Are Taxes a Determinant Factor in Earnings Management Behavior?: Empirical Results from the Brazilian Insurance Market

Are Taxes a Determinant Factor in Earnings Management Behavior?: Empirical Results from the Brazilian Insurance Market

Eduardo Flores (University of São Paulo, Brazil), Joelson Oliveira Sampaio (University of São Paulo, Brazil) and George Sales (University of São Paulo, Brazil)
DOI: 10.4018/978-1-4666-8453-9.ch007
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Abstract

Unequal tax rules between economic sectors can stimulate the practice of earnings management. Our purpose is therefore to determine whether the enforcement of these laws have created incentives for earnings management in Brazil. To test the hypothesis, we selected a sample-data composed by Brazilian insurance companies, since this sector suffered a considerable increase in the income-taxes rate in 2008, moving the global rate from 34% to 40%. The utilization of this group was motivated because according to Brazilian tax regulatory system, technical accruals from insurance companies are considers deductible from income taxes. The results showed a significant relationship between the increased tax rates and the measure of the technical accruals, showing evidence of earnings management behavior in this industry specifically in the period in which the tax-rate was increased for this group of companies.
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7.1. Introduction

Earnings management (EM) is an important issue for accounting researchers. So many authors investigate how this practice leads to biases in financial statements, more specifically in profits (e.g. HEPWORTH, 1953; JONES, 1991, DECHOW; SLOAN; SWEENEY, 1995; DECHOW et al, 2011). According to Healy and Wahlen (1999), earnings management has been defined as the use of judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.

Doupinik (2008) shows that prior research has investigated various incentives for EM: stock prices, income targets, less variable income reports and many other factors that stimulate managers to change results with artificial accounting entries. Logically, EM is only expected to occur in firms where the perceived benefits are greater than the perceived risks incurred in this kind of accounting manipulation. Watts and Zimmerman (1978) established three general lines associated with motivational factors that tend to foster companies' earnings management behavior: (I) capital markets; (II) regulatory costs; and (III) benefits to the accounting performance. Each of these can be interpreted differently and there are therefore multiple perspectives of the main reasons for the practice of EM. More specifically, referring to the incentives of regulatory costs, it is plausible that the tax environment in which a firm operates is a strong stimulus for increasing managers' discretionary judgment in financial statements. Dealing with the involuntary obligation of tax payments, firms usually seek alternative ways to reduce taxes on their core business, even running the risk of reducing the quality of their accounting measurement (e.g. CHEN; DALEY, 1996; BEATY; HARRIS, 1998; BADERTSCHER et al, 2006; DESAI; DHARMAPALA, 2009).

In the Brazilian taxation system, companies may be treated differently for various reasons, such as firm size, capital structure or business sector. In this last one, For example, in 2008 the tax rate was raised in the case of financial companies from 34% to 40% of EBIT. It is reasonable to believe that this encouraged firms to compute lower profits in order to pay less tax.

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