Managing Discretionary Accruals and Book‐Tax Differences in Anticipation of Tax Rate Increases: Evidence from China

• Author: Raymond M. K. Wong,Agnes W. Y. Lo,Michael Firth
• DOI: http://doi.org/10.1111/jifm.12027
• Date: 01 June 2015
• Published date: 01 June 2015

Managing Discretionary Accruals and

Book-Tax Differences in Anticipation of

Tax Rate Increases: Evidence from China

Raymond M. K. Wong

Department of Accountancy, City University of Hong Kong, Tat Chee Avenue, Kowloon

Tong, Hong Kong

e-mail: ac.raymond@cityu.edu.hk

Agnes W. Y. Lo

Department of Accountancy, Lingnan University, Tuen Mun, Hong Kong

e-mail: wylo@ln.edu.hk

Michael Firth

Department of Finance and Insurance, Lingnan University, Tuen Mun, Hong Kong

e-mail: mafirth@ln.edu.hk

Abstract

This paper investigates how firms manage their earnings to trade off various incentives

when tax rates increase. We hypothesize and find that firms generally choose to man-

age their taxable income upward in a book-tax non-conforming manner rather than in

a book-tax conforming manner before a tax rate increment, which in turn reduces the

detection risk of aggressive financial reporting. These results suggest that firms give

more weight to tax incentives and tax audit or regulatory inspection risks than to

boosting financial reporting income in tax management. However, when firms have

higher book management incentives or lower tunneling incentives (i.e., non-state-owned

enterprises), we find that they manage their taxable income and book income upward

together (i.e., in a book-tax conforming manner), whereas their counterparts (i.e.,

state-owned enterprises) do not. Overall, our paper contributes to the literature by

demonstrating the interplay of tax, tunneling and financial reporting incentives in influ-

encing tax management strategies. The findings from our paper should also help gov-

ernment and regulators understand more about firms’ reactions to tax rate increases.

We are especially grateful to the editor (Sidney Gray) and the anonymous referee for their

insightful and constructive suggestions. We also thank Jeong-Bon Kim, Lillian Mills, and semi-

nar participants at the 22nd Asian-Pacific Conference on International Accounting Issues at

Gold Coast, Australia, and the 14th Annual International Conference of the American Society

of Business and Behavioral Sciences at Paris, France, for their helpful comments, discussions,

and suggestions on earlier drafts of the paper. This research has benefited from financial sup-

port from Lingnan University, Hong Kong (DB14A5). Michael Firth acknowledges financial

support from a GRF (GRF390113). Raymond Wong (corresponding author) acknowledges the

financial support of grants from the Research Grants Council of the Hong Kong Special

Administrative Region, China (Project No. CityU 152012 and 195513). All remaining errors

and omissions are our own.

Journal of International Financial Management & Accounting 26:2 2015

©2015 John Wiley & Sons Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

1. Introduction

This paper examines whether and how firms manage income in

response to tax rate increases. Prior research demonstrates that an

anticipated tax rate reduction provides incentives for firms to manage

taxab1e income and book income downward simultaneously (Guen-

ther, 1994; Lopez et al., 1998; Roubi and Richardson, 1998; Adhikari

et al., 2005; Lin, 2006). We note, however, that there is a scarcity of

studies that examine whether and how firms manage (book and/or tax-

able) earnings in anticipation to tax rate increases. Under International

Accounting Standards (IAS 12), effective tax planning includes creating

or increasing taxable profits in an appropriate period (e.g., in the per-

iod before expiry of a tax loss or a tax credit carryforward, or in the

period before a tax rate increase) such that the overall tax liabilities

(i.e., the net present value of tax payments)

1

could be reduced. In other

words, shifting taxable income from the future (high tax rate) period

to the current (low tax rate) period can also achieve tax savings, and

thus, firms should have an incentive to respond to a tax rate increase.

Despite the sparse prior evidence on upward tax management,

2

understanding how firms respond to a tax rate increase is important

for policymakers and the government because some jurisdictions may

consider increasing their tax rates for a short period to pay for their

fiscal budget deficits. Upward tax management, where taxable profits

and the taxes thereon are recognized in the current (low taxed) period,

goes against the original intent of the government. Investors and audi-

tors may also have greater concerns over upward tax management

than downward tax management because the upward tax management

may be coupled with income-increasing discretionary accruals that are

signals of opportunistic earnings management. Therefore, it is impor-

tant to examine whether tax incentives, particularly those driven by a

known future tax rate increase, motivate firms to engage in upward

tax management.

To reduce the overall tax burden before an announced future tax

rate increase, firms are likely to increase their current taxable income

from future periods. In particular, firms can inflate taxable income and

book income simultaneously (i.e., a book-tax conforming tax manage-

ment),

3

or they can manipulate their taxable income upward without

managing their book income (i.e., a book-tax difference tax manage-

ment, which we also call a book-tax non-conforming tax management

in this paper).

4

As discussed previously, prior studies generally find

Managing Discretionary Accruals and Book-Tax Differences 189

©2015 John Wiley & Sons Ltd

that firms use book-tax conforming earnings management to reduce

taxable income before tax rates decrease (Guenther, 1994; Lopez et al.,

1998; Maydew, 1997; Scholes et al., 1992; Adhikari et al., 2005; Lin

et al., 2012). By the same token, one would intuitively expect that

firms would use book-tax conforming earnings management to inflate

their taxable income before tax rates increase. By doing so, firms can

reduce their overall tax liabilities and, at the same time, reduce their

financial reporting costs because of the higher book income reported.

However, one drawback to using upward tax management via income-

increasing discretionary accruals (i.e., a book-tax conformance treat-

ment) before tax rates increase is that it increases the possibility of reg-

ulatory inspections of ostensibly over-aggressive financial reporting

practices. For example, Kim et al. (2003) find that auditors are more

likely to deter and monitor upward discretionary accruals than down-

ward discretionary accruals. Therefore, whether companies will acceler-

ate book income together with taxable income (i.e., book-tax

conforming tax management) or just inflate the taxable income before

a tax rate increase (i.e., book-tax difference tax management) awaits

further investigation.

5

We use Chinese listed companies for our study because China’s

institutional environment allows us to identify clearly firms that have

high tax incentives to manipulate taxable income upward (or down-

ward). The Chinese enterprise income tax rate is 33 per cent. However,

the central and local governments of China offer firms a basket of tax

incentives and tax holidays for a variety of reasons; for example, they

offer tax holidays to encourage firms to restructure, to increase invest-

ment, or to encourage growth in selected industries (Deloitte, 2005).

Therefore, different companies may be subject to different applicable

tax rates during the same time period, and the applicable tax rates will

increase or decrease in a particular year according to the tax preferen-

tial policies that the individual companies are entitled to.

6

As the com-

panies can anticipate the changes 1 year ahead, managers will be

motivated to reduce the overall tax liabilities of their company by

shifting taxable profits from a high tax rate period to a low tax rate

period. Our data set enables us to examine upward tax management

(i.e., before an impending tax rate increase) and to compare the results

with downward tax management (i.e., before an impending tax rate

decrease).

The first objective of our paper is to examine whether firms

would increase their taxable income in a book-tax conforming or

190 R. M. K. Wong, A. W. Y. Lo and M. Firth

©2015 John Wiley & Sons Ltd