The Degradation of Reported Corporate Profits

Journal of Economic Perspectives 19, no. 4 (Fall 2005), 171-192. Reprinted in W. DeBondt (ed.), Financial Accounting and Investment Management, Edward Elgar, 2008.

U.S. firms are afforded the opportunity to characterize profits to capital markets and tax authorities in distinct ways. How does the latitude afforded managers influence the quality of these corporate profit reports? This paper traces the evolution of the dual reporting system and assesses its impact on corporate profit reporting. Case-based evidence suggests that managers exploit the differences between book and tax reporting opportunistically thereby reducing the quality of corporate profit reporting both to tax authorities and the capital markets. More systematic evidence provided in the paper suggests that both types of profit reporting have degraded in quality and various reasons for this degradation, and its relationship to the dual reporting system, are considered. The degradation of profit reporting brings into question the confidential nature of corporate tax returns, the rationale for two books and the nature of the corporate tax.