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JOURNALOFAccountingEconomidsE L SE V IE R J o u r n a l o f A c c o u n t i n g a n d E c o n o m i c s 2 3 (1 99 7 ) 2 2 5 2 4 8F i n a n c i a l r e p o r ti n g t ax c o sts a n d b o o k - t a x c o n fo r m i t y

D a v i d A . G u e n t h e f f , E d w a r d L . M a y d e w b * , S a r a h E . N u t t e r ca S c h o o l o f B u s i n e s s A d m i n i s t ra t i o n , U n i v e r s i t y o f C o n n e c t i cu t , S t o r rs , C I 0 6 2 6 9 , U S A

b G r a d u a t e S c h o o l o f B u s i n e s s , U n i v e r s i ty o f C h i c a g o , C h i c a g o , I L 6 0 6 3 7 , U S Ac I n s t it u t e o f G r a d u a t e a n d P r o f e s s i o n a l B u s i n e s s S t u d i e s , G e o r g e M a s o n U n i v e r si t y, F a i r f a x , V A 2 2 0 3 0 ,

U S A

Re c e iv e d 1 M a r c h 1996 ; r e c e ive d in r e v i se d fo r m I A pr i l 1997

A b s t r a c t

W e i n v e s t ig a t e th e r o l e o f b o o k - t a x c o n f o r m i t y in f i r m s f i n a nc i a l r e p o r t i n g a c t i v it i esu s i n g a u n i q u e s e t o f p u b l i c l y t r a d e d f i r m s t h a t w e r e f o r c e d t o s w i t c h f o r t a x p u r p o s e sf r o m t h e c a s h m e t h o d t o t h e a c c r u a l m e t h o d . P r i o r t o t h e m a n d a t e d c h a n g e , l i tt l et r a d e - o f f e x i s t e d b e t w e e n t a x p l a n n i n g a n d f i n a n c ia l r e p o r t i n g g o a l s f o r t h e se f ir m s. A f t e rt h e c h a n g e , r e c o g n i t i o n c r i te r i a f o r t a x a n d f i n a n ci a l r e p o r t i n g p u r p o s e s b e c a m e m o r ea l i k e , i n c r e a s i n g t h e t r a d e - o f f b e t w e e n f i n a n c i a l r e p o r t i n g a n d t a x o b j e c t i v e s . O u r r e s u l t ss u g g e s t t h a t r e q u i r e d u s e o f t h e a c c r u a l m e t h o d f o r t a x p u r p o s e s c a u s e s fi r m s to d e f e ri n c o m e f o r f in a n c i a l st a t e m e n t p u r p o s e s .Keywords E a r n i n g s m a n a g e m e n t ; B o o k t a x c o n f o r m i t yJEL classification M 4 1

1 I n t r o d u c t i o n

S i m i l a r i t i e s b e t w e e n b o o k a n d t a x r e c o g n i t i o n c r i t e r i a o f t e n r e s u lt in i t e m s o fi n c o m e b e i n g r e c o g n i z e d in t h e s a m e p e r i o d f o r b o t h b o o k a n d t a x p u r p o s e s .T h e r e f o r e , m a n a g e r s f a c e a t r a d e - o f f b e t w e e n f i n a n c i a l r e p o r t i n g a n d t a x p l a n n -i n g o b j ec t i ve s . F o r e x a m p l e , i f f i rm s e n t e r i n t o y e a r - e n d t r a n s a c t i o n s t o a c c e le r -a t e f i n a n c i a l s t a t e m e n t i n c o m e i n t o t h e c u r r e n t y e a r , t h e s a m e t r a n s a c t i o n s w i l l

*C or r e sp on d i ng a u tho r . Te l. : + 1 773 702 9478; fa x: + 1 773 702 0458 ; e - ma i l : e d .m a y de w @g s b s u n . u c h i c a g o . e d u

0165- 410 1 /97 / 17 .00 ~:~ 1997 E l se v i e r Sc i e nc e B .V . A l l r i gh t s r e se r ve d .P I I S 0 1 6 5 - 4 1 0 1 ( 9 7 ) 0 0 0 0 9 - 8

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226 D. A . Gu e n the r e t al . / J ou rna l ~ ?J Ac count ing an d Ec on om ic s 23 ( 1997) 225 248

o f t en a l s o a c c e l e r a t e t h e p a y m e n t o f ta x e s . C o n v e r s e l y , i f a f i rm w a n t s t o d e f e rt h e p a y m e n t o f ta x e s , i t m u s t g e n e r a l l y d e f er f in a n c i a l s t a t e m e n t i n c o m e a s w el l.

I n th i s s t u d y w e e x a m i n e th e i m p a c t o f b o o k - t a x c o n f o r m i t y o n f i r m s 'f i n a n c i a l r e p o r t i n g a n d t a x p l a n n i n g a c t i v i t i e s . O u r r e s e a r c h d e s i g n t a k e s a d -v a n t a g e o f a u n i q u e s et o f f i rm s t h a t w e b e l ie v e e x p e r i e n c e d a d r a m a t i c s h if t i nt h e le v el o f r e q u i re d b o o k - t a x c o n f o r m i t y . B e f o r e t h e T a x R e f o r m A c t o f 1 98 6( T R A 8 6), l a r g e p u b l i c l y tr a d e d f i rm s c o u l d u s e th e c a s h m e t h o d o f a c c o u n t i n gf o r t a x p u r p o s e s ( o t h e r t h a n f o r p u r c h a s e s a n d s a le s o f i n v e n t o r y i t e m s ) a n d t h ea c c r u a l m e t h o d f o r f i n a n c i a l r e p o r t i n g p u r p o s e s , a s r e q u i r e d u n d e r G e n e r a l l yA c c e p t e d A c c o u n t i n g P r i n c i p l e s ( G A A P ) . F o r t h e s e f ir m s , y e a r - e n d a c c e l e r a t i o no f f i n a n c ia l s t a t e m e n t i n c o m e i m p o s e d n o t a x c o s t s s o lo n g a s c a s h c o l le c t i o n sw e r e n o t a l s o a c c e l e r a t e d . I n a d d i t i o n , b y d e f e r r i n g ( a c c e l e r a t i n g ) c a s h c o l l e c -t io n s ( p a y m e n t s ) f ir m s c o u l d d e f e r t a x a b l e i n c o m e w i t h o u t a f fe c ti n g b o o ki n c o m e . I n s h o r t , p r i o r t o T R A 8 6 , t h e l i n k b e t w e e n t a x a n d b o o k i n c o m e w a sr e l a t i v e l y w e a k . T R A 8 6 s t r e n g t h e n e d b o o k - t a x c o n f o r m i t y b y r e q u i r i n g l a r g ef i r m s ( s al e s i n e x c e s s o f 5 m i l l i o n ) t o u s e t h e a c c r u a l m e t h o d o f a c c o u n t i n g f o rt a x p u r p o s e s . 1

W e i n v e s t i g a t e w h e t h e r f i r m s t h a t w e r e f o r c e d b y s t a t u t e t o a d o p t t h e a c c r u a lm e t h o d a l t e r e d t h e i r r e p o r t e d f i n a n c i a l s t a t e m e n t i n c o m e a n d c a s h f l o w s a sa re s ul t. T w o s e t s o f f i rm s a r e u s e d in o u r a n a l y si s . T h e ' c a s h m e t h o d ' s a m p l ec o n s i s ts o f f i rm s t h a t u s e d t h e c a s h m e t h o d f o r ta x p u r p o s e s b e f o r e 1 98 6 a n dw e r e f o r c e d t o s w i t c h t o t h e a c c r u a l m e t h o d a f t e r 1 9 8 6 . T h e ' a c c r u a l m e t h o d 's a m p l e c o n s i s ts o f f i rm s t h a t u s e d t h e a c c r u a l m e t h o d f o r b o t h f i n a n c i a l s ta t e -m e n t a n d t a x p u r p o s e s p r e - a n d p o s t -1 9 8 6 . O u r s t u d y c o m p a r e s th e b e h a v i o r o ft h e s e f i r m s i n t h e p r e - a n d p o s t - 1 9 8 6 p e r i o d s .

O u r f ir st s e t o f t e st s i n v e s ti g a t e s d i ff e re n c e s b e t w e e n t h e l o w - c o n f o r m i t y c a s hm e t h o d a n d h i g h - c o n f o r m i ty a c cr u a l m e t h o d f ir m s b e fo r e t he m a n d a t e d c h a ng e .A s p r e d ic t ed , w e f in d t h a t c a s h m e t h o d f ir m s a c c r u e m o r e i n c o m e t h a n a c c r u a lf ir m s . O u r s e c o n d s e t o f t e s ts c o m p a r e s c h a n g e s i n c a s h a n d a c c r u a l f i r m s in t h ep r e - a n d p o s t - 1 9 8 6 p e r i o d . A r e d u c t i o n i n th e a c c r u a l s o f f i rm s f o r c e d to s w i tc hf r o m t h e c a s h t o a c c r u a l m e t h o d , r e l a ti v e to t h e c h a n g e s i n t h e a c c r u a l s o f f i rm st h a t w e r e a lw a y s a c c r u a l m e t h o d t a x p a y e r s , w o u l d i n d ic a t e t h a t i n c re a s in gb o o k - t a x c o n f o r m i t y c a u s e s f i r m s t o d e f e r i n c o m e f o r f i n a n c i a l s t a t e m e n tp u r p o s e s , I n b o t h u n i v a r i a t e a n d m u l t i v a r i a t e t e s t s , o u r r e s u l t s s u g g e s t t h a ti n c re a s in g b o o k - t a x c o n f o r m i t y c a u s es f ir m s t o d e f er in c o m e . T h e s e r e su l ts a r e

1 As an example of the mag nit ude of the difference in income th at can result from the use of thecash method, consider the 1996 US Tax C our t case of Hospital C orp ora tio n of America (HCA) (TCMem o 1996-105). In this case, the Internal Revenue Service attempt ed (unsuccessfully) to force HCAto use the accrual method for the period 1981 86 rather than the modified cash method that hadbeen adopted for tax purposes . Over the six-year period the IRS co mput ed that the use of the accrualmeth od would increase taxable income by a total of 588 million. HCA's pre-tax financial statementearnings over this same period were approx imately 2,142 million.

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D .A. G ue n t he r e t a l. / J ourn a l o f Ac c ou n t i ng and Ec onom i c s 23 1997) 225 248 227robust to controls for growth and profitability based on a model of cash flowsand accruals p rop ose d by Dec how et al. (1995) and to controls for self-selectionbased on the met hodo logy described by Maddala (1991) and Shehata (1991).

Other researchers have examined tax and financial reporting trade-offs ina nu mber of specific settings such as the 1986 tax rate change, 2 in con nec tionwith the alternative mini mum tax bo ok income adjustment , 3 and in the contextof specific types of income. 4 In this study we examine the trade-off between taxand book earnings objectives in a more general context by addressing how theaccrua l met hod itself affects manage rs decisions to engage in activities thataffect the timing of income and cash flows. The approach we use to study therelation between financial reporting and taxes offers three advantages overprevious studies.

(i) Because there are no tax effects of financial statement accruals made bycash me tho d taxpayers, we can examine the accrual activities of these firmswithout concern for any simultaneous trade-offs involving taxable income.Conversely, because management of cash collections and payments does notaffect financial stat ement earnings, we can examine the tax planning activities ofthese firms without concern for any financial reporting effects.

(ii) Although we are unable to observe the extent of required book-taxconformity of our sample firms, we are able to use the 1986 mandated taxchange to the accrual method as a focal point around which we expect a signifi-cant increase in the level of bo ok -t ax conformityl Since we are able to c ompa rethe behavior of cash me thod firms both before and after TRA 86 and compar ethese firms with a control sample of accrual method firms, we are able to derivetime-series as well as cross-sectional predictions.

(iii) While prev ious studies have found specific settings in which tax- motiv atedincome shifting appears to influence the timing of financial statement earningsrecogn ition (e.g., income shifting around rate reductions), we investigate a mo regeneral case of the role of tax incentives in financial reporting.

The remainder of the paper is organized as follows. In the next two sectionswe develop our hypotheses (Section 2) and discuss how the cash and accrualmetho ds of accountin g for tax purposes relate to the accrual metho d forfinancial statement purposes (Section 3). We outline the sample selection pro-cess and define variables in Section 4. The primary univariate and multivariateresults are presented in Section 5. Section 6 discusses robustness tests in which

2 See Scholes et al. (1992), Guenther (1994), Maydew (1997).3See Boynton et al. (1992), Manzon (1992), Dhaliwal and Wang (1992), Choi et al. (1991),Gramlich (1991).See Scholes et al. (1990), Matsunaga et al. (1992), Dhaliwal et al. (1994), Beatty et al, (1995),Collins et al. (1995), Hunt et al. (1996).

