Why Do Countries Mandate Accrual Accounting for Tax Purposes?

• Author: MARTIN JACOB,IGOR GONCHAROV
• Date: 01 December 2014
• DOI: http://doi.org/10.1111/1475-679X.12061
• Published date: 01 December 2014

DOI: 10.1111/1475-679X.12061

Journal of Accounting Research

Vol. 52 No. 5 December 2014

Printed in U.S.A.

Why Do Countries Mandate Accrual

Accounting for Tax Purposes?

IGOR GONCHAROV

∗AND MARTIN JACOB

†

Received 17 July 2012; accepted 28 August 2014

ABSTRACT

This study investigates why countries mandate accruals in the definition of

corporate taxable income. Accruals alleviate timing and matching problems

in cash flows, which smoothes taxable income and thus better aligns it with

underlying economic performance. These accrual properties can be desir-

able in the tax setting as tax authorities seek more predictable corporate tax

revenues. However, they can also make tax revenues procyclical by increasing

the correlation between aggregate corporate tax revenues and aggregate eco-

nomic activity. Weargue that accruals shape the distribution of corporate tax

revenues, which leads regulators to incorporate accruals into the definition

of taxable income to balance the portfolio of government revenues and ex-

penditures. Using a sample of 26 OECD countries, we find support for several

theoretically motivated factors explaining the use of accruals in tax codes. We

∗Lancaster University Management School; †WHU – Otto Beisheim School of Manage-

ment.

Accepted by Christian Leuz. We thank Johannes Becker,Dan Collins, Josh Coyne, Markus

Hitz, Ed Maydew, Erik Peek, Eddie Riedl, Doug Shackelford, Terry Shevlin, David Veen-

man, Kelly Wentland, two anonymous referees, and seminar participants at the University

of Goettingen, the University of North Carolina, the Erasmus University Rotterdam, the

WHU – Otto Beisheim School of Management, the Free University of Berlin, the 2012

American Accounting Association Annual Meeting, the Annual Congress of the European

Accounting Association, the German Academic Association for Business Research (VHB) An-

nual Meeting, and the Workshop on Current Research in Taxationfor helpful comments and

suggestions. We appreciate help from the local offices of Ernst & Young and KPMG, Wolf-

gang Zieren, Yutaro Murakami, Frederik Zimmer, Annette Alstadsæter, and Jan S¨

odersten in

obtaining information on tax rules. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

1127

Copyright C, University of Chicago on behalf of the Accounting Research Center,2014

1128 I.GONCHAROV AND M.JACOB

first provide evidence that corporate tax revenues are less volatile in high ac-

crual countries, but high accrual countries collect relatively higher (lower)

tax revenues when the corporate sector grows (contracts). Critically, we then

show that accruals and smoother tax revenues are favored by countries with

higher levels of government spending on public services and uncertain future

expenditures, while countries with procyclical other tax collections favor cash

rules and lower procyclicality of corporate tax revenues.

JEL codes: M41; H25; H21; M48

Keywords: accrual accounting; income smoothing; corporate tax revenues;

corporate tax base

1. Introduction

The role of accrual accounting in financial statements has long attracted

the interest of accounting researchers (Dechow [1994], Dechow, Kothari,

and Watts [1998]). However, accruals are also used in the country level

definition of corporate taxable income. For example, each corporate tax

code defines specific rules, different from either cash-based reporting or

financial accounting, for depreciating assets and for capitalization of re-

search and development (R&D) expenses. These accruals affect the time

when cash flows are reported as taxable income, reduce the volatility of

taxable income relative to cash flows, and thus better align taxable income

with underlying economic activity (Dechow [1994]). Previous theoretical

tax literature shows that defining taxable income on a cash basis or full

accrual basis leads to equitable and neutral taxation, while a definition

of taxable income that deviates from those two “extremes” can be distor-

tionary (Samuelson [1964], King [1975], Stiglitz [1976]). Nevertheless, tax

codes rarely define taxable income on a pure cash basis, or employ accrual

norms largely similar to U.S. GAAP or IFRS. Critically, there is consider-

able cross-country variation in the use of accruals in tax codes to define

taxable income. This paper examines the factors associated with this ob-

served heterogeneity in the accrual definition of corporate taxable income

to understand why countries mandate accrual accounting for tax purposes.

