Can Book-Tax Differences Capture Earnings Management and Tax Management? Empirical Evidence From China

Tang, Tanya Y. H.
; Firth, Michael
Working Paper
Can Book-Tax Differences Capture Earnings
Management and Tax Management? Empirical
Evidence from China
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Reference: Tang, Tanya Y. H./Firth, Michael (2011). Can Book-Tax Differences Capture Earnings
Management and Tax Management? Empirical Evidence from China. [S.l.] : SSRN.
https://ssrn.com/abstract=1679190.
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Can Book-Tax Differences Capture Earnings Management and Tax Management?
Empirical Evidence from China
Tanya Tang
University of British Columbia, Okanagan
tanya.tang@ubc.ca
Michael Firth
Lingnan University
mafirth@ln.edu.hk
The International Journal of Accounting, forthcoming
ABSTRACT
This study investigates whether and how book-tax differences (BTDs) are related to
earnings management, tax management, and their interactions in Chinese listed
companies. Using unique tax-effect BTDs obtained from Chinese B-share listed firms, we
find that firms with strong incentives for earnings and tax management exhibit high levels
of abnormal BTDs. This suggests that BTDs can be used to capture both accounting and
tax manipulations induced by managerial motivations. Our results indicate that earnings
management explains 7.4% of abnormal BTDs, tax management accounts for 27.8% of
abnormal BTDs, and their interaction explains 3.2% of abnormal BTDs. Tax-effect BTDs
are more powerful than income-effect BTDs in capturing opportunistic reporting at both
conceptual and empirical levels.
JEL classification: M41; H29
Key Words: Book-tax differences, Earnings management, Tax management, China
An early version of this paper was titled: “Book-tax-differences, a proxy for earnings and
tax management”. We thank A. Rashad Abdel-khalik (the editor), In-Mu Haw (the co-
editor), and an anonymous reviewer for their extensive comments and suggestions. We
are especially grateful to Terry Shevlin for his long-standing support and guidance on this
paper. We also gratefully acknowledge the helpful comments from Millicent Chang, Sharon
Cox, Lillian Mills, John Robinson, Casey Schwab, and workshop participants at the 2006
American Accounting Association Annual Meeting, Simon Fraser University, York
University, and University of British Columbia.
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Can Book-Tax Differences Capture Earnings Management and Tax Management?
Empirical Evidence from China
1. INTRODUCTION
A large body of literature from the U.S. indicates that managers have strong
incentives to engage in earnings and tax management. 1 For example, they manage
earnings to meet the requirements of compensation contracts, debt covenants, stock
market pricing, and government and stock exchange regulations (Healy and Wahlen,
1999; Fields et al., 2001), and they manage taxes to maximize shareholders’ returns
(Scholes et al., 2005; Swenson, 1999), reduce the risk of tax scrutiny and political cost
(Watts and Zimmerman, 1986; Fields et al., 2001), and satisfy tax-based contract
motivations such as after-tax compensation schemes (Phillips, 2003). Detecting earnings
management (EM) and tax management (TM) is important in assessing the quality of
earnings and studying management behavior. Some studies have demonstrated that
book-tax differences (BTDs) reflect earnings management and earnings quality (Mills and
Newberry, 2001; Phillips et al., 2003; Hanlon, 2005), while other studies show that BTDs
are associated with tax sheltering (Shevlin, 2002; McGill and Outslay, 2004; Wilson, 2009;
Frank et al., 2009). However, very few studies examine the simultaneous impacts of EM,
TM, and their interactions, on BTDs. 2
In this study we examine BTDs, EM and TM in China. In doing so, we extend the
literature in terms of research method, empirical design, and country coverage. We use
tax-effect BTDs that are calculated directly from financial statement disclosures. In
contrast, U.S. research has used income-effect BTDs, which are based on estimations that
involve “grossing up” tax payments. These estimations result in well-know measurement
errors that are impossible to avoid (Hanlon, 2003). Estimation problems are eliminated
when we use tax-effect BTDs and we show they are a much better measure of BTDs and
capture opportunistic reporting in a more powerful way, at least in the case of China. In
their review paper, Graham et al. (2009) conclude that BTDs can be a function of earnings
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management, tax planning, regulatory differences, or some other factors. They note that,
while numerous studies document BTDs as evidence of EM and TM, almost all of them
use aggregated BTDs. They suggest that future research should study the disaggregated
components of BTDs to better explain the underlying causes. In this paper, we distinguish
between regulatory and opportunistic components of BTDs. Using a regression model, we
decompose BTDs into normal BTDs (NBTDs) and abnormal BTDs (ABTDs). NBTDs are
explained by differences between GAAP and tax law and we include these factors in the
regression model of BTDs. ABTDs are the result of EM and TM and we use the residual
from the BTD regression model as a proxy for ABTDs. We examine whether firms with
strong incentives for EM and TM have higher ABTDs. Consistent with our argument that
disaggregated BTDs not only inform us of the magnitude of the mechanical differences
between book and tax reporting rules, but also EM and TM, we provide evidence that
abnormal BTDs are associated with EM and TM incentives but normal BTDs are not. Our
results suggest that simply using total BTDs as a proxy for EM and TM may lead to an
overstatement of EM and TM. In addition, evidence that abnormal BTDs can be explained
by EM, TM, and their interaction provides a caveat to researchers when using this
measure to investigate EM or TM separately. We therefore extend the BTD literature.
We develop proxies for EM and TM based on our knowledge of China’s unique
institutional settings. For example, China has variable statutory tax rates, separate tax
reporting versus consolidated tax reporting, a highly concentrated ownership structure,
and rigid capital issuance requirements. These characteristics are very different from those
in the U.S. and they each have an influence on EM and TM. Differences in tax laws
between China and the U.S., and differences in institutional factors, imply that the results
from U.S. studies cannot be automatically imputed to the China setting. This provides a
motivation for our research. We incorporate the special features of China’s corporate
sector and tax law into our model. Examples include the number of different tax rates that
are applicable to a specific consolidated company and government ownership of listed
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firms. These factors have a potential impact on EM and TM. To give some comparative
context to our research design and interpretation of results, we make references to the
extant literature on U.S. research.
China is an important country in which to carry out our research as it has the third
largest economy in the world, the second largest market capitalization, and has unique
institutional characteristics. Inward portfolio investment from the U.S. and other countries
is accelerating as international investors search for growth markets with fast expanding
domestic demand. One impediment to this growth is investors’ real concerns over the
quality of accounting information, which they need in order to make good investment
decisions (Haw et al., 2001; Sami and Zhou, 2004). Our study will highlight some aspects
of earnings management and tax management in China and thus will contribute to
investors’ understandings of accounting and management behavior in Chinese listed firms.
Our empirical results are based on data drawn from Chinese listed firms that have
foreign investors (B-share firms) as these companies have detailed tax notes that allow us
to calculate tax-effect BTDs. The results show that abnormal BTDs (ABTDs) are
significantly related to a set of earnings and tax management incentives. We find that EM
explains 7.4% of ABTDs, TM accounts for 27.8% of ABTDs, and the combined EM and TM
factor explains 3.2% of ABTDs. These findings suggest that ABTDs are a useful proxy for
both EM and TM in China. Our results are robust to a series of sensitivity tests, including
out-of-sample estimation, model misspecification, different measures of the avoiding
losses incentive, the rights issues incentive test, the proportion of temporary and
permanent difference effects, and year effects.
The results provide important insights into the different EM and TM practices that
have emerged in response to the unique institutional settings in the world’s largest
transitional economy, China. Our findings have implications for policymakers, auditors,
international investors, and users of financial reports of listed Chinese companies. BTDs
can help investors estimate and evaluate the quality of financial statements, and tax

authorities and auditing firms can carry out more effective audits by focusing on large BTD
firms. The analysis of BTDs may also assist China’s regulators in their quest to enhance
the credibility of book and tax reporting and the efficiency of China’s capital markets. To
the best of our knowledge, this is the first study to examine whether and how both EM and
TM affect BTDs in a major transitional economy.
The remainder of the paper is organized as follows. The next section discusses prior
research and describes the institutional background in China. In particular, we discuss
Chinese BTDs in terms of its development, measurement, and features. We also discuss
the effects of institutional settings on management incentives for EM and TM in China.
Sections 3 and 4 describe the research design, sample selection, and summary statistics.
The fifth section presents empirical results and the last section concludes.
2. LITERATURE REVIEW AND INSTITUTIONAL BACKGROUND
2.1 BTD-Related Research
BTDs refer to the gap between the pre-tax income reported in a company’s published
financial statements (hereafter book income) and the taxable income reported to the tax
authorities. The conflicting objectives of accounting and tax rules lead to divergent
requirements in income reporting, which generate mechanical BTDs (Smith and Butters,
1949; Beresford et al., 1983). However, accounting rules and tax laws cannot specify the
accounting and tax treatment for every business transaction because business activities
are complex and continually changing. This necessarily leaves considerable uncertainty in
applying accounting standards and tax laws. For example, in an effort to achieve a variety
of social, economic, and political goals, tax laws often vary across time, industries, and
even firms.
GAAP, per se, permits considerable discretion in reporting practices (Fields et al.,
2001; Watts and Zimmerman, 1986; Manzon and Plesko, 2002). For example, the
standards of comparability, consistency and materiality in GAAP allow managers to