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228 D . A . G u e n t h e r e t a l. / Jo u r n a l o f A c c o u n t i n g a n d E c o n o m i c s 2 3 1 9 9 7 ) 2 2 5 - 2 4 8

w e c o n t r o l f o r s e lf - se l ec t io n a n d v a r i a t i o n in p r o f i t a b i li t y a n d g r o w t h a n dS e c t i o n 7 c o n c l u d e s .

2 R e s e a r c h q u e s t io n a n d d e v e l o p m e n t o f h y p o t h e s e sA s s u m e t h a t t h e r e i s a l i n k a g e b e t w e e n f i n a n c i a l s t a t e m e n t G A A P e a r n i n g s

a n d t a x a b l e in c o m e 5 s u c h t h a t t r a n s a c t io n s m e e t i n g G A A P r e q u i r e m e n t s f o ra c c r u i n g e a r n i n g s a l s o m e e t t h e r e q u i r e m e n t s o f ta x r e g u l a t i o n s f o r a c c r u in gt a x a b l e in c o m e . 6 B e c a u s e o f t h is l i n k a g e a n y y e a r - e n d a c c e l e r a t i o n o f b o o ke a r n i n g s i n t o t h e c u r r e n t y e a r a l so r e s u l ts i n a n a c c e l e r a t i o n o f t a x a b l e i n c o m e .S i m i l a r l y a d e f e r r a l o f t a x a b l e i n c o m e i n t o a f u t u r e y e a r r e s u l t s i n th e d e f e r r a l o fb o o k e a r n in g s a s w ell . T h e r e f o r e m a n a g e r s s e e k i n g t o m a n a g e b o t h f i n an c i als t a t e m e n t e a r n in g s a n d c u r r e n t t a x p a y m e n t s f a ce a t r a d e - o f f b e t w e e n a c h i ev i n gt w o m u t u a l l y e x cl u si v e o b j e ct iv e s m a x i m i z i n g b o o k e a r n i n g s w h il e m i n i m i z i n gt a x p a y m e n t s .2.1. Pre 1986 hypotheses

T o i ll u st ra t e t h e t r a d e - o f f f ac e d b y a m a n a g e r o f a n a c c r u a l m e t h o d f ir mc o n s i d e r t h e d e c i s i o n t o e n g a g e i n y e a r - e n d t r a n s a c t i o n s t h a t r e s u l t i n t h ea c c r u a l o f a d d i t i o n a l f i n a n c ia l s t a t e m e n t r e v e n u e f o r t h e y e a r . 7 A c c r u i n g t h isa d d i t i o n a l r e v e n u e w ill a l s o i n c r e a s e a c c r u a l m e t h o d t a x a b l e i n c o m e c a u s i n gt h e a c c e l e r a t i o n o f ta x p a y m e n t s i n t o t h e c u r r e n t y e a r . ~ H o w e v e r a s i m i l a r

5 The reason for this linkage between GAAP earnings and taxab le income is discussed in Section 3.6 This linkage is often greater in co untries oth er than the US. Fo r example, Her rman n et al. (1996),

p. 72, stat e ... profitability ratios are more conservative in Japan, attri butable in part to the closelink between the tax and financial reporting systems. Japanese companies often choose an ac-counti ng practice that maximizes tax benefits rather th an one that best reflects the economic realityof the compa ny. In anot her example, Har ris et al. (1994), p. 188, state relative to the Anglo-American appr oach to financial reporting the Ge rma n system has historically been characterized bya closer link between tax and financial reporting.

7 If accrual accoun ting earnin gs are used as a p erform ance measur e (see Dechow, 1994) we assumethat, on average and across time, managers will attempt to maximize this measure. We also assumethat it is costly to defer cash receipts, and that, in the absence of offsetting costs, managers willattempt to collect cash receipts soone r rather than later, and to make cash p aymen ts (e.g., paymen tsfor taxes) later rather than sooner.

aThe actual timing of the tax payment will depend on whether the firm bases its quarterlyestimated tax payments on current year or prior year taxable income. Estimated tax paymentrequirements for large corporations were gradually changed during the early 1980s to requireestimates other than the first quarter to be based on current year (rather than prior year) taxableincome. Under the curren t rules for large corporati ons, the acceleration of year-end taxable incomewould accelerate the payment of the tax by two quarters.

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D . A . G u e n t h e r e t a l. / J o u r n a l o f A z c o u n t i n g a n d E c o n o m i c s 2 3 ( 1 9 9 7 ) 2 2 5 2 4 8 9

t r a n s a c t i o n b y a f i rm u s i n g t h e c a s h m e t h o d f o r t a x p u r p o s e s w i ll n o t a c c e l e r a t et a x e s b e c a u s e t h e a d d i t i o n a l r e v e n u e w il l n o t b e i n c l u d e d in t a x a b l e in c o m e u n t i li t i s r e c e i v e d i n c a s h i n a f u t u r e y e a r . T h e r e f o r e , w h i l e b o t h c a s h a n d a c c r u a lm e t h o d f ir m s w ill e x p e r ie n c e th e s a m e c h a n g e in n e t i n c o m e f r o m t h e y e a r - e n dt r a n s a c t i o n , t h e c a s h m e t h o d f i r m h a s n o a c c e l e r a t i o n o f t a x es . C o n s e q u e n t l y , w ee x p e c t t h a t m a n a g e r s o f c a s h m e t h o d f i rm s w ill b e m o r e l ik e l y t o a c c e l e r a t er e v e n u e i n to t h e c u r r e n t y e a r t h a n m a n a g e r s o f a c c r u a l m e t h o d f ir m s. F o rs i m i la r r e a s o n s w e e x p e c t t h a t m a n a g e r s o f c as h m e t h o d f ir m s w ill b e m o r e l ik e lyt o d e fe r r e c o g n it io n o f e x p e n s e s th a n m a n a g e r s o f a c c r u a l m e t h o d f ir m s . T h i sl e a d s t o o u r f i r s t h y p o t h e s i s :

H I : C a s h m e t h o d f ir m s a c c r u e m o r e fi n an c i al s t a t e m e n t r e v e n u e s t h a na c c r u a l m e t h o d f ir m s . C a s h m e t h o d f i rm s d e f e r m o r e f in a n c i a l s t a te -m e n t e x p e n s e s t h a n a c c r u a l m e t h o d f i r m s .

T h e l i n k a g e b e t w e e n t a x a b l e i n c o m e a n d f i n a n c i a l s t a t e m e n t e a r n i n g su n d e r t h e a c c r u a l m e t h o d a l s o a ff e ct s t h e w i ll in g n e s s t o c o l le c t c a s h r e c e i p t s a n dp a y c a s h d i s b u r s e m e n t s . F o r e x a m p l e , c o n s i d e r t h e g r o s s s e l l i n g p r i c e a na c c r u a l m e t h o d s e l l e r b i l l s f o r a y e a r - e n d c r e d i t s a l e , a s w e l l a s t h e d i s c o u n to f f e r e d to t h e b u y e r f o r e a r l y c a s h p a y m e n t (e .g ., 2 / 1 0 , n /3 0 ) . A s s u m e t h a tt h e s e te r m s o f s a le a r e s u c h t h a t b o t h t h e s e ll e r a n d b u y e r a r e i n d i ff e r en t b e t w e e nr e c e iv i n g (p a y i n g ) th e c a s h p a y m e n t in t h e c u r r e n t y e a r , n e t o f t h e d i s c o u n t ,o r t h e g r o s s a m o u n t i n t h e s u b s e q u e n t y e a r . U n d e r t h e s e c o n d i t i o n s ,t h e r e i s n o i n c e n t i v e f o r t h e s e l l e r t o a t t e m p t t o a c c e l e r a t e o r d e f e r c a s h c o l l e c -t i ons .

N o w c o n s i d e r t h e c a s e o f a s e ll in g fi r m t h a t u s es th e c a s h m e t h o d f o r t a xp u r p o s e s . I f t h e s e l le r r e c ei v e s t h e c a s h p a y m e n t a t t h e b e g i n n i n g o f t h es u b s e q u e n t y e a r r a t h e r t h a n a t t h e e n d o f t h e c u r r e n t y e a r , t h e s e ll er d e f e rs t h ep a y m e n t o f t h e t a x o n t h e r e v e n u e fo r as m u c h a s o n e y e a r. G i v e n t h e s a m e g ro s ss a le s p r i c e a n d c a s h d i s c o u n t a s t h e a c c r u a l m e t h o d s el le r, i t c a n b e d e m o n -s t r a t e d t h a t t h e c a s h m e t h o d s e l le r s a f t e r - t a x w e a l t h is g r e a t e r i f t h e s e l l e rr e c ei v e s t h e g r o s s a m o u n t o f t h e p r ic e in t h e s u b s e q u e n t y e a r r a t h e r t h a n t h en e t - o f - d i s c o u n t a m o u n t i n t h e c u r r e n t y e a r . T h e r e f o r e , t h e c a s h m e t h o d s e l l e rp r e f e r s to r e c e i v e th e c a s h i n t h e f u t u r e , a n d c a n s t r u c t u r e t h e p a y m e n t t e r m s (i.e.,r e d u c e t h e c a s h d i s c o u n t a n d p u r c h a s e p r i c e s l i g h t l y ) t o e n s u r e t h a t t h e b u y e rp r e f e r s t o p a y i n t h e f u t u r e .

T h e i n t u i ti o n b e h i n d t h is r e su l t is t h a t a n a c c r u a l m e t h o d b u y e r s ta x e s a r e n o ta f fe c t ed b y t h e t i m i n g o f t h e p a y m e n t , w h e r e a s t h e c a s h m e t h o d s e ll e r s ta x e s a r ea f fe c te d . C o n s e q u e n t l y , t h e r e a r e m u t u a l g a i n s t o b e h a d b y s t ru c t u r i n g t h ec o n t r a c t t o d e l a y t h e s e l l e r s t a x l i a b il i ty . T h i s l e a d s t o t h e p r e d i c t i o n t h a tm a n a g e r s o f c a s h m e t h o d f i rm s w i ll b e m o r e l ik e l y t o d e f e r th e r e c e i p t o f c a s ht h a n m a n a g e r s o f a c c r u a l m e t h o d f ir m s. F o r s i m i la r re a s o n s w e e x p e c t t h a tm a n a g e r s o f c a s h m e t h o d f ir m s w o u l d b e m o r e l ik e ly to a c c e l e ra t e che p a y m e n t

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230 D.A. Guenther et al. / Journal o[ Accounting and Economics 23 (1997) 225 248o f a c c o u n t s p a y a b l e t h a n m a n a g e r s o f a c c r u a l m e t h o d f ir m s. T h i s a n a l y s is l ea d st o h y p o t h e s i s H 2 :

H 2 : C a s h m e t h o d f ir m s d ef e r c a s h r e c ei p ts m o r e t h a n a c c r u a l m e t h o d f ir m s .C a s h m e t h o d f ir m s a c c e le r a te ca s h d i sb u r s e m e n t s m o r e t h a n a c c r u a lm e t h o d f i r m s .

2.2. Post -198 6 hypothe sesW h e n f ir m s w e re fo r c ed b y T R A 8 6 t o c h a n g e f r o m t h e c a s h m e t h o d t o th e

a c c r u a l m e t h o d f o r t a x p u r p o s e s , t h e i r i n c e n t i v e s t o c o l l e c t r e c e i p t s a n d p a ye x p e n s e s a l s o c h a n g e d ; t h e y n o l o n g e r h a d a t a x - b a s e d i n c e n t i v e t o p o s t p o n ec a s h c o l l e c t i o n s a n d a c c e l e r a t e c a s h p a y m e n t s . A l s o , f o r r e a s o n s d i s c u s s e d i nS e c t i o n 3 , t h e i r in c e n t i v e s to a c c e l e r a t e d e f er ) f i n a n c i a l s t a t e m e n t r e c o g n i t i o n o fi n c o m e e x p e n s e) c h a n g e d a s w e ll. F i r m s h a d l e ss i n c e n t iv e t o a c c e l e ra t e r e v e n u ea n d d e f e r e x p e n s e s b e c a u s e t o d o s o w o u l d a c c e l e r a t e t h e p a y m e n t s o f t a x es .T h i s c h a n g e i n e x p e c t e d i n c o m e a n d c a s h f l o w m a n a g e m e n t i n c e n t i v e s i se x p r e s s e d i n t h e f o l l o w i n g t w o h y p o t h e s e s :

H 3 : I n t h e p o s t - 1 9 8 6 p e r i o d , f o r m e r l y c a s h m e t h o d f i r m s a c c r u e d e fe r) l es sr e v e n u e e x p e n se ) t h a n p r e - 1 9 8 6 , r e l a ti v e t o a c c r u a l m e t h o d f ir m s .

