Earnings management around tax rate reduction: evidence from China's 2007 corporate tax reform

Abstract

Purpose – The purpose of this paper is to examine earnings management around tax rate reduction in the wake of the 2007 corporate tax reform in China. Design/methodology/approach – This paper is an empirical work using a sample of listed Chinese real estate firms. Findings – This study finds that firms managed earnings, including accrual-based earnings management and real earnings management, to decrease income in the fourth quarter of 2007, and to increase income in the first quarter of 2008. It suggests that the real estate firms were shifting income from the fourth quarter of 2007, when the statutory tax rate was 33 per cent, to the first quarter of 2008, when the statutory tax rate was 25 per cent, and therefore saved on tax payments. It also finds that corporate ownership structures, including ownership concentration and state ownership, affect earnings management. In the fourth quarter, state ownership is negatively associated with accrual-based earnings management, while ownership concentration is positively related to both accrual and real earnings management. In the first quarter, state ownership is negatively related to real earnings management. Social implications – Tax authority and policy makers might be interested in evidence on earnings management around tax rate reduction. Changes in tax rates increase the incentives to shift income, which may warrant a closer scrutiny by both outside auditors and tax auditors. Originality/value – This paper is the first study that relates to both accrual-based earnings management and real earnings management to corporate tax rate changes by showing that firms manipulate income upward in the low-tax-rate periods and downward in the high-tax-rate periods.