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

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 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).