Journal of International Accounting, Auditing and Taxation 20 (2011) 8396

Contents lists available at ScienceDirect

Journal of International Accounting,

Auditing and Taxation

Earnings management induced by tax planning: The case of

Portuguese private rms
Mrio Marques a, , Lcia Lima Rodrigues a,1 , Russell Craig b,2
a
b

University of Minho, School of Economics and Management, Campus de Gualtar, 4710-057 Braga, Portugal
University of Canterbury, College of Business and Economics, Private Bag 4800, Christchurch 8140, New Zealand

a r t i c l e

i n f o

Keywords:
Earnings management
Income tax
Special payment on account

a b s t r a c t
In Portugal, a concept of taxable income associated closely with reported accounting income
is used to determine the tax liability of rms. Recently, the Portuguese government legislated to introduce a system of special payment on account (SPA). Firms were required
to pay an amount of income tax in advance that varied between a promulgated minimum
and maximum. Although such a tax is unique to Portugal, other countries have tax arrangements that are similar in intent. Thus, Portugals experience with the introduction of a
SPA regime is likely to be instructive in scal policy deliberations in other settings.
We assess the extent to which the SPA tax policy measure encouraged private Portuguese
companies to manipulate earnings. We nd that earnings manipulation appears to have
been motivated by desire to minimize SPA. Firms whose estimate of SPA liability fell within
the range of minimum and maximum limits of the SPA had higher levels of discretionary
accruals than rms whose estimate was (equal to or) above the ceiling imposed by the
new legislation. Firms with higher rates of income tax were found to reduce earnings to
near zero. Firms with higher average income tax rates were more likely to manipulate their
earnings than other rms.
Our results reinforce the importance for auditors, stakeholders, and tax policy advisors to
be alert to the close association between tax planning considerations and reported earnings
in their monitoring, analysis, and policy advising activities.
2011 Elsevier Inc. All rights reserved.

1. Introduction
The implication of tax considerations in earnings management practices has been under-researched in continental European countries (such as Germany, Belgium, France, Italy and Portugal) in which a rms liability for taxation is based on
a measure related closely to reported accounting income. In Portugal there is a strong link between accounting and taxation. Article 17 of the Code of Companies Income Tax (Cdigo do Imposto sobre o Rendimento das Pessoas Colectivas CIRC)
calculates income tax liability based on:
. . . the sum of net prot for the year and the positive and negative variations in shareholders equity that were recorded
in the same period but that did not affect the earnings, calculated based on accounting and possibly corrected in
accordance with this Code.

Corresponding author. Tel.: +351 253 601 946; fax: +351 253 601 380.
E-mail addresses: mmarques@eeg.uminho.pt (M. Marques), lrodrigues@eeg.uminho.pt (L.L. Rodrigues), russell.craig@canterbury.ac.nz (R. Craig).
1
Tel.: +351 253 604 559; fax: +351 253 601 380.
2
Tel.: +64 3 364 3026; fax: +64 3 364 2727.
1061-9518/$ see front matter 2011 Elsevier Inc. All rights reserved.
doi:10.1016/j.intaccaudtax.2011.06.003

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M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 8396

Despite this, there has been no study of the association between tax planning and earnings management behaviour by
Portuguese private rms. Thus, the present investigation of whether Portuguese private rms manipulate their earnings to
minimize income tax payments presents timely evidence of some perverse effects that emerge from the connection between
a national accounting system and a national tax system.
Prior studies in other continental European countries (e.g. Baralexis, 2004; Coppens & Peek, 2005; Othman & Zeghal,
2006) show the potential for the accounting basis of income tax liability to inuence accounting manipulations. In Portugal
it is believed widely that private rms pay taxes well below what they would pay if their tax liability was based on the real
income obtained from business operations. In the last decade, like many governments in other countries, the Portuguese
government has attempted to combat tax evasion and tax fraud through legislative measures to reduce abusive tax planning
practices. In 1998, a special payment on account [SPA] initiative required entities to pay income tax in advance, based
on sales revenues for the previous year. This legislative measure was intended to mitigate some undesirable effects of the
alignment of the Portuguese taxation system with the Portuguese accounting system.
Other countries have adopted different scal policy initiatives to help combat corporate tax evasion and fraud. In Australia
and New Zealand, for example, income tax payments based on provisional expectations of taxable income in the succeeding
year are used. But such provisional tax regimes do not have a minimum or maximum specied tax liability. The amount of
provisional tax can be based on last years residual income tax plus an adjustment or be based on an estimate of the next
years income. In the USA, an Alternative Minimum Tax [AMT] was introduced as part of the Tax Reform Act of 1986 in
response to concerns that a number of rms that reported positive book prots to their shareholders paid no corporate
tax to the federal government (Lyon & Silverstein, 1995, p. 153). Under the AMT, a corporation is required to calculate
its tax liability under both the regular tax rules and the AMT rules . . . [and pay] tax according to the system that results in
the largest income tax liability (Lyon & Silverstein, 1995, p. 153). As these examples suggest, the matter of how to combat
under-payment of tax by corporations is of keen interest in many countries. Consequently, the experience of Portugal in
introducing its unique SPA system should be instructive.
Moreiras (2007) assessment of the impact of the new SPA system focused on the extent to which the introduction of a
minimum tax threshold encouraged companies that otherwise would report negative earnings to change to report positive
earnings. The focus of the current paper is on the impact of the amendment to the minimum and maximum limits of SPA
payments that took effect in 2003. Law No. 32-B/2002 (State budget for 2003) increased the minimum SPA limit to D 1250 and
raised the maximum SPA limit to D 200,000. The new system retained the provision that any excess SPA would be repayable
through deduction against income tax for the year or the following four years, if necessary. This new provision seemed to
imply that rms would not seek refunds of excessive SPA because of the requirement for tax audit. The objective of the
present paper is to determine whether this amendment stimulated strong manipulative behaviour by rms to minimize the
amount of the SPA.
This paper contributes to the meagre volume of research on tax-induced earnings manipulation in continental European
countries by providing new empirical data about tax-related practices of Portuguese private rms. With few exceptions,
the present literature is based on empirical data from Anglo-Saxon countries. Evidence from other geographic, cultural and
institutional contexts will be useful in providing a comparative counterpoint, especially as the determinants of earnings
manipulation in Continental Europe (particularly in Portugal) are not well understood. This is in contrast to understandings
of earnings management in common law English-speaking countries (such as Australia, Canada, UK, USA).
The present study highlights an innovative taxation mechanism that aimed to reduce tax evasion. The results indicate
the propensity for private rms to minimize tax payments through SPA arrangements. Although there is a consensus in
Portuguese society that companies manipulate earnings for tax reasons, no study has hitherto provided empirical evidence
in support of such supposition. This study offers an empirical foundation for deliberations regarding the effects of the close
alignment of the accounting system and the tax system in Portugal. The results reveal some of the problems that have
stemmed from implementing legislative measures such as the SPA. They should be benecial to stakeholders of private
rms, auditors, and tax policy advisors.
In the following section we describe the framework used to explore the earnings management, accounting and tax
environments in which Portuguese private rms operate. Thereafter, we present research hypotheses, describe our research
method, and discuss results.
2. Earnings management and the accounting and tax context of Portuguese private rms
2.1. Earnings management incentives
Earnings management (EM) occurs when nancial information is modied to inuence the decisions of stakeholders
(Healy & Wahlen, 1999). Manipulative practices are facilitated by the exibility of accounting standards which allow
considerable discretion in adopting accounting policies, and in making required estimates.
Most studies of EM incentives have been produced in well developed economies where the capital market is the main
source of funding, and thus, where agency problems are potentially more important (e.g. Dechow, Sloan, & Sweeney 1996;
Healy, 1985; Jones, 1991; Sweeney, 1994). Healy and Wahlen (1999) identied three major groups of incentives: capital
markets, contractual relationships (e.g. compensation plans for managers) and political factors (e.g. political costs). These
incentives are not the main factors encouraging EM in economies (such as Portugals) that are composed essentially by small

