Effects of Earnings Management, Compensation, Insider Equity Holding on Tax Structure

By Wang, Ying; Butterfield, Scott et al. | International Management Review, April 1, 2017 | Go to article overview

Effects of Earnings Management, Compensation, Insider Equity Holding on Tax Structure


Wang, Ying, Butterfield, Scott, Campbell, Michael, International Management Review


Introduction

Maximizing profit is a key goal for most companies, which means minimizing expenses while maximizing revenue. While working on a previous paper (Wang, et al 2017), we noted that most Chinese companies pay more taxes than what they report, this struck us as unusual. Tax expense has an unusual nature. First, there is the amount reported as tax expense, calculated according to the financial accounting rules in effect, i.e., GAAP. Then there is the amount of tax paid, calculated according to the tax laws and regulations that can vary significantly from the GAAP rules. We assumed most companies would like to minimize their tax payment, such that this amount would usually be less than GAAP tax expense reported. This is the case for many companies in the US. Reilly (2016) analyzed reported tax expense and the actual amount of tax paid for the top 100 Standards & Poor's companies in 2015 and found that 61 of the 100 paid substantially less in tax than what they reported as tax expense; an average of $734 million less per company! Since it seems clearly beneficial for companies to try minimizing the tax they pay, we wondered what factors influence Chinese companies to act otherwise.

Prior research indicates that equity incentives link corporate performance with the personal wealth of executives, which effectively aligns executives and shareholder interest (Hall & Murphy, 2002). This finding shed light on how equity holdings of board members and executives alleviate book-tax differences (BTD) motivated by earnings management.

Book-tax difference can not only result from mechanical differences in financial reporting and tax rules, but also can depend on managerial discretion (Badertscher et al., 2009; Hanlon, 2005). The goal of this research is to investigate how incentive pay schemes for various groups and actual equity ownership for these groups affect tax planning behavior by Chinese firms. We studied the effect of executive compensations, and equity holding on tax. We incorporated earnings management, Board of Supervisors and management equity holding in the analysis. We contribute to current literature by focusing on temporary BTD and using real temporary BTD data instead of using proxies.

Literature Review

The effect of equity-based compensation on book-tax differences (BTD) has been addressed previously in the literature. Xian, Sun & Zhang (2015) looked at whether equity-based compensation impacts the association between BTD and tax planning, and the association between BTD and earnings management. They found that discretionary BTDs related to tax planning increase as the equity-based compensation of executives increases, and that earnings management-related BTDs decrease as the equity-based pay of executives increases. These findings suggest that although equity incentives promote a higher level of both tax planning and earnings management, they motivate managers to avoid larger BTD. The research does not take into consideration managers' current equity holdings. Armstrong, Blouin, & Larcker (2012) investigate whether the incentives provided to tax directors are associated with lower effective tax rates and/or a wider BTD. They find that the incentive compensation of the tax director has a strong negative relationship with the GAAP effective tax rate (GAAP ETR), indicating that tax directors are provided with incentives to reduce the level of reported tax expense. Both the accounting and finance literature have examined the impact of compensation and governance structure on corporate behavior. Cornett et al. (2008) examine whether the impact of these factors may be in part merely cosmetic. They study whether governance structure and incentive compensation influence firm performance when they control for earnings management. They found that when they adjust for the impact of earnings management, there is a substantial increase in the importance of variables related to governance while also find a substantial reduction in the importance of incentive-based compensation. …

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