Financial reporting incentives: Taxation and external financing need

Abstract

Earnings management literature extensively explores tax regime and debt contracting as possible incentives in financial reporting. Firms engage with aggressive financial reporting to bias earnings in periods when the need for external financing increases. Contrary to this, the tax burden represents incentive for more conservative reporting. We argue that the level of firm's financial reporting aggressiveness is not constant but rather floating from period to period, directly affecting the quality of financial reports. We assume that firm's management on its own discretion determines the level of conservatism, balancing between these two incentives. The prevailing of two incentives, the need for external financing and the tax burden, determines the level of conservatism in particular reporting period. We hypothesised that the reduction in tax burden incentive overcomes the debt contracting incentive in the years of decreasing external financing need, implying more conservative accounting to balance between economic and taxable income. The total accruals are used as a measure of earnings management reflected to working capital accruals. The data analysis conducted on financial reports of 297 firms in the time-series of five years shows a significant correlation between total accruals, external financing needs and difference between economic and taxable income.