The impact of tax holidays on earnings management: An empirical study of corporate

reporting behavior in a developing economy framework

Kenny Z. Lin

Department of Accountancy

Lingnan University, Hong Kong

Abstract:

Many developing economies use tax holidays to attract foreign direct investment. This study investigates whether foreign investment enterprises (FIEs) in China alter their corporate reporting behavior in response to a known schedule of increasing tax rates. Foreign investors in different tax-holiday positions are subject to different tax rates in China: normally 0-15% in the tax-holiday period while 30% in the post-holiday period. If managers attempt to maximize firm value by minimizing tax costs, this spread in tax rates between periods surrounding the rate change would provide a substantial incentive to accelerate revenues and defer expenses. Evidence of tax-induced earnings management is examined by focusing on discretionary portion of current accruals most directly related to taxable income. Based on 750 firm-year observations, the results indicate discretionary accruals in the year immediately preceding the tax rate increase are higher, or more income increasing, than those in other years. The evidence, which indicates that firms can shift income between periods to take advantage of the anticipated increases in tax rates, has important implications for tax policymakers.

Key Words: Discretionary accruals, Earnings management, Foreign investment enterprises (FIEs), Income shifting, Tax holidays.

The impact of tax holidays on earnings management: An empirical study of corporate

reporting behavior in a developing economy framework

1. Introduction

Most tax-induced earnings management research is devoted to publicly traded corporations

in developed economies, particularly the United States (Shackelford and Shevlin, 2001).1 Because

of data limitations, there is little research on the effect of tax on corporate reporting of privately

held corporations in developing economies.2 This study makes the first empirical attempt to uncover

systematic evidence of tax-induced income shifting by privately held firms in a developing

economy. Specifically, the study investigates whether foreign investment enterprises (FIEs) in

China have a tax-rate-based incentive to strategically shift income across different tax-holiday

periods in order to minimize income taxes. This question is important because many developing

countries (e.g., Brazil, India and Mexico) use tax holidays in a similar way to China in order to

attract foreign investment by granting qualified investors a limited period of tax exemptions and

reductions. Evidence from this study should help tax policymakers understand the possible impact

of tax holidays on foreign investor’s reporting behavior and to plan more effective and efficient tax

auditing in order to minimize the loss of revenues arising from abusive tax avoidance.

The current tax incentive scheme of China provides a unique setting in which to test the

effect of different tax concessions on corporate reporting behavior. In China, FIEs of a production

nature generally qualify for a five-year tax holiday (i.e., a tax rate of zero for the first two profit-

making years and a 50% reduction of the applicable tax rate for the following three years), and are

taxed at the normal rate of 30% (or 15% in special zones) when the concession period expires.

These rules provide a productive setting in which to test the incentive to manage earnings created

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by the magnitude of the tax rate change. Chan and Mo (2000) examine the relationship between tax

holidays and tax noncompliance by foreign investors in China and find that tax audit adjustments in

the pre- and post-holiday periods are greater than those in the tax-holiday period. While this means

that firms in the tax-holiday period are most tax compliant, it does not necessarily imply that these

firms lack incentives to shift forward/backward revenues/expenses in order to minimize tax

liabilities. Further, income shifting may not necessarily give rise to tax noncompliance.3 Chan and

Mo (2000) suggest that further research on the financial reporting behavior of FIEs during tax

holidays is warranted. Therefore, this paper examines a more general case of the role of tax holidays

in financial reporting by addressing how a tax-rate-based incentive alters managers’ decisions to

engage in activities that affect the timing of income and cash flows. Evidence of a tax-induced

financial reporting is examined by limiting the measure of discretionary current accruals to items

most directly related to taxable income (Dechow et al., 1995; Guenther, 1994; Lopez et al., 1998).

By knowing ex ante which types of accruals are most likely to affect taxable income, and by

examining if the same group of firms shifts taxable income in periods of pre- vs. post-change in tax

rates, the study reduces noise and avoids the need to control for the effect on accounting earnings of

some confounding factors that are associated with different corporate characteristics, and thus

provides a more powerful test of tax-motivated earnings management (Guenther, 1994).