exercise discretion to make different determinations about the amount of revenue or
expenses to recognize in any given period. These standards also permit flexibility in the
choice of accounting methods, such as depreciation, cost allocation, and asset valuation.
When managers have incentives to distort a firm’s performance, they may opportunistically
use accounting standards and tax laws, and thereby create abnormal BTDs.
Drawing on U.S. data, Mills and Newberry (2001) present evidence that firms with
EM incentives have larger BTDs. Phillips et al. (2003) evaluate the usefulness of BTDs in
detecting EM relative to various accruals measures. Assuming that taxable income is
constant, they find that temporary BTDs are incrementally useful beyond total accruals and
discretionary accruals in classifying firm-years as EM or non-EM for firms that have
earnings declines or are in danger of reporting losses. Hanlon (2005) finds that earnings
and the accrual portion of earnings are less persistent for one-year-ahead earnings for
firms with large temporary BTDs, suggesting that extreme temporary BTDs indicate lower
pre-tax earnings quality.
A growing body of literature (Shevlin, 2002; Desai and Dharmapala, 2006; Plesko,
2004; McGill and Outslay, 2004) suggests a link between BTDs and TM. The underlying
idea is that inconsistent financial accounting and tax reporting should be a characteristic of
tax planning, because the goal of tax planning is to reduce tax payments. If taxable income
is managed without affecting book income, the variation in BTD is reflective of tax
shelters.3 Some U.S. studies (Manzon and Plesko, 2002; Mills et al., 2003; Plesko, 2004)
find that aggregate BTDs have increased over the 1990s, but this growth cannot be
explained by institutional arrangements. These researchers argue that the large
unexplained BTDs may be partly attributable to increased tax sheltering activities. Wilson
(2009) and Frank et al. (2009) find evidence of a positive association between BTDs and
identified tax shelter firms. Mills (1998) finds that proposed audit adjustments increase as
firms’ BTDs widen, suggesting that larger positive BTDs imply high levels of tax non-
compliance. Cho et al. (2006) report similar evidence in New Zealand.

The literature on tax and non-tax trade-offs suggests that EM and TM may exist
simultaneously and interact with each other (Shackelford and Shevlin, 2001). Current
studies indicate that firms engaged in aggressive book reporting may be also involved in
aggressive tax reporting (Frank et al., 2009). The propensity to engage in opportunistic
behavior is predicated on tax and non-tax cost considerations and on a manager’s
incentives. Managers’ actions include aggressive, moderate, or conservative strategies.
These strategies can be summarized as follows: (1) managing book and taxable income
(taxes) in an opposite direction, e.g., reporting higher earnings and lower taxable income
(taxes); (2) managing book income while keeping taxable income (taxes) constant, e.g.,
boosting earnings or taking a bath; (3) managing taxable income (taxes) while keeping
book income constant, e.g., reducing (deferring) taxes or smoothing taxes.4 However, no
matter what strategy management chooses, the ultimate purposes of EM and TM are to
influence book income and tax payments. These actions increase the variation in BTDs
because BTDs are a function of tax-effect book income and tax-effect taxable income. The
resulting variations can help quantify the magnitude of opportunistic book and tax
reporting. Therefore, BTDs inform us not only of the magnitude of the mechanical
discrepancy between book and tax reporting rules, but also of management’s strategies or
behavior in managing earnings and taxes.
2.2 Institutional Background of BTDs in China
Unlike the U.S. and many other developed nations, which have a long history of BTDs,
China’s BTDs emerged when the Chinese accounting and tax systems changed from a
conforming (or dependent) system to a non-conforming (or independent) system beginning
in 1985. Before that, the rules for measuring accounting profit were the same as those for
measuring taxable income, so no BTDs existed in China (Tang et al., 2000; Davidson et al.,
1996). In the transition to a modern business enterprise system, China changed its
accounting standards to comply with IFRS and imported elements from international tax

practices and laws. Since then, Chinese GAAP has departed from Chinese income tax
laws, giving rise to a lot of mechanical BTDs (Tang, 2006). Appendix I lists the major
differences between corporate income tax laws and Chinese GAAP. The harmonization
with IFRS has dual implications: (1) it increases the relevance and comparability of
financial reporting in a global economy; and (2) it increases discretion in accounting
choices and provides greater opportunities for managerial manipulation, especially in
countries where the monitoring of management’s judgments is relatively weak. In addition,
the departure of book income from taxable income provides opportunities for firms to
aggressively report their book income and taxable income simultaneously (Desai, 2005).
Figures 1 and 2 show the patterns of BTDs, permanent differences, and temporary
differences, over time. We identify three major features of Chinese BTDs. First, unlike U.S.
BTDs, aggregate Chinese BTDs are negative during our observation period.5 Tang (2006)
interprets the negative aggregate BTDs as evidence that Chinese income tax laws have
more conservative expense recognition relative to Chinese GAAP and IFRS. Examples of
more conservative expense recognition include limitations in deducting salary expenses,
advertisement fees, entertainment fees, lower tax depreciation vis-a-vis book depreciation,
and numerous non-deductible items such as the provision for impairment of assets and
expenses without authorized supporting invoices. Second, the pattern of BTDs is mainly
determined by permanent differences. On average, the proportion of permanent
differences to total BTDs is 76% for the sample we use in the main tests. Appendix I
details different book and tax treatments as reflected in permanent and temporary
differences. This shows that numerous accounting recognized expenses (unrecognized
revenues) are non-deductable (recognized) under tax laws, resulting in a high proportion
of permanent differences. Third, Chinese BTDs fluctuate overtime and cannot be
explained solely by changes in accounting and tax rules during our sample period.
Therefore, it is interesting to study how management practices explain the variation in
BTDs.

Insert Figures 1 and 2 here
Evidence to date suggests that Chinese managers opportunistically use the
discretion in current accounting standards. For example, Eccher and Healy (2000)
document that Chinese managers are more likely to exercise greater discretion in
reporting accruals, particularly through the write-down of obsolete inventory and accounts
receivable allowance under IFRS. Aharony et al. (2000) conclude that accelerating credit
sales is a widely used method for Chinese B-share firms’ earnings management before
making an IPO. Haw at al. (2005) and Chen and Yuan (2004) provide evidence that
Chinese listed firms manage earnings upward to gain approval to make a rights issue.
Some studies attribute these phenomena to the lack of effective controls that monitor
opportunistic reporting, such as insufficient supervision and scrutiny by the China
Securities Regulatory Commission (CSRC), a lack of independent auditing, and a lack of
legal protection for minority investors (DeFond et al., 2000; Abdel-khalik et al., 1999;
Eccher and Healy, 2000; Lin and Chan, 2000; Aharony et al., 2000). The instruments of
earnings management used in China include, but are not limited to, accruals (Lu, 1999),
non-operating earnings or below-the-line items (Chen and Yuan, 2004; Haw et al., 2005),
related party transactions (Jian and Wong, 2010, Lo et al., 2010a, b), and government
fiscal subsidies (Chen et al., 2008).
China’s tax system is characterized by its uncertainty due to multiple-tier tax
legislations and a multitude of tax incentives driven by strong political-economic objectives
and local governments’ interests (Tang, 2006). For example, the Chinese government
offers favorable tax incentives to domestic firms operating in five special economic zones,
32 economic and technology development zones, 13 free trade zones, and 52 high-tech
development zones (Wu et al., 2007). As a result of that, actual tax rate applied to firms
that enjoy preference policies could be 24%, 15%, 7.5% and even 0, much lower than the
nominal statutory tax rate of 33%. The variation in tax burdens within a country and the
lack of efficiency in tax administration induce firms to engage in tax planning (Chan and

Mo, 2000; Mo, 2003). Wu et al. (2007) find that firms mitigate taxes by changing their
registration location to a low tax rate region. Shevlin et al. (2009) demonstrate that
Chinese listed firms save taxes through shifting income from high tax rate subsidiaries to
low tax rate subsidiaries. In particular, Chan et al. (2009) find that tax noncompliance
increases when the level of book and tax conformity decreases. We incorporate these
unique features of Chinese BTDs into our research design.
3. RESEARCH DESIGN
3.1 The measure of Chinese BTDs
We can measure BTDs in two ways: (1) using book income minus taxable income or the
sum of permanent differences and temporary differences, which is called income-effect BTDs;
and (2) using prima facie income tax expense (i.e., the multiplication of book income by the
statutory tax rate) minus current tax expense (or the sum of the multiplication of the statutory
tax rate by the permanent differences and the multiplication of the statutory tax rate by the
temporary differences), which is called tax-effect BTDs. A common method to estimate BTDs
in the U.S studies is to gross-up current tax expense to estimate taxable income, or to use
the effective tax rate reconciliation to infer total BTDs. The income-effect method from this
estimation introduces measurement error due to credits, tax rate differences, consolidation,
and tax loss carry forwards (see Hanlon, 2003 for a detailed discussion). Appendix II gives
an example of computing tax-effect BTDs and income-effect BTDs. The numbers are quite
different.
Tax-effect BTDs are particularly appropriate in China because firms are subject to
varying tax rates due to different government tax incentives and because they are required
to declare their corporate income tax on an individual firm tax reporting basis. Furthermore,
tax-effect BTDs allow researchers to examine those tax strategies that reduce the overall
tax burden without affecting total book and taxable income (i.e., income shifting).
Conversely, the use of income-effect BTDs may restrict empirical tests as it only can
10

