Book tax differences are they affected by equity based compensation

Description
This study aims to investigate the moderating effect of equity-based compensation on the
sources of book-tax differences. The authors investigate whether equity-based compensation affects the
association between book-tax differences and tax planning, and the association between book-tax
differences and earnings management.

Accounting Research Journal
Book-tax differences: are they affected by equity-based compensation?
Chunwei Xian Fang Sun Yinghong Zhang
Article information:
To cite this document:
Chunwei Xian Fang Sun Yinghong Zhang , (2015),"Book-tax differences: are they affected by equity-
based compensation?", Accounting Research J ournal, Vol. 28 Iss 3 pp. 300 - 318
Permanent link to this document:
http://dx.doi.org/10.1108/ARJ -12-2013-0088
Downloaded on: 24 January 2016, At: 20:51 (PT)
References: this document contains references to 54 other documents.
To copy this document: [email protected]
The fulltext of this document has been downloaded 225 times since 2015*
Users who downloaded this article also downloaded:
Ning Du, Kevin Stevens, J ohn McEnroe, (2015),"The effects of comprehensive income on investors’
judgments: An investigation of one-statement vs. two-statement presentation formats", Accounting
Research J ournal, Vol. 28 Iss 3 pp. 284-299 http://dx.doi.org/10.1108/ARJ -11-2013-0083
Michael Seamer, Adrian Melia, (2015),"Remunerating non-executive directors with stock options:
who is ignoring the regulator?", Accounting Research J ournal, Vol. 28 Iss 3 pp. 251-267 http://
dx.doi.org/10.1108/ARJ -12-2013-0092
Mahfoudh Abdul Karem Mahfoudh Al-Musali, Ku Nor Izah Ku Ismail, (2015),"Board diversity and
intellectual capital performance: The moderating role of the effectiveness of board meetings",
Accounting Research J ournal, Vol. 28 Iss 3 pp. 268-283 http://dx.doi.org/10.1108/ARJ -01-2014-0006
Access to this document was granted through an Emerald subscription provided by emerald-
srm:115632 []
For Authors
If you would like to write for this, or any other Emerald publication, then please use our Emerald
for Authors service information about how to choose which publication to write for and submission
guidelines are available for all. Please visit www.emeraldinsight.com/authors for more information.
About Emerald www.emeraldinsight.com
Emerald is a global publisher linking research and practice to the benefit of society. The company
manages a portfolio of more than 290 journals and over 2,350 books and book series volumes, as
well as providing an extensive range of online products and additional customer resources and
services.
Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the
Committee on Publication Ethics (COPE) and also works with Portico and the LOCKSS initiative for
digital archive preservation.
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
*Related content and download information correct at time of
download.
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
Book-tax differences: are they
affected by equity-based
compensation?
Chunwei Xian
Northeastern Illinois University, Chicago, Illinois, USA
Fang Sun
Queens College, City University of New York, Flushing, New York, USA, and
Yinghong Zhang
Department of Accounting,
University of Central Oklahoma, Edmond, Oklahoma, USA
Abstract
Purpose – This study aims to investigate the moderating effect of equity-based compensation on the
sources of book-tax differences. The authors investigate whether equity-based compensation affects the
association between book-tax differences and tax planning, and the association between book-tax
differences and earnings management.
Design/methodology/approach – The authors use a sample of 9,024 frm-year observations (913
frms) spanning the period 1992-2011, obtained from ExecuComp and Compustat. They estimate
cross-sectional regressions of the proxy for tax planning, discretionary accruals and their interactions
with equity-based compensation on book-tax differences.
Findings – The authors fnd that tax planning-related book-tax differences increase as the
equity-based pay of executives does, and that earnings management-related book-tax differences
decrease as the equity-based pay of executives increases. The results are robust across three alternative
measures of tax planning.
Originality/value – Equity-based compensation plays an important role in managerial discretion on
tax planning and earnings management. The fndings suggest that, although equity incentives promote
a high level of both tax planning and earnings management, they motivate managers to constrain the
level of earnings management to avoid larger book-tax differences.
Keywords Earnings management, Book-tax differences, Equity-based compensation, Tax planning
Paper type Research paper
1. Introduction
This study investigates the moderating effect of equity-based compensation on the
association between book-tax differences and tax planning, and on the association
between book-tax differences and earnings management. Tax planning and earnings
management activities are considered two types of managerial actions that can
signifcantly affect book-tax differences. Equity-based pay is believed to effectively
mitigate the conficts that arise between shareholders and executives by providing a
portion of frmwealth to executives (Hall and Murphy, 2002). Prior studies indicate that
We acknowledge the excellent assistance of NEIU graduate assistant Artesia Walker.
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1030-9616.htm
ARJ
28,3
300
Received2 December 2013
Revised12 June 2014
21 August 2014
Accepted1 September 2014
Accounting Research Journal
Vol. 28 No. 3, 2015
pp. 300-318
©Emerald Group Publishing Limited
1030-9616
DOI 10.1108/ARJ-12-2013-0088
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
larger book-tax differences occur when executives are granted more stock options or
restricted stock (Mills and Newberry, 2001; Frank et al., 2009; Desai and Dharmapala,
2006). However, a high level of book-tax differences may be very costly to frms if
investors see it as a signal of low earnings persistency that may decrease frm value.
Indeed, Hanlon (2005) fnds that investors of frms with large book-tax differences lower
their expectation on earnings persistency. Investors judge book-tax differences
according to their source when they assess frmvalue. For example, Blaylock et al. (2012)
demonstrate that earning response coeffcients are higher for frms whose book-tax
differences likely arise fromtax-planning activities, while earning response coeffcients
are lower for frms whose book-tax differences likely arise from earnings management
activities. Overall, if book-tax differences are earnings management-related, they may
signal low quality, but if they are tax planning-related, investors may view the
differences more favorably. Therefore, managers need to trade-off tax planning and
earnings management activities, which may result in large book-tax differences. In this
study, we investigate whether equity-based pay promotes a higher level of tax
planning-related book-tax differences and constrains the level of earning management
related to book-tax differences.
Book-tax differences have increased dramatically over the past 19 years[1], as the
growing divergence between fnancial reporting income and taxable income draws
attention from government agencies and academics. Basically, book-tax differences
arise from the incongruence between tax laws and accounting standards. Plesko (2000)
asserts that the divide between tax and fnancial reporting is attributable to the
utilization of tax-planning activities[2]. However, Phillips et al. (2003) and Hanlon (2005)
argue that the expanding book-tax gap arises from earnings management. In general,
managerial behavior to minimize corporate tax obligations can increase cash fow and
after-tax income. Firm market value is positively associated with the level of tax
planning in frms with strong corporate governance (Desai and Dharmapala, 2009)[3].
Tucker and Zarowin (2006) fnd that the extent of earnings smoothing increases with
future earnings response coeffcients if discretionary accruals refect managers’
evaluation of future earnings. However, a high degree of earnings management often
signals potential fnancial problems and prior studies show that it is usually associated
with a higher probability of bankruptcy, higher borrowing costs and higher earnings
volatility (Ibrahim, 2009; McNichols and Wilson, 1988; Meek et al., 2007).
Consistent with prior studies (Jensen and Meckling, 1976; Smith and Stulz, 1985), we
assume that equity-based compensation motivates executives to work for the beneft of
shareholders. We expect a higher level of tax planning-related book-tax differences in
companies that grant their chief executive offcers (CEOs) more stock options or
restricted stock because tax-planning activities generally increase frm value. But if
equity-based compensation of executives effectively aligns the interests of both
executives and shareholders, opportunistic behaviors can be reduced. In our test
settings, this means that equity-based compensation can reduce the positive correlation
between book-tax differences and earnings management.
To investigate the moderating effect of equity-based compensation on the
association between tax planning and book-tax differences and on the association
between earnings management and book-tax differences, we use 9,024 frm-year
observations from Compustat and ExecuComp databases for the period 1992-2011. We
regress the book-tax differences on the proxy for tax planning, the proxy for earnings
301
Equity-based
compensation
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
management and their interactions with equity-based compensation. We include control
variables shown to have an association with book-tax differences in prior studies. We
use three alternative proxies for tax-planning activities: discretionary permanent
differences from the Frank et al. (2009) model, the generally accepted accounting
principles (GAAP) effective tax rate and the cash effective tax rate. We use discretionary
accruals from the performance-adjusted Jones model to proxy the degree of earnings
management. The control variables include the variables of frm-specifc characteristics
such as intangible assets, proftability, foreign income and leverage.