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85

companies whose management is exercised mainly by the holders of capital (Moreira, 2006). In these contexts, although
contractual relationships encourage manipulation, tax saving is identied as one of the main incentives prompting rms to
manipulate their accounts (Baralexis, 2004; Blake & Salas, 1996; Moreira, 2006; Othman & Zeghal, 2006). In Portugal some
studies have examined associated matters. Moreira (2006) focused on the impact of the external nancing needs of rms
on accounting choices; and Mendes and Rodrigues (2006) examined earnings smoothing in a sample of listed Portuguese
companies.
2.2. The accounting and tax environment of Portuguese private rms
In Portugal there is a strong link between accounting and taxation. The principal sources of funding of Portuguese private
rms are the banks and the State the main users of nancial statements (Fontes, Rodrigues, & Craig 2005). The present
Portuguese system of income taxation was established in 1989, but by the end of the 1990s it was considered inadequate,
because the actual rate of income tax paid by companies was very low (Decree-Law No. 44/98 of March 3). Subsequently,
Portugal attempted to combat tax evasion and fraud by improving the effectiveness and efciency of inspection services,
and by legislative measures that penalized tax evasion severely.
In 1998, Decree-Law No. 44/98 obliged taxpayers engaged in commercial, industrial or agricultural activity to make an
advance tax payment, known as a special payment on account [SPA]. The SPA was not to be based on the level of earnings,
but on the level of sales revenues. A minimum limit was set for the SPA of approximately D 500, with a maximum limit of
approximately D 1500. According to Sanches and Matos (2003), the SPA payment system was expected to deliver a minimum
value of approximately D 500 to the State by each rm. Article 74 of the decree-law also established the possibility that a
taxpayer could be repaid for any excess payment should the amount of tax liability ultimately be less than the payments
already made.
However, a signicant change to the SPA occurred when Law No. 32-B/2002 was enacted (State budget for 2003). The
minimum SPA limit was increased to D 1250 and the maximum SPA limit was increased to D 200,000. The new system
retained the provision that any excess SPA would be repayable through a deduction against income tax for the present year
or the following four years, if necessary. Amounts not recovered through tax deduction were repayable provided taxpayers
met the requirements of paragraph 3 of Article 87 of the CIRC:
(a) the companys average ratios of protability for the year of the SPA should not be less than 10% of the ratio of other
companies in the same industry;
(b) the situation that gave rise to the reimbursement is considered justied by the inspection which should be made at the
request of the taxpayer within 90 days of the deadline for submission of the tax statement for the year.
3. Research hypotheses
Studies by Hayn (1995) and Burgstahler and Dichev (1997) prompted the adoption of graphical analysis to explore the
statistical distribution of reported earnings and to assess and evaluate EM. Where the distribution of reported earnings of
rms was irregular, this was attributed to EM practices. Coppens and Peek (2005) showed that in European countries with
a strong link between accounting and taxation, the distribution of reported prots was discontinuous between the interval
immediately to the right of zero (the rst positive earnings interval) and the second interval of positive earnings. That is,
the second interval of positive earnings is signicantly lower than the rst interval of positive earnings. The curve for the
distribution of prots to the right of zero was concave. Moreover, Coppens and Peek (2005) noted that in countries where
taxable income and accounting income are calculated using separate rules, the second interval of positive earnings is higher
than the rst interval of positive earnings, and the curve of prots distribution is convex. These ndings have motivated us
to investigate whether the distribution of the earnings of private rms in Portugal (where the tax system and accounting
system are linked closely), is congured with the distribution identied by Coppens and Peek (2005). Thus, we seek to
determine whether there is a large concentration of rms in the rst interval of earnings to the right of zero.
The lack of systematic examination of income tax minimizing manipulations by rms in Portugal encourages us to
investigate whether the large concentration of earnings near zero is due to manipulations motivated by tax avoidance
strategies. We do not expect to nd a large number of companies with negative earnings. This is because nancial statements
are used widely in Portugal in obtaining bank nance, and any reporting of negative earnings would be likely to jeopardize
loan repayment assessments.
With the introduction of the SPA in 1998, the minimum and maximum SPA limits were very low (D 500 and D 1500,
respectively). At that time, rms had little incentive to react strongly to minimize the amount of SPA payments. However, Law
No. 32-B/2002 of December 30, 2002 introduced very signicant changes, particularly with respect to the maximum amount
to be paid (increased to D 200,000). Since the basis of calculation in the changes to the SPA was accounting information for
2002, we expect that Portuguese private rms will have reacted strongly in 2002 to reduce SPA payments through EM
activities.
Burgstahler and Dichev (1997) and Degeorge, Patel, and Zeckhauser (1999) examine whether the earnings reported have
a discontinuous distribution around zero. Such discontinuity is accepted widely to be a consequence of earnings smoothing.
The rst hypothesis tested is:

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M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 8396

Table 1
Sample selection.
Description

No. of companies

Number of companies in SABI

Exclusions:
Listed companies
Financial sector
Cooperatives, associations and companies without legal form
Required data not available for both years
Sample

20,088

Hypothesis 1.
earnings.