capture those tax strategies that affect book income or tax income. 6 To examine this
further, we test whether our EM and TM results are affected by the way we calculate BTDs
(tax-effect and income-effect).
We are able to use tax-effect BTDs in this study because they are disclosed in B-share
listed firms’ financial statement tax footnotes. China’s B-shares are mainly traded and held
by foreign investors. Based on financial information disclosure regulations issued by the
Ministry of Finance (MOF) and the CSRC, B-share firms must prepare financial reports in
two languages and use two sets of accounting standards: the Chinese-version under
Chinese GAAP and the English-version under IFRS. A reconciliation of tax-effect book
income and current tax expense is presented in the IFRS-based reports (see Appendix III
for an example). These data enable us to avoid the measurement errors inherent in having
to estimate BTDs (which is the case for income-effect BTDs).
Most prior BTD studies focus on either temporary differences (e.g., Phillips et al.,
2003; Hanlon, 2005) or permanent differences (Frank et al., 2009) and examine either EM
or TM behavior. However, EM/TM can create both permanent differences and temporary
differences (Wilson, 2009; Hanlon and Heitzman, 2009). Using a sample of firms identified
as engaging in tax shelter activities, Wilson (2009) analyzes nine major types of tax shelter
activities and identifies that three of them create temporary differences. The results in his
Table 4 indicate that both temporary and permanent BTDs are correlated with identified tax
shelter firms. As a result, we use total BTDs that consist of both permanent and temporary
differences to examine EM and TM activities.
3.2 Estimating Normal and Abnormal BTDs
Prior literature has used a residual approach to disentangle the different components
in BTDs. For example, Desai and Dharmapala (2006) use the residual from a regression of
total BTDs on total accruals to estimate a measure of tax planning and assume that BTDs
are a result of EM and TM. Frank et al. (2009) construct a tax aggressiveness measure by
11

regressing total permanent BTDs on nondiscretionary permanent items due to the
differences between accounting and tax rules. In doing so, they restrict their measure to
tax aggressiveness that does not generate temporary differences. In this paper, we follow
their notion and develop ABTD and NBTD measures that take account of the uniqueness
of Chinese accounting and tax systems. As discussed in Section 2.1, BTDs are a function
of accounting-tax misalignment, EM, and TM. To estimate NBTDs, we regress total BTDs
on nondiscretionary items that are known to cause NBTDs but are less likely to relate to
management manipulations. The unexplained portion is our measure of ABTDs. Following
Manzon and Plesko (2002), we use changes in sales, gross property, plant and equipment
(PPE), non-goodwill intangible assets, and NOL to explain NBTDs. We also add tax rate
differences to the model.7 The estimation equation is:
BTDit  0  1INVit  2REVit  3TLit  4TLUit  5TAX _ DIFFit  it (1)
where
BTDit = the reported BTD for firm i in year t;
INVit = the change in investment in gross property, plant and equipment
and intangible assets from year t-1 to year t;
REVit = the change in revenue from year t-1 to year t;
TLit = the value of accounting losses;
TLUit = the value of tax losses utilized for firm i in year t;
TAX _ DIFFit = the difference between the consolidated company’s applicable tax rate
and the average tax rate in the consolidated group;
 it = error term in year t for firm i.
NBTDs are driven by the mechanical divergence between accounting standards and
tax laws and are subject to investment scale in fixed and intangible assets (ΔINV),
economic growth (ΔREV), tax loss positions (TL and TLU), and tax rate differences
12

(TAX_DIFF). For example, Chinese tax laws prescribe the straight-line depreciation
method, useful life, and residual values for specific assets. However, for financial reporting
purposes, these items are all subject to management choice based on Chinese GAAP and
IFRS. Given that tax depreciation is slower than book depreciation in China, taxable
income will be larger than book income in the earlier years of the assets’ lives. When the
investment in fixed and intangible assets increases, it contributes a larger numerator to
calculate depreciation and amortization, thereby giving rise to large negative NBTDs. In
addition, investment growth will increase the provision for impairment of fixed and
intangibles assets. Provisions for impairments are shown in the income statement as
required under existing accounting standards but they are non-deductible under Chinese
tax laws; this leads to a higher (lower) taxable income compared to book income in the
earlier (later) years. Therefore, investment growth will lead to large negative NBTDs in
China, which is quite different from the U.S. setting. We use INVit to capture the effect of
the growth in investment scale on NBTDs that relate to mechanical depreciation and
amortization.8
REVit is used to control for the effect of changes in economic circumstances on
NBTDs.9 Usually, accounting rules tend to prevent companies from overstating revenue or
understating expenses to financial statement users and thus protect third party creditors
and investors. By contrast, tax laws tend to constrain taxpayers from understating revenue
or overstating expenses to tax authorities for the purpose of protecting government
revenue. Thus, growth in revenue will increase NBTDs due to different income and expense
recognition in GAAP and tax laws. As discussed earlier, Chinese income tax laws are more
stringent in expense recognition and less conservative in income recognition. Correspondingly,
higher growth in revenue will lead to larger negative NBTDs.
Wilkie (1992) indicates that BTDs will be understated when a tax loss occurs and
overstated when a tax loss is utilized. For example, when a tax loss occurs, taxable income
13

is recognized as zero leading to negative NBTDs. When a tax loss is utilized, the preceding
year's tax losses are offset against the current year's taxable income, thereby resulting in
positive NBTDs. We use TLit and TLUit variables to control for the mechanical effects of
tax policies specific to tax loss carry forwards and the asymmetric treatment of taxable
income and tax loss.10
Finally, we use TAX _ DIFFit to control for the mechanical effect of tax rate
differentials and the different reporting requirements on NBTDs. Unlike the U.S. tax code,
Chinese tax laws require separate tax reporting. Each entity must compute its income tax
on the basis of its independent taxable income and the applicable tax rate. Therefore,
applicable tax rate variation among subsidiaries in a consolidated group affects NBTDs. 11
All variables are scaled by total assets for year t to control for firm size except for
TAX _ DIFFit .
3.3 Testing the Relations between ABTDs and Incentives for EM and TM
NBTDs are the fitted values from equation (1) and the residuals are abnormal book-
tax differences (ABTDs). To test whether ABTDs can capture EM and TM, we develop the
following multiple regression model in which estimated ABTDs are regressed on a set of
variables that proxy for various EM and TM incentives. If ABTDs are indicative of potential
managerial manipulations, firms with stronger incentives and opportunities for EM and TM
should have high levels of ABTDs.
ABS ( ABTD)   0  1 ATR   2 NUMBER   3 SEON   4 LOSS   5 SOELG

(2)
 6 NUMBER * SOELG   7 IND  8 SIZE  
where
Dependent variable:
ABTD = the absolute value of abnormal BTDs, scaled by total assets.
EM and TM can yield negative or positive ABTDs. For our study, signed ABTDs are not
appropriate measures of manipulations since a firm with positive ABTDs does not necessarily
14

imply that its extent of manipulation is larger than that of a firm with negative ABTDs.12 We
therefore use unsigned ABTDs.
TM incentives variables:
ATR = applicable tax rate for the sample listed firm as shown in the tax note;
NUMBER = the number of different applicable tax rates in a consolidated entity;
EM incentives variables:
SEON = dummy variable that equals 1 when a consolidated entity has a rights issue or
public offering in year t+1, and 0 otherwise;
LOSS = dummy variable that equals 1 when a consolidated entity has a loss in the
current year t, and 0 otherwise;
TM and EM variables:
SOELG = dummy variable that equals 1 when a consolidated entity is a state-owned
enterprise controlled by a local government, and 0 otherwise;
Control variables:
IND = control variable that equals 1 for the manufacturing industry and 0
otherwise;
SIZE = the natural logarithm of total assets at the fiscal year-end.
The tax planning literature suggests that the significant factors that affect TM include
the corporate tax rate (Klassen et al., 1993; Klassen and Shackelford, 1998), non-tax costs
consideration (Scholes et al., 2005), and different tax treatments or jurisdictions (Klassen
and Shackelford, 1998; Gupta and Mills, 2002).
A major feature of Chinese corporate income tax is that the income tax rate varies
across firms with different investors and firms established in different industries and
locations. The applicable income tax rate (ATR) for listed firms’ ranges from 0% to 33%.
This encourages firms with a higher tax rate to engage in tax planning. Chan and Mo
(2000) find that Chinese firms with a high tax rate have high tax audit adjustments,
15

implying more tax noncompliance. Accordingly, we expect that a higher ATR generates
strong incentives to engage in tax planning, resulting in larger ABTDs.
Based on non-tax cost considerations, a well-designed tax strategy can reduce taxes
but does not diminish income reported to investors. Consequently, income-shifting through
exploiting different tax treatments in a consolidated group is an ideal tax strategy due to it
having little or no impact on a firm’s reported profit. Some U.S.-based studies demonstrate
that U.S. multinational and multi-state companies lower their taxes by cross-jurisdiction
income shifting (Klassen et al., 1993; Gupta and Mills, 2002). These studies argue that
firms with different tax rates can strategically arrange operations, capital, and product
flows by shifting income from high tax brackets to low tax brackets. In contrast, firms with a
single tax treatment have no opportunity to pursue these potential tax strategies (Mills et
al., 1998).
Chinese companies with subsidiaries in different regions and industries are commonly
subject to multiple tax rates, making tax-induced income shifting among subsidiaries
possible. In particular, under Chinese income tax laws, all corporations must declare their
tax liabilities on a separate entity reporting basis despite consolidated requirements in
IFRS and Chinese GAAP. Thus, Chinese listed firms have strong incentives and
opportunities to shift income from subsidiaries with a high tax rate to those with a low tax
rate. Shevlin et al. (2009) find evidence that the magnitude of income shifting in Chinese
listed firms increases with the tax rate range in a consolidated group. The greater the
differences in tax rates among subsidiaries, the more likely a holding company engages in
inter-subsidiaries tax-induced income shifting. Accordingly, we expect that the number of
tax rates is positively associated with ABTDs.
We add EM incentives in equation (2). Seasoned equity offering (SEO) research
documents that SEO-issuing firms report income-increasing discretionary accruals around
the time of equity offerings (Teoh et al., 1998; Marquardt and Wiedman, 2004). Many
studies in China (mostly in Chinese) also show that listed firms inflate earnings to reach
16

