Burks, J. J., Randolph, D. W., and Seida, J. A. (2019) - Modeling and Interpreting Regressions With

Journal of Accounting Literature 42 (2019) 61–79
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Journal of Accounting Literature

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Modeling and interpreting regressions with interactions

T
Jeffrey J. Burksa, David W. Randolphb, , Jim A. Seidaa
⁎
a
Mendoza College of Business, University of Notre Dame, Notre Dame, IN, 46556-5646, USA
b
Williams College of Business, Xavier University, 3800 Victory Parkway, Cincinnati, OH, 45207-1211, USA
ARTICLE INFO ABSTRACT
Keywords: This study examines the use of linear regressions that include interaction terms, finding frequent
Interactive interpretation errors in published accounting research. We provide insights on how to estimate,
Interaction interpret, and present interactive regression models, and explain seldom-used but easily-im-
Trade-off plemented methods to report conditional marginal effects. We also examine the use of interaction
Conditional effect
terms in tax and financial reporting trade-off studies, evaluating the conceptual fit between a
Moderating
Tax
regression model with interactions and alternative definitions of trade-off. Although we advocate
the use of interactive models, noise levels common in accounting research greatly reduce the
ability to detect interaction effects.
1. Introduction
Accounting research commonly incorporates interaction terms in a linear regression to examine if hypothesized effects are
moderated, or reinforced, by another variable. However, as found in other social sciences, accounting research sometimes draws
misplaced or incorrect inferences from these regressions, hereafter referred to as an interactive regression.1 In some cases, hy-
potheses unwittingly go untested due to misunderstanding about how an interaction term changes coefficient interpretation. In
recent issues of top accounting journals, we find that about one-fourth of archival studies that use a continuous interaction
variable misinterpret results or discuss them in a misleading way. This study develops insights into regression-based interaction
effects, discusses some common interpretation errors from interactive regressions, and provides recommendations to improve
research.
Much of the discussion focuses on settings in which firms are hypothesized to trade off competing incentives. For example, a large
body of research examines how firms trade off financial reporting incentives to accelerate income recognition against tax incentives
to defer income recognition.2 Although Shackelford and Shevlin (2001) advocate using interaction terms to study such tax trade-offs,
many studies limit the analysis to a linear-additive regression model (i.e., a model without an interaction term). We clarify what can
be inferred from both types of trade-off regressions and discuss their relative advantages.
Corresponding author.
⁎
E-mail addresses: jburks@nd.edu (J.J. Burks), randolphd1@xavier.edu (D.W. Randolph), jseida@nd.edu (J.A. Seida).
1
We use the term interactive regression to refer to a linear regression that includes a cross-product variable term. Synonymous terminology
includes a linear-multiplicative, multiplicative, moderating, and interaction regression model. We use the term interactive model to distinguish the
model from the interaction term.
2
Hanlon and Heitzman (2010), Shackelford and Shevlin (2001), and Shackelford, Slemrod, and Sallee (2007) summarize some of the taxable
income and financial accounting trade-off research.
https://doi.org/10.1016/j.acclit.2018.08.001
Received 1 December 2017; Received in revised form 22 August 2018; Accepted 22 August 2018
Available online 08 September 2018
0737-4607/ © 2018 University of Florida, Fisher School of Accounting. Published by Elsevier Ltd. All rights reserved.
J.J. Burks et al. Journal of Accounting Literature 42 (2019) 61–79
Although we tend to use tax and trade-off settings for illustration, the study’s points about interactive regressions apply to any
research that uses interactions to examine whether the effect of one explanatory variable depends on another.3 As accounting
research matures, more studies will incorporate interactions to examine whether there are systematic differences or limitations
associated with a conjectured effect. It is important that researchers and consumers of accounting research understand when to
include interactions and how to interpret them. We summarize persistent misinterpretations, important concepts, and useful tech-
niques from the multi-disciplinary literature on interactive models.4
In Section 2, we explain the difference between regression models that include or exclude an interaction of two variables. This
section clarifies views expressed by Shackelford and Shevlin (2001) and Maydew (2001) concerning the necessity of including
interaction terms to document trade-offs. Our discussion explains why an interaction term is not necessary if the researcher’s ob-
jective is only to examine whether firms trade off competing considerations. However, including an interaction term provides richer
insights than is possible from a linear-additive model because it allows one to examine whether the rate at which firms trade one
benefit for another depends on the magnitude of the competing incentive, and to assess the statistical significance of a conjectured
effect across the range of the competing (or moderating) variable. Such nuanced findings are not possible without the inclusion of an
interaction term. We encourage researchers that examine trade-offs to move toward methodologies that include interactions between
countervailing incentives. Understanding the conditional nature of trade-offs—e.g., the ability to predict whether some firms will be
more or less responsive to a change in tax law—is a matter of particular importance to research with policy implications.
Section 3 is widely applicable beyond the trade-off literature. It provides examples of published studies that misinterpreted results
from interactive models and illustrates statistical and graphical methods to improve model interpretation and mitigate such in-
ferential errors. A key point is that adding an interaction term to a regression changes the interpretation of the coefficients on the
constituent terms (i.e. the individual terms that comprise the interaction). In an interactive regression, the constituent terms’ coef-
ficients reflect the effect of the variable only when the other constituent variable equals zero. In many cases, this particular effect does
not represent a central tendency because the other constituent variable takes on a value of zero only at an extreme or infeasible point.
We find that accounting research commonly misportrays constituent term coefficients as if they represent central tendencies or “main
effects”.
In addition to the interpretation errors associated with interactive models, the misunderstanding about constituent term coeffi-
cients can also cause researchers to make suboptimal design choices. Researchers sometimes mistakenly downplay or dismiss an
interactive model because they observe a large change in the constituent term coefficient after adding an interaction term to a
previously estimated regression. Not understanding that the change is simply due to the newly conditional nature of the coefficient,
some researchers attribute the change to collinearity between the constituent term and the interaction and infer that the model’s
results are invalid. Section 4 addresses this and other statistical issues associated with interactive models. We discuss why mean
centering cannot alleviate multicollinearity concerns but can simplify the interpretation of the coefficients and mitigate differences in
coefficient estimates when adding an interaction term to a regression model.
Section 4 concludes with a discussion of how statistical noise dramatically reduces the ability to detect interaction effects. The
difficulty to detect a significant interaction term given noise levels common in trade-off studies means that one might have to limit
inferences to the existence of a trade-off. Researchers should be wary about completely ignoring an interactive effect that has a p-
value just outside of the common rejection region. The risk of completely dismissing an interaction effect of questionable statistical
significance is that one may fixate on the unconditional effect and not appreciate the possibility that the effect can systematically
differ across certain firm attributes. Of course, researchers should not make the opposite mistake and claim that an interaction effect
exists based on inconclusive evidence. Our recommendation is for researchers to acknowledge the inconclusiveness of evidence rather
than ignore inconclusive evidence. We also encourage researchers to move beyond standard coefficient tests when examining in-
teractions and to analyze its implied conditional effects. A more thorough analysis should reduce interpretation errors and improve
research.
2. Conceptual issues and tax trade-offs
To understand the conceptual differences between models that include or exclude interactions, we focus on a setting in which
there has been controversy about whether to include interactions: studies of taxable income shifting known as “tax trade-off” studies.
In this section, we contrast a regression model that does not include an interaction term between the tax benefit variable and non-tax
cost variables, i.e., a linear-additive model, to a regression model that includes such terms, i.e., a linear-multiplicative, or interactive,
model. We explain the benefits of including interaction terms in regression-based trade-off research (Shackelford & Shevlin, 2001),
even though such terms are not necessary to conclude that a trade-off exists (Maydew, 2001). While this section focuses on tax and
non-tax trade-offs, the intuition regarding the regression specification is widely applicable, especially to settings where firms balance,
3
Examples of research areas that use interaction terms include: determinants of earnings response coefficients (Collins & Kothari, 1989; Teoh &
Wong, 1993, Krishnan et al., 2005), the cost of complying versus cost of violating corporate debt covenants (Francis, 1990), the relationship
between tax sheltering and equity incentives contingent on quality of corporate governance (Desai & Dharmapala, 2006), the effect of industry
specialization on relationship between audit tenure and audit quality (Lim & Tan 2008, 2010), and how institutional ownership moderates response
to ex-dividend day trading volume (Dhaliwal & Li, 2006).