This study adds to the literature on the link between tax planning and executive
compensation practices by examining the moderating effect of equity-based
compensation on the book-tax differences related to tax planning and earnings
management. Prior studies document the positive effect of equity-based compensation
on tax-planning activities, but they do not examine whether the association between
book-tax differences and tax-planning activities is also affected by equity-based
compensation. Studies also fnd that the level of earnings management is positively
related to managers’ equity incentives (Cheng and Warfeld, 2005). Thus, equity-based
compensation is positively associated with book-tax differences because equity-based
compensation encourages both tax planning and earnings management. Large book-tax
differences can easily draw attention from regulators, auditors and investors and
analysts, and this may impose signifcant costs on companies. Because of the costs of
large book-tax differences for frms, we predict that managers will trade-off tax
planning and earnings management to avoid large book-tax differences. These external
users of fnancial reporting review differently on book-tax differences arising from tax
planning and those from earnings management. It is important, then, to investigate
what factors impact the associations between book-tax differences and the two major
sources: tax planning and earnings management.
We have two key fndings. First, our empirical results indicate that book-tax
differences more likely arise from tax-planning activities when corporations reward
their CEOs with more equity-based compensation. This means that equity-based
compensation motivates executives to engage in tax-planning activities that also beneft
shareholders. Second, our results document the negative moderating effect of
equity-based compensation on the relationship between book-tax differences and
discretionary accruals. The negative moderating effect indicates that equity incentives
effectively deter opportunistic behaviors by executives to increase personal benefts and
sacrifce shareholder wealth.
The remainder of the study is organized as follows: in the next section, we reviewthe
literature and develop hypotheses; in the third section, we explain our sample selection
criteria and descriptive statistics. The fourth section describes our empirical models,
and the ffth section reports the results from the main regressions. The sixth section
summarizes our fndings.
2. Literature review and development of hypotheses
This paper focuses on two types of managerial actions that often result in book-tax
differences: tax-planning activities and earnings management activities. In general,
tax-planning behavior tends to manage earnings downward, whereas earnings
management behavior tends to manage earnings upward. Book-tax differences are
positively associated with tax-planning activities, as many tax-planning activities can
ARJ
28,3
302
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
reduce taxable income without affecting book income (Shevlin, 2002; Plesko, 2004;
McGill and Outslay, 2004). Wilson (2009) and Frank et al. (2009) fnd evidence of a
positive association between book-tax differences and the degree of tax-sheltering
activities that frms engage in. Studies also document that book-tax differences are
positively associated with the level of earnings management (Phillips et al. 2003; and
Hanlon, 2005). Phillips et al. (2003) evaluate the usefulness of book-tax differences in
detecting earnings management compared to various accrual measures. Mills and
Newberry (2001) fnd that the magnitude of book-tax differences is positively associated
with earnings management incentives such as fnancial distress and bonus thresholds.
Large book-tax differences are not always a signal of low earnings quality. This
depends on whether they are more earnings management-related or tax
planning-related. Blaylock et al. (2012) study the earnings persistence and earnings
response coeffcients in frm years with large positive book-tax differences and report
that earnings persistence and earnings response coeffcients are higher for frms with a
higher level of tax planning and that they are lower for frms with a higher level of
earnings management. Thus, book-tax differences that arise from tax-planning
strategies are more likely to increase frmvalue. But book-tax differences that arise from
earnings management are more likely to have negative consequences to shareholders,
such as increasing fnance cost and decreasing earnings persistence.
This study investigates the moderating effect of equity-based pay on the association
among book-tax differences, tax-planning activities and earnings management
activities. While prior studies indicate that equity incentives can motivate executives to
work on tax planning which subsequently contributes to the long-term value of
corporations (Desai and Dharmapala, 2006; Rego and Wilson, 2012), researchers fnd
that the tendency of earnings management is higher when executives are granted a
larger proportion of equity-based pay (Meek et al., 2007; Cheng and Warfeld, 2005).
However, a large difference in book income and tax income may signal a “red fag” for
the corporate management team, especially if the teammanages accounting earnings to
maximize their own benefts at the expense of shareholders. For example, The existence
of a high level of book-tax differences may attract the scrutiny of the Securities and
Exchange Commission and other regulators (Cloyd, 1995; Mills, 1998; Badertscher et al.,
2009). Therefore, managers need to consider the consequences of large book-tax
differences and adjust their involvement in tax planning and earnings management.
The literature on executive compensation demonstrates that equity incentives work
more effectively than cash compensation to reduce conficts of interest between
executives and shareholders. Equity-based compensation motivates executives to
behave in a manner benefcial to shareholders by directly linking corporate performance
and the personal wealth of executives (Hall and Murphy, 2002). Book-tax differences
that likely arise from tax-planning activities are usually viewed positively by investors
(Blaylock et al., 2012). As tax-planning activities can beneft shareholders, we argue that
tax-planning strategies will be more aggressive in those frms that provide more
equity-based compensation to their managers. That is, a larger portion of book-tax
differences comes from tax-planning activities when equity-based pay is higher.
On the contrary, if a strong association between book-tax differences and earnings
management exists, the large book-tax differences may easily draw the attention of
regulators and result in lower frmmarket value. In these scenarios, the cost of earnings
management may exceed the benefts and could potentially be harmful to shareholders.
303
Equity-based
compensation
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
We expect that frms will have fewer earning management-related book-tax differences
when they grant more equity-based pay to managers. In other words, equity-based pay
has a negative moderating effect on the positive relation between the earnings
management and book-tax differences. Overall, executives with more equity-based pay
may engage in more tax planning to increase frmvalue and may be less likely to engage
in earnings management that only increases their own wealth and hurts investors in the
long run.
Therefore, we state our hypotheses in the alternative form:
H1a. The tax planning-related book-tax differences are greater when CEO
equity-based compensation is higher.
H1b. The earnings management-related book-tax differences are smaller when CEO
equity-based compensation is higher.
3. Methodology
We estimate the following Models 1-3 to test the hypotheses[4]. We regress book-tax
differences on the proxy for tax-planning activities, the proxy for earnings management
and their interactions with equity-based compensation. We have three alternative
measures that capture tax-planning activities: DISPERM, ETR and CETR. We use
discretionary accruals to proxy the extent of earnings management. The control
variables include the variables of frm-specifc characteristics such as proftability,
foreign income and leverage:
BTD
i,t
? ?
0
? ?
1
DISPERM
i,t
? ?
2
DISPERM ? EQUITYMIX
i,t
? ?
3
DA
i,t
? ?
4
DA ? EQUITYMIX
i,t
? ?
5
EQUITYMIX
i,t
? ?
6
PPE
i,t
? ?
7
INTANG
i,t
? ?
8
FI
i,t
? ?
9
NOL
i,t
? ?
10
DEBT
i,t
? ?
11
ROA
i,t
? ?
12
RD
i,t
? ?
13
MB
i,t
? ?
14
TA
i,t
? yeardummies ? industrydummies ? ?
i,t
(1)
BTD
i,t
? ?
0
? ?
1
ETR
i,t
? ?
2
ETR ? EQUITYMIX
i,t
? ?
3
DA
i,t
? ?
4
DA ? EQUITYMIX
i,t
? ?
5
EQUITYMIX
i,t
? ?
6
PPE
i,t
? ?
7
INTANG
i,t
? ?
8
FI
i,t
? ?
9
NOL
i,t
? ?
10
DEBT
i,t
? ?
11
ROA
i,t
? ?
12
RD
i,t
? ?
13
MB
i,t
? ?
14
TA
i,t
? yeardummies ? industrydummies ? ?
i,t
(2)
BTD
i,t
? ?
0
? ?
1
CETR
i,t
? ?
2
CETR ? EQUITYMIX
i,t
? ?
3
DA
i,t
? ?
4
DA ? EQUITYMIX
i,t
? ?
5
EQUITYMIX
i,t
? ?
6
PPE
i,t
? ?
7
INTANG
i,t
? ?
8
FI
i,t
? ?
9
NOL
i,t
? ?
10
DEBT
i,t
? ?
11
ROA
i,t
? ?
12
RD
i,t
? ?
13
MB
i,t
? ?
14
TA
i,t
? yeardummies ? industrydummies ? ?
i,t
(3)
where the subscript i stands for the companies, and the subscript t stands for the years
(Table I).