(95)
(132)
(1042)
(12,167)
6652

There is no difference in the frequency of slightly negative earnings and the frequency of slightly positive

We expect to conrm the ndings of Coppens and Peek (2005), outlined earlier. Since accounting earnings in Portugal are
the starting point for determining taxable income, it is expected that companies will make accounting choices to minimize
earnings. This will happen if the distribution of prots is discontinuous between the rst interval of positive earnings
immediately to the right of zero, and the second interval of positive earnings to the right of zero. This expectation is tested
in the following hypothesis:
Hypothesis 2. There is no difference in the frequency of earnings in the rst interval to the right of zero and the frequency
of earnings in the second interval to the right of zero.
Goncharov and Zimmermann (2006) found that companies with higher average tax rates are more prone to develop
earnings manipulation practices to minimize income tax expenditure than companies with lower average tax rates. No
empirical studies have demonstrated the common belief that Portuguese private rms adopt accounting policies for tax
planning.
Hypothesis 3. Firms with high average tax rates are no more likely to manipulate earnings downwards than are rms with
low average tax rates.
Because of the substantially increased limits of the SPA that were introduced on December 31, 2002 (and which were
effective for the nancial year 2003) we expect that rms will have reacted to minimize SPA. Since the SPA for 2003 was a
function of sales revenues for 2002, it is expected that private rms would have reacted in 2002. If manipulation is conrmed,
there will be a higher level of manipulation in rms whose SPA is located between the minimum (D 1250) and maximum
(D 200,000) values. For companies whose SPA is estimated at, or above, the maximum payment of D 200,000, no downwards
manipulation is expected. The hypothesis we explore is:
Hypothesis 4.

In 2002 there was no earnings manipulation induced by the need to minimize expenditure on the SPA.

4. Research design and sample selection

4.1. Sample selection and data
A study of private companies is justied since they are likely to have a strong incentive to save tax (e.g. Baralexis, 2004;
Blake & Salas, 1996; Moreira, 2006). With the exception of Hypothesis 4, the data analysed refer to the tax years 2001 and
2002, thereby yielding a large number of observations.
The data source was individual accounts (since this kind of reporting is used commonly for tax purposes) held by the
Sistema de Anlise de Balancos Ibricos (SABI) [Analysis System of Iberian Balance Sheets]. Financial sector rms, cooperatives
and others companies without legal form were eliminated because they use industry-specic accounting rules and accruals
that are very different. When collecting data, we noticed that many of the remaining 18,819 rms were not in the database
for both years 2001 and 2002, or did not have all of the accounting information necessary for the study. After deleting these
observations, the sample size was 6652 rms: 3255 rms in 2001 and 3397 rms in 2002 (Table 1).
Descriptive statistics for the sample are presented in Table 2. Panel A separates the statistics for the years 2001 and 2002.
In determining discretionary accruals and the levels of manipulation, we used the model proposed by Jones (1991) and
modied by Dechow, Sloan, and Sweeney (1995). This model is used widely for determining discretionary accruals that are
considered to be a proxy of manipulation. We partitioned total accruals into discretionary and non-discretionary accruals,
consistent with Dechow et al. (1995), so that:
TAit = 0 + 1 (REVit RECit ) + 2 (TAssetsit ) + it

(1)

where i and t correspond to the rm i and the year t, respectively, and TA is the variation of total accruals between year
t and t 1, divided by total assets; REV is the revenue for year t less the revenue for year t 1, divided by total assets for
year t 1; REC is the net receipts for year t less net receipts for year t 1, divided by total assets for year t 1; TAssets is the
tangible assets in year t divided by total assets for year t 1; is the disturbance term.The total accruals were determined

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87

Table 2
Descriptive statistics.
Parameters

2001

2002

Panel A: total assets, sales revenues, earnings, income tax, and discretionary accruals (Euros 000s)
Total assets
9011.65
8146.58
Mean
3229.00
3071.00
Median
23,115.07
19,227.80
Standard deviation
Sales revenues
11,622.81
9502.49
Mean
Median
4363.00
3898.00
Standard deviation
38,762.52
34,253.80
Net income
282.07
205.47
Mean
Median
57.00
48.00
Standard deviation
1188.08
1598.94
Income tax
112.08
Mean
152.63
Median
32.00
24.00
Standard deviation
585.73
330.49
Discretionary accruals
99.99
205.68
Mean
4.37
Median
0.40
Standard deviation
4438.52
4060.30
Number of observations
3255
3397
Low AITR

Parameters

High AITR

Panel B: sales revenues, earnings, income tax, and discretionary accruals per average income taxes rates (AITR) (Euros 000s)
Sales revenues
10,014.93
10,871.45
Mean
4239.50
Median
4045.50
Standard deviation
23,463.40
42,786.34
Net income
200.88
269.51
Mean
60.00
48.00
Median
1833.44
1065.49
Standard deviation
Income tax
165.64
Mean
78.51
Median
14.00
39.00
268.32
563.11
Standard deviation
Discretionary accruals
302.81
60.02
Mean
7.15
6.52
Median
5478.10
3240.15
Standard deviation
2574
4078
Number of observations
Sales revenues

Net income

Panel C: Pearson and Spearman correlation coefcients

0.554*** (0.000)
Sales revenues
0.226*** (0.000)
Net income
0.353*** (0.000)
0.659*** (0.000)
Income tax
0.068*** (0.000)
0.190*** (0.000)
Discretionary accruals
0.011 (0.352)
0.024* (0.054)
Average income tax rate

Income tax
0.634*** (0.000)
0.818*** (0.000)
0.054 (0.000)
0.090*** (0.000)

Discretionary accruals
0.008 (0.523)
0.108*** (0.000)
0.055*** (0.000)

Average income tax rate

0.025** (0.038)
0.006 (0.620)
0.277*** (0.000)
0.026** (0.033)

0.028** (0.023)

Pearson correlation coefcients are presented below the diagonal. Spearman correlation coefcients are presented above the diagonal. In parentheses are
the associated p-values of bi-directional tests.
*
Signicance level of 10%.
**
Signicance level of 5%.
***
Signicance level of 1%.

as follows:
TAt = [current assetst cash flowst ] [current liabilitiest Non-current liabilitiest Income taxt ]
Depreciationt

(2)

where  is calculated by the difference between t and t 1.

