Authors: Stylianos Floropoulos, Maria Tsipouridou, Charalambos Spathis

Title: Book-tax conformity and earnings management: review of recent research

Abstract

A tax system must be fair, simple, transparent and efficient. Corporations use two different sets of financial statements: a financial statement that reports «book profits» to the capital markets, investors and shareholders and a separate financial statement that reports «tax profits» to the government and tax authorities. These two statements have mirror-image goals: firms want to maximize the income reported to investors while minimizing the taxable income reported to the tax authorities (paying less taxes). Additionally, the dual nature of corporate profit reporting may be creating a lose-lose situation — less meaningful profit numbers for capital markets, lowered corporate tax revenue for the government and the allocation of resources to exploiting the opportunities created by this curious system. Defenders of the book-tax divide have argued that a unified system cannot accommodate these differing objectives. Moreover, when the links between financial reporting and tax become stronger (i.e., stronger book-tax conformity) the informational role of accounting earnings is reduced. On the other hand, corporations in countries with higher required book-tax conformity have fewer opportunities to avoid taxes without decreasing reported earnings. The potential advantage of shifting to a book income tax base with adjustments is to improve the transparency of the tax base (the whole purpose of the conformed system would be to tax a base of true economic income) and help restore the integrity of the financial accounting system. Studies examining earnings management across countries provide mixed evidence regarding the impact of book-tax conformity. Earnings management is only one aspect of earnings quality. Some managers may take advantage of their reporting discretion to report accounting earnings opportunistically when book-tax-conformity is lower. The propensity to engage in opportunistic behavior is predicated on tax and non-tax cost considerations and on a manager's incentives. Managers' strategies include (1) managing book and taxable income (taxes) in an opposite direction; (2) managing book income while keeping taxable income (taxes) constant; and (3) managing taxable income (taxes) while keeping book income constant. Some researchers mention that higher levels of book-tax conformity are associated with higher, not lower, overall levels of earnings management (i.e. upward and downward) across the world and tax avoidance (i.e. non-conforming and conforming) behavior (tax-induced earnings management). Likewise, higher conformity between accounting and tax reporting in a jurisdiction is associated with more earnings management as a response to an upcoming tax reform that decreases the corporate tax rate. Additionally, firms more widely act according to the income shifting incentive when book-tax conformity is stronger. Conversely other studies claim that book-tax conformity can prevent the earnings management activity. Furthermore, high book-tax conformity is associated with lower levels of earnings management and tax avoidance. Additionally, in a conformed system, managers have weaker incentives to engage in earnings management because upward earnings management will yield higher taxes. The paper analyses the proponents and opponents of high/low book-tax conformity and the association between earnings management and book-tax conformity. Our review can be used in research studies, when accounting principles and book-tax conformity are altering or/and tax reform (tax rates are changing) takes place.