Stopping the Enron End-Runs and Other Trick Plays: The Book-Tax Accounting Conformity Defense

Wednesday, January 1st, 2003 at 12:00 am by Anthony J. Luppino
Anthony J. Luppino, Stopping the Enron End-Runs and Other Trick Plays: The Book-Tax Accounting Conformity Defense, 2003 Colum. Bus. L. Rev. 35

“When you come to a fork in the road, TAKE IT!‘

— Yogi Berra

(philosopher and three-time American League “MVP‘)

Robert Frost must not have known many imaginative accountants or tax professionals. In his classic poem The Road Not Taken, Frost assumed that at the proverbial fork in the road the traveler must choose one path or the other. Had he sufficient exposure to the talents of creative accounting and tax advisors, the poet might have considered Yogi Berra’s third alternative– take both roads.

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 permissible and ‘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 recently become subject to public scrutiny (and head scratching) are: ‘synthetic leases‘ of real estate (where a company claims to ‘own‘ financed property for income tax purposes, but claims to be a mere ‘tenant‘ under an ‘operating lease‘ for financial accounting purposes); ‘off-balance sheet‘ partnerships (one of Enron’s financial accounting ‘end runs‘ under which, among other things, 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 at least the company’s management) may derive substantial benefits from such book-tax divergence, 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 and are by no means unique to Enron. They have been around for many years, and despite some significant criticism, have been utilized by many well-known companies with respect to transactions involving billions of dollars. Long before Enron’s December 2, 2001 bankruptcy filing, the existence of transactions such as 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 subsequent 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 largely below the radar for so many years? Second, and more importantly, how can the administration of the tax and securities laws be improved to bring to these and other 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?

A useful starting place is to acknowledge that this is not the first period of serious accounting crisis in the United States. For example, in the midst of accounting turmoil in the late 1970s, a partner in the accounting firm of Coopers & Lybrand observed:

The accounting profession has been under intense scrutiny this past year. Not since the 1930s, when the congressional hearings that established the Securities and Exchange Commission were held, has there been such interest in accounting. Renewed congressional interest probably began with the highly publicized business failures that occurred over the past few years. The sudden failures of publicly owned companies, such as Equity Funding, Penn Central, Four Seasons Nursing Homes, and National Student Marketing, raised questions of why there was little or no prior warning from the auditors that anything was wrong.

If the names Enron and WorldCom were substituted for the companies cited in that statement, it could easily be repeated today–verbatim. This suggests that analysis of why questionable accounting practices exploiting book-tax differences have flourished and how reforms might be achieved must include an historical perspective. Accordingly, this article will focus its review on two aspects of the circumstances that facilitated the now-criticized opaque financial accounting for transactions with surprising book-tax divergence–a general, and long-standing, consensus that the government should avoid legislating financial accounting standards, and a widespread and also long-standing fear of utilizing the tax law treatment or analysis of a transaction as a guide in determining the proper financial statement reporting of the same transaction. A review of the record of the book-tax conformity debate in the United States over the last half century reveals that these circumstances are grounded in generalizations and assumptions about the roles of the accounting profession and the tax law which merit serious reconsideration.

Most recently, the many legislative initiatives to improve the transparency of public-company financial disclosures, culminating in the enactment of the Sarbanes-Oxley Act of 2002, have perpetuated the tradition of substantial delegation of the accounting standard-setting function to private sector bodies. The new law also failed to address the problem of unwarranted disconnect between the administration of the tax law and public company financial accounting. Although the Sarbanes-Oxley Act takes some major steps to improve public company auditing standards through a broad grant of authority to a new ‘Public Company Accounting Oversight Board‘ as a quasi-governmental overseer of the public company auditing process, the Act continues the role of a private sector body as the primary setter of generally accepted accounting principles, and, despite mandating various studies to improve accounting principles and practices, does not target book-tax divergence as a problem area.

At least some commentators, however, have now begun to embrace the notion of increased utilization of book-tax comparisons to improve both tax and financial accounting. For example, two prominent attorneys, following the enactment of the Sarbanes-Oxley Act, have urged ‘that Congress, the SEC, and the IRS consider adopting a single comprehensive requirement for the public disclosure of a detailed schedule reconciling public companies’ book and tax income statements and balance sheets.‘ Interestingly, the proponents of that public disclosure proposal noted that they had originally been arguing for more comprehensive disclosure of book-tax differences solely on corporate tax returns, to assist IRS audits. But in the aftermath of publicity regarding Enron, WorldCom, and other alleged large company accounting abuses it became clear that such disclosure in financial statements would increase the transparency of financial accounting as well. It thus has taken some audit failures of gargantuan proportion to shine a bright light on the potential dual benefits of book-tax comparisons, in terms of improving both the administration of the tax law and the financial reporting which is critical to the regulation of dealings in securities. This is the case despite the fact that there has been considerable recent attention, largely from a tax perspective, on the growing gap between the book and taxable income of large companies and on suggestions that more attention to book-tax differences is in order to identify and eliminate abusive corporate tax shelters.

One benefit from the otherwise tragic Enron experience may indeed be more widespread awareness that the quest for loopholes typically associated with tax shelters is an equally important concern in regulating financial accounting, thereby warranting a coordinated response to both problems. Better disclosure of book-tax differences is only a first, though critical, step in more effective use of book-tax comparative analysis to identify and eliminate abusive tax and financial accounting practices. Regulatory actions in addition to the imposition of improved disclosure requirements–such as book-tax consistency requirements imposed from both the tax and securities regulation perspective for potentially abusive transactions–also merit consideration.

Evidencing recent manifestations of the need for enhanced governmental attention to book-tax conformity issues, Part II infra explores synthetic leases, off-balance sheet partnerships and nonqualified employee stock options as examples of transactions with dramatic financial statement/income tax reporting divergence. These accounting practices have been widely employed under prevailing interpretations of accounting principles and federal income tax law, but are nevertheless questionable when viewed in the light of the underlying substance of the transactions.

Part III then 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. That history includes an abundance of thoughtful analysis justifying book-tax differences in many situations. It also reflects, however, a questionable degree of deference to non-governmental bodies, primarily the American Institute of Certified Public Accountants (‘AICPA‘) and, since 1973, the Financial Accounting Standards Board (‘FASB‘), in the establishment of auditing and financial accounting standards; unjustified dismissal of the possibility that financial accounting might learn some lessons from tax accounting for certain types of transactions; and, consequently, insufficient use of book-tax accounting comparisons and consistency requirements as part of the process of identifying and eliminating both tax and financial accounting abuses.

Finally, Part IV 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 book and tax accounting consistency in targeted situations in which such consistency comports with common goals of tax and financial reporting. Consistent with the spirit of the Sarbanes-Oxley Act, such coordinated efforts would facilitate the production of clear disclosure of the underlying economic substance of complex transactions–thus facilitating the ‘transparency‘ generally viewed in the aftermath of Enron and other high-profile audit failures as the key to restoring confidence in both financial accounting and the tax system, at a time when such confidence is sorely needed.

Author Information

Associate Professor of Law, University of Missouri-Kansas City School of Law