H 4 : I n t h e p o s t - 1 9 8 6 p e r i o d , f o r m e r l y c a s h m e t h o d f i r m s d e f e r a c c e le r a te )l es s c a s h r e c e i p ts d i s b u r s e m e n t ) t h a n p r e - 1 9 8 6 , r e l a ti v e t o a c c r u a lm e t h o d f i r m s .

A l t h o u g h h y p o t h e s e s H 3 a n d H 4 p r e d i ct t h a t m e a s u r e s o f a c c r u al s a n d c a s hf lo w s o f c a s h m e t h o d f ir m s b e c o m e m o r e l ik e t h o se o f a c c r u a l m e t h o d f ir m s a ft e r1 98 6, w e d o n o t e x p e c t t h a t a c c r u a l s a n d c a s h f l o w s fo r th e t w o t y p e s o f f i rm sb e c o m e id e n ti ca l. T h e c h o i c e o f t h e c a sh o r a c c r u a l m e t h o d f o r t a x p u r p o s e s w a se n d o g e n o u s b e f o r e 1 98 6, a n d m a n a g e r s o f f i rm s w i th l a r g e re v e n u e a c c r u a l s, o ru n u s u a l l y l o n g c a s h c o l l e c ti o n p e r i o d s , m a y h a v e f o u n d i t i n th e i r b e s t i n t e r es t t os e le c t t h e c a s h m e t h o d f o r t a x p u r p o s e s w i t h o u t a l t e r in g c a s h f lo w s o r a c c r u a l so f i n c o m e . 9

3 T h e li n k b e t w e e n b o o k a n d t a x i n c o m e

I n t h is s e c t io n w e d i s cu s s w h y w e e x p e c t c e r ta i n y e a r - e n d t r a n s a c t i o n s e n t e r e di n t o b y m a n a g e r s t o b e r e f l e c t e d i n b o t h f i n a n c i a l s t a t e m e n t e a r n i n g s

9 W e con duct additional robu stness tests for self-selection n Section 6.

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D . A . G u e n t h e r e t a l. / J o u r n a l o f A c c o u n t i n g a n d E c o n o m i c s 2 3 1 9 9 7 ) 2 2 5 - 2 4 8 23

a n d t a x a b l e i n c o m e , w h e n b o t h a r e m e a s u r e d u s in g t h e a c c r u a l m e t h o d o fa c c o u n t i n g . E v e n a f t e r 1 98 6, w h e n l a r g e c o r p o r a t i o n s a r e r e q u i r e d t o u s e th ea c c r u a l m e t h o d f o r t a x p u r p o s e s , f ir m s a r e n o t r e q u i r e d t o u s e e x a c t l y t h e s a m ea c c o u n t i n g m e t h o d s f o r t a x p u r p o s e s t h a t t h e y u s e f o r f in a n c ia l r e p o r ti n g . I nS e c t i o n 3.1 w e d i s cu s s t h e t a x r u l es r e l a t i n g t o t h e c h o i c e o f a c c o u n t i n g m e t h o da n d s h o w t h a t , b e c a u s e t h e r e a p p e a r t o b e c o s ts a s s o c i a t e d w i t h u s i n g d if f er e n tm e t h o d s o f a c c o u n t i n g f o r b o o k a n d t a x p u r p o s e s , fi rm s o f te n u s e t h e s a m em e t h o d s f o r e a c h t y p e o f i n c o m e m e a s u r e m e n t . I n S e c ti o n 3 .2 w e d i sc u ss w h ye v e n w h e n d i ff e r en t a c c o u n t i n g m e t h o d s a r e u s e d f o r b o o k a n d t a x , i t is d i ff ic u ltf o r m a n a g e r s t o e n t e r in t o t r a n s a c t i o n s t h a t i n c re a s e b o o k r e v e n u e w i t h o u t a l soi n c r e a s i n g t a x r e v e n u e , o r t o i n c r e a s e t a x d e d u c t i o n s w i t h o u t a l s o i n c r e a s i n gb o o k e x p e ns e s.

A l t h o u g h w e e x p e c t a c lo s e l in k b e t w e e n b o o k a n d t a x a c c r u a l t r e a t m e n t f o rm a n y g e n e r a l t y p e s o f r e v e n u e a n d e x p e n s e it em s , th e r e a r e n e v e r th e l e ss m a n ys p e ci fi c i t e m s o f r e v e n u e a n d e x p e n s e f o r w h i c h s p e c ia l t a x a c c o u n t i n g r u le s a r er e q u i r e d o r a v a i l a b l e . W e d i s c u ss s o m e e x a m p l e s o f t h e s e sp e c i al ta x a c c o u n t i n gm e t h o d s i n S e c t i o n 3 . 3 .

3 .1 . T he s t a t u t o r y r e qu i r e m e n t t o c l e ar l y re f l e c t i nc om eT h e U S I n t e r n a l R e v e n u e C o d e (S e c t io n 4 4 6( a) ) s ta te s : T a x a b l e i n c o m e

s h al l b e c o m p u t e d u n d e r t h e m e t h o d o f a c c o u n t i n g o n t h e b a si s o f w h i c ht h e t a x p a y e r r e g u l ar l y c o m p u t e s h is i n c o m e in k e e p i n g h is b o o k s . H o w e v e r ,a c c o r d i n g t o t he R e s e a r c h I n s t it u t e o f A m e r i c a F e d e r a l T a x C o o r d i n a t o r 2 d( p a r. 2 0 05 ), d e s p i t e t h e r u le s d e s c r i b e d a b o v e , I R S a n d t h e c o u r t s h a v er e c o g n i z e d t h a t t a x p a y e r s m a y u s e o n e a c c o u n t i n g m e t h o d f o r b o o k k e e p i n gp u r p o s e s a n d a n o t h e r f o r t a x p u r p o s e s , if t h e m e t h o d u s e d f o r t a x p u r p o s e sc l e a rl y r e fl ec ts t h e t a x p a y e r ' s i n c o m e .

T h i s ' c l e a r re f l ec t io n o f i n c o m e ' d o c t r i n e is d i s c u s se d f u r t h e r i n T r e a s u r yD e p a r t m e n t R e g u l a t i o n ( S e c t i o n 1.4 46 -1 (a )(2 )) w h i c h s t a te s : A m e t h o d o fa c c o u n t i n g w h i c h r e fl ec ts th e c o n s i s t e n t a p p l i c a t i o n o f g e n e r a l l y a c c e p t e d a c -c o u n t i n g p r i n c i p l e s i n a p a r t i c u l a r t r a d e o r b u s i n e s s in a c c o r d a n c e w i t h a c c e p t e dc o n d i t i o n s o r p r a c t i c e s i n t h a t t r a d e o r b u s i n e s s w i l l o r d i n a r i l y b e r e g a r d e d a sc l e a r ly r e fl e ct in g i n c o m e . A f t e r a n a l y z i n g t h e t a x c o u r t d e c i s io n s t h a t h a v ei n t e r p r e t e d t h is p a r t i c u l a r p r o v i s i o n o f t h e r e g u l a ti o n s , th e B u r e a u o f N a t i o n a lA f f a i r s ( T a x M a n a g e m e n t P o r t f o l i o 5 70 , S e c t i o n I I I E ) s ta t es : G A A P p l a y s a na m b i g u o u s r o le in t h e r e s o l u ti o n o f t a x a c c o u n t i n g d i sp u t es . C o n f o r m i t y o f t a xr e p o r t i n g t o G A A P w i l l n o t p r o t e c t a t a x p a y e r f r o m I R S a t t a c k , a s n u m e r o u st a x p a y e r s [ . .. ] h a v e l e a r n e d . H o w e v e r , d e v ia t io n o f t a x r e p o r ti n g f r o m G A A Pc a n o p e n a t a x p a y e r u p t o I R S a t t a c k ( e m p h a s i s a d d e d ) . A s a n e x a m p l e o ft h is t y p e o f IR S a t t a c k , t h e B u r e a u o f N a t i o n a l A f fa i rs c it es F o r d M o t o r C o . v .C o m m . ( 10 2 T C 8 7, 1 99 4) i n w h i c h F o r d w a s f o r c e d t o a c c o u n t f o r s t r u c t u r e d

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232 D . A . G u e n t h e r e t a l. / J o u r n a l o f A c c o u n t i n g a n d E c o n o m i c s 2 3 1 9 9 7 ) 2 2 5 2 4 8

s e t t l e m e n t s f o r t a x p u r p o s e s o n t h e s a m e b a s i s t h a t i t u s e d i n i t s f i n a n c i a ls t a t e m e n t s . 1o

I n a d d i t i o n , C l o y d ( 1 9 9 5 ) a n d C l o y d e t a l . ( 1 9 9 6 ) f i n d t h a t t a x p r o f e s s i o n a l sa r e m o r e r e l u c t a n t t o a d v i s e a g g r e s s i v e t a x p o s i t i o n s w h e n t h o s e p o s i t i o n s d on o t c o n f o r m t o G A A P . M i ll s ( 19 96 ) u se s a c t u a l I R S a u d i t a d j u s t m e n t d a t a a n df i n d s t h a t f i r m s w i t h g r e a t e r b o o k - t a x d i f f e r e n c e s f a c e l a r g e r s u b s e q u e n t I R Sa u d i t a d j u s t m e n t s . O v e r a l l , t h e e v i d e n c e s u g g e s t s t h e e x i s te n c e o f im p l i c i tp r e s s u r e to c o n f o r m t a x a c c o u n t i n g m e t h o d s t o t h o s e u s e d f o r f in a n c ia l s ta t e-m e n t p u r p o s e s .3 2 Recording revenue and expense under the accrual method

E v e n i f d i ff e r en t a c c r u a l m e t h o d s a r e u s e d f o r ta x a n d f i n a n c i a l s t a t e m e n tp u r p o s e s , i t i s q u i t e d i f f i c u l t t o d e f e r t a x a b l e i n c o m e w i t h o u t d e f e r r i n g f i n a n c i a ls t a t e m e n t i n c o m e . C o n v e r s e l y , i t i s d i f f i c u l t t o a c c e l e r a t e f i n a n c i a l s t a t e m e n ti n c o m e w i t h o u t a ls o a c c e le r a ti n g t a x a b l e i n co m e . T h e a c c r u a l m e t h o d r e q u ir e se x p e n s e r e c o g n i t i o n i n th e a c c o u n t i n g p e r i o d i n w h i c h t h e e x p e n s e is i n c u r r e d . 1I n a d d i t i o n , u n d e r t h e m a t c h i n g p r i n c i p l e s o m e e x p e n s e s (e.g ., w a r r a n t yc l a im s ) a r e e s t i m a t e d a n d r e c o r d e d b e f o r e th e y a r e p a i d . In c o n t r a s t , a ni t e m m a y n o t b e d e d u c t e d f o r t a x p u r p o s e s u n t il t h r e e c o n d i t i o n s a r es a ti sf ie d : a ll o f t h e e v e n t s t h a t d e t e r m i n e t h e t a x p a y e r s l i a b i li t y f o r t h e e x p e n s eh a v e o c c u r r e d , t h e a m o u n t o f t h e t a x p a y e r s li ab i li ty c a n b e d e t e r m i n e d w i t hr e a s o n a b l e a c c u ra c y , a n d e c o n o m i c p e r f o r m a n c e h a s o c c u r r ed . In th e c a se o fa l i ab i l it y t h a t r e q u i r e s a p a y m e n t f o r p r o p e r t y o r s e rv i ce s , e c o n o m i c p e r f o r -m a n c e is d e e m e d t o o c c u r a s t h e p r o p e r t y o r s e rv ic e s a r e p r o v i d e d t o t h et a x p a y e r .

