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Earnings Management through Income Tax Expense: What is Management's Favorite Tool?

Fri, April 5, 1:45 to 3:25pm, Hyatt Regency Savannah, TBA

Abstract

This study investigates the factors influencing the specific tool managers use to manage reported earnings through income tax expense. These tools include uncertain tax benefits (UTBs), the valuation allowance for deferred tax assets (VA), and the off-balance sheet liability associated with permanently reinvested earnings (PRE). First, we find evidence in the broad cross-section that firms use all three income tax accruals to manage reported earnings. Next, we posit that FIN 48 reduces information asymmetry related to UTBs for domestic firms, but not for multinational firms with UTBs related to foreign tax jurisdictions. Consistent with our predictions, we find that multinational firms prefer to manage reported earnings through UTBs and PRE while domestic firms prefer to manage reported earnings through the VA in the post-FIN48 environment. Additionally, prior literature finds that firms using auditor-provided tax services (APTS) record adequate reserves for tax contingencies, consistent with knowledge spillover. We extend this literature and find that firms with higher levels of APTS prefer to manage reported earnings through the VA and PRE, while firms with lower levels of APTS prefer to manage reported earnings through UTBs. Taken together, these findings indicate that firms respond to constraints on earnings management through certain tax accruals by using alternative tax accruals to manage reported earnings, creating a dynamic rebalancing of preferences for the tools management uses to achieve earnings management through tax expense.

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