4
Given the survey nature of this study, a number of topics are only briefly covered, or simply mentioned, so one should consult the referenced
studies for more details.
62
or trade off, competing incentives.
2.1. Regression model specification: linear-additive and linear-multiplicative models
The model commonly used to investigate tax and non-tax trade-offs regresses a measure of income shifted on variables that proxy
for the tax incentive and non-tax factors believed to influence the optimal amount of income to shift.5 We begin our analysis with a
linear-additive model that includes a measure of income shifted into the future as the dependent variable, denoted IS, and two
independent variables. The first independent variable is the tax incentive to shift income into the future, denoted T, and the second
one is a composite cost-factor variable that captures all costs associated with shifting current period income to future periods, denoted
CF. The linear-additive model is:
IS = αo + αTT + αCFCF + εit. (1)

6
The model represented by Eq. (1) is similar to the regressions that predominate much of the tax trade-off research. Given that
higher values of T represent a greater tax-incentive to shift current period income to the future, the expected coefficient on αT is
positive. Because higher values of CF represent greater income shifting costs, the expected coefficient estimate on αCF is negative.
While the regression equation reflected in Eq. (1) includes only a single cost variable, it could include additional independent
variables that capture different cost factors (e.g., accounting income, leverage, and dividend coverage).
Shackelford and Shevlin (2001) recommend that a trade-off regression model include an interaction term between the tax in-
centive and cost factor variable(s). Adding such a term results in the following interactive (or linear-multiplicative) regression model:
IS = βo + βTT + βCFCF + βT × CFT × CF (2)
Unlike the linear-additive model, the interactive model allows the marginal effect of one independent variable to depend on the
value of the other independent variable. This conditional marginal effect contrasts to the marginal effect implied by the linear-additive
model where each unit increase in an independent variable has the same effect on the predicted value of the dependent variable
regardless of the other variable’s magnitude. The difference between the two models is better conveyed by taking the partial deri-
vatives of Eqs. (1) and (2) with respect to T:
From linear-additive model (1): ∂IS/∂T = αT, (3)
From interactive model (2): ∂IS/∂T = βT + βT × CFCF. (4)
The partial derivative of the regression represented by Eq. (3) shows that a one-unit increase in T is associated with an increase in
IS equal to αT and that the effect is uniform across different cost levels. In other words, the effect of tax incentives on the predicted
income shifting does not change for different CF values. In contrast, the partial derivative represented by Eq. (4) shows that the effect
of a one-unit increase in T is associated with an increase in predicted income shifting that is conditional on the CF level. Assuming a
negative coefficient estimate on βT × CF, the partial derivative of the interactive model implies that the income-shifting response, to a
given change in tax incentive, decreases as the cost factor (CF) level increases.
Fig. 1 shows the differences between the two model specifications. Panel A illustrates the magnitude of income shifting at varying
levels of tax incentives for both a relatively lower- and higher-cost firm assuming an additive model. In this graph, the slope on T, given
by αT, is the same regardless of CF’s level. Although the magnitude of taxable income shifting will be less for the higher-cost firm at all
levels of T, the uniform slope on T (αT), for both the higher- and lower-cost firms implies that both will be equally responsive to a unit
change in T.7 Panel B illustrates the responsiveness of income shifting to tax incentives assuming an interactive model with negative
coefficients on both the cost factor (CF) and interaction (T × CF) terms. Due to the negative interaction term, the slope on T for the
higher-cost firm, given by βT + βT × CFCF, is less than the slope for the lower-cost firm. Like the additive model, the interactive model
indicates that the predicted magnitude of income shifting will be less for a higher-cost firm for a given level of T. In addition, the
interactive model also implies that the two types of firms will respond differently to a change in T: the change in magnitude of income
shifting for the higher-cost firm will be less than the change for the lower-cost firm per unit change in T.
2.2. Defining the term trade-off and documenting trade-offs via regression analysis
Research that utilizes linear-additive models has interpreted statistically significant coefficient estimates on the tax variable as
evidence that firms shift income into the future due to the tax incentive. Similarly, significant coefficient estimates on cost-related
5
We focus on estimating interaction coefficients using a linear estimation technique such as OLS when the dependent variable is continuous.
Interpreting interaction coefficients is not straightforward when using a nonlinear estimation technique, such as logit regression for binary de-
pendent variables (Ai & Norton, 2003; Norton, Wang, & Ai, 2004). However, Kolasinski and Siegel (2010) claim that these concerns are overstated
and that in most cases it is correct to interpret the interaction coefficient in a straightforward manner.
6
The following trade-off studies use a linear regression model: Albring, Dhaliwal, Khurana, & Pereira, 2011; Badertscher, Phillips, Pincus, &
Olhoft-Rego, 2009; Dhaliwal, Frankel, & Trezevant, 1994; Guenther, 1994; Lopez, Regier, & Lee, 1998; Maydew, 1997; Matsunaga, Shevlin, &
Shores, 1992; Scholes, Wilson, & Wolfson, 1990; Wang, 1994).
7
The differences in predicted income shifting across the higher- and lower-cost firm, for all levels of T, is given by αCF times the assumed
difference in CF levels across the higher- and lower-cost firm.
63
Fig. 1. Linear-additive versus Interactive model.

This figure illustrates the basic difference between a linear-additive and a linear-multiplicative (i.e. interactive) regression. Panel A reflects the
linear-additive model (no interaction term) where αo and αT are assume to be positive and αCF is negative. The linear-additive model results in
different predicted values of income shifted (IS) for a given level of tax incentive (T) across firms with different cost levels. Lower-cost firms shift
more income than higher-cost firms do, but the change in the amount of income shifted, for a given change in tax incentive, as indicated by the slope
of the each line, is the same for both the lower- and higher-cost firms.
Panel B reflects the interactive model with a negative coefficient estimate on both the cost (CF) and the interaction (T × CF) terms. As with the
linear-additive model, the graph for the interactive model indicates that both the lower- and higher-cost firms shift more income (IS) as the tax
incentive (T) increases. However, the change in amount of income shifted (IS) in response to a given change in tax incentive differs across the firms,
as indicated by the diverging lines. The lower-cost firms are more responsive, i.e., shift more income, to a given change in tax incentive than are the
higher-cost firms.
variables are interpreted as evidence that non-tax considerations influence the degree of income shifting. Significant coefficients on
both the tax and cost variables are interpreted as evidence that firms trade off, or sacrifice, tax benefits to achieve non-tax benefits
associated with reporting higher income in the current period. Shackelford and Shevlin (2001, p. 370) question the usefulness of the
additive model and the interpretations that can be made from such a model. They suggest that a different model specification is
necessary to “…make the stronger interpretation that firms’ trade off taxes with other non-tax costs and benefits.” They recommend a
specification that includes an interaction term between the tax and cost variables. It is important to note that Shackelford and Shevlin
use the term to imply more than the exchange of competing tax and non-tax considerations. It also implies that the rate of exchange
between tax and non-tax considerations systematically differs across firms. Specifically, they state: “[T]tradeoffs should mean that the
effect of taxes on the firm’s choice depends on the level of the non-tax costs, or conversely, the effect of non-tax costs on the firm’s
choice depends on the firm’s marginal tax rate” (p. 370).
