International Journal of Law and Management

The computation of taxable income when accounting numbers are not reliable: a note on presumptions
António Martins, Cristina Sa,
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António Martins, Cristina Sa, "The computation of taxable income when accounting numbers are not reliable: a note on
presumptions", International Journal of Law and Management, https://doi.org/10.1108/IJLMA-12-2016-0181
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 The computation of taxable income when accounting numbers are not reliable: a note
on presumptions

Abstract

Purpose: The purpose of this paper is to discuss the causes that justify the application of
presumptions in corporate income taxation. We focus on motives showing a connection to
errors or fraud in the recognition of operations by the financial accounting system. The
research question can be framed as follows: how to define the frontier between reliable
accounting records and unreliable information, the later rendering presumptions as an
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admissible way of taxing income?

Approach: The research design of this paper rests on two analytical steps based on the legal
research method. The first step enquires, at the accounting level, how to define and
quantify errors that render accounting statements inappropriate to assess firms´
performance and compute taxable income. The second step explores the practical
application of presumptive tax concepts by Portuguese courts, in order to offer some
criteria that can function as guidelines to firms and tax auditors.

Findings: The judgment about the boundaries of accounting errors that allow the use of
presumption based taxation is often decided by litigation. Portuguese jurisprudence
provides strong evidence that presumptions should only be applied if, even by correcting of
errors and inaccuracies, corporate real income can´t be obtained. The level of
contamination must be obvious, and tax audits must present a strong and documented
claim that presumptions are a last resort mechanism to compute an appropriate tax base.
The Supreme Tax Court has been applying a consistent approach characterized by: i)
Presumptive taxation is a last resort mechanism; ii)Tax audits must prove that a
generalized contamination of accounting data is observed; iii) It is not possible to correct
accounting errors, given their extension and depth, and the taxpayer did not submit
contradictory solid evidence.
Implications: Applying, in practice, legal criteria to decide that accounting manipulation
is so extensive that taxation must be based on presumptions is fraught with subjectivism.
However, we offer an analysis where some guidelines to this complex issue are presented
in a logical way. Principles based taxation can, nonetheless, be applied with a significant
degree of fairness and consistency.
Value: The paper contributes to the literature by offering an analysis of the criteria used by
Portuguese tax courts when deciding that accounting data can be disregarded and
presumptions used as a tax computation tool. Given that the rule, in many countries, is to
base taxable income on accounting records (albeit with adjustments established in
Corporate Income Tax Codes) presumptions are a notable exception to this well
established rule. As such, taxpayers have a significant interest in knowing how courts rule

1
 on tax authorities’ use of presumptions. In this light, the paper has also potential value to
professionals in the accounting and tax fields. They are often confronted with tax audits
that apply presumptions. Therefore, knowing jurisprudential trends in the judgment of
such, usually complex, cases is an important issue.

Key words: Accounting errors, presumptive taxation, judicial control of

presumptions, Portugal
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2
 1.Introduction1

According to Thuronyi (1996) presumptive taxation implies the use of indirect methods to
calculate a tax liability, while disregarding taxpayer's accounting records. The term
"presumptive" indicates that there is a legal basis for considering that the taxpayer's
income is no less than the amount obtained from application of the indirect method.

In Portugal, the application of presumption based taxation is established by articles 87 to

94 of General Taxation Law2 (GTL) and can be based on several motives. Many of them
exhibit a strong connection to financial accounting. Article 88 of the GTL states that
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accounting “irregularities”, “errors” and “inaccuracies” may constitute grounds for

presumption based taxation.

When presumptions are justified on the basis of accounting errors or fraud, the crucial
question that is not addressed by the GTL is how to establish the frontier that, once being
crossed, justifies discarding accounting data and basing the computation of taxable income
on presumptions or indirect methods. That is, how to define the boundaries of what is a
sufficient number of errors or irregularities to break the link between book income and
taxable income, and compute the later through the use of presumptions. As we shall see,
case law can greatly help accountants, taxpayers, tax auditors and other interested parties
in clarifying the meaning of the legal formula.

The purpose of this paper is therefore to discuss the causes justify the application of
presumptions in income taxation. We focus on motives showing a connection to errors or
fraud in the recognition of operations by the financial accounting system. The research
question can be framed as follows: how to define the frontier between reliable accounting
records and unreliable information, the later rendering presumptions as an admissible way
of taxing income?

The paper contributes to the literature by offering an analysis of the criteria used by
Portuguese tax courts when deciding that accounting data can be disregarded and
presumptions used as a tax computation tool. Given that the rule, in many countries3, is to

1
The authors are thankful for the valuable comments of an anonymous referee. The usual disclaimer
applies.
2
The Portuguese acronym is Lei Geral Tributária (LGT).
3
See, for the German and UK cases, Gee et al. (2010). For the Italian case, see Gavana et al (2013).

3
 base taxable income on accounting records (albeit with adjustments established in
Corporate Income Tax Codes) presumptions are a notable exception to this well
established rule. As such, taxpayers have a significant interest in knowing how courts rule
on tax authorities’ use of presumptions. In this light, the paper has also potential value to
professionals in the accounting and tax fields. They are often confronted with tax audits
that apply presumptions. Therefore, knowing jurisprudential trends in the judgment of
such, usually complex, cases is an important issue.

The paper is organized as follows. In section 2 a literature review is presented. Section 3

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deals with methodology. Section 4 explores the issue of manipulation of accounting

income and the economic agents that may have an interest in it. Section 5, deals with the
materiality/extension of errors and the need for the restatement of accounting/tax
statements, applying an hermeneutical/interpretative approach. Section 6 analyses
Portuguese jurisprudence on accounting manipulation and the frontier for using
presumptions, by an evaluative approach. Section 7 extends the analysis to other
jurisdictions. Section8 concludes.

