Discussion Paper No. 140
Book-tax conformity, earnings management, and compensation
contracts

WONG YIU WAI

2020/9/9

TOHOKU MANAGEMENT & ACCOUNTING RESEARCH GROUP
Discussion Paper

GRADUATE SCHOOL OF ECONOMICS AND

MANAGEMENT TOHOKU UNIVERSITY

27-1 KAWAUCHI, AOBA-KU, SENDAI,
980-8576 JAPANBook-tax conformity, earnings management, and compensation contracts

Yiu Wai Wong
Assistant Professor of Graduate School of Economics and Management, Tohoku University, Sendai, Japan

Tel./Fax: +81 3 6869 3195
Email: wong.yiu.wai.e6@tohoku.ac.jp

Abstract
This study investigates how the degree of book-tax conformity affects managers’ compensation contracts andearnings management activity. The arguments for and against requiring book-tax conformity have been
discussed in many countries for many years. There are several empirical studies about the effects of book-tax
conformity on the usefulness of accounting earnings, but the existing literature on the impact of book-tax
conformity on earnings management presents ambiguous results. Further, there are few studies that haveexamined the relationship between the degree of book-tax conformity and managers’ compensation contracts.
This study focuses on this research gap. In this result, I set multi-task principal-agent model in theoretical partand OLS in empirical part to analysis the relationship between book tax conformity and earnings management.
The results showed that the bonus coefficient decreases with the degree of book-tax conformity, demonstratingthat book-tax conformity can indirectly affect compensation contracts. The main findings of the study are as
follows: book-tax conformity prevents managers from engaging in earnings management activity as well assome production activities; and the expected utility of the principal decreases with the degree of book-tax
conformity. that the results of this study can provide policy makers with information on the determine of thebook tax conformity system.

Keywords: Book-tax conformity, earnings management, CEO compensation, principal-agency theory,
multi-task model

Declarations

Funding (information that explains whether and by whom the research was supported): This work was
supported by the Grant-in-Aid for Young Scientists (B), 17K13818, 2017-2019, provided by the Japan Society
for the Promotion of Science, Japan.

Acknowledgements: This work was supported by the Grant-in-Aid for Young Scientists (B), 17K13818,
2017-2019, provided by the Japan Society for the Promotion of Science, Japan.

Book-tax conformity, earnings management, and compensation contracts

1. Introduction

This paper investigates how the degree of book-tax conformity affects managers’ compensation contracts andearnings management activities. According to OECD, there is the widespread perception that “the rules for the
taxation of cross-border activities are regularly broken, and that taxes are paid only by the naive. Multinational
enterprises (MNEs) stand accused of dodging taxes all around the world.” 1 Many MNEs, including Google,
Apple, Facebook, and Amazon (sometimes known as GAFA), take advantage of the different rules of taxation
between countries. For example, there are two prevailing tax reporting systems. The first requires book-tax
conformity, and the other allows taxable income to be different from reported accounting earnings. Book-tax
conformity is required in Japan, but not in the United States. In addition, in order to calculate tax income in theEU, some member states use International Financial Reporting Standards (IFRS), some use Local Generally
Accepted Accounting Principles (GAAP), and others use a separate tax GAAP. The arguments for and against
requiring book-tax conformity have been discussed in many countries for many years. However, there are few
studies that have examined the relationship between the degree of book-tax conformity and managers’
compensation contracts and earnings management activities. This study expands upon the current research on
book-tax conformity to address this gap.

Proponents of book-tax conformity insist that increases in conformity can reduce aggressive financial reportingand excessive tax planning, and, as a result, improve the earnings quality and strengthen tax compliance. It isargued that increased conformity leads to a considerably simpler tax system that would constrain managers'
opportunism (Slemrod and Blumenthal 1996; Yin 2001; Desai 2005; Whitaker 2005). Desai (2005) argues thatlow book-tax conformity has contributed to the simultaneous degradation of profit reporting to capital markets
and tax authorities because it allows managers to mischaracterize tax savings to capital markets, andmischaracterize profits to tax authorities.

On the other hand, opponents of book-tax conformity claim that it impairs earnings quality, and, accordingly,
leads to less informative earnings information than otherwise (Hanlon and Shevlin 2005; Hanlon et al. 2005,2008). They argue that it results in lower earnings quality because tax authorities, and other stakeholders,require different kinds of information. If information is aligned to one measure, the quality of information forinvestors and other financial statement users will be reduced. Because a tax system is designed to meet the
government objectives, such as increasing governmental revenue, the government can provide economic
incentives or disincentives for taxpayers to engage in particular activities, and reward particular constituencies.
In contrast, a financial accounting system typically provides managers with some incentive to convey more
information so as to mitigate information asymmetry between the managers and other constituents. Thus, the1

http://www.oecd.org/forum/what-the-beps-are-we-talking-about.htm

1opponents insist that book-tax conformity impairs the usefulness of earnings information, and, therefore, believe
it is detrimental to the investors’ decision-making ability.

The arguments for and against requiring book-tax conformity have been discussed in many countries for many
years. There are several empirical studies about the effects of book-tax conformity on the usefulness ofaccounting earnings, but the existing literature on the impact of book-tax conformity on earnings management
presents ambiguous results. Further, there are few studies that have examined the relationship between the
degree of book-tax conformity and managers’ compensation contracts. This study focuses on this research gap.

This paper proceeds as follows. Section 2 discusses the literature review. Section 3 describes the theoreticalmodel setting and analysis. Section 4 describes the empirical research design. Section 5 discusses the sample
selection and test results. Section 6 presents the conclusion.

2. Literature Review

Some empirical studies address the relationship between book-tax conformity and earnings management.
Atwood et al. (2010) found that higher conformity is related to lower earnings persistence and a lower
association between earnings and future cash flows. The empirical measure of book-tax conformity developed
by Atwood et al. (2010) has already been applied to study the impact of conformity on earnings management.
For instance, Blaylock et al. (2015) concluded that greater absolute earnings management is connected withstronger book-tax conformity. Watrin et al. (2014) used an alternative specification of the measure for Europe,and showed the same conclusion. In contrast, Tang (2015) associated higher mandatory conformity with lower
levels of earnings management and tax avoidance. Leuz et al. (2003) did not find any significant relationshipbetween the degree of a country’s book-tax conformity and earnings management with sample of public firms.
Burgstahler et al. (2006) documented that higher conformity is associated with greater earnings management for
private firms. Moreover, Coppens and Peek (2005) presented evidence of European private firms not avoiding
the reporting of small losses in countries that had high book-tax conformity. If taxable income and financial
statement earnings are well-aligned, it is expected that private firms would respond more to a change in thecorporate tax rate than public firms would, and that this response is expected to be seen indirectly in thefinancial statements.

Some theoretical studies analyze the relationship between disclosure regulations and earnings management.
Murakami and Shiiba (2015) found that accounting regulations directly affected relative costs of accrual-based
and real earnings management in both static and dynamic settings. Murakami and Ohta (2011) compared thevalue relevance of earnings information under the book-tax conformity reporting and decoupling settings. They
report that the market has more precise information in the conformity setting than in the decoupling setting.
Also, previous studies have examined corporate tax avoidance in a Linear, Exponential, and Normal (LEN)
model, but the results were ambiguous (Chen and Chu 2005; Crocker and Slemrod 2005; Ewert and Niemann22014). However, there are few theoretical research studies that examined the relationship between the degree ofbook-tax conformity and managers’ earnings management. This paper develops a simple model to examine thisrelationship directly, and, by extension, address this gap. Moreover, it also tests the impact of book-tax
conformity on earnings management using cross-country data in the empirical analysis section.

3. Theoretical Model

3.1 Model description
A multi-task principal-agent model, in which the risk-neutral principal owns a firm, was developed. The firm is
operated by a manager who reports the firm’s earnings. The manager chooses an unobservable production effort
𝑎𝑎𝑝𝑝 that produces actual cash flow or unmanaged earnings 𝑥𝑥 = 𝑎𝑎𝑝𝑝 + 𝜀𝜀𝑝𝑝 , where 𝜀𝜀𝑝𝑝 is an uncertainty regarding
the cash flow that is normally distributed with mean zero and variance 𝜎𝜎𝑝𝑝2 . These unmanaged earnings are notavailable as a performance measure.

Besides the production activity, the manager can take actions that increase or decrease unmanaged earnings.
These actions include an earnings management activity, 𝑎𝑎𝑒𝑒 + 𝜀𝜀𝑒𝑒 , where 𝜀𝜀𝑒𝑒 is an uncertainty regarding thereported earnings that is normally distributed with mean zero and variance 𝜎𝜎𝑒𝑒2 . The earnings management
activity has an upward bias in unmanaged earnings. In this paper, it is assumed that 𝑑𝑑𝑐𝑐 is the degree ofbook-tax conformity, and that it has a direct impact on taxable income such that 0 ≤ 𝑑𝑑𝑐𝑐 ≤ 1 is satisfied.
The firm’s reported earnings are written as 𝑓𝑓𝑓𝑓 = 𝑥𝑥 + 𝑎𝑎𝑒𝑒 , and taxable income is written as 𝑡𝑡𝑡𝑡 = 𝑥𝑥 + 𝑑𝑑𝑐𝑐 𝑎𝑎𝑒𝑒 . In

the perfect conformity case, 𝑑𝑑𝑐𝑐 = 1, and taxable income equals reported earnings. Managers’ actions entail
convex psychological costs 𝑐𝑐�𝑎𝑎𝑝𝑝 ; 𝑎𝑎𝑒𝑒 � = �𝑐𝑐𝑝𝑝 𝑎𝑎𝑝𝑝2 + 𝑐𝑐𝑒𝑒 𝑎𝑎𝑒𝑒2 �/2 for the manager, where 𝑐𝑐𝑝𝑝 and 𝑐𝑐𝑒𝑒 arecoefficients of the marginal costs “production cost” and “earnings management cost,” respectively. In otherwords, these coefficients reflect the difficultly, or costs, of each action. The cost of taking productive action isassumed to be different from that of distorting the reported earnings, and production cost is assumed to behigher than earnings management cost (𝑐𝑐𝑝𝑝 > 𝑐𝑐𝑒𝑒 ).
The manager is risk- and effort-averse, and the managers’ utility functions consist of a compensation w andactivity costs, that is, 𝑈𝑈𝑀𝑀 = −exp[−𝜌𝜌(𝑤𝑤 − 𝑐𝑐)], where 𝜌𝜌 represents a constant coefficient of absolute risk
aversion.

