The Influence of Tax Costs on Accounting Conservatism

Abstract

This paper investigates whether the conservatism in financial reporting is driven by taxation. Although conservatism has been examined from the perspectives of contracting, shareholder litigation, and accounting regulation, few studies have examined the relation between taxation and accounting conservatism. Using unconditional conservatism measures, we find that the level of conservatism is positively related with a firm's tax burden. However, the relation is not detected when a conditional conservatism measure is used, suggesting that use of an appropriate conservatism measure is important for testing tax motivated conservatism. Further study shows that the tax motivated conservatism is affected by the degree of book-tax conformity and the level of nontax costs. Firms with a closer link between book and taxable income are likely to have a stronger relation between tax costs and conservatism. Also we find that tax motivated conservatism is more prevalent for the firms with low nontax cost. Overall, this paper shows that taxation is a determinant of financial reporting conservatism in Korea.