As changes in tax rates provide substantial incentives for firms to shift income, it is

hypothesized that firms will report discretionary accruals that are greater in the year prior to the

scheduled tax rate increase than in other years. This tax-induced income shifting can be

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accomplished by acceleration of income from a high-tax to a low-tax year and/or deferral of

expenses from a low-tax to a high-tax year. The hypothesis is tested using OLS estimates from

panel data covering six years and 125 firms. The empirical results support the view that firms alter

their reporting behavior in response to the anticipated changes in future tax rates. Specifically, the

sample firms in the year immediately preceding the tax rate increase report discretionary accruals

that are higher than those reported two years in advance of the tax rate change. From a public policy

perspective, the results provide evidence on the government revenue consequences of changes in

tax rates associated with different tax-holiday breaks. As many developing countries use similar tax

holidays as China to attract foreign investment for their economic development, the results of this

study should provide a useful reference for policymakers in other developing countries. Concern

has long been expressed that developing countries forego too much revenue due to tax holidays

(Tanzil and Zee, 2001). The ability of corporate managers to avoid taxes through earnings

management creates additional constraints on fiscal revenues of these countries.4

The remainder of the paper is organized into four sections. The next section describes the

background to the study and develops the research hypothesis. Section 3 explains the research

methodology. Section 4 presents the empirical results and section 5 concludes.

2. Background and research hypothesis

Like many other developing economies, China provides a comprehensive tax incentive

scheme to qualifying FIEs. This includes the grant of a five-year tax holiday to firms of a

production nature with an operation period exceeding 10 years. In other words, firms are exempted

3

from enterprise income tax in the first two profit-making years and allowed a 50% reduction of tax

in the ensuing three years.5 The first profit-making year is the year in which the firm makes a profit

after offsetting allowable losses accumulated since the business started. Once started, the tax

holidays should not be deferred due to losses incurred during the tax-holiday period. When the

concession period expires, firms pay standard taxes at the normal rate of 30%.6

Since the tax holiday period is generally limited to five years and the normal tax rate

resumes when the concession period expires, firms in the tax holiday period will be motivated to

recognize revenues as early as the facts allow and to capitalize expenditures over as long a period as

credible, while firms in the post-holiday period will be inclined to exaggerate expenses and losses

during the period. For example, an early recognition of $1.00 of taxable income from a year in

which it would be taxed at the normal tax rate of 30% during the post-holiday period into a year in

which it would be taxed at 15% during the tax-reduction period would be equivalent to earning 21%

[i.e., 1.00 x (1 – 0.15) = 1.21 x (1 – 0.30)]. If managers attempt to maximize firm value by

minimizing tax costs, this tax rate change would provide a substantial incentive to shift recognition

of revenues and expenses across periods. Figure 1 identifies the years in which tax-rate incentives to

shift income exist. It is expected that in anticipation of a future tax rate increase, managers would be

inclined to accelerate revenues from relatively high-rate years (i.e., years 3 and 6) to relatively low-

rate years (i.e., years 2 and 5) and/or defer expenses from low-rate to high-rate years.

[Figure 1 here]

Earnings management can be accomplished by a variety of means, including use of current

4

accruals, changes in accounting methods or capital structure, and proper management of the timing

of non-recurring transactions such as the sale of operating assets that have declined in value,

discontinued operations, and extraordinary items (McNichols and Wilson 1998). Although

managers can choose to switch accounting methods (e.g., FIFO vs. LIFO) in order to shift income

across tax years, such changes would be visible and could be easily undone by the tax authorities.

Therefore, this study examines only management via current accruals based on the grounds that

accruals are less visible and comparatively easier to manage over short time period than are changes

in accounting methods or capital structure (Lopez et al., 1998). Management of discretionary

accruals can be achieved by changing procedures or estimates, and/or accelerating/deferring

transactions that trigger income/expense recognitions.7 For example, a manager can produce higher

income by accelerating deliveries of finished goods, decreasing bad debt provisions, decreasing

inventory write-offs, delaying purchases of expensive inventory at year-end when LIFO is used,

deferring advertising campaign, classifying more manufacturing overhead costs as inventoriable

costs rather than period costs, or treating revenue expenditures as capital expenditures. Additionally,

this study focuses on current accruals because these accruals are more closely linked to book

income and taxable income than non-current accruals (Dechow et al., 1995; Jones, 1991; Lopez et

al., 1998).8 Therefore, this study examines the discretionary component of current accruals most

susceptible to tax-related earnings management. Current accruals (CA) for firm i in year t are

captured by the change in accounts receivable (AR) plus inventory (INV) less the change in

accounts payable (AP) plus accrued expenses (AE) from year t-1 to t. In conformance with Lopez et

