Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
Book-Tax Income Differences: A New Measure of Earnings
Management
Quang Viet Vu*, Charles W. DuVal**, Will Quilliam*** and Noema “Amy”
Santos****
Earnings management is prevalent in the corporate world and can take various forms,
to include manipulating the difference between book and taxable income. This type
of earnings management is usually done in an effort to make book income larger for
financial reporting purposes while minimizing taxable income (and therefore the
amount of taxes paid).
Researchers have reported conflicting results when earnings management is
examined using conventional measures. Based on the extant evidence that United
States and European firms carry out taxable-income-related earnings management,
we propose a comprehensive regression model that captures both taxable income
related earnings management and conventional book income related accruals
management. In our final sample of 8,723 firm-years from 2004-2010, we provide
evidence that the new measure performs equally well or better than conventional
earnings management measures that focus on book income accruals only.
To confirm the adequacy of the new measure of earnings management developed in
this study, we revisit an earnings management related issue previously investigated
in the literature to see if the new measure performs better than conventional
measures. Specifically, we find that managers tend to exercise more stock options
when earnings management is greater. Our evidence is quite robust.
Our
investigation opens a new channel to understanding corporate earnings management
and shows the importance to have a comprehensive view of earnings management
rather than the conventional focus on book income accruals management alone.
There are also practical implications for investors, corporate tax payers, as well as
taxing authorities.
Track: Finance
Key words: Taxable income, book income, earnings management
JEL codes: G100, M410, and M490
1. Introduction
The computation of income depends upon the rules under which it is measured.
Companies compute one measurement of income under financial accounting
standards (such as International Financial Reporting Standards or United States
Generally Accepted Accounting Principles) and another measurement of income
under applicable tax laws (such as the Internal Revenue Code in the United States).
These two measurements are called “book income” and “tax income,” respectively,
and the difference between the two is called “book-tax difference.” Book-tax
differences can be a part of an attempt by a company to manage its earnings to
_____________________________________________________________
*School of Finance, University of Economics Ho Chi Minh City, 59C Nguyen Dinh Chieu Street, District 3, Ho Chi
Minh City, Vietnam. Telephone: 096-697-5712. FAX: 84-8-38250359. Email: qvu@ueh.edu.vn
**Barney Barnett School of Business and Free Enterprise, Florida Southern College, 111 Lake Hollingsworth
Drive, Lakeland, FL, USA 33801.
Telephone:
863-944-0965.
FAX:
863-680-4355.
Email:
cduval@flsouthern.edu
***Barney Barnett School of Business and Free Enterprise, Florida Southern College, 111 Lake Hollingsworth
Drive, Lakeland, FL, USA 33801.
Telephone:
941-730-6987.
FAX:
863-680-4355.
Email:
wquilliam@flsouthern.edu
th
****Department of Business and Technology, State College of Florida, 5840 West 26 Street, Bradenton, FL,
USA 34207. Telephone: 954-488-8988, Email: santosa@scf.edu
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
further various management objectives.
This strategy is called “earnings
management.” (Lev and Nissim, 2004). There is evidence that book-tax differences
have increased significantly in past years (Yin, 2003; Hanlon, 2005, Desai and
Dharmaphala, 2009; Atwood, Drake, and Myers, 2010). This pattern is present in
both the United States and Europe, as well as possibly in other countries (Guenther
and Young, 2000).
Even though book-tax differences are extremely common, relatively few studies have
examined their effect on earnings management and the exercise of executive stock
options. This study examines book-tax differences for a sample of companies in
relation to executive stock options. We develop a regression model to relate
executive stock option exercises to variables relating to earnings management and
find executives tend to exercise higher levels of stock options when earnings
management is elevated.
2. Literature Review
While book-tax differences exist because of the differences between financial
accounting standards and tax laws, some research indicates that these differences
are made as a part of the company’s desire to manage earnings (Joos et al., 2000).
Tax laws tend to be more inflexible than are financial accounting standards.
Financial accounting standards tend to provide companies with more discretion than
do tax laws, so this provides companies with opportunities to manage financial
accounting income. Joos et al. (2000) found evidence indicating that the covariance
between earnings and stock returns will diminish as book-tax differences become
larger. The authors posit that investors react to earnings to a lesser extent because
they regard large book-tax differences as signals of opportunism on the part of
management. In fact, there is evidence that book-tax differences are correlated with
future earnings growth and are therefore indicative of earnings management (Lev
and Nissim, 2004).
