Differential Effects of Tax on Choice of Earnings Management Method

This study aims to examine whether tax incentives affect a manager’s choice of earnings management strategies; accrual-based earnings management and real-activities manipulation. According to a previous study (Zang 2012), managers selectively use accrual-based earnings management and real-activities manipulation, and decisions on the use of each earnings management method can be affected by various factors. When focusing on upward earnings management incentives, most eanings management using accruals do not affect the corporate tax burden, while real-activities manipulation directly affect the cash flow, which directly affects the corporate tax burden. Thus, the corporate tax burden increases when companies manage earnings upward using real-activities manipulation, compared to the upward earnings management using accruals. As the two types of earnings management incur different tax consequences, we expect the tax burden and a firm’s ability to pay tax will differently affect the earnings management choice. In terms of the current corporate tax burden level of a company, the additional corporate tax burden accompanying the upward earnings management will be a greater cost for companies with a high effective tax rate. Therefore, it will be preferred to accural-based earnings management with a relatively lower tax burden rather than the real-activities manipulation with a greater tax burden. In addition, considering the ability to pay tax of a company, companies with higher ability to pay tax will relatively prefer real-activities manipulation to accural-based earnings management because the additional corporate tax accompanying the upward earnings management will feel less costly to such companies. For analysis, the tax burden was measured as an effective tax rate(ETR), and the ability to pay tax was measured as excess cash holdings(ECH) according to Opler, Pinkowitz, Stulz, and Williamson, (1999). Using the large sample of 7,032 firm-year over the period of 2004-2019, we show empirical evidence that firms with higher ETR have a propensity to prefer accrual-based earnings management over real-activities earnings manipulation, while higher ECH firms prefer real earnings manipulation over accrual-based earnings management. This results indicate that firms with higher tax burdens tend to prefer accrual-based earnings management to real-activities earnings manipulation, while those with higher ability to pay tax tend to prefer real earnings manipulation to accrual earnings management. Further analysis examined whether companies suspected of manage earnings shows differential effect compare to other companies. As a result of the analysis, the main results of the hypothesis that earnings management method is selected according to the tax burden or ability to pay tax shows greater for companies suspected of manage earnings. These results indicate that managers consider their own tax status (i.e., tax burden and their ability to pay tax) when constructing an earnings management portfolio. Our study adds to the existing earnings management researches by showing that choice of earnings management is affected by tax burden as well as a firm’s ability to pay tax in a more general setting. In addition, our study suggests that investors and auditors should be more concerned about a firm’s tax incentives in order to better understand financial reporting.