As Fig. 1, Panel A illustrates, an additive model can test whether a trade-off exists. Both a positive coefficient estimate on T and a
corresponding negative coefficient estimate on CF (αT and αCF) are consistent with both conflicting factors affecting firms’ reporting
decisions. Both estimates together are consistent with a trade-off because the higher-cost firm shifts less income (which results in
higher reported earnings and higher taxes) compared to the amount of income shifted by the lower-cost firm. Thus, Maydew (2001,
400), in his discussion of Shackelford and Shevlin (2001), correctly asserts that an interaction term is not a necessary condition for
uncovering the existence of a trade-off, where trade-off is defined as the exchange of one thing (e.g., non-tax benefits) in return for
another (e.g., tax benefits).8
However, an interaction term is necessary to determine if the trade-off varies across levels of the cost or tax incentive, which is
often equivalent to determining if the trade-off systematically varies across firms.9 Such findings would help, for example, predict
which types of firms would be most responsive to tax policy change. To determine whether the rate of exchange varies across levels of
8
If the estimate on CF in the additive model is not significant, the model does not provide evidence consistent with a trade-off because the
predicted income shifting, for a given level of T, is not statistically different across cost levels. An insignificant estimate on CF means that the two
lines in panel A representing higher and lower-cost firms’ responsiveness to tax incentives are statistically indistinguishable from each other.
9
Larcker (1992, 75), expresses a similar view about the importance of testing whether the trade-off varies across firms. In discussing the
Matsunaga, Shevlin, and Shores (1992) study that investigates the decision to disqualify incentive stock options (ISOs), he recommends using an
interaction model, instead of a linear model, because “firms most likely to disqualify their ISOs are those with high NTB (net tax benefit) and low
financial reporting costs.” This suggestion implies that the effect of the tax benefit on the decision to disqualify ISOs should be higher for firms with
relatively lower financial reporting costs.
64
the tax or cost measure necessitates the use of an interaction term. The coefficient estimate on the tax and cost interaction term in Eq.
(2), i.e., βT × CF, allows the estimated responsiveness of income shifting to tax incentives to vary with the cost level. More specifically,
this responsiveness is captured by the conditional effect of the tax incentive (T) given by βT + βT × CFCF. A statistically significant
negative coefficient estimate for βT × CF implies that higher-cost firms are less responsive to a given tax incentive and is consistent
with Shackelford and Shevlin’s richer definition of a trade-off that implies that the exchange rate between tax and non-tax con-
siderations differ across cost levels.
3. Interactive models and conditional effects
While Section 2 focused on defining the term trade-off and highlighted the role of interactive effects in testing trade-offs, Section 3
expands the focus to include the general use of interactive models in accounting research. This section further discusses differences
between linear-additive and interactive regressions with an emphasis on model interpretation (section 3.1) and assessment of con-
ditional marginal effects, referred to as “conditional effects” for short (section 3.2). Section 3.3 discusses some common mis-
understandings associated with interactive models that cause researchers to misinterpret regression results. Although we review a few
individual studies within this subsection for illustrative purposes, the types of misinterpretations reviewed occur frequently in ac-
counting research.
3.1. Coefficient interpretation and conditional effects
We first address how an interaction term affects the interpretation of the coefficient estimates on those terms that comprise the
interaction, referred to as constituent terms. As described later, misinterpretation of the coefficient estimates on the constituent terms
is common. Part of the problem is the use of misleading terminology. Accounting research frequently refers to the coefficient esti-
mates on the constituent terms as main effects. Taking as an example regression (2), which includes the T × CF interaction term,
research commonly refers to the coefficient estimates on T and CF as main effects. However, this terminology is misleading because
each coefficient actually represents the effect of the variable under a very limited condition, namely the condition that the other
variable equals zero.
To expand on this point, recall that in a linear-additive model, the coefficient estimate on T, αT, represents the expected effect of T
on income shifting after controlling for CF, regardless of CF’s magnitude. Referring to this coefficient estimate on T as a main effect is
acceptable because it represents the expected unconditional effect of T (i.e., the single estimated slope on T). In contrast, in the
interactive model, the coefficient estimate on T does not exclusively reflect the expected effect of T. As shown in Section 2, the
expected effect of T is computed from the derivative of Eq. (2) with respect to T, which is βT + βT × CFCF. This is a conditional effect
because the slope on T is conditional on the level of CF. In isolation, the coefficient estimate on T, βT, is the estimated slope that
represents the effect of T on income shifting only when CF is zero. Given that this particular conditional effect represents a narrow
circumstance, and is one of many possible conditional effects of T, it is not a main effect. We encourage accounting researchers to refer
to the interaction term’s components as constituent or constitutive terms and to think of each constituent term’s coefficient as an
estimated conditional effect rather than as a main effect.10
Due to the conditional nature of the constituent term coefficients, the coefficient estimate on T or CF is not necessarily noteworthy
and might have little inferential value. For example, an insignificant estimate on T merely means that the effect of T on income
shifting when CF equals zero is not statistically different from zero. The insignificant estimate on the constituent term does not mean
that the effect of T on income shifting is insignificant for all CF levels. Similar caveats apply to cases when a constituent term
coefficient estimate is statistically significant; the effect may not be statistically significant across the entire range of the other
constituent variable. The magnitude and significance of the conditional effect of T may vary widely across values of CF, but such
inferences are not apparent from standard regression output. When using an interactive model, the focus often should switch from the
estimated coefficients to the estimated conditional effects, which vary across the values of the other constituent variable. The next
section discusses how to assess the significance of conditional effects and methods to convey insights from an interactive regression.
3.2. Testing and presenting conditional effects
As explained above, the expression for conditional effects, e.g. βT + βT × CFCF, is derived from the partial derivative of the
interactive regression model with respect to one of the constituent variables. Unlike the single t-test from a linear-additive model used
to assess an unconditional marginal effect, the statistical significance of a hypothesized effect from an interactive model requires
multiple t-tests across a range of the conditioning variable. For example, the statistical significance of the estimated tax incentive
effect, as measured by the slope on T (βT+ βT × CFCF), should be evaluated across a range of CF values. Given that higher costs are
expected to reduce the income shifting response to tax incentives (i.e., βT × CF < 0), the conditional marginal effect of T, i.e., slope on
10
Friedrich (1982) refers to the terms that comprise the interaction as constituent terms, while Brambor et al. (2006) refers to them as constitutive
terms. Afshartous and Preston (2011) stress that there are no “main effects” in an interactive model. Kam and Franzese (2010) stress that coefficients
from an interactive model are not the same as effects and caution researchers from using terms such as main effect (pp. 19–20). Even when
evaluating the conditional effect at the mean level of the other variable, they state (p. 21) that calling this conditional effect “…’main’ seems an
unnecessary and possibly misleading substantive imposition.”
65
T, is expected to decrease as costs (CF) increase. In essence, the hypothesized effect of tax incentives on income shifting is tested
multiple times at different cost levels.11 Just as the slope on T changes with CF, so does the related standard error necessary to assess
the conditional slope’s statistical significance. Using our tax example, Eq. (5) shows how to compute the estimated variance of the
slope on T at a particular CF level using data from the variance-covariance matrix of the coefficient estimates.12
VAR ( IS / T ) = VAR ( T + T*CF CF ) = VAR (BˆT ) + 2CFCOV (BˆT , BˆT * CF ) + CF 2VAR (BˆT * CF ) (5)
Brambor, Clark, and Golder (2006, 70) note that if the covariance term in Eq. (5) is negative, the estimated conditional slope
could be significant at certain levels of the moderating variable even if all of the estimated coefficients are insignificant. Thus,
returning to the tax example, insignificant coefficient estimates on T, CF, and T × CF does not preclude statistical support for a non-
zero conditional effect of T at some level of CF.13 To test whether a conditional slope is significantly different from zero, a t-statistic is
computed by dividing the estimated conditional slope by its computed standard error (i.e., square root of the estimated variance of
βT+ βT × CFCF) at the specified CF level. Eq. (6) shows the general computation for a t-test to assess a conditional effect of T on
income shifting.
