TAXATION AND INCOME SMOOTHING: EVIDENCE FROM ACCRUALS (EARNINGS MANAGEMENT)

This study examines the effects of taxation on managers' income smoothing activities. Risk-averse managers are motivated to reduce the variability of accounting earnings when their compensation heavily depends on such earnings. Taxation enters into managers' income smoothing decisions in two ways. First, the tax provision included in the financial statements affects the variability of after-tax accounting earnings (the earnings effect). Regardless of the tax rate structure, after-tax earnings variability decreases as book effective tax rates increase. Therefore, managers were predicted to smooth less as book effective tax rates increased. This relation was predicted to be stronger when bonus compensation was tied to after-tax earnings. Second, the net present value of taxes paid may change due to income smoothing activities (the cash flow effect). Managers were predicted to smooth less as the marginal change in the net present value of taxes paid increased.; In this study, expected accruals were estimated using a two-stage least squares procedure in which accruals were regressed on gross property, plant and equipment and the change in cash revenues. Income smoothing was measured as the absolute decrease in unexpected pre-tax earnings due to unexpected accruals (scaled by lagged assets). The relation between smoothing and two tax variables (book effective tax rates and marginal changes in the net present value of taxes paid) was tested cross-sectionally.; The prediction of a negative relation between managers' income smoothing actions and book effective tax rates was supported by the test results. In addition, this relation was stronger for managers whose bonuses were based on after-tax accounting earnings. No relation was found between managers' income smoothing activities and marginal changes in the net present value of taxes paid.; Because current accounting rules do not provide for discounting of the income tax liability, financial accounting earnings do not reflect changes in the net present value of taxes paid when managers smooth income. The results of this study suggest that managers focus primarily on the accounting earnings impact of taxation rather than changes in the net present value of taxes paid when making income smoothing decisions. In addition, managers whose bonus plans are tied to after-tax accounting earnings are more sensitive to the impact of taxation on the variability of after-tax earnings.