January 05, 2006

Federal Regulators Do the FASBury Flop

Everyone remembers the spectacular flameout of the Enron corporation a few years back. But federal regulators seem not to have learned any lessons from the Enron debacle, if a recent ruling by the Financial Accounting Standards Board (FASB) is any indicator.

Most people remember that Enron wildly overstated its profitability on its financial statements-- but few remember how it was done. This article describes one of the tax loopholes that made Enron's phantom profits possible.

In hindsight, we know that many of the tax breaks cooked up for Enron and other companies by Arthur Andersen and their ilk were phony, insubstantial tax maneuvers designed with no other purpose than to reduce the taxes paid by the biggest and most profitable corporations.

With this in mind, FASB decided this past summer to make it harder for companies to use doubtful tax shelters. A proposed FASB regulation, available on the FASB site here, would have required that companies claiming dubious tax breaks should only be allowed to record these tax breaks on their financial statements if "that position is probable of being sustained on audit based solely on the technical merits of the position." In other words, firms shouldn't be able to claim newfangled tax breaks unless they have a pretty good reason to believe they would stand up to legal scrutiny. In the reckoning of tax accountants, the new rule was understood to mean that any tax break should have at least a 70% to 80% chance of actually being legal.

After publishing the proposed rule this past summer, FASB opened up the floor to public comments. As you can see here, the rule attracted 119 comments, all but two of which were from irate corporations who felt that such a rule would diminish the creativity of their accounting. The two comments from outside the corporate world, from Senator Carl Levin and the Tax Justice Network, supported the proposed rule as a way of preventing a torrent of creative corporate accounting a la Enron. As Levin's letter put it:
If companies knew that they were required to meet a "probable" standard before they could incorporate a tax position into their financial statements, it would not only protect the integrity of their financial reports, but also reduce the incentive to buy a risky tax shelter for the purpose of reporting more favorable financial results.
Unfortunately, these two voices were drowned out by 117 corporations eager to preserve their liberty to create new and unimagined tax shelters-- and FASB retracted the proposed rule. In place of the proposed 70% rule, FASB decided instead to use a 50% rule-- in other words, that it should be more likely than not that any new tax break will stand up to legal scrutiny.

No one-- whether it's individuals or corporations-- should be able to make up dubious tax shelters and hope they get away with it. The draft standard put forth by FASB this past summer would have made a good start toward restoring the integrity of financial statements--an important goal in the post-Enron era. But now that FASB has backed away from applying a heightened level of scrutiny for Enron-style accounting shenanigans, corporations are now once again free to roll the dice on shady tax schemes with little fear of reprisal.


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