BˆT + BˆT * CF CF
t=
[VAR ( T + T*CF CF )] (6)
Since a standard regression output only includes a test of a single conditional effect via the coefficient estimates on the constituent
terms, researchers should incorporate additional analyses of conditional effects into their studies. There are many techniques to
communicate the significance of the conditional effect(s) implied from an interactive regression. A simple improvement is to show the
estimated conditional slope at various levels of the other variable along with its corresponding t-statistic. A broader picture is possible
if one also identifies the end-points associated with the range of the conditioning variable where the conditional effect is statistically
significant. This technique, from Johnson and Neyman (1936), and referred to as the J-N technique, is becoming more common in
other disciplines, but to our knowledge is relatively rare in accounting.14
A more thorough and sophisticated presentation is to graph the conditional effects. We highlight two different graphical tech-
niques. The first technique simply involves showing the relationship between the independent and dependent variable across arbi-
trarily chosen, but relevant, levels of the conditioning variable. A graph showing how T is predicted to affect income shifting would
reflect the tax incentive on the x-axis and the corresponding predicted income shifting on the y-axis. Separate lines for each chosen
level of CF, e.g., high, mean, and low, will show the estimated effect of T. The plot in Fig. 1 Panel B reflects such a graph, but it only
shows two levels of CF. We recommend that the graph, or its corresponding discussion, include some notation regarding the statistical
significance of each line’s slope.
The second graphical technique is a conditional slope plot; it presents a single line that shows how the slope on T varies across the
entire range of CF (rather than at just a few selected CF values). A conditional slope plot typically includes confidence bands to
facilitate easy assessment of statistical significance. The y-axis of the conditional slope plot represents the slope on T, while the x-axis
reflects the level of the conditioning variable, CF in this case. Fig. 2 illustrates a hypothetical conditional slope plot for T across CF
levels.15 The downward-sloping line represents the estimated conditional slope on T for the range of CF values; it implies that as costs
increase firms are less responsive to tax incentives. As drawn, for extremely high CF levels the slope on T is near zero (where there is no
responsiveness to tax incentives). The confidence bands in the plot represent the confidence interval for the estimated slope at the
particular CF value for a specified level of significance. The slope is significantly different from zero if the confidence bands, at a
particular CF level, do not overlap with zero. In this plot, the conditional slope on T is statistically different from zero for CF levels of
approximately 0.7 or less.16 Knowledge about the distribution of the conditioning variable is important because one should be
11
Ersay and Sumner (2018) note that the multiple tests associated with a conditional effect could result in either an increased or decreased ability
to find a significant conditional effect at some level of the conditioning variable, despite the fact that within the population there is not an
interactive effect. The paper presents a method to correct for the false positive rate.
12
For a comprehensive discussion of the variance computation see Friedrich (1982) or Kam & Franzese (pp. 47–48, 2010). The variance-
covariance matrix of the estimated coefficients is available as a default item on some statistical packages, but is an optional item on SAS through the
inclusion of COVB as a regression option.
13
Brambor et al. (2006, p. 74) state, “[T]the analyst cannot even infer whether X has a meaningful conditional effect on Y from the magnitude
and significance of the coefficient on the interaction term either. As we showed earlier, it is perfectly possible for the marginal effect of X on Y to be
significant for substantively relevant values of the modifying variable Z even if the coefficient on the interaction term is insignificant.”
14
Spiller, Fitzsimons, Lynch, and McClelland (2013) refer to a presentation of the effect at particular points as a spotlight because it cast light on
the effect at the arbitrarily selected values of the conditioning variable and refer to the Johnson-Neyman points as a floodlight because it illuminates
over a range of values.
15
The conditional slope plots in this paper were created using http://www.quantpsy.org/interact/hlm2 The website has an interface to generate
R-language programs that run over various R-servers. Required inputs include the regression estimates, the variance-covariance matrix of the
estimated coefficients, and range of the conditioning variable. Preacher, Curran, and Bauer (2006) describes the online tool and provides an
example.
16
Assuming CF’s limit is zero, the significance region for the conditional effect of T is bound by CF values of zero and 0.7. Assuming a conditional
effect is significant at some points, the J-N technique will result in an upper and lower bound value for the significance area. However, unlike the
plot in Fig. 1, in which the significance region was within the two J-N values, in other cases, two significance areas might exist on both sides of the J-
N values (Preacher et al., 2006, p. 440).
66
Fig. 2. Conditional Slope and Confidence Bands for Regression Coefficient Estimate on T Conditional on the Level of CF.
Graph shows conditional slope for the relationship between income shifted (IS) and tax incentive (T) for levels of cost factor (CF). The slope is most
positive for low levels of CF (implies that dollars shifted are greater for firms with greater tax incentives to shift income but do not have high costs).
The slope decreases for higher levels of CF (implies that dollars shifted are lower for firms with greater tax incentives but higher levels of CF). The
magnitude of the cost factor moderates the effect that tax incentives have on the amount of income shifting. The slope is not statistically different
from zero where the 95% confidence bands, represented by the red lines, straddle positive and negative conditional slope values.
skeptical of inferences made outside the conditioning variable’s range (Berry, Golder, & Milton, 2012, p. 665), or where there are only
a small number of observations. Thus, if the lowest CF value is zero, inferences should be limited to only non-negative CF values. Both
graphical techniques highlight the conditional nature of the relationship between income shifting and tax incentives, but the con-
ditional slope plot presents a more complete picture. The next section includes examples of the above techniques.
3.3. Interpretation issues in accounting research
While an interaction term yields additional insights relative to those from a linear-additive model, it also adds complexity. Many
studies that incorporate interactions do not examine conditional effects and only discuss the coefficient estimates from the standard
regression output. The focus on only the estimated coefficients, particularly those on the constituent terms, results in frequent
interpretation errors that sometimes affect the validity of the hypothesis test. Brambor et al. (2006, p. 77) report that 62% of the
identified articles in top-level political science journals interpret coefficient estimates on constituent terms incorrectly. Unfortunately,
accounting research is not immune to such errors. In a review of recent issues of the three top accounting research journals, we find
that about 25% of the archival studies that use an interaction term with a continuous variable misinterpret at least one constituent
term’s coefficient estimate.17 We discuss several studies across different accounting research areas to illustrate the interpretation
issues and to offer suggestions to improve the presentation of interactive models. Our intent is not to discredit these studies, but to
learn from them so that accounting researchers are better equipped to conduct and evaluate research. Effectively communicating and
appropriately interpreting regressions that include interactions is important because their use will increase as accounting research
matures.
We first discuss Eldenburg, Gunny, Hee, and Soderstrom (2011) to illustrate interpretation errors associated with the constituent
term’s coefficient estimates. Eldenburg et al. examines earnings management via real activities by nonprofit hospitals. The first two
hypotheses involve unconditional relations, positing that when accounting performance is below (above) a benchmark, managers will
decrease (increase) spending on particular types of activities to draw reported results closer to the benchmark. The explanatory
variables that capture these incentives are binary. The third hypothesis involves a conditional relation, positing that pay-for-per-
formance (P4P) plans will moderate real earnings management incentives. They test the three hypothesis using a single interactive
regression that includes the continuous P4P variable interacted with binary variables. The authors interpret the marginally significant
coefficient estimates on the binary constituent terms as support for the two unconditional hypotheses. However, such an inference
cannot be made from these coefficient estimates because each one represents a conditional effect when P4P equals zero. Eldenburg
et al. seem to treat these constituent term coefficient estimates as main effects and do not analyze the hypothesized effects at other P4P
levels. Given that the P4P variable is a continuous variable that does not span zero (its values range from a minimum of 0.07 to a
maximum of 27.17), these conditional coefficient estimates alone do not have a meaningful interpretation and the first two
17
We focused our search on the last three available issues (at the time of our search) of The Accounting Review (2017, volume 92, issue 6; 2018,
volume 93, issues 1 and 2), The Journal of Accounting Research (2017, volume 55, issues 4 and 5; 2018, volume 56, issue 1), and The Journal of
Accounting Economics (2017, volume 64, issues 2 and 3; 2018, volume 65, issue 1). Some of the articles use an interactive model only as part of the
sensitivity analysis, so the interpretation errors often do not affect the general tenor of the results.