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al. (1998), this relationship can be written as:

CAit = (ARit + INVit) – (APit + AEit) (1)

Based on the above equation, increasing accounts receivable and inventory to accelerate

revenue or decreasing accounts payable and accrued expenses to defer expenses (or both) will cause

accruals to be positive. Thus, if managers use accruals to accelerate financial statement income in

anticipation of a tax rate increase, current accruals in the year immediately preceding the year of the

rate increase will be positive. This leads directly to the following hypothesis:

Firms will report discretionary accruals that are greater in the year immediately preceding

the tax rate increase than in other years.

3. Research methodology

3.1 Sample selection

To test the hypothesis, firms’ financial statement data were collected from local tax bureaus

in China. To be included in the sample, the following criteria were imposed. First, firms should

have gone through the five-year tax-holiday period over their investment horizon. Second, firms

must have seven consecutive calendar years of financial statement data available.9 Third, to limit the

time effect on firms’ reporting behavior, the tax-holiday period should commence during the last 10

years. Fourth, firms should not be eligible to any extended tax holiday after the initial five-year

holiday expires. Finally, to control for corporate characteristics and audit risk, firms should belong

to the Class B category.10 To reduce the selection bias, the tax bureaus selected firms from Class B

at random when the first four criteria were satisfied. As a result, 125 firms that meet the criteria

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were identified. To examine whether firms alter their reporting discretionary accruals in light of

changes in tax rates, accruals for six years were computed. These six years cover two years before

there is a tax motivation to manage earnings (i.e., years 1 and 4 in Figure 1), two years that appear

to have a tax motivation to manage earnings (years 2 and 5), and two years after there is a tax

motivation to manage earnings (years 3 and 6). This design facilitates comparisons of the changes

in accrual estimates on a longitudinal basis. All the sample firms are located in the designated areas

(e.g., Special Economic Zones) that are subject to the same reduced tax rate of 15% in the post-

holiday period. Most of the selected firms operate in the manufacturing industry. Fifty eight percent

of the sample firms are joint ventures and the remainder is wholly foreign-owned enterprises. Hong

Kong, Taiwan, the U.S., Korea and the U.K. are the major sources of foreign investment in these

firms. The sample firms have the average assets (sales) of US$9 million (US$7 million) over the

test period.

3.2 Estimation of discretionary accruals

As mentioned earlier, this research limits the measure of current accruals to those tax-related

items over which management may have discretion. Discretionary current accruals are the

differences between the reported current accruals and the expected current accruals, and the

expected current accruals are a function of the change in sales (Jones, 1991). Discretionary current

accruals for 125 firms over the six-year period are estimated using the residuals of a covariance

model that regresses tax-related current accruals on the change in sales and dummy variables that

represent each firm and year (Cahan, 1992). This model can be written as:

(2)

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where SALESit is the change in sales for firm i between year t and t-1. Current accruals (CAit) in

year t are computed for each firm i over the six-year period. CAit and SALESit are deflated by

lagged total assets to reduce heteroscedasticity. The YR-dummy variables, coded as 1 for year j (j =

1 to 5), measure the time effect for each of the six years, while the FIRM variables, dummy-coded

as 1 for firm k (k = 1 to 124), measure the firm effect for each of the 125 firms. The prediction

error, εit, or the difference between the reported current accruals and the expected current accruals,

can be interpreted as the part of accruals being ‘managed’.

To test whether changes in discretionary accruals are systematically correlated to changes in

tax rates between periods (i.e., between the tax exemption and tax reduction period as well as

between the tax reduction and post-holiday period), discretionary accruals are regressed on four

YR-dummy variables that distinguish observations on the basis of a firm’s tax-holiday position.

Notationally:

DAit = β0 + β1YRi2 + β2YRi3 +β3YRi5 +β4YRi6 +β5INDUSTRYi + β6JVi

+β7OWNERSHIPi +β8SIZEit +β9EXEMPTIONi + μit (3)

where DAit is the discretionary accruals estimate for observation it, as described earlier in this

section, and YRi2, YR i3, and YRi5 are dummy-coded as 1 if firm i is respectively in the second,

third, and fifth year of the five-year tax-holiday period. Similarly, YRi6 is coded as 1 if firm i is in

the year immediately after the tax-holiday period, and zero otherwise. Since YR i2 and YRi5 are the

years that appear to have an incentive to manage earnings to take the greatest advantage of lower

tax rates, these two variables are expected to be significantly and positively signed (i.e., firms tend

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to choose income-increasing accruals in these two years). However, YR i3 and YRi6 are expected to

have negative coefficients, because of reversals of the managed accruals in prior years.

