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Journal Articles

An Examination of Factors Influencing the Financial Reporting Decisions of Small Business Owner-Managers

1998, Behavioral Research in Accounting

Peggy A. Hite

Abstract

This study reports the results of a survey questionnaire sent to small business owner-managers across the country. Experimental manipulations investigated how a tax reporting rule either to expense or capitalize an item influences financial reporting preferences. The results indicate that those owner-managers who prepare GAAP financial statements for their businesses may be more likely to capitalize ambiguous expenditures than those who do not prepare GAAP-based financial statements. Among those who use GAAP financial statements, owner-managers with controlling interests in the business are more likely to expense rather than capitalize ambiguous expenditures while minority owners are less likely to expense. In addition, the GAAP users who are minority owners are more likely than majority owners to make financial reporting decisions that are consistent with tax reporting rules. Although data on small businesses is difficult to obtain, this study provides some preliminary data on the financial reporting preferences of small business owner-managers. 

A financial reporting decision may be influenced by how an item is reported for tax purposes. Scholes and Wolfson (1992) enumerate a variety of frictions between financial and tax reporting, and Watts and Zimmerman (1986) provide several examples of how tax consequences affect accounting choices. Recent empirical evidence supports their assertions. For example, several researchers have found that large corporations managed reported financial earnings in response to alternative minimum tax (AMT) provisions (Gramlich 1991; Manzon 1992; Dhaliwal and Wang 1992). No research to date, however, has examined trade-offs between financial and tax reporting for small nonpublic businesses.

Although GAAP is required for publicly traded firms, its use by nonpublic businesses is more limited. Rosenfield and Gill (1991) have reported that financial statements of small businesses are often not prepared according to GAAP, but according to other comprehensive bases of accounting.

Small nonpublic businesses have the option of using Generally Accepted Accounting Principles (GAAP) or tax reporting rules (one of the other comprehensive bases of accounting) in the preparation of their financial statements. Small business owner-managers make frequent financial reporting decisions, and the selection of accounting methods can be geared toward tax reduction.

Cloyd et al. (1996) surveyed large firms about their reporting decisions. They found that subjects made financial reporting decisions that were consistent with their tax reporting decisions when it reduced their probability of an audit by the Internal Revenue Service (IRS). Tax reporting influences on the financial reporting of closely held small businesses is an empirical issue which has not been addressed in the literature. Since small businesses tend to be oriented toward tax reporting, it is posited that tax reporting rules influence financial reporting decisions in small businesses.

The motivation for this study is derived from the lack of information on the friction between financial and tax reporting for small businesses. Large businesses have investors, creditors, internal and external auditors monitoring their financial reporting decisions. In contrast, closely held firms have significantly fewer analysts following their reporting decisions. Just as large firms have nontax costs to consider when making reporting decisions, nontax costs may also influence the reporting decisions of small businesses. Several factors are examined in the present study-level of ownership, use of GAAP financial statements, and tax reporting rules.

First, it is posited that those who use GAAP-based financial statements are less likely to expense items than are those who do not prepare GAAP-based financial statements. Second, as stock ownership increases, there is an increased tendency to expense items rather than capitalize. This results in lower net incomes, which is consistent with a desire to minimize taxable income. Third, when decision makers are not majority owners, tax reporting rules will influence their GAAP reporting decisions. These hypotheses are supported.

The results of this study will be informative to those interested in the financial reporting decisions of small businesses. If the results of this study are generalizable to other small businesses who use GAAP, then reporting decisions by controlling owner-managers may tend to understate financial net income because of a bias toward expensing capital expenditures. In contrast, reporting decisions by minority owner-managers may under- or overstate financial net income because of a bias toward conforming with tax law whether it requires expensing or capitalizing an expenditure. This desire to be consistent in tax and financial reporting by minority owner-managers is analagous to the results of Cloyd et al. ( 1996) who found that the financial officers of large firms tended to make the same reporting decisions for tax and financial purposes when it reduced the probability of scrutiny by a third party (e.g., the IRS).

The primary objective of this research is to examine the influence of tax regulations on the financial reporting decisions of small businesses. Specifically, this study examines, first, the conditions under which tax reporting rules for asset capitalization affect financial reporting decisions and, second, whether majority owner-managers' reporting decisions vary from nonmajority owner-managers. If tax reporting decisions influence the recognition of assets on financial statements, then financial reporting may be inadvertently distorted.

The second section of this paper provides the background literature for this research. The third section describes the methodology, and the results are presented in the fourth section. The final section contains a summary of the results and concludes the discussion.

Citation

Hite, Peggy A. (1998), "An Examination of Factors Influencing the Financial Reporting Decisions of Small Business Owner-Managers," Behavioral Research in Accounting, Vol. 10, pp. 159-178.