67
hypotheses are not properly tested.18

Similar to Eldenburg et al. (2011), Shevlin, Tang, and Wilson (2012) include unconditional hypotheses in their study of geo-
graphic income shifting by Chinese-listed firms. Shevlin et al. (p. 7) use an interactive model to examine if “firms facing lower costs
and greater benefits (incremental to the dollar tax savings)” shift more income into low-tax jurisdictions. Their model includes a
continuous variable that captures the extent of intangible assets (denoted INTS and computed as intangible assets divided by
shareholders’ equity) and a binary variable coded one if the firm conducts a stock rights offering (denoted RIGHTS). They predict that
both INTS and RIGHTS have an unconditionally positive association with shifting income to low-tax jurisdictions because (i) in-
tangible assets are easier to relocate to low-tax jurisdictions than are physical assets (e.g., stores and factories), and (ii) a rights
offering provides incentive to increase after-tax earnings to meet government-imposed ROE minimums.19 They also predict that
intangible-intensive firms take greater advantage of their income-shifting ability when a rights offering provides incentive to do so
(i.e., the third hypothesis predicts a positive coefficient estimate on INTS × RIGHTS).
Unlike Eldenburg et al. (2011), which only estimated an interactive regression, Shevlin et al. (correctly) use a regression that
excludes the INTS × RIGHTS interaction term to examine the unconditional hypotheses. The reported results for this linear-additive
regression provide statistical evidence consistent with the two unconditional hypothesis; the coefficient estimates on RIGHTS and
INTS are positive and statistically significant. Consistent with our previous points made about linear-additive models using the
generic example of Panel A of Fig. 1, the results from the Shevlin et al. linear-additive model imply that the slopes of the lines
representing the effect of INTS on income shifting for both RIGHTS groups are the same, but the line for the sample firms with a rights
offering (RIGHTS = 1) is above that for the other sample firms. If one wishes to assess an unconditional hypothesis, then it is
appropriate to use a linear-additive regression because it estimates unconditional marginal effects.
Shevlin et al. (2012) also report results for an interactive regression that includes the INTS × RIGHTS term. While their hypothesis
related to the interactive model focuses exclusively on the interaction term’s coefficient estimate, they also discuss the constituent
terms’ coefficient estimates. Similar to the misinterpretation in Eldenburg et al. (2011), Shevlin et al. also appear to ignore the
conditional nature of the constituent terms’ estimates. In contrast to the linear-additive model’s statistically significant (p < .10)
estimated coefficient on RIGHTS, the interactive model’s estimated coefficient on RIGHTS is statistically insignificant (p. 20). Given
the conditional nature of this estimate, the insignificant coefficient estimate on the constituent term merely means that the effect of
RIGHTS is not statistically significant when INTS equals zero. However, the authors seem to view the insignificant coefficient on
RIGHTS as a sign that the interactive model’s estimates are unduly affected by multicollinearity because, when estimated without the
INTS × RIGHTS interaction term, the RIGHTS coefficient was statistically significant and its magnitude was considerably higher.20
The large change in the estimated coefficient on RIGHTS is not ipso facto evidence of estimation problems due to multicollinearity. A
better explanation is that there exists a substantive difference between the effect of RIGHTS on income shifting when estimated across
the entire sample, compared to the effect only applicable to firms with a zero level of INTS.
The misplaced concern about multicollinearity potentially led to increased emphasis on the estimated unconditional effect from
the linear-additive model. The drawback of emphasizing an unconditional effect is that it may leave readers with an oversimplified
view of the hypothesized effect. While the reported unconditional effect of 0.35 for RIGHTS represents an average firm response, it is
likely less representative of the expected effect for firms that have high or low INTS. For example, in contrast to the 0.35 un-
conditional estimated effect of RIGHTS from the linear-additive model, the statistically insignificant estimated coefficient of 0.03 on
RIGHTS from the interactive model implies that there is essentially no effect of RIGHTS when INTS is zero. This result is potentially
insightful. Perhaps RIGHTS has no discernable effect because firms without intangibles have no flexibility to shift income in a cost
efficient manner. Thus, the interaction results may identify the conditions under which a firm’s behavior will deviate from average
behavior.
Taking this conditional analysis further, the interactive model allows the assessment of the effect of RIGHTS across the range of
INTS values. However, a reader is unable to perform such an analysis using the disclosed regression results because the estimated
coefficient variance-covariance matrix is required to compute appropriate standard errors. Upon our request, the authors of Shevlin
et al. shared their data so that we could perform further analysis related to their Table 4 regression results. Our Table 1 Panel A shows
the exactly replicated results for the linear-additive model in column (1) and the interactive model in column (2). Column (3),
discussed in the next section, presents results using mean-centered data. The statistically insignificant estimates on RIGHTS and
INTS × RIGHTS in the interactive model (see column 2) do not necessarily mean that all of the conditional effects of RIGHTS will be
insignificant and do not imply that the interactive model should be discarded in favor of the linear-additive model.21
18
Other examples of papers that purport to test a hypothesis about an unconditional relation by mistakenly focusing on a constituent term that
has been interacted with a continuous variable include Cadman, Carter, and Hillegeist (2010), which examines the effect of compensation con-
sultants on CEO pay, and Chan, Lin, and Mo (2010), which examines how switching from a tax-based form of accounting affects income tax
compliance. Due to the interaction, the estimated coefficient on the constituent term reflects the effect of the variable of interest only at the zero
level of the other continuous variable.
19
The income shifting within China, captured by the dependent variable, reduces the total amount of Chinese income taxes because the related
companies file separate company tax returns, as opposed to a single consolidated tax return.
20
In the discussing these results, Shevlin et al. (2012, p. 19) state, “…adding this interaction results in multicollinearity between the interaction
term and INTS and RIGHTS. The estimated coefficient on the interaction term, although positive as predicted, is not significant at conventional
levels. Further, the RIGHTS variable loses significance.”
21
As discussed earlier, the negative covariance between the coefficient estimates on INTS and INTS × RIGHTS (see Table 1 Panel B) means a
conditional effect can be significant despite the insignificance of the coefficient estimates.
68
Table 1
Analysis of Shevlin et al. (2012).
Panel A: Regression results for linear-additive and interactive model using raw and mean-centered data
(1) (2) (3)
Raw Raw Mean-centered
Coef Est Std Err Coef Est Std Err Coef Est Std Err
** * *
INTS + 1.1694 0.6454 1.0149 0.7189 1.0149 0.7189
RIGHTS + 0.3469* 0.2632 0.0338 0.1890 0.3871* 0.2754
INTS*RIGHTS + 3.7780 3.6062 3.7780 3.6062
NONTRD ? −0.1097 0.1128 −0.1139 0.1117 −0.1139 0.1117
LEV −0.3111 0.3451 −0.3464 0.3377 −0.3464 0.3377
SIZE −0.0047 0.0726 −0.0125 0.0739 −0.0125 0.0739
Intercept 0.2234 1.1160 0.4222 1.1478 0.5171 1.1234
R2 38.83% 39.84% 39.84%
Panel B: Estimated coefficient variances and covariances from interactive model
INTS RIGHTS INTS*RIGHTS Intercept
INTS 0.516767 0.046637 −0.690837 −0.320847

RIGHTS 0.035739 −0.393746 −0.081375
INTS × RIGHTS 13.004505 1.127642
Intercept 1.317524
Panel C: Analysis of conditional effect on RIGHTS for various INTS levels
INTS distribution points INTS level Estimated simple slope on RIGHTS Standard error t-statistic
10% 0.0000 0.0338 0.1890 0.18

25% 0.0094 0.0695 0.1716 0.40
50% 0.0451 0.2042 0.1633 1.25
J-N lower 0.0475 0.2133 0.1664 1.28*
mean 0.0935 0.3871 0.2754 1.41*
75% 0.1155 0.4703 0.3440 1.37*
J-N upper 0.1711 0.6802 0.5308 1.28*
90% 0.2635 1.0294 0.8551 1.20
95% 0.3522 1.3646 1.1713 1.16
99% 0.6318 2.4208 2.1748 1.11
This table reports results from replicating and extending the analysis in columns one and two of table four in Shevlin et al. (2012). Panel A shows
regression results: col. (1) for the linear-additive model and column (2) for the interactive model both using the raw data, and col. (3) for the
interactive model using mean-centered INTS. Panel B reflects elements of the variance-covariance matrix of the estimated coefficients from the
interactive model shown in col. (2) of Panel A. Panel C presents an analysis of the conditional effects of RIGHTS for various INTS levels. The levels
denoted J-N upper and lower reflect the endpoints of the region of statistical significance.