Five additional variables are included in the equation to control for the effect of corporate

characteristics on discretionary accounting practices. As industry affiliation, form of investment and

ownership control affect tax noncompliance (Chan and Mo, 2000), three dummy variables, namely,

INDUSTRY (manufacturing vs. others), JV (joint ventures vs. wholly foreign-owned enterprises),

and OWNERSHIP (manager-controlled vs. owner-controlled firms) are included in the model. In

addition, a continuous SIZE variable (which takes the logarithm of the firm’s year-end total assets)

is used to control for the effect of firm size on accrual management (Watts and Zimmerman, 1978).

Finally, as some firms may be less sensitive to the amount of tax paid overseas if the country in

which their parent companies reside operates a tax credit rather than an exemption system, a

dummy variable EXEMPTION is used to control for this confounding effect.

4. Empirical results

4.1 Univariate results

Table 1 presents overall and by-year mean current accruals for equation (1). Mean accruals

are 3.2% of total assets for all firms over the six-year period. On average, the sample firms report

mean accruals of 6.6% of assets in year 2, 5.5% higher than those reported in year 3. Similarly,

mean accruals as a percentage of assets are significantly higher for year 5 than for year 6 (6.9% vs.

1.8%).

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[Table 1 here]

Table 2 presents the univariate analysis of discretionary accruals estimated over a six-year

period. Mean discretionary accruals, which were 0.0011 two years before the tax rate change (i.e.,

year 1 in Figure 1), increased to 0.0088 in the year before the tax rate change (year 2), and then

decreased to 0.0016 in the year after the rate change (year 3). There is a similar trend from years 4

through 6. Comparisons of mean accruals indicate that firms report discretionary accruals in years 2

and 5 that are significantly higher than those reported in years 3 and 6, respectively to the extent of

0.72% and 0.75% of assets. The pattern shows a trend toward income increasing accruals in years

immediately prior to tax rate increases. Further, while central tendencies of mean accruals for years

2 and 5 are significantly positive, the same measures are not significantly different from zero for

years 1, 3, 4, and 6. Taken at face value, these results suggest that the magnitude of accruals is

related to the level of tax rate in a way that is consistent with the tax-motivated income shifting

behavior.

[Table 2 here]

4.2 Multivariate results

Table 3 reports the results of regressing current accruals on the change in sales and dummy

year and firm variables (Equation (2)). The model assumes the residual is composed of a time

effect, which will be the same for all firms in a particular year, and a firm effect, which will be the

same for each firm over all years (Cahan, 1992). The F-statistic for the model is significant at the

1% level and the adjusted R2 is 8.2%. The variable, SALESit/ASSETSit-1, is significant at the 1%

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level and the sign is as expected. The YR and FIRM variables as a whole are also significantly

related to current accruals. These results suggest that the variations in accruals can be largely

explained by the change in sales, and time and firm effects. Therefore, the portion of accruals

‘unexplained’ can be assumed to be discretionary accruals.

[Table 3 here]

Table 4 provides the results for equation (3), which formally tests the hypothesis of whether

discretionary accruals are higher in periods prior to the tax rate increase. The model is significant at

the 1% level, which indicates that the model is well specified. All of the correlations among the

independent variables are below 0.653, suggesting that multicollinearity is unlikely to affect the

results. The four YR-dummies measure the incremental ability to explain the remaining cross-

sectional, intertemporal variation in residuals from equation (2). As expected, YRi2 and YRi5 are

significantly and positively signed. A Wald coefficient test (EViews 3 User’s Guide, 1998) indicates

that the coefficients for YRi2 and YRi5 are respectively significantly higher than those for YRi3 and

YRi6. Moreover, the coefficients on YRi2 and YRi5 indicate firms in the year immediately preceding

the tax rate increase respectively report discretionary accruals that are higher than the average of

discretionary accruals reported two years prior to the tax rate change. While Chan and Mo (2000)

find that firms are most compliant in the tax-holiday period, the results of the current study

demonstrate that firms in the tax-holiday period have greater than normal incentives to minimize tax

burden over a longer horizon. The coefficient on SIZEit is (weakly) significantly negative at the 5%

level, suggesting that larger firms may be more sensitive to political costs and thus more likely to

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use accruals that decrease financial statement income (Watts and Zimmerman, 1978).