Earnings management usually includes inflating reported financial accounting
income while decreasing tax income to the extent possible. Higher reported financial
accounting income is more desirable to investors while lower tax income reduces the
amount of taxes paid. Prior research indicates that earnings quality and book-tax
differences are inversely correlated. Researchers in general look for the presence of
earnings management by studying earnings quality of the firm. A number of
researchers have focused on the association between earnings and stock returns in
evaluating earnings quality (Blaylock, Gaertner, and Shevlin, 2014; Ecker et al.,
2006; Francis and Schipper, 1999). This approach extracts information about
earnings from stock prices by assuming the market is efficient. However, for directly
measuring earnings management, the general approach is based on deducing
earnings quality from accounting information. The measures based on this approach
are typically related to the level of accruals (Sloan, 1996); the estimation error in
accruals (Dechow and Dichev, 2002); and accruals volatility (Francis et al., 2005). In
a survey of the literature, Dechow et al. (2010) report that conventional measures of
earnings management have produced considerable conflicting results. Thus, some
researchers argue that book-tax differences may serve as an indicator of earnings
management given the documented correlation between book-tax differences and
earnings quality (Ayers 2009; Hanlon 2005; Palepu et al. 2005; Lev and Nissim
2004). To infer earnings management from book-tax differences, Lev and Nissim
(2004) study the disparity between temporary and permanent differences whereas
Schallheim and Wells (2006) compare current tax spread and total tax spread. Ayers
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
et al. (2006) investigate the difference between high tax-planning and low taxplanning firms whereas Poterba et al. (2007) analyze tax footnote disclosures.
Despite the frequently alleged relation between book-tax differences and earnings
management, few attempts have been made to develop a measure of earnings
management based on the characteristics of book-tax differences. To fill this void,
we develop a simple model that measures earnings management directly from booktax differences.
3. Methodology
3.1 Sample Selection
The initial sample includes United States companies on Compustat from 2004 to
2010 which have total asset book values of over $100 million. This sample is the
same as in Vu, DuVal, Quilliam, and Santos (2015). We then discarded American
Depository Receipts, regulated companies with SICS from 4900 to 4999, and
financial companies with SICS from 6000 to 6999. The final sample includes 8,723
firm-year observations.
Table 1 includes the list of variables in this study. Table 2 contains the 25
companies with the highest book-tax differences during the study period. Table 2
also shows the sample selection criteria and descriptive statistics of the sample’s key
variables.
3.2 Measuring Earnings Management from Companies’ Book-Tax Differences
Relatively little research has attempted to measure earnings management from
book-tax income differences. One probable reason is that few income tax returns
are publicly-disclosed, and therefore researchers do not have access to this
important information. However, there is a clue to help researchers which is present
on external financial statements. This clue is deferred tax expense, and it can help
detect earnings management (Phillips, Pincus, and Rego, 2003). Based on available
financial accounting information, we develop a model to comprehensively measure
book-tax total earnings management (BTTEM). This model is similar to that used in
Vu, DuVal, Quilliam, and Santos (2015). We hypothesize that BTTEM is more
powerful than earnings management measures used in past research which
considered mainly accruals earnings management. One way in which BTTEM is
more powerful is that it can find earnings management related to deferred tax
expense, and therefore taxable income, even when there is little or no management
of accruals in book income.
Our estimation of BTTEM is comprised of two parts. First, we classified book-tax
differences into “explainable” and “unexplainable” components by developing a
regression model, using variables from prior studies which examined variability in
book-tax differences. This enables us to quantify the amount of book-tax differences
which structural factors can explain. In the second part of the estimation, we posit
that the unexplainable residual is total earnings management which is explained by
other factors, such as tax sheltering activity and management of accruals by
management (Manzo and Plesko, 2002). We then calculate the standard deviation
of each company’s unexplained residuals across the sample period. This standard
deviation is our variable BTTEM. This standard deviation indicates the level of
discretionary total earnings management, which fluctuates over time.