2. Presumption based taxation: an overview

2.1 Issues in the legal basis of presumptive taxation

The legal basis of presumptive methods of taxation has often been the focus of research
and policy recommendations (Tanzi and Jantscher, 1987; Avi-Yonah, 1997; Basto, 2001;
Thurony, 1996; Ribeiro, 2010; Logue and Vettori, 2011). However, literature on this
subject is largely devoted to presumptive methods seen as a aprioristic designed options
for hard to tax or small taxpayers and much less as a tax tool for dealing, a posteriori, in
litigation settings, with accounting errors and fraud. This paper is concerned with the later
but, regardless of the adopted perspective, some conceptual issues can be discussed as the
pillars of presumptive taxation.
The mandatory or optional nature of presumptive taxation in the simplification effort to
reduce compliance costs to small firms is often mentioned (Centro de Estudos Fiscais,

4
 2007; Basto, 2001; Logue and Vettori, 2011). In the Portuguese case, as the Constitution
establishes that taxation must be fundamentally based on "real" income, that is interpreted
as not forbidding presumptive taxation but implying that it must be optional. This optional
nature of presumptive taxation has been identified in the literature as implying that its
adoption is more dependent on tax savings and less on reducing compliance costs
(Dâmaso, 2015).
Presumptive law must define what are the (economic or physical) variables that may
constitute the tax base. When accounting errors of fraud are the motive for presumptions,
the recalculation of taxable income must also have an anchor, be it economic or physical.
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In fact, when designing presumptive systems, assets, sales, employees or input

consumption may be used as benchmarks for computing income deemed to flow from the
business. Similarly, when accounting numbers are disregarded by tax audits, these
variables, and also industry margins, can be used as proxies for recalculating the true tax
base.
Fairness and efficiency considerations influence the adoption of presumptive taxation
(Tanzi and Jantscher, 1987). Regarding fairness, when presumptive simplified systems
are available, a significant number of small economic agents, usually outside the formal
economy, can be brought to contribute to the public revenue, helping to displace the
feeling that it pays to be in the shadow economy (Thurony, 1996). On efficiency grounds,
presumptive taxation can induce lower compliance costs for firms and the tax authorities
and reduce the impact of taxes in firms´ decision making, given the automatic nature of
many presumptions, independent of management choices..
The legal nature of presumptions is also a relevant issue. When dealing with presumptive
taxation, applied as a normal substitute of regular income tax, presumptions should not be
rebuttable. If they are, then the system loses its simplicity appeal (Tanzi and Jantscher,
1987; Centro de Estudos Fiscais, 2007). On the other hand, if presumptions are applied, a
posteriori, in the face of accounting errors or fraud, computations made by tax auditors are
usually open to rebuttal. If taxpayers present solid evidence that an excessive tax burden is
produced by presumptions courts can disallow presumptive taxation4.

4
According to Thurony (1996:3) "Presumptive methods can be rebuttable or irrebuttable. Rebuttable
methods include administrative approaches to reconstructing the taxpayer's income, and may or may not be
specifically described in the statute. If the taxpayer disagrees with the result reached, the taxpayer can
appeal by proving that his or her actual income, calculated under the normal tax accounting rules, was less

5
 The coordination between different taxes is also an important issue. If a presumptive
income tax is not coordinated with the VAT, in terms of thresholds, bookkeeping
requirements, frequency of filings, its attractiveness may be diminished. And the design of
presumptive systems, especially when they are intended to very small taxpayers, should
not discourage the migration to the regular (accounting based) systems.
According to Avi-Yonah (1997) presumptive systems can simplify the auditing task of tax
administrations. This outcome diverges from the use of presumptions after regular auditing
tasks. When tax auditors find errors or fraud and use presumptions, a complex
administrative and litigation process is usually set in motion. This is the price of trying to
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increase the equity level, by bringing the taxpayer to pay its fair share of the burden.

2.2 Presumptions as a tool to collect revenue from hard to tax firms and individuals

At the conceptual level, as noted by Basto (2001) the taxation of income based on
presumptive, forfait or indirect methods is usually not favored. It is seen as a last resort
solution normally applied to “hard to tax” groups of individuals or firms, that have no
reliable accounting information, or when the technical ability of the tax administration is
low.
There is a perception that if taxable income is based on accounting values, the degree of
truthfulness of accounting information can sometimes be seriously affected in order to
minimize taxes. This is particularly visible in SME, and also when the tax administration is
seen as not particularly diligent and, consequently, the probability of tax audits is low
(Santos and Rodrigues, 2006).
Avi-Yonah (1999), discussing the tradeoff between taxation of real income (supposedly
based on accounting values), and taxation of presumptive income (which suffers from
some unfairness given the general nature of presumptions) states that it remains to be seen
whether the difficulties of enforcing the income tax will growth to such an extent that all
countries will be forced to use presumptive forms of taxation as a permanent replacement
for the income tax.

than that calculated under the presumptive method. By contrast, irrebuttable presumptive assessments should
be specified in the statute or in delegated legislation. Because they are legally binding, they must be defined
precisely."

6
 In many countries, the recognition of the administrative costs faced by small businesses,
and the lack of resources of tax administrations to fully control this large segment of
taxpayers, has led to the introduction of legislation establishing simplified tax regimes
(Thuronyi, 1996). These regimes can contribute to the overall fairness of the tax system, by
collecting revenue from taxpayers that are usually known for evasive practices. Moreover,
by imposing some (albeit rudimentary) form of record keeping to small businesses, they
can be an important element for the gradual inclusion of their activities in the formal sector
of the economy.
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Regardless of the choice of the method for the assessment of taxable income, presumptive
systems should meet the following criteria (Thurony, 1996; Santos and Rodrigues, 2006;
Centro de Estudos Fiscais, 2007).

i) They should be simple to comply with and administer. Thus, the eligibility criteria
and calculation of the tax liability should be clearly established and perceived as
straightforward.
ii) They should be coordinated with other taxes (especially the VAT), in order to avoid
the proliferation of thresholds.
iii) They should provide the taxpayer with the possibility of opting out and join the
normal regime, based on regular bookkeeping.
iv) The tax burden should be perceived as appropriate. It should not be to low that it
gives an unfair advantage regarding other taxpayers that cannot benefit from the
system.
v) Once in place, the system should be stable, and frequent changes should be
avoided.

