Earnings Management Induced by Tax Planning

Journal of International Accounting, Auditing and Taxation 20 (2011) 83 96

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Journal of International Accounting,Auditing and Taxation

Earnings management induced by tax planning: The case ofPortuguese private rms

Mrio Marquesa,, Lcia Lima Rodriguesa,1, Russell Craigb,2

a University of Minho, School of Economics and Management, Campus de Gualtar, 4710-057 Braga, Portugalb University of Canterbury, College of Business and Economics, Private Bag 4800, Christchurch 8140, New Zealand

a r t i c l e i n f o

Keywords:Earnings managementIncome taxSpecial payment on account

a b s t r a c t

In Portugal, a concept of taxable income associated closely with reported accounting incomeis used to determine the tax liability of rms. Recently, the Portuguese government legis-lated to introduce a system of special payment on account (SPA). Firms were requiredto pay an amount of income tax in advance that varied between a promulgated minimumand maximum. Although such a tax is unique to Portugal, other countries have tax arran-gements that are similar in intent. Thus, Portugals experience with the introduction of aSPA regime is likely to be instructive in scal policy deliberations in other settings.

We assess the extent to which the SPA tax policy measure encouraged private Portuguesecompanies to manipulate earnings. We nd that earnings manipulation appears to havebeen motivated by desire to minimize SPA. Firms whose estimate of SPA liability fell withinthe range of minimum and maximum limits of the SPA had higher levels of discretionaryaccruals than rms whose estimate was (equal to or) above the ceiling imposed by thenew legislation. Firms with higher rates of income tax were found to reduce earnings tonear zero. Firms with higher average income tax rates were more likely to manipulate theirearnings than other rms.

Our results reinforce the importance for auditors, stakeholders, and tax policy advisors tobe alert to the close association between tax planning considerations and reported earningsin their monitoring, analysis, and policy advising activities.

2011 Elsevier Inc. All rights reserved.

1. Introduction

The implication of tax considerations in earnings management practices has been under-researched in continental Euro-pean countries (such as Germany, Belgium, France, Italy and Portugal) in which a rms liability for taxation is based ona measure related closely to reported accounting income. In Portugal there is a strong link between accounting and taxa-tion. Article 17 of the Code of Companies Income Tax (Cdigo do Imposto sobre o Rendimento das Pessoas Colectivas CIRC)calculates income tax liability based on:

. . . the sum of net prot for the year and the positive and negative variations in shareholders equity that were recordedin the same period but that did not affect the earnings, calculated based on accounting and possibly corrected inaccordance with this Code.

Corresponding author. Tel.: +351 253 601 946; fax: +351 253 601 380.E-mail addresses: [email protected] (M. Marques), [email protected] (L.L. Rodrigues), [email protected] (R. Craig).

1 Tel.: +351 253 604 559; fax: +351 253 601 380.2 Tel.: +64 3 364 3026; fax: +64 3 364 2727.

1061-9518/$ see front matter 2011 Elsevier Inc. All rights reserved.doi:10.1016/j.intaccaudtax.2011.06.003

84 M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 83 96

Despite this, there has been no study of the association between tax planning and earnings management behaviour byPortuguese private rms. Thus, the present investigation of whether Portuguese private rms manipulate their earnings tominimize income tax payments presents timely evidence of some perverse effects that emerge from the connection betweena national accounting system and a national tax system.

Prior studies in other continental European countries (e.g. Baralexis, 2004; Coppens & Peek, 2005; Othman & Zeghal,2006) show the potential for the accounting basis of income tax liability to inuence accounting manipulations. In Portugalit is believed widely that private rms pay taxes well below what they would pay if their tax liability was based on the realincome obtained from business operations. In the last decade, like many governments in other countries, the Portuguesegovernment has attempted to combat tax evasion and tax fraud through legislative measures to reduce abusive tax planningpractices. In 1998, a special payment on account [SPA] initiative required entities to pay income tax in advance, basedon sales revenues for the previous year. This legislative measure was intended to mitigate some undesirable effects of thealignment of the Portuguese taxation system with the Portuguese accounting system.

Other countries have adopted different scal policy initiatives to help combat corporate tax evasion and fraud. In Australiaand New Zealand, for example, income tax payments based on provisional expectations of taxable income in the succeedingyear are used. But such provisional tax regimes do not have a minimum or maximum specied tax liability. The amount ofprovisional tax can be based on last years residual income tax plus an adjustment or be based on an estimate of the nextyears income. In the USA, an Alternative Minimum Tax [AMT] was introduced as part of the Tax Reform Act of 1986 inresponse to concerns that a number of rms that reported positive book prots to their shareholders paid no corporatetax to the federal government (Lyon & Silverstein, 1995, p. 153). Under the AMT, a corporation is required to calculateits tax liability under both the regular tax rules and the AMT rules . . . [and pay] tax according to the system that results inthe largest income tax liability (Lyon & Silverstein, 1995, p. 153). As these examples suggest, the matter of how to combatunder-payment of tax by corporations is of keen interest in many countries. Consequently, the experience of Portugal inintroducing its unique SPA system should be instructive.

Moreiras (2007) assessment of the impact of the new SPA system focused on the extent to which the introduction of aminimum tax threshold encouraged companies that otherwise would report negative earnings to change to report positiveearnings. The focus of the current paper is on the impact of the amendment to the minimum and maximum limits of SPApayments that took effect in 2003. Law No. 32-B/2002 (State budget for 2003) increased the minimum SPA limit to D 1250 andraised the maximum SPA limit to D 200,000. The new system retained the provision that any excess SPA would be repayablethrough deduction against income tax for the year or the following four years, if necessary. This new provision seemed toimply that rms would not seek refunds of excessive SPA because of the requirement for tax audit. The objective of thepresent paper is to determine whether this amendment stimulated strong manipulative behaviour by rms to minimize theamount of the SPA.