The compensation contract is assumed to be linear in managers’ performance and is based on the after-tax
earnings. Therefore, in the conformity case, the managers’ compensation takes the form:
𝑤𝑤𝑀𝑀 = γM + 𝛽𝛽𝑀𝑀 (𝑓𝑓𝑓𝑓 − 𝑡𝑡 ⋅ 𝑡𝑡𝑡𝑡),

where 𝛾𝛾𝑀𝑀 is a fixed compensation, 𝛽𝛽𝑀𝑀 is a bonus coefficient, and t is a corporate tax rate that satisfies

0 < 𝑡𝑡 ≤ 1/2. This tax rate range is observed in practice.

3(1)

3.2 Analysis
For unobservable managerial activities, the principal can offer performance-based compensation contracts tomotivate the manager into providing the desired activity levels. In this case, the optimal contract solves thefollowing problem:

s.t.

max𝛾𝛾𝑀𝑀 ,𝛽𝛽𝑀𝑀 𝐸𝐸 [𝑥𝑥 − 𝑡𝑡 𝑡𝑡𝑡𝑡 − 𝑤𝑤𝑀𝑀 ](2)

2
𝐸𝐸[𝑤𝑤𝑀𝑀 ] − 𝑐𝑐 − 𝜌𝜌/2 𝛽𝛽𝑀𝑀
�(1 − 𝑡𝑡)2 𝜎𝜎𝑝𝑝2 + (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 𝜎𝜎𝑒𝑒2 � ≥ 0(PC)

2𝑎𝑎𝑖𝑖 = argmax𝑎𝑎𝑖𝑖 𝐸𝐸 [𝑤𝑤𝑀𝑀 ] − 𝑐𝑐 − 𝜌𝜌/2 𝛽𝛽𝑀𝑀
�(1 − 𝑡𝑡)2 𝜎𝜎𝑝𝑝2 + (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 𝜎𝜎𝑒𝑒2 � , 𝑖𝑖 ∈ {𝑝𝑝, 𝑒𝑒}(IC)

The principal’s utility is equal to the cash flow that is determined by unmanaged earnings minus the tax expensethat is based on the taxable income minus managers’ compensation. In other words, although managers’
earnings management do not affect the unmanaged earnings, the result for earnings management may affect realcash flow via tax payments. (PC) is a manager’s participation constraint. The left-hand side of (PC) is amanager’s certainty equivalent of compensation 𝑤𝑤𝑀𝑀 and effort costs.
The optimal activity choices of the mangers are:𝑎𝑎𝑝𝑝 =(1−𝑡𝑡)𝛽𝛽𝑀𝑀
𝑐𝑐𝑝𝑝, 𝑎𝑎𝑒𝑒 =(1−𝑑𝑑𝑐𝑐 𝑡𝑡)𝛽𝛽𝑀𝑀

(3)

𝑐𝑐𝑒𝑒

In the optimum, again, (PC) is binding so that the expected compensation can be written as 𝐸𝐸[𝑤𝑤𝑀𝑀 ] = 𝑐𝑐 +2
𝜌𝜌/2 𝛽𝛽𝑀𝑀
�(1 − 𝑡𝑡)2 𝜎𝜎𝑝𝑝2 + (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 𝜎𝜎𝑒𝑒2 �. Substituting this condition and (IC) into the principal’s utility function,and differentiating it with respect to 𝛽𝛽𝑀𝑀 , shows that the first order conditions derive the following optimal

bonus coefficient and level of activities:

𝑐𝑐𝑒𝑒 (1−𝑡𝑡)2 −𝑐𝑐𝑝𝑝 𝑑𝑑𝑐𝑐 𝑡𝑡(1−𝑑𝑑𝑐𝑐 𝑡𝑡)

∗
𝛽𝛽𝑀𝑀
=

𝑐𝑐𝑝𝑝 (1−𝑑𝑑𝑐𝑐 𝑡𝑡)2 +𝑐𝑐𝑒𝑒 (1−𝑡𝑡)2 + 𝑐𝑐𝑒𝑒 𝑐𝑐𝑝𝑝 𝜌𝜌�(1−𝑡𝑡)2 𝜎𝜎𝑝𝑝2 +(1−𝑑𝑑𝑐𝑐 𝑡𝑡)2 𝜎𝜎𝑒𝑒2 �𝑎𝑎𝑝𝑝∗ =

𝑐𝑐𝑝𝑝 �𝑐𝑐𝑝𝑝 (1−𝑑𝑑𝑐𝑐 𝑡𝑡)2 +𝑐𝑐𝑒𝑒 (1−𝑡𝑡)2 + 𝑐𝑐𝑒𝑒 𝑐𝑐𝑝𝑝 𝜌𝜌�(1−𝑡𝑡)2 𝜎𝜎𝑝𝑝2 +(1−𝑑𝑑𝑐𝑐 𝑡𝑡)2 𝜎𝜎𝑒𝑒2 ��

𝑎𝑎𝑒𝑒∗ =

𝑐𝑐𝑒𝑒 �𝑐𝑐𝑝𝑝 (1−𝑑𝑑𝑐𝑐 𝑡𝑡)2 +𝑐𝑐𝑒𝑒 (1−𝑡𝑡)2 + 𝑐𝑐𝑒𝑒 𝑐𝑐𝑝𝑝 𝜌𝜌�(1−𝑡𝑡)2 𝜎𝜎𝑝𝑝2 +(1−𝑑𝑑𝑐𝑐 𝑡𝑡)2 𝜎𝜎𝑒𝑒2 ��(4)(1−𝑡𝑡)[𝑐𝑐𝑒𝑒 (1−𝑡𝑡)2 −𝑐𝑐𝑝𝑝 𝑑𝑑𝑐𝑐 𝑡𝑡(1−𝑑𝑑𝑐𝑐 𝑡𝑡)],(5)(1−𝑑𝑑𝑐𝑐 𝑡𝑡)[𝑐𝑐𝑒𝑒 (1−𝑡𝑡)2 −𝑐𝑐𝑝𝑝 𝑑𝑑𝑐𝑐 𝑡𝑡(1−𝑑𝑑𝑐𝑐 𝑡𝑡)].

(6)

It is assumed that 𝑐𝑐𝑝𝑝 < 𝑐𝑐𝑒𝑒 (1 − 𝑡𝑡)2 /[𝑑𝑑𝑐𝑐 𝑡𝑡 (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)] so the bonus coefficient and activity levels are positive.

Differentiating Equations (4), (5), and (6) with respect to the degree of book-tax conformity produces:∗𝜕𝜕𝛽𝛽𝑀𝑀𝜕𝜕𝑑𝑑𝑐𝑐= 〈𝑐𝑐𝑝𝑝 𝑡𝑡�𝑐𝑐𝑒𝑒 (1 − 𝑡𝑡)2 − 𝑐𝑐𝑝𝑝 (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 − 𝑐𝑐𝑒𝑒 𝜌𝜌�(1 − 𝑡𝑡)2 (1 − 2 𝑑𝑑𝑐𝑐 𝑡𝑡)𝑐𝑐𝑝𝑝 𝜎𝜎𝑝𝑝2 + (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)�(1 − 𝑑𝑑𝑐𝑐 𝑡𝑡) 𝑐𝑐𝑝𝑝 −22(1 − 𝑡𝑡)2 𝑐𝑐𝑒𝑒 �𝜎𝜎𝑒𝑒2 ��〉/�𝑐𝑐𝑒𝑒 (1 − 𝑡𝑡)2 + 𝑐𝑐𝑝𝑝 (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 + 𝑐𝑐𝑝𝑝 𝑐𝑐𝑒𝑒 𝜌𝜌 �(1 − 𝑡𝑡)2 𝜎𝜎𝑝𝑝2 + (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 𝜎𝜎𝑒𝑒2 �� < 0.
∗𝜕𝜕𝑎𝑎𝑝𝑝𝜕𝜕𝑑𝑑𝑐𝑐(7)= 〈(1 − 𝑡𝑡)𝑡𝑡�𝑐𝑐𝑒𝑒 (1 − 𝑡𝑡)2 − 𝑐𝑐𝑝𝑝 (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 − 𝑐𝑐𝑒𝑒 𝜌𝜌�(1 − 𝑡𝑡)2 (1 − 2 𝑑𝑑𝑐𝑐 𝑡𝑡)𝑐𝑐𝑝𝑝 𝜎𝜎𝑝𝑝2 + (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)�(1 − 𝑑𝑑𝑐𝑐 𝑡𝑡) 𝑐𝑐𝑝𝑝 −22(1 − 𝑡𝑡)2 𝑐𝑐𝑒𝑒 �𝜎𝜎𝑒𝑒2 ��〉/�𝑐𝑐𝑒𝑒 (1 − 𝑡𝑡)2 + 𝑐𝑐𝑝𝑝 (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 + 𝑐𝑐𝑝𝑝 𝑐𝑐𝑒𝑒 𝜌𝜌 �(1 − 𝑡𝑡)2 𝜎𝜎𝑝𝑝2 + (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 𝜎𝜎𝑒𝑒2 �� < 0.

4(8)𝜕𝜕𝑎𝑎𝑒𝑒∗𝜕𝜕𝑑𝑑𝑐𝑐= 𝑡𝑡�𝑐𝑐𝑒𝑒2 (1 − 𝑡𝑡)2 𝑐𝑐𝑝𝑝 𝜌𝜌�(1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 𝜎𝜎𝑒𝑒2 − (1 − 𝑡𝑡)2 𝜎𝜎𝑝𝑝2 � − 𝑐𝑐𝑝𝑝2 (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)4 − 𝑐𝑐𝑒𝑒2 (1 − 𝑡𝑡)4 + 2 𝑑𝑑𝑐𝑐 𝑡𝑡 𝑐𝑐𝑝𝑝 𝑐𝑐𝑒𝑒 (1 − 𝑡𝑡)2 −(1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)𝑐𝑐𝑝𝑝2 𝑐𝑐𝑒𝑒 𝜌𝜌�(1 − 𝑡𝑡)2 (1 − 3 𝑑𝑑𝑐𝑐 𝑡𝑡)𝜎𝜎𝑝𝑝2 + (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)3 𝜎𝜎𝑒𝑒2 ��/𝑐𝑐𝑒𝑒 �𝑐𝑐𝑒𝑒 (1 − 𝑡𝑡)2 + 𝑐𝑐𝑝𝑝 (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 + 𝑐𝑐𝑝𝑝 𝑐𝑐𝑒𝑒 𝜌𝜌 �(1 −2𝑡𝑡)2 𝜎𝜎𝑝𝑝2 + (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 𝜎𝜎𝑒𝑒2 �� < 0.

