The effect of tax accounting rules on capital structure and discretionary accruals

Abstract

This study investigates the effect of changing tax accounting provisions for long-term manufacturing contracts between 1984–1985 and 1989–1990 on debt and accrual policies using a simultaneous equations approach. The results indicate that firms adjust debt ratios and discretionary accruals with relatively high book-tax conformity to achieve tax planning goals and use discretionary accruals with relatively low book-tax conformity to accomplish financial reporting objectives. Manufacturing firms directly affected by the change in tax rules for long-term contracts increase their leverage by 6.2 percentage points more than other manufacturers.

Introduction

This paper investigates the effect of changes in the tax accounting rules for long-term manufacturing contracts on debt and accrual policies. More specifically, I determine the extent to which affected firms simultaneously adjust debt ratios and accounting accruals in response to changes in their marginal tax rates due to tax law changes between 1986 and 1989. I predict that affected firms will react to the increase in marginal tax rates by increasing debt ratios and reducing income-increasing accruals that have relatively high book-tax conformity to reduce their expected taxable income. Because these decisions reduce both taxable income and financial statement income, I argue that firms will simultaneously increase their financial statement income by recording income-increasing accruals that have relatively low book-tax conformity to avoid approaching debt covenant violations.

This investigation follows an important line of research on how firms coordinate their corporate policies to achieve potentially conflicting objectives (e.g., Trezevant, 1994; Beatty et al., 1995; Collins et al., 1995; Hunt et al., 1996). Previous research shows that tax rules can affect debt ratios (e.g., MacKie-Mason, 1990; Graham, 1996b) and discretionary accruals (e.g., Guenther, 1994; Guenther et al., 1997). However, empirical research does not document the interaction of changes in debt and discretionary accrual policies due to changes in tax rules. Documenting relations between leverage and financial reporting decisions that result from changes in tax accounting rules creates a richer theory of corporate policy differences across firms (Smith and Watts, 1992).

The analysis compares the changes in debt ratios and discretionary accruals for 54 manufacturing firms with significant revenues from long-term contracts and 410 other manufacturers between 1984–1985 (before the tax law change) and 1989–1990 (after the tax law change was fully phased-in). During this period, the average sample firm increased its debt ratio by approximately 38%. Using a simultaneous equations approach, the results indicate that changes in debt ratios during this period are negatively related to changes in discretionary accruals with relatively high book-tax conformity and positively related to changes in discretionary accruals with relatively low book-tax conformity. These results are consistent with the hypothesis that firms adjust debt ratios and discretionary accruals with relatively high book-tax conformity to achieve tax planning goals and use discretionary accruals with relatively low book-tax conformity to accomplish financial reporting objectives. The results also show that manufacturing firms directly affected by the change in tax accounting rules for long-term contracts increased their leverage by 6.2 percentage points more than other manufacturers. Though I do not find that affected firms adjusted their discretionary accruals between 1984–1985 and 1989–1990 more than other firms, I provide evidence that changes in income-increasing discretionary accruals with relatively high book-tax conformity are inversely related to expected changes in the marginal tax rates due to the change in the taxation of long-term contracts.

The results in this study are important for several reasons. First, I provide evidence that tax accounting rules can affect both financing and accounting policies. These results should interest policy makers who are concerned about the relation between tax law changes and tax revenue and finance and accounting scholars who investigate the relation between taxes and corporate policies. The results imply that it is important to analyze the effect of taxes on corporate policies across a variety of dimensions. Second, I provide additional evidence that discretionary accruals with relatively high book-tax conformity are used to achieve tax-planning goals. This finding extends previous research that documents the use of discretionary current accruals to manage earnings for tax-based objectives (e.g., Manzon, 1992; Guenther, 1994; Guenther et al., 1997) and managers’ reluctance to make income-increasing estimate revisions when the revision has potential tax ramifications (Keating and Zimmerman, 1999). Third, I find that managers are more likely to use discretionary accruals with relatively low book-tax conformity to manage earnings than accruals with relatively high book-tax conformity. This finding extends and generalizes the conclusions of previous studies that identify specific types of discretionary accruals that are used to manage earnings for financial reporting-based objectives (e.g., Beatty et al., 1995; Collins et al., 1995; Teoh et al., 1998). This finding will interest standard setters, auditors, and accounting researchers who are engaged in identifying the types of accruals used for earnings management (Healy and Wahlen, 1999).

The next section provides background on the tax accounting change examined in this study and analyzes the effect of tax accounting provisions on marginal tax rates and firm value. Section 3 describes prior research and develops the hypotheses. Section 4 describes sample selection procedures and the methodology used to test the hypotheses. Section 5 presents some descriptive statistics and the results. Section 6 offers some concluding remarks.