To estimate the coefcients, the model was regressed for each sector of economic activity, including all rms with same
rst digit of the Portuguese Classication of Economic Activities [Classicaco das Actividades Econmicas] (CAE) (i.e. 0#, 1#,
2#, 3#, 4#, 5#, 6#, 7#, 8#, 9#). The model assumes implicitly that all rms in each industry share the same incentives for
manipulation.

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M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 8396

Because total accruals (TA) include non-discretionary accruals (NDA) and discretionary accruals (DA), the difference
between total accruals and non-discretionary accruals is the discretionary accruals. These are considered to be a proxy for
EM.
TAt = NDAt + DAt DAt = TAt NDAt
In terms of the operationalization of the model, this means that the component not explained by the model variables,
the disturbance term (it ), is the discretionary accruals.
Panel A shows a marked reduction in sales revenues and associated economic performance indicators from 2001 to 2002,
possibly because of the sharp slowdown in economic growth in Portugal that started in the latter half of 2001. Consequently,
there was a marked reduction in the average income tax paid by rms in 2002. However, there was an increase in the average
level of discretionary accruals in 2002: the median is well below that of the previous year. A reasonable conjecture is that
this change arises because the legislation in 2002, introducing the SPA, created incentive for rms to minimize tax payments.
Panel B reports data for the two years together, for companies in terms of their average income tax rate (AITR). The
classication of rms as high AITR or low AITR was based on the income tax rate in force in the year. Thus, for the year 2001,
rms with an AITR 32% were classied as having a high AITR; and those <32% were considered low AITR rms. For 2002 a
rate of 30% was used to differentiate high AITR rms and low AITR rms, since the tax rate had decreased.
In Panel B, despite the mean of the net income for low AITR rms being below the mean of the net income for high
AITR rms, the median of the high AITR rms is signicantly lower than that of the low AITR rms. This signal is consistent
with companies with low AITR being more likely to manipulate their earnings upwards; and with taxes not being the main
prevailing incentive for these companies. In companies with high AITR, discretionary accruals are less in terms of mean and
median than those estimated for rms with low AITR.
Panel C presents Pearson correlation coefcients and Spearman correlation coefcients for the various parameters examined in Panel B.
Panel C conrms the relationship between estimated discretionary accruals and AITR, since rms with high AITR have
higher levels of manipulation downwards.
In this study, it is expected that the amendment to the SPA law was a catalyst for the manipulation of earnings. Since
the SPA in 2003 is a function of sales revenues for 2002, it is expected that, to reduce SPA, earnings (E) should be correlated
negatively with the SPA. The assumptions required for calculation of the Pearson correlation coefcient do not exist, and
so we calculated the Spearman correlation coefcient. As expected, Spearmans correlation coefcient (0.154) revealed a
signicant negative correlation between E and the SPA (p 0.001).

4.2. Graphical analysis

Consistent with Hayn (1995) and Burgstahler and Dichev (1997), we analysed the frequency distribution of reported
company earnings, assessing whether the distribution of earnings within less favourable intervals has frequencies lower
than those expected; and whether the distribution of earnings within more favourable intervals has frequencies higher
than expected.
The magnitude of the interval used to graphically and statistically analyze the distribution of earnings is important: the
scale is crucial in the provision of results and will affect the analysis. Thus, consistent with Goncharov and Zimmermann
(2006), to dene the magnitude of intervals, we considered the optimal size of intervals to be a positive function of the
variability of the sample (i.e. inter-quartile range), and a negative function of sample size:
A = 2 (IQ ) N 1/3

(3)

where A is the amplitude of the optimal intervals; IQ is the inter-quartile range (i.e. the difference between quartile 1 and
quartile 3); N is the number of observations.
In the sample, the optimal interval is approximately 0.01.
After observing the distributions of earnings (Hypotheses 1 and 2), we tested whether the discontinuities are statistically
signicant, using the test of standardized differences applied by Burgstahler and Dichev (1997):
=

na ne
=


ni ((ni1 + ni+1 )/2)

Npi (1 pi ) + ((N(pi1 + pi+1 )(1 pi1 pi+1 ))/4)

(4)

where  is the statistic test with approximately normal distribution na is the number of observations present in the interval;
ne is the expected number of observations in the interval;  is the standard deviation of the difference; ni is the number of
observations in interval I; N is the number of observations; pi is the proportion of observations in interval i.
According to the  statistic, the number of observations expected in an interval (ne ) is the average of the observations in
adjacent intervals.

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89

4.3. Logit model

To test Hypothesis 3 (that the discontinuity around zero is due to rms manipulating their earnings to minimize tax) we
apply a logit model to the data for 2001 and 2002:
EMit = 0 + 1 DAit + 2 CFit + 3 Ln Ait + 4 AITRit + it