I f a f ir m w a n t s t o a c c e l e r a t e a t a x d e d u c t i o n f r o m a f u t u r e y e a r i n t o t h ec u r r e n t y e a r t o r e d u c e t a x a b l e i n c o m e , it m u s t n o t o n l y f ix t h e l ia b i l it y f o r t h ee x p e n s e i n t h e c u r r e n t y e a r a n d b e a b l e t o r e a s o n a b l y e s t i m a t e t h e e x p e n s e b u tm u s t a l s o a c c e l er a te t h e e c o n o m i c p e r f o r m a n c e o f t h e e x p e n s e in t o t h e c u r r e n ty e a r . I f a ll t h r e e c o n d i t i o n s a r e m e t , th e e x p e n s e w i ll b e d e d u c t i b l e f o r t a xp u r p o s e s in t h e c u r r e n t y e a r a n d w i ll a l s o b e p r o p e r l y a c c r u e d i n t h e c u r r e n t y e a rf i n a n c ia l s t a te m e n t s . T h u s , d e d u c t i b i l i ty o f a n a c c r u e d e x p e n s e f o r t a x p u r p o s e s

lo In ano ther example, sugges ting that failure to conf orm tax a ccounting me thod s to financialaccount ing methods can subject one to increased IRS scrutiny, Raby (1995), p. 392, writes, Whilethere is no financial statement conformity rule in the tax law, [...] differences between tax andfinancial accounting frequently encourage revenue agents to argue that the financial accounting isa type of admission I-...] as to wha t clearly reflects income. Here Raby is writing in general terms,recognizing of course that a LIFO conformity requirement does exist.

11 Note t hat b oth tax an d GAAP rules require capitalization of costs that are in the nature ofinventory or that result in an asset having a useful life of longer than one year.

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D.A. Guenther et aL / Journal of Accounting and Economics 23 1997) 225 248 233is a sufficient but not a necessary condition for accrual of the expense forfinancial statement purposes.

Firms can also defer taxable income by deferring the recognition of revenue.For example, a firm could defer revenue by delaying the occurrence of all eventsthat determine the taxpayer s right to receive the revenue. In most cases, as withthe treatment of expenses, deferral of revenue for tax purposes will be a sufficientbut not a necessary condition for deferral of revenue for financial statementpurposes. These different book and tax rules reflect the different incentives thatunderlie financial and tax accounting. Under the conservatism convention,accountants generally try to avoid overstating revenues or understating ex-penses. In order to protect government revenues, the tax rules are designed toprevent taxpayers from understating revenues or overstating expenses.

The same underlying rules for accrual recognition would also apply toa manager entering into year-end transactions to increase accounting earnings.For example, if a manag er a ttempted to accelerate the time that income wasearned for financial repor ting purposes, this would also likely accelerate the timethat the taxpayer s right to receive the revenue becomes fixed, thus resulting inaccrual under tax accounting rules as well. Similarly, if a manager delayeda year-end transac tion in an a ttempt to defer the recogn ition of an expense forfinancial reporting purposes, it is likely that the expense would not meet the allevents test, and would therefore not be recognized for tax purposes as well.3.3. Accountin g fo r specific items o f revenue and expense

The tax accounting rules discussed in the previous section are general rulesthat apply to most items of revenue and expense, such as sales and oper atingexpenses, in the absence of special rules to the contr ary. Ou r empirical testsfocus on sales and oper ating expenses becaase we expect those two items to haveclose book-tax conformity for accrual method taxpayers, and much less con-formity for cash metho d taxpayers. 12

We exclude certain items of revenue and expense from our analysis (e.g.,depreciation expense) that are not affected by the overall metho d of accounti ngfor tax purposes. Because of special tax rules associated with these items, thechange from the cash to accrua l metho d for tax purposes will not affect the levelof bo ok -t ax conformity. For example, the Internal Revenue Code containsspecific rules concerning how much depreciation firms can deduct each year fortax purposes ~/nd these rules apply regardless of much deprecia tion expense is

12Two other advantages of sales and operating expenses are: (1) they are typically the mostsignificant items of revenue and expense on the income statement, and (2) by adjusting sales andoperating expenses for changes in accounts receivable and accounts payable we can derive the cashreceipts and cash disbursements, respectively.

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234 D , A . G u e n t h e r e t a l. / J o u r n a l o f A c c o u n t i n g a n d E c o n o m i c s 2 3 1 9 9 7 ) 2 2 5 - 2 4 8

t a k e n f o r f in a n c ia l r e p o r t i n g p u r p o s e s . T h e r e f o r e , t h e m a n d a t e d c h a n g e f r o m t h ec a s h t o a c c r u a l m e t h o d s h o u l d n o t a ff ec t t h e le v el o f b o o k - t a x c o n f o r m i t y t h a te x i s t s f o r d e p r e c i a t i o n e x p e n s e . 1 3

4 Sam ple se lec tion and measurem ent of variab lesW e s e l e ct a n i n it ia l s a m p l e o f f i rm s u s i n g a k e y w o r d s e a r c h o f fi n a n c i a l

s t a t e m e n t t a x f o o t n o t e s o n t h e N A A R S file o f t h e L E X I S / N E X I S d a t a b a s e f o r1 98 5. T h e f i r m s id e n t if ie d f r o m t h i s s e a r c h c o n s t i t u t e t h e s a m p l e o f c a s h m e t h o df i r m s . W e e x c l u d e f i r m s i n t h e c o m m e r c i a l b a n k i n g a n d s a v i n g s a n d l o a ni n d u s t r ie s b e c a u s e t h e s e f i rm s h a v e s p e c i a l ta x a n d f i n a n ci a l a c c o u n t i n g r u l es n o ta p p l i c a b l e t o t h e m a j o r i t y o f f i r m s ( S c h o l e s e t a l. , 19 90 ; Be a t t y e t a l ., 1 9 95 ;Col l ins e t a l . , 1995) .

T h e k e y w o r d s e a r c h is b a s e d o n i d e n t if i c a ti o n o f a n i t e m i n t h e d e f e r r e d t a xp r o v i s i o n r e p r e s e n t i n g t h e d i ff e re n c e b e t w e e n t h e c a s h a n d a c c r u a l m e t h o d s o fa c c o u n t i n g . W e s e a r c h t h e i n c o m e t a x f o o t n o t e f o r t h e t e r m s ' c a s h b a s i s ' o r ' c a s hm e t h o d ' . F o r t h o s e f i r m s id e n t if ie d b y t h e s e a r c h , w e re a d t h e e n t i r e t a x f o o t n o t et o d e t e r m i n e w h e t h e r t h e f ir m a p p e a r s t o b e u s in g t h e c a sh m e t h o d f o r t a xp u r p o s e s . F i r m s a r e e l im i n a t e d i f t h e y d o n o t a p p e a r t o u s e t h e c a sh m e t h o d , u s ei t o n l y f o r o n e t y p e o f r e v e n u e o r e x p e n s e i te m , o r u s e i t f o r o n l y o n e s u b s i d i a ry .T h i s s e a r c h a n d r e a d i n g o f f o o t n o t e s r e s u l t s in a s a m p l e o f 9 4 f ir m s f o r 1 98 5.

W e t h e n i m p o s e s e v e ra l a d d i t i o n a l r e s tr i c ti o n s . F i r st , e a c h f i rm m u s t h a v e1 98 5 s a le s i n e x c e s s o f 5 m i l li o n ; fi r m s w i t h s a le s l es s t h a n t h is a m o u n t a r e n o tr e q u i r e d t o c h a n g e a c c o u n t i n g m e t h o d s u n d e r t h e T R A 8 6 p r o v i s i o n s . S e c o n d ,w e r e q u i r e t h a t e a c h c a s h m e t h o d f i r m b e i n a n i n d u s t r y ( d e f i n e d a s f o u r - d i g i tC o m p u s t a t S I C c o d e ) c o n t a i n i n g a t le a s t o n e n o n - c a s h m e t h o d f ir m . F i n al ly , th ef i r m m u s t h a v e s u f f i c i e n t d a t a a v a i l a b l e t o c o m p u t e t h e v a r i a b l e s u s e d i n t h ee m p i r i c a l t e s t s f o r a t l e a s t o n e y e a r i n b o t h t h e p r e - T R A 8 6 ( 1 9 8 3 - 8 5 ) a n dp o s t - T R A 8 6 (1 9 8 8 - 9 0 ) p e r i o d s . 14 T h e s e r e s t r i c t io n s r e s u lt i n a s a m p l e o f 6 6 c a s hm e t h o d f i r m s .

F o r t y - f o u r d i f f e r e n t f o u r - d i g i t S I C c o d e s a r e r e p r e s e n t e d , w i t h n o c o d e a c -c o u n t i n g f o r m o r e t h a n 1 0 % o f t h e sa m p l e . T h e S I C c o d e w i t h m o s t f ir m s ,

1~ Othe r examples of items subject to special tax trea tment are bad debt expense, war rant yexpense, interest income an d dividend income. Bad debt expense is required to be based on the firm'sactual write-offs. Additions to warr anty reserves are not allowed as a tax deduction under either thecash or accrual method. Low-yield bonds can be subject to 'original issue discount' rules, whichrequire accrual of interest income under the yield-to-maturity method. Taxable income typicallyexcludes 70 to 100 of dividends.

1,~ 1986 and 1987 are excluded because they are tr ansi tion years during which tax rate r educ tionsgave firms additional incentives to defer taxable income (Scholes et al., 1992).

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D.A. Guenther et aL / Journal o f Accounting and Economics 23 1997) 225-248T a b l e 1D e s c r i p t iv e s t a t is t i c s f o r c a s h m e t h o d f i rm s a n d t h e i r a c c r u a l m e t h o d c o n t r o l p o r t f o l io s

2 3 5

M e a n 2 5 % M e d i a n 7 5 % S td . d e v.

C a s h m e t h o d f i r m sS a l e s 1 7 0 .1 2 3 8 .2 9 7 9 .3 9 1 8 4 .3 0 2 4 4 .2 9A s s e t s 1 9 1 .3 3 3 2 . 0 4 8 6 . 9 2 2 3 8 . 6 2 2 6 4 . 9 9I n v / A s s e t s 0 . 0 5 0 . 0 0 0. 01 0 . 0 7 0 . 0 9A c c r u al m e t h o d f ir m sbS a l e s 1 4 7 . 8 4 2 3 . 1 2 5 1 . 9 9 9 9 . 03 4 0 3 . 9 2A s s e t s 1 9 9 .3 3 2 4 . 6 8 6 4 . 6 2 1 0 6 . 0 6 6 2 8 . 3 3I n v / A s s e t s 0 . 0 7 0 . 0 0 0 .0 2 0 . 1 5 0 . 0 9

N o t e s : S a l e s a n d a s s e t s i n m i l l i o n s o f d o l l a r s .S i x t y -s i x c a s h m e t h o d f i r m s i n 1 98 5. C a s h m e t h o d f i r m s a r e i d e n t i fi e d u s i n g a k e y w o r d s e a r c h o f

f in a n c i a l s t a t e m e n t t a x f o o t n o t e s o n t h e N A A R S f ile o f t h e L E X 1 S / N E X I S d a t a b a s e f o r 19 85. F i r m si n t h e c o m m e r c i a l b a n k i n g a n d s a v i n g s a n d l o a n i n d u s t r i e s a r e e x c lu d e d . E a c h s a m p l e fi r m m u s th a v e 1 9 85 s a l e s i n e x c e s s o f $ 5 m i l l io n , m u s t b e i n a n i n d u s t r y ( d e fi n e d a s f o u r -d i g i t C o m p u s t a t S I Cc o d e ) c o n t a i n i n g a t l e a s t o n e n o n - c a s h m e t h o d f i r m , a n d m u s t h a v e s u f f ic i e n t d a t a a v a i l a b le t oc o m p u t e t h e v a r i a b l e s u s e d in t h e e m p i r i c a l t e s ts f o r at l e a s t o n e y e a r i n b o t h t h e p r e - T R A 8 6( 1 9 8 3 - 8 5 ) a n d p o s t - T R A 8 6 ( 1 9 8 8 - 9 0 ) p e ri o d .

b S i x ty - si x a c c r u a l m e t h o d p o r t f o li o m e d i a n v a l u e s i n 1 98 5. F o r e a c h c a s h m e t h o d f i r m w e f o r ma p o r t f o l i o o f a l l a c c r u a l m e t h o d f i r m s fr o m t h e s a m e f o u r d i g it S I C c o d e , w i t h t h e s e t o f a l l a c c r u a lm e t h o d f i r m s i n a g iv e n i n d u s t r y d e f i ne d a s t h e c o m p l e m e n t o f t h e c a s h m e t h o d s a m p l e .

p r e p a c k a g e d s o f t w a r e ( S I C = 7,3 72 ), h a s s e v e n f ir m s . F o r e a c h c a s h m e t h o d f i r mw e f o r m a p o r t f o l i o o f a ll a c c r u a l m e t h o d f i rm s f r o m t h e s a m e f o u r d ig i t S I Cc o d e . x5

T a b l e 1 p r e s e n t s d e s c r i p t i v e s ta t is t ic s f o r t h e c a s h a n d a c c r u a l m e t h o d f ir m s .T h e c a s h m e t h o d f i rm s h a v e m e a n a n n u a l s a le s o f 1 7 0 .1 2 m i l li o n , w h i l e t h ea c c r u a l m e t h o d f i rm s h a v e s a le s o f 1 4 7.8 4 m i ll io n . T h e c a s h ( a c c ru a l ) f i rm s h a v ea v e r a g e a s s e t s o f 1 9 1 .3 3 ( 1 9 9 .3 3 ) m i l l i o n . T h e s e d i f f er e n c e s a r e n o t s t a t i s t i c a l l ys ig n i fi c an t . T h e c a s h m e t h o d f i rm s a r e s i g n i f ic a n t ly le ss i n v e n t o r y - i n t e n s i v e t h a nt h e a c c r u a l m e t h o d f ir m s , w i t h a v e r a g e i n v e n t o r y t o a s s et s r a t i o s o f 0 .0 5 a n d0 . 0 7 , r e s p e c t i v e l y . T h i s i s t o b e e x p e c t e d , s i n c e f i r m s w i t h l a r g e a m o u n t s o fi n v e n t o r y h a v e l e s s i n c e n t i v e t o a d o p t t h e c a s h m e t h o d ( b e c a u s e t h e t a x l a wr e q u i r e s u s e o f t h e a c c r u a l m e t h o d f o r p u r c h a s e s a n d s a le s o f i n v e n t o r y ) .

