Short Term Incentive Effects of a Reduction in the NOL Carryback Period

Abstract

The Taxpayer Relief Act of 1997 (TRA 1997) reduced the net operating loss (NOL) carryback period from three to two years, thereby creating a short term incentive effect due to the increased opportunity cost of not recognizing a NOL in the transitional fiscal year of 1997. Specifically, failure to recognize a NOL in 1997 results in the loss of recovery of taxes paid in two prior tax years as opposed to the usual forgone recovery of taxes paid for a single tax year. In light of this higher opportunity cost, we examine whether these firms undertook income shifting to accelerate loss recognition in the tax year 1997. Our findings support this prediction. Compared to a control sample of loss firms, we find the NOL firms in the treatment year of 1997 display higher (lower) levels of income decreasing (increasing) earnings management. To further identify the incentive effect, we focus strictly on the NOL firms in the transition year. We find firms with higher incremental opportunity costs undertook greater income shifting to accelerate loss recognition. Among the treatment firms, we also identify firms for which income shifting to accelerate loss recognition is feasible (i.e., firms for which analysts expect future losses). We find a higher level of earnings management among these firms. Overall, our study highlights the influence of tax incentives on firm reporting behavior. While much of prior research focuses on tax effects arising from tax rate changes, we study how changes in tax law provisions can also create incentive effects which may not be readily apparent.