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Tax Implications of Earnings Management Activities: Evidence from Restatements

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.