Earnings Management Choices in Response to Tax Rate Increases

Posted: 22 Feb 2013

See all articles by Michael Firth

Michael Firth

Lingnan University - Department of Finance and Insurance

Agnes W. Y. Lo

Lingnan University

Raymond M. K. Wong

City University of Hong Kong (CityU) - Department of Accountancy

Date Written: February 2013

Abstract

This paper investigates the underexplored issue of whether and how firms manage their earnings when tax rates increase. We hypothesize and find that firms generally choose to manage their taxable income upward in a book-tax non-conforming manner rather than in a book-tax conforming manner before a tax rate increment, which in turn reduces the book-tax difference as well as the detection risk of earnings management. These results suggest that firms give more weight to tax incentives and tax audit or regulatory inspection risks than to boosting financial reporting income in tax management. However, when firms have higher earnings management incentives or lower tunneling incentives (i.e., non-state-owned enterprises), we find that they manage their taxable income and book income upward together (i.e., in a book-tax conforming manner), whereas their counterparts (i.e., state-owned enterprises) do not. Overall, our paper contributes to the literature by demonstrating the interplay of tax, tunneling and earnings management incentives in influencing tax management strategies.

Keywords: tax-induced earnings management, book-tax conformance, book-tax differences, financial reporting

JEL Classification: M4, H25

Suggested Citation

Firth, Michael and Lo, Agnes W. Y. and Wong, Raymond M. K., Earnings Management Choices in Response to Tax Rate Increases (February 2013). Available at SSRN: https://ssrn.com/abstract=2221209

Michael Firth

Lingnan University - Department of Finance and Insurance ( email )

Castle Peak Road
Tuen Mun, New Territories
Hong Kong
China
+852 2616 8160 (Phone)
+852 2466 4751 (Fax)

Agnes W. Y. Lo (Contact Author)

Lingnan University ( email )

Department of Accountancy
Tuen Mun
Hong Kong
Hong Kong

Raymond M. K. Wong

City University of Hong Kong (CityU) - Department of Accountancy ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong
China

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