Earnings Management through Discretionary Expenditures in The U.S., Canada, and Asia

Abstract

There is a considerable literature on U.S. companies’ earnings management through discretionary accruals and real earnings management. We extend this literature to the international setting and include the effects of corporate tax on earnings management decisions. We find that US based models of earnings management work reasonably well in the Canadian setting, and except for the effects of taxes, in the Hong Kong, Japanese, Korean, and Taiwanese settings as well. We predict that firms’ tax status may have a countervailing effect on such management. Consistent with this prediction, we find that firms with larger potential tax savings are more likely to use real earnings management to accelerate discretionary expenditures. Since these discretionary deductions have income-reducing effects for financial reporting purposes, the results suggest that income taxes have a strong incentive effect. However, this tax effect occurs for only U.S. and Canadian firms; Hong Kong, Japanese, Korean, and Taiwanese firms’ discretionary accrual decisions appear to not be influenced by taxes. The results may have policy implications for other countries as well.

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