Publication Date

2003

Document Type

Article

Abstract

In accounting for business transactions in the United States, it has long been the case that keeping two different sets of books (one for financial reporting and one for income tax reporting) is 'generally accepted.' A company can often effect a transaction that in economic substance begins at 'point A' and ends at 'point B,' but account for the path taken in one manner in its financial statements and in a markedly different manner in the company's income tax returns.

Three prominent examples of this accounting divergence that have become subject to public scrutiny are: 'synthetic leases' of real estate (where a company claims to 'own' financed property for income tax purposes, but to be a mere 'tenant' under an 'operating lease' for financial accounting purposes); 'off-balance sheet' partnerships (one of Enron's 'end runs' under which a company in effective control of a partnership may claim responsibility for all or part of the partnership's liabilities in its income tax reporting, but exclude such liabilities from its balance sheet for financial statement purposes); and accounting for the grant and exercise of compensatory 'nonqualified' employee stock options at a bargain price (whereby a tax deduction is recognized for the compensation represented by the bargain element of the transaction, but financial accounting under U.S. 'generally accepted accounting principles' ('GAAP') has failed to require that a charge be taken against the employer's income in its financial statements).

In each of those three cases, the company (or its management) may derive substantial benefits, in terms of both tax savings and better looking financial statements than would be the case if the book reporting of the transactions more closely corresponded with the associated tax reporting. Moreover, these 'take both roads' transactions are not recent innovations nor unique to Enron. Despite some significant criticism, they have been utilized for years by many well-known companies in transactions involving billions of dollars. Long before Enron's bankruptcy, the existence of synthetic leases, with blatantly inconsistent book and tax accounting treatment, implied inadequate interaction among the institutions charged with shaping and regulating tax and accounting rules.

The Enron bankruptcy and revelations of questionable accounting practices by other major companies have placed these divergent accounting transactions on the public radar, raising two pivotal questions. First, why were such large 'blips' allowed to fly below the radar for so many years? Second, how can the administration of the tax and securities laws be improved to bring to these divergent accounting transactions the degree of 'transparency' the markets are demanding, and regulators and other interested observers are professing to seek, in the aftermath of Enron?

This article explores examples of transactions with dramatic financial statement/income tax reporting divergence and summarizes the history of the book-tax accounting conformity debate in the United States, describing the political environment and institutional decisions that have allowed substantial divergence to exist. It also suggests ways for the appropriate regulatory bodies to more regularly employ book-tax comparisons to identify improper accounting practices and to cause the implementation of rules and standards which require consistency in targeted situations with common goals of tax and financial reporting.

Publication Title

Columbia Business Law Review

Volume

2003

Issue

1

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