Listed companies' income tax planning and earnings management: Based on China's capital market

Hu, Nanwei; Cao, Qiang; Zheng, Lulu Article Listed companies' income tax planning and earnings management: Based on China's capital market Journal of Industrial Engineering and Management (JIEM) Provided in Cooperation with: The School of Industrial, Aerospace and Audiovisual Engineering of Terrassa (ESEIAAT), Universitat Politècnica de Catalunya (UPC) Suggested Citation: Hu, Nanwei; Cao, Qiang; Zheng, Lulu (2015) : Listed companies' income tax planning and earnings management: Based on China's capital market, Journal of Industrial Engineering and Management (JIEM), ISSN 2013-0953, OmniaScience, Barcelona, Vol. 8, Iss. 2, pp. 417-434, https://doi.org/10.3926/jiem.1310 This Version is available at: https://hdl.handle.net/10419/188690 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc/3.0/ Journal of Industrial Engineering and Management JIEM, 2015 – 8(2): 417-434 – Online ISSN: 2013-0953 – Print ISSN: 2013-8423 http://dx.doi.org/10.3926/jiem.1310 Listed Companies’ Income Tax Planning and Earnings Management: Based on China’s Capital Market Nanwei Hu1, Qiang Cao2*, Lulu Zheng1 1China University of Mining & Technology (Beijing), (China) 2Central University of Finance and Economics (China) [email protected], *Corresponding author: [email protected], [email protected] Received: November 2014 Accepted: February 2015 Abstract: Purpose: The Ministry of Finance issued the new China accounting standards on February 15, 2006(CAS2006), which requires the listed companies to use the balance sheet liability method for the income tax accounting. Thus, it gives us an opportunity to investigate the earnings management of listed companies from the perspective of income tax. Under the balance sheet liability method, our researches just try to investigate the relationship between the listed companies’ income tax planning and earnings management. Design/methodology/approach: Our research approach combines theoretical analysis and empirical analysis. This paper first makes a deep theoretical analysis on the listed companies’ choice between pretax earnings management activities and earnings management activities, and then we exemplify our theory. Next, we come up with two hypotheses based on the theoretical analysis, build up a restatement model and conduct the empirical examination. The empirical analysis employs the method of descriptive statistics and logistic regression. Findings: When engaging in earnings management, listed companies will trade off conforming and nonconforming earnings management from the perspective of income tax cost. We find that managers’ motivations and purposes will influence the choice. When the company has motivations to turn losses into gains and has motivations to avoid penalty cost -417- Journal of Industrial Engineering and Management – http://dx.doi.org/10.3926/jiem.1310 associated with fraud being found, the company prefers to employ more conforming earnings management strategies. Research limitations/implications: The limitation in our research is as follows. First, we mainly focus on the conforming and nonconforming earnings management when the listed companies restate their financial statements. However after the issue of CAS2006, many listed companies still not disclose income tax account, which restrict our sample. Second, without the acquisition of private companies’ data, our empirical results may have some errors. We will solve these problems in our future study. Practical/social implications: First of all, our research provides new perspective and theoretical evidence for exploring the listed companies’ choice of conforming and nonconforming earnings management. Meanwhile, our results are helpful for regulators to strengthen the administration of listed companies’ restatement. Finally, our results will help us to deeply understand the impact of the accounting processes of income tax under the balance sheet liability method on the listed companies. Originality/value: So far, there are few studies discussing the choice of earnings management strategies and how different purposes and motivations affect the choice from the perspective of income tax. The issue of CAS2006 offers an opportunity for this research. This paper use restatement as sample to investigate the choice of conforming earnings management and nonconforming earnings management under different motivations and purposes for the first time. Keywords: earnings management, book-tax differences, deferred tax expense 1. Introduction With the stakeholders pay more attention to earnings information, earnings management prevail among the listed companies. But there is no doubt that it decreases the quality of listed companies’ financial information and whitewashed earnings information can’t fairly reflect firms’ financial status and operating results, which hurts the interests of information users. So it is especially