3.1 Dependent variable
As Manzon and Plesko (2002), Wilson (2009) and Lisowsky (2010) do, we calculate total
book-tax difference (BTD) as pre-tax book income minus estimated taxable income
scaled by the beginning balance of total assets, where estimated taxable income equals
ARJ
28,3
304
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
the sumof current federal tax expenses, current foreign income tax expenses, divided by
the statutory tax rate. Accounting income includes the income from controlled foreign
subsidiaries, but taxable income generally excludes income from foreign subsidiaries
until a company’s dividends are repatriated. We estimate foreign income as current
foreign income tax expenses divided by the US statutory tax rate, and we calculate
taxable income by including both foreign and domestic income. The taxable income
measure is limited and very likely underestimated because the foreign statutory tax rate
is generally lower than the US statutory tax rate. To control for the effect of foreign
income on the BTD, we include the foreign income (FI) control variable in our regression
models later. We use BTD instead of temporary differences because many tax shelter
activities, which we consider a basic tax-planning strategy, generate permanent
differences, an important part of tax planning-related differences. Hanlon (2005) and
Blaylock et al. (2012) investigate whether temporary book-tax differences provide
information about earnings persistence. They exclude permanent differences in their
Table I.
Variable defnition
Variables Defnition
BTD The book-tax difference, which is calculated as pre-tax book income minus
estimated taxable income scaled by the beginning balance of total assets,
where estimated taxable income ?(current federal tax expenses ?current
foreign income tax expense)/statutory tax rate; Compustat{PI-[(TXFED ?
TXFO)/STR]}/lag(AT)
DISPERM The discretionary permanent difference from Frank et al. (2009) model
ETR The GAAP effective tax rate, which is calculated as total income tax
expense divided by pre-tax income (Compustat TXT/PI)
CETR The cash effective tax rate, which is calculated as cash taxes paid divided
by pre-tax income (Compustat TXPD/PI)
DA The absolute value of discretionary accruals from the performance-
modifed Jones model (Jones, 1991; Kothari et al. 2005)
EQUITYMIX The sum of granted stock options (Black and Scholes value) and restricted
stock divided by the total CEO compensation
PPE Net value of property, plant and equipment (Compustat PPE) scaled by the
beginning balance of total assets
INTANG Intangible assets (Compustat INTAN) scaled by the beginning balance of
total assets
FI A dummy variable coded as one if the frm has foreign income (Compustat
PIFO); and zero otherwise
NOL A dummy variable coded as one if the loss carryforward (Compustat
TLCF) is positive at the beginning of the fscal year; and zero otherwise
DEBT Total liabilities (Compustat DLTT and DLC) scaled by the beginning
balance of total assets
ROA Income before extraordinary items (Compustat IB) divided by the
beginning balance of total assets
RD Research and development expense (Compustat XRD) divided by the
beginning balance of total assets
MB The ratio of market value of equity to book value of equity at the
beginning of the fscal year (Compustat CSHO*PRCC_F /CEQ)
TA The natural logarithm of total assets at the beginning of the fscal year
(Compustat AT).
305
Equity-based
compensation
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
main test because some permanent differences (e.g. tax-exempt interest and the
dividend received deduction) do not refect the quality of earnings related to accrual
accounting (Hanlon, 2005)[5].
3.2 Testing variables
3.2.1 Measures of tax planning. We employ three proxies for the level of tax-planning
activities. Our frst proxy, DISPERM, captures the discretionary permanent differences
using the Frank et al. (2009) model[6]. We frst regress total permanent differences
(PERMDIFF) on non-discretionary items known to cause permanent differences (e.g.
intangible assets) but are probably not related to tax-planning activities. We estimate
Model 4 for each of the two-digit Standard Industrial Classifcation (SIC) industry
groups for each year from 1992 to 2011. All variables are scaled by the balance of total
assets at the beginning of the fscal year. Discretionary permanent differences
(DISPERM) are the residuals fromthe annual cross-sectional regressions of Model 4. We
use the discretionary permanent differences to proxy the level of tax planning. The
higher residual indicates a higher tax-planning involvement. As discussed by Frank
et al. (2009), this measure of tax planning has several advantages over alternative
measures. First, we control for factors that are probably unrelated to tax planning, such
as goodwill and other intangible assets that generate permanent differences because of
variations between the fnancial and tax rules. Studies document that the changes in net
operating loss carryforward ( ?NOL) often impact book-tax differences (e.g. Miller and
Skinner, 1998; Schrand and Wong, 2003; Frank and Rego, 2006) but are not typically
associated with tax planning. Last, this measure is statistically better than the tax
avoidance measure used by Desai and Dharmapala (2006) in predicting tax shelter
activity (Frank et al. 2009):
PERMDIFF
it
TA
i,t?1
? ?
0
?
1
TA
i,t?1
?
? ?
1
?
INTANG
it
TA
i,t?1
?
? ?
2
?
UNCON
it
TA
i,t?1
?
? ?
3
?
MI
i,t
TA
i,t?1
?
? ?
4
?
CSTE
it
TA
i,t?1
?
? ?
5
?
?NOL
it
TA
i,t?1
?
? ?
6
?
LAGPERM
it
TA
i,t?1
?
? ?
it
(4)
Where:
PERMDIFF
it
? total book-tax differences less temporary book-tax differences for
frm i in year t {BI
it
- [(CFTE
it
?CFOR
it
)/STR
t
]} - (DTE
it
/STR
t
)[7];
TA
i,t-1
? total assets (Compustat AT) for frm i at the beginning of fscal
year t;
INTANG
it
? goodwill and other intangibles (Compustat INTAN) for frm i in
year t;
UNCON
it
?income (loss) reported under the equity method (Compustat ESUB)
for frm i in year t;
MI
it
? income (loss) attributable to minority interest (Compustat MII) for
frm i in year t;
CSTE
it
? current state income tax expense (Compustat TXS) for frm i in
year t;
?NOL
it
? change in net operating loss carryforwards (Compustat TLCF) for
frm i in year t;
ARJ
28,3
306
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
LAGPERM
it
?one-year lagged PERMDIFF for frm i in year t; and
?
it
?discretionary permanent difference (DISPERM
it
) for frmi in year t.
In addition to the discretionary permanent differences, we employ two effective tax rates
to measure the level of tax planning, ETR and CETR, commonly used to evaluate the
tax-planning level in prior studies (Callihan, 1994; Mills et al., 1998; Yin, 2003; Chen et al.,
2010; Dyreng et al., 2010). The frst ratio, ETR, also called the GAAP ETR, is the ratio of
total income tax expense to pre-tax income[8]. The numerator, total income tax expense,
includes both current tax expenses and deferred tax expenses. Thus, it does not refect
temporary differences of tax income and book income and only refects permanent
book-tax differences. The second ratio is the cash effective tax rate, CETR, calculated as
cash taxes paid divided by pre-tax income. Unlike the GAAP ETR, CETRrefects actual
cash tax payments. Tax-planning activities can often defer cash tax payments.
Generally, the more a frm engages in tax-planning activities, the lower its effective tax
rates (both ETR and CETR). These two measures are inverse measures of tax planning.
3.3 Measure of earnings management
The absolute value of discretionary accruals (DA) is calculated from the
performance-modifed Jones model by Kothari et al. (2005). The discretionary accruals
are the residuals from running the cross-sectional modifed Jones models by two-digit
SIC industry and year. H1b expects negative signs on the interaction term of DA and
EQUITMIX in our testing models (1–3), which indicates that book-tax differences are
less likely related to earnings management when executives receive more equity-based
compensation.
3.4 Measure of equity-based compensation
One of our main testing variables is EQUITYMIX, the sumof granted stock options and
restricted stock divided by total CEO compensation. It measures the weight of
equity-based compensation, including stock options and restricted stock, in total CEO
compensation. EQUITYMIX is calculated by using the ExecuComp variables.
Equity-based pay is the sumof ExecuComp item“Option_Awards_BLK_VALUE” and
ExecuComp item“RSTKGRNT”. Total CEOcompensation is ExecuComp item“TDC1”
which is composed of salary, bonus, total value of restricted stock granted, total value of
stock options granted, long-termincentive payouts and all other total. The stock options
are valued by the Black and Scholes (1973) method. Equity-based compensation is often
considered a more effective incentive than cash compensation for two reasons:
(1) the stock options and restricted stock are considered as long-term pay because
they usually have a three- to fve-year vesting period. Studies demonstrate that
long-term pay works more effectively than cash compensation to discourage
opportunistic behaviors (Hall and Murphy, 2002; Bryan et al., 2000; Kwon and
Yin, 2006).
