Last-Chance Earnings Management: Using the Tax Expense to Meet Analysts' Forecasts*

Authors


  • *

    Accepted by Ken Klassen. Lillian F. Mills appreciates funding provided by the Stevie Eller Accounting Research Fellowship. We thank Thomas Dyckman, Don Goldman, Sanjay Gupta, Michelle Hanlon, Shane Heitzman, Ed Outslay, Kathy Petroni, Karen Pincus, Mort Pincus, Sonja Rego, William Schwartz, Terry Warfield, Connie Weaver, and workshop participants at Arizona State University, University of Arkansas, University of Cincinnati, Michigan State University, and University of Wisconsin for their thoughtful suggestions. The authors acknowledge the contribution of the Institutional Brokers Estimate System (I/B/E/S), a service of Thomson Financial, for providing the earnings per share forecast data. These data have been provided as part of a broad program to encourage earnings expectation research. The Internal Revenue Service (IRS) provided confidential tax information to one of the authors pursuant to provisions of the Internal Revenue Code that allow disclosure of information to a contractor to the extent necessary to perform a research contract for the IRS. None of the confidential tax information received from the IRS is disclosed in this paper. Statistical aggregates were used so that a specific taxpayer cannot be identified from information supplied by the IRS.

Abstract

We assert that the tax expense is a powerful context in which to study earnings management, because it is one of the last accounts closed prior to earnings announcements. Although many pre-tax accruals must be posted in the year-end general ledger, managers estimate and negotiate tax expense with their auditors immediately prior to earnings announcements. We hypothesize that changes from third- to fourth-quarter effective tax rates (ETRs) are negatively related to whether and how much a firm's earnings absent tax expense management miss analysts' consensus forecast, a proxy for target earnings. We measure earnings absent tax expense management as actual pre-tax earnings adjusted for the annual ETR reported at the third quarter. We provide robust evidence that firms lower their projected ETRs when they miss the consensus forecast, which is consistent with firms decreasing their tax expense if non-tax sources of earnings management are insufficient to achieve targets. We also find that firms that exceed earnings targets increase their ETR, but this effect is less significant. By studying the tax expense in total, rather than narrow components of deferred tax expense, our results provide general evidence that reported taxes are used to manage earnings.

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