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
We then selected company variables to explain the “explainable” component of
book-tax differences, based on the work of Manzon and Plesko (2002) and
Schallheima and Wells (2006). The estimation model from their work is:
Book-tax differencesi,t = αi,t + β1dSALE + β2dPRBA + β3dGDWL + β4PPENT/PPEGT
+ β5PPEGT + β6PIFO + β7DCLO + β8NonGDWLINTAN + εi,t where dSale is change
in net sales, dPRBA is change in post-retirement benefits funded, dGDWL is change
in goodwill, PPNET/PPEGT is net Plant, Property and Equipment to gross Plant,
Property and Equipment, PIFO is foreign pretax income, DCLO is capitalized lease
obligations, and NonGDWLINTA is non-goodwill tangible assets.
We then calculate the two conventional variables which help to indicate the
adequacy of BTTEM. These two conventional measures are abnormal accruals and
accruals quality. Abnormal accrual is the absolute value of the residuals in the Lee
and Masulis (2009) model. Accruals quality is the standard deviation of abnormal
accruals. It is also calculated based on the Lee and Masulis (2009) model.
Table 1: Variable Definitions
These variables are also used in Vu, DuVal, Quilliam, and Santos (2015).
Variable
BTD
OPTEXD
OPTGR
ROA
CAPX
SIZE
PTB
HighTaxPlanning
LowTaxPlanning
BTTEM
Abnormal Accruals
Accruals Quality
OPEPS
Loss
dCFO
STDROA
INTCOV
BLEV
dSale
MTB
SCASH_AT
Zscore
Dividend cut
Definition
Book-tax difference measured by the difference
between book income and taxable income
Stock options exercised during the year
Stock options granted
Return on assets
Capital expenditures
Firm size, measured as Ln(Total Assets)
Price to Book ratio is defined as Market Value divided by Common Equity – Total.
A dummy variable for firms with an effective tax
rate in the bottom quartile
A dummy variable for firms with an effective tax
rate in the top quartile
Book-tax total earnings management
Abnormal accruals measured by the modified
Dechow and Dichev (2002) model Absolute
Lee and Masulis (2009) and modified Dechow
and Dichev (2002) models
Standard deviation of abnormal accruals
measured by the Francis et alLee and Masulis .
(20095) and modified Dechow and Dichev
(2002) - MDD models
Earnings per share from operations
A (01) dummy that has a value of 1 if EPS is
negative, and 0 otherwise
Change in operating cash flow
Standard deviation of ROA over 5 years
Interest coverage ratio measured as operating
income before depreciation divided by interest
expense
Book leverage
Sales growth
Market to book ratio
Cash surplus scaled by total assets
Altman Z-score
An indicator variable that takes the value of
one if there is a reduction in annual dividend,
and zero otherwise
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
Table 2: Top 25 US Firms with the Highest BTDTEM, Abnormal Accruals and Absolute Accruals per Year over
2004 - 2010 Periods (Millions of Dollars)
These firms are also used in Vu, DuVal, Quilliam, and Santos (2015).
Panel A: This table reports the firms with the highest average of Total Book-Tax Differences over sample period of 2004
to 2010. This sample is ranked by Total book tax spread. Firms with non-reporting or missing variables were dropped from
this sample.
Company_Name
GAZPROM O A O - ADR
HEWLETT-PACKARD CO
GENERAL MOTORS CO
GENERAL ELECTRIC CO
LIBERTY GLOBAL INC
HONEYWELL INTERNATIONAL INC
PEPSICO INC
INTL BUSINESS MACHINES CORP
OWENS CORNING
KONINKLIJKE PHLPS ELC - ADR
PETROBRAS BRASILEIRO SA - ADR
COCA-COLA CO
JDS UNIPHASE CORP
DOW CHEMICAL
PROCTER & GAMBLE CO
WAL-MART STORES INC
PETROCHINA CO LTD - ADR
NESTLE SA - ADR
SPRINT NEXTEL CORP
UNITED TECHNOLOGIES CORP
NOVARTIS AG - ADR
VALE SA - ADR
FLEXTRONICS INTERNATIONAL
BHP BILLITON GROUP (GBR) - ADR
JOHNSON & JOHNSON
MKVALT
NA
92651.87
55295.05
194155.23
8419.00
41624.28
103286.73
180220.25
3865.72
NA
NA
150744.84
2175.89
39848.79
170553.13
197142.12
NA
NA
12639.24
72522.30
NA
NA
5654.74
NA
169351.30
AVG_TBTD
15,761.93
14,663.27
13,919.69
12,500.57
10,335.66
10,272.51
8,865.47
8,221.92
7,848.43
7,576.78
7,212.35
7,083.51
6,759.65
6,042.12
5,843.31
5,610.55
5,534.30
4,265.05
4,228.90
4,030.80
3,929.39
3,925.98
3,877.71
3,438.19
3,252.76
AVG_BTDTEM
0.0211
0.0386
0.0647
0.0088
0.0206
0.0682
0.0184
0.0134
0.2360
0.0158
0.0208
0.0174
0.3597
0.0195
0.0211
0.0103
0.0160
0.0154
0.0412
0.0158
0.0236
0.0302
0.0679
0.0352
0.0185
AVG_Accruals
0.0205
0.0175
0.0227
0.0072
0.0121
0.0121
0.0113
0.0107
0.0585
0.0095
0.0173
0.0137
0.0497
0.0151
0.0127
0.0085
0.0140
0.0090
0.0152
0.0095
0.0197
0.0281
0.0192
0.0247
0.0171
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
Table 2: Top 25 US Firms with the Highest BTDTEM, Abnormal Accruals and Absolute Accruals per Year over
2004 - 2010 Periods (Millions of Dollars)
Panel B: This table reports the firms with the highest average of BTTEM and Accruals over sample period of 2004 to
