Marie Curie Research Training Network The IFRS Revolution: Compliance, Consequences and Policy Lessons

MRTN-CT-2006-035850 INTACCT

Write-offs and profitability in private firms – disentangling the impact of tax-minimisation incentives

Urska KosiUniversity of Macedonia, Lancaster University

Aljosa Valentincic University of Ljubljana

Varna, Mar 2010

MRTN-CT-2006-035850 INTACCT

Motivation

Burgstahler, Hail and Leuz (2006, p. 988): Studies (e.g. Ball et al., 2000) hypothesize that the link between financial and tax accounting can play an important role in firms’ reporting behavior. … However, there is little direct evidence supporting this hypothesis.

Private-firms setting: Role of incentives on financial reporting outcomes Concentrated ownership agency conflicts, demand for financial reporting Accounting discretion governed by reporting incentives:

tax-minimisation, dividend payout, debt financing, employee relationsAccounting discretion captured by specific accrual asset write-offs (increase power of tests)Isolating specific reporting incentive exogenous change in tax legislation (type of a “natural experiment”)

One incentive changed, other remain unchanged

Approach substitutes for direct modelling of reporting incentives

MRTN-CT-2006-035850 INTACCT

Hypothesis

Relation between accounting discretion and firms’ reporting incentives asset write-offs and profitability

Accounting standards negative relationEmpirical literature positive relation (economic benefits)(e.g. Brown et al. 1992, Garrod et al. 2008, Szczesny, Valentincic 2009)

Important economic benefit tax-savings Change in corporate tax legislation from 2005 current and fixed asset write-offs no longer tax deductible

The same reporting incentives but different tax treatment of write-offs substitutes for direct modelling of firms’ (unobservable) reporting incentivesControlling for known factors in existing literature

H: The magnitude of write-offs will decrease if write-offs cease to be a tax-deductible expense, conditional on the decision to write off.

MRTN-CT-2006-035850 INTACCT

Data & sample

Small private firms in Slovenia: 2004 & 2005

2004 2005

Final sample of small private companies 20,505 (100.00%) 20,505 (100.00%)

Companies writing-off assets 6,126 (29.88%) 5,089 (24.82%)

Companies writing-off current assets 4,824 (23.53%) 3,723 (18.16%)

Companies writing-off fixed assets 2,262 (11.03%) 2,159 (10.53%)

Non-writing-off companies 14,379 (70.12%) 15,416 (75.18%)

MRTN-CT-2006-035850 INTACCT

Data & sample (cont.)

  Mean SD Q25 Median Q75 Skew

Total assets 465,016 1,635,878 42,664 129,987 406,923 25.460

Debt 57,805 366,237 0 0 16,692 35.261

Current assets 148,564 506,105 11,576 39,301 136,154 33.320

Fixed assets (incl. intangibles) 200,558 943,159 5,896 29,791 139,526 37.739

Cash 21,485 78,767 1,052 5,016 17,280 36.126

Revenue 443,061 727,996 48,105 150,334 478,309 2.917

Operating profit (pre-write-off) 27,613 123,511 192 4,878 24,090 59.801

Net income 19,896 135,892 225 2,833 15,240 85.029

Tax 4,959 48,989 0 346 2,637 150.706

Audited 0.007 0.082 0.000 0.000 0.000 12.089

Big-4 auditor 0.002 0.047 0.000 0.000 0.000 21.390

MRTN-CT-2006-035850 INTACCT

Methodology

ttt

tttttt

tCAtttCA

Dummies IndustryYEARBIGAUDIT

EMPNLNPCASHDEBTCA

WOFFSOPADJWOFF

*)4

_(

1110

9876514

1,3210,

ttt

tttttt

tFAtttFA

Dummies IndustryYEARBIGAUDIT

EMPNLNPCASHDEBTFA

WOFFSOPADJWOFF

*)4

_(

1110

9876514

1,3210,

ttt

ttttt

tFAtCAtttFACA

Dummies IndustryYEARBIGAUDIT

EMPNLNPCASHDEBT

WOFFWOFFSOPADJWOFF

*)4

_(

1110

98765

1,'41,3210,&

MRTN-CT-2006-035850 INTACCT

Tobit regressionExplanatory Variables

Constant -0.1055 (0.000) -0.0771 (0.000) -0.0904 (0.000)