(9)

The result derives the following proposition.
𝑐𝑐 (1−𝑡𝑡)2

Proposition 1. If the production cost is relatively low �[𝑑𝑑 𝑒𝑒 (1−𝑑𝑑
𝑐𝑐 𝑡𝑡

𝑐𝑐 𝑡𝑡)]> 𝑐𝑐𝑝𝑝 > 𝑐𝑐𝑒𝑒 �, the optimal production and∗always decrease
earnings management activities 𝑎𝑎𝑝𝑝∗ , 𝑎𝑎𝑒𝑒∗ , respectively, and the optimal bonus coefficient 𝛽𝛽𝑀𝑀with the degree of book-tax conformity.

Proposition 1 states if the cost production cost is sufficiently low, the production and earnings management
activities, and the bonus coefficient decrease with the degree of book-tax conformity. The intuition of
Proposition 1 is as follows. An increase in the degree of book-tax conformity has several effects on theprincipal’s utility. First, according to Equation (3), the increase in the degree of book-tax conformity leads to adecrease in the levels of earnings management activities, but not in the production activities. This makes the∗principal set have relatively low incentive because the marginal impact of increasing 𝛽𝛽𝑀𝑀
decreases due to thedegree of book-tax conformity. Second, the impact of the degree of book-tax conformity purely increases tax

expense. This effect decreases the bonus coefficient. Third, the increase in the degree of book-tax conformity
increases the compensation volatility for the manager. This effect decreases the bonus coefficient because themanager is risk averse. All things considered, the impact of the degree of book-tax conformity affects managers’
earnings management activity and bonus coefficient directly. This effect decreases managers’ production
activity, coinciding with most of the current literature. Atwood et al. (2010) found that the higher conformity isrelated to lower earnings persistence. Proposition 1 shows that a higher conformity is related to lower
production activity, which may lead to lower earnings persistence. Further, Desai (2005) and Tang (2015)
associated higher conformity with lower levels of earnings management.
Substituting Equations (4)–(6) into the binding (PC), the expected utility of the principal 𝐸𝐸𝐸𝐸𝑃𝑃 was derived asfollows:

�𝑐𝑐 (1−𝑡𝑡)2 −𝑐𝑐 𝑑𝑑 𝑡𝑡(1−𝑑𝑑 𝑡𝑡)�

2

𝑒𝑒
𝑝𝑝 𝑐𝑐
𝑐𝑐
𝐸𝐸𝐸𝐸𝑃𝑃∗ = 2 𝑐𝑐 𝑐𝑐 �𝑐𝑐 (1−𝑑𝑑 𝑡𝑡)2 +𝑐𝑐.
(1−𝑡𝑡)2 + 𝑐𝑐 𝑐𝑐 𝜌𝜌�(1−𝑡𝑡)2 𝜎𝜎2 +(1−𝑑𝑑 𝑡𝑡)2 𝜎𝜎 2
𝑒𝑒 𝑝𝑝

𝑝𝑝

𝑐𝑐

𝑒𝑒

𝑒𝑒 𝑝𝑝

𝑝𝑝

𝑐𝑐

𝑒𝑒 ��

(10)

Differentiating Equation (11) with respect to the degree of book-tax conformity results in:𝜕𝜕𝐸𝐸𝐸𝐸𝑃𝑃∗＝
𝜕𝜕𝑑𝑑𝑐𝑐〈−𝑡𝑡 �𝑐𝑐𝑒𝑒 (1 − 𝑡𝑡)2 − 𝑐𝑐𝑝𝑝 𝑑𝑑𝑐𝑐 𝑡𝑡(1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)��𝑐𝑐𝑝𝑝 (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)3 (1 + 𝑐𝑐𝑒𝑒 𝜌𝜌 𝜎𝜎𝑒𝑒2 ) − 𝑐𝑐𝑒𝑒 (1 − 𝑡𝑡)2 [𝑑𝑑𝑐𝑐 𝑡𝑡 + 𝑐𝑐𝑒𝑒 𝜌𝜌(1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)𝜎𝜎𝑒𝑒2 ] + 𝑐𝑐𝑝𝑝 𝑐𝑐𝑒𝑒 𝜌𝜌(1 − 𝑡𝑡)2 (1 − 2 𝑑𝑑𝑐𝑐 𝑡𝑡)𝜎𝜎𝑝𝑝2 �〉2�𝑐𝑐𝑒𝑒 �𝑐𝑐𝑒𝑒 (1 − 𝑡𝑡)2 + 𝑐𝑐𝑝𝑝 (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 + 𝑐𝑐𝑝𝑝 𝑐𝑐𝑒𝑒 𝜌𝜌 �(1 − 𝑡𝑡)2 𝜎𝜎𝑝𝑝2 + (1 − 𝑑𝑑𝑐𝑐 𝑡𝑡)2 𝜎𝜎𝑒𝑒2 �� �

< 0.

This result derives the following proposition.

5

(11)

𝑐𝑐 (1−𝑡𝑡)2

Proposition 2. If the production cost is relatively low �[𝑑𝑑 𝑒𝑒 (1−𝑑𝑑
𝑐𝑐 𝑡𝑡

principal always decreases with the degree of book-tax conformity.

𝑐𝑐 𝑡𝑡)]> 𝑐𝑐𝑝𝑝 > 𝑐𝑐𝑒𝑒 �, the expected utility of the

As mentioned above, the degree of book-tax conformity has an indirect impact on managers’ production activity
via the bonus coefficient.

The change in managers’ activities according to the degree of book-tax conformity is analyzed next. According
to Proposition 1, if the production cost is sufficiently low, the managers’ optimal production and earnings
management activities 𝑎𝑎𝑝𝑝∗ , 𝑎𝑎𝑒𝑒∗ , respectively, always decrease with the degree of book-tax conformity. A

comparison of optimal managers’ activities shows that:∗𝑎𝑎𝑝𝑝

The result derives the following proposition.

𝑎𝑎𝑒𝑒∗

=

𝑐𝑐𝑒𝑒 (1−𝑡𝑡)

𝑐𝑐𝑝𝑝 (1−𝑑𝑑𝑐𝑐 𝑡𝑡)<1

𝑐𝑐 (1−𝑡𝑡)2

Proposition 3. If the production cost is relatively low �[𝑑𝑑 𝑒𝑒 (1−𝑑𝑑
𝑐𝑐 𝑡𝑡

𝑐𝑐 𝑡𝑡)](12)> 𝑐𝑐𝑝𝑝 > 𝑐𝑐𝑒𝑒 �, the degree of production

activity is never higher than the degree of earnings management activity.

Increases in the degree of book-tax conformity leads to the degree of earnings management being relatively low.
The ratio of production activity to earnings management activity shows that production activity will never behigher than the earnings management activity because of the effort cost. In this paper, it is assumed that the costof production activity is higher than that of earnings management activity. Therefore, the manager has more
incentive to engage in earnings management activities. Though, when there is an increase in the degree ofbook-tax conformity, managers’ incentive to engage in earnings management decreases. According to Equation(12), the degree of book-tax conformity will only affect the denominator of the ratio. As mentioned above, thedegree of book-tax conformity impacts the managers’ earnings management activity both directly and indirectly,
while the book-tax conformity impacts the managers’ production activity indirectly, via the bonus coefficient.
Overall, when the degree of book-tax conformity increases, the degree of earnings management decreases.

4. Empirical Research Design

4.1 Hypotheses development
Prior international studies found that earnings persistence, and the association between earnings and future cash
flows, are lower when book-tax conformity is higher (Atwood et al. 2010). Watrin et al. (2014) showed thathigher book-tax conformity yields greater downward earnings management. Also, as the Proposition 1 in
Section 3 shows, managers’ earnings management activities decreases with the degree of book-tax conformity.
Therefore, the following was hypothesized:
H1: The degree of book-tax conformity is negatively associated with accrual-based earnings management.

6

Assuming book-tax conformity has a negative impact on earnings management, this study next explores how
book-tax conformity affects managers’ compensation contracts. Gaertner (2014) was extended by including thedegree of book-tax conformity. In traditional principal-agency models, the principal pays the manager a risk
premium to encourage him or her to accept the compensation contract. In fact, CEOs who are compensatedafter-tax bear significant additional risks associated with the tax accounts. Thus, the possibility of exogenouschanges in the tax rate introduces significant compensation risks to CEOs paid on an after-tax basis (Newman1989). The higher the book-tax conformity, the lower the compensation risk to CEOs, so the principal can pay alower risk premium to the manager. Also, as Proposition 1 in Section 3 shows, the bonus coefficient ofmanagers’ compensation decreases with the degree of book-tax conformity. Therefore, the following was
hypothesized:
H2: The degree of book-tax conformity is negatively associated with CEO compensation.

