Earnings Management: New Evidence Based on Deferred Tax Expense

Abstract

We examine the usefulness of deferred tax expense as compared to various accrual measures employed in prior research in detecting earnings management in three settings where earnings management likely occurs. The motivation for using deferred tax expense to detect earnings management is that there is typically more discretion under generally accepted accounting principles than under tax rules, and we assume that managers exploit such discretion to manage income upwards primarily in ways that do not affect current taxable income. Thus, we expect that decisions to manage earnings upwards will generate book-tax differences that increase deferred tax expense.

Our results provide evidence of the incremental usefulness of deferred tax expense in detecting earnings management activities vis-a-vis total accruals and abnormal accruals derived from two versions of the Jones model. Deferred tax expense is generally incrementally useful beyond all three accruals-based measures with regard to detecting earnings management to avoid an earnings decline and with regard to detecting earnings management to avoid a loss. With regard to meeting analysts' earnings forecasts, only total accruals is incrementally useful in detecting earnings management. We also find that deferred tax expense is significantly more accurate than any of the accrual measures in classifying firm-years as successfully avoiding a loss, whereas no one measure is relatively more accurate than the others in classifying firm-years as successfully avoiding an earnings decline or meeting analysts' forecasts.

Keywords: earnings management, deferred tax expense, accruals

JEL Classification: M41, M43, M49, H29