Financial reporting incentives, earnings management, and tax avoidance in SMEs

This paper examines earnings management and tax aggressiveness in SMEs. First, we find a discontinuity around zero in the distribution of earnings but not in the distribution of earnings change, and provide evidence that SMEs engage in accrual and real earnings management to beat zero earnings, to achieve a stable net income over the years, and also when in situations of financial constraints. We also find an overall negative association between income‐increasing earnings management and non‐conforming tax avoidance. In addition, we show that SMEs are less tax aggressive in those settings where we have previously found that they engage in upward earnings management (i.e., small profits, smoothed net income, financial constraints). This suggests that under financial reporting incentives to report higher earnings, upward earnings management clearly prevail over tax aggressiveness. On the contrary, in settings without the pressure to report higher earnings, our findings suggest that SMEs may simultaneously engage in conforming and non‐conforming tax avoidance to reduce taxes paid.