4.2 Resign design and sample selection
4.2.1 Book-tax conformity measure
Atwood et al. (2010) defined book-tax conformity measures as the amount of variation in current tax expensethat is not captured by the variation in pre-tax income, in any given country-year. Countries that allow greater
flexibility in the reporting of taxable income, given a particular level of pre-tax income, have lower book-tax
conformity. Thus, to keep in line with Atwood et al. (2010), book-tax conformity is calculated by estimating theconditional variance of current tax expenses from the following model, estimated by country-year:
CTEt = θ0 + θ1 PTBIt + θ2 ForPTBIt + θ3 DIVt + et ,

(13)

2

where CTE is current tax expense , t is the year indicator, PTBI is the pre-tax book income, ForPTBI is theestimated foreign pre-tax book income (foreign tax expense / total tax expense x PTBI) 3, DIV is the total
dividends, and e is a disturbance term with mean zero. CTE, PTBI, ForPTBI, and DIV are divided by lagged
total assets to control for cross-sectional scale differences. The measure of book-tax conformity is calculated as
the scaled ranking of the root mean squared errors (RMSEs) obtained from country-year estimates of Equation(13).
Like Atwood et al. (2010), when a higher RMSE corresponds to lower book-tax conformity, vice versa, theanalysis uses descending ranks (i.e., the highest RMSE in a given year is ranked 0, and the lowest is ranked n - 1,
where n is the number of included countries in that year), then divides them by n - 1 to scale the rankings so thatthey range between zero and one. The higher ranks on the book-tax conformity measure indicates higher
conformity.
As a robustness test, Watrin et al. (2014) was followed to calculate book-tax conformity by calculating the2

All financial variables are drawn from Standard & Poor’s (S&P) Capital IQ platform.

3

Like Atwood et al. (2010), the database does not break pre-tax book income into its domestic and foreigncomponents, nor does it break foreign tax expenses into its current and deferred components. ForPTBI is theforeign percentage of pre-tax book income as foreign tax expense/total tax expense.

7

absolute value of permanent book-tax differences for each country-year:
PermBTDi,t = PTBIi,t − (Taxationi,t / TaxRatek,t ),(14)

where PermBTD is the permanent book-tax difference, t is the year indicator, i is the firm indicator, Taxation is
the total taxation 4, and TaxRate is the corporate tax rate of the country k 5. Like Watrin et al. (2014), the mean of
all the absolute values of permanent book-tax differences in one country in a given year was taken, and a rank
assigned to each country in each year based on PermBTDi,t in Equation (14). Also, the analysis uses

descending ranks (i.e., the highest RMSE in a given year is ranked 0 and the lowest is ranked n - 1, where n is
the number of included countries in that year), then divides them by n - 1 to scale the rankings. The final scaled
rank is calculated as the average rank over a 10-year period (2008–2018).

4.2.2 Earnings management measure
Following prior literature, discretionary accruals were used as a proxy for accrual-based earnings management.
In this study, the discretionary accruals, based on the Jones model in Equation (15), were modified in Equation(16) (Dechow et al. 1995). The abnormal accruals were also based on the Jones model in Equation (17), andaugmented for net income (Kothari et al. 2005) as the measure of earnings management in Equation (18). The
discretionary accrual is estimated cross-sectionally each country-year using all firm-year observations in thesame two-digit SIC code 6:
TAit = ι0 + ι1 (1/ASSETit−1 ) + ι2 ΔSALESit + ι3 PPEit + νit ,(15)

TAit = λ0 + λ1 (1/ASSETit−1 ) + λ2 ΔSALESit + λ3 PPEit + λ4 ROAit + 𝜋𝜋it ,(17)

TAit = κ0 + κ1 (1/ASSETit−1 ) + κ2 (ΔSALESit − ΔAR it ) + κ3 PPEit + ξit ,TAit = μ0 + μ1 (1/ASSETit−1 ) + μ2 (ΔSALESit − ΔAR it ) + μ3 PPEit + μ4 ROAit + τit ,

(16)

(18)

where TAit is the total accruals as the change in non-cash current assets minus the change in current liabilities,

excluding the current portion of long-term debts, minus depreciation and amortization, scaled by lagged total

assets; t is the year indicator; i is the firm indicator; ASSET is the total assets; ΔSALESit is the change in sales
scaled by lagged total assets; PPEit is net property, plant and equipment scaled by lagged total assets; ΔAR itis the change in accounts receivables scaled by lagged total assets; and ROAit is net income scaled by lagged
total assets.

4

Total taxation is the sum of current and deferred tax expenses of firm i in year t. Like Watrin et al. (2014), all

the financial variables are scaled by lagged total assets.
5

The tax rate of country k in year t are taken from KPMG’s Corporate Tax Rate Table (seehttps://home.kpmg/xx/en/home/services/tax/tax-tools-and-resources/tax-rates-online/corporate-tax-rates-table.ht
ml).
6

To further strengthen the quality of measure, all industry-country-years with fewer than 10 observations were

excluded.

8

4.3 Test for CEO compensation and the association between book-tax conformity and earnings
management
CEO compensation and the association between book-tax conformity and earnings management was tested
using the cross-section of firm-year observations. To mitigate the influence of error terms that are correlated
across firms; across time and across country, I follow the recommendation in Petersen (2009) by estimating all
regression models using ordinary least squares(OLS), using standard errors clustered by industry, and includingyear fixed effects . Specifically, the following models (with country and firm subscripts suppressed) were
estimated:
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑡𝑡 =𝜙𝜙0 + 𝜙𝜙1 𝐵𝐵𝐵𝐵𝐵𝐵𝑡𝑡 + 𝜙𝜙2 𝑁𝑁𝑁𝑁𝑁𝑁𝑡𝑡 + 𝜙𝜙3 𝑁𝑁𝑁𝑁𝑁𝑁 ∗ 𝐵𝐵𝐵𝐵𝐵𝐵𝑡𝑡 + 𝜙𝜙4 𝐶𝐶𝐶𝐶𝐶𝐶𝑡𝑡 + 𝜙𝜙5 𝐿𝐿𝐿𝐿𝑉𝑉𝑡𝑡−1 + 𝜙𝜙6 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝑡𝑡 + 𝜙𝜙7 𝑆𝑆𝑆𝑆𝑆𝑆𝐸𝐸𝑡𝑡−1 +𝜙𝜙8 𝑀𝑀𝑀𝑀𝑅𝑅𝑡𝑡−1 + 𝜙𝜙9 𝐽𝐽𝐼𝐼𝑡𝑡 + 𝜙𝜙10 𝑆𝑆𝐼𝐼𝑡𝑡 + 𝜙𝜙11 𝐼𝐼𝑃𝑃𝑡𝑡 + 𝜙𝜙12 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑡𝑡 + 𝜙𝜙13 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑡𝑡 + 𝜙𝜙14 𝑅𝑅𝑅𝑅𝑅𝑅𝑡𝑡−1 +𝜙𝜙15 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝑡𝑡−1 + ∑𝑗𝑗 𝜙𝜙16,𝑗𝑗 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌_𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑡𝑡,𝑗𝑗 + ∑𝑗𝑗 𝜙𝜙17,𝑘𝑘 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑠𝑠𝑡𝑡𝑡𝑡𝑡𝑡_𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑡𝑡,𝑘𝑘 +∑𝑗𝑗 𝜙𝜙17,𝑘𝑘 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶_𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑡𝑡,𝑘𝑘 + 𝜐𝜐𝑡𝑡 ,(19)

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝑡𝑡 = 𝜒𝜒0 + 𝜒𝜒1 𝐵𝐵𝐵𝐵𝐵𝐵𝑡𝑡 + 𝜒𝜒2 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝑡𝑡 + 𝜒𝜒3 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 ∗ 𝐵𝐵𝐵𝐵𝐵𝐵𝑡𝑡 + 𝜒𝜒4 𝐶𝐶𝐶𝐶𝐶𝐶𝑡𝑡 + 𝜒𝜒5 𝑅𝑅𝑅𝑅𝑅𝑅𝑡𝑡 + 𝜒𝜒6 𝑅𝑅𝑅𝑅𝑅𝑅𝑡𝑡−1 + 𝜒𝜒7 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑡𝑡 +𝜒𝜒8 𝑅𝑅𝑅𝑅𝑅𝑅𝑡𝑡 + 𝜒𝜒9 𝑅𝑅𝑅𝑅𝑅𝑅𝑡𝑡−1 + 𝜒𝜒10 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑡𝑡 + 𝜒𝜒11 𝐿𝐿𝐿𝐿𝐿𝐿𝑡𝑡 + 𝜒𝜒12 𝐶𝐶𝐶𝐶𝐶𝐶𝑡𝑡 + 𝜒𝜒13 𝑃𝑃𝑃𝑃𝑃𝑃𝑡𝑡 + 𝜒𝜒14 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡 + 𝜒𝜒15 𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡 +𝜒𝜒16 𝑆𝑆𝑆𝑆𝑆𝑆𝐸𝐸𝑡𝑡−1 + 𝜒𝜒17 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑡𝑡 + 𝜒𝜒18 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑡𝑡 + ∑𝑚𝑚 𝜒𝜒19,𝑚𝑚 𝑌𝑌𝑌𝑌𝑌𝑌𝑌𝑌_𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑡𝑡,𝑚𝑚 +∑𝑛𝑛 𝜒𝜒20,𝑛𝑛 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼_𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝑡𝑡,𝑛𝑛 + ∑𝑛𝑛 𝜒𝜒20,𝑛𝑛 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶_𝐷𝐷𝐷𝐷𝑚𝑚𝑚𝑚𝑚𝑚𝑡𝑡,𝑛𝑛 + 𝜔𝜔𝑡𝑡 ,(20)

where 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 is the discretionary accruals, and 𝐵𝐵𝐵𝐵𝐵𝐵 is the measure for book-tax conformity.
Based on H1 and the result of Proposition 1, if firm-years with higher conformity are associated with greater(downward) earnings management, 𝜙𝜙1 < 0 is predicted. The following dummy variable was inserted: 𝑁𝑁𝑁𝑁𝑁𝑁

equals 1 if discretionary accruals are negative, and 0 otherwise. The measure of book-tax conformity interacts

with this indicator variable to empirically assess how much higher or lower the discretionary accruals are whenbook-tax conformity changes. Consistent with the expectation that higher book-tax conformity is associatedwith greater downward earnings management, compared with lower book-tax conformity, 𝜙𝜙3 > 0 was

predicted.

Several controls and fixed effects were used because accounting research has identified numerous factors that
affect earnings management behaviors. The controlling for statutory tax rate (𝐶𝐶𝐶𝐶𝐶𝐶) variable is to ensure that thebook-tax conformity measure is not just reflecting differences in statutory tax rates that exist across different
countries (Atwood et al. 2010). Controlling for leverage (𝐿𝐿𝐿𝐿𝐿𝐿) is based on the assumption that managers are
more likely to use discretion in accounting as they offset tightening debt-covenant constraints (Sweeny 1994).
Also, control for loss (𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿) was included because of the incentive to manage earnings in order to avoid
reporting losses.

