The Association Between Deferred Tax Expense And Earning Management

Because of the impact on capital markets, management and investors, earning management has been one of the most popular and important topics in accounting research and corporate governance area in a long time. Research on earnings management, starting in the1980s, has been continued in three decades. In this period, various researches have been done on earnings management. However, how to define earning management is still in controversy. It is believed, in this dissertation, that the subject of earnings management is management of a company. And it is also considered, by the author, that the process of earnings management includes trading design, accounting selection, and financial reporting. Further, the aim of earning management is to make reported earnings achieve the wanted reporting goals. According to the ways of earning managing, it can be divided into two types:one is earning management about what is disclosed, and the other is real earnings management. The former type is mainly done by using accruals. This means choosing to use different accounting policies, changing accounting estimates and using different ways in impairment can lead to earning management. This type of earning management does not influence the company’s cash flow and economic activities. On the other hand, the latter category is to manage earnings by changing real economic activities of the company, for instance abnormal promotion at the end of each period, offering loose credit policy, cutting R&D expense and reducing unit production costs.Because the different aims and accounting criteria between Chinese accounting regulation and tax laws, accounting profits and taxable profits could not equal to each other. More discretion is left to the company management by accounting standards, comparing with tax law. Comparing with accounting profits, when paying income tax, taxable profits should be clearly reflected. This means deferred earning and unrealised income should not be accounted in the taxable income. Besides, the deduction of the expenses must be under strict provision. These regulations weaken discretion of company for calculating taxable income. This leads to the difference between accounting profit before tax and taxable profit, which can reflect how management use accruals in accounting.The abbreviation of difference between accounting profit and taxable profit is BTD. There are two species of BTD-permanent BTD and temporary BTD. It has been proved that permanent BTD cannot provide evidence about manipulating accruals may trigger decline in the quality of earnings. The deferred income tax expense is one can cause temporary BTD. Thus it may reflect discretion in accounting accruals to some extend.New Chinese GAAP is implemented in listed companies on January1st2007, and will be gradually implemented in other enterprises. According to regulations in Accounting Standards for Enterprises No.18-Income tax, temporary BTD should be accounted by applying the balance sheet liability method. Some studies have been done to find out how the new income tax accounting standards may impact earnings management. Some ideas can be found in literatures. First, when using the balance sheet liability method, it is very flexible about the tax basis of assets and the calculation of temporary differences resulting from it. Second, in the regulation, after changes in tax rate, accounting on deferred income tax expenses should obey the new tax rate. This will result in listed companies easily make use of it to manage earnings. Third, listed companies could manipulate deferred income tax expense by recognising deferred income tax assets and deferred tax liabilities. This can influence income tax expense in income statement, and even result in income tax benefit. Therefore, increase or decrease of current net profit can be faked. From the above ideas, deferred income tax could be produced when the tax basis and book value of the assets is inconsistent. Thereby deferred income tax expense and income tax expense could be affected. This means the willingness and professional judgment of company management play important roles in appropriately recognising deferred tax assets and deferred tax liabilities. On the other hand, subjective choice of management makes possibility to manipulate earnings.Due to short period of the implementation of new income tax accounting standards, there are rare literatures about earning management from the aspect of income tax. But loads of academic achievements in earning management from the deferred tax accounting or accounting-tax difference perspective are reached in foreign countries. Hence, the theme, in this dissertation, is to explore whether earning management can be found out through researching deferred income tax expense in China.The issue will be studied by combining of theoretical analysis and empirical research. On the basis of theoretical analysis, two hypotheses will be tested. The first hypothesis is deferred income tax expense, holding the same effect as accrual model, can explain earning management about avoiding reporting earnings decline. The second hypothesis is deferred income tax expense, the same as accrual model, has explanatory power on investigating earning management about avoiding reporting losses.This study is based on Burgstahler and Dichev’s research in1997. And a probit model which will be used to detect the relationship between deferred tax expense and earning management is constructed on the basis of the Phillps et al.’s (2003) model and the Modified Jones Model. And data from1209A share listed non-finance companies during the year from2008to2010are collected.This dissertation is divided into five chapters. The first chapter is the Introduction. In this chapter, research background, research motivation, research ideas, as well as the research structure, possible innovations and shortcomings are contained. The second chapter is literature review. Literatures about earnings management and deferred income tax are introduced and discussed. And it is introduced the association between deferred income tax expense and the motivation of manipulating earning to be hypothesis of this research. Also research methods are referred to these literatures. The third chapter is about theoretical foundation and research design. The theoretical basis is about researches on the deferred income tax expense. Furthermore, research design is about hypothesis-setting, sample-selection and model-selecting based on these theories based on assumptions made, the sample selection and model choice. The fourth chapter is empirical test, including result of empirical test and analysis of it. In this chapter, it can be found information about selected sample data, descriptive statistics, correlation analysis of variables, multiple regression analysis and sensitivity analysis. Conclusion, recommendations and short is in the fifth chapter. Based on the result of empirical evidence in the fourth chapter, conclusion and recommendations are drawn in this chapter. Moreover, some limitations are mentioned for some problem faced in the research.It is found that deferred income tax expense could help investigate earning management, which is used to avoid reporting decrease of earnings. And it is more explanatory comparing with manipulative accruals estimated in the Modified Jones Model. However, when applying to detect the behaviour of avoiding reporting loss, deferred tax income does not associated with earning management. This is slightly different with results of research in foreign countries. This might be due to short period of reforming in income tax and accounting, companies do not accustomed to or specialised in applying deferred tax to manage earnings. Therefore, researching on earning management aiming at avoiding losses would be more effective by using Modified Jones Model. In other words, deferred tax income could not provide help in finding all the earning management because companies can make earning management by using other methods rather than temporary differences. For example, management can do earning management through planning transaction making permanent BTD. Management also can make transactions to change operating cash flow, and influence the accounting income and taxable income at the same time. If the latter method is used, current taxable income will increase, and it would be impossible to detect earning management by testing deferred income tax expense.In addition, because the new income tax accounting standard is used in a3-year period, only data from2008to2010can be tested. The limited data reduce the effect of finding out earning management through deferred income tax expense which is reflected by the use of accounting-producing temporary BTD. If extending the period of research with the implementation of new standard, the result of investigating the relationship between deferred income tax expense and earnings management could be more convincible.At present, there are a wide range of researches about earning management in and out of China. The main difference among them is how to measure earning managements. The most commonly used earnings management measurement methods is the accruals method. In this method, accrual profit is grouped into non-manipulative profit and manipulative profit. In this study, a new perspective and means are approached. This study researches on earning management from the perspective of deferred tax expense, which offers a novel approach on researching earning manipulation.