Urska Kosi University of Macedonia , Lancaster University Aljosa Valentincic

1. Write-offs and profitability in private firms – disentangling the impact of tax-minimisation incentives Urska Kosi University of Macedonia, Lancaster University Aljosa Valentincic University of Ljubljana Varna, Mar 2010

2. Motivation • Burgstahler, Hail and Leuz (2006, p. 988): • Studies (e.g. Ball et al., 2000) hypothesize that the link between financial and tax accounting can play an important role in firms’ reporting behavior. … However, there is little direct evidence supporting this hypothesis. • Private-firms setting: • Role of incentives on financial reporting outcomes • Concentrated ownership  agency conflicts, demand for financial reporting • Accounting discretion governed by reporting incentives: • tax-minimisation, dividend payout, debt financing, employee relations • Accounting discretion captured by specific accrual  asset write-offs (increase power of tests) • Isolating specific reporting incentive  exogenous change in tax legislation (type of a “natural experiment”) • One incentive changed, others remain unchanged • Approach substitutes for direct modelling of reporting incentives

3. Hypothesis • Relation between accounting discretion and firms’ reporting incentives asset write-offs and profitability • Accounting standards  negative relation • Empirical literature  positive relation (economic benefits) (e.g. Brown et al. 1992, Garrod et al. 2008, Szczesny, Valentincic 2009) • Important economic benefit  tax-savings • Change in corporate tax legislation  from 2005 current and fixed asset write-offs no longer tax deductible • The same reporting incentives but different tax treatment of write-offs  substitutes for direct modelling of firms’ (unobservable) reporting incentives • Controlling for known factors in existing literature • H: The magnitude of write-offs will decrease if write-offs cease to be a tax-deductible expense, conditional on the decision to write off.

4. Data & sample Small private firms in Slovenia: 2004 & 2005

5. Data & sample (cont.)

6. Methodology

7. Tobit regression

8. Reverse regression

9. Sensitivity analyses • Test if write-offs signal weakening future performance  insignificant coefficient estimates • Including loss dummy variable • Modelling decision to write-off (logit models)  incremental decrease in the positive relation

10. Conclusions • Findings confirm that magnitude of write-offs, conditional on the decision to write-off, are positively associated to firm profitability • Accounting discretion used to extract economic benefits • tax-savings, dividend payouts, employee relations • Econometric challenge to disentangle the tax benefit • Type of a “natural experiment” (tax legislation change) • Approach substitutes for direct modelling of (unobserved) reporting incentives  direct evidence on the tax hypothesis • When tax incentives decrease, magnitude of write-offs, conditional on the decision to write-off, decreases

11. Thank you for questions, comments, suggestions!