Regarding the firm size (𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆), positive accounting theory postulates that large firms engage in greater earnings
management than small firm do because of the differences in political costs (Watts and Zimmerman 1978). The

9market-to-book ratio (𝑀𝑀𝑀𝑀𝑀𝑀) was used to control for growth. In addition to judicial independence andshareholder interests, investor protection was used to determine country-specific effects, as prior research has
shown that investor protection has a negative influence on the magnitude of earnings management (Leuz et al.
2003; La Porta et al. 1998). Also, prior research shows that the Big 8 audit firms constrain earnings management
through discretionary accruals (DeFond and Jiambalvo 1991; Becker et al. 1998), but, according to the period of
the sample, a Big 4 dummy variable (𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷) was used to control the auditor type between the largest four
audit firms. Also, Zang (2012) found that firms with longer operating cycles (𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶) have greater flexibility
for accrual management because they have larger accrual accounts and a longer period for accruals to reverse.
Furthermore, the industry and year fixed effects were controlled.

Equation (20) estimates how book-tax conformity affects CEO compensation (𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶). In this study, the naturallog of CEO cash compensation and total board member cash compensation was the dependent variable 7. Basedon H2 and the result of Proposition 1, if firm-years with higher conformity are associated with lesscompensation through greater downward earnings management, then 𝜒𝜒1 < 0 is predicted. The following

dummy variable was inserted: 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 equals 1 if pre-tax incomes are negative, and 0 otherwise. ROA and RET

were included because they are important determinants of cash compensation (Sloan 1993). Also, the standard
deviation of incomes and stock returns are to control for risks in earnings dependent compensation (Gaertner
2014). Controlling for firm size (𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆) is based on political costs, as larger firms face more scrutiny on CEO

pay than smaller firms do (Leone et al. 2006). Several control variables that prior research have shown were also
included.

4.4 Sample selection
The group structure data, financial data, and compensation data were drawn from the Standard & Poor’s (S&P)
Capital IQ platform. All firm-year observations from 2007 to 2018 were obtained from the necessary data tocompute the earnings management and book-tax conformity measure. Following the prior literature, allobservations with missing SIC code and financial institutions (SIC 6000-6999), and regulated industries (SIC
4400-5000) were excluded from the sample. All firm-year observations from countries that do not have at least
40 usable firm-year observations, which is a less stringent data availability criterion than previous research used,were deleted. To mitigate the influence of outliers, the top and bottom 0.5% of each year were winsorized. To
test Equation (20), the firm-year observations with missing compensation data were removed. The sample
selection procedure yields 163,195 firm-year observations from 34 countries to test Equation (19), and 38,988
firm-year observations from 34 countries to test Equation (20).
Table 1 lists the sample countries and country-specific averages from the results of estimating Model (13) and(14). Also, it presents the average RMSE, average BTD, average Corporate tax rate (CTR) for each country, as
well as the number of years, N(years) and the number of firms, N(firms), that each country appears in thesample. The countries are sorted from high to low average book-tax conformity (Watrin et al. (2014) measure).

7

Cash compensation is the sum of salary, bonus, and non-equity incentive.

10

As corporate tax rate increases, book-tax conformity decreases. In other words, when the statutory tax rate ishigh, firms have higher incentives for tax planning. As the result, high statutory tax rate countries have arelatively high BTD (indicating low book-tax conformity). The relationship between statutory tax rate and
RMSE is shown to be similar.
[Insert Table 1 here]

4.5 Descriptive statistics
Table 2 presents the descriptive statistics for the sample of equation (19), the means of EM group are near zero.
The mean of BTC(A) and BTC(W) are 0.469 and 0.555, because the rank of two book-tax conformity measures
are different. For example, the average Wartin et al. (2014) measure of Japan is 0.8672, but under the average
Atwood et al. (2010) measure is 0.1746, also the number of firms of Japan is 2,642 per year. This different
causes the different in the mean of BTC(A) and BTC(W). Table 3 presents the descriptive statistics for the
sample of equation (20), due to the difficulty of collecting data, the number of data of dependent variable
LNCOMP is only 51,251. As the result the sample size of regression of equation (20) is 38,988. Thisphenomenon has been seen in many previous studies related to CEO compensation. The mean of ROA and
ROAt-1 are -0.039 and -0.035, but the median 0.026 and 0.027. Although the distribution of ROA and ROAt-1
are left-skewed, the impact on the analysis is not big.
[Insert Table 2 here][Insert Table 3 here]
Table 4 presents the correlation between the sample of equation (19). First the correlation between EM group
and BTC are all negative (p<0.01), the correlation between BTC and CTR are all negative (p<0.01). The
correlation between EM group and LOSS are all positive (p<0.01), that means when a firm have a loss after tax,
manager will have more incentive to manage the earnings. The correlation between EM group and ROA also
show the same result. Table 5 presents the correlation between the sample of equation (20). First the correlation
between LNCOMP and BTC are all negative (p<0.01). Also, the correlation between CTR and ROA are
negative. That means when the statutory corporate tax rate is high, firm will have less incentive to make a higher
profit. About the correlation between SIZE and ROA is positive (p<0.01) and correlation between SIZE and
STDROA, RET and STDRET are all negative (p<0.01), big firm can raised a good performance in such scaleeffect, on another hand, the performance is more stable and the stock price is relatively low.
[Insert Table 4 here][Insert Table 5 here]

5. Results
The results reported in Table 6 and 7. Table 6 address the effect of book tax conformity on earnings
management. Regarding the signed values of discretionary accruals (Table 6, Panel A) and absolute values of
discretionary accruals (Table 6, Panel B), the coefficients of book tax conformity (𝛷𝛷1 ) are all significant

11negative 8. Thus, as book tax conformity increases, earnings management decreases for positive discretionary
accrual firms, consistent with H1. Simultaneously, as book tax conformity increases, downward earnings
management increases. As the result, when book tax conformity increase, earnings management (absolutevalues of discretionary accruals) will decrease. The result is different from Wartin et al. (2014), but in this study,
I included more control variable for the cost of earnings management. Also, the result from theoretical part had
shown that when the degree of book-tax conformity increases, manager will have less incentive to manage
earnings. The second regression (Table 7) examines the impact of book tax conformity on CEO compensation(H2). I find that book tax conformity is associated with significantly less CEO compensation (𝜒𝜒1 < 0). Even

though I had already included some firm performance as the control variables, the coefficients are still negative,
consistent with H2. About the relationship between firm’s performance and CEO compensation, the resultshows that the coefficients of ROA, ROAt-1 and STDRET are negative, on other hand, coefficients of STDROA,
RET and RETt-1 are positive. Rego and Wilson (2009) also reported the similar result. They estimated US datafrom 1996 to 2001 and their results showed that the relationship between CEO compensation and RET ispositive but the relationship between ROA and compensation is not significant. As in equation (1), Total
compensation can be divided into fixed compensation and bonus. For the part of fixed compensation, no matter
firm have a loss or profit, it will not be negative. In general, the fixed compensation of a big firm is higher, if
more big firms have a loss, the coefficients of ROA may be negative. Compare with ROA, investor focus on
RET because of the investment return. So, the coefficients of RET is positive. Simultaneously, the coefficient of
STDRET show that investors do not prefer uncertainty.

6. Concluding Remarks
Regarding the increase in elaborate international tax shelter strategies during early 2000s, the internationallyagreed standards of transparency and exchange of information in tax area ensured consistent and effective
implementation of international transparency standards. However, BEPS is still a big issue on the political
agenda because of the aggressive tax planning by multinational enterprises (MNEs). This paper investigated
how the degree of book-tax conformity affects managers’ compensation contracts and earnings management
activity by using theoretical and empirical model simultaneously. This paper found that the bonus coefficientdecreases with the degree of book-tax conformity. The main findings are as follows: book-tax conformity
prevents the manager from engaging in earnings management activity as well as some production activities, as
the result, the CEO compensation will be relatively decrease; and the expected utility of the principal decreases
with the degree of book-tax conformity. These findings are supported by theoretical and empirical test. Some ofthese results are consistent with previous literature and real-world examples. For example, according to Ito
Review 9, the performance and compensation bonus of Japanese companies appears to be considerably lower
than global standards, especially in countries with lower book-tax conformity, such as the United States. The
8

I got the same result with different book tax conformity measure BTC(W).

9

See the Ito Review of Competitiveness and Incentives for Sustainable Growth-Building Favorable

Relationships between Companies and Investors, Ministry of Economy, Trade and Industry Japan (2014).

12

results of this paper provide one reason why compensation contracts are different among countries. Also, Zicke
and Kiy (2017) founded that the effect of German Accounting Law Modernization Act is a greater amount of
absolute discretionary accruals. Thus, when the degree of book-tax conformity decrease, earnings management
activity will become more aggressive.
In summary, this study shows that book tax conformity can prevents the earnings management activity.
However, this investigation has some caveats. First, the model in this study had not separate earnings
management activity and tax aggressiveness. Some theoretical models tested firm’s tax avoidance behavior(Ewert and Niemann 2014; Waegenaere et al. 2015). If I add a tax planning or tax avoidance activity into thetheoretical analysis part, the result may be different. However, the main purpose of this study is to investigate
the relationship between book-tax conformity affects managers’ compensation contracts and earnings
management activity by using theoretical and empirical model simultaneously. Generally, BTD is used in manystudies as the measure of tax avoidance, but it is used in the calculation of book-tax conformity measures BTC.
Thus, I did not add tax planning or tax avoidance activity into the model. Second, compare with equation (19),the number of observations of equation (20) is less than 1/4, only 38,988. Compare with firm’s financial or
accounting data, the number of available data on CEO compensation is less. Most prior literature on CEO
compensation faces the same problem. Since the result of this study is useful.
Using Global data allows me to study countries that employ different systems. Therefore, this study contributes
to the ongoing debate in many countries regarding whether high book tax conformity is associated with moreearnings management. Of course, earnings management is one aspect of earnings quality. The results suggestthat a higher book tax conformity can prevent earnings management. Therefore, the results indicate that U.S.
should move from a low book tax conformity system to a high book tax conformity system. If mandatory
application of IFRS is decided by Japanese government, they should keep the high book tax conformity system.
Overall, this study provides a new aspect for the relationship between book tax conformity and earnings
management. I build a theoretical model to comprehensively investigate the relationship between book-tax
conformity affects managers’ compensation contracts and earnings management activity. Prior literature tested
the relationship between book tax conformity and earnings management or earnings management and CEO
compensation, respectively. I believe that the results of this study can provide policy makers with informationon the determine of the book tax conformity system.