the threshold for eligibility to make SEOs (i.e., the 10 percent ROE rule). This phenomena
can be explained by Chinese listed firms’ heavy reliance on equity financing and the high
threshold for making SEOs set by the CSRC (see Aharony et al., 2000). Jian and Wong
(2010) find that China’s listed firms use recurring related party transactions to manage
operating earnings upward to meet the SEO hurdle. Chen et al. (2000) and Haw et al.
(2005) show that firms with ROEs in the range of 10 to 11 percent have unusually high
discretionary items such as abnormal accruals and non-core profits. Following these
studies, we predict that SEO applicants (SEON firms) face an immediate incentive to
improve profits through EM in year t so as to gain SEO eligibility in year t+1 and this will
result in larger ABTDs relative to non-SEON firms.
While numerous studies show that avoiding a loss is a strong incentive for EM (e.g.,
Burgstahler and Dichev, 1997), Chinese listed firms exhibit an even stronger motivation to
report positive earnings because of the CSRC’s delisting and trading restrictions
regulations.13 Much of the literature demonstrates that Chinese firms are keen to report
positive earnings to avoid delisting from the stock market (Cai et al., 2003). Lu (1999)
demonstrates that loss firms manipulate their earnings upward or downward in different
time periods to avoid delisting and trading restrictions. Accordingly, we expect that loss
firms have strong incentives for EM, thereby giving rise to larger ABTDs.
The tax and non-tax trade-offs literature suggests that EM and TM may exist
simultaneously and interact with each other (Shackelford and Shevlin, 2001). We include
an ownership variable, SOELG, to investigate the association of ABTDs with combined EM
and TM incentives. A distinct characteristic of Chinese capital markets is that the share
ownership is highly concentrated in the hands of the central and local governments. The
state is the largest shareholder in approximately 73% of B-share listed firms. The state’s
shares are administered by government bodies such as state asset management agencies
or institutions authorized to hold shares on behalf of the state, such as wholly state-owned
investment companies (CSRC, 2005). The government frequently appoints top managers
17

and the managers’ compensations do not relate to stock returns, which suggests that
managers may have more incentives to act in the best interests of the state rather than in
the best interest of public shareholders (Firth et al., 2006). In addition, concentrated
ownership implies controlling shareholders are rarely challenged by other shareholders
and this can lead to poor corporate governance (Liu and Lu, 2007). By examining firms
that had allegations of accounting manipulation made by the CSRC during 1994 to 2002,
Liu and Du (2003) demonstrate that state-owned enterprises (SOEs) are more likely to
manage earnings.
Some listed firms are controlled by the central government (SOECG) and some are
controlled by local governments (SOELG).14 Local governments play multiple roles such as
providing public services, monitoring listed firms as China’s central government agents,
and being major shareholders of listed firms (Chen et al., 2008). This complicated
relationship and conflicts of interest between local governments and the central
administration in China create a unique incentive for SOELGs to engage in both EM and
TM. On the one hand, local governments want to attract more investment to develop the
local economy, increase employment opportunities, and create regional revenue as the
performance of the local economy affects government officers’ promotions and political
careers (Li, 1998). Chen et al. (2008) find that local governments use fiscal subsidies as a
means to help their listed firms boost earnings to meet the threshold for making a SEO and
to avoid delisting. Their evidence shows that 21% of SEO qualified firms are unqualified
before fiscal subsidies and 96% of firms with a slight loss become profitable after receiving
fiscal subsidies.
On the other hand, local governments have strong incentives to encourage their listed
firms to engage in tax planning for their own interests. As the largest shareholders, local
governments are the largest beneficiaries of high post-tax returns. Further, the tax-sharing
system in China requires that income tax paid by a state controlled listed firm must be
shared with the central government.15 In this context, SOELG firms may have incentives to
18

boost their earnings and minimize income taxes. We expect a positive relationship
between ABTDs and SOELG.
Recent studies show that local governments provide their listed firms with generous
tax preferences as a means to attract and retain more equity capital into their own
jurisdictions (e.g., Wu et al., 2007; Chen et al., 2008). In an untabulated test, we find that
the means of number of tax rates (NUMBER) and ATR for SOELG firms are 3.11 and 15%,
in contrast to 2.4 and 20% for SOECGs, suggesting that SOELG firms have more tax
incentives and lower applicable tax rates.16 Tax incentives have contrasting effects on the
tax planning decisions of SOELG firms. Tax rate differentials facilitate tax aggressiveness
in a consolidated group. SOELG firms are likely to maximize tax benefits via income
shifting. However, tax aggressiveness is costly and risky. Studies in other countries have
documented that tax aggressiveness is associated with low stock returns (Hanlon and
Slemrod, 2009) and those large BTDs due to tax aggressiveness lead to high tax
adjustments (Mills, 1998; Cho et al., 2006). If SOELG firms can reduce their tax burdens
directly by taking advantage of tax preferences, they may reduce aggressive tax planning
activities as reflected in ABTDs.17 To investigate the tax preference effect on SOELG firms’
tax planning decisions, we include the interaction term of Number*SOELG in Equation 2.
We expect that firms that have a number of tax rates are less likely to engage in
aggressive tax reporting due to risk and cost considerations, thereby having lower ABTDs.
The variables IND and SIZE are used to control for industry and size effects on ABTDs.
4. DATA COLLECTION AND SUMMARY STATISTICS
We collect BTD data from companies’ English-version financial reports available at the
CSRC’s designated official website (www.cninfo.com.cn and www.sse.com.cn) and
financial reports offered voluntarily by firms upon our request. The initial sample contains
all Chinese B-share firms18 listed on either the Shanghai or Shenzhen Stock Exchanges
from 1999 to 2004, resulting in 664 firm-year observations. We exclude firms without three-
19

years of consecutive data19 and firms in industries that are subject to special tax policies or
accounting rules (e.g., agriculture, mining, and construction). Table 1 shows that out of the
664 firm-years that comprise the population of Chinese B-share listed firms over the period
1999-2004, our sample consists of 525 firm-year observations. The sample by year and by
industry is shown in Panels B and C. Panel B shows that approximately 70% of
observations are in the manufacturing industry.
Insert Table 1 here
Table 2 reports the summary statistics and correlation matrix for the variables used in
the BTD and ABTD models. Panel A shows that the mean (median) of BTD is -0.008 (-
0.001), suggesting that aggregate Chinese BTDs are generally negative and opposite to
aggregate BTDs in the U.S. (Plesko, 2004; Hanlon and Shevlin, 2005). The means
(medians) of ∆REV and ∆INV are 8.1% (6.7%) and 1.9% (1.1%) of total assets,
respectively. The univariate correlation analysis shows that BTD has a significantly
negative association with ∆INV and NOL and a positive relation with ∆REV and TLU,
consistent with our predictions.
Insert Table 2 here
Panel C of Table 2 presents descriptive statistics for variables in the ABTD model.
The mean (median) of ABS (ABTD) is 0.7% (0.3%) of total assets. The mean of ATR is
19.6%, which is far below the statutory rate of 33%. The mean and the maximum of
NUMBER for sample firms are 2.60 and 11, consistent with Chinese listed firms being
subject to multiple tax rates within a consolidated group due to different tax incentives
offered by the government. About 18.7% of observations have a loss and 72% of firm-year
observations are companies controlled by SOELGs. Only 3.4% of our firm-year
observations make a seasoned equity offering in the following year (the number of SEOs
is quite small because, in part, the CSRC severely limits the number of SEOs in any given
year). ABS (ABTD) is positively correlated with ATR and LOSS.
20

5. EMPIRICAL RESULTS
5.1 Results of the BTD Model
We use the residual calculated from cross-sectional model (1) to estimate ABTDs.
Table 3 shows that the overall model is a good fit and explains most of the variation in
BTDs. The adjusted R² is 77% and the F-statistic is 352.90 (significant at the 0.01 level).20
The coefficients are all significantly different from zero. In line with expectations, the signs
on ∆INV, ∆REV, and TL are negative and the signs on TLU and TAX_DIFF are positive.
Insert Table 3 here
5.2 The Relation between ABTDs and EM and TM Incentives
Table 4 presents the results of the regression of the estimated ABTDs on TM and EM
incentives. In the main results (column 1), all estimated coefficients are significant at the
0.05 level using a one-tailed test (two-tailed when there is no predicted sign).21Consistent
with the prediction that a higher ATR creates incentives for tax planning, resulting in larger
ABTDs, ATR is significantly positive. Holding other variables constant, the coefficient on
ATR suggests that a one-percent increase in ATR contributes a 3.8 percent increase in the
absolute value of ABTDs, which is approximately 0.82 million RMB (about 0.13 million U.S.
dollars) for the average firm.
The coefficient on NUMBER is significantly positive, suggesting that firms that face
more tax rates engage in tax planning, presumably by shifting income from subsidiaries
with high tax rates to those with low tax rates. This finding is also consistent with the U.S.
literature suggesting that greater differences in tax rates provide more opportunities for tax
avoidance.
As expected, SEON firms and LOSS firms have larger ABTDs than their
counterparts due to their strong EM incentives. The estimated coefficients on both dummy
variables are significantly positive. This finding is consistent with the prior literature
suggesting that meeting the SEO profitability hurdle and avoiding delisting are two major
EM incentives in China. SOELG firms exhibit larger ABTDs than their counterparts as they
21