W e u s e th e f i n a n c ia l r a t i o s d e fi n e d in T a b l e 2 to m e a s u r e t h e a c c r u a l a n d c a s hf l o w e ff e ct s p r e d i c t e d b y h y p o t h e s e s H 1 a n d H 2 . T h e r a t i o o f a c c o u n t s r e c e i v a b l e

15 T h e s e t o f a ll a c c r u a l m e t h o d f i rm s i n a g i v e n i n d u s t r y i s d ef i n e d a s t h e c o m p l e m e n t o f t h e c a s hm e t h o d s a m p l e .

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236 D.A. Guenther et al. / Journal of Accounting and Economics 23 1997) 225 248

Table 2Expected difference in financial ratios of firms using the cash met hod of accounting for tax purp osescompared with firms using the accrual method

Actions by cash method taxpayerRatio a Defer cash Accelerate cash Accelerate Defer book Overall

receipts disbur sement s boo k revenue expenses effectOverall measure of accrual and~or cash.flow managementAR/AP higher higher higherMeasure of receipts and~or payments mana~lementCR/CD lower lower

higher higher

Measure o f revenue and~or expense managementSALES/EXP no diff. no difl2

no diff. no diff. lower

higher higher higherNotes: AR - accounts receivable. CR = cash receipts. AP - accounts payable. CD = cash disbursements. SALES = accrual method sales for financial reporting purposes. EXP = accrual methodexpenses for financial reporting purposes.

t o a c c o u n t s p a y a b l e AR/AP)m e a s u r e s t h e o v e r a l l e f fe c t o f d i f f e re n c e s in c a s ha n d a c c r u a l r e c o g n i t i o n p a t t e r n s . T h e o t h e r r a t i o s a l l o w u s t o i d e n ti f y t h e s o u r c eo f t h e d i f fe r e n ce a n d d e t e r m i n e i f t h e d i f fe r e n ce is c a u s e d b y c a s h m a n a g e m e n ta c c r u a l m a n a g e m e n t o r a c o m b i n a t i o n o f t h e t w o . F o r e x a m p l e s in c e t h e c a s hr e c e i p ts t o c a s h d i s b u r s e m e n t s r a t i o CR/CD) s n o t a f fe c te d b y a c c r u a l m a n a g e -m e n t a l o w e r r a t i o fo r c a s h m e t h o d f i r m s r e l a ti v e t o a c c r u a l m e t h o d f i rm si n d i c a t e s t h a t c a s h m e t h o d f i r m s a r e s l o w e r t o c o l l e c t c a s h f r o m s a l e s a n d / o rf a s t er a t p a y i n g e x p e n s e s .

S i m il a rl y c o m p a r i s o n s o f t h e r a ti o o f b o o k s al es to b o o k e x p e n s e sSALES/EXP)a l lo w u s t o d e t e rm i n e if c a s h a n d a c c r u a l m e t h o d t a x p a y e r s h a v es y s t e m a t i c a l l y d i f fe r e n t r e c o g n i t i o n p o l ic i e s f o r f i n a n c ia l s t a t e m e n t p u r p o s e s .C a s h m e t h o d f ir m s c a n a c c e l e r a te t h e r e c o g n i t io n o f b o o k r e v e n u e o r d e f e r t h er e c o g n i t io n o f b o o k e x p e n s e s w i t h o u t a f fe c ti n g t a x a b l e i n c o m e . C o n s e q u e n t l yw e e x p e c t t h e r a t io o f r e c e i v a b l e s t o p a y a b l e s a n d s a le s to o p e r a t i n g e x p e n s e s t ob e h i g h e r f o r c a s h m e t h o d f i r m s t h a n a c c r u a l f i r m s .

T h e p o s t - 1 9 8 6 a c c r u a l a n d c a s h f l o w e f fe c ts p r e d i c t e d b y h y p o t h e s e s H 3 a n dH 4 s u g g e st t h a t t h e r a ti o s f o r th e c a s h m e t h o d f ir m s b e c o m e m o r e l ik e th o s e o ft h e a c c r u a l m e t h o d f i rm s a f t e r 19 86 b e c a u s e b o t h g r o u p s o f f i rm s n o w u s e th ea c c r u a l m e t h o d . T h e c a s h m e t h o d f i r m s a r e e x p e c t e d t o r e d u c e t h e d e f e r r a l o fc a s h r e ce i p t s a n d t h e a c c e l e r a t io n o f c a s h d i s b u r s e m e n t s a n d t o d e f e r r e c o g n i -t i o n o f f i n a n c ia l s t a t e m e n t r e v e n u e a n d a c c e l e r a t e r e c o g n i t i o n o f f i n a n c ia ls t a t e m e n t e x p e n s e s. T h e e f fe c ts l is te d i n t h e r i g h t h a n d c o l u m n o f T a b l e 2 a r ee x p e c t e d t o r e v e r s e a f te r 1 98 6. W e e x p e c t t h e a c c o u n t s r e c e i v a b le to a c c o u n t sp a y a b l e r a t io AR/AP)a n d t h e s a l e s t o e x p e n s e s r a t i o SALES/EXP) o d e c r e a s e

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D.A. Guenther et al. / Journal of Accounting and Economics 23 1997) 225-248 237f o r c a s h m e t h o d f i rm s c h a n g i n g t o th e a c c r u a l m e t h o d . W e e x p e c t t h e ca s hr e c e ip t s t o c a s h d i s b u r s e m e n t s r a t i o CR/CD) t o i n c r e a s e f o r f i rm s c h a n g i n g t ot h e a c c r u a l m e t h o d . B e c a u s e p e r i o d - s p e c i f i c f a c t o r s m a y a l s o a f fe c t c h a n g e s i nt h e se r a t i o s , w e m e a s u r e t h e s e c h a n g e s r e l a t iv e to c h a n g e s o f t h e c o n t r o l s e t o ff ir m s , w h ic h w e r e a c c r u a l m e t h o d t a x p a y e r s d u r i n g b o t h t h e p r e a n d p o s tp e r i o d s . 1 6

5 R e s u l t s o f e m p i r ic a l t e s ts5.1. Cross-sectional tests of cash versus accrual firms before TRA 86

F o r e a c h o f t h e c a sh m e t h o d f i rm s w e c o m p u t e t h e r a t i o s l i s te d i n T a b l e 2 f o rt h e p e r i o d 1 98 3 8 5. F o r t h e a c c r u a l m e t h o d f i rm s w e s e le c t t h e m e d i a n v a l u e o fe a c h i n d u s t r y - y e a r a s t h e s a m p l e v a lu e . W e t h e n c o m p a r e t h e m e a n s o f e a c h o ft h e r a t i o s d u r i n g t h e t h r e e y e a r s 1 98 3 -8 5 f o r th e c a s h a n d a c c r u a l m e t h o d f i r m s ,r e s p e c t i v e l y , y i e l d i n g 6 6 p a i r s o f d a t a .

T h e r e s u l t s r e p o r t e d i n T a b l e 3 i n d i c a t e t h a t f o r t h e p e r i o d 1 98 3 8 5 t h ed i f f e r en c e s i n th e r a t i o s o f t h e c a sh m e t h o d a n d a c c r u a l m e t h o d f i rm s a r eg e n e r a l l y in t h e p r e d i c t e d d i r e c t i o n . T h e d i f fe r en c e s fo r A R / A P a n dS A L E S / E X P a r e b o t h p o s i t i v e a n d s i g n i f i c a n t a t t h e 5 % l ev e l. 17 T h e CR/CDd i f f e r e n c e s a r e n o t s i g n i f i c a n t l y d i f f e r e n t f r o m z e r o , b u t w o u l d b e s i g n i f i c a n t i nt h e d i r e c t i o n n o t p r e d i c t e d h a d a t w o - t a i l e d t e s t b e e n u s ed .

T h e m e d i a n r a t i o o f a c c o u n t s r e c e i v a b l e t o a c c o u n t s p a y a b l e i s l a r g e r fo r th ec a s h m e t h o d f i rm s t h a n t h e a c c r u a l m e t h o d f i rm s (5 .0 87 v e r s u s 2 .8 77 ). T h ed i f f e r en c e i n t h e m e a n s i s e v e n m o r e p r o n o u n c e d , w i t h c a s h m e t h o d f i rm s h a v i n ga r a t i o m o r e t h a n t w i c e a s l a r g e a s th e a c c r u a l m e t h o d f i r m s ( 8 . 77 3 a n d 3 .2 83 ).T h e d i f f e r e n c e i n t h e A R / A P r a t i o s o f t h e c a s h a n d a c c r u a l f i r m s i s s i g n i f i c a n t a tt h e p = 0 . 0 0 1 l e v e l . T h e A R / A P r a t i o is th e b r o a d e s t m e a s u r e o f a c c r u a l a n dc a s h f lo w m a n a g e m e n t , c a p t u r i n g t h e e ff ec ts o f a c c e l e r a t i o n ( d e fe r ra l ) o f a c c r u e dr e v e n u e s ( e x p e n s e s ) a n d t h e d e f e r r a l ( a c c e l e r a t i o n ) o f c a s h r e c e i p t s ( p a y m e n t s ) .A s s u c h , A R / A P r e p r e s e n t s t h e o v e r a l l t e s t o f a c c r u a l a n d / o r c a s h f l o w m a n a g e -m e n t , w i t h l a r g e r r a t i o s c o n s i s t e n t w i t h o n e o r m o r e o f t h e a b o v e a c t i o n s .

16 Th e C om pu stat da ta items used are tota l receivables ( 2), accounts paya ble ( 70), sales ( 12),and opera ting income before deprecia tion ( 13). The expenses used in the SALES/EXP ra tio areoperating expenses, defined as sales less ope ratin g income before depreciation. C ash receipts areestim ated as beginning accounts receivable plussales lessending accounts receivable. Cas h disburse-ments are estimated as beginning accounts payable plusexpenses lessending accounts payable. Tocon trol for the effects of a sm all num ber o f extreme values, we winsorize the rati os of the cash andaccrual f irms a t the t op a nd botto m 1% o f their respective dis tr ibutions .lV Significance is assessed at the 5% level (one-tailed) using pa ired t-tests. N on par am etricsigned-rank tests are reported in the tables for comparison with the t-tests.