13

References
Atwood, T. J., Drake, M. S., & Myers, L. A. (2010) Book-tax conformity, earnings persistence and theassociation between earnings and future cash flows. Journal of Accounting and Economics, 50(1), 111–125.
Becker, C. L., DeFond, M. L., Jiambalvo, J., & Subramanyam, K. R. (1998). The effect of audit quality on
earnings management. Contemporary accounting research, 15(1), 1-24.
Blaylock, B., Gaertner, F., & Shevlin, T. (2015) The association between book-tax conformity and earnings
management. Review of Accounting Studies, 20(1), 141–172.
Burgstahler, D. C., Hail, L., & Leuz, C. (2006) The importance of reporting incentives: Earnings management inEuropean private and public firms. The Accounting Review, 81(5), 983–1016.
Chen, K. P., & Chu, C. C. (2005) Internal control versus external manipulation: A model of corporate income tax
evasion. RAND Journal of Economics, 36(1), 151–164.
Coppens, L., & Peek, E. (2005) An analysis of earnings management by European private firms. Journal ofInternational Accounting, Auditing and Taxation, 14(1), 1–17.
Crocker, K. J., & Slemrod, J. (2005) Corporate tax evasion with agency costs. Journal of Public Economics,
89(9-10), 1593–1610.
Dechow, P. M., Sloan, R. G., & Sweeney, A. P. (1995). Detecting earnings management. Accounting review,193-225.
DeFond, M. L., & Jiambalvo, J. (1991). Incidence and circumstances of accounting errors. Accounting review,
643-655.
Desai, M. A. (2005) The degradation of reported corporate profits. Journal of Economic Perspectives, 19(4),171–192.
Desai, M. A., & Dharmapala, D. (2006). Corporate tax avoidance and high-powered incentives. Journal of
financial Economics, 79(1), 145-179.
De Waegenaere, A., Sansing, R., & Wielhouwer, J. L. (2015). Financial accounting effects of tax aggressiveness:
Contracting and measurement. Contemporary Accounting Research, 32(1), 223-242.
Ewert, R., & Niemann, R. (2014) A theory of tax avoidance: Managerial incentives for tax planning in a
multi-task principal-agent model. CESifo Working Paper No. 4851. CESifo Group Munich.
Gaertner, F.B. (2014) CEO after-tax compensation incentives and corporate tax avoidance. Contemporary
Accounting Research, 31(4), 1077–1102.
Hanlon, M., Kelley Laplante, S., & Shevlin, T. (2005) Evidence for the possible information loss of conforming
book income and taxable income. The Journal of Law and Economics, 48(2), 407–442.
Hanlon, M., Maydew, E. L., & Shevlin, T. (2008) An unintended consequence of book-tax conformity: A loss ofearnings informativeness. Journal of Accounting and Economics, 46(2-3), 294–311.
Hanlon, M., & Shevlin, T. (2005) Book-tax conformity for corporate income: An introduction to the issues. In J.
M. Poterba (Ed.), Tax policy and the economy, volume 19 (pp. 101-134). Cambridge, MA: MIT Press.
Jones, J. J. (1991). Earnings management during import relief investigations. Journal of accounting research,
29(2), 193-228.
Kothari, S. P., Leone, A. J., & Wasley, C. E. (2005). Performance matched discretionary accrual measures.

14

Journal of accounting and economics, 39(1), 163-197.
Petersen, M. A. (2009). Estimating standard errors in finance panel data sets: Comparing approaches. The
Review of Financial Studies, 22(1), 435-480.
Porta, R. L., Lopez-de-Silanes, F., Shleifer, A., & Vishny, R. W. (1998). Law and finance. Journal of political
economy, 106(6), 1113-1155.
Leone, A. J., Wu, J. S., & Zimmerman, J. L. (2006). Asymmetric sensitivity of CEO cash compensation to stock
returns. Journal of accounting and economics, 42(1-2), 167-192.
Leuz, C., Nanda, D., & Wysocki, P. D. (2003) Earnings management and investor protection: An international
comparison. Journal of Financial Economics, 69(3), 505–527.
Murakami, Y., & Shiiba, A. (2015) Accrual-based and real earnings management in dynamic settings. Available
at SSRN 1435992.
Murakami, Y., & Ohta, Y. (2011) Conformity or decoupling: A comparative analysis on different tax regimes.
2011 American Accounting Association Annual Meeting – Tax Concurrent Sessions.
Newman, H. A. (1989) Selection of short-term accounting-based bonus plans. The Accounting Review, 64(4),758–772.
Slemrod, J. B., & Blumenthal, M. (1996) The income tax compliance cost of big business. Public Finance
Quarterly, 24(4), 411–438.
Sloan, R. G. (1993). Accounting earnings and top executive compensation. Journal of accounting andEconomics, 16(1-3), 55-100.
Sweeney, A. P. (1994). Debt-covenant violations and managers' accounting responses. Journal of accounting
and Economics, 17(3), 281-308.
Tang, T. Y. (2015) Does book-tax conformity deter opportunistic book and tax reporting? An international
analysis. European Accounting Review, 24(3), 441–469.
The Ministry of Economy, Trade and Industry (METI) (2014) , Final report of the Ito Review “Competitivenessand Incentives for Sustainable Growth : Building Favorable Relationships between Companies andInvestors” Retrieved fromhttps://www.meti.go.jp/english/policy/economy/corporate_governance/pdf/FRIR.pdf
Watrin, C., Ebert, N., & Thomsen, M. (2014) Book-tax conformity and earnings management: Insights from
European one- and two-book systems. The Journal of the American Taxation Association, 36(2), 55–89.
Watts, R. L., & Zimmerman, J. L. (1978). Towards a positive theory of the determination of accounting
standards. Accounting review, 112-134.
Whitaker, C. (2005) How to build a bridge: Eliminating the book-tax accounting gap. The Tax Lawyer, 59(4),981–1020.
Yin, G. K. (2001) Getting serious about corporate tax shelters: Taking a lesson from history. SMUL Rev., 54,
209.
Zang, A. Y. (2012). Evidence on the trade-off between real activities manipulation and accrual-based earnings
management. The accounting review, 87(2), 675-703.

15

Table 1. Level of Book Tax conformity measures by country
Avg. RANK

Avg. RANKCountryN(years)

Avg. RMSE

Avg. BTD

Avg. CTR

N(firms)(Atwood et al.)(Watrin et al.)Taiwan11

0.06230.9617(1)0.01030.9363(1)0.1873

1,354South Korea

110.07120.8942(2)0.01420.7593(8)0.2417

1,368

Japan

11

0.06780.8672(3)0.03460.1746(30)0.3644

2,642

Sri Lanka

11

0.08320.8186(4)0.01920.5749(16)0.2873

88

Egypt

7

0.07450.8007(5)0.02410.3848(21)0.2364

68

Italy

11

0.08680.7465(6)0.025

0.3584(25)0.3005

107

China

11

0.08440.7404(7)0.013

0.7956(6)

0.25

2,525

Spain

1

0.086

0.7273(8)0.020.4545(19)

0.25

39

Thailand11

0.08220.7264(9)0.011

0.8961(2)0.2391296

Vietnam

11

0.08720.6835(10)0.01310.7909(7)0.2355163

Pakistan

110.08910.6808(11)0.02450.3591(24)0.3364203

Turkey110.08820.6697(12)0.01150.8788(3)0.2018135

Malaysia

11

0.08850.6459(13)0.01310.7964(5)0.2473

542

India

11

0.09390.5869(14)0.02590.3259(26)0.33972,552South Africa

30.09980.5801(15)0.01380.7404(10)

0.28

41

Bangladesh

80.09410.5693(16)0.03590.0981(32)0.262593

Switzerland

110.14070.5664(17)0.01510.7106(11)0.182679

Singapore110.10230.5281(18)0.0186

0.5778(15)0.1718219

Indonesia

11

0.11780.518(19)0.02470.3663(22)0.2573178

Finland7

0.11740.4654(20)0.01820.5914(13)0.212943

Russia3

0.11680.4378(21)0.01390.7566(9)0.2

41Philippines

110.13050.4373(22)0.01220.8363(4)0.304552

Germany110.13090.3924(23)0.01950.5617(17)

0.296

261

France11

0.188

0.2796(24)0.0531

0(34)

0.333

292

Netherlands

5

0.198

0.2714(25)0.01690.6475(12)

0.25

42

Poland11

0.191

0.2589(26)0.03570.0778(33)

0.19

245

Norway80.23620.2574(27)0.02040.5027(18)0.262545

Denmark2

0.217

0.2467(28)0.02180.429(20)

0.22

41

Sweden11

0.27860.182(29)0.02750.273(27)0.2411

288

UK

11

0.30050.1555(30)0.03030.1932(29)0.2345525

Israel11

0.359

0.1326(31)0.01920.5891(14)0.2505

139

Australia

110.66810.0723(32)0.03180.1694(31)

0.3

691

US

11

1.08260.023(33)0.02750.2579(28)0.3882

1,767

Canada11

1.12130.0131(34)0.0250.3605(23)0.28181,123

16

Table 2. Descriptive Statistics of Select Variables: Discretionary Accruals

count

mean

sd

min

p25

p50

p75

max

EM1

205,771

0.020

0.128

-0.357-0.043

0.008

0.070

0.444

EM2

205,771

0.020

0.129

-0.364-0.043

0.007

0.070

0.447

EM3

205,771

0.000

0.109

-0.391-0.050-0.001

0.048

0.365

EM4

205,771

0.001

0.109

-0.383-0.050-0.002

0.048

0.365

ABSEM1

205,771

0.089

0.094

0.000

0.023

0.055

0.119

0.444

ABSEM2

205,771

0.090

0.095

0.000

0.023

0.056

0.120

0.447

ABSEM3

205,771

0.076

0.079

0.000

0.021

0.049

0.101

0.391

ABSEM4

205,771

0.076

0.079

0.000

0.021

0.049

0.101

0.383

BTC(A)