have strong incentives for both EM and TM. The negative association of ABTD with
NUMBER*SOELG suggests that a SOELG that has obtained favorable tax rates is less
likely to engage in aggressive tax reporting.
Insert Table 4 here
Overall, ABTDs are positively associated with all EM and TM incentives. Firms with
more incentives and opportunities for tax and earnings management exhibit larger ABTDs,
suggesting that the magnitude of ABTDs captures reporting distortions induced by
managerial incentives in response to China’s institutional features. We interpret this as
evidence that BTDs are a useful proxy for the combined effect of EM and TM after
controlling for accounting-tax misalignment.
To test if our tax-effect BTDs are superior to income-effect BTDs in capturing EM and
TM, we calculate income-effect BTDs following the procedures used in U.S. studies. We
estimate taxable income by grossing up current tax expense in a consolidated firm by
dividing by the company’s applicable tax rate (See Appendix II). We then rerun the BTD
model to estimate ABTDs and regress ABTDs on EM and TM incentives. Column 3 of
Table 4 shows that the results from this estimation are quite different. The coefficients are
insignificant except for NUMBER and SEON. ABTDs estimated from income-effect BTDs
appear to be weak in capturing management opportunism (the adjusted R2 is only 9%),
suggesting that tax-effect BTDs are more powerful in identifying EM and TM.
5.3 Sensitivity Tests
5.3.1 Tests on a Hold-out Sample
Some studies suggest that in-sample evidence based on pooled cross-section time
series data is likely to lead to spurious conclusions, especially when there is parameter
instability due to unmodelled structural change across time (Poon and Granger, 2003).
Therefore, to validate our results, we use an out-of-sample test where we estimate ABTD
in a different time period to the test period. In particular, we use the parameters estimated
in year t-1 to calculate NBTDs for year t. Because the parameters are re-estimated each
22

year, this approach can capture the effects of specific-year changes in GAAP and tax laws
on NBTDs, assuming they take at least one year to implement.
Column 2 of Table 4 shows that the out-of-sample tests do not qualitatively change
our inferences. All independent variables are significant with their predicted signs,
suggesting that the prior regression results are robust to an alternative measurement of
ABTDs.
5.3.2 Tests for Model Misspecification
We estimate abnormal BTDs based on a cross-sectional model that attempts to
remove underlying determinants driven by different book and tax treatments in GAAP and
income tax laws leaving the portion driven by EM and TM in the residual. A major concern
is whether our model successfully distinguishes mechanical differences from opportunistic
differences. To examine this concern, we regress NBTDs (instead of ABTDs) as the
dependent variable in Equation (2). Our results (untabulated) indicate that none of the
independent variables, except for LOSS, is significantly different from zero. This test
suggests that only opportunistic differences (ABTDs) capture EM and TM, and that our
model disentangles ABTDs and NBTDs.
5.3.3 Loss Avoidance Incentives in Prior Year
We use the LOSS dummy variable as a proxy for one of the EM incentives, where the
dummy variable is set to one if firms have a loss in year t and zero otherwise. However,
the loss or profit level in year t might have been an outcome of EM. For example, firms
with losses in a prior year have incentives to boost earnings and so yield a profit in year t.
To address this concern, we examine firms’ incentives to avoid losses in the previous year.
We use “Loss”, “Loss1” and “Loss2” to replace LOSS. Where Loss = 1 if firms have a loss
in year t but not in year t-1, 0 otherwise; Loss1 = 1 if firms have a loss in year t-1 but not in
year t-2, 0 otherwise; Loss2 = 1, if firms have a loss in year t-1 and in year t-2, 0 otherwise.
This classification allows us to test whether ABTDs relate to loss avoidance incentives at a
more robust level. The untabulated results show that Loss and Loss2 are positively
23

associated with ABTDs but Loss1 is insignificant. These findings are consistent with
previous predictions that loss firms desire to take a big bath in the first loss year to create
reserves for future use while two-consecutive-year-loss firms are keen to boost earnings in
order to avoid delisting and trading restrictions. In a relative sense, the loss avoidance
incentives for firms with a one-year loss in year t-1 (Loss1) are weaker than Loss and
Loss2 firms. This robustness check does not qualitatively change our prior conclusions.
5.3.4 SEO Incentive
Haw et al. (2005) find that all SEO applicants (successful and unsuccessful
applicants) boost earnings so as to meet the ROE hurdle. We investigate a relatively
focused sample, namely successful applicants. A potential concern is that successful SEO
applicants whose real economic performance has met ROE requirements may not have
EM motivations. In this case, using the SEON dummy variable as an EM incentive will
affect the power of the test. To mitigate this concern, we analyse the ROE distribution for
the SEON sample. We find that only two SEON firms exhibit high and stable ROE before
and after making SEOs. The remainder either exhibit a dramatic jump (a big drop) in ROE
before (after) making SEOs. We remove these two firms and find that the significance level
of SEON holds (p-value = 0.025), suggesting that the positive association of ABTDs with
SEON is attributable to SEO incentives. Other inferences remain the same.
5.3.5 Year Effects, the Proportion of Permanent and Temporary Differences
Figures 1 and 2 show that the differences between temporary differences and
permanent differences vary across the sample period and are especially high in 2001 and
2002. To assess the impact of this on our results, we exclude Y2001 and Y2002 and rerun
Model (2). Our results are similar to those shown in Table 4, suggesting the prior results
are not driven by the variation in these two years. We also add year variables in Model 2 to
control for time effects. The previous results hold.
Permanent differences dominate temporary differences in China as shown in Figure 2
and Appendix I, and this raises a concern that the high proportion of permanent
24

differences may influence our results. To alleviate this concern, we rerun the regression by
excluding firms with a ratio of permanent differences higher than 60%. Our results do not
qualitatively change. Therefore, the proportion of permanent and temporary differences
does not have a major impact on our results.
5.3.6 The Explanatory Power of EM and TM
Table 5 reports the extent to which different factors affect ABTDs. The results from
the four models indicate that EM explains 7.4% of ABTDs, TM accounts for 27.8% of
ABTDs, and the combined EM and TM factor explains 3.2% of ABTDs. These findings
suggest that TM and EM are dependent and interactive, consistent with the tax and non-
tax cost literature. Evidence from BTDs on the interplay of EM and TM in China extends
Frank et al. (2009) and Wilson (2009), where they find U.S. tax sheltering firms also report
a high level of discretionary accruals, implicitly suggesting that firms manage book income
upwards on the one hand and taxable income downwards on the other hand.
Insert Table 5 here
6. CONCLUSIONS
Pervasive earnings manipulations, tax planning, and accounting scandals have
drawn considerable attention from researchers, regulators, and financial information users.
Accordingly, how to detect unobservable management manipulations has become an
important issue. Evidence from the U.S. shows that BTDs can detect EM in some settings
(Phillips et al., 2003) and BTDs are a good indicator of tax shelters (Frank et al., 2009;
Wilson, 2009). Our paper extends the current literature by demonstrating that BTDs
capture not only EM but also TM in China, a country with different regulatory and market
contexts from those in the developed world.
Making use of China’s unique institutional features and data advantages, we
simultaneously investigate the association of Chinese BTDs with various EM and TM incentives.
We extend the BTD literature by using a different method to calculate BTDs (i.e., tax-effect
25

BTDs) and distinguishing between regulatory differences and opportunistic differences. We
identify factors that determine BTDs and construct a regression model to explain them.
The fitted values from the regression give NBTDs and the residuals give the ABTDs. This
decomposition is of particular importance because it helps us to isolate managers’
manipulations. Our evidence indicates that ABTDs capture reporting distortions induced by
management motivations but NBTDs do not. We also find that tax-effect BTDs are
superior to income-effect BTDs in capturing earnings and tax management at both the
conceptual and empirical levels. Evidence that ABTDs are caused by EM, TM, and their
interaction provides a caveat to researchers when using ABTD measure to investigate EM
or TM separately.
Our findings provide additional insights into international accounting and EM/TM
research. Provided that NBTDs and ABTDs are reliably measured, the estimated NBTDs
allow researchers to quantify the extent of accounting-tax nonconformity across countries
and how it changes over time. Although nonconformity is not a new issue in developed
countries, how to evaluate the level of accounting-tax nonconformity is contentious. For
example, prior international accounting research, such as Alford et al. (1993) and Ali and
Hwang (2000), evaluate the major differences in accounting and tax rules in a specific
country to measure the level of book-tax nonconformity.
We examine how the distinct characteristics of China’s corporate sector, accounting
standards, tax policies, and government ownership influence management’s opportunistic
decisions in a leading emerging capital market. Specifically, we investigate how EM and
TM practices affect the variation in BTDs. ABTDs provide investors with an indicator to
assess the quality of financial reports. Tax authorities and auditing firms can exploit this
indicator to perform efficient and effective audits. The findings of our paper have
implications for Chinese regulators who want to enhance the credibility of book and tax
reporting and the efficiency of China’s capital markets.
26

Our paper also sheds light on the policy debates regarding accounting-tax conformity.
EM and TM occur when management has incentives and discretion, and when
uncertainties exist in accounting standards and tax laws. Whether accounting-tax
conformity can reduce opportunistic tax and book reporting is an empirical issue for future
research.
27

