Evidence of Earnings Management by the Early Adopters of SFAS 96

The provisions of Statement of Financial Accounting Standard (SFAS) 96, "Accounting for Income Taxes," provide a high degree of flexibility in structuring the most advantageous transition to the liability method. SFAS 96 accords a long adoption window and the choice of adoption method, cumulative effect method or retroactive restatement method. A sample of early adopting firms is used to explore whether management's choice of transition method and adoption timing is motivated by its desire to manage earnings. Evidence of earnings management is found. Most firms with a positive cumulative effect chose the cumulative effect method, which enhanced their earnings in the transition year. Firms with a negative cumulative effect chose the retroactive restatement method, which bypasses the income statement and adjusts retained earnings for the cumulative effect. The financial statements of adopters are markedly different from those of nonadopters.