DISCUSSION OF Book-Tax Conformity and Earnings Management: Insights from European One- and Two-Book Systems

Abstract

W atrin, Ebert, and Thomsen (2012; hereinafter, WET) examine the influence of financial and tax reporting requirements on earnings management by European firms. WET explain two reporting requirements imposed on European firms that differ from those placed on U.S. firms. First, parent and subsidiary corporations are required to file tax statements on a separate-company basis rather than on a consolidated-group basis and, second, corporations are required to disclose separate-company financial statements as well as consolidated-group financial statements. Using these two unique aspects of European reporting, WET investigate how discretionary accruals in the consolidated-group financial statements are related to the magnitude of book-tax differences in separate-company financial statements and to the use of IFRS versus local GAAP accounting standards in the separate-company financial statements. WET conclude that firms operating in a one-book system (where corporations use IFRS for consolidated-group financial statements, separate-company financial statements, and tax reporting) show significantly more earnings management in consolidated financial statements compared with those in a two-book system (where corporations use IFRS for consolidated-group financial statements but use local GAAP for separate-company financial statements and for tax reporting). They further conclude that conformity between separate-company financial statements and tax reporting shows a stronger association with earnings management in consolidated financial statements than does the accounting standard used in the separate-company financial reports. Generally, book-tax conformity and book-tax differences are measured based on differences between the earnings a firm reports to its investors (in consolidated-group financial statements) and the income it reports to tax authorities. WET add to the existing literature by focusing on permanent book-tax differences in separate-company financial statements and the accounting standards used in separate-company versus consolidated-group financial statements. Examining earnings management in this rich institutional setting is the primary strength of this study. My questions and concerns about this study relate to (1) the choice between IFRS and local GAAP, (2) the tax filing