2.3 Presumptions as a method to tax income when accounting numbers suffer from
severe deficiencies

According to Ribeiro (2010) even in OECD countries presumption based taxation is used
to fight tax evasion that is related to errors and fraud in accounting statements with tax

7
 minimization purposes.5 In Germany, the tax authorities can use presumption based
taxation when, among other reasons, taxable income is influenced by accounting
irregularities. However, the tax law establishes that presumptions are acceptable only when
alternative methods of computing taxable income are exhausted. The burden of proof is on
the tax authorities, to justify the use of presumptive taxation, and taxpayers can challenge
tax audits in courts.

In France, indirect methods of taxation can also be used, when taxpayers fail to fulfil legal
obligations, namely the timely presentation of tax returns, or the accounting and tax data
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are seen as unreliable by tax authorities.

In the United States, according to Hanlon et al. (2012) the Internal Revenue Code gives the
IRS the power to make assessments and determine deficiencies in tax returns. Permissible
ways, like the use of indirect methods, for correcting supposed tax evasive purposes have
been analyzed and elaborated in judicial decisions. Thus, American taxpayers and tax
auditors have a body of jurisprudence that clarifies legal concepts related to the use of
presumptions.
Thurony (1996) stated that, in India, tax law requires best judgment assessments when the
taxpayer has failed to file a return, and authorizes such assessments when the taxpayer's
accounts are incorrect or when no reliable method of accounting has been used by
taxpayers to assess their tax base.
A common trend emerges from this literature review: indirect methods are permissible as
kind of last resort mechanism, especially when accounting numbers are seen as unreliable
and no specific technical adjustments can solve the issue. However, judicial control of the
criteria used by the tax authorities when applying presumptions is also a general feature of
presumption based taxation.

3. Methodology

The research design of this paper rests on two analytical steps based on the legal research
method. The first step enquires, at the accounting level, how to define and quantify errors

5
In sections 3 and 4 of this paper the concepts of accounting “error” and “fraud” will be dissected. For now,
and as examples of tax induced accounting fraud, omission of sales, overstatement of costs and
undocumented records that reduce income, can be highlighted.

8
 that render accounting statements inappropriate to assess firms´ performance and compute
taxable income.
The second step explores the practical application of presumptive tax concepts by
Portuguese courts, in order to offer some criteria that can function as guidelines to firms
and tax auditors.
As stated by Bell (2011) the distinctive feature of the legal research is its focus on
normativity. Legal frameworks are constructed in an institutional setting and use of a
range of concepts.
As van Hoecke (2011) argues, this method can be applied in many research designs. It can
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focus on the explanatory side of law (e.g., by exploring historical backgrounds in

comparative research). It can be based on an hermeneutical approach, stressing the
interpretative and argumentative issues surrounding normative changes. Additionally, the
explorative path (looking for new avenues in legal research) and empirical side (identifying
and justifying the ‘best solution’ in comparative law) are also valid methodological tools
within the legal research framework. Finally, the evaluative approach (discussing whether
rules are in accordance with desirable moral, political and economic aims) is also a fruitful
area of analysis.
In our study, and within the legal research methodology, the hermeneutical and the
evaluative angles are followed. The hermeneutical one (section 5.1) tries to interpret the
legal rules pertinent to presumption based taxation.
The evaluative approach (section 5.2) discusses ho courts apply those concepts in practice,
and how they define the frontier between local of specific errors and generalized
accounting manipulation that justifies presumptions.
As a cautionary note, it must be said that here are no general valid principles derived from
legal research. Many problems are, by nature, related to national legal systems and,
therefore, proposed solutions are not valid outside a specific territory. However, we believe
that the accounting and tax issues identified and discussed in the paper are relevant outside
Portugal, given that many countries allow presumption based taxation when extensive
accounting manipulation is proven by tax authorities.

9
 4. Irregularities, fraud and accounting errors

4.1 Conceptual issues

The problem of accounting errors, its impact on financial statements and the criteria for
distinguishing between error and fraud, is an old one. Analysing the origin of accounting
errors, in a broad and economic sense, Christensen (2010) argues that error is intrinsic to
accounting systems, as it is to all information systems that seek to represent synthetically
and objectively a corporate environment that is complex and subjective. According to the
author, accounting serves several interested parties, with diverse and contradictory views.
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The Financial Accounting Standards Board (FASB) mentions existing and potential
investors, lenders and other creditors, employees, customers, the government, as
beneficiaries of accounting information (FASB, 2010).

Weygandt et al. (2012) sustain there are two broad groups of users of financial
information: internal and external users. Internal users are managers who organize
and run the business. External users are individuals and organizations who need
financial information about the company. The two most common types of external users
are investors and creditors. Conflict between users is common. Thus, errors arise from this
conflict. Considering that accounting information stakeholders´ are diverse and have
different interests (Azim and Ara, 2015) also place a high importance on this conflict.

Even if we adhere to these views, it is necessary to adopt a more practical level of analysis
in order to understand the distinction between the accounting concepts of error and fraud.
In the Portuguese case, Lourenço and Sarmento (2008: 34) state that “error” will emerge
from a random, unintentional or deliberate act caused by negligence or ignorance. “Fraud”
is understood as an intentional or deliberate act, in order to obtain illicit or illegal benefits.

The distinguishing feature between error and fraud would be the intentional nature of
fraud. Error would result from a fortuitous action, not intentionally malicious and without
any explicit purpose to distort the true financial performance of firms. An irregularity can
be seen as an intentional act that does not have the purpose of generating an illegal
advantage. The authors highlight the difficulty in distinguishing such concepts.

10
 The issue is also stressed by Mulford and Comiskey (2002), when distinguishing
between error and fraud. When making “errors” firms do not deliberately cross the
boundaries of the Generally Accepted Accounting Principles (GAAP), whereas in fraud
these limits are surpassed with the intent to mislead users of financial information (e.g.,
investors, suppliers and employees). However, this apparent certainty in the definition of
the criterion that separates error from fraud is nuanced by the authors, emphasizing that
determining the line at which aggressive accounting turns fraudulent is more art than
science.
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Concerning the distinction between error and fraud in the Brazilian case, Santos et al.
(2006) state that the Brazilian Accounting Standards define fraud as an intentional act of
omission or manipulation of data, tampering of documents and records to produce
misleading financial statements. On the other side, error would result from an unintentional
act of omission, neglect or misinterpretation of facts in the preparation of financial
statements. Once again, the intentional purpose to falsify financial information, with the
aim of gaining an advantage for some economic agents, is placed at the centre of this
distinction. Moreira (2008) and Amat and Blake (2002) argue that in real life situations the
distinction between fraud, errors and irregularities is not so clear cut.