(5)

where EM is the dummy variable which takes the value 1 if the rm reported deated earnings in the interval [0.00; 0.01);
and 0, if it reported deated earnings in any other interval; DA is the deated estimated discretionary accruals; CF is the
deated cash ows calculated as the difference between operating earnings and total accruals (consistent with Leuz, Nanda,
& Wysocki, 2003); Ln A is the natural logarithm of assets; AITR is the dummy variable that takes the value 1 if the rm has
a high average income tax rate; and 0, if the rm has a low average tax income rate; is the disturbance term; i and t are,
respectively, the rm i and the year t (with t = 2001, 2002).
Phillips, Pincus, and Rego (2003) found the sign of the variables DA and CF to be positive. They interpret this as evidence
that rms tend to manipulate to avoid losses. In the present sample, the expectation is that rms use accruals and cash ows
to manipulate prots downwards, for reasons of tax planning. Thus, it is expected that the sign of the coefcients of these
two variables will be negative. According to Goncharov and Zimmermann (2006), if rms have high marginal tax rates they
will reduce earnings for tax reasons. Similarly, it is expected that the higher the average tax rate, the greater the likelihood
that rms will report earnings close to zero; and that therefore, the coefcient of this variable will be positive. The Ln A
variable controls for the company size. We do not predict the sign for its coefcient.
4.4. Regression analysis
Because of the imposition of new and more onerous limits for the SPA, rms are expected to have reacted by minimizing
income tax expense. However, such behaviour is not expected in rms whose SPA reached the maximum level. To test
Hypothesis 4 we used the following regression model:
DAi = 0 + 1 SPAi + 2 LIMi + 3 AITRi + 4 Ln Ai + 5 LIMi AITRi + i

(6)

where DA is the estimated discretionary accruals; SPA is the estimated special payment on account; AITR is the dummy
variable that takes the value 1 if the company has a high average income tax rate; and 0, if the average tax income rate is
low; LIM is the dummy variable which takes the value 1 if the estimated SPA is greater than D 200,000 and 0, if the estimated
SPA is in the range [1250; 200,000); Ln A is the natural logarithm of assets; LIM AITR is the interactive variable that is the
product of variables LIM and AITR; is the disturbance term; i represents each of the rms in the sample in 2002.
The discretionary accruals used are those that were estimated from the modied model of Jones (1991).
To determine the value of SPA we used the following expression, which is based on the decree-law that implemented
the SPA regimen:
SPA2003 = 1% REV2002 PA2002

(7)

where SPA is the special payment on account to be made in 2003; REV2002 is the revenues and gains for the year 2002; PA2002
is the estimate of the value of payments on account in 2002.
If rms manipulated earnings to minimize SPA expenditure, we expect to nd a signicant relationship between discretionary accruals and SPA. To minimize SPA, rms could have deferred recognition of revenues. Thus, it is expected that the
sign of the coefcient of this variable will be negative.
We expect the coefcient of variable AITR to be negative since companies with a higher income tax rate will have incentives
to manipulate accounts to decrease revenues. Regarding the LIM variable, we expect a positive coefcient, since rms
with more than the SPA ceiling will tend not to manipulate revenues. In these rms, other incentives (such as endeavours
to strengthen negotiating power with nancial institutions) seem likely to dominate. The interactive variable LIM AITR
controls the prevailing incentives in rms with high average income tax rates and with a SPA exceeding the maximum limit
of D 200,000. For these companies, we expect discretionary accruals will have the effect of minimizing income tax. The sign
of this variable should be negative. Finally, the variable Ln A controls for the size of the private rms. No sign is predicted
for it.
5. Results and discussion
5.1. Earnings distribution
Graph 1 shows net earnings reported by rms for 2001 and 2002. To reduce the problem of heteroscedasticity, net
earnings of each rm were deated by the corresponding total assets of the previous nancial year (e.g. Coppens & Peek,
2005; Gore, Pope, & Singh, 2007).
Table 3 sets out the number of companies in the intervals close to zero, the standardized differences () for each of the
intervals, and the respective p-values.

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M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 8396

1,500

1,200

Frequency

900

600

300

0
-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

Intervals of deflated earnings

Graph 1. Distribution of net income for 2001 and 2002. N = 6652. Amplitude of interval = 0.01. The y-axis represents the number of observations for each
range of deated earnings. The x-axis represents the range of earnings deated by total assets of the previous year. For example, in the rst interval to the
right of zero, the number of rms with deated earnings in the range [0; 0.01) can be observed. The histogram was truncated at the 30th intervals, on both
sides, without disturbance.

Graph 1 and Table 3 highlight a signicant discontinuity around zero: that is, between the interval [0.01; 0) (the rst
interval left to the left of zero) and the interval [0; 0.01) (the rst interval to the right of zero). Table 3 shows the rst interval
to the left of zero has 234 rms per year, and the rst interval to the right of the zero has 1504 rms per year. Furthermore,
in the intervals to the right of zero, net earnings are pushed to the barrier of zero, as evidenced by the concave nature of the
distribution to the right of zero. Moreover, there is a signicant discontinuity between the rst and second interval to the
right of zero.
The discontinuity around zero is conrmed by the  statistic in Table 3; that is,  [0.01, 0) = 24.63 (p-value < 0.01). This
indicates that this range is signicantly under-represented. As in Burgstahler and Dichev (1997), Gore et al. (2007) and
Moreira (2006), the number of observations in the interval immediately to the left of zero is signicantly lower than the
expected number of observations. For the rst positive interval the situation is the reverse:  [0, 0.01) = 23.62 (p-value < 0.01),
suggesting that the number of observations in the interval of deated earnings immediately to the right of zero is signicantly
larger than the expected number of observations.
The general conguration of the distribution of earnings is consistent with the presence of EM (e.g. Burgstahler & Dichev,
1997; Degeorge et al., 1999; Hayn, 1995). In the absence of manipulation, Burgstahler and Dichev (1997) argue that the
distribution of earnings would be approximately symmetric. Indeed, we conrm an abnormally low frequency of slightly
negative net earnings, and an abnormally high frequency of slightly positive net earnings. Thus, this is consistent with rms
Table 3
Distribution of deated net earnings in intervals close to zero.
Category

Number of companies
Standardized differences 
p-Value

Negative intervals

Positive intervals

0.02 < E < 0.01

0.01 E < 0

0 E < 0.01

0.01 E < 0.02

98
4.081
0.000

234
24.633
0.000

1.504
23.622
0.000

997
-3.210
0.001

The number of rms represents the absolute frequency of rm-years with deated earnings for 2001 and 2002 in two intervals to the left of zero and two
intervals to the right of zero. The  statistic for each interval represents the standardized difference between the number of observations and the current
number of expected observations. The expected observations represent the average of expected observations of adjacent intervals.