Endnotes:
1
Earnings management refers to managers using their judgment in financial reporting to alter
financial reports to either mislead some stakeholders about the underlying economic
performance of the company, or to influence outcomes that depend on reported accounting
numbers (Healy and Wahlen, 1999). We define tax management, tax planning, tax avoidance
or tax shelter as taxpayers exploiting uncertainty in tax law to choose an advantageous
method in tax reporting that influences their tax liabilities.
2
While Wilson (2009) and Frank et al. (2009) find that firms involved in tax sheltering also
exhibit large discretionary accruals, they do not investigate whether BTDs can detect both
EM and TM. Desai and Dharmapala (2006) assume BTDs are driven by EM and TM and
they develop a measure of tax avoidance by controlling for the component attributable to
accounting accruals. However, the main focus of their study is to analyze the links
between tax avoidance and incentive compensation.
3
For example, a report by the U.S. Department of the Treasury states that a hallmark of a
corporate tax shelter is a reduction in taxable income with no concomitant reduction in
book income (McGill and Outslay, 2004, p743).
4
Scholes et al. (2005) define effective tax planning as a tax-favored activity that
maximizes the firm’s expected discounted after-tax cash flows. Effective tax planning
requires firms to make trade-offs between the benefits of tax planning and the non-tax
costs associated with financial statement reporting, which suggests that tax minimization
might not be the optimal business strategy. Thus, effective tax planning should include the
possibilities of managing taxes upward and downward instead of minimizing taxes only.
5
Plesko (2004) reports positive aggregate U.S. BTDs from 1995-2000. He also finds
negative BTDs after the event of 9.11 in 2001 due to the effect of loss firms and accounting
conservatism. Hanlon and Shevlin (2005) extend data to 2003 and find that aggregate BTDs
are positive except in the years 2001 and 2002. They explain that, in addition to the loss effect,
negative BTDs are driven by special items such as write downs for the impairment of goodwill
and other intangible assets, restructuring charges, and the write-off of acquired in-process
research and development.
6
Income-effect BTDs cannot capture income shifting strategies because, conceptually,
tax-induced income-shifting will not affect total book and taxable income in a consolidated
group.
7
Manzon and Plesko (2002) also include other variables such as post-retirement benefits
and foreign operations to explain the book-tax spread. However, post-retirement benefits
are not available in China during our observation period. Only 16 of 525 firm-year
28

observations disclose overseas profit taxes. Therefore, we do not incorporate post-
retirement benefits and foreign operations into our model. Given that our model
decomposes normal and abnormal components from total BTDs, we compare our work to
Manzon and Plesko (2002). Frank et al. (2009) also provide a model that distinguishes
discretionary permanent differences and nondiscretionary permanent differences.
8
Managers usually take advantage of the judgment (discretion) in depreciation method
choices or the depreciable lives of the assets to manage earnings. The “∆INV” variable is
less related to earnings management than depreciation. Frank et al. (2009) also use
goodwill and other intangibles to control for institutional effects in their model to
decompose discretionary and non-discretionary permanent BTDs.
9
Most earnings management models use ΔREV to control for the effect of changes in the
economic environment on total accruals. We follow this philosophy.
10
With actual tax data, the values of “TL” and “TLU” are not related to management
discretion. Since tax data are not publicly available, we follow prior literature and use
financial statement data (see Mills et al. (2003) for a detailed discussion). For firms without
TL or TLU, we denote that figure as zero.
11
Applicable tax rate is the actual tax rate imposed after considering tax preferences,
which differ from the statutory tax rate and effective tax rate. For example, the statutory
income tax rate is 33% in China. Firms may be given an applicable tax rate of 15% if they
are high technology enterprises located in high-tech industry development zones.
However, firms may have an effective tax rate of 12.5% due to some non-taxable income
items and tax planning. Thus, applicable tax rate is purely a result of tax preference policy.
12
For example, firm A smoothes its book income $1000 and taxable income $2000 (i.e., B' = -
1000, T ' = -2000), leading to $1000 ABTDs. Firm B smoothes its book income $4000 and
taxable income $2000 (i.e., B' = -4000, T ' = -2000), thereby yielding $-2000 ABTDs. In this
case, the degree of manipulation for firm B is larger than that of firm A. However, we reach a
completely different conclusion when we compare firms’ ABTDs based on the numbers of
1000 and -2000.
13
The CSRC issued the Special Treatment (ST) regulation in 1998, in which listed firms with
two successive years of losses would be specially treated on the stock exchanges. The stocks
of ST firms are traded with a +5% price change limit each day, versus +10% for normal stocks.
If ST firms continue to suffer a loss for one more year, it will be classified as a “particular
transfer” (PT) firm. The price increases in a PT firm cannot be more than 5% on any
trading day to prevent insider manipulation. However, the price of a PT share is allowed to
fall without limit. The PT shares can be traded only on Fridays. PT firms will be de-listed if
29

they cannot become profitable within one year, meaning they will lose the ability to raise
capital from the stock market. In 2001, new regulations mandated that firms with consecutive
three-year losses be suspended until they become profitable and be delisted if they report a
loss in the first midterm reports in the fourth year (see http://www.csrs.com.cn).
14
In this study, local governments include provincial and municipal governments.
15
For example, corporate income tax is shared with the central government on a 50:50
basis until the end of 2002. In 2003, the central government sharing rate increased to 60
percent and the local governments sharing rate decreased to 40 percent of the total
shared income taxes.
16
The mean and median tests are significant at the 0.01 level (two tail tests).
17
Some tax planning activities will not be reflected in tax-effect BTDs if they do not affect
tax-effect book income and current tax expense; for example, changing the registration
location of a company to gain a tax favorable rate. Anecdotal evidence suggests
companies in China reduce their tax burden by “negotiating” tax rates with governments.
However, this is not the case for the sample firms during our observation period. According
to the Chinese Tax Administration and Collection Law, local tax offices can levy income
taxes at a pre-determined rate instead of statutory tax rate only if (1) taxpayers lack a
complete accounting record in that either their revenue or expenses cannot be determined
by tax audits, or (2) taxable income declared by tax payers is unreasonably low and if their
revenue and costs can be determined through audits (Clauses 35 and 37). These
applications mainly focus on small-scaled cash-oriented businesses, such as noodle
restaurants, hair dressing salons, etc. When a pre-determined tax rate needs to be set,
local tax offices must follow prescribed procedures, standards and methods as in the Tax
Administration and Collection Law. The final pre-determined tax rate is set at an industry
or regional level rather than on an individual basis (see Qiong Guoshuifa [2002] 364,
http://www.chinatax.gov.cn).
18
In the Chinese capital market, there are five categories of shares. These are state-
shares, legal-person-shares, employee-shares, A-shares (ordinary domestic individual
shares), and foreign individual shares, such as B-shares, H-shares, and N-shares. Only A-
shares and B-shares are publicly tradable on the domestic Stock Exchange. The major
differences between A- and B-shares are the types of investors permitted to own and trade
them and the currencies used for trading and paying cash dividends. A-shares can be
traded and purchased by private Chinese citizens in domestic exchanges, while B-shares
are traded and held by foreign entities and foreign individuals, including overseas Chinese
30

residents in Hong Kong, Macau, or Taiwan (they were not open to domestic investors until
early 2001 and then only if domestic investors have access to foreign currencies).
19
We need a minimum of three years of data as we use first differences (i.e., change
variables) in our model of BTDs and we use firms with seasoned equity offers in year t+1
in our hypothesis test. We start our observation period in 1999 because most B-share firms
did not disclose their English language reports before 1998.
20
The variance-inflation factors are all less than 2, and the maximum condition index is
3.0, suggesting that multicollinearity does not influence the statistical results.
21
Variance inflation factors are all less than 1.5, and the maximum condition index is 14.7,
indicating that multicollinearity is unlikely to affect the inferences.
31

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35

Figure 1
Aggregate Tax-Effect BTDs from 1999-2004
(With 525 Firm-year Observations, Thousand Yuan)
5,000,000
4,000,000
3,000,000
2,000,000
1,000,000
0
1999 2000 2001 2002 2003 2004
-1,000,000
-2,000,000
-3,000,000
Tax-effect Book Income Current Tax Expense Tax-effect BTDs
Figure 2
The Comparison of Permanent Differences and Temporary Differences
(With 525 Firm-year Observations, Thousand Yuan)
0
1999 2000 2001 2002 2003 2004
-500,000
-1,000,000
-1,500,000
-2,000,000
-2,500,000
Permanent Differences Temporary Differences
36

Table 1
Sample Selection
Panel A: Pooled Sample
Total sample of B-share firms 664
Missing BTD data (52)
Firms without 3-year consecutive data (54)
Firms in agriculture, mining, construction, wholesale & retailer (33)
Total firm-year observations: 525
Panel B: Sample by Year

1999 56
2000 87
2001 99
2002 99
2003 94
2004 90
Panel C: Sample by Industry Classification

Manufacturing:
Food, beverage 18
Textile, clothing, leather, fiber 46
Paper, printing 18
Petroleum, Chemical products, plastics 22
Electrical equipment 73
Metal, non-metal mineral products 41
Machinery 108
Medicine, biological products 20
Others 6
Non-manufacturing:
Transportation, storage 41
Real estate 40
Tourism, hotel 32
Utilities 23
Intelligent technology 20
Transmission & entertainment 6
Others 11
37

Table 2
Descriptive Statistics and Correlations
Panel A: Descriptive Statistics for BTD Model
N Mean Std. Dev. Minimum Median Maximum
BTD 525 -0.008 0.067 -1.194 -0.001 0.328
∆REV 525 0.081 0.552 -7.744 0.067 8.166
∆INV 525 0.019 0.163 -1.462 0.011 1.109
TLU 525 0.001 0.014 0.000 0.000 0.328
NOL 525 0.047 0.299 0.000 0.000 3.660
TAX_DIFF 525 -0.004 0.077 -0.160 0.000 0.199
TA 525 3099968 3213382 147388 2042605 24151351
Panel B: Pearson (top) and Spearman (bottom) Correlation Coefficients