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238 D.A. Guenther et al. / Journal o f Accounting and Economics 23 1997) 225-248Table 3Univariate comparisons of financial ratios of cash method and accrual method firms 1983 85(n = 66)

Values of ratiosRatio ~ Sample firms Mean Median 25 75Overall measure of accrual and~or cash flow manayementAR/AP

Cash method 8.773 5.087 2.690 9.653Accrual me th od 3.283 2.877 1.885 3.518Cash - Accrual ( + )b 5.490 1.709 0.095 6.654p-value c 0.001 0.001

Measure of receipts and~or payments managementCR/CD Cash me th od 1,218 1.113 1.038 1.263

Accrual me th od 1,148 1.090 1.033 1.179Cash - Accrual ( - ) 0,071 0.021 - 0.044 0.169p-value 0,984 0.964

Measure of revenue and~or expense managementSALES/EXP

Ca sh me thod 1.288 1.164 1.088 1.330Accrual me th od 1.212 1.116 1.072 1.219Cash Accrual ( + ) 0.076 0.020 - 0.032 0.160p-value 0.026 0.010

aAR = accounts receivable. C R - cash receipts. A P - accounts payable. CD = cash disburse-ments, SALES = accrual method sales for financial reporting purposes, EXP = accrual methodexpenses for financial reporting purposes,

bSymbols in parentheses represent the predicted sign of the difference.Cp-values are for one-tailed t-tests (report ed below the mean) and signed ran k tests (repor ted below

the median)

T h e r a t i o o f c a s h r e c e i p ts t o c a s h d i s b u r s e m e n t s , CR/CD r e f l e c t s t he c a s hc o l l e c ti o n a n d p a y m e n t p o li c ie s o f t h e fi rm . T h e c a s h a n d a c c r u a l m e t h o d f i rm sd o n o t a p p e a r t o h a v e s i g n i f i c a n t l y d i f f e r e n t CR/CD m e a s u r e s , c o n s i s t e n t w i t hc a s h c o l l e c t i o n s a n d p a y m e n t s n o t b e i n g u s e d t o d e f e r s i g n i f i c a n t a m o u n t s o ft a x a b l e i n c o m e f o r c a s h m e t h o d f i r m s .

T h e r a t i o o f s a le s to o p e r a t i n g e x p e n s e s , SALES/EXP i s t h e a c c r u a l c o m p -l e m e n t t o CR/CD m e a s u r i n g t h e r a te a t w h i c h t h e f i rm r e c o g n i z e s re v e n u e s a n de x p e n s e s . T h e m e a n m e d i a n ) r a t i o o f s a le s t o o p e r a t i n g e x p e n s e s o f t h e c a s hm e t h o d f i r m s i s 1 .2 88 1 .1 6 4) c o m p a r e d t o a m e a n m e d i a n ) r a t i o o f 1 .2 12 1 .1 1 6)f o r t h e a c c r u a l m e t h o d f i r m s . T h e d i f f e r e n c e i n t h e r a t i o s i s s t a t i s t i c a l l y s i g n i f i -c a n t p = 0 .0 2 6) . T h e l a r g e r SALES/EXP r a t i o o f t h e c a s h m e t h o d f i rm s isc o n s i s t e n t w i t h t h e s e f i rm s r e c o g n i z i n g m o r e r e v e n u e s a n d / o r l e ss e x p e n s e s t h a n

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D . A . G u e n t h e r et a l. / J o u r n a l o f A c c o u n t i n g a n d E c o n o m i c s 2 3 1 9 9 7 ) 2 2 5 - 2 4 8 239

a c c r u a l m e t h o d f ir m s . T h e i n c re a s e d f i na n c ia l s t a te m e n t i n c o m e d o e s n o t c a u s ea c o r r e s p o n d i n g i n c r e a s e i n th e t a x a b l e i n c o m e o f t h e c a s h b a s i s fi rm s , m a k i n ge a r n i n g s m a n a g e m e n t c o s tl e ss f r o m a t a x p e r s p e ct iv e .

O v e r a l l , t h e s e re s u l ts a r e c o n s i s t e n t w i t h b o o k - t a x c o n f o r m i t y a f f ec t in g t h er e c o g n i t i o n o f i n c o m e f o r f in a n c i a l r e p o r t i n g p u r p o s e s .1 8 A s n o t e d e a r li e r, t h e s er e s u lt s s h o u l d b e i n t e r p r e t e d c a u t i o u s l y , a s it is p o s s i b l e t h a t f i rm s t h a t v o l u n t -a r i ly se l e ct e d th e c a s h m e t h o d f o r t a x p u r p o s e s h a v e d if f e re n t r a ti o s t h a n a c c r u a lm e t h o d f i r m s e v e n w i t h o u t a n y e a r n i n g s o r c a sh f lo w m a n a g e m e n t . F u r t h e r , ifw e c a n a s s u m e t h a t f i r m s t h a t s e le c t ed th e c a s h m e t h o d f o r t a x p u r p o s e s a r et h o s e f o r w h i c h t h e c a s h m e t h o d w o u l d r e s u lt in a d e f e r r a l o f t a x es , t h e n t h er a t i o s w il l a p p e a r a s if e a r n i n g s m a n a g e m e n t w a s t a k i n g p l a ce , e v e n in t h ea b s en c e o f e a rn i n g s m a n a g e m e n t .

5 2 Tests of changes after for ce d switch fro m cash to accrual after TRA 86I n o r d e r t o i s o l a t e th e e f fe c ts o f a n y e a r n i n g s o r c a s h f l o w m a n a g e m e n t , w e

e x a m i n e h o w t h e r a t io s c h a n g e a f t e r t h e c a sh m e t h o d f ir m s w e r e fo r c ed t o s w i t cht o t h e a c c r u a l m e t h o d . I f b o o k - t a x c o n f o r m i t y a f fe c ts t h es e d e c is io n s , th e n w ee x p e c t th e r a t i o s o f t h e c a s h m e t h o d f ir m s to m o v e t o w a r d s t h o s e o f t h e a c c r u a lm e t h o d f ir m s a f te r T R A 86 . A s a re s u lt , t h e d i r e c t io n a l p r e d i c t i o n s a r e o p p o s i t et h o s e in t h e r i g h t h a n d c o l u m n o f T a b l e 2 .

F o r e a c h c as h m e t h o d a n d a c c ru a l m e t h o d f ir m , w e c o m p u t e t he c h a n g e o v e rt h e p e r io d b y s u b t r a c t in g t h e m e a n r a t io f o r 1 9 8 3 -8 5 f r o m t h e m e a n r a t io f o r1 9 8 8 -9 0 . T h e r e su l ts , s h o w n i n T a b l e 4 , a r e l a r g e l y c o n s i s t e n t w i t h t h o s e o fT a b l e 3 . S p e c if ic a ll y , t h e a c c o u n t s r e c e i v a b l e t o a c c o u n t s p a y a b l e r a t i o o f th ec a s h m e t h o d f i r m s d e c r e a s e s s i g n i fi c a n tl y a f te r th e y w e r e f o rc e d t o s w i tc h t o t h ea c c r u a l m e t h o d p = 0 . 01 1) , c o m p a r e d t o f i rm s th a t w e r e a l w a y s o n t h e a c c r u a lm e t h o d . T h i s i s c o n s i s t e n t w i t h c a s h m e t h o d f i r m s e i t h e r a c c r u i n g l e s s i n c o m e ,a c c e l e r a t i n g t h e i r n e t c a s h in f lo w s , o r b o t h , a s t h e l ev e l o f b o o k - t a x c o n f o r m i t yi n c r e a s e s . T h e c a s h r e c e i p t s t o c a s h d i s b u r s e m e n t s r a t i o i s n o t s i g n i f i c a n t .F i n a l l y , t h e r a t i o o f s a l es to o p e r a t i n g e x p e n s e s , S A L E S / E X P i s e x p e c t e d t od e c r e a s e t o t h e e x t e n t t h a t f ir m s sl o w t h e ir i n c o m e r e c o g n i t i o n a s th e c o n f o r m i t yb e t w e e n b o o k a n d t a x a b l e i n c o m e in c r e as e s . C o n s i s t e n t w i th t h is p r e d i c t i o n , t h ec h a n g e i n th e S A L E S / E X P r a t io o f t h e c a s h m e t h o d f ir m s is m o r e n e g a t iv e t h a nt h e c h a n g e o f t h e a c c r u a l m e t h o d f i r m s p = 0 .0 24 ). O v e r a l l , t h e r e s u l ts i n

i s Ideally, we would like to have mo re direct m easure s of the econo mic magnitu de o f the earningsmanage ment. F or example, we could apply a variation of the Jones model Jones, 1991) to the data.Two difficulties with such an approach are the lack of an esti mation period in which we expect noearnings management and, more importantly, expected manag ement of cash receipts and disburse-ments as well as accruals.

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240 D.A. Guenther et al. / Journal of Accounting and Economics 23 1997) 225 248T a b l e s 3 a n d 4 a r e c o n s i s t e n t w i t h i n c r e a s i n g b o o k t a x c o n f o r m i t y c a u s i n gf i r m s t o a c c r u e f i n a n c i a l s t a t e m e n t i n c o m e m o r e s l o w l y . 19

5.3. Multivariate analysis of book-tax conformity, recognition, andcash flow decisions

I n t h i s s e c t i o n w e c o m b i n e b o t h o f t h e u n i v a r i a t e t e s t s i n t o a s i n g l e m u l t i v a r i -a t e t e s t . W e r e g r e s s t h e d i f f e r e n c e i n f i n a n c i a l r a t i o s o f c a s h m e t h o d a n d a c c r u a lm e t h o d f i r m s o n a s e r i e s o f v a r i a b l e s t h a t p r o x y f o r t h e a b i l i t y a n d i n c e n t i v e s t om a n a g e e a r n i n g s a n d t a x a b l e i n c o m e . W e e s t i m a t e t h e f o l l o w i n g r e g r e s s i o n so v e r t h e c a s h a n d a c c r u a l m e t h o d p a i r s t i m e a n d f i r m s u b s c r i p t s o m i t t e d f o rs i m p l i c i t y ) :

AR/AP)c_A = :~o + c~ICONFORM + ~z I N V+ ~3INV*C ONF ORM + a4SIZE+ esS I ZE* C O N FO RM + ~:~, 1)

CR/CD)c_A = 7o + 71CONFORM + 2INV+ 7alNV* CON FOR M + 74SIZE+ 75SIZE*CONFORM + e2 2 )

SALES/EXP)c_A = 2 0 + 21CONFORM+ 22INV + ) .3INV*CONFORM + 24SIZE+ 25SIZE*CONFORM + c3 . 3 )

T h e d e p e n d e n t v a r i a b l e s r e p r e s e n t t h e d i f f e re n c e i n t h e f i n a n c i a l r a t i o s o f t h ec a s h a n d a c c r u a l m e t h o d f i r m s . T h e r e a r e t w o o b s e r v a t i o n s f o r e a c h c a s hm e t h o d f i r m : o n e t h a t is t h e m e a n v a l u e f o r t h e p e r i o d 1 9 8 3 8 5 , w h e n b o o k t a xc o n f o r m i t y w a s r e l a t i v e ly l o w , a n d a n o t h e r t h a t i s t h e m e a n v a l u e f o r 1 9 8 8 - 9 0 ,w h e n b o o k - t a x c o n f o r m i t y w a s h i g h . z

1~ W e r e p e a t t h i s a n a ly s i s o n a s u b s a m p l e o f a c c r u a l f i rm s s e l e ct e d t o m a t c h t h e p r e - 1 9 8 6 r a t i o s o ft he ca sh f i rms , a s we ll a s t he i r i ndu s t ry , t o co n t ro l fo r t he poss i b i l i ty t ha t t h e pos t -198 6 chan ges a ret h e r e s u l t o f m e a n - r e v e r s i o n . T h e r e s u l ts a r e c o n s i s t e n t w i t h t h e r e s u l t s i n T a b l e 4 , t h o u g h n o t a ss t rong . T he re a re t wo l i ke l y rea sons for t h is . F i r s t , t he sam pl e s ize is muc h sm a l l e r because t he re a refew acc rua l f i rms wi t h pre -1986 ra t i os a t t he same l eve l s a s t he ca sh me t hod f i rms . Second , wes u s p e c t t h a t s o m e o f th e s e a c c r u a l f ir m s a r e r e a ll y c a s h m e t h o d f ir m s t h a t d o n o t d i s c lo s e t h a t f a c tc l ea r ly i n t h e i r f i n a n c i a l s t a t e m e n t s a n d h e n c e w o u n d u p i n t h e a c c r u a l s a m p l e b y d e f a u lt . T o t h eex t en t t ha t we co m pare ca sh f i rms t o a m i x t ure o f c a sh an d acc rua l f irms, t h i s mi sc la s s i fi c a ti on wi ll b i a saga i ns t ou r hypo t hese s . Because f irms wi t h t he se ex t reme ra t i os a re p rec isel y t he on es wi t h t he grea t e s ti ncen t i ve t o a do pt t he ca sh me t hod , t h i s mi sc l a ss i f ic a t ion is p roba bl y grea t e s t i n t h i s subsampl e .