2010. This sample is ranked by BTTEM and Accruals.
Company_Name
MKVALT
Abnormal
Accruals
MKVALT
Absolute
Accruals
WAVE SYSTEMS CORP -CL A
320.5
0.5818
WAVE SYSTEMS CORP -CL A
EMAGIN CORP
127.2
0.5304
BIOTIME INC
320.5
0.8220
NA
0.6867
NA
0.4193
281.0
0.3531
NYMOX PHARMACEUTICAL CORP
229.3
0.6247
KERYX BIOPHARMACEUTICALS INC
281.0
145.2
0.5214
0.3397
CELL THERAPEUTICS INC
297.0
0.4570
DEPOMED INC
CYTORI THERAPEUTICS INC
336.8
0.3390
ACHILLION PHARMACEUTICALS
242.2
0.4124
269.6
0.3361
DEPOMED INC
336.8
0.4884
0.3677
VALENCE TECHNOLOGY INC
241.7
0.3188
AMERICA'S CAR-MART INC
256.9
0.3579
MKVALT
BTTEM
1 ACURA PHARMACEUTICALS INC
145.2
1.4963
2 ZIX CORP
286.8
1.3957
3 WAVE SYSTEMS CORP -CL A
320.5
0.7691
BIOTIME INC
NA
0.7462
KERYX BIOPHARMACEUTICALS INC
5 LIGHTING SCIENCE GROUP CORP
408.1
0.7336
ACURA PHARMACEUTICALS INC
6 EMAGIN CORP
127.2
0.6856
7 KERYX BIOPHARMACEUTICALS INC
281.0
0.5874
8 CLEVELAND BIOLABS INC
209.0
4 BIOTIME INC
Company_Name
Company_Name
9 SANTA FE GOLD CORP
83.6
0.4646
CELL THERAPEUTICS INC
297.0
0.3112
LIGHTING SCIENCE GROUP CORP
408.1
0.3511
10 ACHILLION PHARMACEUTICALS
242.2
0.4511
CLEVELAND BIOLABS INC
209.0
0.2863
VALENCE TECHNOLOGY INC
241.7
0.3508
11 IDENIX PHARMACEUTICALS INC
368.3
0.4113
NYMOX PHARMACEUTICAL CORP
229.3
0.2584
INTERSECTIONS INC
186.1
0.3291
12 OSIRIS THERAPEUTICS INC
255.4
0.3875
APRICUS BIOSCIENCES INC
64.2
0.2377
GTX INC
137.0
0.3212
13 NYMOX PHARMACEUTICAL CORP
229.3
0.3826
AVANIR PHARMACEUTICALS INC
306.1
0.2247
SPANSION INC
1,278.0
0.2977
14 APPLIED MICRO CIRCUITS CORP
660.8
0.3690
POZEN INC
2,175.8
0.3597
AARON'S INC
16 DEPOMED INC
336.8
0.3454
TARGACEPT INC
17 SPANSION INC
1,278.0
0.3379
241.7
0.3365
15 JDS UNIPHASE CORP
18 VALENCE TECHNOLOGY INC
19 OCE NV -ADR
198.8
0.2163
ACURA PHARMACEUTICALS INC
145.2
0.2808
1,632.9
0.2088
HALOZYME THERAPEUTICS INC
796.0
0.2669
765.0
0.1955
DYNAVAX TECHNOLOGIES CORP
369.9
0.2634
TERRA NITROGEN CO -LP
2,020.1
0.1915
ACORDA THERAPEUTICS INC
1,056.7
0.2631
VONAGE HOLDINGS CORP
496.3
0.1913
STAR SCIENTIFIC INC
247.8
0.2522
3,677.4
0.2491
855.2
0.2449
2,488.5
0.2372
NA
0.3268
LEAPFROG ENTERPRISES INC
359.3
0.1907
CTC MEDIA INC
20 CYTORI THERAPEUTICS INC
269.6
0.3233
U S ANTIMONY CORP
33.7
0.1894
LIONS GATE ENTERTAINMENT CP
21 MERGE HEALTHCARE INC
314.2
0.3228
DYNAVAX TECHNOLOGIES CORP
369.9
0.1835
DREAMWORKS ANIMATION INC
22 EMERGENT BIOSOLUTIONS INC
821.3
0.3211
METROPOLITAN HLTH NTWRKS INC
182.1
0.1796
SANTA FE GOLD CORP
83.6
0.2256
23 GEEKNET INC
157.0
0.3175
STAR SCIENTIFIC INC
247.8
0.1731
MICROMET INC
740.2
0.2140
24 CELL THERAPEUTICS INC
297.0
0.3163
WINN-DIXIE STORES INC
530.9
0.1720
EMAGIN CORP
127.2
0.2127
25 LEAPFROG ENTERPRISES INC
359.3
0.3068
IMMERSION CORP
189.4
0.1664
OPTIMER PHARMACEUTICALS INC
444.2
0.2078