We hypothesize that the use of accruals in the definition of taxable in-

come affects the properties of corporate tax revenues and that countries

choose the desired level of accrual accounting that will balance the portfo-

lio of government revenues and expenditures. Prior research shows that the

definition of taxable income is a major determinant of corporate tax rev-

enues (Auerbach and Poterba [1987], Desai, Dyck, and Zingales [2007]).

Using accruals in the definition of taxable income can lead to lower volatil-

ity of aggregate corporate taxable income and, accordingly, also lower the

volatility of the resulting corporate tax revenues. This can be desirable for

tax purposes because stable tax revenues allow a country to maintain an ex-

isting volume and quality of government services (Groves and Kahn [1952],

Misiolek and Elder [1988]). Furthermore, accruals can simplify prediction

THE USE OF ACCRUAL ACCOUNTING FOR TAX PURPOSES 1129

of both future tax collections and government expenditures. This is of par-

ticular importance in the case of corporate tax revenues, which typically

represent the most volatile tax in governments’ portfolios (Felix [2008])

and average 3% (maximum 13%) of GDP in OECD countries.

However, the use of accrual accounting in the tax setting can present two

potential costs. First, accrual accounting requires judgment in estimating

income, leading to potential opportunistic discretion to manage taxable in-

come (Boynton, Dobbins, and Plesko [1992]). Such earnings management

can weaken the relationship between income and underlying economic ac-

tivity (Leuz, Nanda, and Wysocki [2003]). Second, the use of accrual ac-

counting in the tax setting can lead to undesirable outcomes even if accru-

als achieve their purported goal. By smoothing out transitory fluctuations

in cash flows and aligning taxable income with economic income, accru-

als may increase the correlation between aggregate corporate tax revenues

and economic activity (Guenther and Young [2000], Hanlon and Maydew

[2009]). This can lead to procyclical accrual-based taxable income: higher

tax revenues when the economy is booming, and reduced funds when the

economy is contracting (Lane [2003]).

We predict this trade-off between lower volatility and higher procyclical-

ity of corporate tax collections in high-accrual regimes as a primary deter-

minant explaining countries’ use of accruals for tax purposes.1Specifically,

whether a country chooses a more accrual-based tax regime depends on its

preference for smoothness and predictability of tax revenues over respon-

siveness of corporate tax revenues to economic shocks given a country’s

portfolio of government revenues and expenditures. That is, countries de-

fine taxable income to best fit their revenue and spending portfolio: coun-

tries with high uncertainty and higher volume of projected expenditures

are more likely to favor accrual norms that produce more predictable cor-

porate tax revenues. In contrast, those with more procyclical spending or

alternative revenue sources are more likely to rely on cash norms that lead

to lower procyclicality of corporate tax revenues.

We test this conjecture using a sample of 26 OECD countries over the

years 1997–2009. We construct a tax accrual index, which proxies for the

extent to which corporate taxable income deviates from cash accounting.

We then map the definition of taxable income in each country using ac-

crual norms required for major categories of fixed and current assets such

as capitalization of R&D and use of provisions.

Using this empirical proxy, we then assess whether accrual properties

affect a country’s choice to adopt a more accrual-based tax regime using

1There is anecdotal evidence that tax regulators face this trade-off. For example, the “Prin-

ciples of a High-Quality State Revenue System” promulgated by the U.S. National Conference

of State Legislatures (NCSL) states that a “high-quality revenue system produces revenue in a

reliable manner. Reliability involves stability, certainty, and sufficiency” (NCSL [2007]). While

lower volatility of revenues is desirable, the document acknowledges that some rules aimed to

decrease the volatility of tax revenues can increase their responsiveness to economic shocks.