This paper contributes to the meagre volume of research on tax-induced earnings manipulation in continental Europeancountries by providing new empirical data about tax-related practices of Portuguese private rms. With few exceptions,the present literature is based on empirical data from Anglo-Saxon countries. Evidence from other geographic, cultural andinstitutional contexts will be useful in providing a comparative counterpoint, especially as the determinants of earningsmanipulation in Continental Europe (particularly in Portugal) are not well understood. This is in contrast to understandingsof earnings management in common law English-speaking countries (such as Australia, Canada, UK, USA).

The present study highlights an innovative taxation mechanism that aimed to reduce tax evasion. The results indicatethe propensity for private rms to minimize tax payments through SPA arrangements. Although there is a consensus inPortuguese society that companies manipulate earnings for tax reasons, no study has hitherto provided empirical evidencein support of such supposition. This study offers an empirical foundation for deliberations regarding the effects of the closealignment of the accounting system and the tax system in Portugal. The results reveal some of the problems that havestemmed from implementing legislative measures such as the SPA. They should be benecial to stakeholders of privaterms, auditors, and tax policy advisors.

In the following section we describe the framework used to explore the earnings management, accounting and taxenvironments in which Portuguese private rms operate. Thereafter, we present research hypotheses, describe our researchmethod, and discuss results.

2. Earnings management and the accounting and tax context of Portuguese private rms

2.1. Earnings management incentives

Earnings management (EM) occurs when nancial information is modied to inuence the decisions of stakeholders(Healy & Wahlen, 1999). Manipulative practices are facilitated by the exibility of accounting standards which allowconsiderable discretion in adopting accounting policies, and in making required estimates.

Most studies of EM incentives have been produced in well developed economies where the capital market is the mainsource of funding, and thus, where agency problems are potentially more important (e.g. Dechow, Sloan, & Sweeney 1996;Healy, 1985; Jones, 1991; Sweeney, 1994). Healy and Wahlen (1999) identied three major groups of incentives: capitalmarkets, contractual relationships (e.g. compensation plans for managers) and political factors (e.g. political costs). Theseincentives are not the main factors encouraging EM in economies (such as Portugals) that are composed essentially by small

M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 83 96 85

companies whose management is exercised mainly by the holders of capital (Moreira, 2006). In these contexts, althoughcontractual relationships encourage manipulation, tax saving is identied as one of the main incentives prompting rms tomanipulate their accounts (Baralexis, 2004; Blake & Salas, 1996; Moreira, 2006; Othman & Zeghal, 2006). In Portugal somestudies have examined associated matters. Moreira (2006) focused on the impact of the external nancing needs of rmson accounting choices; and Mendes and Rodrigues (2006) examined earnings smoothing in a sample of listed Portuguesecompanies.

2.2. The accounting and tax environment of Portuguese private rms

In Portugal there is a strong link between accounting and taxation. The principal sources of funding of Portuguese privaterms are the banks and the State the main users of nancial statements (Fontes, Rodrigues, & Craig 2005). The presentPortuguese system of income taxation was established in 1989, but by the end of the 1990s it was considered inadequate,because the actual rate of income tax paid by companies was very low (Decree-Law No. 44/98 of March 3). Subsequently,Portugal attempted to combat tax evasion and fraud by improving the effectiveness and efciency of inspection services,and by legislative measures that penalized tax evasion severely.

In 1998, Decree-Law No. 44/98 obliged taxpayers engaged in commercial, industrial or agricultural activity to make anadvance tax payment, known as a special payment on account [SPA]. The SPA was not to be based on the level of earnings,but on the level of sales revenues. A minimum limit was set for the SPA of approximately D 500, with a maximum limit ofapproximately D 1500. According to Sanches and Matos (2003), the SPA payment system was expected to deliver a minimumvalue of approximately D 500 to the State by each rm. Article 74 of the decree-law also established the possibility that ataxpayer could be repaid for any excess payment should the amount of tax liability ultimately be less than the paymentsalready made.

However, a signicant change to the SPA occurred when Law No. 32-B/2002 was enacted (State budget for 2003). Theminimum SPA limit was increased to D 1250 and the maximum SPA limit was increased to D 200,000. The new systemretained the provision that any excess SPA would be repayable through a deduction against income tax for the present yearor the following four years, if necessary. Amounts not recovered through tax deduction were repayable provided taxpayersmet the requirements of paragraph 3 of Article 87 of the CIRC:

(a) the companys average ratios of protability for the year of the SPA should not be less than 10% of the ratio of othercompanies in the same industry;

(b) the situation that gave rise to the reimbursement is considered justied by the inspection which should be made at therequest of the taxpayer within 90 days of the deadline for submission of the tax statement for the year.

3. Research hypotheses

Studies by Hayn (1995) and Burgstahler and Dichev (1997) prompted the adoption of graphical analysis to explore thestatistical distribution of reported earnings and to assess and evaluate EM. Where the distribution of reported earnings ofrms was irregular, this was attributed to EM practices. Coppens and Peek (2005) showed that in European countries witha strong link between accounting and taxation, the distribution of reported prots was discontinuous between the intervalimmediately to the right of zero (the rst positive earnings interval) and the second interval of positive earnings. That is,the second interval of positive earnings is signicantly lower than the rst interval of positive earnings. The curve for thedistribution of prots to the right of zero was concave. Moreover, Coppens and Peek (2005) noted that in countries wheretaxable income and accounting income are calculated using separate rules, the second interval of positive earnings is higherthan the rst interval of positive earnings, and the curve of prots distribution is convex. These ndings have motivated usto investigate whether the distribution of the earnings of private rms in Portugal (where the tax system and accountingsystem are linked closely), is congured with the distribution identied by Coppens and Peek (2005). Thus, we seek todetermine whether there is a large concentration of rms in the rst interval of earnings to the right of zero.

