January 31, 2005
How Firms Can Manage Earnings Through Foreign Subsidiaries
McCombs accounting experts take a fresh look at permanently reinvested earnings, based on research from Linda Krull into the potential for multinationals to manage earnings through revenue from foreign subsidiaries.
By Dorothy Brady

Even armed with a magnifying glass, most investors probably won’t be inclined to examine the voluminous footnotes in multinational companies’ financial statements. But important information about foreign earnings can escape even the notice of financial analysts and auditors shareholders may depend on to do their homework.

A recent study about how multinationals report foreign earnings and a change in corporate tax law may motivate everyone to focus on the fine print.

The margin for managing earnings

Linda Krull, an accounting professor and tax researcher at the McCombs School, has found that a current accounting standard leaves room for multinationals to manage earnings by designating foreign subsidiary profits as permanently reinvested earnings (PRE). Since these earnings are not subject to U.S. taxes until they are repatriated, increasing the amount designated as PRE can lower a company’s tax liability and boost its bottom line.

“There are some perfectly legitimate economic reasons to designate earnings as permanently reinvested,” says Krull. Firms may increase PRE because of profitable foreign investment opportunities. Conversely, they may decrease the amount because domestic investment opportunities make better financial sense or because payments from foreign subsidiaries to the U.S. parent create tax savings for the global organization.

But in examining PRE disclosures in the financial statements of 267 multinational firms from the 1990s, Krull found that some use this designation as a way to make up an earnings shortfall in order to align their numbers with Wall Street’s projections. During the period covered in her study, the positive earnings effect of upping the designated amount of PRE topped out at 88 cents per share, enough to make the difference between meeting and missing analysts’ projections.

Financial statements: what’s there, what’s not

Since information included about foreign operations in financial statements is largely up to the discretion of managers, there usually isn’t much there. Current accounting standards require only an explanation of why they haven’t recognized U.S. income tax on the amount of PRE.

“Technically, they are also supposed to estimate what the tax liability would be if they did bring back earnings designated as PRE, but most firms don’t,” says Krull. The current standard requires them to do so only if the estimation is “practicable.”

Corporate America is vocal in claiming that figuring tax liability of PRE is a difficult, if not impossible, undertaking. “Companies cite their inability to know when or if they are going to bring foreign earnings back, what their tax situation will be if they do bring back the earnings, and differences in foreign tax laws where the investments are made,” Krull explains. Some multinationals maintain these calculations would be unreliable and of minimum benefit to users of financial statements.

Auditing expert William Kinney, the Charles & Elizabeth Prothro Regents Chair in Business at the McCombs School, says aside from providing the opportunity for earnings management, the rule may also be an excuse for not disclosing all the facts. “If it helped their bottom line,” he says, “managers would probably find a way to approximate the figure.”

Standard setters assess the loophole

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board recently met to discuss alignment of several standards, including the current rule governing disclosure of tax liability for PRE. Due to the “practical complexities of calculating the amount,” and the short time available for consideration of the issue, the Board decided that the exception for recognition of deferred tax liabilities on PRE will stand.

John Robinson, the C. Aubrey Smith Professor in Accounting at McCombs, agrees with the decision. “I don’t think the rule needs any more specificity,” he says. “Permanently reinvested means that management never expects the earnings to come back.” A problem arises, however, when management’s expectations change over time. While expectations could occur in a relatively short period, managers should be able to explain what events caused them to reexamine PRE.

A tax break and repatriation

A recent tax law change will give firms a one-time chance to repatriate foreign profits at a tax rate of 5.25 percent rather than at the usual 35 percent rate for the 2004-2005 fiscal year.

Krull says that the real financial benefit of bringing the funds back to the U.S. will most likely outweigh that of using funds simply as a tax reserve. “You might see a lot of firms that had intended to keep money abroad decide to bring it back because it’s a better financial decision under the new tax law,” says Krull.

If a company repatriates a large amount of what it originally called PRE this year, she says, it shouldn’t raise any red flags about earnings management. But future years will tell the tale.

Robinson concurs. “If a company’s repatriations fluctuate inexplicably in subsequent years, then it would be up to auditors and financial advisors to determine if these fluctuations indicate instances of abuse.”

Taking a closer look

With the change in tax legislation, financial analysts will take a step back and examine PRE disclosures more closely, says Professor Michael Clement, a financial accounting specialist at McCombs: “Since this is discretionary behavior on the part of firms, it will be another spot in the decision tree that analysts will have to consider.” Analysts’ opinions on changes in PRE will rest on the past behavior of a company, its accounting culture and how it manages its taxes worldwide.

Kinney says that auditors should consider the possibility of earnings management using PRE, but identifying it will be problematic. “There is often justification for the assessments that managers make about opportunities in the U.S. versus those in foreign countries. If the only evidence an auditor has is a change in PRE, that alone may not be enough to raise suspicion,” he says.

Should standard-setters revisit the issue?

Because the economic world has vastly changed since the current standard was passed in 1972, Kinney says the FASB and the IASB should take a closer look. “Multinationals were less dominant then, there was much less of a global economy. Now technology allows nightly reporting of earnings forecasts and with it comes the necessity for companies to explain why they were above or below analysts’ forecasts,” he points out.

If the standard setters do embark on a more comprehensive analysis of this exemption, Krull expects that one concern will be the tradeoff between the relevance and reliability of information. Managers have private information that can be helpful to investors, she says, and making standards too exact could potentially decrease the information conveyed by the disclosures.

More eyes, a keener focus

Krull says that although earnings management through adjustments of PRE has not been obvious in the past, new emphasis on the possibility may curtail this type of earnings management. For investors, she has basic advice: “Pay attention to how much companies repatriate this year, and then be on the lookout for big year-to-year variations in PRE.” The fine print in financial statements might not get any bigger, but under the scrutiny of auditors, financial analysts, and investors, the meaning will definitely become clearer.