Earnings Management Strategies and the Trade-Off between Tax Benefits and Detection Risk: To Conform or Not to Conform?

Abstract

Prior research has separately examined pretax earnings management activities that have current taxable income consequences (book-tax “conforming earnings management”) and those that do not have current taxable income consequences (book-tax “nonconforming earnings management”). Our study documents the prevalence of, and then investigates the firm-specific characteristics that impact the choice between, these earnings management strategies. We utilize a sample of firms that restated their earnings downward due to accounting irregularities and thus can be presumed to have managed earnings upward. We find that nonconforming earnings management is more prevalent and that firms trade off the net present value of tax benefits against the net expected detection costs associated with nonconforming earnings management. In particular, firms having NOL carryforwards, using a high-quality auditor, or engaging in the most egregious misstatements rely less on nonconforming earnings management strategies. We also find that book-tax differences are useful in predicting restatements.