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KeepAtLeastTwoSetsOfBooks

Warning -- Accounting minutia ahead:

In the United States, financial accounting and federal tax accounting are governed by different rules.

Financial accounting rules are used for financial disclosures like annual reports and quarterly statements. The SEC has authority to set these rules, but has delegated that authority to a private group, Federal Accounting Standards Board (FASB).

The rules used to complete a corporate tax return, and figure taxes owed are governed by the laws and regulations that the IRS enforces. It is possible to commit fraud in one set of figures while not committing fraud with the other set of books. One of the checks of financial integrity is to look at the tax expense line in the public income statement. Does the taxes paid match, more or less, with reported earnings. There have been (old) cases where companies legitimately weren?t paying any taxes because they weren?t actually making money.

Of course it is possible to commit fraud in both locations by overstating earnings to the public and understating taxable income to the IRS.

(It may be that companies only keep one set of books and can translate to the other style of reporting. Instead of actually keeping two sets of books.)

In addition, both accounting systems, financial and tax, do a poor job of providing numbers that are useful in descision making. So many companies have a third set of accounting numbers that are used as inputs into descision making.

- ShannonSeverance 2002.06.27

I'm assuming what you're talking about might be the reporting that public companies do? What is reported to the SEC and what goes to the IRS?

I wonder what other ways organizations create "multiple views" for their convenience? Marketing versus production versus testing? - BeckyWinant 2002.06.27

An example of how the two systems diverge: In the US, entertainment expenses, such as taking a prospective client to lunch, are not fully deductable for income tax purposes. So if you take a prospective client to lunch and expense $60 the company is only able to lower their taxable income by $30. But net income as reported to the shareholders had better drop by $60*, because the money left the building.

.* Technically it would drop by 60*(1/2)(1-T) where T is the marginal tax rate, since tax expense was lowered by this lunch.

Much tax accouting of large companies is driven by the country that the activity is taking place in. As an investor I don?t want the fact that Ford is installing a new machine in their Jaguar subisidary in England to effect how it is treated in the financials I look at. But I can pretty much guarentee that depreciation is handled differently by the powers that be in England than they are here in the US.

Again, I don?t know what system a large multinational firm uses to keep track of all the numbers in all the different ways that are required.

And, just to pile on: Public financial accounting is usually governed by the countries where the equity is registered and actively trading. So a company, like Daimler-Chrysler, that trades on exchanges in two different countries, will have to produce financials that meet both countries requirements. (There is some work on international standards and getting the standards accepted.) - ShannonSeverance 2002.06.27

As a certified math geek, I will take this opportunity to tell people of a cool math application to accounting. Some auditors are looking for fraud by testing the books for the distribution of expenses. If people are committing fraud it is very hard to keep the distributions mathematically correct. They perform two tests for randomness:

1) look at the interarrival times, (times between expenses) these should be Poisson.

2) look at the leading digit of each bill, these should follow Benfords law. That is MOST bills (1/3) should have a leading digit of 1 and very few should have a leading digit of 9. In fact you can make a nice graph using the first two leading digits (it's one digit if you think of it as base 100) and plot the ratio of expected to actual occurrences. You can clearly see anomalies in the graph around company meaningful numbers ('any expense over 50$ must be itemized' so there are slightly more bills just under 50$ and slightly less just over.) and fraud often stands out very strongly compared with bills from another part of the company (which tend to follow Benfords law quite closely). For more detail on Benfords law see Knuth volume 2. I can dig up the accounting reference for the geeks who care, but it is not that well written.

KenEstes 2002.06.28