20 To con t ro l fo r t he e ffec ts o f ou t l ie r s , obse rva t i o ns wi t h s t ud ent i zed re s i d ua l s g rea t e r t h an 2 .5 orless th an - 2 .5 a re rem ov ed fro m the ana lys i s Belsley e t a l. , 1980) .

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D.A. Guenther et al. / Journal o f Accounting and Economics 23 1997) 225-248 2 4 1T a b l e 4U n i v a r i a t e t e s ts o f c h a n g e s i n f i n a n c i a l r a t i o s o f c a s h a n d a c c r u a l m e t h o d f i r m s 1 9 8 3 - 8 5 t o 1 9 8 8 9 0( n = 6 6 )

V a l u e s o f c h a n g e i n r a t i o s

R a t i o a S a m p l e f i r m s M e a n M e d i a n 2 5 7 5

Overall measure of accrual and~or cash flow managementAR/APA r a t i o : C a s h - 2 . 4 5 3 - 0 . 4 3 0 - 2 . 6 3 7 1 . 2 8 8A r a t i o : A c c r u a l - - 0 . 0 7 8 - - 0 . 1 6 5 0 . 6 0 0 0 . 1 7 9A C a s h - A A c c r u a l ( - )~ - 2 . 5 3 1 - 0 . 2 9 2 - 3 . 8 0 0 1 . 1 5 0p - v a l u e c 0 . 0 1 1 0 . 0 2 1

Measure of receipts and/or payments managementCR/CD A r a t i o : C a s h 0 . 0 0 0 0 . 0 2 0 - 0 . 0 7 3 0 . 0 7 9

A r a t i o : A c c r u a l 0 . 0 1 0 0 . 0 0 0 - 0 . 0 2 2 0 . 0 3 7A C a s h A A c c r u a l ( + ) - 0 . 0 0 9 0 . 0 0 0 - 0 . 0 8 3 0 . 0 6 5p - v a l u e 0 . 6 2 7 0 . 5 98

Measure ~f revenue and/or expense managementSALES/EXP

A r a t i o : C a s h - 0 . 0 8 7 - 0 . 0 4 9 - 0 . 1 4 3 0 . 0 2 3A r a t i o : A c c r u a l - - 0 . 0 0 8 - - 0 . 0 1 6 0 . 0 6 1 0 . 0 2 3A C a s h - A A c c r u a l ( - ) - - 0 . 0 7 8 - - 0 . 0 3 0 - - 0 . 0 9 1 0 . 0 2 6p - v a l u e 0 . 0 2 4 0 . 0 03

aAR = a c c o u n t s r e c e i v a b l e . CR = c a s h r e c e i p t s . AP = a c c o u n t s p a y a b l e . CD = c a s h d i s b u r s e -m e n t s . SALES = a c c r u a l m e t h o d s a l es f o r f i n a n c i a l r e p o r t i n g p u r p o s e s . EXP = a c c r u a l m e t h o de x p e n s e s f o r f i n a n c i a l r e p o r t i n g p u r p o s e s .

b S y m b o l s i n p a r e n t h e s e s r e p r e s e n t t h e p r e d i c t e d s i g n o f t h e d i f f e r en c e .p - v a l u e s a r e f o r o n e - t a i l e d t - te s t s ( r e p o r t e d b e l o w t h e m e a n ) a n d s i g n e d r a n k t e s t s ( r e p o r t e d

b e l o w t h e m e d i a n ) .

The CONFORM variable takes on a value of one during the pe riod after 1986and zero otherwise. Together the intercept and the coefficient on CONFORMare similar to the univaria te analysis of Tables 3 and 4. For example c~0 reflectsthe difference between the AR/AP ratios of cash and accrua l firms before 1986and is predicted to be positive as in Table 3. The coefficient on CONFORM ~1reflects the change in the AR/AP of cash method firms after they were forced toswitch to the accrua l method and is predicted to be negative as in Table 4. Thesum of ~o and at represents the remaining difference if any in the AR/AP ofcash and accrual firms after the cash method firms were forced to switch to theaccrual method.

The variable INV indicates an inventory-int ensive firm taking on a value ofone when the ra tio of inventor y to total assets of the cash me tho d firm exceeds

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2 4 2 D . A . G u e n t h e r e t a l. / J o u r n a l o f A c c o u n t i n g a n d E c o n o m i c s 23 1 9 9 7 ) 2 2 5 2 4 8

0 .0 5 , a n d z e r o o t h e r w i s e . A b o u t o n e - t h i r d o f t h e f ir m s m e e t t h is c r i te r i o n .E s s e n t i a l l y , t h e s e f i r m s r e p r e s e n t a n a d d i t i o n a l c o n t r o l g r o u p . F i r m s w i t h l a r g ea m o u n t s o f i n v e n t o r i e s h a v e le ss i n c e n t iv e t o a l t e r i n c o m e r e c o g n i t i o n o f c a s hf lo w s a f t e r s w i t c h in g f r o m t h e c a s h t o a c c r u a l m e t h o d b e c a u s e t h e t a x l aw h a sa l w a y s r e q u i re d p u r c h a s e s a n d s al es o f i n v e n t o r y t o b e a c c o u n t e d f o r u n d e rt h e a c c r u a l m e t h o d , e v e n w h e n t h e r e st o f t h e f ir m s o p e r a t i o n s a r e a c c o u n t e df o r u n d e r t h e c a s h m e t h o d . C o n s e q u e n t l y , ~ 2 i s p r e d i c t e d t o b e n e g a t i v ei n t he AR/AP a n a l y s i s , r e d u c i n g t h e e x t e n t t o w h i c h c a s h m e t h o d f i r m sm a n a g e t h e i r e a r n i n g s . S i m i l a r l y , t h e c o e f f i c i e n t o n INV CONFORM,~ 3 i s p r e d i c t e d t o b e p o s i t i v e , o f f s e t t i n g t h e p r e d i c t e d n e g a t i v e c o e f f i c i e n t o nCONFORM, ~1.

T h e SIZE v a r i a b l e m e a s u r e s t h e s iz e o f t h e c a s h m e t h o d f i rm s r e l a t iv e t o t h e i ra c c r u a l m e t h o d p e e r s in t h e s a m e i n d u s t r y . S p e c i fi ca ll y , SIZE e q u a l s t h e l o g o fr a t i o o f a s s e ts o f t h e c a s h m e t h o d f i rm s t o t h e m e a n t o t a l a s s e ts o f t h e a c c r u a lm e t h o d f ir m s in t h e s a m e f o u r d ig i t S I C c o d e a n d s a m e t i m e p e r io d . P r i o rr e s e a r c h h a s f o u n d c o n f l i c t i n g e v i d e n c e o n t h e r e l a t i o n b e t w e e n f i r m s i z e a n dt a x - i n d u c e d e a r n i n g s m a n a g e m e n t . S o m e r e s ea r c h e r s m a i n t a i n t h a t s m a l l f ir m sa r e l i k e l y t o b e m o r e a g g r e s s i v e m a n i p u l a t o r s t h a n l a r g e f i r m s b e c a u s e t h e y a r es u b j e c t t o l e s s s c r u t i n y f r o m t h e I R S ( B o y n t o n e t a l . , 1 9 9 2 ) . O t h e r s a r g u e t h a tl a r g e f i rm s a r e m o r e l ik e l y t o h a v e i n - h o u s e t a x p l a n n i n g d e p a r t m e n t s a b l e t oi d e n t i f y a n d e x e c u t e t a x p l a n n i n g s t r a t e g i e s a t l o w e r c o s t t h a n s m a l l e r f i r m s( S c h o l e s e t a l., 1 99 2). B e c a u s e o f t h e c o n f l i c t i n g p r i o r e v i d e n c e a n d a r g u m e n t s ,w e m a k e n o d i r e c t i o n a l p r e d i c t i o n s r e g a r d i n g f i rm s iz e.

T a b l e 5 p r e s e n t s t h e e s t i m a t i o n o f E q s. ( 1 ~ (3 ) . T h e r e s u lt s a r e g e n e r a l l yc o n s i s t e n t w i t h t h e u n i v a r i a t e r e s u l t s p r e s e n t e d e a r l i e r a n d i n d i c a t e t h a tb o o k - t a x c o n f o r m i t y a f fe c ts t h e s p e e d w i t h w h i c h f i rm s r e c o g n i ze f in a n c i a ls t a t e m e n t i n c o m e . I n a d d i t i o n , t h e r e i s s o m e e v i d e n c e t h a t f i r m s w i t h l a r g ea m o u n t s o f i n v e n t o r y d o n o t a p p e a r t o b e a f fe c te d b y th e u s e o f t h e c as h o ra c c r u a l m e t h o d f o r t a x p u r p o s e s . T h e f i r m s i z e r e s u l t s a r e m i x e d .

T h e i n t e r ce p t , w h i c h m e a s u r e s t h e d i ff e re n c e b e t w e e n t h e r a t i o s o f c a s h a n da c c r u a l f i r m s b e f o r e T R A 8 6 , i s s i g n i f i c a n t i n t h e r e g r e s s i o n s o f AR/AP a n dSALES/EXP. T h i s i s c o n s i s t e n t w i t h t h e u n i v a r i a t e r e s u l t s in T a b l e 3 . T h ec o e f f i c ie n t o n CONFORM, w h i c h r e f le c t s t h e c h a n g e i n t h e r a t i o s o f f i r m s f o r c e dt o s w i t c h f r o m t h e c a s h t o a c c r u a l m e t h o d s , i s s i g n i f i c a n t i n t h e r e g r e s s i o n s o fAR/AP a n d SALES/EXP. A g a i n , t h i s i s c o n s i s t e n t w i t h t h e u n i v a r i a t e r e s u l t so f T a b l e 3 . 21

T h e c o e f f i c i e n t o n INV i s o n l y s i g n i f i c a n t w h e n t h e i n t e r c e p t i s s i g n i f i c a n t .T h i s i s t o b e e x p e c t e d , s i n c e INV r e p r e s e n t s t h e d e c r e a s e d e x t e n t o f e a r n i n g sm a n a g e m e n t b y f i r m s w i th l i tt le i n c e n ti v e t o m a n a g e t h e i r e a r n in g s . I f t h e r e is n oe a r n i n g s m a n a g e m e n t t o b e g i n w i t h, t h e n t h is v a r i a b l e s h o u l d n o t b e s ig n i fi c an t .

21 N o t e t h a t t h e s e r e s u lt s s h o u l d n o t b e i n t e r p r e t e d a s i n d e p e n d e n t o f o n e a n o t h e r

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D.A. Guenther et al. / Journal o f Accounting and Economics 23 1997) 225 248 2 4 3

T a b l e 5M u l t i v a r i a te t e s t s o f e a r n i n g s a n d c a s h f l ow m a n a g e m e n t b y c a s h m e t h o d f i r m sI n d e p e n d e n t v a r i a b l e a P r e d i c t e d s i g n C o e f f i c i e n t t - s t a t is t i c p - v a l u e c

PanelA: A R/A P ) c . h aI N T E R C E P T ( + ) 5 . 6 0 9 7 . 4 5CONFORM ( - ) - 3 . 09 6 - 2 . 94I N V ( - ) - 3 . 8 5 0 - 3 . 1 5INV* CONF ORM + ) 2 . 7 1 5 1 . 5 7SIZE - 1 . 409 - 3 . 31SIZE*CONFORM 1 . 5 5 3 2 . 8 4A d j . R 2 1 2 . 2 %O b s e r v a t i o n s 1 2 6

0 . 0 0 10 . 0 0 20 . 0 0 10 . 0 6 00 . 0 0 10 . 0 0 4

Panel B: CR/CD)c_ AI N T E R C E P T ( - ) 0 . 0 1 2 0 . 4 8CONFORM ( + ) 0 . 041 1 . 16I N V ( + ) - 0 . 0 3 7 - - 0 . 8 7INV* CON FORM -- ) 0 . 0 0 6 0 . 1 1SIZE 0 . 0 6 9 4 . 7 5SIZE*CONFORM - 0 . 0 6 5 - 3 . 4 4A d j . R 2 1 3 . 5 %O b s e r v a t i o n s 1 2 4

0 . 6 8 30 . 1 2 30 . 8 0 60 . 5 4 30 . 0 0 10 . 0 0 1

Panel C: SA LE S/ EX P)c.AI N T E R C E P T ( + ) 0 . 071 1 . 70CONFORM ( - ) - 0 . 141 - 2 . 36I N V ( - ) - - 0 . 1 4 3 - - 2 . 0 3INV* CONF ORM + ) 0 . 0 9 2 0 . 9 4SIZE 0 . 0 6 6 2 . 6 9SIZE*CONFORM 0 . 0 1 1 0 . 3 4A d j . R 2 1 6 . 0 %O b s e r v a t i o n s 1 3 1