In the Portuguese context, NCRF6 No.4 – “Accounting policies, changes in accounting

estimates and errors”, §5, states that:

“Prior period errors: are omissions and misstatements in financial statements of the entity
of one or more prior periods, arising from the non-use, or misuse of, reliable information
that:

(a) was available when financial statements for those periods were authorized for
issuance, and
b) could reasonably be expected to have been obtained and taken into account in the
preparation and presentation of these financial statements.
Such errors include the effects of mathematical errors, mistakes in applying accounting
policies, oversights or misinterpretations of facts and fraud.”

6
NCRF-“Norma Contabilísitica e de Relato Financeiro”, the Portuguese designation of “Accounting and
Financial Standard”.

11
 Is it worth highlighting a significant feature of this definition of accounting errors: as
defined, they include also fraud. It might be thought that the distinction between error and
fraud, explicitly shown before, was merged in this Standard. The two concepts are used in
an unusual similar way.

Nevertheless, it should be noted that this Standard establishes criteria to correct or restate
financial information. Thus, the essential feature of the Standard is the definition of the
type of errors that, when committed in prior periods, require corrections to financial
statements in future periods. Therefore, within the meaning of (unintentional)
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misapplication of accounting rules when they are materially relevant, errors have a similar
consequence to fraud: the restatement of financial statements, in order to restore their
reliability.

As we will see, for tax purposes - particularly for decisions about whether to apply
“presumptions” or “indirect methods of taxation” - accounting errors and irregularities are
viewed through a quite different perspective. If accounting errors and fraud are a regularly
exposed phenomena, why do they happen?

4.2 Accounting errors, fraud and their interested parties

Wang (2008) states that complexity and unpredictability of economic conditions make it
difficult to avoid error and fraud. The “game” of manipulation of financial information
has many names and forms. Mulford and Comiskey (2002) mention, for example,
aggressive accounting, creative accounting, earnings management, income smoothing and
fraudulent report. Naser (1993) defines creative accounting as the transformation of
financial figures from what they actually are to what preparers want them to be, by taking
advantage of existing rules or by ignoring them. Shah (1998) stresses the active
exploitation of gaps or ambiguities in accounting rules in order to portray a preferred
management picture of financial performance.

Jones (2011) made a literature review about earnings management. Some reviewed studies
focused on incentives for managers to meet their own annual forecasts and also of stock
market analysts. Other researchers examined accounting income changes associated with
not breaching loan covenants.

12
 What are the reasons behind the practice of such management acts? The answer lies in the
rewards linked to manipulation. Below, we will present the results of earnings management
in three groups: tax motivations, effect on share prices and contracting motivations, with a
special emphasis on the tax side.

4.2.A- Tax motivations

Shackelford and Shevlin (2001) extensively document the relation between earnings
management and the tax position of firms. By deferring revenue recognition when it should
be booked, or using accruals to manipulate net income, firms have a extensive set of tools
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to report unreliable accounting information. As accounting numbers (mainly reported

income) are the starting point for taxable base computation, tax authorities must be quite
alert to these practices. Hanlon et al. (2012) show that the tax authorities reaction to
accounting irregularities can act as a deterrent to these management activities.

Lopez et al. (1998) find evidence that firms’ tax aggressive positions are positively related
to the probability of recording negative current accruals, and the magnitude of income
shifting is dependent on the tax-rate changes faced by corporations. Maydew (1997) finds
that firms with net operating loss carrybacks defer operating income and recognize more
nonrecurring losses, to enjoy an increase in tax refunds.

For the Chinese case, Lin et al. (2012) show that, in reaction to the announcement of a tax
rate reduction, Chinese listed companies with high marginal tax rates deferred revenue
recognition, using negative accruals, as a tax saving device.

In the EU, at a general level, Remeur (2015) argues that an example of interplay between
accounting rules and tax avoidance consists of shifting profit between subsidiary
companies. Some national tax systems allow companies that do not have tax residence in
a certain country to set up operations in that state with the sole objective of transferring
profits to tax havens.

13
 In Portugal, tax motivated accounting choices are also well documented in the literature.
Sanches (2006) states that many cases of tax avoidance (e.g., transfer pricing, inverse
mergers) have strong links to the accounting treatment of operations and its tax impact.7

4.2.B- Effect on share prices

Financial information is used by investors and other financial experts to value stocks
(Brealey et al. 2014). The manipulation of financial information can influence short-term
stock prices. DeAngelo (1988) states the importance of earnings management for
valuations in management buyouts or equity offers and hypothesizes that managers of
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target firms have an incentive to "understate" earnings. Sometimes financial results can
also be managed in order to comply with financial analysts´ expectations. Several studies
provide evidence consistent with the intuition that firms manage earnings upward to avoid
reporting losses, earnings declines, or negative earnings surprises (Knauer and Wohrmann,
2016; Ayers, Jiang, and Yeung, 2006; Degeorge et al., 1999). Several studies show that
firms tend to inflate their earnings prior to seasoned equity offerings (Rangan, 1998; Teoh
et al., 1998) or initial public offerings (Teoh et al., 1998).

Fraudulent information may, if such informational vices are only known to a selected
group of insiders, lead to higher prices of securities. It may also cause lower volatility in
prices and, therefore, reduce the cost of capital (Brealey et al., 2014; Damodaran, 2011). In
a context of incentives through the allocation of stock options to high level managers,
fraudulent information may increase the value of these financial options and significantly
increase managers´ wealth. If the compensation of corporate officers is dependent not on
share appreciation but on reported accounting income, it is also clear the incentive to
manipulate recorded revenues and expenses.

4.2.C – Contracting motivations

Earnings management can be used to influence the execution of contracts between a firm
and its stakeholders. Empirical studies provide evidence consistent with the idea that

7
For example, if a merger is deemed neutral and taxation deferred, or non-neutral and taxation is
immediate. Or, in transfer pricing, if the arm´s length analysis f done by comparing prices or margins and
what accounting elements are considered in calculating a margin.

