The Relationship Between the Management of Book Income and Taxable Income Under a Moderate Level of Book-Tax Conformity

Abstract

We find evidence suggesting that taxable income management is not related to book income management in firms operating under a moderate level of book-tax conformity. For a sample of Israeli firms that the tax authorities determined had understated their earnings to avoid taxes, we do not find evidence of an overstatement of book earnings. Notably, public firms do not differ from private firms in this regard. Using a control sample of firms that were not subject to tax audits, we validate that self-selection does not affect our inferences. Given Israel’s unique “intermediate” level of book-tax conformity, an important practical contribution of the findings is in shedding more light on the question of the need for a substantial transition from nonconformity to full alignment in countries with large book-tax gaps (such as the United States). Our results showing that tax-avoiding firms in Israel, public and private alike, avoid book income management even if areas of book-tax nonconformity allow them to do so imply that a reduction in the divergence between the tax and the accounting rules may suffice to reduce managers’ opportunistic (reporting) behavior.

The roles of book‐tax conformity and tax enforcement in regulating tax reporting behaviour following International Financial Reporting Standards adoption

“…A possible explanation for the negative relationship with NOL is that the presence of NOLs may reduce the need or motivation for tax avoidance, as these losses are deducted from the annual pretax book income when calculating the taxable income (see also, e.g. Chen et al ., ). As for the relationship with leverage, for both tax avoidance measures it is insignificant.…”

“…While some studies provide evidence suggesting a negative relationship between the two (e.g. Chen et al ., ), others document that leverage is positively associated with tax avoidance (e.g. Frank et al ., ; Atwood et al ., ).…”

“…The immediate impact has been a significant decline from the moderate degree of BTC that existed in Israel prior to the adoption of IFRS to an extreme nonconformity position (see, e.g. Chen et al ., ). In concomitance with the change in BTC, the level of tax enforcement in Israel increased when ITA added an ‘antiplanning’ norm to the Income Tax Ordinance (Section 145a2 of the Income Tax Ordinance), aiming to improve the scrutiny over aggressive tax planning.…”

“…While some countries tend to align tax profits with book profits and others seek to make tax profits diverge from book profits, Israel combined or fell in between the two approaches, resulting in a moderate level of BTC (see Income Tax Ordinance Amendment No. 188, ; Chen et al ., ). In 2008, Israeli public companies formally adopted IFRS, although most companies had been reporting according to IFRS since 2007.…”

“…Chen et al . () examined the association between book and tax reporting quality during Israel's ‘intermediate’ level of BTC, which existed prior to the adoption of IFRS. The evidence implies that book and tax reporting aggressiveness were not materially related in the pre‐IFRS period.…”