M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 8396

91

with slightly negative net earnings (as in Burgstahler & Dichev, 1997) manipulating their earnings gure to make it slightly
positive: that is, rms tend to manipulate their earnings upwards to avoid reporting losses.
In assessing such behaviour, Carslaw (1988) deemed the zero point to be a cognitive reference point where perceptions
of funders and investors about the performance of rms are inuenced strongly by the sign (negative or positive) of net
earnings. Thus, rms with negative net earnings have incentives to manipulate earnings to break through the barrier of zero.
Since there are graphical and statistical differences in the frequency of slightly negative earnings and the frequency of
slightly positive earnings Hypothesis 1 is not conrmed.
Studies by Gore et al. (2007), Burgstahler and Dichev (1997), and Coppens and Peek (2005) in Anglo-Saxon countries
found that the peak of the distribution was in the positive intervals beyond the rst interval. This is explained by evidence
that managers tend to manipulate earnings to show their rm is in a healthy economic and nancial situation. In such cases,
managers are not constrained by tax planning considerations, since taxation is based on statements made specically for
this purpose. In countries whose accounting and tax systems are related closely, a similar pattern of earnings distribution is
not found because nancial statements are used primarily for tax purposes. Managers have strong incentives to manipulate
nancial statements to minimize tax expenditure (e.g. Coppens & Peek, 2005; Goncharov & Zimmermann, 2006; Moreira,
2006).
In Portugal, because taxable income is based on accounting earnings, it is expected that rms adopt accounting policies
to maximize tax savings. Graph 1 shows a signicant discontinuity between the rst and second range of positive deated
income levels (as with Coppens & Peek, 2005). The peak of the distribution of earnings occurs in the interval [0; 0.01). The
number of rms in the rst interval (1504) is signicantly higher than the number of rms (997) concentrated in the second
interval [0.01; 0.02) (or any other interval).
Table 3 conrms the graphical evidence and reveals a signicant negative difference between the actual and the expected
observations in the second interval of positive earnings, where  [0.01, 0.02) = 3.210 (p < 0.01). This conrms that the observed
number of rms in this interval is signicantly lower than expected. A plausible explanation for this is that rms manipulate earnings downwards to minimize the burden of income tax. (This is analysed further in the following discussion of
Hypothesis 3.)
Although there is an incentive to save tax, rms are not interested in pushing net earnings into the loss intervals to the
left of zero. The reason for this is that in recent years in Portugal, tax audits of rms that reported negative earnings have
increased. Another explanation is that the nancial statements are relied upon commonly by rms when obtaining bank
funding (e.g. Moreira, 2006). Thus, the higher frequency of rms in the rst interval is explained by them wanting to avoid
reporting losses. However, for tax reasons, rms have a countervailing incentive to push positive earnings into the region
closest to the limit of zero. Again, Hypothesis 2 cannot be conrmed since there are graphical and statistical differences in
the frequency of earnings in the rst and the second intervals to right of zero.
5.2. Earnings management to reduce income tax
5.2.1. Graphical analysis
To test Hypothesis 3, the sample was divided into two sub-samples: those with high average income tax rate and those
with low average income tax rate. The average income tax rate (AITR) was determined by dividing the income tax paid by the
income (earnings) before taxes. For the reason mentioned above, both variables were deated by total assets of the previous
period.
In determining income tax, companies often make adjustments in accord with the tax law (since there are accounting
expenses which are not tax expenses). Because of this, the nominal tax rate in the tax law will only be the AITR dened above
in exceptional circumstances. Thus, companies with high AITRs are more likely to use discretionary accruals to reduce net
income to avoid reporting losses.
If the behaviour of the two sub-samples in relation to the various incentives differs, the graph of net earnings distributions
will differ signicantly. For the sub-sample of rms with low AITR, if no manipulation occurs for tax reasons, then the
distribution of net earnings should correspond with what is happening in countries where the link between accounting and
taxation is less signicant (Goncharov & Zimmermann, 2006). So, it is expected that these rms will show signs of upward
EM. With regard to the distribution of earnings of rms with high AITR, a signicant discontinuity between the rst and
second interval to the right of zero is expected, because these rms have strong incentives to save tax. The peak of the
distribution in the sub-sample of high AITR is expected to be in the rst interval to the right of zero. In the sub-sample with
low AITR, the peak is expected to be observed in a positive range, but not in the rst interval.
Graph 2 shows the distribution of earnings for 2001 and 2002 of high AITR rms (32% and 30%, respectively). Graph 3
represents the distribution of net income for 2001 and 2002 of low AITR rms (<32% and 30%, respectively).
In Table 4 we present, for the two sub-samples, the number of rms in the intervals close to zero, the standardized
differences () for each of the intervals and the respective p-values.
Graph 2 and Panel A of Table 4 show that for rms with high AITR, the highest concentration of rms is located in the rst
interval to the right of zero. There is a signicant discontinuity between this interval and the second interval to the right of
zero. Graph 3 and Panel B of Table 4 show that for rms with low AITR, the distribution to the right of zero is much smoother,
with the peak of the distribution in the second interval to the right of zero, as expected. Unlike the case of high AITR rms, in
Graph 3 it is unclear whether there is any discontinuity to the right of zero. The reason for the different pattern of earnings

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M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 8396

1,500

1,200

Frequency

900

600

300

0
-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

Intervals of deflated earnings

Graph 2. Distribution of earnings of rms with high average income tax rates for 2001 and 2002. N = 4078. Amplitude of interval = 0.01. The y-axis represents
the number of observations for each range of deated earnings for 2001 and 2002 of rms with high AITR. The histogram was truncated at the 30th intervals
on both sides with no disturbance.

700

600

500

Frequency
400

300

200

100

0
-0.30

-0.20

-0.10

0.00

0.10

0.20

0.30

Intervals of deflated earnings

Graph 3. Distribution of earnings of rms with low average income tax rates for 2001 and 2002. N = 2574. Amplitude of the interval = 0.01. The y-axis
represents the number of observations for each range of deated earnings. The x-axis represents the range of deated earnings for 2001 and 2002 of rms
classied as low AITR. The histogram was truncated at the 30th intervals on both sides, with no disturbance.

M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 8396

93

is that rms with low AITR do not have a major incentive to minimize income tax expense, contrary to the experience of
rms with a high AITR.
In both sub-samples there is a discontinuity between the rst interval to the left of zero and the rst interval to the right
of zero. In both cases rms avoid reporting losses: this seems likely to be related to the need of most Portuguese rms to
resort to external nancing (Moreira, 2006).