(2) CEOs share the risk of operational performance when their ownership increases,
aligning the interests of shareholders and executives. Consistent with Desai and
Dharmapala (2006), we expect a positive sign on EQUITYMIX in all three
models; frms will have a larger book-tax difference if they pay executives more
equity-based compensation.
307
Equity-based
compensation
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
H1a predicts that the association between book-tax differences and tax planning
increases with the CEO’s equity-based compensation. Executives with high
equity-based pay tend to engage in tax-planning activities, resulting in higher book-tax
differences. Generally, the more tax-planning activities a frm has, the higher the
DISPERMdifference. But the more tax-planning activities a frmhas, the lower the ETR
and CETR. Therefore, H1a predicts a positive sign on the interaction term DISPERM*
EQUITYMIXin Model 1, whereas H1a predicts a negative sign on the interaction terms
CETR*EQUITYMIX in Model 2, and ETR*EQUITYMIX in Model 3.
H1b, which expects a negative sign on the interaction termDA?EQUITYMIXin all
three models, investigates the moderating effect of equity-based compensation on the
relationship between book-tax differences and earning management. Earning
management-related book-tax differences create negative images with regard to
investor perspective on earnings quality. High equity incentives can reduce interest
conficts, and thus, executives are less likely to become involved with earning
management activities that result in higher book-tax differences.
3.5 Control variables
We include the variables of frm-specifc characteristics such as proftability, foreign
income and leverage. These factors usually have an impact on book-tax differences, but
they are not subject to managerial discretions on tax planning or earnings management.
We control for these variables to ensure that our results are not driven by factors related
to corporate opportunities to get involved in tax shelters.
We expect positive signs on both PPE and INTANG in the three models. The tax
treatments on plant assets and intangible assets are usually different from fnancial
accounting standards. Firms with more long-term assets generate a lower effective tax
rate due to a high volume of depreciation expenses (Mills et al., 1998). Firms with more
investment opportunities can engage in tax-planning activities through their operations
and investment strategies.
We expect that a larger book-tax difference exists for frms with foreign operations
(FI). Firms with foreign operations have greater opportunities to avoid income tax
through relocation of operations, repatriation and transfer pricing (Phillips, 2003; Rego,
2003). For instance, they can reduce effective tax rates by shifting operating income to
foreign countries with low income tax rates. We include the NOL variable because a
frm’s positive balance of a loss carryforward can be used to reduce the amount of
taxable income, as a loss carryforward produces a “tax shelter” for a corporation. Thus,
we predict a positive relation between book-tax differences and NOL.
DEBT captures the extent of the tax shield of debt, as interest expenses are
deductible (Armstrong et al., 2012). DEBT is also associated with a frm’s tax-planning
strategies because risk-taking CEOs may be more likely to engage in aggressive
tax-planning strategies. Therefore, we expect companies with higher leverage to have a
higher book-tax difference. We control for ROA because prior studies fnd that more
proftable companies are more likely to engage in tax-sheltering activities (Wilson, 2009;
Lisowsky, 2010). We expect that more proftable companies will have larger book-tax
differences. Increasing expenses in RDcan often generate research and development tax
credits; thus, we expect a positive relation between RD and book-tax differences. MB is
a proxy for growth opportunities, expected to be positively related to book-tax
differences. Growing frms, which are often in the earlier stages of the business life cycle,
ARJ
28,3
308
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
typically have more tax incentives fromtax authorities, for example, Amazon and Tesla
Motors. TA is the measurement for a frm’s size. We control for the effect of frm size
because larger frms tend to involve more efforts on tax planning due to the benefts of
economies of scale (Rego, 2003).
4. Sample selection and data description
We start with a sample of 35,673 observations (company-years) in ExecuComp that
reports total compensation data for CEOs for the period 1992-2011. We exclude
companies in fnancial services (with two-digit SIC codes 60-69). We then merge this
sample with Compustat and eliminate companies with incomplete data. We remove the
frm-years with negative book-tax differences because the motivation to have a positive
book-tax difference may be different from the motivation to have a negative book-tax
difference. Our fnal sample includes 913 companies covering 9,024 company-years for
the period 1992-2011.To remove the effect of outliers, we winsorize all the continuous
variables at 1 and 99 per cent levels.
Table II presents descriptive statistics for CEO total compensation, equity-based
compensation and other frm characteristics. The statistics in Panel A of Table II show
that the mean and median of book-tax differences are $200,298 and $30,737,
respectively. After the log transformation, the distribution of book-tax differences is less
skewed, with a mean of 0.041 and a median of 0.030. The mean and median of
discretionary permanent differences (DISPERM) are 0.008 and 0.001, respectively,
comparable to prior studies (Frank et al., 2009; Rego and Wilson, 2012). The mean and
median of GAAP effective tax rates (ETR) is 0.308, indicating that one-third of pre-tax
income is income tax expenses on fnancial reporting. The mean and median of cash
effective tax rates (CETR) is 0.258, which indicates that taxes actually paid by frms
account for one-quarter of pre-tax income. The mean of discretionary accruals equals to
0.077 with a lower quartile 0.025 and an upper quartile 0.092, comparable to the data of
Meek et al. (2007). On average, total assets are $5,829 million and the mean ROAis 0.095.
On average, 21.9 per cent of a frm’s total assets are fnanced with debt. The statistics in
Panel B show that the mean value for the total CEO compensation and equity-based
compensation are $4,760,000 and $1,846,000, respectively. On average, 30.6 per cent of
total CEOcompensation is composed of equity-based pay, with the upper quartile of 51.1
per cent.
Table III presents the Pearson and Spearman correlations among the variables.
Seven correlation coeffcients are greater than 0.3. Among these relatively high
correlation coeffcients, the Pearson correlation coeffcient between book-tax
difference (BTD) and ROA is 0.447, which indicates that more proftable companies
have a higher level of book-tax income differences. The Pearson and Spearman
correlation coeffcients between ROA and MB are 0.429 and 0.566, respectively,
showing that a frm with more investment opportunities tends to have a greater
return-on-asset ratio. The Pearson correlation between BTD and DISPERM is 0.315,
indicating that book-tax differences are greater in frms with high tax-planning
levels. The Spearman correlation between BTD and CETR is ?0.375, showing that
book tax differences are negatively correlated with the cash effective tax rate, an
inverse measure of tax-planning activities.
The correlation coeffcients among the three proxies for tax planning, DISPERM,
ETR and CETR, are all signifcant at the 0.01 level (p ? 0.01). The Pearson
309
Equity-based
compensation
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
correlation coeffcient and the Spearman correlation coeffcient between ETR and
CETR are 0.454 and 0.483, respectively, indicating that the GAAP effective tax rates
are highly correlated with cash effective tax rates in our sample. The Pearson
correlation coeffcient and the Spearman correlation coeffcient between
DISPERM and ETR are ?0.094 and ?0.222, respectively. The Pearson correlation
coeffcient and the Spearman correlation coeffcient between DISPERM and CETR
are ?0.128 and ?0.110, respectively. These correlation coeffcients indicate that
frms with high discretionary permanent differences have relatively lower ETR and
CETR.
Table II.
Descriptive statistics
Variable Mean SD
Lower
quartile Median
Upper
quartile
Panel A: Corporate fnancial characteristics
BTD (scaled by total assets) 0.041 0.040 0.015 0.030 0.053
BTD1 (thousand dollars) 200.298 791.242 9.990 30.737 104.309
DISPERM 0.008 0.043 ?0.007 0.001 0.016
ETR 0.308 0.199 0.281 0.345 0.380
CETR 0.258 0.161 0.188 0.269 0.337
DA 0.077 0.097 0.025 0.052 0.092
EQUITYMIX 0.306 0.274 0.000 0.266 0.511
PPE 0.286 0.225 0.119 0.223 0.389
INTANG 0.235 0.235 0.043 0.171 0.358
FI 0.625 0.484 0.000 1.000 1.000
NOL 0.402 0.490 0.000 0.000 1.000
DEBT 0.219 0.195 0.038 0.198 0.331
ROA 0.095 0.063 0.052 0.081 0.121
RD 0.033 0.051 0.000 0.009 0.047
MB 3.422 2.888 1.744 2.595 3.970
TA 7.135 1.512 6.043 7.022 8.096
Total assets (million dollars) 5829.328 24046.935 470.854 1258.996 3788.144
Panel B: Components of executive compensation (thousand dollars)
TOTALPAY 4760.572 6456.273 1354.964 2922.454 5781.181
EQUITYPAY 1846.750 4556.058 0.000 699.078 1994.039
TOTAL_ALT1 2953.082 5917.032 0.000 0.000 3961.635
RSTKGRNT 205.081 1303.832 0.000 0.000 0.000
EQUITYMIX 0.306 0.274 0.000 0.266 0.511
Notes: This panel reports the descriptive statistics of corporate fnancial characteristics for 9,024
frm-year observations from 1992 to 2011. Variable defnitions can be found in Table I. Total
book-tax differences are measured in thousand dollars and total assets are measured in million
dollars. To alleviate outlier problems, we winsorize observations with continuous variables at the
bottom 1% and the top 1% levels; This panel reports the descriptive statistics of CEO
compensation for 9,024 frm-year observations from 1992 to 2011. TOTALPAY is the total
CEO compensation. EQUITYPAY is the sum of stock options and restricted stock granted to the
CEO. TOTAL_ALT1 is the Black and Scholes value of stock options granted to the CEO.
