Incentives, Opportunities, and Earnings Management Using Tax Expense

Prior studies that examine the effect of managerial incentives on investment or misreporting decisions typically hold firm characteristics constant and focus on a particular managerial incentive. However, managers’ responses to different types of incentives likely depend on firm characteristics that create opportunities to respond to those incentives. Using year-end tax expense manipulations as our setting, we examine the extent to which equity incentives, firm characteristics that create opportunities, and their interaction are associated with the decision to manage earnings. We show that stock price incentives (portfolio delta), risk-taking incentives (portfolio vega), and firm characteristics that create opportunities are associated with a greater propensity for firms to manage earnings using tax expense. Importantly, we find that portfolio delta has a greater effect on the earnings management decision when firm opportunities are higher, while we do not find evidence that the effect of portfolio vega varies with firm opportunities. Collectively, our results suggest that managers respond to stock price and risk-taking incentives differently depending on their opportunity sets.