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
4. Findings/Discussion
The existing literature has provided evidence that corporate insiders manipulate
earnings accruals to obtain a better exercise price for their stock options. Baker et al.
(2008) reports that insiders manage earnings to lower the share price on the option
grant date so that a lower exercise price could be selected. Aboody and Kasznik
(2000) find that bad news tends to precede grant dates and good news tends to
follow. Heron and Lie (2007) document that managers have the ability to manipulate
the grant date around known share price history. However, there is conflicting
evidence regarding the relation between earnings management and executive stock
option exercises. For example, Bartov and Mohanram (2004) and Bergstresser and
Philippon (2006) find evidence that managers influence share price movements and
time their stock option exercises accordingly. In sharp contrast, Carpenter and
Remmers (2001) find no evidence that insiders use private information to time option
exercises. Aboody, Hughes, Liu and Su (2008) also report only weak evidence that
option exercises precede bad news. Armstrong, Jagolinzer, and Larcker (2010) find
that accounting irregularities occur less frequently at firms where CEOs have higher
levels of stock and option based compensation. Armstrong et al. (2010) also find
conflicting results among ten recent studies on the relation between accounting
manipulation and executive stock option holdings.
Given the conflicting evidence on executive stock option exercises when earnings
management is measured by accruals, we re-examine the relation between earnings
management and executive stock option exercises using the book-tax total earnings
management (BTTEM) measure developed in this study. It is similar to the model
developed in Vu, DuVal, Quilliam, and Santos (2015). We hypothesize that the new
measure is better than conventional measures of earnings management because it
can detect the influence of taxable income related earnings management on
executive stock option exercises even when book income earnings management is
absent. This also helps us to determine whether our model is more powerful than
conventional earnings management measures.
We developed the following model based on that of McCannally (2008):
OPTEXDi,t
=
c
+
β1BTTEMi,t
+
β2HighTaxPlanning*BTTEMi,t
+
β3LowTaxPlanning*BTTEMi,t + β4Optgri,t + β4EPSi,t -1 + β5ROA,t + β6DVi,t + β7CAPXi,t
+ β8SIZEi,t + β9PTBi,t + β10HighTaxPlanningi,t + β11Industry Dummies + β12Year
Dummies + ϵi,t
Where OPTEXDi,t is executive stock option exercises, BTTEM is the book-tax total
earnings management measure, and PTB is Price to Book ratio which is defined as
market value divided by total common equity.