RSTKGRNT is the restricted stock granted to the CEO. All of the four compensation variables are
measured in thousand dollars. To alleviate outlier problems, we winsorize observations with
continuous variables at the bottom 1% and the top 1% levels.
ARJ
28,3
310
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
Table III.
Pearson and
Spearman correlation
B
T
D
D
I
S
P
E
R
M
E
T
R
C
E
T
R
D
A
E
Q
U
I
T
Y
M
I
X
P
P
E
I
N
T
A
N
G
F
I
N
O
L
D
E
B
T
R
O
A
R
D
M
B
T
A
B
T
D
0
.
3
1
5
?
0
.
2
0
9
?
0
.
2
6
9
0
.
1
5
0
0
.
0
4
3
?
0
.
0
2
0
?
0
.
0
0
1
0
.
0
3
5
0
.
0
7
1
?
0
.
0
6
5
0
.
4
4
7
0
.
2
8
8
0
.
1
7
5
?
0
.
1
0
6
D
I
S
P
E
R
M
0
.
1
8
6
?
0
.
0
9
4
?
0
.
1
2
8
0
.
0
8
3
0
.
0
6
2
?
0
.
0
7
4
?
0
.
0
7
0
0
.
0
8
9
0
.
0
4
7
?
0
.
0
6
8
0
.
3
2
5
0
.
2
7
1
0
.
1
0
2
?
0
.
0
3
7
E
T
R
?
0
.
2
9
1
?
0
.
2
2
2
0
.
4
5
4
?
0
.
0
4
5
0
.
0
0
6
0
.
0
8
8
0
.
0
2
1
?
0
.
0
8
8
?
0
.
1
0
1
0
.
0
8
5
?
0
.
0
4
4
?
0
.
1
8
8
?
0
.
0
1
0
0
.
0
3
9
C
E
T
R
?
0
.
3
7
5
?
0
.
1
1
0
0
.
4
8
3
?
0
.
0
5
6
?
0
.
0
6
1
0
.
0
3
9
?
0
.
0
4
6
?
0
.
0
4
4
?
0
.
1
2
2
?
0
.
0
1
8
?
0
.
0
0
9
?
0
.
1
4
2
?
0
.
0
2
0
?
0
.
0
2
0
D
A
0
.
1
3
1
0
.
0
3
6
?
0
.
0
3
8
?
0
.
0
8
8
0
.
0
9
3
?
0
.
0
1
0
?
0
.
0
1
7
?
0
.
0
2
3
0
.
0
0
9
?
0
.
0
4
9
0
.
1
9
6
0
.
1
7
7
0
.
1
4
6
?
0
.
1
2
9
E
Q
U
I
T
Y
M
I
X
0
.
0
3
3
0
.
0
6
0
?
0
.
0
1
5
?
0
.
0
8
6
0
.
0
4
1
?
0
.
0
0
1
0
.
0
2
3
0
.
0
2
7
?
0
.
0
3
2
0
.
0
5
3
0
.
0
5
3
0
.
1
5
4
0
.
1
2
1
0
.
0
8
7
P
P
E
?
0
.
0
2
0
?
0
.
0
4
5
0
.
1
2
0
0
.
1
0
9
?
0
.
0
8
1
0
.
0
0
9
?
0
.
3
4
2
?
0
.
2
6
6
?
0
.
1
9
1
0
.
2
7
1
?
0
.
0
4
2
?
0
.
2
7
1
?
0
.
0
2
9
0
.
0
0
8
I
N
T
A
N
G
?
0
.
0
0
8
?
0
.
0
8
7
0
.
0
0
8
?
0
.
0
8
5
?
0
.
0
2
6
0
.
0
2
9
?
0
.
3
8
5
0
.
0
8
6
0
.
1
4
9
0
.
3
2
6
?
0
.
1
0
3
?
0
.
0
9
2
?
0
.
0
7
1
0
.
1
3
8
F
I
0
.
0
6
9
0
.
1
3
2
?
0
.
2
7
4
?
0
.
0
8
8
?
0
.
0
2
9
0
.
0
4
2
?
0
.
2
1
9
0
.
1
6
7
0
.
2
3
3
?
0
.
0
2
4
?
0
.
0
4
3
0
.
2
0
8
0
.
0
2
3
0
.
2
9
4
N
O
L
0
.
0
8
2
0
.
0
3
1
?
0
.
1
7
2
?
0
.
1
6
6
0
.
0
0
1
?
0
.
0
2
7
?
0
.
1
9
0
0
.
1
8
9
0
.
2
3
3
0
.
0
5
4
?
0
.
0
6
4
0
.
0
7
4
?
0
.
0
2
0
0
.
1
4
4
D
E
B
T
?
0
.
0
7
7
?
0
.
0
9
4
0
.
0
9
5
?
0
.
0
0
7
?
0
.
1
4
0
0
.
0
6
8
0
.
2
6
0
0
.
2
8
6
0
.
0
1
0
0
.
0
5
8
?
0
.
2
5
3
?
0
.
2
4
0
0
.
0
5
3
0
.
2
5
8
R
O
A
0
.
3
3
7
0
.
2
2
6
?
0
.
0
7
4
0
.
0
3
5
0
.
2
0
3
0
.
0
3
4
?
0
.
0
0
4
?
0
.
1
1
4
?
0
.
0
0
9
?
0
.
0
7
4
?
0
.
3
0
5
0
.
2
9
3
0
.
4
2
9
?
0
.
2
4
6
R
D
0
.
1
9
7
0
.
2
1
8
?
0
.
3
6
5
?
0
.
1
9
2
0
.
1
4
9
0
.
1
3
5
?
0
.
2
8
3
?
0
.
0
0
4
0
.
3
5
2
0
.
1
0
2
?
0
.
2
2
5
0
.
2
0
4
0
.
1
5
5
?
0
.
1
7
0
M
B
0
.
1
9
0
0
.
1
3
4
?
0
.
0
5
8
?
0
.
0
3
5
0
.
1
9
1
0
.
1
3
6
?
0
.
0
2
7
?
0
.
0
2
7
0
.
0
6
1
?
0
.
0
3
2
?
0
.
0
5
5
0
.
5
6
6
0
.
2
2
4
0
.
0
3
9
T
A
?
0
.
0
4
8
0
.
0
2
6
?
0
.
0
8
7
?
0
.
0
4
9
?
0
.
1
7
3
0
.
1
1
0
0
.
0
4
5
0
.
2
2
5
0
.
2
9
6
0
.
1
5
9
0
.
3
5
2
?
0
.
2
1
2
?
0
.
0
7
5
0
.
0
4
1
N
o
t
e
s
:
T
h
e
s
a
m
p
l
e
s
i
z
e
i
s
9
,
0
2
4
o
b
s
e
r
v
a
t
i
o
n
s
.
U
p
p
e
r
(
l
o
w
e
r
)
d
i
a
g
o
n
a
l
r
e
p
o
r
t
s
P
e
a
r
s
o
n
(
S
p
e
a
r
m
a
n
)
c
o
r
r
e
l
a
t
i
o
n
s
,
a
n
d
a
l
l
b
o
l
d
e
d
c
o
r
r
e
l
a
t
i
o
n
s
a
r
e
s
i
g
n
i
f
c
a
n
t
a
t
p
?
0
.