14
 managers manipulate earnings to increase their earnings-based compensation (Guidry,
Leone and Rock, 1999), or to avoid debt covenant violations (Dichev and Skinner, 2002).

Obtaining a higher credit rating is another frequent reason to induce earnings manipulation.
The lower cost of debt improves financial outcomes and conveys an image of financial
strength (De Fond and Jiambalvo, 1991; Damodaran, 2011, Brealey et al. 2014).

Moreover, it is usual to include protective covenants, or safeguards, in loan contracts.

These clauses impose to the debtor the achievement of targets, periodically measurable,
for certain indicators such as EBITDA/sales, debt ratios, or liquidity levels. The pressure
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for reaching such contracted financial targets can induce manipulation of accounting data.

In this wide range of ways to manipulate information, it is not easy to draw the line that
separates an allowed flexibility, according to the principles established in GAAP-IFRS,
from fraud.

5. The materiality/extension of errors and the need for the restatement of

accounting/tax statements: an hermeneutical/interpretative approach

5.1 The accounting perspective

The role of financial information in decision-making is well known. If information

contains errors, the correction of financial statements should be made. However,
accounting standards make the restatement of financial statements depend on a criterion of
materiality of error. It is, therefore, worth analysing this question, even if it is peripheral to
the topic discussed here. In Portugal, NCRF No.4, §5 - “Definitions” -, contains what it
should be meant by “material”. It stresses that omissions or misstatements are material if
they could, individually or collectively, influence users´ economic decisions based on
financial statements. Materiality depends on the size and nature of the omission or
misrepresentation in a given context. The size and nature of the item, or a combination of
both, could be the determining factor. The same NCRF, §37, states that: (...)an entity shall
correct prior period material errors retrospectively regarding the first set of financial
statements approved after its discovery “.

15
 What to conclude from this set of accounting principles? In our view, firstly and foremost,
the concept of materiality, although having a definition that seems clear – information will
be materially relevant if its disclosure could influence the decisions of economic agents– it
is often of complex application. Appealing to criteria of size and nature opens a wide field
of subjectivity in applying the principle. For example, omitting the registration of an
expense representing 2% of the total expenses is material or not? The error arising from the
registration of some fixed asset in an inappropriate account (e.g., “basic equipment”
instead of “administrative equipment”) is of a material nature?
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Most organizations adopt, in what concerns the scale, a criteria of relative importance. For
the error to be material it is common to establish, for example, a quantitative dimension,
like exceeding x% of sales, or y% of EBITDA, or z% of total assets.

In the U.S., many managers and auditors stressed the need for the SEC to define more
precisely and objectively what is meant by “material”. Acito et al (2009) point out that the
guidelines issued by various regulatory accounting and auditing bodies (including the
SEC) provide general criteria for assessing materiality. However, they do not specify
objective, or quantitative, criteria to determine whether a particular accounting error is
material. Instead, accountants, managers and auditors must assess materiality based on
professional judgment and in the light of specific circumstances. Several stakeholders have
pressed SEC to issue a more concrete definition of materiality, criticizing the current
guidelines as being too vague.

Materiality assessments, in order to determine the magnitude of an accounting error, are

made by comparing the size of the error with the revenue, gross income, net income, total
assets or equity. Although there are certain quantitative limits, such as, for example, 5% of
net income, widely used in practice, it has often been stressed the importance of qualitative
aspects and quantitative considerations as important elements in determining the limit of
the materiality of errors.

Exploring now the relation between accounting and taxation, the judgement process
arising from Article 88 of the GTL also contains a certain ambiguity and uncertainty. What
is the limit for accounting data (because of errors and inaccuracies) failing to represent a
reliable basis for the calculation of taxable income and the use of presumptions? That is, if

16
 the accounting application of the materiality criterion exhibits a highly subjective
component, the same happens with the definition of the frontier where the extent of the
accounting errors precludes its use in the calculation of taxable income. The determination
of such a dividing line also involves an appreciable degree of complexity and subjectivism.

The GTL defines some principles and attempts to exemplify a set of circumstances
justifying presumptions, but tax auditors will always have to judge whether errors and
inaccuracies lead to a “substantial” or “material” deterioration of taxable income
assessment that prevents the use of accounting numbers as an essential basis for assessing
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taxable income (Basto, 2001).

Sometimes, this judgment process paves the way for litigation. As seen in the literature
review, when countries allow presumption based taxation, it is usually controlled by the
judicial power. In Portugal, from the application of Article 88 of the GTL, companies will
generally try to prove that accounting, even with errors and inaccuracies, can be the basis
for assessing taxable income. In this context, what are the frontiers from the tax
perspective?

5.2 The tax perspective

Article 87 of the GTL, § 1, states that the assessment of taxable income by indirect
methods may happen, among other reasons, because of “the impossibility of direct and
accurate quantification” of the necessary accounting data.

On the other side, Article 88 of the GTL establishes that:

Impossibility of direct and accurate quantification of taxable income (...) may result from
the following anomalies and inaccuracies when impeding the correct computation of
taxable income:
a) Lack of or inadequate accounting elements or statements, failure or delay in the
exhibition of statutory books and records, or irregularities in its organization, even when
the absence of these elements is due to accidental reasons;
b) Refusal to exhibit accounting statements and other documents required by law, as well
as its concealment, destruction or falsification;
c) Existence of different accounting books, with the purpose of simulating a certain
income, accounting errors and inaccuracies in the recognition of operations that are not
corrected within the financial period.

17
 d) Existence of manifest discrepancy between the book value and the market value of
goods or services, as well as of specifically identified facts that may justify a greater ability
to pay than the one declared to tax authorities.
In search of an operationalization of the concept of “impossibility of direct and accurate
quantification”, the GTL stresses the importance of several accounting anomalies. If
accounting income, as a rule, is the basis for the calculation of taxable income, then
reasons for applying presumptions depend on accounting irregularities and errors.

However, the question remains. What kind of irregularities, errors or vices must affect
accounting statements that prevent their use as a basis for taxable income assessment?
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Where to establish the dividing line between technical tax adjustments (from minor
accounting errors) and the total disregard of financial data because of a general
contamination of taxable income from accounting errors or fraud?