205,771

0.469

0.315

0.000

0.188

0.414

0.786

1.000

BTC(W)

205,771

0.555

0.353

0.000

0.172

0.643

0.897

1.000

CTR

205,771

0.291

0.069

0.150

0.250

0.280

0.340

0.407

LEV

205,771

0.465

0.295

0.011

0.257

0.447

0.627

2.212

LOSS

205,771

0.296

0.456

0.000

0.000

0.000

1.000

1.000

LNTA

205,77118.296

2.253

12.58116.85618.34319.75423.870MBR

178,965

2.558

4.151

-6.232

0.672

1.351

2.826

36.628

JI

205,771

4.929

0.922

2.230

4.099

4.899

5.829

6.818

SI

205,771

4.770

0.589

3.035

4.366

4.906

5.244

6.371

IP

205,771

6.485

1.263

2.000

5.300

6.300

7.300

9.300

DBIGFOUR

205,771

0.391

0.491

0.000

0.000

0.000

1.000

2.000

DAUDITCHA

205,771

0.162

0.368

0.000

0.000

0.000

0.000

1.000

ROA

205,771-0.0350.283-2.125-0.020

0.027

0.069

0.343

CYCLE

186,908

0.251

0.617

-3.472

0.078

0.210

0.383

4.137

Variable Definitions:
𝐸𝐸𝐸𝐸1 = earnings management in consolidated financial statements of firm measured as signed values of discretionary accruals based on the
Jones model in Equation (15); 𝐸𝐸𝐸𝐸2 = earnings management in consolidated financial statements of firm measured as signed values of
discretionary accruals based on the Modified Jones model in Equation (16); 𝐸𝐸𝐸𝐸3 = earnings management in consolidated financial
statements of firm measured as signed values of discretionary accruals based on the Performance Jones model in Equation (17); 𝐸𝐸𝐸𝐸4 =earnings management in consolidated financial statements of firm measured as signed values of discretionary accruals based on the
Performance modified Jones model in Equation (18); 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴1 = earnings management in consolidated financial statements of firmmeasured as absolute values of discretionary accruals based on the Jones model in Equation (15); 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴2 = earnings management inconsolidated financial statements of firm measured as absolute values of discretionary accruals based on the Modified Jones model inEquation (16); 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴3 = earnings management in consolidated financial statements of firm measured as absolute values of discretionary
accruals based on the Performance Jones model in Equation (17); 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴4 = earnings management in consolidated financial statements offirm measured as absolute values of discretionary accruals based on the Performance modified Jones model in Equation (18); 𝐵𝐵𝐵𝐵𝐵𝐵(𝐴𝐴) =book-tax conformity of firm as measured by Atwood et al. (2010); 𝐵𝐵𝐵𝐵𝐵𝐵(𝑊𝑊)= book-tax conformity of firm as measured by Watrin et al.
(2014); 𝐶𝐶𝐶𝐶𝐶𝐶= corporate tax rate of firm as measured by Watrin et al. (2014); 𝐿𝐿𝐿𝐿𝐿𝐿= leverage of firm calculated as the sum of liabilities
divided by lagged total assets; 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿= dummy variable of firm equal to 1 if a firm reports a loss after tax,0 otherwise; 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆= size of firm
calculated as the natural logarithm of firm’s lagged total assets; 𝑀𝑀𝑀𝑀𝑀𝑀= market-to-book ratio of firm; 𝐽𝐽𝐽𝐽= judicial independence of firm;
𝑆𝑆𝑆𝑆= protection of minority shareholder’s interest of firm; 𝐼𝐼𝐼𝐼= strength of investor protection of firm; 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷= dummy variable of firm
equal to 1 if the firm’s auditor is one of Big 4,0 otherwise; 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷= dummy variable of firm equal to 1 if the firm’s auditor changed
in previous year, 0 otherwise; 𝑅𝑅𝑅𝑅𝑅𝑅= return on asset of firm calculated as the after tax net income divided by lagged total assets; 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶=
business cycle of firm calculated as the days receivable plus the days inventory less the days payable and then divided by 365.

17

Table 3. Descriptive Statistics of Select Variables: Compensation
count

mean

sd

min

p25

p50

p75

max

LNCOMP

51,25125.9761.718

20.01624.92726.15427.18829.343

BTC(A)

205,771

0.469

0.315

0.000

0.188

0.414

0.786

1.000

BTC(W)

205,771

0.555

0.353

0.000

0.172

0.643

0.897

1.000

CTR

205,771

0.291

0.069

0.150

0.250

0.280

0.340

0.407

LOSS

205,771

0.304

0.460

0.000

0.000

0.000

1.000

1.000

ROA

205,771-0.0390.271-2.103-0.024

0.026

0.066

0.295

ROAt-1

205,771-0.0350.283-2.125-0.020

0.027

0.069

0.343

STDROA

177,611

0.121

0.316

0.002

0.017

0.036

0.083

2.990

RET

178,988

0.198

0.928

-0.938-0.276-0.0030.359

10.983

RETt-1

170,586

0.263

0.989

-0.940-0.236

0.037

0.425

11.000STDRET143,695

0.821

1.070

0.067

0.308

0.516

0.902

10.011

LEV

205,770

0.543

0.607

0.006

0.269

0.472

0.680

12.983

CFO

205,771

0.019

0.210

-1.387-0.015

0.050

0.111

0.478

MBR

178,965

2.558

4.151

-6.232

0.672

1.351

2.826

36.628PPE

205,771

0.322

0.278

0.000

0.104

0.264

0.464

1.781

INTANG

205,771

0.040

0.101

0.000

0.000

0.000

0.029

0.740

INV

205,771

0.133

0.140

0.000

0.015

0.100

0.195

0.754

SIZE

205,77118.296

2.253

12.58116.85618.34319.75423.870

DBIGFOUR

205,771

0.391

0.491

0.000

0.000

0.000

1.000

2.000

DAUDITCHA

205,771

0.162

0.368

0.000

0.000

0.000

0.000

1.000

Variable Definitions:
𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 = Firm’s CEO compensation calculated as the natural logarithm of CEO compensation; 𝐵𝐵𝐵𝐵𝐵𝐵(𝐴𝐴) = book-tax conformity of firm

as measured by Atwood et al. (2010); 𝐵𝐵𝐵𝐵𝐵𝐵(𝑊𝑊)= book-tax conformity of firm as measured by Watrin et al. (2014); 𝐶𝐶𝐶𝐶𝐶𝐶= corporate tax rateof firm as measured by Watrin et al. (2014); 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿= dummy variable of firm equal to 1 if a firm reports a loss after tax,0 otherwise; 𝑅𝑅𝑅𝑅𝑅𝑅=

return on asset of firm calculated as the after tax net income divided by lagged total assets; 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆= standard deviation of return on asset
for the prior four years; 𝑅𝑅𝑅𝑅𝑅𝑅= firm’s return; 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆= standard deviation of firm’s return for the prior four years; 𝐿𝐿𝐿𝐿𝐿𝐿= leverage of firm
calculated as the sum of liabilities divided by lagged total assets; 𝐶𝐶𝐶𝐶𝐶𝐶= cash flow operations of firm calculated as cash flow operations

divided by lagged total assets; 𝑀𝑀𝑀𝑀𝑀𝑀= market-to-book ratio of firm; 𝑃𝑃𝑃𝑃𝑃𝑃= net property, plant and equipment of firm calculated as the net
property, plant and equipment divided by lagged total assets; 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼= intangible asset of firm calculated as the sum of intangible asset

divided by lagged total assets; 𝐼𝐼𝐼𝐼𝐼𝐼= inventory of firm calculated as the sum of inventory divided by lagged total assets; 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆= size of firm
calculated as the natural logarithm of firm’s lagged total assets; 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷= dummy variable of firm equal to 1 if the firm’s auditor is oneof Big 4,0 otherwise; 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷= dummy variable of firm equal to 1 if the firm’s auditor changed in previous year, 0 otherwise.

18

Table 4: Correlations: Discretionary Accruals
EM1

EM2

EM3

EM4

BTC(A)BTC(W)

CTR

LEV

LOSS

LNTA

EM1

1.000

EM2

0.982***

1.000

EM3

0.713***

0.697***

1.000

EM4

0.698***

0.716***

0.979***1.000

BTC(A)-0.095***-0.096***-0.008***-0.011***1.000

BTC(W)-0.238***-0.238***-0.025***-0.031***0.496***

1.000

CTR

0.119***

0.120***

0.004

0.007**-0.593***-0.258***

1.000

LEV

-0.064***-0.062***-0.014***-0.011***-0.080***0.001

0.131***

1.000

LOSS

0.031***

0.029***

0.052***

0.056***-0.156***-0.342***0.044***

0.041***

1.000

LNTA

-0.027***-0.028***-0.057***-0.057***0.114***

0.233***

0.037***

0.075***-0.349***

1.000

MBR

0.033***

0.037***

0.011***

0.014***

0.027***-0.087***-0.034***-0.032***0.026***-0.082***

19

MBR

1.000

Table 4 (continued)
EM1

EM2

EM3

EM4

BTC(A)BTC(W)