Following McCannally, option grants (OPTGR) is added as a second incentive
variable to allow for the situation that insiders may face multiple option related
incentives. The other control variables are chosen based on findings in the existing
literature. Similar to Dyreng et al. (2008), high tax planning firms are firms that have
an accumulated effective tax rate in the bottom quartile and low tax planning firms as
firms that have an accumulated effective tax rates in the top quartile. For
comparison, we also perform the model estimation using conventional measures of
earnings management, namely, abnormal accruals and accruals quality,
respectively. Table 3 includes descriptive statistics for the variables in the
regression model.
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
Table 3: Descriptive Statistics for Key Variables
Variables for examining insiders’ stock option exercises and earnings management
(N=8,723)
/Variable
OPTEXD
Maximum
309.000
Minimum
0.000
Mean
1.894
Median
0.430
Std Dev
7.061
STDRES
15.343
0.004
0.103
0.053
0.274
OPTGR
230.000
0.000
1.911
0.510
7.032
OPEPS
130.000
-36.000
1.427
1.110
3.759
69.500
-534.710
2.616
5.210
16.857
12408.000
0.000
110.464
0.000
564.337
ROA
DIVIDEND
CAPX
40595.200
0.000
323.817
35.780
1341.920
TOTAL ASSETS
797769.000
1.710
6079.400
1016.930
26521.280
PRICE to BOOK
1574.980
0.075
3.850
2.255
20.323
1.000
0.000
0.237
0.000
0.425
HIGHTAXPLANNING
Table 4 presents the estimation result of the model. A priori, we posit that BTTEM is
more accurate and powerful in predicting executive stock option exercises because
of the additional information captured by taxable-income related earnings
management. In column 1 of the book-tax earnings management model, the
coefficient on BTTEM is positive and significant at the 1% level. It confirms that there
are higher levels of executive stock option exercises when earnings management is
elevated. The result is consistent with the findings of Bartov and Mohanram (2004)
and Bergstresser and Philippon (2006). In column 2 of the book-tax earnings
management model, we add to the model the interaction between tax planning and
book-tax
total
earnings
management.
The
interaction
variable
HighTaxPlanning*BTTEM indicates that the book-tax total earnings management
(BTTEM) has high levels of taxable income related earnings management. The
interaction variable LowTaxPlanning*BTTEM indicates that the BTTEM has lower
levels of taxable-income related earnings management as the firm is a low taxplanner. The coefficient on HighTaxPlanning*BTTEM is positive and significant at the
1% level, indicating that executives exercise their options upon managing book
income and/or taxable income. The coefficient on LowTaxPlanning*BTTEM is also
positive and also significant at the 1% level, suggesting that executives exercise
their options upon managing book income and taxable income even though the
amount of taxable income related earnings management might be relatively smaller.
In short, executives exercise their options following earnings management
regardless of the source of earnings management.
The result of the abnormal accruals model shows that abnormal accruals has a
positive coefficient that is significant at the one percent level. However, the result of
the accruals quality model shows that accruals quality has a negative coefficient that
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
Table 4: Regression Analysis of Insiders’ Stock Option Exercises and Earnings Management
Book-tax earnings management model
(Earnings management is measured by BTTEM)
Intercept
t value
Earnings Management
(1)
(2)
-0.124
(-1.62)
0.018***
(2.92)
-0.164**
(-2.19)
HighTaxPlanning*EarningsManagement
LowTaxPlanning*EarningsManagement
OPTGR (Options Granted)
OPEPS
ROA
Dividend
CAPX
Size
Price To Book
LagOptexd
HighTaxPlanning
Industry dummies
Year dummies
Adj R-squared
0.335***
(24.96)
-0.002**
(-2.18)
0.002***
(5.63)
0.001
(0.27)
0.008
(1.23)
0.094***
(12.85)
0.131***
(16.96)
0.133***
(28.40)
-0.073***
(-5.67)
Yes
Yes
0.6623
Abnormal accruals model
(Earnings management is
measured by abnormal
accruals)
Accruals quality model
(Earnings management
is measured by
accruals quality)
3.762***
(7.76)
0.210***
(3.23)
3.402***
(8.43)
0.063***
(3.26)
0.032***
(6.53)
0.009***
(2.78)
0.335***
(25.39)
-0.002**
(-2.22)
0.002***
(6.15)
-0.000
(-0.01)
0.007
(1.06)
0.095***
(13.01)
0.130***
(17.03)
0.133***
(28.54)
0.507***
(9.74)
-0.652***
(-10.37)
0.322***
(6.49)
-0.016
(-1.25)
0.031
(0.77)
-0.398***
(-7.29)
0.496***
(7.79)
0.027*
(1.76)
0.512***
(9.72)
-0.661***
(-10.31)
0.319***
(6.42)
-0.020
(-1.62)
0.026
(0.65)
-0.417***
(-7.23)
0.505***
(7.69)
0.027*
(1.76)
Yes
Yes
0.6625
Yes
Yes
0.2401
Yes
Yes
0.2423
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
Observations
8,723
8,723
5,622
5,622
*, **, *** Significant at the 10 percent, 5 percent, and 1 percent levels, respectively.
