This study investigates whether compensating chief executive officers and business-unit managers using after-tax accounting-based performance measures leads to lower effective tax rates, the empirical surrogate used for tax-planning effectiveness. Utilizing proprietary compensation data obtained in a survey of corporate executives, the relation between effective tax rates and after-tax performance measures is modeled and estimated using a two-step approach that corrects for the endogeneity bias associated with firms' decisions to compensate managers on a pre- versus after-tax basis. The results are consistent with the hypothesis that compensating business-unit managers, but not chief executive officers, on an after-tax basis leads to lower effective tax rates.

Prior research has separately examined pretax earnings management activities that have current taxable income consequences (book-tax “conforming earnings management”) and those that do not have current taxable income consequences (book-tax “nonconforming earnings management”). Our study documents the prevalence of, and then investigates the firm-specific characteristics that impact the choice between, these earnings management strategies. We utilize a sample of firms that restated their earnings downward due to accounting irregularities and thus can be presumed to have managed earnings upward. We find that nonconforming earnings management is more prevalent and that firms trade off the net present value of tax benefits against the net expected detection costs associated with nonconforming earnings management. In particular, firms having NOL carryforwards, using a high-quality auditor, or engaging in the most egregious misstatements rely less on nonconforming earnings management strategies. We also find that book-tax differences are useful in predicting restatements.