The lack of systematic examination of income tax minimizing manipulations by rms in Portugal encourages us toinvestigate whether the large concentration of earnings near zero is due to manipulations motivated by tax avoidancestrategies. We do not expect to nd a large number of companies with negative earnings. This is because nancial statementsare used widely in Portugal in obtaining bank nance, and any reporting of negative earnings would be likely to jeopardizeloan repayment assessments.

With the introduction of the SPA in 1998, the minimum and maximum SPA limits were very low (D 500 and D 1500,respectively). At that time, rms had little incentive to react strongly to minimize the amount of SPA payments. However, LawNo. 32-B/2002 of December 30, 2002 introduced very signicant changes, particularly with respect to the maximum amountto be paid (increased to D 200,000). Since the basis of calculation in the changes to the SPA was accounting information for2002, we expect that Portuguese private rms will have reacted strongly in 2002 to reduce SPA payments through EMactivities.

Burgstahler and Dichev (1997) and Degeorge, Patel, and Zeckhauser (1999) examine whether the earnings reported havea discontinuous distribution around zero. Such discontinuity is accepted widely to be a consequence of earnings smoothing.The rst hypothesis tested is:


Table 1Sample selection.

Description No. of companies

Number of companies in SABI 20,088Exclusions:Listed companies (95)Financial sector (132)Cooperatives, associations and companies without legal form (1042)Required data not available for both years (12,167)Sample 6652

Hypothesis 1. There is no difference in the frequency of slightly negative earnings and the frequency of slightly positiveearnings.

We expect to conrm the ndings of Coppens and Peek (2005), outlined earlier. Since accounting earnings in Portugal arethe starting point for determining taxable income, it is expected that companies will make accounting choices to minimizeearnings. This will happen if the distribution of prots is discontinuous between the rst interval of positive earningsimmediately to the right of zero, and the second interval of positive earnings to the right of zero. This expectation is testedin the following hypothesis:

Hypothesis 2. There is no difference in the frequency of earnings in the rst interval to the right of zero and the frequencyof earnings in the second interval to the right of zero.

Goncharov and Zimmermann (2006) found that companies with higher average tax rates are more prone to developearnings manipulation practices to minimize income tax expenditure than companies with lower average tax rates. Noempirical studies have demonstrated the common belief that Portuguese private rms adopt accounting policies for taxplanning.

Hypothesis 3. Firms with high average tax rates are no more likely to manipulate earnings downwards than are rms withlow average tax rates.

Because of the substantially increased limits of the SPA that were introduced on December 31, 2002 (and which wereeffective for the nancial year 2003) we expect that rms will have reacted to minimize SPA. Since the SPA for 2003 was afunction of sales revenues for 2002, it is expected that private rms would have reacted in 2002. If manipulation is conrmed,there will be a higher level of manipulation in rms whose SPA is located between the minimum (D 1250) and maximum(D 200,000) values. For companies whose SPA is estimated at, or above, the maximum payment of D 200,000, no downwardsmanipulation is expected. The hypothesis we explore is:

Hypothesis 4. In 2002 there was no earnings manipulation induced by the need to minimize expenditure on the SPA.

4. Research design and sample selection

4.1. Sample selection and data

A study of private companies is justied since they are likely to have a strong incentive to save tax (e.g. Baralexis, 2004;Blake & Salas, 1996; Moreira, 2006). With the exception of Hypothesis 4, the data analysed refer to the tax years 2001 and2002, thereby yielding a large number of observations.

The data source was individual accounts (since this kind of reporting is used commonly for tax purposes) held by theSistema de Anlise de Balanc os Ibricos (SABI) [Analysis System of Iberian Balance Sheets]. Financial sector rms, cooperativesand others companies without legal form were eliminated because they use industry-specic accounting rules and accrualsthat are very different. When collecting data, we noticed that many of the remaining 18,819 rms were not in the databasefor both years 2001 and 2002, or did not have all of the accounting information necessary for the study. After deleting theseobservations, the sample size was 6652 rms: 3255 rms in 2001 and 3397 rms in 2002 (Table 1).

Descriptive statistics for the sample are presented in Table 2. Panel A separates the statistics for the years 2001 and 2002.In determining discretionary accruals and the levels of manipulation, we used the model proposed by Jones (1991) andmodied by Dechow, Sloan, and Sweeney (1995). This model is used widely for determining discretionary accruals that areconsidered to be a proxy of manipulation. We partitioned total accruals into discretionary and non-discretionary accruals,consistent with Dechow et al. (1995), so that:

TAit = 0 + 1(REVit RECit) + 2(TAssetsit) + it (1)where i and t correspond to the rm i and the year t, respectively, and TA is the variation of total accruals between yeart and t 1, divided by total assets; REV is the revenue for year t less the revenue for year t 1, divided by total assets foryear t 1; REC is the net receipts for year t less net receipts for year t 1, divided by total assets for year t 1; TAssets is thetangible assets in year t divided by total assets for year t 1; is the disturbance term.The total accruals were determined


Table 2Descriptive statistics.

