TWO EMPIRICAL STUDIES ON THE EFFECTS OF EARNINGS MANAGEMENT OBJECTIVES AND TAX INCENTIVES ON ADVERTISING, RESEARCH AND DEVELOPMENT AND CAPITAL EXPENDITURES

In determining their firm' s advertising, R&D and capital expenditures, managers face trade-offs between the pursuit of tax incentives and the need to meet earnings objectives. These trade-offs exist because advertising and R&D expenditures are expensed for both financial reporting and tax purposes, so that they cannot be used simultaneously to decrease taxes and increase reported earnings. The trade-offs for depreciation of capital expenditures are less pronounced, because depreciation may be calculated differently for financial reporting and tax purposes.; The first study examines the influence of earnings management objectives and tax incentives and their interaction on R&D expenditures. The earnings management objectives considered in this study are earnings smoothing and debt cost minimization. The three tax factors are the simulated marginal tax rate, the tax credit for increasing R&D expenditures, and the disincentive associated with R&D when calculating the foreign tax credit. I find that higher leverage is associated with smaller increases in R&D expenditures while higher marginal tax rates are associated with larger increases in R&D expenditures. Managers whose firms face debt costs associated with high leverage make larger increases in R&D in response to increases in the marginal tax rate than other firms. Managers whose firms have earnings below target earnings make smaller increases in R&D in response to increases in the marginal tax rate than other firms.; The second study explores whether managers jointly determine advertising, R&D and capital expenditures, given the trade-offs associated with earnings management objectives and tax incentives. I estimate a simultaneous system of equations, but find no evidence that the three investment decisions are jointly determined. Individually, changes in the expenditures are associated with earnings smoothing motivations and the marginal tax rate, but are unrelated to the amount of a firm's leverage.; These results provide evidence that earnings management considerations and tax incentives influence managers' decisions concerning advertising, R&D and capital expenditures. This information should be considered by financial accounting standard setters and tax policymakers, whose actions influence managers' fundamental investment decisions.