important to study on earnings management, and the implement of the CAS2006 highlights the importance of our study at the same time. The Ministry of Finance issued the CAS2006 on February 15, 2006, which consists of the basic criteria, 38 specific criteria and application guide for criteria. CAS2006 require the listed companies to use balance sheet liability approach to conduct tax income accounting, and firstly -418- Journal of Industrial Engineering and Management – http://dx.doi.org/10.3926/jiem.1310 introduce the concept of assets, liabilities tax basis and confirm deferred tax assets, deferred liabilities on the basis of ‘Asset-Liability View’. There are some huge differences in the concepts and methods of tax accounting between the balance sheet liability approach and the taxes payable methods or tax effect accounting, thus the new standards provide new space for the options of earnings management strategies. National People's Congress passes the “PRC Enterprise Income Tax Law” on March 16, 2007 and the law is implemented from January 1, 2008. Tax will not only affects companies’ profits, but also be closely related to firms’ earnings management activities. Different earnings management strategies have different tax cost and the amount of income tax that needs to pay in current period will also vary. Besides, the amount of income tax that needs to pay is closely related to firms’ free cash flow. On one hand, the amount of income tax that needs to pay in current period is firms’ cash outflow which decrease the net amount of cash flow generated from the business activities and thus decrease the free cash flow. On the other hand, the level of free cash flow restricts the amount of income tax that needs to pay and thus influences firms’ choice of earnings management strategies, for example, when a firm has the high level of free cash flow, which means the cash that can be available to pay for income tax is sufficient, the firm won’t care the amount of income tax that need to pay in current period. So because income tax cost is associated with earnings management, firms need to choose conforming earnings management and/or nonconforming earnings management. It is clear that the promulgation of CAS2006 and the implementation of the tax law provide the background for our study. Presently, the researches of earnings management in academia mostly focus on the cost, motivations, means and results of earnings management. There are few studies discuss the choice of earnings management strategies and the different purposes and motivations that affect the choice from the perspective of income taxes. We try to explore the choice of different earnings management strategies and the motivations that affect the choice from the perspective of the income tax. We not only investigate the effect of earnings management on income tax, but also the effect of different earnings management motivations on the choice of earnings management strategies. In addition, our sample offers the potential for this study. Consistent with Erickson, Hanlon and Maydew (2004), income-increasing conforming earnings management results in a downward restatement of current tax expense as well as pretax income. Consistent with Phillips, Pincus and Rego (2003), income-increasing nonconforming earnings management results in a downward restatement of deferred tax expense and pretax income. Restatement companies that managed pretax earnings upward in ways that create permanent book-tax differences would restate pretax income downward, but not restate either current or deferred tax expense. By definition, companies that manage earnings in such a manner do not incur any current or deferred income tax costs related to the earnings management. We measure this type of pretax earnings management by our misstatement companies and find little evidence of such activity, consistent with companies having limited opportunities to engage in this type of -419- Journal of Industrial Engineering and Management – http://dx.doi.org/10.3926/jiem.1310 earnings management. Accordingly, we focus on nonconforming earnings management that creates temporary book-tax differences and thus greater deferred tax expense. Hence, restatements of income tax accounts reveal the type of pretax earnings management (i.e., book-tax conforming or nonconforming) that managers employ. Based on this, we choose misstatement firms as our sample, which enable us to investigate the choice of conforming and nonconforming earnings management through measuring the differences of tax account between originally reported and restated financial statements, and to measure the amount of pretax earnings management more accurately. Restating financial results can presumably still reflect unacknowledged earnings management, nonetheless, we assume that restated amounts reflect strictly less earnings management than the amounts companies originally reported. 