The Impact Of Fin48 On Earnings Management

Abstract

The purpose of this study is to examine the impact of FASB Interpretation No. 48 (FIN48), on earnings management. FIN48 is an interpretation of FASB Statement No. 109 (FAS109), instituted by FASB in 2006 to provide stringent disclosure requirements on tax estimates subject to measurement judgment. Because of FIN48 disclosure requirements, managers' ability to manage earnings through deferred tax assets valuation allowance (DTVA) was somehow compromised. Pre-FIN 48 studies on the association between DTVA and earnings management (EM) find mixed evidence. To determine the effectiveness of FIN48 in curtailing DTVA as a tool to manage earnings, this study examines the association between the level of changes in DTVA and five EM motive hypotheses: namely, debt/equity, bonus compensation, political costs, big bath, and income smoothing hypotheses, in the pre- and post-FIN48 periods. Using pooled data of 164 firms from Compustat, for the period 2003-2010, the data is separated into two test periods: pre-FIN48 (2003-2006) and post-FIN48 (2007-2010). The analysis of all five motives in the pre- and post-FIN48 periods reveals that big bath was most prevalent during the pre-FIN48 period. This indicates that managers recorded higher levels of changes in DTVA to manage earnings downward, which supports big bath hypothesis. However, the post-FIN48 period indicates a prevalence of upward earnings smoothing, suggesting that managers recorded lower levels of changes in DTVA to manage earnings upward. Year-by-year cross-sectional regressions also show evidence of political costs, big bath, and downward earnings smoothing motives during the pre-FIN48 period (2003-2006). Although there is no evidence of bonus compensation during this period, there is evidence of bonus maximization, which is an income decreasing motive. So it appears that the pre-FIN48 period was a time of downward EM. For the first two years (2007-2008) of the post-FIN48 period, there is no evidence of any of the five EM motives, which suggests that FIN48 was effective in curtailing the use of DTVA to manage earnings. However, in the latter two years (2009-2010), which was a perilous time of the recession, results show evidence of bonus compensation, earnings smoothing (upward), and big bath motives. This suggests that FIN48 was less effective in a recessionary period. When managers face a recession, with anticipation of a drastic loss, the motivation to survive becomes a more influential factor in mangers' accounting choices. This study contributes to the literature in two major ways. First, it appears to be the first study to conduct a pre- and post-FIN48 analysis of an association between DTVA and EM motives to demonstrate the efficacy of FIN48 to curtail EM. Second, this study updates and resolves the pre-FIN48 mixed evidence of an association between DTVA and EM.