Tax Implications of Earnings Management Activities: Evidence from Restatements

50 Pages Posted: 13 Mar 2006

See all articles by Brad A. Badertscher

Brad A. Badertscher

University of Notre Dame

John D. Phillips

University of Connecticut - Department of Accounting

Morton Pincus

University of California, Irvine

Sonja O. Rego

Indiana University - Kelley School of Business - Department of Accounting

Date Written: May 17, 2006

Abstract

This study examines the tax implications of pretax earnings management. Prior research has examined pretax earnings management activities that have current income tax consequences (book-tax 'conforming earnings management') and earnings management activities that do not have current income tax consequences (book-tax 'nonconforming earnings management'). Our study investigates the prevalence of, and firm-specific characteristics that impact the choice between, these earnings management strategies. This investigation leads to a better understanding of the book-tax trade-offs managers face when managing earnings upward.

We utilize a sample of firms that restated their earnings downward due to accounting irregularities and thus can be presumed to have managed their earnings upward. We find that nonconforming earnings management is more prevalent than conforming earnings management. Using the Heckman (1979) two-step estimation approach to control for sample selection bias, we predict and find that firms trade off the net present value of tax benefits against the net expected detection costs associated with nonconforming earnings management. In particular, the presence of NOL carryforwards, high free cash flow, a Big 4/5/6 auditor, or fraud mitigate the general reliance on nonconforming earnings management strategies.

Keywords: Earnings management, book-tax differences, earnings restatements, deferred tax expense, current tax expense

JEL Classification: M41, M43, M49, H26

Suggested Citation

Badertscher, Brad A. and Phillips, John D. and Pincus, Morton P.K. and Rego, Sonja O., Tax Implications of Earnings Management Activities: Evidence from Restatements (May 17, 2006). Available at SSRN: https://ssrn.com/abstract=888564 or http://dx.doi.org/10.2139/ssrn.888564

Brad A. Badertscher

University of Notre Dame ( email )

Mendoza College of Business
Notre Dame, IN 46556-5646
United States

John D. Phillips

University of Connecticut - Department of Accounting ( email )

School of Business
Storrs, CT 06269-2041
United States
860-486-2789 (Phone)
860-486-4838 (Fax)

Morton P.K. Pincus

University of California, Irvine ( email )

Irvine, CA 92697-3125
United States
949-824-4062 (Phone)
949-725-2812 (Fax)

Sonja O. Rego (Contact Author)

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States
812 855-6356 (Phone)

HOME PAGE: http://kelley.iu.edu/Accounting/faculty/page12887.cfm?ID=33017

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