Earnings Management and Tax Avoidance
While earnings management is primarily used to hit an earnings target, it can also be intended to obtain some other
form of gain. Firms can trade off tax savings and meet their earnings target for financial reporting purposes by
delaying discretionary expenditures. Alternatively, firms can reduce taxes by accelerating discretionary expenditures,
but this may have an unfavorable effect if it causes the firm to miss earnings targets. Such dual objectives appear
likely when firms determine the level of their book-tax conforming earnings management accounts such as R&D,
advertising, and SG&A expenditures.
Lin (2006) reports that firms manage earnings for tax purposes. Examining Chinese firms which were about to lose
their tax holiday benefits, i.e., experience a tax increase., Lin finds that in the year immediately before the tax rate
increase, firms report discretionary accruals, on average, 1% higher than those in the years after tax rate increase.
Badertscher et al. (2006) analyze the tax implications of pretax earnings management. They investigate the
firm-specific characteristics that impact the choice between book-tax conforming earnings management and
book-tax nonconforming earnings management strategies and find that ‘nonconforming earnings management’ is
more prevalent than ‘conforming earnings management’. Finally, Desai and Dharmapala (2006) examine the link
between earnings management and corporate tax avoidance by illustrating how tax shelter products to make
managers able to manipulate reported earnings.
4. Data and Econometric Specification
Assume that firms make earnings management decisions in the following order. First, they use discretionary
accruals, which (because they have no cash flow implications) are considered to be less costly than discretionary
expenditures. Next, they decide on discretionary expenditures. From an earnings management perspective, we
expect a negative relationship between discretionary accruals and discretionary expenditures.
Our financial data is derived from Compustat Global for all U.S., Canadian, Hong Kong, Korean, Japanese, and
Taiwanese firms from 1990-2007. We first estimate each firm’s DACC (discretionary accruals), using the Jones
model, modified by Kothari et al. (2005). Abnormal accruals are the residuals from modified Jones model
regressions including ROA as shown in the following equation