Earnings management in South Korea: Using tax expenses

Abstract

We expect that tax expenses will provide a last opportunity to meet an earnings target, and involve the complexity and discretion necessary for information asymmetry to persist. Hence, tax expenses are powerful settings to examine earnings management among a wide range of firms. Considering this background, we hypothesize that changes in tax expenses are related to whether firms miss their reported earnings of the previous year. We also examine the possibility and effectiveness of earnings management through tax expenses depending on the amount to be managed. Consistent with our hypothesis, we find that firms decrease the fourth quarter effective tax rate (ETR) to meet the previous year’s reported earnings. However, tax expenses could be a successful tool to manage earnings, but only when unmanaged earnings are very close to a target. These results provide general evidence that tax expenses are used to manage earnings, and suggest that stricter external audit procedures for tax expenses are required to prevent self-interested discretion by managers on their firm’s tax returns.