[Table 4 here]

5. Conclusions

Tax holidays are by far the most popular type of tax inducement employed by developing

economies. This study investigates whether foreign investors in China’s developing economy

manage accounting earnings to take advantage of lower tax rates available during the tax holiday

period. Evidence of tax-induced earnings management is examined by focusing on discretionary

current accruals that are expected to have a significant effect on taxable income. The study develops

the hypothesis that predicts income-increasing accruals in the year prior to the tax rate increase. The

evidence, which indicates that firms adjust their discretionary accruals in anticipation of the change

in tax rates, is consistent with income shifting behavior. Evidence from this study may be of interest

to tax policymakers in enforcing tax rules designed to prevent abusive tax avoidance. For example,

given that changes in tax rates create incentives for firms to record transactions in one period rather

than another, government tax inspectors should closely scrutinize the exact timing of transactions in

periods surrounding the tax rate revision. The results also have implications for external auditors

who often face conflicting incentives between provision of tax minimization advice on one hand

and detection of material cases of client earnings management on the other.

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References:

Cahan, S.F., “The Effect of Antitrust Investigation on Discretionary Accruals: A Refine Test of the Political Cost Hypothesis,” The Accounting Review (January 1992), pp.77-96.

Chan, H.K. and P.L. Mo, “Tax Holidays and Tax Noncompliance: An Empirical Study of Corporate Tax Audits in China’s Developing Economy,” The Accounting Review (October 2000), pp. 469-484.

Dechow, P.M., R. Sloan and A. Sweeney, “Detecting Earnings Management,” The Accounting Review (April 1995), pp.193-225.

EViews 3 User’s Guide, Quantitative Micro Software (CA: Irvine, 1998).

Guenther, D.A., “Earnings Management in Response to Corporate Tax Rate Changes: Evidence from the 1986 Tax Reform Act,” The Accounting Review (January 1994), pp.230-243.

Harris, D., “The Impact of U.S. Tax Law Revision on Multinational Corporations’ Capital Location and Income-Shifting Decisions,” Journal of Accounting Research (Supplement 1993), pp.111-140.

Jones, J., “Earnings Management during Import Relief Investigations,” Journal of Accounting Research (Autumn 1991), pp.193-228.

Lopez, T.J., P.R. Regier and T., Lee, “Identifying Tax-Induced Earnings Management around TRA 86 as a Function of Prior Tax-Aggressive Behavior,” Journal of the American Taxation Association (Fall 1998), pp.37-56.

Maydew, E., “Tax Induced Earnings Management by Firms with Net Operating Losses,” Journal of Accounting Research (Spring 1997), pp.83-95.

McNichols, M. and G. Wilson, “Evidence of Earnings Management from the Provision for Bad Debts,” Journal of Accounting Research (Supplement 1998.), pp.1-31.

Mills, L.F., “Book-Tax Differences and Internal Revenue Service Adjustments,” Journal of Accounting Research (Autumn 1998), pp.343-356.

Scholes, M.S., G.P. Wilson M.A. Wolfson, “Firms’ Responses to Anticipated Reductions in Tax Rates: The Tax Reform Act of 1986,” Journal of Accounting Research (Supplement 1992.), pp.161-185.

Shackelford, D. and T. Shevlin, “Empirical Tax Research in Accounting,” Journal of Accounting and Economics (September 2001), pp.321-388.

South China Morning Post (SCMP), Beijing Recovers Hong Kong$14b in Clampdown on Tax Dodgers (September 28, 2002).

Tanzil, V. and H. Zee, “Tax Policy for Developing Countries,” Economic Issues (IMF, 2001).

Watts, R.L. and J.L. Zimmerman, “Towards a Positive Theory of the Determination of Accounting Standards,” The Accounting Review (January 1978), pp.112-34.

