Trade‐offs between Tax and Financial Reporting Benefits: Evidence from Purchase Price Allocations in Taxable Acquisitions

Abstract

Under U.S. GAAP, firms recognize assets acquired in business combinations at fair value. Similarly, in taxable asset acquisitions firms adjust the tax basis of assets to fair value. Managers can increase the present value of future tax savings by allocating a greater portion of the purchase price to shorter‐lived assets than to goodwill or indefinite‐lived intangibles. However, this tax planning strategy imposes a financial reporting cost because it reduces book income following the acquisition; all else equal, allocations to shorter‐lived depreciable assets increase book depreciation expense, whereas allocations to goodwill and indefinite‐lived intangibles do not increase book amortization expense. We exploit the features of taxable asset acquisitions to investigate trade‐offs between tax and financial reporting incentives. We predict and find greater allocations to depreciable versus intangible assets when managers have strong tax incentives and weak financial reporting incentives. However, we also find that strong financial reporting incentives moderate the effects of strong tax incentives. These findings contribute new evidence to the literature on the importance of nontax costs in tax planning decisions

Strategic Interactions Between Tax and Statutory Auditors and Different Information Regimes: Implications for Tax Audit Efficiency

“…Although we also study variations in the importance of book income, we explicitly exclude from our analysis those firms that prioritize financial reporting over tax outcomes. Thus our analysis does not fully cover public firms, which prior research finds place greater emphasis on financial reporting outcomes than private firms (Mills, 1998;Mills and Newberry, 2001;Beuselinck et al, 2015;Lynch et al, 2018). Nevertheless, we can still transfer some of our considerations to those firms that prioritize financial reporting over tax outcomes.…”

Earnings Management around the Tax Cuts and Jobs Act of 2017

“…Indicator that takes a value of 1 if the firm is a "habitual earnings target beater" (Bartov et al 2002) defined as a firm has a suspect quarter in more than 3 quarters (upper quartile of the sample distribution) over the prior 12 fiscal quarters (Lynch et al 2019). We define a fiscal quarter to be suspect for earnings management to meet/beat earnings targets when the earnings per share (obtained from IBES), (i) are larger or equal to zero and do not exceed 1 cent, and/or (ii) exceed the earnings per share in the same fiscal quarter in the previous fiscal year and do not exceed them by more than one cent, and/or (iii) exceed the last earnings per share financial analyst consensus forecast available prior to the end of the fiscal quarter and do not exceed it by more than one cent.…”

Differences in the Value Relevance of Identifiable Intangible Assets Acquired in Business Combinations

“…The fourth specification eliminates 421 firm-year observations from the sample where the acquiring firm recognizes an indefinite-lived intangible other than IPR&D. The purpose of this sensitivity test is to address whether compensation or financial reporting incentives provide alternative explanations that might explain the difference in the coefficients on Wasting_IIi,t and Organic_IIi,t. Prior research demonstrates that managers with strong earnings-based compensation or financial reporting incentives are more likely to allocate larger portions of the purchase price to goodwill and indefinite-lived intangibles to reduce the effects of post-acquisition amortization (e.g., Shalev et al 2013;Lynch et al 2019). By eliminating transactions involving indefinite-lived intangibles other than goodwill, we can better attribute differences in the association between equity prices with wasting and organically replaced intangibles to their underlying economic characteristics.…”

“…We also contribute to the literature on the market consequences of, and factors influencing managers' decisions regarding accounting for business combinations. Several studies in this literature have examined how compensation, financial reporting, and tax incentives influence firms' purchase price allocation decisions (Shalev, Zhang, and Zhang 2013;Lynch et al 2019;Wangerin 2019). Other studies suggest that the accounting model for business combinations contributes to increases in information uncertainty (Erickson et al 2012;Dickinson et al 2016).…”