The GAAP lock-out effect of worldwide corporate profits and firm value
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Prior studies have attributed the lock-out effect of permanently reinvested foreign earnings (PRE) designation to cash tax deferral and accounting expense deferral associated with PRE designation. Because PRE designation effectively reduces GAAP effective tax rate (ETR), thus affects stock prices and compensation contracts, I answer the underlying question - why firms care so much about the GAAP ETR and reporting GAAP accounting earnings by (1) Examining how a lower GAAP ETR due to PRE designation affects shareholders returns; and (2) Examining how compensation contracts are affected by increased after-tax accounting income due to PRE designation. I provide strong evidence that investors react negatively to earnings management by way of the PRE designation. Further, by examining the determinants of PRE designation, I find that in addition to the variables defined in previous studies, the sensitivity of the relationship between PRE designation and the meet-or-beat figure is significantly associated with the portion of top managers’ compensation that is tied to stock performance. This finding speaks to the agency view of PRE related real corporate decisions and shows that investors may put a price discount on a firm’s shares if they are able to see through the firm’s earnings management strategy via PRE designation, which may be used by managers to mask the extraction of rents. This paper makes an important contribution to what we know about the joint effects of tax policy, generally accepted accounting principles, and incentive compensation on the earnings reporting process.