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Figure 1

The magnitude of the tax rate change and income shifting across periods

Tax exemption period (0%) Tax reduction period (15%) Post-holiday period (30%)

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Accruals increase

Accelerate revenue and/or defer expenses

Income====shifting

Accruals decrease (reversal s )

Accruals increase

Accelerate revenue and/or defer expenses

Income====shifting

Accruals decrease (reversal s )

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Table 1

Descriptive statistics for sample firms by year (n=750)

Tax exemption period

Tax reductionperiod

Post-holidayperiod

t-tests for significant between-year differences a

Pooled Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Current accruals / total assets

0.032b

(0.214)c0.013

(0.090)0.066

(0.234)0.011

(0.123)0.020

(0.151)0.069

(0.207)0.018

(0.105)1&2, 1&5, 2&3, 2&6, 3&5, 5&6

Natural log of assets 4.583(0.463)

4.537(0.456)

4.551(0.450)

4.573(0.456)

4.582(0.463)

4.618(0.474)

4.636(0.480)

1&6, 2&6

Accounts receivable / total assets

0.017(0.124)

0.007(0.060)

0.035(0.140)

0.008(0.070)

0.010(0.010)

0.033(0.020)

0.011(0.130)

1&2, 1&5, 2&3, 2&4,2&6, 3&5, 4&5, 5&6

Inventory / totalassets

0.020(0.108)

0.010(0.040)

0.036(0.201)

0.009(0.074)

0.013(0.101)

0.041(0.116)

0.013(0.130)

1&2, 1&4, 2&3,3&5, 4&5, 5&6

Accounts payable /total assets

0.003(0.031)

0.002(0.027)

0.003(0.065)

0.005(0.032)

0.002(0.016)

0.004(0.028)

0.003(0.020)

1&3

Accrued expenses/ total assets

0.002(0.005)

0.002(0.004)

0.002(0.004)

0.001(0.005)

0.001(0.004)

0.001(0.008)

0.003(0.007)

4&6, 5&6

a t-tests of differences in means, significant at the 5% level.b Mean.c Standard deviation

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Table 2

Mean discretionary accruals for sample firms by year (n=750)

Tax exemption period Tax reduction period Post-holiday t-tests for significant

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 between-year differences a

Discretionary accruals(two-tailed p-value)

0.0011(0.341)

0.0088(0.048)

0.0016(0.286)

0.0022(0.196)

0.0105(0.001)

0.0030(0.175)

1&2, 1&5, 2&3, 2&4,2&6, 3&5, 4&5, 5&6

Discretionary accruals are computed as the error term from the following regression:

where:CAit = (ARit + INVit) – (APit + AEit)

where:CAit = current accruals for firm i in year t,ARit = the change in accounts receivable for firm i from year t-1 to t,INVit = the change in inventory for firm i from year t-1 to t,APit = the change in accounts payable for firm i from year t-1 to t,AEit = the change in accrued expense for firm i from year t-1 to t.

ASSETSit-1 = total assets for sample firm i in year t-1,SALESit = the change in sales for firm i from year t-1 to t,YRj = 1 for year j (j = 1 to 5), 0 otherwise,FIRMk = 1 for firm k (k = 1 to 124), 0 otherwise,

a t-tests of differences in means, significant at the 5% level.

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Table 3

OLS regression of current accruals on the change in sales and dummy variables representing each firm and year

Expected Sign Coefficient t-value p-value

1/ASSETS it-1 0.0078 0.531 0.601

SALESit/ASSETS it-1 + 0.0569 3.532 0.000***

F-statistic = 6.55, p = 0.001, adjusted R2 =0.082.

Estimation model:

(See Table 2 for definitions of variables)

The model was estimated by using least square regression for 750 observations related to 125 firms for 6 years. For brevity, coefficients and t-values for the dummy variables are not reported.

*** Significant at the 1% level.

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Table 4

OLS regression of discretionary accruals on tax-holiday year and control variables (n=750)

Expected sign Coefficient t-value p-value

Intercept 0.0269 0.162 0.750

YR i2 + 0.0089 2.104 0.034**

YR i3 - -0.0012 -1.152 0.148

YR i5 + 0.0113 2.179 0.013**

YR i6 - -0.0003 -0.094 0.821

INDUSTRYi ? 0.0019 0.286 0.570

SIZEit - -0.0038 -1.890 0.053*

JVi - -0.0025 -0.844 0.391

OWNERSHIPi - 0.0013 0.189 0.776

EXEMPTIONi - -0.0021 -0.838 0.412

F-statistic = 7.09, p = 0.001, adjusted R2 = 0.099.

