Exactly a year ago, we witnessed the spectacular fall of one of the signposts of the success of Corporate India?Satyam. This day a year back, Raju confessed the accounting fraud that he had been perpetrating at Satyam. Accounting frauds constitute a common theme that connects the Satyam scandal with other international corporate scandals such as Enron, Tyco, WorldCom. As we look back at the year that has passed since the startling revelations by Satyam and attempt to develop appropriate policy responses, it is critical to understand the common mechanisms firms use to commit accounting frauds.

Using a sample consisting of firms prosecuted by the US SEC for accounting frauds, Merle Erickson of the Chicago Booth School of Business and his co-authors have examined the mechanisms used by firms to inflate their earnings. They find that reporting fictitious sales is the most common source of income inflation for sample firms. For example, one firm in the sample created a fictitious customer and shipped empty boxes to this customer at the address of a firm employee. Subsequently, the firm sent invoices to this fictitious customer, which made it appear that a sale had taken place, even though nothing had actually been sold. Ultimately, this transaction increases the firm?s financial statement net income, but not its economic income. Firms also understate their costs or overstate their inventory.

Who executes the financial statement fraud? For the majority of the sample firms, the CEO was accused of assisting in the alleged accounting fraud. In about 50% of the cases, the CFO was accused of perpetrating the fraud. Other corporate executives accused of fraud by the SEC included the chairman of the board, president, controller, vice-president of sales, chief operating officer and vice-president of finance. Overall, the data indicate that the accounting fraud was committed by the most senior members of management, though it is reasonable to believe that there are many more people involved than those accused by the SEC.

Why might firms pay taxes on overstated earnings? Why don?t firms simply choose not to report the non-existent accounting earnings to the tax authorities? Many firms may willingly pay taxes on the non-existent earnings to avoid raising the suspicion of savvy investors, the regulators or the tax authorities.

When firms do overstate earnings for financial reporting purposes, there are typically four ways of accounting for the income tax effects associated with the earnings. First, a firm could choose not to report the overstated earnings on its tax return and classify the book-tax difference as temporary (which creates a deferred tax liability). Second, a firm could omit the additional income from its taxable income and classify the inflated earnings as a permanent book-tax difference (for example, overstating the income of a foreign subsidiary in a low-tax country). Third, a firm could choose to pay taxes on the overstated earnings. Thus, it would not report a book-tax difference in its financial statements. Fourth, firms with tax losses or excess deductions can include the overstated earnings on their tax returns, but use other existing tax loss carry forwards or deductions to avoid paying taxes on the bogus income.

Suppose a firm overstates its earnings by Rs 100. Management knows that the earnings don?t exist. If they pay the tax on this amount, no one will notice, because this appears to be the normal course of business. If the firm reports the extra Rs 100 of earnings and doesn?t pay the tax, the firm will have to make an accounting entry that shows why it didn?t pay taxes on those earnings. At that point, an analyst may inquire about these additional earnings and the fraud can unravel. In addition, if a firm reports higher earnings on its financial statements to the securities regulator, but does not report that amount to the tax authorities on its tax return, it has to file a schedule with its tax return to explain the difference. On the other hand, if the firm just pays tax on the false earnings, that item does not appear on the statements to the tax authorities, and the tax authorities are unlikely to realise that the earnings are not legitimate. Moreover, the tax authorities may have no reason to investigate overpayment of taxes on non-existent earnings.

Thus, managers of some firms will sacrifice substantial amounts of firm resources to make their financial statements appear better than they are. Erickson and his co-authors find that the average firm paid $11.84 million in additional annual taxes, which is the equivalent of $0.11 in additional income taxes per $1 of inflated pre-tax earnings. Therefore, managers that inflated earnings believed that $1 of overstated accounting earnings was more valuable than $0.11 of cash.

From a policy perspective, their results suggest that mandating public disclosure of tax return information will not deter financial reporting fraud because some managers appear to be willing to include the fraudulent earnings on corporate tax returns as well.

The author is assistant professor of finance at Emory University, Atlanta, and a visiting scholar at ISB, Hyderabad