0 . 0 4 60 . 0 1 00 . 0 2 20 . 1 7 50 . 0 0 80 . 7 3 8

T h e d e p e n d e n t v a r i a b l e s ar e d e f i n ed a s t h e d e v i a t i o n o f t h e c a s h m e t h o d f i r m f r o m t h e a c c r u a lm e t h o d f i rm s i n th e s a m e f o u r d i g i t S I C c o d e . AR = a c c o u n t s r e c e i v a b l e , AP = a c c o u n t s p a y a b l e ,CR = c a s h r e c e i p t s , CD = c a s h d i s b u r s e m e n t s , SALES = a c c r u a l m e t h o d s a le s f o r f i n a n c ia l r e p o r t-i n g p u r p o s e s , EXP - a c c r u a l m e t h o d e x p e n s e s f or f i n a n c ia l r e p o r t i n g p u r p o s e s . E a c h o f t h e 6 6 c a s hm e t h o d f i rm s h a s t w o o b s e r v a t i o n s , o n e r e p r e s e n t i n g t h e m e a n v a l u e s fo r t h e p r e- 1 9 8 6 p e r i o d o f1 9 83 8 5 , a n d t h e o t h e r r e p r e s e n t i n g th e m e a n v a l u e s f o r t h e p o s t - 1 9 8 6 p e r i o d f r o m 1 9 8 8 - 9 0 .

b T h e i n d e p e n d e n t v a r i a b l e s a r e d e f i n e d a s f o l lo w s . CONFORM i s a n i n d i c a t o r v a r i a b l e t h a te q u a l s o n e f o r t h e p o s t - 1 9 8 6 p e r i o d a n d z e r o o t h e r w i s e . I N V i s a n i n d i c a t o r v a r i a b l e f o r f i rm s w i t hl a r g e a m o u n t s o f i n v e n t o r y , e q u a l i n g o n e f o r f i rm s w i t h i n v e n t o r y t o t o t a l a s se t s g r e a t e r t h a n 0 .0 5a n d z e r o o t h e r w i s e . SIZE r e p r e s e n t s t h e l o g o f th e r a t i o o f t h e a s s e t s o f t h e f i r m t o t h e m e a n t o t a la s s e t s o f th e a c c r u a l m e t h o d f i rm s i n t h e s a m e f o u r - d i g i t S I C c o d e.

C p - v al u es a r e o n e - t a i l e d f o r c o e f f ic i e n t s w i t h d i r e c t i o n a l p r e d i c t i o n s a n d t w o - t a i l e d o t h e r w i s e .O b s e r v a t i o n s w i t h s t u d e n t i z e d r e s i d u a l s g r e a t e r t h a n 2 . 5 o r l e ss t h a n - 2 .5 a r e d e l e t e d ( B e l s le y e t a l. ,1980) .

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44 D . A . G u e n t h e r e t a l. / J o u r n a l o f A c c o u n t i n g a n d E c o n o m i c s 2 3 1 9 9 7 ) 2 2 5 2 4 8

T h e i n t e r a c ti o n o f I N V w i t h C O N F O R M h o w e v e r , i s n o t s i g n i f i c a n t i n a n y o ft h e t h r e e r e g r e s s i o n s .

T h e f i r m s i z e r e s u l t s a r e m i x e d , a s i n t h e p r i o r s t u d i e s . I n t h e A R / A Pr e g r e s s i o n t h e c o e f f i c i e n t o n S I Z E is n e g a t i v e , c o n s i s t e n t w i t h l a r g e f i rm s b e i n gm o r e c o n s e r v a t i v e t h a n s m a l l fi rm s in t h e i r i n c o m e r e c o g n i t i o n a n d t a x p l a n n i n ga c t i v i t i e s . H o w e v e r , i n t h e S A L E S / E X P r e g r e s s i o n t h e c o e f f i c i e n t o n S I Z E isp o s i t i v e , c o n s i s t e n t w i t h l a r g e fi rm s b e i n g m o r e a g g r e s s i v e t h a n s m a l l f ir m s i nt h e i r i n c o m e r e c o g n i t i o n .

5.4. Economic s ign~JicanceT o p r o v i d e a n e x a m p l e o f t h e e c o n o m i c s i gn i fi c an c e o f t h e s t a t is t ic a l d i ff er -

e n c e s r e p o r t e d i n t h e e m p i r i c a l t es ts , w e c o n v e r t t h e a c c o u n t s r e c e i v a b l e f o r e a c hs a m p l e f ir m in t o a n a v e r a g e n u m b e r o f d a y s r e c e i v a b le s o u t s t a n d i n g . F o r t h ep r e -1 9 8 6 p e r i o d , t h e a v e r a g e d a y s r e c ei v a b le s f o r th e c a s h m e t h o d s a m p l e f ir m sis 1 14 d a y s , w h i l e t h e a v e r a g e d a y s r e c e i v a b l e s f o r t h e a c c r u a l m e t h o d s a m p l ef i rm s i s 9 5 d a y s . A f t e r t h e f o r c e d m e t h o d c h a n g e , t h e d i f f e re n c e b e t w e e n t h e c a s ha n d a c c r u a l f i r m s d e c r e a s e s f r o m 1 9 d a y s t o 4 d a y s . W e a l s o c o n v e r t t h ea c c o u n t s p a y a b l e f o r e a c h s a m p l e f i rm i n t o a n a v e r a g e n u m b e r o f d a y s p a y a b l e so u t s t a n d i n g . F o r t h e p r e - 1 9 8 6 p e r i o d , t h e a v e r a g e d a y s p a y a b l e s f o r t h e c a s hm e t h o d s a m p l e f ir m s is 4 0 d a y s , w h il e th e a v e r a g e d a y s p a y a b l e s f o r t h e a c c r u a lm e t h o d s a m p l e f i r m s is 51 d a y s . A f t e r t h e f o r c e d c h a n g e , t h i s d i ff e r e n c e d e c r e a s e sf r o m 1 1 d a y s t o 7 d a y s .

6 . R o b u s t n e s s t e s ts f o r s e l f -s e l e c t io n p r o f it a b il it y a n d g r o w t hI n t h is s e c t i o n w e s u m m a r i z e t e s ts o f a l t e r n a t iv e e x p l a n a t i o n s f o r o u r r e s u lt s.

I n p r e v i o u s s e c t i o n s w e d i s c u s s e d t h e f a c t t h a t t h e f i rm s i n o u r s a m p l e s e l f -s e le c ti n t o e i t h e r t h e c a s h o r a c c r u a l m e t h o d s . I t i s p o s s i b l e t h a t t h e r e p o r t e d d i f f e r -e n c e s b e t w e e n o u r c a s h a n d a c c r u a l m e t h o d s a m p l e f ir m s a re a c a u s e of , r a t h e rt h a n a r e s u l t of , t h e s e l e c ti o n o f t h e c a s h m e t h o d . I n t h i s s e c ti o n w e e x a m i n e o u rp r e v i o u s l y r e p o r t e d r e su l t s u s in g a s e l f -s e le c ti o n m o d e l d i s c u s s e d b y M a d d a l a1 9 8 3 , 1 99 1), a n d a p p l i e d i n a n a c c o u n t i n g c o n t e x t b y A b d e l - k h a l i k 1 9 9 0 ) a n d

S h e h a t a 1 99 1). W e a l s o c o n t r o l f o r c r o s s - s e c t i o n a l d i f f er e n c e s i n p r o f i t a b i l i t ya n d / o r g r o w t h a c ro s s t h e s am p l e f i rm s u s in g a m o d e l d e v e l o p e d b y D e c h o w e ta l. 1 9 9 5) a n d i n c l u d e v a r i a b l e s t o c o n t r o l f o r t h i s p o s s i b i l it y .

M a d d a l a 1 9 9 1 ) d i s c u ss e s s e lf - s el e c ti o n b i a s a s i t r e l a t e s t o a c c o u n t i n g r e -s e a r c h , a n d s u g g e s t s u s i n g t h e t w o - s t a g e s w i t c h i n g r e g r e s s i o n H e c k m a n , 1 9 76 ,1979 ; Le e , 1976, 1978) to c o r r e c t f o r th i s b ia s . As po in t e d ou t by M a d da la 1991) ,a f i n d i n g t h a t t h e t w o - s t a g e e s t i m a t e s a r e s i m i l a r t o t h e O L S e s t i m a t e s i se v i d e n c e t h a t t h e r e s u l t s a r e n o t c a u s e d b y s e l f- s e le c t io n .

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D.A. Guenther et al. / Journal of Accounting and Economics 23 1997) 225 -248 2456 .1 . E f f e c ts o f p ro f i t ab i l i t y and /or g row th

T h e r a t i o s A R / A P , C R / C D , a n d S A L E S / E X P m a y b e a f f e c t e d b y c r o s s -s e c t i o n a l d i f f e r e n c e s i n p r o f i t a b i l i t y a n d / o r g r o w t h i n t h e s a m p l e f i r m s . T oe x p l o r e t h is f u r th e r , w e m o d i f y t h e m o d e l o f a c c r u a l s d e v e l o p e d b y D e c h o w e t a l.( 19 9 5 ) b y a s s u m i n g t h a t s a l e s g r o w a t a c o n s t a n t r a t e (g ) s u c h t h a tS , = S t - 1(1 + g). D e c h o w e t a l. a s s u m e t h a t e n d i n g a c c o u n t s r e c e i v a b le A R , ) ise q u a l t o a p e r c e n t a g e ( a) o f c u r r e n t y e a r s al es , s o t h a t ARt = ~S~ . P u r c h a s e s f o rt h e p e r i o d a r e e q u a l t o a p e r c e n t a g e o f s a le s e q u a l t o (1 - g ), w h e r e ~ is t h e p r o f i tm a r g i n o n s ale s. 22 E n d i n g a c c o u n t s p a y a b l e A P t ) is e q u a l t o a p e r c e n t a g e (fl) o fc u r r e n t y e a r p u r c h a s e s , s o th a t A P t = t i P , = fl(1 -- re)S,.

U s i n g t h i s n o t a t i o n , t h e r a t i o s i n t h is s t u d y c a n b e e x p r e s s e d i n t e r m s o fg r o w t h (g ) a n d p r o f i t a b i l i t y ( g ) a s f o l l o w s

A R / A P = ~/fl(1 -- ~z), (4)1 + g 1 - - ~)C R / C D = (5)1 - - ~ ) [ 1 + g 1 - - f l)]

S A L E S / E X P = l/( 1 -- ~z). (6)B y t a k i n g p a r t i a l d e r i v a t iv e s o f t h e s e e x p r e s s i o n s w i t h r e s p e c t t o g r o w t h

a n d p r o f i t a b i l i t y ( n o t s h o w n ) , i t c a n b e d e m o n s t r a t e d t h a t d i f fe r e n ce s inp r o f i t a b i l i t y a r e e x p e c t e d t o a f f e c t a ll th r e e o f t h e r a t i o s u s e d i n t h is s t u d y ,w h i l e d if f er e n c e s in g r o w t h a r e o n l y e x p e c t e d t o a f fe c t t h e r a t i o C R / C D . W ec o n t r o l f o r t h e se e x p e c t e d e ff ec ts i n t h e s e c o n d s t a g e o f t h e t w o - s t a g e s w i t c h i n gr e g r e s s i o n .

6 .2 . Es t ima t ing the tw o- s tage re gre s s ionT h e s a m p l e o f c a s h m e t h o d f ir m s u s e d i n th e t w o - s t a g e e s t i m a t i o n is s i m i la r t o

t h e s a m p l e u s e d i n th e p r e v i o u s t es ts , e x c e p t t h a t w e r e st r i c t t h e p e r i o d t o1 9 83 8 5. B e c a u s e t h e f ir st s t a g e o f t h e e s t i m a t i o n u s e s a p r o b i t m o d e l , w e n ol o n g e r u s e d i f fe re n c es b e t w e e n c a s h m e t h o d f ir m s a n d m a t c h e d p o r t f o l io s o fa c c r u a l m e t h o d f ir m s, b u t i n s t e a d s e le c t a s a m p l e o f a c c r u a l m e t h o d f ir m s f r o mt h e C o m p u s t a t P S T t a p e t h a t h a v e t h e s a m e f o u r - d ig i t S I C c o d e as a t l ea s t o n e

22 Dech ow et al. (1995) ignore inventories in this mo del, which they refer to as their simple mo del.Since under the tax law the cash method cannot be appli