DAit = β0 + β1YRi2 + β2YRi3 +β3YRi5 +β4YRi6 +β5INDUSTRYi +β6SIZEit +β7JVi +β8OWNERSHIPi +β9EXEMPTIONi + μit

where:DAit = discretionary accruals estimate for firm i in year t,YRi2 = 1, if firm i is in the 2nd year of the five-year tax-holiday period, 0 otherwise,YRi3 = 1, if firm i is in the 3rd year of the five-year tax-holiday period, 0 otherwise,YRi5 = 1, if firm i is in the 5th year of the five-year tax-holiday period, 0 otherwise,YRi6 = 1, if firm i is in the year immediately following the five-year tax-holiday period, 0 otherwise,INDUSTRYi = 1, if firm i is in manufacturing industry, 0 otherwise,SIZEit = natural log of total assets for firm i in year t,JVi = 1, if firm i is a joint venture in year t, 0 otherwise,OWNERSHIPi = 1, if firm i is sourced from Hong Kong or Taiwan in year t, 0 otherwise.EXEMPTIONi = 1, if firm’s parent company uses a tax exemption system, 0 otherwise.

*, ** Significant at the 10% and 5% level, respectively.

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Endnotes:

1. For example, Harris (1993), Guenther (1994), Lopez et al. (1998), Maydew (1997), and

Scholes et al. (1992) provide evidence that accounting earnings of U.S. publicly held firms

are managed in response to changes in corporate income tax rates. As different social

contexts and business environments may create different incentives and opportunities for

earnings management, corporate reporting behavior in developed countries may not be

similar to that in developing countries.

2. Although both types of firms have incentives to avoid corporate taxation, privately held firms

are more aggressive than publicly traded firms because 1) they are expected to have smaller

financial reporting costs than publicly held firms (Mills, 1998), and 2) their share ownership

is often highly concentrated and the owners are usually managers of the same firm.

3. For example, a firm can shift income across years via accelerating or delaying shipments of

goods to produce a more appropriate sales figure. Firms that accelerate or defer financial

statement income will in many cases be accelerating or deferring taxable income as well

(Guenther, 1994). While firms reporting conforming book income in the same accounting

period are less likely to trigger tax audit adjustments (Mills, 1998), firms shifting income

between periods surrounding the tax rate change could save current taxes.

4. For example, China’s anti-avoidance campaign in 2002 resulted in a recovery of

underreported tax payment of about US$1.82 billion (SCMP, 2002). The effect of tax

avoidance on developing countries’ economy is more pronounced because the governments

face large fiscal deficits and rely heavily on public sector borrowing.

5. When the normal five-year tax holiday expires, technologically advanced or export-oriented

firms can enjoy a 50% tax reduction for another three years.

6. However, firms established in the designated areas such as Special Economic Zones and

Economic and Technological Development Zones pay enterprise income tax at the reduced

rate of 15% in the post-holiday period.

7. However, there are nontax costs associated with accruals management. For example, delaying

deliveries of finished goods may deteriorate customer relations and increase inventory

holding costs. There are also nontax financial reporting costs associated with reporting low

levels of accounting income (Guenther, 1994; Mills, 1998). For example, costs of violating

debt covenant restrictions and costs associated with negative market reaction. Thus, managers

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who engage in this form of earnings management typically trade off potential tax savings

with nontax costs. As the sample firms in this study are all privately held, accruals

management may have little capital market effect.

8. Because taxable income is not readily available, some researchers (e.g., Harris, 1993;

Guenther, 1994; Maydew, 1997; Scholes et al., 1992) use book income as a surrogate of

taxable income, and argue that book income shifting is equivalent to taxable income shifting.

As there is a close link between financial reporting and tax in China, book income can be used

to infer taxable income.

9. Because accruals cannot be computed without a lagged year, seven consecutive years of data

are needed to compute accruals for six years (i.e., the five tax-holiday years plus one year

after).

10. To facilitate selection of tax audits, most large tax bureaus in China have developed computer

programs to classify FIEs into three audit classes according to the firm’s perceived likelihood

of tax avoidance and evasion. Class “A” firms are “good” taxpayers that are subject to tax

audits every two years. While class “C” firms are taxed based on a deemed profit rate because

they do not keep a full set of books for audit, class “B” firms represent the majority of FIEs

that are subject to annual audit when resources permit.

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