0
1
(
t
w
o
-
t
a
i
l
e
d
t
e
s
t
)
311
Equity-based
compensation
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
5. Empirical results
Table IVshows the ordinary least square (OLS) regression results for Models 1-3 for the
CEO sample. The results provide supportive evidence for H1a and H1b. The frst
column shows the results of Model 1, where we use DISPERM to proxy the level of tax
planning. The result on the interaction term (DISPERM*EQUITYMIX) is positively
signifcant, consistent with H1a, which says that the link between book-tax differences
and the level of tax-planning activities is positively associated with the CEO’s
equity-based pay. The second column presents the results of Model 2. We use ETR to
proxy the level of tax planning. The coeffcients on ETR and the interaction term
(ETR*EQUITYMIX) are both negative and signifcant. Because ETR is a reverse
measure of tax planning, our fndings suggest that the book-tax difference and the
magnitude of tax planning are more positively associated when CEO equity-based pay
is higher. Similarly, we obtain consistent results in the third column. The negative and
signifcant coeffcient on the interaction term (ETR*EQUITYMIX) shows that the
effective cash tax rates (CETR) are more negatively associated with the book-tax
differences in companies that give their CEOs more equity-based pay. As CETR is also
a reverse measure of tax planning, this result is consistent with H1a that CEO
equity-based pay increases the tax planning-related book-tax differences. Overall, H1a
receives strong support from the data analysis. Consistent with H1b, the coeffcients of
the interaction term(DA* EQUITYMIX) are negative and signifcant in all three models,
demonstrating that equity incentives decrease the extent of book-tax difference related
to earning management. The coeffcient on EQUITYMIX in Model 1 is insignifcant.
The coeffcient on EQUITYMIX is positive and signifcant (p-value ?0.001) in Models
2 and 3, indicating that larger book-tax differences occur when executives are rewarded
more stock options or restricted stock[9].
In general, the results for control variables are consistent with prior studies (Desai
and Dharmapala, 2006; Chen et al., 2010; Frank et al., 2009). Among the results for the
control variables, PPE is positively associated with book-tax differences in all three
models, consistent with Chen et al. (2010). INTANG is not signifcant in the frst two
models and is marginally signifcant in Model 3. FI is positively related to book-tax
differences in Models 2 and 3, a fnding similar to those of Phillips (2003) and Lisowsky
(2010), which document that the likelihood of using tax shelters is positively related to
foreign-source income. NOLis positively related to the level of book-tax differences in all
three models, as the positive loss carryforward can increase book-tax difference when
corporate taxable income is positive. DEBT is positively related to the level of book-tax
differences in all three models, consistent with Atwood et al. (1998), who fnd that the
more fnancing activities, the more chances to engage in tax shelter activities. ROA is
positively related to the level of book-tax differences in all three models. Finally, frm
size is marginally negatively related to book-tax differences in Model 1 and is not
signifcant in Models 2 and 3, possibly because the measure of book-tax differences is
already scaled by the beginning balance of total assets.
6. Conclusion
Prior studies show that equity-based pay is associated with larger book-tax differences
(Mills and Newberry, 2001; Frank et al., 2009; Desai and Dharmapala, 2006), but
companies with a high level of book-tax differences risk attract unwanted scrutiny from
governmental and regulatory agencies. Therefore, managers need to trade-off tax
ARJ
28,3
312
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
Table IV.
OLS regression
results for Models 1-3
D
e
p
e
n
d
e
n
t
V
a
r
i
a
b
l
e
¡
I
n
d
e
p
e
n
d
e
n
t
V
a
r
i
a
b
l
e
2
B
T
D
(
M
o
d
e
l
1
)
B
T
D
(
M
o
d
e
l
2
)
B
T
D
(
M
o
d
e
l
3
)
E
x
p
e
c
t
e
d
s
i
g
n
C
o
e
f
f
c
i
e
n
t
t
-
s
t
a
t
i
s
t
i
c
s
C
o
e
f
f
c
i
e
n
t
t
-
s
t
a
t
i
s
t
i
c
s
C
o
e
f
f
c
i
e
n
t
t
-
s
t
a
t
i
s
t
i
c
s
I
n
t
e
r
c
e
p
t
0
.
0
0
2
0
.
4
0
0
.
0
0
3
0
.
5
6
0
.
0
0
6
0
.
9
7
D
I
S
P
E
R
M
?
0
.
0
9
6
*
*
*
8
.
2
4
D
I
S
P
E
R
M
?
?
0
.
1
5
0
*
*
*
5
.
2
1
E
T
R
?
?
0
.
0
2
5
*
*
*
?
1
0
.
1
9
E
T
R
?
E
Q
U
I
T
Y
M
I
X
?
?
0
.
0
2
3
*
*
*
?
3
.
4
4
C
E
T
R
?
?
0
.
0
4
4
*
*
*
?
1
3
.
8
3
C
E
T
R
?
E
Q
U
I
T
Y
M
I
X
?
?
0
.
0
3
9
*
*
*
?
4
.
3
1
D
A
?
0
.
0
3
3
*
*
*
5
.
4
7
0
.
0
3
0
*
*
*
4
.
9
1
0
.
0
4
8
*
*
*
7
.
5
7
D
A
?
E
Q
U
I
T
Y
M
I
X
?
?
0
.
0
5
1
*
*
*
?
4
.
0
0
?
0
.
0
4
4
*
*
*
?
3
.
4
3
?
0
.
0
9
8
*
*
*
?
7
.
0
8
E
Q
U
I
T
Y
M
I
X
?
0
.
0
0
2
1
.
0
0
0
.
0
1
0
*
*
*
3
.
6
5
0
.
0
1
4
*
*
*
4
.
8
7
P
P
E
?
0
.
0
1
0
*
*
*
4
.
3
9
0
.
0
0
8
*
*
*
3
.
2
4
0
.
0
0
8
*
*
*
3
.
2
5
I
N
T
A
N
G
?
0
.
0
0
2
1
.
2
4
0
.
0
0
1
0
.
5
4
0
.
0
0
3
*
1
.
6
4
F
I
?
0
.
0
0
1
1
.
1
4
0
.
0
0
2
*
1
.
8
4
0
.
0
0
2
*
*
2
.
4
7
N
O
L
?
0
.
0
0
5
*
*
*
6
.
9
3
0
.
0
0
5
*
*
*
6
.
9
2
0
.
0
0
5
*
*
*
6
.
1
0
D
E
B
T
?
0
.
0
1
5
*
*
*
6
.
8
6
0
.
0
1
8
*
*
*
8
.
2
4
0
.
0
1
4
*
*
*
5
.
7
6
R
O
A
?
0
.
2
5
0
*
*
*
3
7
.
5
1
0
.
2
8
7
*
*
*
4
4
.
2
6
0
.
2
6
8
*
*
*
3
8
.
4
4
R
D
?
0
.
1
0
2
*
*
*
1
2
.
0
1
0
.
1
1
8
*
*
*
1
3
.
6
8
0
.
1
1
2
*
*
*
1
2
.
0
8
M
B
?
?
0
.
0
0
1
*
*
*
?
3
.
8
7
?
0
.
0
0
1
*
*
*
?
5
.
4
5
?
0
.
0
0
1
*
*
?
3
.
9
5
T
A
?
?
0
.
0
0
1
*
?
1
.
7
6
?
0
.
0
0
0
2
?
0
.
8
6
?
0
.
0
0
0
1
?
0
.
5
3
Y
e
a
r
d
u
m
m
i
e
s
N
o
t
r
e
p
o
r
t
e
d
I
n
d
u
s
t
r
y
d
u
m
m
i
e
s
N
o
t
r
e
p
o
r
t
e
d
N
o
b
s
9
0
2
4
9
0
2
4
9
0
2
4
A
d
j
u
s
t
e
d
R
2
0
.
3
0
0
1
0
.
3
0
6
8
0
.
3
1
6
2
N
o
t
e
s
:
T
h
i
s
t
a
b
l
e
r
e
p
o
r
t
s
t
h
e
O
L
S
r
e
g
r
e
s
s
i
o
n
r
e
s
u
l
t
s
f
o
r
M
o
d
e
l
s
1
-
3
f
o
r
C
E
O
s
a
m
p
l
e
.
T
h
e
l
a
r
g
e
s
t
v
a
r
i
a
n
c
e
i
n
f
a
t
i
o
n
f
a
c
t
o
r
i
s
2
.
1
1
5
a
n
d
t
h
e
l
a
r
g
e
s
t
c
o
n
d
i
t
i
o
n
i
n
d
e
x
i
s
3
.
0
0
9
,
w
h
i
c
h
s
h
o
w
s
t
h
a
t
t
h
e
r
e
g
r
e
s
s
i
o
n
s
d
o
n
o
t
h
a
v
e
s
e
r
i
o
u
s
m
u
l
t
i
-
l
i
n
e
a
r
i
t
y
p
r
o
b
l
e
m
s
.