2. Prior Research Our study builds upon several streams of researches, including studies that investigate earnings management accomplished via book-tax conforming and nonconforming strategies. Scholes, Wilson and Woflson (1990), Matsunaga, Shevlin and Shores (1992), and Dhaliwal, Frankel and Trezevant (1994) focus on book-tax conforming upward earnings management, which increases both financial and taxable incomes and thus has current tax consequences. That is, conforming earnings management includes any transaction that has the same impact on the current financial and taxable incomes. A common example of conforming earnings management is accelerating revenue recognition by recording receivables sooner than justifying and postponing inventory purchases under LIFO. In contrast, Mills and Newberry (2001), Joos, Pratt and Young (2003), Phillips, Pincus and Rego (2003) and Phillips, Pincus, Rego and Wan (2004) focus on nonconforming upward earnings management, which increases financial accounting income with no current tax consequences. This type of earnings management includes transactions that accelerate revenue recognition or defer expense recognition for financial reporting purposes relative to tax purposes, such as aggressively recognizing unearned revenue, extending the useful lives of depreciable assets, or reducing the provision for doubtful accounts for financial reporting purposes. Frank, Lynch and Rego (2009) find that previous studies conclude that firms will make a tradeoff between increase financial incomes and decrease taxable incomes. In fact, this understanding is based on the consistence between accounting and tax rules, that is, firms need to pay high tax cost for increasing financial incomes. But with the book-tax differences, which tends to expand, and managers’ discretion given by CAS2006, firms are able to increase financial incomes without increasing taxable incomes, that is, pay little or no tax cost for increasing financial incomes. -420- Journal of Industrial Engineering and Management – http://dx.doi.org/10.3926/jiem.1310 Ye (2006) investigates the trade-off between the cost of financial report and income tax based on A-shares manufacturing firms’ data. The empirical results show that the more earnings listed companies’ managers manage, the higher the book-tax differences are, which means the listed companies accomplish earnings management via nonconforming earnings management to avoid income tax cost, but results also show that the avoidance is limited. Liang (2010) concludes that no matter what the goal of earnings management is, listed companies prefer to earnings management strategies accompanying "zero tax cost". Long and Chen (2010) use book-tax difference to measure earnings management. Based on the listed companies’ data in stock markets of Shanghai and Shenzhen from 2000 to 2006, they find that the book-tax differences are significantly different in firms with different ownership structure and private listed companies with system whereby state-owned enterprises pay tax plus a percentage of profits will pay more attention to trade-off cost of financial report and income tax and thus tend to choose nonconforming strategies when engaging in earnings management activities. Hu (2010) confirms that in order to make the right decisions, firms have the motivation to avoid income tax cost through nonconforming earning management and the higher the degree of earnings management and the tax rate is, the higher earnings firms manage through nonconforming earnings management. The study also finds that income tax cost evaded by this approach is extremely limited and it perhaps reveals that firms in fact pay income tax cost for most earnings management. The above studies examine the relationship between earnings and income tax and the balance of financial reporting and income tax costs, but few domestic researches reflect earnings management behavior by financial restatements, also few are based on the differences of income tax account between originally reported and restated financial statements to investigate firms’ choice among different earnings management strategies and how manager's motivations and purposes influence this choice. Relative to previous studies, we estimate the choice of conforming earnings management and nonconforming earning management from the perspective of income tax and we use the changes in current and deferred tax expense disclosed in earnings’ restatements to measure conforming and nonconforming earnings management. 