Parameters 2001 2002

Panel A: total assets, sales revenues, earnings, income tax, and discretionary accruals (Euros 000s)Total assets

Mean 9011.65 8146.58Median 3229.00 3071.00Standard deviation 23,115.07 19,227.80

Sales revenuesMean 11,622.81 9502.49Median 4363.00 3898.00Standard deviation 38,762.52 34,253.80

Net incomeMean 282.07 205.47Median 57.00 48.00Standard deviation 1188.08 1598.94

Income taxMean 152.63 112.08Median 32.00 24.00Standard deviation 585.73 330.49

Discretionary accrualsMean 99.99 205.68Median 0.40 4.37Standard deviation 4438.52 4060.30

Number of observations 3255 3397

Parameters Low AITR High AITR

Panel B: sales revenues, earnings, income tax, and discretionary accruals per average income taxes rates (AITR) (Euros 000s)Sales revenues

Mean 10,014.93 10,871.45Median 4045.50 4239.50Standard deviation 23,463.40 42,786.34

Net incomeMean 200.88 269.51Median 60.00 48.00Standard deviation 1833.44 1065.49

Income taxMean 78.51 165.64Median 14.00 39.00Standard deviation 268.32 563.11

Discretionary accrualsMean 302.81 60.02Median 7.15 6.52Standard deviation 5478.10 3240.15

Number of observations 2574 4078

Sales revenues Net income Income tax Discretionary accruals Average income tax rate

Panel C: Pearson and Spearman correlation coefcientsSales revenues 0.554*** (0.000) 0.634*** (0.000) 0.008 (0.523) 0.025** (0.038)Net income 0.226*** (0.000) 0.818*** (0.000) 0.108*** (0.000) 0.006 (0.620)Income tax 0.353*** (0.000) 0.659*** (0.000) 0.055*** (0.000) 0.277*** (0.000)Discretionary accruals 0.068*** (0.000) 0.190*** (0.000) 0.054 (0.000) 0.026** (0.033)Average income tax rate 0.011 (0.352) 0.024* (0.054) 0.090*** (0.000) 0.028** (0.023)

Pearson correlation coefcients are presented below the diagonal. Spearman correlation coefcients are presented above the diagonal. In parentheses arethe associated p-values of bi-directional tests.

* Signicance level of 10%.** Signicance level of 5%.

*** Signicance level of 1%.

as follows:

TAt = [current assetst cash flowst] [current liabilitiest Non-current liabilitiest Income taxt] Depreciationt (2)

where is calculated by the difference between t and t 1.To estimate the coefcients, the model was regressed for each sector of economic activity, including all rms with same

rst digit of the Portuguese Classication of Economic Activities [Classicac o das Actividades Econmicas] (CAE) (i.e. 0#, 1#,2#, 3#, 4#, 5#, 6#, 7#, 8#, 9#). The model assumes implicitly that all rms in each industry share the same incentives formanipulation.


Because total accruals (TA) include non-discretionary accruals (NDA) and discretionary accruals (DA), the differencebetween total accruals and non-discretionary accruals is the discretionary accruals. These are considered to be a proxy forEM.

TAt = NDAt + DAt DAt = TAt NDAt

In terms of the operationalization of the model, this means that the component not explained by the model variables,the disturbance term (it), is the discretionary accruals.

Panel A shows a marked reduction in sales revenues and associated economic performance indicators from 2001 to 2002,possibly because of the sharp slowdown in economic growth in Portugal that started in the latter half of 2001. Consequently,there was a marked reduction in the average income tax paid by rms in 2002. However, there was an increase in the averagelevel of discretionary accruals in 2002: the median is well below that of the previous year. A reasonable conjecture is thatthis change arises because the legislation in 2002, introducing the SPA, created incentive for rms to minimize tax payments.

Panel B reports data for the two years together, for companies in terms of their average income tax rate (AITR). Theclassication of rms as high AITR or low AITR was based on the income tax rate in force in the year. Thus, for the year 2001,rms with an AITR 32% were classied as having a high AITR; and those


4.3. Logit model

To test Hypothesis 3 (that the discontinuity around zero is due to rms manipulating their earnings to minimize tax) weapply a logit model to the data for 2001 and 2002:

EMit = 0 + 1DAit + 2CFit + 3Ln Ait + 4AITRit + it (5)where EM is the dummy variable which takes the value 1 if the rm reported deated earnings in the interval [0.00; 0.01);and 0, if it reported deated earnings in any other interval; DA is the deated estimated discretionary accruals; CF is thedeated cash ows calculated as the difference between operating earnings and total accruals (consistent with Leuz, Nanda,& Wysocki, 2003); Ln A is the natural logarithm of assets; AITR is the dummy variable that takes the value 1 if the rm hasa high average income tax rate; and 0, if the rm has a low average tax income rate; is the disturbance term; i and t are,respectively, the rm i and the year t (with t = 2001, 2002).

Phillips, Pincus, and Rego (2003) found the sign of the variables DA and CF to be positive. They interpret this as evidencethat rms tend to manipulate to avoid losses. In the present sample, the expectation is that rms use accruals and cash owsto manipulate prots downwards, for reasons of tax planning. Thus, it is expected that the sign of the coefcients of thesetwo variables will be negative. According to Goncharov and Zimmermann (2006), if rms have high marginal tax rates theywill reduce earnings for tax reasons. Similarly, it is expected that the higher the average tax rate, the greater the likelihoodthat rms will report earnings close to zero; and that therefore, the coefcient of this variable will be positive. The Ln Avariable controls for the company size. We do not predict the sign for its coefcient.

4.4. Regression analysis

Because of the imposition of new and more onerous limits for the SPA, rms are expected to have reacted by minimizingincome tax expense. However, such behaviour is not expected in rms whose SPA reached the maximum level. To testHypothesis 4 we used the following regression model:

DAi = 0 + 1SPAi + 2LIMi + 3AITRi + 4 Ln Ai + 5LIMi AITRi + i (6)where DA is the estimated discretionary accruals; SPA is the estimated special payment on account; AITR is the dummyvariable that takes the value 1 if the company has a high average income tax rate; and 0, if the average tax income rate islow; LIM is the dummy variable which takes the value 1 if the estimated SPA is greater than D 200,000 and 0, if the estimatedSPA is in the range [1250; 200,000); Ln A is the natural logarithm of assets; LIM AITR is the interactive variable that is theproduct of variables LIM and AITR; is the disturbance term; i represents each of the rms in the sample in 2002.

