The Effects of IFRS Adoption on the Association between the Provision of Tax Services by Incumbent Auditors and Earnings Management: Evidence from Korea

Firms are expected to recognize more unrealized gains or losses on their financial statements when IFRS is adopted. As current tax law does not permit the recognition of unrealized gains or losses, book tax conformity is expected to decline when IFRS is adopted. We examine whether more unrealized gains or losses recognition on the book would actually result in lower book-tax conformity (higher book-tax income difference) and larger earnings management (higher discretionary accruals). Lower book-tax conformity is expected to have the most noticeable earnings management impact on the firms with tax services provided by incumbent auditors since those firms pursue explicitly both higher book income and lower taxable income. Since we do not have post-IFRS data, we use sample firms in pre-IFRS era with higher unrealized gains or losses as a proxy test group for post-IFRS. The results show that unrealized gains or losses significantly increase both book-tax income difference and discretionary accruals when they are interacted with tax service fee by incumbent auditors. The significant impacts are mostly due to unrealized gains or losses on nonfinancial assets than on financial assets. We argue that adoption of IFRS and extended recognition of unrealized gains or losses could result in more earnings management at least for the firms with tax services provided by incumbent auditors.