ADJ_OP_DEC t 0.0025 (0.000) 0.0005 (0.000) 0.0022 (0.000)

S t 0.0056 (0.000) 0.0035 (0.000) 0.0052 (0.000)

WOFF CA,t -1 0.4440 (0.000) 0.3811 (0.000)

WOFF FA,t -1 0.4752 (0.000) 0.3842 (0.000)

CA t -1 0.0055 (0.000)

FA t -1 0.0099 (0.000)

DEBT t -0.0022 (0.444) 0.0066 (0.003) 0.0012 (0.636)

CASH t -0.0092 (0.002) -0.0047 (0.069) -0.0107 (0.000)

NP t 0.0002 (0.001) 0.0000 (0.633) 0.0001 (0.048)

LP t 0.0015 (0.000) 0.0006 (0.029) 0.0012 (0.000)

EMP t 0.0001 (0.006) 0.0001 (0.000) 0.0001 (0.003)

AUDIT t 0.0119 (0.002) 0.0059 (0.035) 0.0104 (0.002)

BIG4 t -0.0051 (0.509) -0.0006 (0.916) -0.0037 (0.591)

YEAR 0.0079 (0.043) 0.0042 (0.193) 0.0086 (0.009)

Y*ADJ_OP_DEC t -0.0007 (0.000) -0.0001 (0.440) -0.0007 (0.000)

Y*OtherVariables t

IND j

Log likelihood 6,300.792 2,683.328 11,255.448

WOFF CA,t WOFF FA,t WOFF CA&FA,t

YES YES YES

YES YES YES

MRTN-CT-2006-035850 INTACCT

Reverse regressionExplanatory Variables

Constant -0.2082 (0.000) -0.2622 (0.000) -0.2333 (0.000)

WOFF CA,t 0.9225 (0.000)

WOFF FA,t 0.5134 (0.001)

WOFF CA&FA,t 0.8114 (0.000)

S t 0.0251 (0.000) 0.0282 (0.000) 0.0265 (0.000)

WOFF CA,t -1 0.0512 (0.581) 0.0227 (0.789)

WOFF FA,t -1 0.1708 (0.552) 0.1918 (0.469)

CA t -1 -0.0212 (0.017)

FA t -1 0.0117 (0.236)

DEBT t -0.0385 (0.024) -0.0329 (0.067) -0.0354 (0.014)

CASH t 0.1473 (0.000) 0.1660 (0.000) 0.1533 (0.000)

NP t -0.0006 (0.121) -0.0009 (0.021) -0.0005 (0.108)

LP t -0.0072 (0.002) -0.0094 (0.000) -0.0073 (0.000)

EMP t -0.0010 (0.000) -0.0009 (0.000) -0.0011 (0.000)

AUDIT t -0.0328 (0.069) -0.0513 (0.004) -0.0396 (0.013)

BIG4 t 0.0442 (0.206) 0.0230 (0.545) 0.0440 (0.171)

YEAR -0.0959 (0.000) -0.0024 (0.939) -0.0748 (0.001)

Y*Other Variables t

IND j

nAdj. R2

12,2520.102

9,6480.102

4,5240.110

YES YES YES

ADJ_OP t ADJ_OP t ADJ_OP t

YES YES YES

MRTN-CT-2006-035850 INTACCT

Sensitivity analyses

Test if write-offs signal weakening future performance insignificant coefficient estimates

Including loss dummy variable

Modelling decision to write-off (logit models) incremental decrease in the positive relation

MRTN-CT-2006-035850 INTACCT

Conclusions

Findings confirm that magnitude of write-offs, conditional on the decision to write-off, are positively associated to firm profitability

Accounting discretion used to extract economic benefits tax-savings, dividend payouts, employee relations

Econometric challenge to disentangle the tax benefit Type of a “natural experiment” (tax legislation change)Approach substitutes for direct modelling of (unobserved) reporting incentives direct evidence on the tax hypothesis

When tax incentives decrease, magnitude of write-offs, conditional on the decision to write-off, decreases

MRTN-CT-2006-035850 INTACCT

Thank you for questions, comments, suggestions!