Earnings Management Through Effective Tax Rates: The Effects of Tax Planning Investment and the Sarbanes-Oxley Act of 2002

32 Pages Posted: 27 Apr 2006 Last revised: 26 Feb 2008

See all articles by Kirsten A. Cook

Kirsten A. Cook

Texas Tech University - Area of Accounting

George Ryan Huston

Arizona State University (ASU) - School of Accountancy

Thomas C. Omer

University of Nebraska at Lincoln - School of Accountancy

Abstract

Dhaliwal, Gleason, and Mills (DGM 2004) document that firms manage earnings through decreases in effective tax rates (ETRs) between the third and fourth quarters. We investigate how firms' investments in tax planning impact this association between ETR changes and earnings management incentives. We also study two additional questions related to this association. First, we examine the impact of firms' choices to purchase tax services from providers other than their auditors on their use of third-to-fourth-quarter ETR changes. Second, we explore whether the Sarbanes-Oxley Act of 2002 (SOX) altered firms' propensity to engage in earnings management using changes in ETRs. For firms that would miss consensus earnings forecasts in the absence of ETR changes, higher tax service fees paid to auditors are associated with greater reductions in ETRs between the third and fourth quarters. Among firms that do not purchase tax services from their auditors, companies that would miss their earnings forecasts absent ETR changes also experience greater third-to-fourth-quarter reductions in ETRs than companies that would otherwise meet or beat these estimates. We find no statistically significant impact of the passage of SOX on the relation between tax fees paid to auditors and third-to-fourth-quarter decreases in ETRs for firms that would miss their earnings targets without managing tax expense. However, for firms not purchasing tax services from their auditors, a negative association exists between third-to-fourth-quarter ETR changes and missing income goals absent ETR changes in the pre-SOX period, but our tests fail to detect this relation in the post-SOX period.

Keywords: effective tax rate, earnings management, tax planning, Sarbanes-Oxley

JEL Classification: H25, M41, M43

Suggested Citation

Cook, Kirsten A. and Huston, George Ryan and Omer, Thomas C., Earnings Management Through Effective Tax Rates: The Effects of Tax Planning Investment and the Sarbanes-Oxley Act of 2002. Contemporary Accounting Research, Vol. 25, No. 2, 2008. Available at SSRN: https://ssrn.com/abstract=897749 or http://dx.doi.org/10.2139/ssrn.897749

Kirsten A. Cook

Texas Tech University - Area of Accounting ( email )

P.O. Box 42101
Lubbock, TX 79409
United States

George Ryan Huston

Arizona State University (ASU) - School of Accountancy ( email )

Tempe, AZ 85287
United States

Thomas C. Omer (Contact Author)

University of Nebraska at Lincoln - School of Accountancy ( email )

307 College of Business Administration
Lincoln, NE 68588-0488
United States

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