Last Chance Earnings Management: Using the Tax Expense to Achieve Earnings Targets

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Abstract
We assert that the tax expense is a powerful context in which to study earnings management, because it is one of the last accounts closed prior to the earnings announcement. While many pre-tax accruals must be posted in the year-end general ledger, managers estimate and negotiate tax expense with their auditors immediately prior to the earnings announcement. We hypothesize that changes from 3rd to 4th quarter effective tax rates (ETRs) are negatively related to whether and how much a firm's earnings absent tax expense management miss analysts' consensus forecast, a proxy for target earnings. We measure earnings absent tax expense management as actual pretax earnings adjusted for the annual ETR reported at the third quarter. We provide robust evidence that firms lower their projected ETRs when they miss the consensus forecast, consistent with firms decreasing their tax expense if non-tax sources of earnings management are insufficient to achieve targets. We also find that firms that exceed earnings targets increase their ETR, but this effect is smaller. By studying the tax expense in total, rather than narrow components of deferred tax expense, our results provide general evidence that reported taxes are used to manage earnings.