We use the estimates from the interactive model to evaluate the effect on RIGHTS at different levels of INTS. Given the
importance of measures of central tendency, we first evaluate the conditional effect of RIGHTS at the mean level of INTS, which is
approximately 0.0935. The estimated simple slope on RIGHTS at mean INTS is 0.3871 [0.0338 + 3.7780(0.0935)]. The com-
putation of the standard error requires information from the estimated coefficients’ variance-covariance matrix as shown in Panel
B of Table 1. The standard error of this conditional effect is approximately 0.2754, which results in a t-statistic of 1.41 [0.3871/
0.2754].22 Thus, at the mean INTS level, the effect of RIGHTS is significantly different from zero (based on one-tailed p < 0.10);
the magnitude and significance level of this particular conditional effect is similar to the unconditional effect of RIGHTS from the
linear-additive model.
Given the continuous nature of INTS, we recommend analyzing the effect of RIGHTS over a range of INTS values. While it is
common to evaluate the conjectured effect at the conditioning variable’s mean value plus/minus one standard deviation, we re-
commend including additional data points. The computed effect of RIGHTS is not significant at both points representing a one
standard deviation change (+/− 0.1326) from the mean INTS (untabulated). Panel C of Table 1 shows statistical tests of the
estimated slope on RIGHTS at other values of INTS. The table also reflects the Johnson and Neyman (1936) “J-N” endpoints of the
statistical significance region. These points correspond to INTS values of 0.0475 and 0.1711; the table shades the range of INTS values
22
The variance used to compute the standard error is 0.0758 and is computed as: 0.035739 + 2 × 0.0935 × (−0.393746) +
0.09352 × 13.0045.
69
Fig. 3. Conditional Slope and Confidence Bands for RIGHTS Conditional on INTS.
This graph shows the conditional slope for the relationship between income shifted and rights offering (RIGHTS) conditional on the level of
intangible intensity (INTS). The x-axis reflects intangible intensity and the y-axis reflects the simple slope on the binary rights offering variable. The
upward sloping line shows the reinforcing effect of intangible intensity has on the incentive to shift income following a rights offering. The
confidence bands surrounding the simple slope line, in red, indicate the standard error of the conditional slope. The area between the blue vertical
lines is the region where the conditional slope is statically significantly greater than zero based on a one-tailed p-value of 0.10. The vertical lines
correspond to values of INTS equal to 0.0475 and 0.1711. The conditional slope plot was created using the online tool available at http://www.
quantpsy.org/interact/hlm2
where the slope on RIGHTS is significantly different from zero.23

The information reflected in Table 1 is more effectively communicated via a conditional slope plot as shown in Fig. 3. Given that
INTS reinforces the effect of RIGHTS, the slope of the line representing the plotted conditional effects of RIGHTS increases with INTS.
The vertical dotted lines mark the range of INTS values for which the effect of RIGHTS is significantly different from zero (identical to
the J-N endpoints). Unlike inferences from the linear-additive model, a more thorough presentation of the interactive model’s results
allows a deeper understanding of the predicted effects of RIGHTS. From the conditional slope plot, one can observe that firms with a
rights offering shift more income, but unlike the linear-additive model, the positive slope on RIGHTS is only significant for INTS
values between 0.0475 and 0.1711. Thus, whereas the interactive model identifies the region of INTS where the effect of RIGHTS is
significant, with the marginal effect of RIGHTS within this region varying between 0.2133 and 0.6802, the linear-additive model
implies a uniform marginal effect of RIGHTS on income shifting of 0.3469 regardless of the INTS level.24
One clarification about the tabular and graphical presentation of conditional effects is in order. These presentations do not
directly test whether the effects of RIGHTS at different levels of INTS are statistically different from each other. In other words,
RIGHTS may have statistically significant effects at various levels of INTS, but this does not mean that those effects statistically differ
from each other across INTS levels. The interaction coefficient’s t-test assesses whether or not the slope on RIGHTS is significantly
different across a unit change in INTS.25 The estimated coefficient on INTSxRIGHTS is 3.7780, but it is not statistically significant due
to the large standard error (3.6062). The interaction term simply tests whether INTS reinforces the effect of RIGHTS on income
shifting; it does not test whether RIGHTS affects income shifting.
An example of a study where a conditional slope plot and confidence bands would aid interpretation is Lo, Wong, and Firth
(2010). Lo et al. examine how tax, financial reporting, and tunneling incentives affect the income shifting of Chinese-listed
23
It is useful incorporate information about the distribution of the conditioning variable. Of the 320 observations, 101 have INTS values within
the J-N significance area, 169 (50) observations have INTS values above the J-N minimum (maximum) values.
24
While we focus on the conditional effect of RIGHTS across INTS levels, one could also evaluate the conditional effect of INTS across RIGHTS.
Given RIGHTS is a binary variable, this analysis is relatively straightforward. Based on the results in Table 1 Column 2, the estimated simple slope on
INTS if RIGHTS = 0 is 1.0149, while the simple slope on INTS if RIGHTS = 1 is 4.79 (1.0149 + 3.778). Both estimated slopes are significantly
different from zero, but as indicated by the interaction estimate, these two slopes are not statistically different from each other. Using the meth-
odology in Eq. (5) we constructed confidence intervals for these estimates (p < .10). The confidence interval for the RIGHTS = 0 group is an
estimated slope between 0.0915 and 1.9383; the confidence interval for the RIGHTS = 1 group is 0.3174 and 9.2683. Berry et al. (2012) recommend
examining both derivatives from a two-way interaction to improve understanding and strengthen empirical tests.
25
Robinson, Tomek, and Schumaker (2013) suggests using differences in simple slopes to assess the significance of an interaction effect because
of its increased statistical power relative to the t-test on the interaction term. Regardless of the testing method, an insignificant term does not mean
that one should revert to a linear model.
70
companies.26 The proxy for income shifting is regressed on, among other variables, (1) a measure of the firm’s marginal tax rate
(MTR), (2) the percentage of shares owned by the government (GCONTROL), and (3) the interaction term MTR × GCONTROL. The
estimated coefficients on GCONTROL and MTR are statistically significant, but the estimated coefficient on MTR × GCONTROL is
not. As with the previously discussed papers, the authors misinterpret the GCONTROL and MTR coefficients, describing them as
unconditional effects despite the presence of an interaction term. The authors state that the significant coefficient on the MTR
constituent term means “…management is more likely to shift profits to the listed company when its marginal tax rate is low” (p. 12),
with no qualification that this interpretation is conditional on GCONTROL being zero.
