Home News Commentary This Proposal Could Inadvertently Improve Corporate Accounting

This Proposal Could Inadvertently Improve Corporate Accounting

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Illustration by erhui1979, via Getty Images

A provision within the Biden administration’s Build Back Better bill that assesses a minimum tax on certain companies based on their income reported to Wall Street could improve corporate accounting. 


Buried away deep on page 1741 of the Build Back Better bill (BBB) that is logrolling precariously through the US Congress is a provision that could transform corporate accounting for the better. 

That’s not its primary intent—the provision, which calls for a 15 percent minimum tax on companies with over $1 billion in profits, focuses on defining an alternative tax-basis for corporations, to help prevent corporate tax-avoidance. Currently, corporate taxes are generally assessed on income self-reported by companies to the US Internal Revenue Service. The BBB provision says such taxes can alternatively be assessed on companies’ financial-accounting income (also called GAAP income), usually prepared for investors. 

Many people are surprised to learn that companies can legally have two sets of accounting books: one for the taxman and another for Wall Street. After all, this is not a situation most individuals would enjoy—imagine being able to present one earnings number to your mortgage officer and another on your tax filing. And moreover, while US individuals are subject to a cap on deductions to taxable income—the dreaded Alternative Minimum Tax (AMT) that ensnares many professionals—US corporations have no limits to tax deductions. The result is that companies like Amazon, FedEx, and Nike often pay little or no taxes to the IRS, even as they declare handsome profits to shareholders. 

Within reason, some divergence between income reported to investors and tax authorities can be productive: for instance, tax income can be lower due to accelerated deductions on infrastructure investments, which can spur economic activity. In proposing an AMT for corporations, Congress is creating a floor for corporate deductions from taxable income, even those with legitimate policy purposes, as some companies abuse the privilege. Unsurprisingly, then, those companies are unhappy with this proposal, and their lobbying has reached a fever pitch.

As is often the case with such lobbying, corporations have selectively co-opted certain scholarly arguments to make their stance look less self-interested. Here, their claim is that assessing taxes on GAAP income will politicize the GAAP rule-making process—as the process starts to look like the raucous debates in Congress that define taxable income—and thereby dilute the quality of information needed by those making investment decisions across the economy. 

“When describing political power, we tend to see those who prevail in a public political argument as the powerful; but still more powerful are those who can control the agenda and ideology of rule-making so much so that a public debate isn’t even necessary.”

Not only are these criticisms misplaced, the opposite is likely true. Take the claim that assessing taxes this way would reduce information quality: All else equal, companies have strong incentives to overstate financial-accounting income, to make themselves look good to investors and to try drive up stock prices; conversely, companies have strong incentives to understate tax-accounting income, to reduce taxes due. The BBB bill folds these countervailing incentives into one consolidated income number, potentially equilibrating some of the more-bombastic claims in GAAP reporting.

As for the politicization argument, GAAP rule-making is already political due to its enormous financial implications, but sometimes so uncompetitive that corporate special-interests can prevail even without much of a fight. In fact, for nearly thirty years now, academics have been warning that the rules that define GAAP income are being quietly watered down to be less “prudent”—meaning, that they allow for greater corporate showboating on their own performance. Unlike tax-accounting rules, which are hammered out noisily in the halls of a divided Congress, under the spotlight of the media and the scrutiny of the IRS, US GAAP-accounting rules are made by a private organization in a genteel office-park in leafy suburban Connecticut. The BBB proposal can improve GAAP rule-making by encouraging greater Congressional and IRS oversight of the process.

When describing political power, we tend to see those who prevail in a public political argument as the powerful; but still more powerful are those who can control the agenda and ideology of rule-making so much so that a public debate isn’t even necessary. For instance, in January 2009, even as the world was still reeling from a financial crisis that threatened to send the economy into a second Great Depression, the private rulemaking board for GAAP income revised their own standards to remove the need for financial-accounting income to be “reliable” or “verifiable.” The result can be that companies and senior managers find it easier to mislead (mostly) small investors through overstated GAAP income. Linking GAAP and tax accounting would bring more sunshine to the GAAP rule-making process.

But even as the BBB proposal can improve GAAP, the proposed changes could unintentionally accelerate another dangerous shift in financial accounting over recent decades: that toward so-called pro-forma income. Today, if a CEO is dissatisfied with their GAAP-income number in a given year, they can simply define an ad-hoc (or “pro-forma”) income number in a press release, for instance, by opportunistically deferring some expenses to future periods. Pro-forma income is the Wild West of accounting. 

So, one probable side-effect of the proposal to assess a corporate AMT on GAAP income is to indeed create more alignment between financial-accounting and tax-accounting books—both being downward adjusted to keep taxes-payable low—whilst encouraging companies to supply more pro-forma income numbers to Wall Street. Put differently, companies, seeing that their bombastic claims in GAAP are now taxable, would shift any exaggeration of their performance to pro-forma statements.

Anticipating this side-effect, the BBB proposal gives the US Treasury some discretion to respond to omissions from GAAP income. But if Congress wants to make the most out of raising public revenue by assessing taxes on aggressive corporate claims of profitability, then they could go further than using GAAP income as a basis, to using CEOs’ pro-forma income claims to generate IRS bills-payable. This approach could invite still-sharper pushback from some corporations, but if that is the case, it would suggest that the approach might work even better.

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Karthik Ramanna is a professor of business and public policy at Oxford university’s Blavatnik School of Government. Ramanna joined Oxford in 2016, after nearly a decade on the faculty of Harvard Business School. At Harvard, he also held the Henry B. Arthur Fellowship in ethics, the Marvin Bower Fellowship recognizing innovative faculty research, and a visiting fellowship at the Kennedy School of Government. Additionally, he is a faculty associate of the Weatherhead Center for International Affairs. He received his Ph.D. in management from the Massachusetts Institute of Technology. Ramanna’s scholarship explores the role of business leadership in shaping the basic rules that govern capital-market societies. His book Political Standards (University of Chicago Press) studies the political and economic forces that have shaped corporate financial reporting standards over the last 30 years. He argues that accounting rulemaking is an allegory for the “thin political markets” where businesses shape – and sometimes subvert – the essential technical edifices of our economy. Ramanna has authored over two-dozen HBS case materials and over a dozen original research articles in leading professional outlets such as the Accounting Review, the California Management Review, and the Harvard Business Review. His scholarship has won awards from numerous bodies such as the American Accounting Association. He serves on the editorial boards of several scientific journals, including as co-editor of the interdisciplinary journal Accounting, Economics & Law and as associate editor of the Journal of Accounting & Economics, the most-cited outlet in that field.

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