Washington ? An interesting irony is unfolding in the wake of the corporate earnings scandal. Everyone is bemoaning the overstatement of corporate earnings and lamenting the impact on shareholders. What is being missed is the impact on the U.S. and state treasuries.

Take WorldCom, a company that misstated earnings by $4 billion. As a result, it is now in bankruptcy and two of its former executives have been arrested. But what about the IRS and state treasuries in all this? A reduction of $4 billion in earnings means tax refunds of roughly $1.6 billion, a boon to the offending company, an unexpected drain on government treasuries.

But what is a billion dollars or so to the U.S. Treasury? It is a great deal, especially when multiplied by a factor 100 or 200 or much more, which is what could happen before all the corporations are through restating earnings. And the impact on state treasuries is even more severe, because states do not print money and do not have the borrowing ability of the federal government.

The problem becomes even more complicated if the IRS steps in and disagrees with the Securities and Exchange Commission (SEC) about what constitutes a legitimate and proper tax deduction. In the case of WorldCom, the SEC is claiming that the company improperly counted expenses as capital investments. A capital investment usually involves the purchase of an asset such as real estate, equipment, or products. A product purchase can involve development and patent costs which are more intangible than hard assets, but legitimate capitalized purchases nonetheless. Indeed, the IRS requires that they be capitalized rather than expensed.

Capital assets are then depreciated or amortized over what is determined by the IRS to be the useful life of the asset. In other words, funds spent on a capital purchase cannot be expensed in one year, but, instead, must be expensed over a period that typically runs three to 20 years.

In the worst of all worlds, WorldCom is forced to expense items that the SEC claims were not capital purchases, but which the IRS insists are. The result was that WorldCom’s reported earnings were lowered, causing lenders and investors to jump ship, throwing the company into bankruptcy. Meanwhile, the IRS will take the opposite approach, insisting that the money does properly belong on the capital side of the ledger. The result would be that the $4 billion cannot be expensed and no tax refund would be made.

In this case, the issue would end up in tax court, where the IRS and accompanying state revenue departments would likely lose as an outpouring of politicians, the public, accountants and the SEC make their views known.

The situation will become even more severe as private companies enter the fray. Take a typical private company that wants to show low earnings because it is more interested in its taxes than its stock price. And let us suppose that the IRS had forced it to capitalize certain expenditures that the company had wanted to expense. In the wake of an adverse WorldCom tax court decision, the private company if its capitalization expenditures are remotely similar to WorldCom’s would also have grounds for a tax refund.

Prediction: Federal and state treasuries are going to take the biggest hit from the corporate earnings scandal.