5.2.2. Logit analysis

To conrm the graphical evidence statistically, we used the logit model described earlier. The results are presented in
Table 5.
As expected, the signs of the coefcients of the variables DA and CF are negative and signicant, suggesting that the
increase in discretionary accruals and cash ows reduces the likelihood of rms reporting positive earnings in the rst
interval. As with Goncharov and Zimmermann (2006), the coefcient of the AITR variable is positive, highly signicant, and
consistent with the evidence obtained graphically. This result is consistent with the hypothesis that the higher the AITR, the
greater the likelihood that rms manipulate their earnings to very close to zero.
The results conrm the graphical analysis. The large concentration of rms immediately to the right of zero can be
explained by tax planning behaviour intended to minimize income tax. Thus, Hypothesis 3 is rejected.

5.3. The impact of the change in the SPA system on earnings manipulation
Hypothesis 4 contends that changes in the SPA rules in 2002 had no effect on earnings management. In 2003, rms had to
comply with a SPA whose maximum value (D 200,000) was particularly high. The changed rules took effect from 2003 and
beyond. However, because the calculation of the SPA is a function of sales revenues for 2002, it is expected that manipulation
will have taken effect in the 2002 nancial year. This is the reason for examining the impact of this change using accounting
information for 2002.

Table 4
Distribution of deated net earnings in intervals close to zero.
Category

Negative intervals
0.02 < E < 0.01

Panel A: rms with high average income tax rates

5
Number of companies
10.534
Standardized differences 
0.000
p-Value
Panel B: rms with low average income tax rates
93
Number of companies
Standardized differences 
1.153
0.125
p-Value

Positive intervals
0.01 E < 0

0 E < 0.01

0.01 E < 0.02

140
25.808
0.000

1.243
25.320
0.000

718
4.874
0.000

94
6.425
0.000

261
4.202
0.000

279
1.497
0.067

The number of rms represents the absolute frequency of rm-years with high (Panel A) and low (Panel B) average income tax rates with deated earnings
for 2001 and 2002 in two intervals to the left of zero and two intervals to the right of zero. The  statistic for each interval represents the standardized
difference between the number of observations and the current number of expected observations. The expected observations represent the average of
expected observations of adjacent intervals.

Table 5
Logit model of the effect of income taxation.
EMit = 0 + 1 DAit + 2 CFit + 3 Ln Ait + 4 AITRit + it
Independent variables

Predicted sign

Estimated coefcients (p-value)

Intercept
DA
CF
Ln A
AITR
N
2 (Pearson goodness-of-t test)

?
+

2.957*** (0.000)
3.606*** (0.000)
4.444*** (0.000)
0.139*** (0.000)
1.461*** (0.000)
6.647
6.73703 (0.217)

Dependent variable: EM = dummy variable which takes the value 1 if the rm reported earnings (deated) in the interval [0.00; 0.01); and 0, if it reported
earnings in any other interval. Independent variables: DA = deated estimated discretionary accruals; CF = deated cash ows calculated as the difference
between operating earnings and total accruals (consistent with Leuz et al., 2003); Ln A = natural logarithm of assets; AITR = dummy variable that takes the
value 1 if the rm has a high average income tax rate; and 0, if the rm has a low average tax income rate. = disturbance term. i and t are, respectively,
the rm i and the year t (with t = 2001, 2002). The p-values correspond to bi-directional tests.
***
Signicance level of 1%.

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M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 8396

Table 6
Pearson and Spearman correlation coefcients.
DA
DA
SPA
LIM

0.050*** (0.004)
0.044** (0.013)

SPA

LIM

0.017 (0.345)

0.035** (0.049)
0.361*** (0.000)

0.342*** (0.000)

Pearson correlation coefcients are presented below the diagonal. Spearman correlation coefcients are presented above the diagonal. In parentheses are
the associated p-values of bi-directional tests.
**
Signicance level of 5%.
***
Signicance level of 1%.

5.3.1. Regression analysis

The Pearson correlation coefcient (see Table 6) shows a signicant negative correlation between variables SPA and
DA and a signicant positive correlation between the coefcients of variables DA and LIM. These correlations evidence a
downward manipulation in rms whose SPA is between the minimum and maximum limits under the new income tax
regime. For the subset of rms whose estimated SPA is greater than or equal to the maximum, there is an upward EM.
Table 7 shows that all the signs of coefcients of explanatory variables, except for the AITR variable, are highly signicant
and consistent with expectations. For the SPA variable (which reects the estimated value of the SPA to be settled in 2003)
there is a signicant relationship with the level of discretionary accruals. This is consistent with a higher level of manipulation
downwards because the outstanding balance of the SPA is greater. For rms whose SPA is equal to or greater than D 200,000
(after controlling for LIM), there was a positive a coefcient, suggesting upward EM via discretionary accruals.
As expected, LIM indicates that rms in this sub-sample did not manipulate earnings to minimize SPA, as did other rms.
This incentive is not important for rms liable to pay the maximum SPA. Firms whose estimated SPA reached the maximum
seem to have incentives that promote upward EM. However, this pattern of manipulation is not observed in rms with high
AITR, because the coefcient of an interactive variable, LIM AITR, is negative and signicant. The result for this variable is
consistent with the idea that incentives for rms in this subset to engage in upwards manipulation do not dominate. Further,
inuenced by tax burden, rms with high AITR and a SPA estimated at (or above) the ceiling, manipulated downwards. The
dominant incentive is the tax burden. Although the level of prediction is reduced, the evidence is not consistent with
Hypothesis 4.
5.3.2. Additional evidence
The effect of introducing and amending rules governing the SPA can also be gauged, albeit partially, by observing the
evolution in the income tax paid by rms. Assuming that the implementation of the SPA (and its amendments) involved
changes in the income tax collected by the State, we would expect a signicant increase in tax paid by rms. As noted in
Graph 4, this was not the case. Graph 4 shows the history of the median and mean income tax payments between 2000 and
2004.
Although this result could be inuenced by other factors in the macroeconomy, Graph 4 shows that there were only minor
changes in the mean and the median income tax over the period 20002004. The increase in SPA limits did not produce
signicant impacts on the collection of tax by the State.
To check for manipulation through the recognition of deferred revenues, we use Levenes univariate test of the equality
of variances for variation in the revenues between 2001 and 2002 (REV).We analysed the standard deviations for the two
sub-samples: rms whose estimate of SPA is located in the interval [D 1250; D 200,000); and rms whose estimated SPA is
at, or above, the ceiling. We expected to reject the null hypothesis; in other words, to nd that the variances are equal. If
rms whose SPA is estimated to be in the range [D 1250, D 200,000) manipulated earnings by deferring revenues, then the
Table 7
Regression model on the impact of the change of the SPA.
DAi = 0 + 1 SPAi + 2 LIMi + 3 AITRi + 4 Ln Ai + 5 LIMi AITRi + i
Independent variables