BTD ∆INV ∆REV TLU NOL TAX_DIFF
BTD -0.10 0.18 0.19 -0.58 0.21
(0.02) (0.00) (0.00) (0.00) (0.00)
∆INV -0.36 -0.18 0.03 0.23 -0.02
(0.00) (0.00) (0.45) (0.00) (0.72)
∆REV 0.09 -0.03 0.05 -0.33 -0.05
(0.03) (0.44) (0.22) (0.00) (0.30)
TLU 0.22 -0.17 0.01 -0.11 -0.05
(0.00) (0.00) (0.88) (0.01) (0.21)
NOL -0.88 0.34 -0.14 -0.01 0.02
(0.00) (0.00) (0.00) (0.82) (0.68)
TAX_DIFF 0.01 -0.01 -0.02 -0.01 -0.01
(0.83) (0.79) (0.73) (0.90) (0.84)
38

Table 2: Continued
Panel C: Descriptive Statistics for ABTD Model
Variables N Mean Std. Dev. Minimum Median Maximum

ABS(ABTD) 525 0.007 0.027 0.000 0.003 0.558
ATR 525 0.196 0.084 0.000 0.150 0.330
NUMBER 525 2.600 1.356 1.00 2.00 11.00
SEON 525 0.034 0.12 0.00 0.00 1.00
SOELG 525 0.720 0.449 0.00 1.00 1.00
LOSS 525 0.187 0.390 0.00 0.00 1.00
Panel D: Pearson (bottom) and Spearman (top) Correlation Coefficients
ABS(ABTD) ATR NUMBER SEON SOELG LOSS

ABS(ABTD) 0.27 0.05 0.04 0.13 0.14
(0.00) (0.22) (0.38) (0.00) (0.00)
ATR 0.15 -0.19 -0.09 0.14 0.07
(0.00) (0.00) (0.03) (0.00) (0.12)
NUMBER -0.06 -0.17 0.07 -0.10 -0.03
(0.17) (0.00) (0.10) (0.02) (0.50)
SEON -0.01 -0.07 0.09 -0.09 -0.06
(0.89) (0.11) (0.05) (0.03) (0.15)
SOELG 0.04 0.12 -0.15 -0.09 0.01
(0.33) (0.00) (0.00) (0.03) (0.91)
LOSS 0.02 0.04 -0.05 -0.06 0.01
(0.00) (0.36) (0.29) (0.15) (0.91)
Note:
(1) The figure in parentheses is the p-value using two-tailed tests.
(2) Variable definitions:
BTD = reported book-tax differences in year t, scaled by total assets;
∆REV = changes in revenues from year t-1 to year t and proxies for economic growth,
scaled by total assets;
TL = the value of accounting loss and proxies for tax loss, scaled by total assets;
TLU = reported tax loss utilized for firm in year t, scaled by total assets;
∆INV = changes in investment in the sum of gross property, plant and equipment and
intangible assets in year t, and proxies for investment growth, scaled by total assets;
TAX_DIFF = the gap between the consolidated company’s applicable tax rate and the
average tax rate of its consolidated parties.
ABS (ABTD) = the absolute value of ABTD, calculated as the residual from the cross-
sectional regression (Equation 1);
ATR = applicable tax rate of the sample company;
39

SEON = dummy variable that equals 1 when a consolidated entity has rights issuing or
public offering in next year, and 0 otherwise;
SOELG = dummy variable that equals 1 if a consolidated entity is a state-owned enterprise
controlled by local governments, and 0 otherwise;
LOSS = dummy variable that equals 1 when a consolidated entity is loss in current year t,
and 0 otherwise.
(3) Panel A and B are descriptive statistics and correlation matrix for BTD model which
contain 525 firm-year observations. Panel C and D are descriptive statistics and correlation
matrix for ABTD model.
(4) The currency unit for TA is thousands (RMB).
40

Table 3
Estimated Coefficients from the BTD Model
BTDit  0  1INVit  2REVit  3 NOLit  4TLUit  5TAX _ DIFF   it
(Equation 1)
Variables Predicted Sign Coefficient

Intercept (  0 ) ? 0.000
(0.60)
∆INV ( 1 ) - -0.002**
(0.02)
∆REV(  2 ) - -0.002***
(<0.001)
NOL( 3 ) - -0.175***
(<0.001)
TLU(  4 ) + 0.795***
(<0.001)
TAX_DIFF (  5 ) + 0.002***
(<0.001)
Adjusted R² 0.77
F-statistic 352.90
Sample 525
Notes:
(1) Asterisks *, **, and *** denote two-tailed (one-tailed when there is a predicted sign) statistical
significance at 10%, 5%, and 1% respectively.
BTD = reported book-tax differences in year t;
∆INV = changes in investment in the sum of gross property, plant and equipment and intangible
assets in year t;
∆REV = changes in revenues from year t-1 to year t, and proxies for economic growth;
NOL = the value of accounting losses;
TLU = reported tax loss utilized for firm in year t;
TAX_DIFF = the gap between the consolidated company’s applicable tax rate and the average tax
rate of its consolidated parties.
All variables are scaled by total assets except for TAX_DIFF.
41

Table 4
Regression of ABTD on TM and EM Incentives
Pred.Sig Incentives ABTD estimated ABTD estimated ABTD
n for EM from tax-effect from tax-effect estimated from
or/and TM BTD (in sample) BTD (out of income-effect
(1) sample) (2) BTD (3)
Intercept ? 0.009*** 0.021** 0.095***
(<0.001) (<0.001) (<0.001)
ATR + TM 0.038*** 0.035*** -0.007
(<0.001) (<0.001) (0.17)
NUMBER + TM 0.001*** 0.001** 0.002***
(<0.001) (0.02) (<0.001)
SEON + EM 0.002** 0.005** 0.007**
(0.02) (0.02) (0.02)
LOSS + EM 0.005*** 0.003*** -0.002
(<0.001) (0.01) (0.12)
0.003*** 0.004** -0.002
SOELG + EM/TM
(<0.001) (0.03) (0.48)
-0.001*** -0.001** -0.002
NUMBER*SOELG - TM
(0.01) (0.02) (0.24)
0.001** 0.002** -0.002*
IND ? (0.05) (0.02) (0.06)
-0.001*** -0.002*** -0.005***
SIZE ? (<0.001) (<0.001) (<0.001)
0.44 0.19 0.09
Adj. R² 52.67 15.46 8.16
F-statistic (<0.001) (<0.001) (<0.001)
525 469 522†
Sample
Notes:
(1) Asterisks *, **, and *** denote two-tailed (one-tailed when there is a predicted sign) statistical
significance at 10%, 5%, and 1% respectively. P-values are provided in parentheses and are based on robust
panel corrected standard errors (Beck and Katz 1995)
ABS (ABTD_full) = the absolute value of ABTD, calculated as the residual from Equation 1;
ABS (ABTD_out) = the absolute value of ABTD, calculated as the residual from an annual cross-sectional
regression in period t-1;
ATR = applicable tax rate;
SEON = dummy variable that equals 1 when a consolidated entity has a rights issuing or public offering in the
next year, and 0 otherwise;
LOSS = dummy variable that equals 1 when a consolidated entity has a loss in the current year t, and 0
otherwise;
SOELG = dummy variable that equals 1 when a consolidated entity is a state-owned enterprise controlled by
local governments, and 0 otherwise;
IND=dummy variable that equals 1 for manufacturing industry and 0 otherwise;
SIZE= the natural logarithm of total assets at the fiscal year-end.
†
Three observations with zero ATR are dropped, leading to 522 firm-years.
42

Table 5
The Explanatory Power of Earnings Management and Tax Management
Factors Model Adjusted R²

EM factors (SOEN, LOSS) ABTD  0   EM   7.4%
TM factors (ATR, NUMBER, NUMBER*SOELG) ABTD   0   TM   27.8%
Combined TM/EM factor (SOELG, NUMBER*SOELG) ABTD  0  TM / EM   3.2%
EM, TM and EM/TM ABTD   0   TM   EM  TM / EM   38%

See Table 4 for variable definitions. The above models exclude control variables.
43

Appendix I: The Major Differences between Corporate Income Tax Laws and Chinese GAAP
BTD Items Chinese Income Tax Law Chinese GAAP
Permanent Sponsor costs Non-deductible Expensed
differences
Non-public welfare Non-deductible Expensed
donation
Penalties and fines Non-deductible Expensed
Expenditure without Non-deductible Expensed
authorized invoice
Bad debt expense Allowable deductions are Determined based on
less than 0.3% (0.5% after management judgment
2000) of year-end
outstanding balances for
enterprises engaged in
financing and leasing.
Entertainment fees Entertainment fees should be No limits
less than 0.5% of the net
sales for the first
RMB15million, plus 0.3% of
sales in excess of RMB 15
million
Provisions for Non-deductible Expensed when made.
impairment of fixed and
intangible assets, short-
term and long-term
investment
Borrowing costs Interest rate is limited to the No limits
existing commercial rate, the
excess cannot be deducted
Employees’ salaries for The standard for salaries Expensed when
domestic enterprises payment deductions is incurred
stipulated based on different
areas and industries. The
excess payment cannot be
deducted.
Welfare, union fees and Provision of 14%, 2%, and Expensed when
education fees for 1.5% of the total salaries is incurred
domestic enterprises deductible; the excess part
cannot be deducted.
Donation Deductible donation is No limits
limited to 3% of taxable
income per year.
Research and Additional 50% of R&D can Expensed all R&D
development costs be deducted from taxable (except that patent
income after approval of the registration and legal
local tax office costs are capitalized)
44