3. Theoretical Analysis Based on the treatment of book-tax differences using the balance sheet liability method, this article analyzes the effect that different earnings management strategies have on book-tax differences and the level of income tax burden under different earnings management -421- Journal of Industrial Engineering and Management – http://dx.doi.org/10.3926/jiem.1310 strategies. We conclude that when manage earnings, managers tend to choose nonconforming earnings management strategies from the perspective of income tax. 3.1. Treatment of Book-Tax Differences Figure 1 schematically illustrates the accounting processes of Corporate Income Tax under the balance sheet liability method. The balance sheet liability method means starting from the balance sheet, recognizing taxable temporary differences and deductible temporary differences by comparing difference between the book value that is determined in accordance with GAAP and tax basis that is determined according to the provisions of the Income Tax Law and then recognizing deferred income tax liabilities and deferred income tax assets and thus determining the income tax expense for each period. Shown in Figure 1, when companies engage in earnings management, managers can choose conforming earnings management strategies, strategies affect both accounting profit and taxable income and thus have effect on current income tax expense without having effect on deferred income tax expense, and they can also choose nonconforming earnings management strategies, strategies only affect accounting profit and don’t affect taxable income and thus have effect on deferred income tax expense without having effect on current income tax expense. Of course, companies can adopt both two kinds of earnings management strategies. The two earnings management strategies have different influence on current income tax expense. Thus, the company can decrease the current period’s tax payable through choosing different earnings management. -422- Journal of Industrial Engineering and Management – http://dx.doi.org/10.3926/jiem.1310 Figure 1. The accounting processes of corporate income tax 3.2. Earnings Management Strategies and Book-Tax Differences With the steady progress in the reform process of CAS, companies get more opportunities to choose accounting policies and accounting estimates, these factors led to the differences between Chinese listed companies’ accounting profits and taxable income. And this also result in the increase of managers’ choice of earnings management strategies. This paper mainly discusses the relationship between the choice of different earnings management strategies, conforming earnings management strategies and nonconforming earnings management strategies, and book-tax differences. We focus on earnings management bringing temporary differences, because companies rarely have the opportunity to engage in earnings management generating permanent differences. When companies engaged in conforming earnings management strategies, the book-tax differences will be generated, while when companies engaged in nonconforming earnings management strategies, the book-tax differences will not be generated. And the more nonconforming earnings management -423- Journal of Industrial Engineering and Management – http://dx.doi.org/10.3926/jiem.1310 strategies companies engaged in, the greater the book-tax differences are. We illustrate the relationship between the two different earnings management strategies and book-tax temporary differences through the following example. Assume that in the current year t and also in year t + n, both company A and company B have ￥1000 of "true" pretax book income. The company A engages in ￥100 of earnings management through a conforming manner and thus originally reports ￥1100 of pretax income in year t. While the company B engages in ￥100 of earnings management through a nonconforming manner and thus also originally reports ￥1100 of pretax income in year t. As a result, the changes in the two companies’ book-tax differences and income tax expenses before and after engaging in earnings management is as follows (the income tax rate is 25 percent): Company A Company B Accounting profit 1,100 1,100 Taxable income 1,100 1,000 Current income tax payable 275 250 Book-tax differences 0 100 Deferred tax expenses 0 25 Table 1. After engaging in earnings management. (Unit: million) Company A Company B Accounting profit 1,000 1,000 Taxable income 1,000 1,000 Current income tax payable 250 250 Book-tax differences 0 0 Deferred tax expenses 0 0 Table 2. Before engaging in earnings management. (Unit: million) As shown in Table 1 and Table 2, conforming earnings management will not cause book-tax differences, but it will affect taxable income and thus this earnings management strategy only affects current income tax payable and has no effect on deferred income tax expense. In the contrary, nonconforming earnings management will cause book-tax differences, but it will not affect taxable income and thus this earnings management strategy only affects deferred income tax expense and having no effect on current income tax payable. -424- Journal of Industrial Engineering and Management – http://dx.doi.org/10.3926/jiem.1310 Symbol Coefficient Sig. Z value (Constant)? -1.96 0.053 3.732 TLTG －-1.903* 0.078 3.096 FRAUD －-0.900** 0.022 5.248 REV_ONLY ? 0.685* 0.067 3.361 EXP_ONLY ? -0.262 0.577 0.311 LAG_DTE －8.372 0.308 1.041 LNLAG_TA ? 