Do Firms Modify Investments in Tax Planning to Manage Earnings?

Abstract

SYNOPSIS We examine whether suspect firms (that precisely meet or narrowly beat earnings benchmarks) decrease investments in tax planning to manage earnings; we refer to this strategy as the direct method of modifying discretionary tax fees to increase net income. We analyze investments in tax planning by suspect firms and find that most suspect firms increase earnings by curtailing these investments. Thus, suspect firms appear to prefer this direct method to the indirect method that prior studies have examined, in which firms increase investments in tax planning to reduce tax expense and, in turn, increase net income. We next examine the association between investments in tax planning by suspect firms and tax avoidance. Our findings suggest that suspect firms that increase investments in tax planning experience reductions in ETRs during the same period. In contrast, suspect firms that decrease investments in tax planning do not experience symmetric increases in ETRs.