Predicted sign

SPA
LIM
AITR
Ln A
LIM AITR

R2 Ajust. (%)
N

Estimated coefcients (p-value)

0.082*** (0.000)
0.064*** (0.009)
0.014 (0.425)
0.136*** (0.000)
0.073*** (0.002)
3.5
3217

Dependent variable: DA = estimated discretionary accruals deated. Independent variables: SPA = special payment on account; LIM = dummy variable that
takes the value 1 if the estimated SPA is greater or equal to D 200,000 and 0, if the estimated SPA is in the range [1250; 200,000). Ln A = natural logarithm
of assets. LIM AITR = interactive variable that is the product of variables LIM and AITR. The AITR is a dummy variable that takes the value 1 if the company
was classied as having a high average tax rate and 0 otherwise. = disturbance term. i is the rm i. The p-values correspond to bi-directional tests.
***
Signicance level of 1%.

M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 8396

95

600
500
400
300
200
100
0
-100

2000

2001

2002

2003

2004

-200
-300
Mean - SD

Mean

Mean + SD

Median

Graph 4. Evolution of the median and average income tax paid between the years 2000 and 2004. The y-axis expresses income tax in D 000s. The x-axis
represents years 20012004.

Table 8
Analysis of variability of REV.
Snedcors F statistic

Signicance

Panel A: Levenes test for equality of variances

694.415

0.000

Sub-samples

Standard deviation (N)

Panel B: standard deviation of REV

Firms with SPA in range [D 1250; D 200,000)
Firms with SPA D 200,000

2,319,071 (2.924)
14,669,031 (141)

variability of the revenues relative to the mean will be lower than in rms with no incentive to minimize the SPA. The results
for the test and for the standard deviations of the two sub-samples are shown in Table 8.
Despite the difference in the number of companies, as predicted, the hypothesis that there will be equal variances was
rejected. Moreover, there was a signicant difference for the standard deviation of REV between the two sub-samples.
These results show that rms with greater motivation to minimize SPA expenditure had less variability in revenues in
relation to the mean. In the other sub-sample, the extent of variation is signicantly higher, corroborating results obtained
in the regression model. Firms with greater incentives to minimize SPA expenditure converged comparatively more in the
recognition of revenues.
6. Conclusions
Legislative measures to minimize tax planning to combat tax evasion and fraud (such as the SPA in Portugal) have been
a feature of many national tax regimes. For countries where there is a close relationship between accounting earnings and
taxable income (such as France, Belgium, Italy and Japan), the ndings we report for Portugal should be especially instructive.
Thus, for rms with higher AITR there appears to be a greater propensity for downwards earnings manipulation. These rms
have a strong incentive to minimize income tax and to report earnings close to zero. The frequency distribution of reported
earnings is concentrated very signicantly in the rst interval of earnings to the right of zero. For rms with low AITR, the
distribution of earnings is consistent with results in countries where accounting and taxation are not aligned. The graphical
and statistical evidence show that, in addition to earnings distribution, these rms have a convex conguration to the right
of zero, with the peak on the second range of earnings. Thus, the incentive for the minimization of income tax does not
appear to be dominant for these rms.
We tested whether the legislation increasing SPA limits from 2003 onwards had an impact on the reporting of earnings
for 2002. Our prediction that the sharp increase in the maximum SPA due to the new law would increase income tax
signicantly was conrmed: rms whose SPA was estimated between the minimum and maximum levels had discretionary
accruals higher than other rms. Indeed, the perceived discretion in this set of rms shows a more signicant manipulation
of SPA expenditure. This is consistent with expectation that rms minimize SPA by deferring the recognition of revenues. The
sub-sample of rms with greater motivation to minimize expenditures on SPA had a lower standard deviation of changes
of revenues in relation to the mean, while in the other sub-sample the extent of variation was signicantly higher. This

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M. Marques et al. / Journal of International Accounting, Auditing and Taxation 20 (2011) 8396

suggests that rms with greater motivation to make income tax savings converged comparatively more in the recognition
of revenues.
Portugal should be regarded as one of the bloc of countries in which rms report earnings very close to zero due to
a dominant income tax savings incentive (Coppens & Peek, 2005). There is a large concentration of rms with deated
earnings in the rst positive interval, consistent with the high degree of alignment between the accounting and tax systems.
The results also point to the potential inadequate outcome of the implementation of legislative measures such as the SPA.
Thus, it is unsurprising that in the State Budget for 2004, the Portuguese government again changed the rules governing the
SPA. The ceiling was reduced from D 200,000 to D 40,000 and the basis of calculation was modied completely. With this
new amendment, income tax was generally considered fairer and less onerous.
The effect of tax policy on cash ow and earnings is a sensitive matter for private rms everywhere. Tax policy appears
to have had a signicant effect on accounting policy choices because tax liability is based on a measure closely related to
reported earnings. Thus, those who audit and regulate the accounting behaviour of rms should renew efforts to ensure
(as best they can) that reported earnings, even if prepared in accord with generally accepted accounting principles, are not
contrived to represent distortions of a rms real nancial performance. Accordingly, tax policy bureaucrats, advisors and
legislators should draw on the results of this study to re-invigorate efforts to introduce scal revenue raising measures
that are less capricious (at least in the eyes of taxpayers) and less avoidable through deployment of allowable discretion in
accounting policy choices.
Acknowledgements
We are indebted to Jos Moreira, Adrian Sawyer, Hai Lu, Jos Machado, the editor, and two anonymous referees for their
helpful comments and suggestions on earlier versions of this paper.
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