Given the insignificant interaction coefficient estimate, the authors conduct supplemental tests to investigate further the tax and
tunneling trade-off. They separate firms into groups according to whether the firm faces (1) both tax and tunneling incentives, (2)
only tax incentive, (3) only tunneling incentive, or (4) neither tax nor tunneling incentives. The tax (tunneling) effect is found to hold
for the group of firms that do not have a tunneling (tax) incentive to shift income, but neither effect is dominant for the group of firms
that face both tax and tunneling incentives. The authors conclude that when the countervailing incentives are present, “…they cancel
each other out such that there is no significant earnings management via transfer pricing manipulations.” (p. 20) A conditional slope
plot with confidence bands could show the range of MTR where GCONTROL has a statistically significant conditional effect, and vice
versa, thereby giving readers a better understanding of the trade-off.27
4. Interactive modeling issues
This section discusses several issues related to interactive models, including the omission of constituent terms, the inclusion of
squared constituent terms, using mean centered data, and the effect of statistical noise.
4.1. Omission of constituent terms
It is recommended that the regression model include all the constituent terms that are components of the interaction unless a term
is specifically excluded by economic theory (Brambor et al., 2006, 66; Ozer-Bali & Sørensen, 2011, 6). The failure to include a
constituent term could create a correlated-omitted-variable bias that affects the estimate of the coefficient on the interaction term. In
the context of a tax trade-off model, a plausible reason to exclude a cost-related constituent term is that there will not be any tax-
motivated income shifting when the tax incentive to shift is zero. In an interactive model, the coefficient estimate on the cost factor
variable (CF) captures the effect of the cost factor when the tax incentive to shift income is zero. Because one would not expect any
tax-motivated income shifting when the tax incentive to shift is zero, one could argue that there is a theoretical reason to omit the cost-
related constituent term from the model. However, we caution that the dependent variable used in trade-off studies often does not
exclusively measure tax-motivated income shifting; rather, it often also includes income shifted for other purposes. Hence, a corre-
lated-omitted-variable bias still arises if the tax-motivated income shifting is correlated with other sources of income shifting cap-
tured by the dependent variable. Given that financial and tax reporting decisions are likely made simultaneously, and in a co-
ordinated fashion (Shackelford, Slemrod, and Sallee 2007), researchers should generally include the cost factor constituent terms in
the model. The analytical modeling in Randolph, Salamon, and Seida (2005) also suggests that the constituent terms play an im-
portant role in trade-off studies.
Klassen and LaPlante (2012b) is an example of a study where there is theoretical support for omitting a constituent term. They
analyze how detection costs affect cross-border income shifting by U.S.-based multinational corporations. The incentive to shift
income across borders is a function of the tax-rate differences between U.S. and foreign jurisdictions. Klassen and LaPlante examine if
the tax-rate incentive to engage in cross-border income shifting is mitigated by potential costs associated with tax authority en-
forcement actions. These costs are measured using a combined cost variable, denoted Reg, that captures enforcement costs associated
with both U.S. and foreign tax authorities (p. 1261). This cost variable is interacted with all tax-rate variables, but it is not included as
a constituent term in the regression model (p. 1261, 1272-73). Omitting the cost variable as a constituent term is justifiable in this
model because, alone, the tax enforcement cost is not a countervailing incentive. The cost variable in Klassen and LaPlante captures
the risk of detection and is a (mitigating) factor only if a tax-rate incentive to shift income exists. This contrasts with the counter-
vailing incentives between tax and financial reporting income present in studies that examine tax-motivated intertemporal income
shifting. In these settings, financial reporting incentives (such as concern over meeting earnings targets and/or leverage ratios) create
incentive to shift income into the current period, whether or not there is tax incentive to defer income.
4.2. Squared constituent terms
Ozer-Bali and Sørensen (2011, 6) recommend that an interactive regression model include squared terms of the constituent
26
Tunneling incentives refers to the expropriation of minority shareholder wealth by the controlling shareholder(s). The controlling shareholder
is the Chinese government, which expropriates wealth via transfer prices among related entities.
27
Evans, Gao, Hwang, and Wu. (2018) utilize a conditional slope plot to show the moderating effect of performance on the probability of CEO
departure across those with short and long performance periods. The conditional slope plot shows a significant difference in the relationship
between performance and CEO departure across short and long periods when performance is poor (i.e., negative returns) but not when returns are
near zero or positive.
71
variables that are included in the interaction terms. Including the squared-terms as controls helps to rule out the possibility that the
estimated interaction coefficient is reflecting non-linear relations between the constituent terms and the dependent variable rather
than a true interaction effect. Matsunaga et al. (1992), for example, as part of their sensitivity analysis include a squared net income
measure in their regression because reporting additional compensation expense “may not increase financial reporting costs when net
income is far away from the target, so the relation between financial reporting costs and the net income variable may be U-shaped.”
The Matsunaga et al. results were not sensitive to the inclusion of the squared income term. Another suggested benefit of including
squared terms is that it provides protection against both type I and type II errors related to the interaction term when the true model
includes squared terms (Ganzach, 1998). We recommend that research, as part of sensitivity analyses, include squared terms for those
constituent terms that might have a non-linear response function.
4.3. Mean-centered data: multicollinearity and coefficient interpretation
In the accounting literature, researchers sometimes emphasize a particular regression model, disclaim the results from an in-
teractive model, and/or mean-center variables due to concerns about multicollinearity (e.g., Ben-Nasr, Narjess, & Cosset, 2012, 625;
Chen, Chen, Lobo, & Wang, 2010, 991; Guo & Jiang, 2011, 200; Huang, Lee, & Rose-Green, 2012, 729; Miller, Fedor, & Ramsay,
2006, 140; Shevlin et al., 2012, 20). Multicollinearity may increase when including an interaction term in a model because of
correlation between the constituent and interaction terms. However, one should not immediately assume that multicollinearity is the
reason that the estimated coefficients on the constituent terms change in magnitude or significance level. The coefficient estimates on
the constituent terms often change when adding an interaction term, not because of multicollinearity, but because the meaning of the
constituent terms’ coefficient estimates change (Afshartous & Preston, 2011).
As explained in Section 3, the coefficient on each constituent term in an interactive model does not represent the unconditional
effect of the term; instead, it represents the conditional effect of the term when the other constituent term equals zero. Often, the
constituent term coefficients will reflect a more representative conditional effect after the continuous variables are mean-centered.
After centering the constituent terms, each term has a mean of zero, and hence the coefficients reflect the conditional effect of one
term when the other is at its raw mean. Centering is not necessary to interpret models that contain interactions of continuous
variables, nor does it alleviate the negative effects of multicollinearity if present. However, as noted in Robinson and Stocken (2013,
pp. 1275-76), centering allows the “main effect”, i.e., the constituent term coefficient, to be “meaningfully interpreted.󈭰
Because the mean is a measure of central tendency, it is often a relevant point for evaluating and tabulating the conditional effect.
Although, as mentioned earlier, even referring to this particular effect as a “main effect” might create some confusion.
As an example of the potential benefits of data centering, we return to the Shevlin et al. study discussed in Section 3. The last
column of Table 1 Panel A shows the regression output for the interactive model after mean centering the INTS variable. The
estimated coefficient on RIGHTS in the mean-centered interactive model is 0.3871.29 Because this estimate now represents the effect
of RIGHTS at mean INTS, the estimate differs greatly from the estimated coefficient on RIGHTS from the original interactive model
(0.0338), and instead is more similar to the estimated coefficient on RIGHTS from the original linear-additive model (0.3469). The
similarity of the estimated coefficient on RIGHTS across the linear-additive and centered interactive models would have made the
interaction results look more stable, likely making multicollinearity less of a concern.