Adj. R-Squared
Observations
0.8816
1,593 x 5
0.8816
1,593 x 5
0.7705
6,022
0.7705
6,022
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
is significant at the 10 percent level. The negative coefficient is unexpected and
contradictory to existing results in the literature. This inconsistency and its conflict
with the abnormal accruals model, however, confirms that survey result of Dechow et
al. (2010) that conventional measures of earnings management sometimes could
lead to inconsistent findings. The results of Table 4 confirm the importance of
considering taxable income related earnings management in examining a firm’s
manipulation of earnings.
5. Conclusions/Implications
In this study a new measure of earnings management is developed from book-tax
differences. The new BTTEM is a comprehensive measure that encompasses
taxable income related earnings management as well as conventional book income
related accruals management. As such, the measure is able to detect the influence
of taxable income related earnings management even when book income earnings
management is absent.
Using the new measure, we find executives time their stock option exercises
regardless of the source of earnings management. This study shows that the new
measure of earnings management performs equally well or better than conventional
accrual based measures of earnings management and is well suited to examine the
relationship between earnings management and stock option exercises. All these
results have practical implications for investors.
The finding that executives time their stock option exercises regardless of the source
of earnings management should be explored further. If the source of earnings
management is irrelevant for the timing of stock option exercises, what other
incentives do companies find for using one source or another?
References
Aboody, David et al. 'Are Executive Stock Option Exercises Driven By Private
Information?'. Review of Accounting Studies 13.4 (2007): 551-570. Web.
Aboody, David, Ron Kasznik, and Michael Williams. 'Purchase Versus Pooling In
Stock-For-Stock Acquisitions: Why Do Firms Care?'. Journal of Accounting and
Economics 29.3 (2000): 261-286. Web.
Armstrong, et al. 'Performance-Based Incentives For Internal Monitors'. SSRN
Electronic Journal (2010): n. pag. Web.
Armstrong, Chris S., Alan D. Jagolinzer, and David F. Larcker. 'Chief Executive
Officer Equity Incentives And Accounting Irregularities'. Journal of Accounting
Research 48.2 (2010): 225-271. Web.
Atwood, T.J., Michael S. Drake, and Linda A. Myers. 'Book-Tax Conformity, Earnings
Persistence And The Association Between Earnings And Future Cash Flows'.
Journal of Accounting and Economics 50.1 (2010): 111-125. Web.
Ayers, Benjamin C., John (Xuefeng) Jiang, and Stacie K. Laplante. 'Taxable Income
As A Performance Measure: The Effects Of Tax Planning And Earnings
Quality'. Contemporary Accounting Research 26.1 (2009): 15-54. Web.
Ayers, Benjamin C., John (Xuefeng) Jiang, and P. Eric Yeung. 'Discretionary
Accruals And Earnings Management: An Analysis Of Pseudo Earnings
Targets'. The Accounting Review 81.3 (2006): 617-652. Web.
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
Baker, T., D. Collins, and A. Reitenga. 'Stock Option Compensation And Earnings
Management Incentives'. Journal of Accounting, Auditing and Finance 18
(2003): n. pag. Print.
Bartov, Eli, and Partha Mohanram. 'Private Information, Earnings Manipulations, And
Executive Stock‐Option Exercises'. The Accounting Review 79.4 (2004): 889920. Web.
Bergstresser, Daniel, and Thomas Philippon. 'CEO Incentives And Earnings
Management'. Journal of Financial Economics 80.3 (2006): 511-529. Web.
Bernard, V., J. Healy, and K. Palepu. 'Business Analysis And Valuation.Using
Financial Statements'. Cincinnati, OH; South-Western College Publishing
(2005): n. pag. Print.
Blaylock, Bradley, Fabio Gaertner, and Terry Shevlin. 'The Association Between
Book-Tax Conformity And Earnings Management'. Review of Accounting
Studies 20.1 (2014): 141-172. Web.