Suppose two extremes. In one case, the accounting statements of a certain entity exhibit, in
the context of a tax audit and concerning machinery depreciation, the declining balance
method when only straight-line depreciation was admitted. It would certainly be absurd to
argue that such a local and precise error would prevent accounting to be the basis of
taxable income computation. Once this error is corrected all other elements remain valid,
and the adjustment of net income is “local” or “specific”. Such an error does not
contaminate or vitiate, at a general level, accounting data upon which taxable profit is
based.

At the other extreme, assume there is clear evidence of unrecorded sales, relevant bank
dealings and cash movements unrecorded and also unexplained, persistently negative
margins within a line of business that is highly profitable, and that the cross-check between
purchases, inventories and suppliers reveals very large discrepancies. It would be difficult
to deny that accounting is not extremely vitiated or contaminated, and sustain that it can
continue to serve as the basis for assessing taxable income (Lopes and Martins, 2014).

The problem is that the neat dividing line between the two auditing situations is not often
found in real life. In many circumstances, there are doubts about whether a certain
accounting error (or a set of errors and vices) is sufficient to call the whole accounting
records into question as a basis to determine taxable income (Sanches, 2006).

18
 In general terms, what criterion should be followed? In our view, this criterion must take
into account the degree of contamination of uncovered errors or irregularities to the total
accounting records. That is, to analyse if the nature of such errors contaminates or vitiates
the reliability of accounting elements in such a way as to put into question the general
credibility of reported income. Additionally, to assess if the extent or depth of errors
prevents that, even by correcting them, the possibility of reconstructing the actual earned
income.

In situations where the (localized or specific) correction of such errors is sufficient to

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restore accounting credibility, the use of presumptions is not justified. But if, even with
corrections, justified reasons still persist to deny accounting a solid basis to compute
taxable income, then presumptions should be called as a tax tool.

It should be emphasised that, in tax terms, we are far from errors and their treatment in an
accounting perspective. In the later, it must be firstly determined whether errors are
material, then checking if the retrospective restatement of financial statements is
practicable and, if so, to determine the period under which such restatement should be
performed. Errors, being material, are assumed as correctable, and accounting income is
considered to be adjustable for the restatement of financial data.

In tax auditing, a particular type of user is at issue: the State, with its power to impose
taxes whose revenue is intended to meet the needs of the community. It is therefore
understandable that the consequences of errors, in a tax audit, have a different treatment in
relation to the financial information available for investors, customers, suppliers, unions
and other agents than tax administration.

However, in our view, there is still an approximate common perspective. The consequence
of errors in financial reporting is to be determined by a materiality assessment. This
process is affected by a considerable margin for subjectivity. Similarly, in the context of
errors or vices established in Article 88 of the GTL, one cannot escape to the following
question: when do errors contaminate accounting information in such a way that
accounting records cannot be used for determining taxable income? As such, both
processes (accounting and tax) exhibit a significant influence of personal judgments.

19
 Basto (2001) and Sanches (2006) argue that the determination of income by presumptions
can only be used when it is totally inappropriate to base it on the accounting records
provided by the taxpayer. They add that checking for anomalies is not a sufficient
condition to apply indirect methods. It is particularly necessary that, as stated in the GTL,
errors, anomalies and inaccuracies make it impossible to determine taxable income.

Given these general interpretative lines of reasoning, how have Portuguese courts been
ruling on the use of presumptions by the tax authorities? Where do they draw the legally
admissible dividing line? An evaluative approach of jurisprudence is presented in the next
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section.

6. Jurisprudence on accounting manipulation and the frontier for using

presumptions: an evaluative approach

After exposing a conceptual and interpretative view of the frontier that, once crossed,
justifies the use of presumptions, we will now consider how courts evaluate real life cases,
and in this process, operationalize and give a practical meaning to the abstract concepts
established in article 88 of GTL.

In Case 0256778 the Supreme Administrative Court (SAC)9 ruled that if a taxpayer´s
accounting is plagued by errors and inaccuracies, it does not automatically prevent the
determination of taxable income from the accounting base if, after correcting these errors
and inaccuracies, the actual or real income can still be obtained. Presumptions were, in
this case, disallowed by the court.

In our view, this SAC position seems quite appropriate, and in line with Article 88 of the
GTL, which states that only the impossibility to accurate quantification the taxable income
may justify presumption based taxation. That is, the set of anomalies must be so broad as
to invalidate the computation of taxable income.

8
Ruling issued in 21- 03- 2001
9
In Portugal, the SAC is the highest ranking court to rule on tax disputes.

20
 In line with the discussion shown in the previous section, this means that the degree of
contamination, or loss of accuracy, of accounting data and their disqualification as a basis
to calculate the tax base must be clearly proved by tax auditors. Only then can accounting
data be disregarded and presumptions used to calculate the company supposedly earned.

As noted by Basto (2001) the use of indirect methods is still a means for reaching the
(supposed) real income a company earned. It is obviously not an accounting based amount,
but an surplus that would, nonetheless, have been earned in the context of the regular
conditions of the business activity.
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This SAC position is greatly relevant to tax auditors. Indeed, since errors and inaccuracies
are detected, the function of tax audits is to prove that they are generalized, strongly
vitiating the accounting records, and that book based income is no longer a credible basis
for determining taxable income.

A clear preference for the application of indirect methods as a last option is observed by
courts. Only after demonstrating the impossibility to determine the actual income, by
correcting accounting errors, is it assumed that earned income can be determined by the
use of indirect methods. We are thus confronted with the distinction between several
corrections. Since this is a critical question, how has the SAC dealt with this distinction?