The discretionary accruals used are those that were estimated from the modied model of Jones (1991).To determine the value of SPA we used the following expression, which is based on the decree-law that implemented

the SPA regimen:

SPA2003 = 1% REV2002 PA2002 (7)where SPA is the special payment on account to be made in 2003; REV2002 is the revenues and gains for the year 2002; PA2002is the estimate of the value of payments on account in 2002.

If rms manipulated earnings to minimize SPA expenditure, we expect to nd a signicant relationship between discre-tionary accruals and SPA. To minimize SPA, rms could have deferred recognition of revenues. Thus, it is expected that thesign of the coefcient of this variable will be negative.

We expect the coefcient of variable AITR to be negative since companies with a higher income tax rate will have incentivesto manipulate accounts to decrease revenues. Regarding the LIM variable, we expect a positive coefcient, since rmswith more than the SPA ceiling will tend not to manipulate revenues. In these rms, other incentives (such as endeavoursto strengthen negotiating power with nancial institutions) seem likely to dominate. The interactive variable LIM AITRcontrols the prevailing incentives in rms with high average income tax rates and with a SPA exceeding the maximum limitof D 200,000. For these companies, we expect discretionary accruals will have the effect of minimizing income tax. The signof this variable should be negative. Finally, the variable Ln A controls for the size of the private rms. No sign is predictedfor it.

5. Results and discussion

5.1. Earnings distribution

Graph 1 shows net earnings reported by rms for 2001 and 2002. To reduce the problem of heteroscedasticity, netearnings of each rm were deated by the corresponding total assets of the previous nancial year (e.g. Coppens & Peek,2005; Gore, Pope, & Singh, 2007).

Table 3 sets out the number of companies in the intervals close to zero, the standardized differences () for each of theintervals, and the respective p-values.


Intervals of deflated earnings0.300.200.100.00-0.10-0.20-0.30

1,500

1,200

900

600

300

0

Frequency

Graph 1. Distribution of net income for 2001 and 2002. N = 6652. Amplitude of interval = 0.01. The y-axis represents the number of observations for eachrange of deated earnings. The x-axis represents the range of earnings deated by total assets of the previous year. For example, in the rst interval to theright of zero, the number of rms with deated earnings in the range [0; 0.01) can be observed. The histogram was truncated at the 30th intervals, on bothsides, without disturbance.

Graph 1 and Table 3 highlight a signicant discontinuity around zero: that is, between the interval [0.01; 0) (the rstinterval left to the left of zero) and the interval [0; 0.01) (the rst interval to the right of zero). Table 3 shows the rst intervalto the left of zero has 234 rms per year, and the rst interval to the right of the zero has 1504 rms per year. Furthermore,in the intervals to the right of zero, net earnings are pushed to the barrier of zero, as evidenced by the concave nature of thedistribution to the right of zero. Moreover, there is a signicant discontinuity between the rst and second interval to theright of zero.

The discontinuity around zero is conrmed by the statistic in Table 3; that is, [0.01, 0) = 24.63 (p-value < 0.01). Thisindicates that this range is signicantly under-represented. As in Burgstahler and Dichev (1997), Gore et al. (2007) andMoreira (2006), the number of observations in the interval immediately to the left of zero is signicantly lower than theexpected number of observations. For the rst positive interval the situation is the reverse: [0, 0.01) = 23.62 (p-value < 0.01),suggesting that the number of observations in the interval of deated earnings immediately to the right of zero is signicantlylarger than the expected number of observations.

The general conguration of the distribution of earnings is consistent with the presence of EM (e.g. Burgstahler & Dichev,1997; Degeorge et al., 1999; Hayn, 1995). In the absence of manipulation, Burgstahler and Dichev (1997) argue that thedistribution of earnings would be approximately symmetric. Indeed, we conrm an abnormally low frequency of slightlynegative net earnings, and an abnormally high frequency of slightly positive net earnings. Thus, this is consistent with rms

Table 3Distribution of deated net earnings in intervals close to zero.

Category Negative intervals Positive intervals

0.02 < E < 0.01 0.01 E < 0 0 E < 0.01 0.01 E < 0.02Number of companies 98 234 1.504 997Standardized differences 4.081 24.633 23.622 -3.210p-Value 0.000 0.000 0.000 0.001

The number of rms represents the absolute frequency of rm-years with deated earnings for 2001 and 2002 in two intervals to the left of zero and twointervals to the right of zero. The statistic for each interval represents the standardized difference between the number of observations and the currentnumber of expected observations. The expected observations represent the average of expected observations of adjacent intervals.


with slightly negative net earnings (as in Burgstahler & Dichev, 1997) manipulating their earnings gure to make it slightlypositive: that is, rms tend to manipulate their earnings upwards to avoid reporting losses.

In assessing such behaviour, Carslaw (1988) deemed the zero point to be a cognitive reference point where perceptionsof funders and investors about the performance of rms are inuenced strongly by the sign (negative or positive) of netearnings. Thus, rms with negative net earnings have incentives to manipulate earnings to break through the barrier of zero.

Since there are graphical and statistical differences in the frequency of slightly negative earnings and the frequency ofslightly positive earnings Hypothesis 1 is not conrmed.

Studies by Gore et al. (2007), Burgstahler and Dichev (1997), and Coppens and Peek (2005) in Anglo-Saxon countriesfound that the peak of the distribution was in the positive intervals beyond the rst interval. This is explained by evidencethat managers tend to manipulate earnings to show their rm is in a healthy economic and nancial situation. In such cases,managers are not constrained by tax planning considerations, since taxation is based on statements made specically forthis purpose. In countries whose accounting and tax systems are related closely, a similar pattern of earnings distribution isnot found because nancial statements are used primarily for tax purposes. Managers have strong incentives to manipulatenancial statements to minimize tax expenditure (e.g. Coppens & Peek, 2005; Goncharov & Zimmermann, 2006; Moreira,2006).