Carpenter, Jennifer N., and Barbara Remmers. 'Executive Stock Option Exercises
And Inside Information'. The Journal of Business 74.4 (2001): 513-534. Web.
Cheng, C.S., and Q.J. Yin. 'Earnings Management Of Profit Firms And Loss Firms In
Response To Tax Rate Reductions'. Review of Accounting & Finance 3 (2004):
67-92. Print.
Dechow, Patricia M., and Ilia D. Dichev. 'The Quality Of Accruals And Earnings: The
Role Of Accrual Estimation Errors'. The Accounting Review 77.s-1 (2002): 3559. Web.
Dechow, Patricia, Weili Ge, and Catherine Schrand. 'Understanding Earnings
Quality: A Review Of The Proxies, Their Determinants And Their
Consequences'. Journal of Accounting and Economics 50.2-3 (2010): 344-401.
Web.
Desai, Mihir A., and Dhammika Dharmapala. 'Earnings Management, Corporate Tax
Shelters, And Book-Tax Alignment'. National Tax Journal 62.1 (2009): 169-186.
Web.
Dyreng, Scott D., Michelle Hanlon, and Edward L. Maydew. 'Long‐Run Corporate
Tax Avoidance'. The Accounting Review 83.1 (2008): 61-82. Web.
Ecker, Frank et al. 'A Returns‐Based Representation Of Earnings Quality'. The
Accounting Review 81.4 (2006): 749-780. Web.
Francis, Jennifer, and Katherine Schipper. 'Have Financial Statements Lost Their
Relevance?'. Journal of Accounting Research 37.2 (1999): 319. Web.
Francis, Jennifer et al. 'The Market Pricing Of Accruals Quality'. Journal of
Accounting and Economics 39.2 (2005): 295-327. Web.
Guenther, David A, and Danqing Young. 'The Association Between Financial
Accounting Measures And Real Economic Activity: A Multinational Study'.
Journal of Accounting and Economics 29.1 (2000): 53-72. Web.
Hanlon, Michelle. 'The Persistence And Pricing Of Earnings, Accruals, And Cash
Flows When Firms Have Large Book‐Tax Differences'. The Accounting Review
80.1 (2005): 137-166. Web.
Heron, Randall A., and Erik Lie. 'Does Backdating Explain The Stock Price Pattern
Around Executive Stock Option Grants?'. Journal of Financial Economics 83.2
(2007): 271-295. Web.
Joos, P., J. Pratt, and D. Young. 'Book-Tax Differences And The Value Relevance Of
Earnings'. SSRN Working Paper Series (2000): n. pag. Print.
Proceedings of Annual Spain Business Research Conference
14 - 15 September 2015, Novotel Barcelona City Hotel, Barcelona, Spain
ISBN: 978-1-922069-84-9
Lee, Gemma, and Ronald W. Masulis. 'Seasoned Equity Offerings: Quality Of
Accounting Information And Expected Flotation Costs☆'. Journal of Financial
Economics 92.3 (2009): 443-469. Web.
Lev, Baruch, and Doron Nissim. 'Taxable Income, Future Earnings, And Equity
Values'. The Accounting Review 79.4 (2004): 1039-1074. Web.
Manzon, Jr., Gil B., and George A. Plesko. 'The Relation Between Financial And Tax
Reporting Measures Of Income'. SSRN Electronic Journal (2002): n. pag. Web.
McAnally, Mary Lea, Anup Srivastava, and Connie D. Weaver. 'Executive Stock
Options, Missed Earnings Targets, And Earnings Management'. The
Accounting Review 83.1 (2008): 185-216. Web.
Phillips, John, Morton Pincus, and Sonja Olhoft Rego. 'Earnings Management: New
Evidence Based On Deferred Tax Expense'. The Accounting Review 78.2
(2003): 491-521. Web.
Schallheim, J., and K. Wells. 'Debt And Taxes: A New Measure For Non-Debt Tax
Shields'. Working Paper (2006): n. pag. Print.
Sloan, R. 'Do Stock Prices Fully Reflect Information In Accruals And Cash Flows
About Future Earnings'. The Accounting Review 71 (1996): 289-315. Print.
Vu, Q., C. DuVal, W. Quilliam, and N. Santos. “Examining the Effects of Book-Tax
Differences on Stock Price Manipulations’. Working Paper (2015).