Accrual-Based and Real Earnings Management Activities

There is a considerable literature on US companies’ earnings management through discretionary accruals and real
expenditures management. We extend this literature to the international setting and include the effects of corporate
tax on earnings management decisions, examining U.S., Canadian, Hong Kong, Japanese, Korean, and Taiwanese
firms. We find that U.S. based models of earnings management (of discretionary expenses) work reasonably well in
the international setting. We predict that firms’ tax status may have a countervailing effect on such management.
Consistent with this prediction, we find that U.S. and Canadian firms operating in higher tax rate years are more
likely to use real earnings management to accelerate discretionary expenditures. Since these discretionary
deductions have income-reducing expenses for financial reporting purposes, the results suggest that income taxes
have a strong incentive effect. The results may also have policy implications. If countries raise statutory rates in a
year, firms may react by accelerating expenses into that year. Such tax effects are not significant for East Asian
firms, a finding for which we can explain only for Japanese and Hong Kong firms.