B
e
l
s
l
e
y
e
t
a
l
.
(
1
9
8
0
)
h
e
t
e
r
o
s
c
e
d
a
s
t
i
c
i
t
y
t
e
s
t
s
s
h
o
w
t
h
e
m
o
d
e
l
s
a
r
e
n
o
t
i
n
v
i
o
l
a
t
i
o
n
o
f
t
h
e
a
s
s
u
m
p
t
i
o
n
o
f
t
h
e
h
o
m
o
s
c
e
d
a
s
t
i
c
e
r
r
o
r
s
.
*
,
*
*
a
n
d
*
*
*
i
n
d
i
c
a
t
e
s
t
a
t
i
s
t
i
c
a
l
s
i
g
n
i
f
c
a
n
c
e
l
e
v
e
l
s
a
t
1
0
,
5
a
n
d
1
%
,
r
e
s
p
e
c
t
i
v
e
l
y
,
i
n
t
w
o
-
t
a
i
l
e
d
t
e
s
t
s
.
T
o
a
l
l
e
v
i
a
t
e
o
u
t
l
i
e
r
p
r
o
b
l
e
m
s
,
w
e
w
i
n
s
o
r
i
z
e
t
h
e
o
b
s
e
r
v
a
t
i
o
n
s
w
i
t
h
c
o
n
t
i
n
u
o
u
s
v
a
r
i
a
b
l
e
s
a
t
t
h
e
b
o
t
t
o
m
1
%
a
n
d
t
h
e
t
o
p
1
%
l
e
v
e
l
s
.
313
Equity-based
compensation
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
planning and earnings management activities to avoid large book-tax differences. We
focus on these two main sources of book-tax differences that managers can control
because Blaylock et al. (2012) show that investors look beyond book-tax differences to
their sources rather than focusing on the aggregate differences. Equity-based
compensation aims to align the interests of executives with shareholder interests. Thus,
we expect that equity-based compensation motivates executives to exert more effort in
tax-planning activities and avoid higher degrees of earnings management.
Our results consistently show that the association between book-tax differences and
tax planning increases with executives’ equity-based compensation and that the
association between book-tax differences and earnings management decreases with
executives’ equity-based compensation. A larger portion of book-tax differences comes
from discretionary permanent book-tax differences (a proxy for the level of tax
planning) when executives receive more equity-based pay. Both GAAP effective tax
rates and cash effective rates are lower for frms that give more equity-based
compensation to their executives. Equity-based pay thus encourages managers to make
greater efforts to engage in tax-planning activities that can increase frm value by
reducing tax liability and increasing cash fows.
However, when the objective of managers is to manipulate earnings to meet or beat
the earnings target, the consequences of large book-tax differences are negative for
corporate shareholders. Managers may be tempted to put their own benefts ahead of
shareholder interests. We show that equity-based compensation reduces book-tax
differences related to earnings management. These fndings are robust to the alternative
measure of equity incentives which incorporate CEO ownership.
Although the literature indicates that the sources of book-tax differences have an
incremental effect on explaining earnings quality, no study explains managerial
incentives that can infuence the sources of book-tax differences. Researchers fnd that
tax planning-related book-tax differences are positively associated with frm value
while earnings management-related book-tax differences drive frm value in the
opposite direction (Desai and Dharmapala, 2009; Blaylock et al., 2012). Our study
complements these studies by showing that equity-based compensation motivates
managers to generate higher tax planning-related book-tax differences and lower
earnings management-related book-tax differences by reducing effective tax rates and
limiting the degree of earnings management.
Notes
1. Our data showthat total book-tax differences increased from$43 billion in 1992 to $313 billion
in 2011.
2. In many studies, such as those of Plesko (2000), Desai (2003) and Lisowsky (2010),
tax-planning activities are called tax-sheltering activities. In our study, tax shelters, tax
avoidance and tax planning are used interchangeably.
3. Our results may be biased due to omitting certain control variables. We are not able to control
for frms’ corporate governance practices due to a lack of data availability. Further research
can explore whether stronger corporate governance might drive higher tax planning-related
book-tax differences and lower earnings management-related book-tax differences.
4. We use the SAS 9.3 to estimate the various models.
ARJ
28,3
314
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
5. Earnings based on accrual accounting can measure performance better than cash fows.
Deferred tax expenses are recorded when accruals are recorded differently for book purposes
and for tax purposes (Blaylock et al. 2012). Only temporary differences are captured by
deferred tax expenses, not permanent differences.
6. DISPERM is a measure that is based on permanent differences and excludes temporary
differences, consistent with Frank et al. (2009). In our robustness tests, we use discretionary
total differences instead of discretionary permanent differences in Model 1. We calculate
discretionary total differences by replacing permanent differences (PERMDIFF) with total
book-tax differences (BTD) in Model 4. The regression results are qualitatively similar.
7. BI
it
is pre-tax book income (Compustat item PI) for frm i in year t; CFTE
it
is current federal
tax expense (Compustat item TXFED) for frm i in year t; CFOR
it
is current foreign tax
expense (Compustat itemTXFO) for frmi in year t; DTE
it
is deferred tax expense (Compustat
item TXDI) for frm i in year t; and STR
t
is statutory tax rate in year t.
8. We derive qualitatively similar results from a robustness test by using the ratio ETR/STR
instead of ETR to control for differences in STR between frms due to differing year-ends.
9. Untabulated results show that our fndings are robust to using the simultaneous models and
the cluster standard error regressions.
References
Armstrong, C., J. Blouin, J. and Larcker, D. (2012), “The incentives for tax planning”, Journal of
Accounting and Economics, Vol. 53 Nos 1/2, pp. 391-411.
Atwood, T.J., Omer, T. and Shelley, M. (1998), “Before versus after-tax earnings as performance
measures in compensation contracts”, Managerial Finance Vol. 24 No. 11, pp. 29-43.
Badertscher, B., Phillips, J., Pincus, M. and Rego, S. (2009), “Earnings management strategies and
the trade-off between tax benefts and detection risk: to conform or not to conform”, The
Accounting Review Vol. 84 No. 1, pp. 63-97.
Belsley, D., Kuh, E. and Welsch, R.E. (1980), Regression Diagnostics: Identifying Infuential Data
and Sources of Collinearity, John Wiley & Sons, NY.
Black, F. and Scholes, M. (1973), “The pricing of options and corporate liabilities”, Journal of
Political Economy, Vol. 81 No. 3, pp. 637-654.
Blaylock, B., Shevlin, T. and Wilson, R.J. (2012), “Tax avoidance, large positive temporary
book-tax differences, and earnings persistence”, The Accounting Review, Vol. 87 No. 1,
pp. 91-120.
Bryan, S., Hwang, L. and Lilien, S. (2000), “CEO stock-based compensation: an empirical analysis
of incentive-intensity, relative mix and economic determinants”, Journal of Business,
Vol. 73 No. 4, pp. 661-693.
Callihan, D. (1994), “Corporate effective tax rates: a synthesis of the literature”, Journal of
Accounting Literature, Vol. 13, pp. 1-43.
Chen, S., Chen, X., Cheng, Q. and Shevlin, T. (2010), “Are family frms more tax avoidance than
non-family frms”, Journal of Financial Economics, Vol. 95 No. 1, pp. 41-61.
Cheng, Q. and Warfeld, T. (2005), “Equity incentives and earnings management”, The Accounting
Review, Vol. 80 No. 2, pp. 441-476.
Cloyd, C.B. (1995), “The effects of fnancial accounting conformity on recommendations of tax
preparers”, Journal of the American Taxation Association, Vol. 17 No. 2, pp. 50-70.
315
Equity-based
compensation
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
Desai, M.A. (2003), “The divergence between book and tax income”, Tax Policy and the Economy,
Vol. 17, pp. 169-206.
Desai, M.A. and Dharmapala, D. (2006), “Corporate tax avoidance and high powered incentives”,
Journal of Financial Economics, Vol. 79 No. 1, pp. 145-179.
Desai, M.A. and Dharmapala, D. (2009), “Corporate tax avoidance and frm value”, The Review of
Economics and Statistics, Vol. 91 No. 3, pp. 537-546.
Dyreng, S.D., Hanlon, M. and Maydew, E.L. (2010), “The effects of executives on corporate tax
avoidance”, The Accounting Review, Vol. 85 No. 4, pp. 1163-1189.
Frank, M.M., Lynch, L.J. and Rego, S. (2009), “Tax reporting aggressiveness and its relation to
aggressive fnancial reporting”, The Accounting Review, Vol. 84 No. 2, pp. 467-496.
