Last‐Chance Earnings Management: Using the Tax Expense to Meet Analysts' Forecasts*

TLDR

Tax expense, one of the last accounts closed before earnings announcements, offers a unique window into earnings management as managers estimate and negotiate it with auditors immediately prior to reporting. The study tests whether shifts in effective tax rates between the third and fourth quarters predict whether and how much firms miss analysts’ consensus earnings forecasts. Earnings absent tax expense management were quantified by adjusting pre‑tax earnings with the third‑quarter effective tax rate. Firms that miss forecasts lower their projected effective tax rates, while those that exceed targets raise them, indicating that reported taxes are routinely manipulated to meet earnings goals.

Abstract

Abstract We assert that the tax expense is a powerful context in which to study earnings management, because it is one of the last accounts closed prior to earnings announcements. Although many pre‐tax accruals must be posted in the year‐end general ledger, managers estimate and negotiate tax expense with their auditors immediately prior to earnings announcements. We hypothesize that changes from third‐ to fourth‐quarter effective tax rates (ETRs) are negatively related to whether and how much a firm's earnings absent tax expense management miss analysts' consensus forecast, a proxy for target earnings. We measure earnings absent tax expense management as actual pre‐tax earnings adjusted for the annual ETR reported at the third quarter. We provide robust evidence that firms lower their projected ETRs when they miss the consensus forecast, which is consistent with firms decreasing their tax expense if non‐tax sources of earnings management are insufficient to achieve targets. We also find that firms that exceed earnings targets increase their ETR, but this effect is less significant. By studying the tax expense in total, rather than narrow components of deferred tax expense, our results provide general evidence that reported taxes are used to manage earnings.