In Portugal, because taxable income is based on accounting earnings, it is expected that rms adopt accounting policiesto maximize tax savings. Graph 1 shows a signicant discontinuity between the rst and second range of positive deatedincome levels (as with Coppens & Peek, 2005). The peak of the distribution of earnings occurs in the interval [0; 0.01). Thenumber of rms in the rst interval (1504) is signicantly higher than the number of rms (997) concentrated in the secondinterval [0.01; 0.02) (or any other interval).

Table 3 conrms the graphical evidence and reveals a signicant negative difference between the actual and the expectedobservations in the second interval of positive earnings, where [0.01, 0.02) = 3.210 (p < 0.01). This conrms that the observednumber of rms in this interval is signicantly lower than expected. A plausible explanation for this is that rms manipu-late earnings downwards to minimize the burden of income tax. (This is analysed further in the following discussion ofHypothesis 3.)

Although there is an incentive to save tax, rms are not interested in pushing net earnings into the loss intervals to theleft of zero. The reason for this is that in recent years in Portugal, tax audits of rms that reported negative earnings haveincreased. Another explanation is that the nancial statements are relied upon commonly by rms when obtaining bankfunding (e.g. Moreira, 2006). Thus, the higher frequency of rms in the rst interval is explained by them wanting to avoidreporting losses. However, for tax reasons, rms have a countervailing incentive to push positive earnings into the regionclosest to the limit of zero. Again, Hypothesis 2 cannot be conrmed since there are graphical and statistical differences inthe frequency of earnings in the rst and the second intervals to right of zero.

5.2. Earnings management to reduce income tax

5.2.1. Graphical analysisTo test Hypothesis 3, the sample was divided into two sub-samples: those with high average income tax rate and those

with low average income tax rate. The average income tax rate (AITR) was determined by dividing the income tax paid by theincome (earnings) before taxes. For the reason mentioned above, both variables were deated by total assets of the previousperiod.

In determining income tax, companies often make adjustments in accord with the tax law (since there are accountingexpenses which are not tax expenses). Because of this, the nominal tax rate in the tax law will only be the AITR dened abovein exceptional circumstances. Thus, companies with high AITRs are more likely to use discretionary accruals to reduce netincome to avoid reporting losses.

If the behaviour of the two sub-samples in relation to the various incentives differs, the graph of net earnings distributionswill differ signicantly. For the sub-sample of rms with low AITR, if no manipulation occurs for tax reasons, then thedistribution of net earnings should correspond with what is happening in countries where the link between accounting andtaxation is less signicant (Goncharov & Zimmermann, 2006). So, it is expected that these rms will show signs of upwardEM. With regard to the distribution of earnings of rms with high AITR, a signicant discontinuity between the rst andsecond interval to the right of zero is expected, because these rms have strong incentives to save tax. The peak of thedistribution in the sub-sample of high AITR is expected to be in the rst interval to the right of zero. In the sub-sample withlow AITR, the peak is expected to be observed in a positive range, but not in the rst interval.

Graph 2 shows the distribution of earnings for 2001 and 2002 of high AITR rms (32% and 30%, respectively). Graph 3represents the distribution of net income for 2001 and 2002 of low AITR rms (


Intervals of deflated earnings0.300.200.100.00-0.10-0.20-0.30

1,500

1,200

900

600

300

0

Frequency

Graph 2. Distribution of earnings of rms with high average income tax rates for 2001 and 2002. N = 4078. Amplitude of interval = 0.01. The y-axis representsthe number of observations for each range of deated earnings for 2001 and 2002 of rms with high AITR. The histogram was truncated at the 30th intervalson both sides with no disturbance.

Intervals of deflated earnings 0.300.200.100.00-0.10-0.20-0.30

700

600

500

400

300

200

100

0

Frequency

Graph 3. Distribution of earnings of rms with low average income tax rates for 2001 and 2002. N = 2574. Amplitude of the interval = 0.01. The y-axisrepresents the number of observations for each range of deated earnings. The x-axis represents the range of deated earnings for 2001 and 2002 of rmsclassied as low AITR. The histogram was truncated at the 30th intervals on both sides, with no disturbance.


is that rms with low AITR do not have a major incentive to minimize income tax expense, contrary to the experience ofrms with a high AITR.

In both sub-samples there is a discontinuity between the rst interval to the left of zero and the rst interval to the rightof zero. In both cases rms avoid reporting losses: this seems likely to be related to the need of most Portuguese rms toresort to external nancing (Moreira, 2006).

5.2.2. Logit analysisTo conrm the graphical evidence statistically, we used the logit model described earlier. The results are presented in

Table 5.As expected, the signs of the coefcients of the variables DA and CF are negative and signicant, suggesting that the

increase in discretionary accruals and cash ows reduces the likelihood of rms reporting positive earnings in the rstinterval. As with Goncharov and Zimmermann (2006), the coefcient of the AITR variable is positive, highly signicant, andconsistent with the evidence obtained graphically. This result is consistent with the hypothesis that the higher the AITR, thegreater the likelihood that rms manipulate their earnings to very close to zero.

The results conrm the graphical analysis. The large concentration of rms immediately to the right of zero can beexplained by tax planning behaviour intended to minimize income tax. Thus, Hypothesis 3 is rejected.

5.3. The impact of the change in the SPA system on earnings manipulation

Hypothesis 4 contends that changes in the SPA rules in 2002 had no effect on earnings management. In 2003, rms had tocomply with a SPA whose maximum value (D 200,000) was particularly high. The changed rules took effect from 2003 andbeyond. However, because the calculation of the SPA is a function of sales revenues for 2002, it is expected that manipulationwill have taken effect in the 2002 nancial year. This is the reason for examining the impact of this change using accountinginformation for 2002.