Frank, M.M. and Rego, S. (2006), “Do managers use the valuation allowance account to manage
earnings around certain earnings targets”, Journal of the American Taxation Association,
Vol. 28 No. 1, pp. 43-65.
Hall, B.J. and Murphy, K.J. (2002), “Stock options for undiversifed executives”, Journal of
Accounting and Economics, Vol. 33 No. 1, pp. 3-42.
Hanlon, M. (2005), “The persistence and pricing of earnings, accruals, and sash fows when frms
have large book-tax differences”, The Accounting Review, Vol. 80 No. 1, pp. 137-166.
Ibrahim, S.S. (2009), “The usefulness of measures of consistency of discretionary components of
accruals in the detection of earnings management”, Journal of Business Finance and
Accounting, Vol. 36 Nos 9/10, pp. 1087-1116.
Jensen, M. and Meckling, W. (1976), “Theory of the frm: managerial behavior, agency costs, and
ownership structure”, Journal of Financial Economics, Vol. 3 No. 4, pp. 305-360.
Jones, J. (1991), “Earnings management during import relief investigations”, Journal of
Accounting Research, Vol. 29 No. 2, pp. 193-228.
Kothari, S.P., Leone, A.J. and Wasley, C.E. (2005), “Performance matched discretionary accrual
measures”, Journal of Accounting and Economics, Vol. 39 No. 1, pp. 163-197.
Kwon, S. and Yin, Q. (2006), “Executive compensation, investment opportunities and earnings
management: high-tech frms versus low-tech frms”, Journal of Accounting, Auditing, and
Finance, Vol. 21 No. 2, pp. 119-148.
Lisowsky, P. (2010), “Seeking shelter: empirically modeling tax shelters using fnancial statement
information”, The Accounting Review, Vol. 85 No. 5, pp. 1693-1720.
McGill, G.A. and Outslay, E. (2004), “Lost in translation: detecting tax shelter activity in fnancial
statement”, National Tax Journal, Vol. 57 No. 3, pp. 739-756.
McNichols, M. and Wilson, G.P. (1988), “Evidence of earnings management fromthe provision for
bad debts”, Journal of Accounting Research, Vol. 26, pp. 1-31.
Manzon, G. and Plesko, G. (2002), “The relation between fnancial and tax reporting measures of
income”, Tax Law Review, Vol. 55 No. 2, pp. 175-214.
Meek, G.K., Rao, R.P. and Skousen, C.J. (2007), “Evidence on factors affecting the relationship
between CEO stock options compensation and earnings management”, Review of
Accounting and Finance, Vol. 6 No. 3, pp. 304-323.
Miller, G. and Skinner, D. (1998), “Determinants of the valuation allowance for deferred tax assets
under SFAS No. 109”, The Accounting Review, Vol. 73 No. 2, pp. 213-233.
Mills, L. (1998), “Book-tax differences and internal revenue service adjustments”, Journal of
Accounting Research, Vol. 36 No. 2, pp. 343-356.
Mills, L., Erickson, M. and Maydew, E. (1998), “Investments in tax planning”, Journal of the
American Taxation Association, Vol. 20 No. 1, pp. 1-20.
ARJ
28,3
316
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
Mills, L. and Newberry, K. (2001), “The infuence of tax and non-tax cost on book-tax reporting
differences: public and private frms”, Journal of the American Taxation Association,
Vol. 23 No. 1, pp. 1-19.
Phillips, J.D. (2003), “Corporate tax-planning effectiveness: the role of compensation-based
incentives”, The Accounting Review, Vol. 78 No. 3, pp. 847-874.
Phillips, J.D., Pincus, M. and Rego, S. (2003), “Earnings management: new evidence based on
deferred tax expense”, The Accounting Review, Vol. 78 No. 2, pp. 491-521.
Plesko, G. (2000), “Evidence and theory on corporate tax shelters”, Proceedings of the 92nd
Annual Conference on Taxation, National Tax Association, Washington, DC,
pp. 367-371.
Plesko, G. (2004), “Corporate tax avoidance and the properties of corporate earnings”, National
Tax Journal, Vol. 57 No. 3, pp. 729-737.
Rego, S.O. (2003), “Tax-avoidance activities of US multinational corporations”, Contemporary
Accounting Research, Vol. 20 No. 4, pp. 805-833.
Rego, S.O. and Wilson, R. (2012), “Equity risk incentives and corporate tax aggressiveness”,
Journal of Accounting Research, Vol. 50 No. 3, pp. 775-810.
Schrand, C. and Wong, M.H.F. (2003), “Earnings management using the valuation allowance for
deferred tax assets under SFAS No. 109”,Contemporary Accounting Research, Vol. 20 No. 3,
pp. 579-611.
Shevlin, T. (2002), “Commentary: corporate tax shelters and book-tax differences”, Tax Law
Review, Vol. 55 No. 3, pp. 427-443.
Smith, C.W. and Stulz, R. (1985), “The determinants of frm’s hedging policies”, Journal of
Financial and Quantitative Analysis, Vol. 20 No. 4, pp. 391-405.
Tucker, J.W. and Zarowin, P.A. (2006), “Does income smoothing improve earnings
informativeness?”, The Accounting Review, Vol. 81 No. 1, pp. 251-270.
Wilson, R.J. (2009), “An examination of corporate tax shelter participants”, The Accounting
Review, Vol. 84 No. 3, pp. 969-999.
Yin, G. (2003), “How much tax do large public corporation pay? Estimating the effective tax rates
of the S&P 500”, Virginia Law Review, Vol. 89 No. 8, pp. 1793-1856.
Further reading
Cheng, S. (2004), “R&D expenditures and CEO compensation”, The Accounting Review, Vol. 79
No. 2, pp. 305-328.
Datta, S., Iskandar-Datta, M. and Raman, K. (2001), “Executive compensation and corporate
acquisition decisions”, The Journal of Finance, Vol. 56 No. 6, pp. 2299-2336.
Dhaliwal, D., Huber, R., Lee, H.S. and Pincus, M. (2008), “Book-tax differences, uncertainty about
fundamentals and information quality, and cost of capital”, Working paper.
Graham, J. and Tucker, A. (2006), “Tax shelters and corporate debt policy”, Journal of Financial
Economics, Vol. 81 No. 3, pp. 563-594.
Hausman, J.A. (1978), “Specifcation tests in econometrics”, Econometrica, Vol. 46, pp. 1251-1271.
Kang, S., Kumar, P. and Lee, H. (2006), “Agency and corporate investment: the role of
executive compensation and corporate governance”, Journal of Business, Vol. 79 No. 3,
pp. 1127-1148.
Petersen, M. (2009), “Estimated standard errors in fnance panel data sets: Comparing
approaches”, Review of Financial Studies, Vol. 22 No. 1, pp. 435-480.
317
Equity-based
compensation
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)
Robinson, J.R., Sikes, S.A. and Weaver, C.D. (2010), “Performance measurement of corporate tax
departments”, The Accounting Review, Vol. 85 No. 3, pp. 1035-1064.
Wooldridge, J.M. (2002), Econometric Analysis of Cross Section and Panel Data, MIT Press,
Cambridge.
About the authors
Chunwei Xian, PhD, is Assistant Professor of Accounting at Northeastern Illinois University. Her
research interests include fnancial reporting, executive compensation and tax accounting. She is
a member of both the American Accounting Association and the AICPA. Chunwei Xian is the
corresponding author and can be contacted at:[email protected]
Fang Sun, PhD, is Assistant Professor of Accounting at Queens College, CUNY. Her main
research interests include pension accounting, executive compensation, capital market and
auditing. She is a member of the American Accounting Association.
Yinghong Zhang, PhD, is Assistant Professor of Accounting at the University of Central
Oklahoma. Her research interests include audit quality, internal control, earnings management,
bank regulation, corporate governance, executive compensation and accounting conservatism.
She is a member of the American Accounting Association.
For instructions on how to order reprints of this article, please visit our website:
www.emeraldgrouppublishing.com/licensing/reprints.htm
Or contact us for further details: [email protected]
ARJ
28,3
318
D
o
w
n
l
o
a
d
e
d

b
y

P
O
N
D
I
C
H
E
R
R
Y

U
N
I
V
E
R
S
I
T
Y

A
t

2
0
:
5
1

2
4

J
a
n
u
a
r
y

2
0
1
6

(
P
T
)

doc_642438309.pdf