Management fees paid Non-deductible Expensed when
to associated enterprises, incurred
consulting fees,
royalties, licensing fees
made by the China
establishment of a
foreign enterprise to its
head office
Use self-built products Taxable income No income recognized
for construction,
investment, sponsorship,
donations, or welfare
purposes
Donation received Donation received in cash Add to “capital
and non-cash assets must surplus” account and
recorded as current taxable increase shareholders’
income equity.
Interests on national Excluded from taxable Revenue recognized.
bonds income
Dividends from foreign Dividends received by FIEs Included in non-
Invested enterprises are non-taxable. operating income
Government subsidies Non-taxable Non-operating income
Temporary Depreciation-fixed assets Using straight-line method The depreciation
differences and the residual value not method, minimum
less than 10% of original useful life and scrap
value. Useful life is value can be
prescribed. Other methods determined by
can be adopted only if management.
approved by State
Administrator of Taxation
(SAT).
Depreciation-intangible Not less than 10 years Not more than 10
assets years
Organization costs Amortize over not less than 5 Expensed when
years. incurred.
Advertisement fees Not more than 2% (8% since Expensed to current
2001) of turnover, the excess period
part can be deducted in the
future periods.
Expense recognition Deductible only when incurred. Accrual basis
(i.e., prepaid rental, etc.)
Revenue recognition Recognized when cash Recognized when all
(i.e., unearned revenue, received or proof of charging the conditions are
etc.) received. satisfied for a legal
sale.
Tax loss and tax loss Tax losses incurred Recognized as loss and
utilized previously can be carried profit as in the year
forward for a following they occur.
period of up to 5 years,
thereby reducing later
taxable income.
45

Sources:
The Accounting Law of the PRC (2000), Financial Accounting and Reporting Rules for Enterprises
(FARR) issued by the State Council in 2000, Accounting Standard for Business Enterprises (ASBE)
issued by the Ministry of Finance (MOF) in 1993, Chinese Accounting Standards (CAS) issued by
the MOF in 1997, Accounting System for Business Enterprises (new ASBE) issued by the Ministry
of Finance (MOF, 2001).
Regulations for Income Tax of the People’s Republic of China issued by State Council in 1993,
Detailed Rules and Regulations for the Implementation of Income Tax of the People’s Republic of
China issued by the MOF in 1994, The Income Tax Law of the People’s Republic of China for
Enterprises with Foreign Investment and Foreign Enterprises issued by National People’s Congress
(NPC) in 1991, Detailed Rules and Regulations for the Implementation of Income Tax of the
People’s Republic of China Concerning Enterprises with Foreign Investment and Foreign
Enterprises issued by State Council in 1991, The Tax Administration and Collection Law of the
People’s Republic of China issued by NPC in 1995, The revised Tax Administration and Collection
Law of the People’s Republic of China issued by NPC on April 28, 2001, Regulations for detailed
implementation issued by the State Administration of Taxation (SAT) and the MOF.
46

Appendix II: The Comparison of Tax-Effect BTDs and Income-Effect BTDs
This appendix contains a numerical example of how the measure of tax-effect BTDs
in this paper is technically superior to the measure of income-effect BTDs used in the U.S.
studies.
Based on the definition, BTDs can be measured in two ways:
Tax-effect BTDs = book income * statutory tax rate (STR) – taxable income*STR
Income-effect BTDs = book income –taxable income
Income-effect BTDs are widely used in the U.S.-based studies, where they gross-up
current tax expense to measure taxable income and then infer total BTDs. This method
introduces measurement errors due to credits, tax rate differences, consolidation and tax
loss carry forwards (Hanlon, 2003). The measurement error due to consolidation and tax
rate differences is even more obvious in the Chinese setting as firms within a consolidated
group are subject to different tax rates and a separate tax reporting is required by tax laws.
Under separate tax reporting, each entity must calculate its current tax expense on a
basis of its own taxable income and tax rate. As a result, in a consolidated entity, its current
tax expense is the sum of individual controlled subsidiaries’ current tax expenses rather
than simply multiplying the consolidated entity’s total taxable income by its tax rate.
N
The consolidated group’s current tax expense=  (TI * t )
i 0
i i (1)
N
Estimated taxable income =  (TI i * ti ) / t0 (2)
i 0
Assume that a consolidated entity A has $600 taxable income for itself in year t, and it
has 3 subsidiaries called B, C and D. Their taxable income and tax rates are $400, $500 and
$500, 24%, 33% and 10%, respectively. Assume the statutory tax rate for the consolidated
entity is 15%. Assume the consolidated group’s total book income is $1000. Thus,
Total taxable income = (600+400+500+500) = $2000
Income-effect BTDs = $1000- $2000 = -1000
Tax-effect BTDs = 1000*15% - (600*15% +400*24% +500*33% +500*10%) = -$251
However, if we use equation (2) to estimate taxable income,
Current tax expense = 600*15% + 400*24% + 500*33% + 500*10% =402
Estimated taxable income = 402/15% = $2673
Income-effect BTDs = $1000 – $2673 = $-1673
47

Tax-effect BTD = 1000*15% - (600*15%+400*24%+500*33%+500*10%) = $-251
From the above example, we can see that using current tax expense to estimate taxable
income introduces measurement errors arising from separate tax reporting and different tax
rates. In contrast, tax-effect BTDs do not have this concern. Therefore, tax-effect BTDs are
expected to provide a more accurate measure in the Chinese setting.
48

Appendix III: Tax-Effect BTD Disclosure on a Chinese B-share Firm’s Financial
Statements
Tax-effect BTD calculation:

Item 2004 2003
Prima Facie Income Tax (1) 74543 75617
Expense
Current Tax Expense (2) 72043=23862+48181 38091=26977+11114
Tax-effect BTDs (3) =(1)-(2) 2500 37526
Tax-effect Permanent (4) 13250 45614

Differences =(458)+22677+(54185)+ =(81327)+14194+(37915)
56242+(12145)+1119 +166272+(16979)+1369
Tax-effect Temporary (5) (10750) (8088)
Differences
Tax-effect BTDs (3)=(4)+(5) 2500 37526
49

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Tang, Tanya Y. H.

Provided in Cooperation with:

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Standard-Nutzungsbedingungen: Terms of use:

The International Journal of Accounting, forthcoming

earnings management, tax management, and their interactions in Chinese listed

conceptual and empirical levels.

JEL classification: M41; H29

Key Words: Book-tax differences, Earnings management, Tax management, China

earnings to meet the requirements of compensation contracts, debt covenants, stock

motivations such as after-tax compensation schemes (Phillips, 2003). Detecting earnings

TM, and their interactions, on BTDs. 2

between regulatory and opportunistic components of BTDs. Using a regression model, we

measure to investigate EM or TM separately. We therefore extend the BTD literature.

We develop proxies for EM and TM based on our knowledge of China’s unique

reporting versus consolidated tax reporting, a highly concentrated ownership structure,

are applicable to a specific consolidated company and government ownership of listed

Electronic copy available at: https://ssrn.com/abstract=1679190

extant literature on U.S. research.

investors’ understandings of accounting and management behavior in Chinese listed firms.

out-of-sample estimation, model misspecification, different measures of the avoiding

permanent difference effects, and year effects.

Electronic copy available at: https://ssrn.com/abstract=1679190

TM affect BTDs in a major transitional economy.

research and describes the institutional background in China. In particular, we discuss

the effects of institutional settings on management incentives for EM and TM in China.

2. LITERATURE REVIEW AND INSTITUTIONAL BACKGROUND

2.1 BTD-Related Research

standards of comparability, consistency and materiality in GAAP allow managers to

Electronic copy available at: https://ssrn.com/abstract=1679190

detecting EM relative to various accruals measures. Assuming that taxable income is

discretionary accruals in classifying firm-years as EM or non-EM for firms that have

pre-tax earnings quality.

explained by institutional arrangements. These researchers argue that the large

compliance. Cho et al. (2006) report similar evidence in New Zealand.

Electronic copy available at: https://ssrn.com/abstract=1679190

behavior is predicated on tax and non-tax cost considerations and on a manager’s

incentives. Managers’ actions include aggressive, moderate, or conservative strategies.

behavior in managing earnings and taxes.

2.2 Institutional Background of BTDs in China

conforming (or dependent) system to a non-conforming (or independent) system beginning

Electronic copy available at: https://ssrn.com/abstract=1679190

financial reporting in a global economy; and (2) it increases discretion in accounting

choices and provides greater opportunities for managerial manipulation, especially in

countries where the monitoring of management’s judgments is relatively weak. In addition,

more conservative expense recognition include limitations in deducting salary expenses,

determined by permanent differences. On average, the proportion of permanent

differences. This shows that numerous accounting recognized expenses (unrecognized

of permanent differences. Third, Chinese BTDs fluctuate overtime and cannot be

Therefore, it is interesting to study how management practices explain the variation in

Electronic copy available at: https://ssrn.com/abstract=1679190

Evidence to date suggests that Chinese managers opportunistically use the

opportunistic reporting, such as insufficient supervision and scrutiny by the China

Securities Regulatory Commission (CSRC), a lack of independent auditing, and a lack of

fiscal subsidies (Chen et al., 2008).

China’s tax system is characterized by its uncertainty due to multiple-tier tax

legislations and a multitude of tax incentives driven by strong political-economic objectives