Table 4Distribution of deated net earnings in intervals close to zero.

Category Negative intervals Positive intervals

0.02 < E < 0.01 0.01 E < 0 0 E < 0.01 0.01 E < 0.02Panel A: rms with high average income tax rates

Number of companies 5 140 1.243 718Standardized differences 10.534 25.808 25.320 4.874p-Value 0.000 0.000 0.000 0.000

Panel B: rms with low average income tax ratesNumber of companies 93 94 261 279Standardized differences 1.153 6.425 4.202 1.497p-Value 0.125 0.000 0.000 0.067

The number of rms represents the absolute frequency of rm-years with high (Panel A) and low (Panel B) average income tax rates with deated earningsfor 2001 and 2002 in two intervals to the left of zero and two intervals to the right of zero. The statistic for each interval represents the standardizeddifference between the number of observations and the current number of expected observations. The expected observations represent the average ofexpected observations of adjacent intervals.

Table 5Logit model of the effect of income taxation.

EMit = 0 + 1DAit + 2CFit + 3Ln Ait + 4AITRit + it

Independent variables Predicted sign Estimated coefcients (p-value)

Intercept ? 2.957*** (0.000)DA 3.606*** (0.000)CF 4.444*** (0.000)Ln A ? 0.139*** (0.000)AITR + 1.461*** (0.000)N 6.6472 (Pearson goodness-of-t test) 6.73703 (0.217)

Dependent variable: EM = dummy variable which takes the value 1 if the rm reported earnings (deated) in the interval [0.00; 0.01); and 0, if it reportedearnings in any other interval. Independent variables: DA = deated estimated discretionary accruals; CF = deated cash ows calculated as the differencebetween operating earnings and total accruals (consistent with Leuz et al., 2003); Ln A = natural logarithm of assets; AITR = dummy variable that takes thevalue 1 if the rm has a high average income tax rate; and 0, if the rm has a low average tax income rate. = disturbance term. i and t are, respectively,the rm i and the year t (with t = 2001, 2002). The p-values correspond to bi-directional tests.*** Signicance level of 1%.


Table 6Pearson and Spearman correlation coefcients.

DA SPA LIM

DA 0.017 (0.345) 0.035** (0.049)SPA 0.050*** (0.004) 0.361*** (0.000)LIM 0.044** (0.013) 0.342*** (0.000)

Pearson correlation coefcients are presented below the diagonal. Spearman correlation coefcients are presented above the diagonal. In parentheses arethe associated p-values of bi-directional tests.

** Signicance level of 5%.*** Signicance level of 1%.

5.3.1. Regression analysisThe Pearson correlation coefcient (see Table 6) shows a signicant negative correlation between variables SPA and

DA and a signicant positive correlation between the coefcients of variables DA and LIM. These correlations evidence adownward manipulation in rms whose SPA is between the minimum and maximum limits under the new income taxregime. For the subset of rms whose estimated SPA is greater than or equal to the maximum, there is an upward EM.

Table 7 shows that all the signs of coefcients of explanatory variables, except for the AITR variable, are highly signicantand consistent with expectations. For the SPA variable (which reects the estimated value of the SPA to be settled in 2003)there is a signicant relationship with the level of discretionary accruals. This is consistent with a higher level of manipulationdownwards because the outstanding balance of the SPA is greater. For rms whose SPA is equal to or greater than D 200,000(after controlling for LIM), there was a positive a coefcient, suggesting upward EM via discretionary accruals.

As expected, LIM indicates that rms in this sub-sample did not manipulate earnings to minimize SPA, as did other rms.This incentive is not important for rms liable to pay the maximum SPA. Firms whose estimated SPA reached the maximumseem to have incentives that promote upward EM. However, this pattern of manipulation is not observed in rms with highAITR, because the coefcient of an interactive variable, LIM AITR, is negative and signicant. The result for this variable isconsistent with the idea that incentives for rms in this subset to engage in upwards manipulation do not dominate. Further,inuenced by tax burden, rms with high AITR and a SPA estimated at (or above) the ceiling, manipulated downwards. Thedominant incentive is the tax burden. Although the level of prediction is reduced, the evidence is not consistent withHypothesis 4.

5.3.2. Additional evidenceThe effect of introducing and amending rules governing the SPA can also be gauged, albeit partially, by observing the

evolution in the income tax paid by rms. Assuming that the implementation of the SPA (and its amendments) involvedchanges in the income tax collected by the State, we would expect a signicant increase in tax paid by rms. As noted inGraph 4, this was not the case. Graph 4 shows the history of the median and mean income tax payments between 2000 and2004.

Although this result could be inuenced by other factors in the macroeconomy, Graph 4 shows that there were only minorchanges in the mean and the median income tax over the period 20002004. The increase in SPA limits did not producesignicant impacts on the collection of tax by the State.

To check for manipulation through the recognition of deferred revenues, we use Levenes univariate test of the equalityof variances for variation in the revenues between 2001 and 2002 (REV).We analysed the standard deviations for the twosub-samples: rms whose estimate of SPA is located in the interval [D 1250; D 200,000); and rms whose estimated SPA isat, or above, the ceiling. We expected to reject the null hypothesis; in other words, to nd that the variances are equal. Ifrms whose SPA is estimated to be in the range [D 1250, D 200,000) manipulated earnings by deferring revenues, then the

Table 7Regression model on the impact of the change of the SPA.