CTR

LEV

LOSS

LNTA

JI

0.109***

0.110***

0.023***

0.025***-0.574***-0.454***0.278***-0.067***0.253***-0.074***SI

0.106***

0.106***

0.016***

0.018***-0.386***-0.413***0.170***-0.071***0.215***-0.079***IP

0.147***

0.147***

0.024***

0.026***-0.373***-0.466***0.325***

0.004

0.220***-0.104***

DBIGFOUR

0.026***

0.026***-0.032***-0.031***-0.053***0.005*-0.009***-0.018***-0.056***0.365***DAUDITCHA-0.034***-0.032***

0.002

0.004

0.017***

0.050***

0.006**

0.023***

0.021***-0.041***

ROA-0.015***-0.015***-0.062***-0.065***0.157***

0.328***-0.064***-0.174***-0.556***

0.372***

CYCLE-0.031***-0.031***-0.008***-0.008***0.126***

0.148***-0.071***-0.099***-0.072***0.044***

20

Table 4 (continued)
MBR

JI

SI

IP

DBIGFOUR

JI-0.022***

1.000

SI

-0.025***0.839***

1.000

IP

-0.067***0.421***

0.471***

1.000

DBIGFOUR-0.059***0.245***

0.274***

0.177***

1.000

DAUDITCHA

0.008***-0.064***-0.082***-0.046***-0.122***

1.000

ROA

-0.085***-0.253***-0.205***-0.191***0.070***-0.016***

1.000

CYCLE

-0.046***-0.145***-0.102***-0.094***-0.053***-0.0020.135***21

DAUDITCHA

ROA1

Cycle11.000

Table 5: Correlations: Compensation

LNCOMP

BTC(A)BTC(W)

CTR

LOSS

ROA

ROAt-1

STDROA

RET

RETt-1

LNCOMP

1.000

BTC(A)-0.198***1.000

BTC(W)-0.361***0.496***

1.000

CTR

0.123***-0.593***-0.258***

1.000

LOSS

-0.141***-0.147***-0.345***0.043***

1.000

ROA

0.108***

0.162***

0.348***-0.066***-0.569***1.000

ROAt-1

0.096***

0.157***

0.328***-0.064***-0.455***0.683***

1.000

STDROA-0.098***-0.114***-0.314***0.026***

0.336***-0.578***-0.577***

1.000

RET

-0.038***-0.034***-0.068***0.017***

0.016***-0.032***-0.087***0.065***

1.000

RETt-1-0.024***-0.010***-0.054***-0.021***-0.022***0.016***-0.023***0.070***-0.084***

1.000

STDRET-0.155***-0.009***-0.204***-0.013***0.195***-0.213***-0.213***0.289***

0.249***

0.269***

22

STDRET

1.000

Table 5 (continued)

LNCOMP

BTC(A)BTC(W)

CTR

LOSS

ROA

ROAt-1

STDROA

RET

RETt-1

STDRETLEV

0.004-0.050***-0.047***0.046***

0.023***-0.095***-0.164***0.133***

0.015***

0.052***

0.049***

CFO

0.129***

0.120***

0.269***-0.026***-0.472***0.683***

0.664***-0.482***-0.024***-0.056***-0.216***MBR

0.080***

0.027***-0.087***-0.034***0.006*-0.051***-0.085***0.111***-0.085***0.246***

0.124***

PPE-0.093***0.029***-0.036***-0.021***0.055***

0.072***-0.002-0.018***0.033***

0.090***

0.105***INTANG

0.210***-0.011***-0.200***-0.027***0.048***-0.056***-0.072***0.040***

0.008**

0.018***

0.002

INV

-0.053***0.150***

0.178***-0.046***-0.239***0.206***

0.175***-0.175***-0.006*0.027***-0.062***SIZE

0.610***

0.114***

0.233***

0.037***-0.338***0.355***

0.372***-0.368***-0.093***-0.076***-0.257***

DBIGFOUR

0.454***-0.053***0.005*-0.009***-0.061***0.075***

0.070***-0.099***-0.030***-0.052***-0.140***DAUDITCHA-0.087***0.017***

0.050***

0.006**

0.017***-0.013***-0.016***0.014***-0.009***0.011***

0.024***

23

Table 5 (continued)

LEV

CFO

MBR

PPE

INTANGINVSIZE

DBIGFOUR

LEV

1.000

CFO

-0.121***

1.000

MBR

0.046***-0.124***

1.000

PPE

0.069***

0.052***-0.034***

1.000

INTANG

0.085***-0.041***0.122***-0.155***

1.000

INV

0.142***

0.088***-0.009***-0.070***-0.061***

1.000

SIZE

-0.051***0.373***-0.082***0.003

0.070***

0.081***

1.000

DBIGFOUR-0.043***0.097***-0.059***-0.047***0.051***-0.070***0.365***

1.000

DAUDITCHA

0.027***-0.019***0.008***

0.003-0.010***0.013***-0.041***-0.122***24

DAUDITCHA

1.000

Table 6, Panel A Results of Regressions: Discretionary Accruals
Predicted Sign

EM1

EM2

EM3

EM4

-0.0172-0.0157

0.0716***0.0707***(-1.31)(-1.21)(12.68)(12.41)-0.0390***-0.0391***-0.00969***-0.0102***(-7.39)(-7.23)(-4.30)(-4.44)-0.179***-0.180***-0.146***-0.146***(-37.70)(-37.54)(-45.51)(-45.63)0.0500***0.0490***0.0270***0.0262***(8.56)(8.30)(6.53)(6.33)

0.00262*

0.00208-0.00136-0.00134(1.68)(1.30)(-1.28)(-1.23)-0.000752-0.00134-0.00292***-0.00280***(-0.64)(-1.12)(-4.41)(-4.27)-0.00793***-0.00810***0.000530

0.0000596(-4.16)(-4.15)(0.72)(0.08)

0.0126***0.0126***-0.00161-0.00104(4.84)(4.64)(-1.55)(-1.08)0.00727***

0.00714***0.000989***0.000926***(6.50)(6.33)(3.47)(3.22)-0.00131*-0.00138*-0.00118***-0.00131***(-1.78)(-1.84)(-2.70)(-3.05)-0.00437***-0.00407***-0.000909*-0.000488(-6.08)(-5.59)(-1.91)(-1.02)-0.00267***-0.00282***-0.00138***-0.00125***(-5.22)(-5.40)(-3.01)(-2.66)0.0124***0.0117***-0.0179***-0.0186***(4.14)(3.91)(-8.12)(-8.52)0.00150***0.00154***-0.000152-0.0000866(3.85)(3.93)(-1.01)(-0.58)0.000875***0.000956***0.000330***0.000421***(8.27)(9.04)(4.45)(5.63)YEAR fixed effect

Yes

Yes

Yes

Yes

Industry fixed effect

Yes

Yes

Yes

Yes

Country fixed effect

Yes

Yes

Yes

Yes

N

163,195

163,195

163,195

163,195

R^2a

0.474

0.475

0.479

0.480

Constant

BTC(A)－DNEG

DNEG*BTC

LEV

LOSS

JI

SI

IP

DBIGFOURDAUDITCHA

CYCLE

ROA

LNTA

MBR

t statistics in parentheses+* p<0.10, ** p<0.05, *** p<0.01

25

26

Table 6, Panel B Results of Regressions: Absolute Discretionary Accruals
Predicted Sign

ABSEM1

ABSEM2

ABSEM3

ABSEM40.0740***0.0778***0.141***

0.144***(4.26)(4.43)(16.50)(16.84)-0.0221***-0.0225***-0.00938***-0.00938***(-5.72)(-5.68)(-4.38)(-4.41)0.0232***0.0231***0.0175***0.0174***(15.55)(15.19)(15.82)(15.52)0.0122***0.0126***0.00270***0.00229***(11.40)(11.59)(3.90)(3.41)-0.0150***-0.0156***-0.00705***-0.00721***(-6.64)(-6.75)(-5.68)(-5.80)0.0161***0.0168***0.00782***

0.00783***(5.03)(5.06)(4.58)(4.66)

0.00949***

0.00926***

0.00284***

0.00271***(7.44)(7.21)(5.30)(5.07)-0.00446***-0.00446***-0.00276***-0.00273***(-5.23)(-5.17)(-4.87)(-4.86)-0.00278***-0.00266***-0.00101-0.000998(-3.46)(-3.31)(-1.43)(-1.41)-0.00195***-0.00189***-0.00147***-0.00154***(-3.91)(-3.74)(-3.51)(-3.64)-0.0317***-0.0310***-0.0298***-0.0303***(-12.84)(-12.66)(-13.17)(-13.32)-0.00372***-0.00378***-0.00566***-0.00573***(-8.22)(-8.28)(-28.74)(-29.17)0.00197***

0.00200***

0.00168***0.00173***(17.99)(18.01)(21.53)(21.75)YEAR fixed effect

Yes

Yes

Yes

Yes

Industry fixed effect

Yes

Yes

Yes

Yes

country fixed effect

Yes

Yes

Yes

Yes

N

163,195

163,195

163,195

163,195

R^2a

0.127

0.126

0.115

0.114

Constant

BTC(A)

LEV

LOSS

JI

SI

IP

DBIGFOURDAUDITCHA

CYCLE

ROA

LNTA

MBR

t statistics in parentheses－* p<0.10, ** p<0.05, *** p<0.01

27

Table 7, Results of Regressions: Compensation
Predicted Sign
Constant

BTC(A)－

LNCOMPLNCOMP

18.16***

18.33***(62.74)(62.82)-1.790***(-18.33)

BTC(W)－-1.860***(-29.94)

LOSS

LOSS*BTC

CTR

ROA

ROAt-1

STDROA

RET

RETt-1

STDRET

LEV

CFO

MBR

PPE

INTANG

INV

28-0.307***-0.108***(-7.58)(-4.17)0.419***-0.615***(3.75)(-8.07)0.740***

0.365*(2.83)(1.74)-0.128***-0.0252(-3.37)(-0.81)-0.305***-0.244***(-8.74)(-8.49)0.150***

0.0520**(5.80)(2.50)

0.0601***0.0362***(5.82)(3.96)

0.0338***0.0395***(3.72)(4.31)-0.0344***-0.0327***(-4.18)(-4.57)-0.0334**-0.0115(-1.99)(-1.13)-0.191***-0.149***(-3.15)(-2.77)0.0273***0.0223***(13.69)(11.89)-0.0611-0.0142(-1.64)(-0.42)

0.973***

0.351***(14.72)(6.06)

0.0512

0.0945(0.67)(1.37)

SIZE

0.415***

0.416***(67.79)(72.39)0.260***

0.0856***(12.95)(4.41)-0.113***-0.0300(-4.74)(-1.42)

YEAR fixed effect

Yes

Yes

Industry fixed effect

Yes

Yes

country fixed effect

Yes

Yes

N

38,98838,988

R^2a

0.508

0.544

DBIGFOURDAUDITCHAt statistics in parentheses * p<0.10, ** p<0.05, *** p<0.0129