the same time be aggressive on the tax books and report income that isn’t so good. They get the best of both worlds,” Lynch says. “It’s important to note that when we say aggressive, we don’t necessary mean illegal.”

“Most of the academic literature had been about the trade-off,” adds Frank. “If you want to increase book income, you have to pay more taxes, and vice versa. We examined situations in which there isn’t a trade-off. Nobody had looked at firms doing both.”

To examine those firms, the professors first had to tackle the issue of measuring tax aggressiveness — a difficult task. But the two, along with their co-author Sonja Rego, a professor at the Kelley School of Business at Indiana University, Bloomington, developed a measure “to capture tax-aggressive behavior using data analytics on publicly traded corporations,” says Frank. The professors validated their new measure of tax aggressiveness by showing it is associated with companies that have been identified using corporate tax shelters. When they developed the measure, it isolated tax aggressive activity “as well as, or better than, the few other existing measures,” they said. Their findings were borne out by other researchers and helped inspire substantial literature on tax aggressiveness.

Using their new measure, and the standard measure in accounting literature for financial reporting aggressiveness, the professors found a “strong, positive relation between financial and tax reporting aggressiveness.”

Their research should be helpful to regulators seeking to reduce corporate malfeasance and to investors who could be fooled by aggressive financial reporting into thinking a company is doing better than it is, the professors say.

But their findings are really just a first step to answering a bigger question.

“The big question is, can you measure corporate culture — specifically, aggressive corporate culture, in which management decisions push the envelope — in acquisitions, in tax reporting, in debt leveraging, in all things business?” says Frank. “We want to explore the culture of aggressiveness in the business world.”

Lynch says that in pursuing that question “it became clear that we had to bite off a smaller piece of that larger question. And the piece we bit off was the piece we’re more familiar with from our financial and tax world, because we realized nobody had shown even in that limited context that there was a cultural tendency towards aggressiveness. So if we could show there was aggression in both areas of reporting, then we might be a step closer to answering our big question.”

That research paper on the big question — in which the professors are trying to develop a measure of corporate culture using data analytics on publicly traded corporations and look beyond the accounting world — does indeed show that firms with aggressive reporting habits exhibit a propensity toward other aggressive corporate policies. The authors are hoping to see that paper in print in the near future.

Carlos Santos is a freelance writer and co-author of Rot, Riot and Rebellion: Mr. Jefferson’s Struggle to Save the University that Changed America.