In Case 037/0710 the SAC held that:

“In an arithmetic correction, the tax base is identified by the taxpayer in the face of the tax
return file, so that the tax administration does not need to go through any method of
evaluation - direct or indirect - to determine the due tax. The tax authority only corrects
miscalculations, aiming to ensure the accuracy of self-assessed tax. It is therefore the
result of a normal control function that tax administration performs ( ... )
This is distinct from technical corrections that tax administration applies to taxable income
under direct evaluation, e.g. when it aims to determine the real value of taxable income
without resort to evidence or presumptions, still using taxpayer´s accounting data.
These corrections are quantitative, although also qualitative: quantitative because they
change the tax base, qualitative because these corrections are a consequence of a different
legal impact given to the elements that the taxpayer presented.
Finally, corrections may have another nature (...) that happens when tax administration
applies indirect methods, changing the tax base through the use of presumptions or other
information it holds.”
10
Ruling issued in 24.06.2007

21
 As stated, this ruling points to the variety of acceptable corrections, given the control of tax
auditors over the tax base declared by taxpayers. On one side, there are the designated
miscalculations or “mere errors of quantification”. They may result, for example, from
incorrect calculation of depreciations through an arithmetic lapse in their quantification, or
from a wrong estimation of the discounted value in the recognition of a provision. These
errors are clearly not the result of misinterpretation of the tax law, or errors and
inaccuracies that vitiate the general role of accounting data.

In “technical corrections” what is at stake here are adjustments having a localized or

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specific nature, and that emerge from an inadequate legal qualification. It is the case, for
example, of an expense that the taxpayer deducted by considering to it be proven and
indispensable, but the tax auditor does not grant similar characteristics and denies its
deductibility. Or a certain amount of income that the taxpayer exempted, but that the tax
auditor concludes should have been taxed. These are corrections that change the tax base.
But, in the end, they still allow the computation of real income in accordance with
accounting rules. Accounting is not plagued by irremediable errors, far from it. They can
be corrected and, as a result, the actual income is determined.

Finally, the SAC highlights the case when a tax auditing, finding a large set of errors,
disregards the whole accounting income and uses presumptions. In this case, the boundary
of specific or technical corrections is clearly overtaken. Irregularities, improprieties and
accounting errors assume such a deepness and extension that it is no longer possible to use
accounting records as a basis for calculating taxable income.

It should be noted that accounting records are not completely set aside, even when
applying presumptions. If, hypothetically, it is proved that there was an extensive omission
of sales, and when such omission cannot be mended by technical corrections, the use of
presumptions is often based the application of a margin on (recorded) consumed goods. In
other words, an accounting element (cost of goods sold) is still used.

However, in such circumstances, income is computed via a presumption procedure,

according to which the recorded consumption of goods should have produced an estimated
amount of sales. It is deemed that the conditions for the exercise of the business activity
would determine a certain attainable income, and that accounting, by omitting sales and

22
 contaminating the overall credibility of financial statements, is not suitable to calculate
taxable income.

A situation when accounting errors can be no longer fixed by simple technical corrections
is illustrated in the next ruling. It also shows the importance of evidence submitted by
companies in the judicial procedure. In Case 01097/1211 the use of indirect methods by the
tax administration was under discussion, following an audit to a company whose corporate
purpose was the production and sale of newspapers. The audit detected errors in the
following areas: excessive and no justified amount of paper consumption, and omission of
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newspapers’ sales.

The Court found that the audit clearly exhibited irregularities and errors, thereby
producing a strong indication that accounting did not accurately reflect the financial
position and the real earned income. The auditors provided a well-documented proof and
stated the legal appropriate reasons for using indirect methods. Consequently, for the
Court, the company needed to demonstrate facts that would disprove errors and
irregularities pointed out by tax auditors. However, in the Court's perspective, the
defendant did not make use of such evidence, and the case was decided for the plaintiff.

The extent of irregularities and errors proven by the tax audit convinced the court that
accounting was vitiated in such a way that it could no longer serve as a basis for the tax
base computation. The defendant failed to oppose a convincing argument to the facts
described in the audit report.

The court, given the specificity and length of accounting errors presented by tax
authorities, required a defendant´s rebuttal based on an equally detailed assessment, which
could undermine the economic and material base used by tax auditors to apply
presumptions. Arguing, in a vague sense, for an incorrect reasoning from the tax auditors,
without specifying precisely why, or to sustain that errors were deemed correctable but
without specifying how, will be certainly a path that hardly merited the approval of the
court.

11
Ruling issued in 05.08.2013

23
 In our view, this is a correct way of applying the frontier that, once crossed, justifies he use
of presumptions. Not only the tax audit uncovered extensive evidence of fraud, but the
taxpayer, when requested to supply evidence to disprove allegations, was not able to do it.

Finally, we present a case that provides a set of reasons that induce the application of
indirect methods. They come from accounting areas that are quite often influenced by
errors: sales, inventories and cash flows.

In Case 01015/0212 the SAC summarizing errors found by auditors stated that:
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“The defendant is a private limited company and operates as wholesaler of fish. There are
usually 4 books simultaneously in use, without chronological, and often even numeric,
sequence.
There are no recorded cash inflows, the monthly sales value being obtained by the total
sum of the tapes of each of set of bills. Records related to stocks inventories on 31/12 of
years 1989, 1990 and 1991, do not allow to effectively control inventory inflows and
outflows.
There were errors in the accounting value of issued invoices; Maps nº 7 and 8 reveal
strong divergences between quantities of fish bought and sold, without appropriate
explanations from the firm.
There were omissions in accounting records related to sales, preventing the unambiguous
knowledge of elements necessary to calculate the VAT.”
In this case, the extent of the irregularities, its depth, and impact on core variables in the
calculation of the tax base are so blatant that the taxpayer did not even consider to oppose
the use of indirect methods. He went to court just to fight for a different quantification of
presumed income.

This case exhibits a situation where the range of errors, the key contaminated accounting
areas, and the implication of errors in the overall income assessment process, produced a
setting where it was unfeasible to use technical corrections to get the real income of the
taxpayer. This is a quite good example of the reasons that will lead to an unequivocal
application of indirect methods, given the magnitude and type of errors that plague
taxpayer´s accounting.

The SAC, albeit not producing a mechanic or deterministic approach to define the frontier
or the dividing line, has nonetheless been applying a consistent approach characterized by:

12
Ruling issued in 13-11-2002

24
 i) Presumptive taxation is a last resort mechanism;

ii)Tax audits must prove that a generalized contamination of accounting data is observed;

iii) It is not possible to correct accounting errors, given their extension and depth, and the
taxpayer did not submit contradictory solid evidence.

