Accounting Option Facilitates Multinational Earnings Manipulation

An accounting construct known as permanently reinvested earnings is helping U.S.-based multinational corporations keep tens of billions of dollars in profits overseas, according to a new study.

Not only does it greatly reduce earnings repatriation, but it appears to be used extensively to manipulate corporate earnings and thereby mislead investors. A tax director of a Fortune 500 company has compared permanently reinvested earnings to crack cocaine, explaining that "once you start using it, it's hard to stop."

The accounting tool, known as PRE for short, goes one better than IRS rules that each year permit companies to defer paying U.S. taxes on tens of billions of dollars' worth of earnings by their foreign subsidiaries. PRE gives the multinationals the additional option of omitting from their financial statements entirely, except in footnotes, an admission that any taxes at all are owed to Washington on those profits, which they are able to do by declaring their intention to indefinitely reinvest them abroad. PRE have accumulated over time, and by the end of last year they amounted to more than $1.5 trillion, about 42 percent above their level of two years earlier.

While accounting scholars have for some time agreed that the PRE option lowers the repatriation of foreign earnings, it has remained unclear by how much. New research offers an answer.

A study in the current issue of the journal The Accounting Review, published by American Accounting Association, concludes that the PRE option reduces multinational firms' repatriation of foreign affiliates' earnings (through dividends paid to U.S. parent firms) by approximately 20 percent a year. While acknowledging that high U.S corporate tax rates and the ability to defer payment play a major role in keeping earnings abroad, it finds that "repatriation is more sensitive to the repatriation tax rate in the presence of reporting incentives," so much so that "firms with high reporting incentives repatriate, on average, 16.6 to 21.4 percent less per year than firms with low reporting incentives."

"Our study suggests that companies would repatriate about 20 percent more than they currently do if they didn't have this accounting tool that enables them to put a gloss on their financial statements," said Leslie A. Robinson, an accounting professor at Dartmouth College, who conducted the study with professors Linda Krull of the University of Oregon and Jennifer Blouin of the University of Pennsylvania.

Even though U.S. tax law permits multinationals to defer payment of U.S. taxes due on earnings abroad, Robinson explained, mere deferral does not exempt these firms from recording a tax liability on their financial statements. In contrast, declaring profits to be PRE provides this exemption, which has the effect of enhancing firms' bottom lines.

The accounting standard responsible for PRE, known as APB 23, came under attack last month during a one-day Senate hearing, chaired by Carl Levin, D-Mich., which probed offshore corporate profit-shifting (see Senate Probes Offshore Profit Shifting by Microsoft and HP). Indeed, one expert witness called for abolishing APB 23 entirely, describing it as "provid[ing] enormous potential to call up earnings as needed —or postpone them —in a large multinational operation."

Foreign affiliates' permanently invested earnings, he added, can be “sliced as finely as needed to meet earnings estimates with pinpoint precision.”

Levin commented: "On the one hand these companies assert that they intend to indefinitely or permanently invest that money offshore. Yet, they promise on the other hand to bring it home as soon as it is granted a tax holiday. That's not any definition of' 'permanent'' that I understand. While this may seem like an obscure matter, it is a major issue for U.S. multinational corporations."

While the authors of the new Accounting Review paper do not offer specific policy prescriptions, their findings make clear the special appeal PRE have for U.S. parent companies that, in the study's words, "face reporting incentives to consistently report strong earnings numbers." The study’s authors find that public firms are likely to declare a considerably greater proportion of their assets as PRE than private firms do, since "capital-market pressures vary between public and private firms due to differences in the constituents to which the two types of firms report...Public-firm managers typically have a strong focus on reported earnings because of its effect on both firm value and managerial compensation. In contrast, private firms have high levels of insider ownership and encounter...less incentive to focus on reported earnings."

Among public multinationals, the study suggests, PRE are especially favored by firms highly sensitive to the capital markets, including those whose stock prices have above-average responsiveness to company earnings, those with a consistent record of matching or narrowly beating earnings forecasts, and those with relatively few dedicated investors—that is, institutional investors whose focus is on companies' long-term performance.

In addition, the more PRE that firms accumulate over time, the lower their repatriation of current foreign earnings. The study explains that, if companies designate high levels of undistributed foreign earnings as PRE, they may find themselves in a bind in repatriating current earnings, since their financial statements will have to recognize both higher tax expenses and lower earnings than were recorded for previous periods.

The study's findings derive from a sample of 577 U.S.-based multinational corporations, including 479 public companies with 23,669 foreign affiliates and 98 private firms with 1,790 foreign affiliates. The professors combine data from the U.S. Bureau of Economic Analysis with information from other sources to construct measures of tax-reporting incentives over a six-year period. To isolate the effect on repatriation of tax-reporting incentives, as distinguished from incentives to avoid actual tax payments, the professors "identify and measure firm attributes across which reporting incentives vary while holding the cash payment for repatriation taxes constant." The reporting incentives include whether a company is public or private, how sensitive it is to capital markets, and how much PRE it has accumulated.

Robinson noted that most of the discussions to date on how to encourage repatriation of corporate foreign earnings has focused on congressional action to lower or even eliminate (whether temporarily or permanently) U.S. tax rates on foreign earnings, now among the highest in the world.

"Clearly any such approach has its drawbacks at a time when there is an urgent need for new federal revenues and when it is estimated that the amount of tax liability in S&P-500 earnings parked overseas is in the range of $350 to $400 billion,” she said. “Changing APB 23 would not require congressional action, since it is the responsibility of the FASB, the nongovernment group that oversees accounting standards. The FASB has contemplated revising the standard on several occasions since it was promulgated in 1972, and, given the findings of our study and others, further reconsideration may now be in order."

Entitled "Is U.S. Multinational Dividend Repatriation Policy Influenced by Reporting Incentives?" the study appears in the September/October issue of The Accounting Review, published six times a year by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research and practice.

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