Listed companies’ income tax planning and earnings management: Based on China’s capital market

Abstract

Purpose: The Ministry of Finance issued the new China accounting standards on February 15, 2006(CAS2006), which require the listed companies to use the balance sheet liability method for the income tax accounting. Thus, it give us an opportunity to investigate the earnings management of listed companies from the perspective of income tax. Under the balance sheet liability method, because conforming earnings management strategies and nonconforming earnings management strategies have different income tax cost and the current income payable will also vary, the listed companies need to choose conforming earnings management and nonconforming earnings management. Our research just try to investigate the relationship between the listed companies’ income tax planning and earnings management on the background of this new system.

Design/methodology/approach: Our research approach combines theoretical analysis and empirical analysis. This paper first make a deep theoretical analysis on the listed companies’ choice between pretax earnings management activities that have current income tax consequences (book-tax ‘conforming earnings management’) and earnings management activities that do not have current income tax consequences (book-tax ‘nonconforming earnings management’),and then we exemplify our theory. Next, we come up with two hypotheses based on the theoretical analysis, build up a restatement model and conduct the empirical examination. The empirical analysis employs the method of descriptive statistics and logistic regression.

Findings: When engaging in earnings management, listed companies will trade off conforming and nonconforming earnings management from the perspective of income tax cost. We find that managers’ motivations and purposes will influence the choice. On the one hand, when companies are facing the punishment of the suspension or termination of the listing for three consecutive losses, they will have a great incentive to manage earnings in order to turn losses into gains. In this case, companies can’t wait to manage earnings to increase incomes and won’t consider income tax cost too much. And if they employ nonconforming earnings management bringing greater book-tax differences, it may increase the probability of being detected and earnings management behavior may also be found. Thus, in this motivation, listed companies will employ more conforming earnings management. On the other hand, when companies engage in fraudulent activities, they will avoid the use of earnings management strategies which bringing greater book-tax difference to avoid penalty cost associating with fraud being found, since greater book-tax difference will possibly attract regulatory agencies’ and auditors’ attention therefore lead to the fraud being found. In this motivation, listed companies will employ more conforming earnings management. In summary, the main conclusion is when the company has motivations to turn losses into gains and has the motivation to avoid penalty cost associated with fraud being found, the company prefers to employ more conforming earnings management strategies.

Research limitations/implications: The limitation in our research is as follows. First, we mainly focus on the conforming and nonconforming earnings management when the listed companies restate their financial statements. However after the issue of CAS2006, many listed companies still not disclose income tax account, which restrict our sample. Second, without the acquisition of private companies’ data, our empirical results may have some errors. We will solve these problems in our future study.

Practical/social implications: Based on the sample of restatement companies, our research explores the listed companies’ choice of conforming and nonconforming earnings management under different motivations, which provides our study with new perspective and theoretical evidence. Meanwhile, because this paper focuses on restate firms’ earnings management, the results are helpful for regulators to strengthen the administration of listed companies’ restatement, as well as decrease the damage of restatement on our capital market. Finally, our results indicate that when the company has motivations to turn losses into gains and has motivations to avoid penalty cost associated with fraud being found, the company prefers to employ more conforming earnings management strategies. It will help us to deeply understand the impact of the accounting processes of income tax under the balance sheet liability method on the listed companies, therefore provide companies’ income tax planning with essential empirical and theoretical evidences.

Originality/value: So far, earnings management researches in academia mostly focus on the cost, motivations, means and results of earnings management, there are few studies discuss the choice of earnings management strategies and how different purposes and motivations affect the choice from the perspective of income tax. The issue of CAS2006 offers an opportunity for this research. This paper use restatement as sample to investigate the choice of conforming earnings management and nonconforming earnings management under different motivations and purposes for the first time. And not only study the effect that earnings management have on income tax, but also study the effect of different earnings management motivations on the choice of earnings management strategies.