DAi = 0 + 1SPAi + 2LIMi + 3AITRi + 4Ln Ai + 5LIMi AITRi + iIndependent variables Predicted sign Estimated coefcients (p-value)

SPA 0.082*** (0.000)LIM + 0.064*** (0.009)AITR 0.014 (0.425)Ln A ? 0.136*** (0.000)LIM AITR 0.073*** (0.002)R2 Ajust. (%) 3.5N 3217

Dependent variable: DA = estimated discretionary accruals deated. Independent variables: SPA = special payment on account; LIM = dummy variable thattakes the value 1 if the estimated SPA is greater or equal to D 200,000 and 0, if the estimated SPA is in the range [1250; 200,000). Ln A = natural logarithmof assets. LIM AITR = interactive variable that is the product of variables LIM and AITR. The AITR is a dummy variable that takes the value 1 if the companywas classied as having a high average tax rate and 0 otherwise. = disturbance term. i is the rm i. The p-values correspond to bi-directional tests.*** Signicance level of 1%.


-300

-200

-100

0

100

200

300

400

500

600

20012000 2002 200 3 200 4

Mean - SD Mean Mean + SD Median

Graph 4. Evolution of the median and average income tax paid between the years 2000 and 2004. The y-axis expresses income tax in D 000s. The x-axisrepresents years 20012004.

Table 8Analysis of variability of REV.

Snedcors F statistic Signicance

Panel A: Levenes test for equality of variances694.415 0.000

Sub-samples Standard deviation (N)

Panel B: standard deviation of REVFirms with SPA in range [D 1250; D 200,000) 2,319,071 (2.924)Firms with SPA D 200,000 14,669,031 (141)

variability of the revenues relative to the mean will be lower than in rms with no incentive to minimize the SPA. The resultsfor the test and for the standard deviations of the two sub-samples are shown in Table 8.

Despite the difference in the number of companies, as predicted, the hypothesis that there will be equal variances wasrejected. Moreover, there was a signicant difference for the standard deviation of REV between the two sub-samples.These results show that rms with greater motivation to minimize SPA expenditure had less variability in revenues inrelation to the mean. In the other sub-sample, the extent of variation is signicantly higher, corroborating results obtainedin the regression model. Firms with greater incentives to minimize SPA expenditure converged comparatively more in therecognition of revenues.

6. Conclusions

Legislative measures to minimize tax planning to combat tax evasion and fraud (such as the SPA in Portugal) have beena feature of many national tax regimes. For countries where there is a close relationship between accounting earnings andtaxable income (such as France, Belgium, Italy and Japan), the ndings we report for Portugal should be especially instructive.Thus, for rms with higher AITR there appears to be a greater propensity for downwards earnings manipulation. These rmshave a strong incentive to minimize income tax and to report earnings close to zero. The frequency distribution of reportedearnings is concentrated very signicantly in the rst interval of earnings to the right of zero. For rms with low AITR, thedistribution of earnings is consistent with results in countries where accounting and taxation are not aligned. The graphicaland statistical evidence show that, in addition to earnings distribution, these rms have a convex conguration to the rightof zero, with the peak on the second range of earnings. Thus, the incentive for the minimization of income tax does notappear to be dominant for these rms.

We tested whether the legislation increasing SPA limits from 2003 onwards had an impact on the reporting of earningsfor 2002. Our prediction that the sharp increase in the maximum SPA due to the new law would increase income taxsignicantly was conrmed: rms whose SPA was estimated between the minimum and maximum levels had discretionaryaccruals higher than other rms. Indeed, the perceived discretion in this set of rms shows a more signicant manipulationof SPA expenditure. This is consistent with expectation that rms minimize SPA by deferring the recognition of revenues. Thesub-sample of rms with greater motivation to minimize expenditures on SPA had a lower standard deviation of changesof revenues in relation to the mean, while in the other sub-sample the extent of variation was signicantly higher. This


suggests that rms with greater motivation to make income tax savings converged comparatively more in the recognitionof revenues.

Portugal should be regarded as one of the bloc of countries in which rms report earnings very close to zero due toa dominant income tax savings incentive (Coppens & Peek, 2005). There is a large concentration of rms with deatedearnings in the rst positive interval, consistent with the high degree of alignment between the accounting and tax systems.The results also point to the potential inadequate outcome of the implementation of legislative measures such as the SPA.Thus, it is unsurprising that in the State Budget for 2004, the Portuguese government again changed the rules governing theSPA. The ceiling was reduced from D 200,000 to D 40,000 and the basis of calculation was modied completely. With thisnew amendment, income tax was generally considered fairer and less onerous.

The effect of tax policy on cash ow and earnings is a sensitive matter for private rms everywhere. Tax policy appearsto have had a signicant effect on accounting policy choices because tax liability is based on a measure closely related toreported earnings. Thus, those who audit and regulate the accounting behaviour of rms should renew efforts to ensure(as best they can) that reported earnings, even if prepared in accord with generally accepted accounting principles, are notcontrived to represent distortions of a rms real nancial performance. Accordingly, tax policy bureaucrats, advisors andlegislators should draw on the results of this study to re-invigorate efforts to introduce scal revenue raising measuresthat are less capricious (at least in the eyes of taxpayers) and less avoidable through deployment of allowable discretion inaccounting policy choices.

Acknowledgements

We are indebted to Jos Moreira, Adrian Sawyer, Hai Lu, Jos Machado, the editor, and two anonymous referees for theirhelpful comments and suggestions on earlier versions of this paper.

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Earnings management induced by tax planning: The case of Portuguese private firms1 Introduction2 Earnings management and the accounting and tax context of Portuguese private firms2.1 Earnings management incentives2.2 The accounting and tax environment of Portuguese private firms

3 Research hypotheses4 Research design and sample selection4.1 Sample selection and data4.2 Graphical analysis4.3 Logit model4.4 Regression analysis

5 Results and discussion5.1 Earnings distribution5.2 Earnings management to reduce income tax5.2.1 Graphical analysis5.2.2 Logit analysis

5.3 The impact of the change in the SPA system on earnings manipulation5.3.1 Regression analysis5.3.2 Additional evidence

6 ConclusionsAcknowledgementsReferences

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Earnings Management Induced by Tax Planning

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