0.190** 0.050 3.834 Note: *, **, *** indicate the coefficient is significant at the level of 10%, 5%, 1%. TLTG, which represents turning losses into gains, equals 1 if the firm turns losses into gains in year t, and 0 otherwise. FRAUD, which represents fraudulent activities, equals 1 if the firm engages in fraudulent activities in year t, and 0 otherwise. REV_ONLY, control variable, equals 1 if the firm only restates revenue accounts in year t, and 0 otherwise. EXP_ONLY, control variable, equals 1 if the firm only restates expense accounts in year t, and 0 otherwise. LAG_DTE equals deferred tax expense in year t-1, scaled by total assets at year-end t-2. LAG_TA equals logarithm of total assets at year-end t-1. Table 5. Logistic regression of Model (1) 6. Conclusions and Recommendations Based on CAS2006, we examine listed companies’ choice of two types of earnings management: book-tax conforming and book-tax nonconforming. And we also examine how firm-specific motivations and purposes impact the choice among these earnings management strategies. We base our analyses on a sample of firms that restated their earnings (and thus had managed earnings), and we measure conforming and nonconforming earnings management by using the changes in current and deferred tax expense account disclosed in originally and restated financial statements. We compare the relative amounts of changes in current and deferred tax expense to judge which type of earnings management a firm is engaged in. Using hand-collected data from the misstatement firms’ financial statements, we get values of the variables in Model (1). Then we get the conclusions by analyzing results of descriptive statistics and correlation test and logistic regression of Model (1). The study indicates that when the firm has motivations to turn losses into gains and has the motivation to avoid penalty cost associating with fraud being found, the firm prefers to employ more conforming earnings management strategies. Based on the study, we present several policy recommendations to regulate earnings management. 6.1. Improve Accounting Standards The relevant authorities should learn from the relevant provisions of international accounting standards to improve and revise our existing accounting standards and its core ideas should be -431- Journal of Industrial Engineering and Management – http://dx.doi.org/10.3926/jiem.1310 to narrow space that firms are free to choose. Specifically, the language and concept of accounting standards should be standardized; reduce the alternative accounting policies and methods; minimize management's accounting estimates and professional judgment; standardize changing conditions of accounting policies and accounting estimates and corrections of accounting error. 6.2. Optimization Pay System Currently, managers’ revenues consist of basic salary and bonus in most enterprises and the basic salary and bonus are linked to managers’ performance. It can be seen that managers’ compensation mechanisms not only incentive managers to focus on financial performance of corporate, but also induce earnings management activities. Therefore, to optimize the compensation mechanisms is an effective method to prevent earnings management activities. On the one hand, combine long-term development of the firm to managers’ revenues; on the other hand, give managers the appropriate option awards to align the interests of managers and shareholders together, so that to promote managers to pay more attention to the firm’s long-term development and thus weaken their incentives to manage earnings. Current Projects This paper has been supported by grants from the National Natural Science Foundation of China (No.71302123) (No.71102126), Science Foundation of Ministry of Education of China (No. 13YJC790048) and the Specialized Research Fund for the Doctoral Program of Higher Education of China (Grant No. 20120023120015) and the Innovative Research Team of Central University of Finance and Economics. References Dhaliwal, D., Frankel, M., & Trezevant, R. (1994). The taxable and book income motivations for a LIFO layer liquidation. Journal of Accounting Research, 2, 278-289. http://dx.doi.org/10.2307/2491286 Erickson, M., Hanlon, M., & Maydew, E. (2004). How much will firms pay for earnings that do not exist? Evidence of taxes paid on allegedly fraudulent earnings. The Accounting Review, 79(2), 387-408. http://dx.doi.org/10.2308/accr.2004.79.2.387 -432- Journal of Industrial Engineering and Management – http://dx.doi.org/10.3926/jiem.1310 Frank, M., Lynch, L., & Rego, S. (2006). 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Readers are allowed to copy, distribute and communicate article's contents, provided the author's and Journal of Industrial Engineering and Management's names are included. It must not be used for commercial purposes. To see the complete license contents, please visit http://creativecommons.org/licenses/by-nc/3.0/. -434-