As a critical appreciation, these general principles that Portuguese tax courts have been
adopting in ruling on presumptions can, nonetheless, be difficult to apply to every single
case. In some situations, court rulings on presumptions missed a clear application of the
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dividing line discussed in this paper. Given the complexity of the topic, this is
understandable.

On the one hand, every case rests on the accounting errors or fraud documented in tax
auditors´ reports. The strength or weakness of the litigants´ position is very dependent of
the level of detail and documental proof that audits carry to the lawsuit. Taxpayers have a
strong incentive to go to court and argue that their accounting records, albeit vitiated, are
reliable enough to support a reconstruction the real income without resorting to
presumptions. Judges must navigate these very delicate arguments.

On the other hand, the problem of the quantification in applying presumptions is also a
tough one. If, for example, a bakery is audited, accounting is found vitiated with a high
level of omitted sales, what margin can be applied to operating costs to arrive at presumed
effective sales? If tax auditors use the median margin of the sector the taxpayer may argue
that economic and financial indicators places the business in the first quartile, not on the
median. Again, a fine and balanced reasoning must be done by judges, which are not often
exposed to statistical issues.

Elaborating on this critical note, the fact that accounting systems based on IFRS
increasingly depend on estimates and value judgements can be a further element of
complexity in applying presumptions. Suppose a company has an operating margin of
10%, within the sector acceptable range. A tax audit founds that a capital gain contributed
heavily to the margin. In an IFRS based accounting system this is possible, given the wide
notion of operating income. If the audit founds a "true" margin of 4% and uses this
deviation as a starting point for a presumptive recalculation of taxable profit, then lawyers,

25
 judges and accountants can be involved in endless arguments about the true profitability of
the firm.

Finally, court guidelines on presumptions previously stated in this paper do not eliminate
the fact that, in many cases, the dividing line between a technical correction and the use if
presumptions is quite thin. If, for example, expenses or revenues are found to suffer from
accounting irregularities, the auditor must ponder if available additional information can
produce a (supposed) real income without resorting to presumptions, or the contamination
is so deep the no other alternative is possible.
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Portuguese courts did an important job in producing guidelines on presumptions. But to

extrapolate them to every single case if still fraught with difficulties.

7. A brief perspective on tax presumptions and courts

In section 2.3 we highlighted that developed and developing countries have tax laws
allowing the use of presumptions when accounting records are deeply vitiated. However, it
is also true that literature related to presumptive taxes is undeniably much larger regarding
simplified systems designed to collect revenue from hard to tax firms and individuals, in
comparison to the discussion about the application of presumptions following tax audits
uncovering accounting fraud.

According to Logue and Vettori (2011) an example of presumptive taxation in the USA
occurs when tax administrators use proxies to compute income when the taxpayer has no
records to support the calculation of the tax base. If this happens, the IRS is allowed to
reconstruct the taxpayer’s income based on other sources of data, including information
from firms in comparable businesses. Yoon et al. (2011) argue that, in the USA, disputes
between taxpayers and the Internal Revenue Service are often resolved in court. They
mention, as primary causes, the ambiguity in tax law and taxpayers disagreement with
audit adjustments to taxable income. These adjustments can be either technical or
presumptive. They also state that the amount of taxes and penalties assessed by U.S.

26
 courts was, in the last two decades, about one third of the adjustments originally computed
by the IRS auditors.

Thuronyi (1996) argues that, in India, law requires "best judgment" assessments by tax
auditors when the taxpayer has failed to file a return or to produce information, and
authorizes presumptions when the taxpayer's accounts are incorrect or incomplete.
Nonetheless, taxpayers can litigate if they find presumed income to be outside a reasonable
range. The High Court of Delhi, in the case opposing the Director of Income-Tax and
Royal Jordanian Airlines, held that13 "in the scheme of presumptive taxation, the Assessee
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is presumed to have earned income at the rate of a certain percentage of his total turnover
or gross receipts. If the Assessee agrees to be taxed on presumed income, he is not
required to maintain books of account. If, however, he claims that his income is less than
the presumed figure, he is required to support his claim by producing books of account.”
This ruling highlights the thorny nature of litigation related to presumptive taxation. When
taxpayers find that audit corrections are excessive they must be able to prove their claim
with solid evidence in order to influence court rulings.

Yitzhaki (2007) argues that in the design of presumptive taxes - and, one supposes, in
auditing and court settings trying to estimate the effective earned income through
presumptions - easy-to-measure inputs and other observable characteristics of the activity
should be applied to estimate income. The higher these inputs correlate with income, the
lower the excess burden of the tax. However, in court settings, this well grounded principle
be difficult to apply. If an audit uncovers accounting fraud in a certain business, which
input is better correlated with sales? It can be either personnel costs, consumption of raw
materials or even the electricity bill.
Thus, the difficulties highlighted at the end of last section for the Portuguese scene, are
also observed in other countries, given the complex nature of the legal issues related to
presumptions. Even in jurisdictions where a large body of jurisprudence is available each
case presents its own challenges.

13
In November 24, 2015.

27
 8. Conclusion

The usual sources to compute a corporation’s taxable income are its accounting records.
Due to the flexibility of accounting standards and the diversity of stakeholders interested in
misrepresented financial information, errors and irregularities can be found in accounting
statements. However Portuguese GTL states that accounting errors and inaccuracies
are possible grounds for presumption based taxation. Based on accounting and tax
concepts, and then jurisprudence, we discussed the type and relevance accounting errors
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that constitute basis for the application of presumptions.

According to accounting standards, errors should be corrected if they are materially

relevant. But the materiality criterion is not so objective regarding the calculation of
taxable income. There are accounting errors and irregularities that support application of
presumptions to calculate corporate tax, but other do not. It all depends on the overall
degree of accounting manipulation.

The judgment about the boundaries of accounting errors that allow the use of presumption
based taxation calculation is often decided by litigation. Portuguese jurisprudence provides
strong evidence that presumptions should only be applied if, even by correcting of errors
and inaccuracies, corporate real income can´t be obtained. The level of contamination must
be obvious, and tax audits must present a strong and documented claim that presumptions
are a last resort mechanism to compute an appropriate tax base.

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