We emphasize that the advantage of centering is to facilitate interpretation, not to reduce multicollinearity. Centering is often
suggested as a solution for multicollinearity (Aiken & West, 1991), and has been employed in accounting research for such reasons
(e.g. Huang et al., 2012; Kanagaretnam, Krishnan, & Lobo, 2010, 2032Kanagaretnam et al., 2010Kanagaretnam, Krishnan, & Lobo,
2010, 2032; Krishnan, Sami, & Zhang, 2005; Miller et al., 2006). However, multicollinearity arises when one cannot estimate the
model parameters accurately because there is not enough information in the data. Centering does not provide any new, or more
accurate, data and therefore does not improve the accuracy of estimated parameters, does not change the sampling accuracy of any of
the estimates, and does not change measures of fit (Brambor et al., 2006; Echambadi & Hess, 2007). Researchers may mistakenly
believe that centering reduces multicollinearity because the coefficient estimates and related t-statistics on constituent terms often
become more like those observed in the linear-additive model, and in many cases coefficient estimates on constituent terms change
from insignificant to significant. However, these changes occur only because the interpretation of the coefficients change, not because
of a reduction in multicollinearity.30
28
Robinson and Stocken (2013, p. 1276 footnote 14) correctly note that mean-centering “…does not change the coefficient on the interaction
effect.” However, this particular point is not always understood. For example, in the same issue of the Journal of Accounting Research that contained
the Robinson and Stocken study, a study by Shroff, Sun, and White (2013) on voluntary disclosure and information asymmetry states “[G]iven that
our regressions include interaction terms of continuous variables (i.e., DISC) we demean DISC to ease the interpretation of the interaction terms”
(italics added).
29
Note that this coefficient magnitude is identical to the effect we obtained from the original interactive model in Panel C when computing the
conditional effect of RIGHTS at mean INTS.
30
The variance inflation factor (VIF) is typically employed as a safe harbor to indicate whether collinearity problems are negligible but the cut-
offs applied are arbitrary (common cut-offs include 5 and 10). Mean-centering often reduces VIF values but it does not resolve any of the underlying
collinearity issues. Chennamaneni, Echambadi, Hess, and Syam (2016) discuss issues with the VIF measure with respect to detecting cases of
harmful multicollinearity and propose a new collinearity measure, called C2, to identify when collinearity is likely to affect statistical significance of
the estimated coefficients from an interactive model.
72
4.4. Converting a continuous variable to a binary variable
Often times a continuous variable that is part of an interaction term is recast in the form of a binary variable. Converting a
continuous variable to a binary variable might be justified if the continuous measure contains a high level of measurement error,
or as part of a sensitivity analysis. However, one generally should not “dummitize” (more commonly referred to as dichotomize) a
continuous variable to ease model interpretation without careful consideration of its consequences. The conversion to a binary
variable requires an ad hoc determination of where to split the distribution, limits the insights available from the multiplicative
model, and reduces statistical power (Stone-Romero & Anderson, 1994). If researchers incorporate improved discussion on the
conditional effects generated from a multiplicative model, present tests of the conditional effects at various levels of the
moderating variable, and/or conditional slope plots, then readers will better understand the inferences drawn from the inter-
active model. The enhanced presentation should reduce the necessity to dummitize continuous variables to ease model inter-
pretation.
4.5. Statistical noise
It is well known that statistical noise can inflate standard errors and/or bias coefficient estimates. Studies in other disciplines have
found that an interactive model compounds these problems, mostly because the interaction term magnifies the effects of measure-
ment error in the constituent terms. Noise in the residual can also reduce the ability to detect an interaction effect (Aguinis &
Gottfredson, 2010; Busemeyer & Jones, 1983; Jaccard & Turrisi, 2003; McClelland & Judd, 1993). Based on simulations discussed in
Appendix A, we find that it is difficult to detect interaction effects amid the noise levels common in tax trade-off studies, and those
likely in other accounting settings. We find that measurement error in the explanatory variables, and residual noise in the dependent
variable, reduce the ability to detect interaction effects. Across a range of assumptions regarding the level of statistical noise, the Type
II error rates for the interaction effect average approximately 80 percent. Strategies to overcome the effects of noise include in-
creasing sample size and oversampling extreme values of the variables involved in the interaction. However, increasing the sample
size might not be practical and oversampling is controversial (McClelland & Judd, 1993). Statisticians have also proposed non-OLS
methods to estimate interaction effects, but these methods tend to rely on restrictive assumptions about the structure and distribution
of the data (Murad & Freedman, 2007,).
Given the high type II error rate, we suggest that future trade-off research identify settings where the income-shifted, tax benefits,
and shifting costs can be measured with increased precision (such as income shifting via insurers’ loss reserves, e.g., Petroni, 1992;
Randolph et al., 2005). We also recommend that researchers not completely ignore interaction coefficients that have p-values just
outside conventional significance thresholds (see also Aguinus, 1995; Jaccard & Wan, 1995, 354; McClelland & Judd, 1993, 387). In
the simulation (see Appendix A), the probability of correctly detecting the interaction effect approximately doubled when the one-
tailed p-value cutoff was increased to 0.15 from 0.05. While we are not advocating a new acceptable p-value threshold of 0.15, we
recommend that researchers cautiously discuss the implications of the potential interaction effects when an interaction’s p-value is
within 0.15 and is potentially economically significant, so that readers appreciate the possibility that an estimated unconditional
effect may not be representative of the effect across the range of firms.31
5. Conclusion
This study discusses issues that accounting researchers should be aware of when using interactive regression models. We find that
interpretation errors related to interactions are common, and, in some cases, major hypotheses inadvertently go untested due to
misunderstanding about how an interaction term changes what one can infer from a regression model. The most common error is
failing to understand that in an interactive model the coefficient on a so-called “main effect” variable actually represents the con-
ditional effect of the variable only at the zero-level of the conditioning variable. We recommend referring to the so-called “main
effect” variables as constituent variables and explaining their estimated coefficients as conditional effects.
Failing to keep in mind the conditional nature of constituent term coefficients can also lead researchers to assume that multi-
collinearity is responsible for observed changes in the magnitude and significance of the coefficients after adding interaction terms to
a model. In actuality, these changes often occur because the so-called “main effect” is no longer truly a main effect but is instead the
conditional effect at what is often a tail value of the conditioning variable. Centering the constituent variables can make the estimated
coefficients reflect conditional effects that are more representative of central tendencies, but it does not alleviate the effects of
multicollinearity.
31
Grabner and Moers (2013, 1205) use a fifteen percent significance level to assess the interaction term. Given the difficulty in detecting
significant interactions, it is advisable to exercise caution when interpreting a null result. For example, Rego and Wilson (2012, 803) examine if “…
corporate governance strength moderates the relation between CEO and CFO equity risk incentives and risky tax avoidance.” The authors do not find
convincing statistical support for the interaction terms and “…conclude that the positive relation between equity risk incentives and risky tax
avoidance does not vary by strength of corporate governance” but acknowledge in a footnote that noise in the proxies for corporate governance may
be responsible for the predominately-insignificant interaction term coefficients. Similarly, Lim and Tan (2008) temper findings of an insignificant
interaction between non-audit services and auditor specialization by noting that the inability to document a significant interaction could be due to
measurement error. Also, see disclaimer in Shroff et al. (2013) regarding insignificant interaction term due to measurement error.
73
The study explains why researchers should evaluate conditional effects at various levels of the conditioning variable in order to
identify ranges where an effect is strongest and statistically significant. This can be done most comprehensively using conditional
slope plots but can also be done using other graphical or tabular analyses. For studies of how firms tradeoff financial reporting, tax, or
other incentives, we explain why including interaction terms in linear regression models is necessary in order to obtain insight into
how firms differentially respond to changes in competing incentives.
Noisy sample data is a major hurdle for accounting research that incorporates interactions because noise, particularly mea-
surement error, reduces the ability to detect interaction effects. In noisy settings, inferences may be limited to the existence of a trade-
off rather than the existence of systematic variations in a trade-off. However, the risk of ignoring or disclaiming results from models
that include interaction effects is that readers will fixate on the unconditional effect and not appreciate the possibility that un-
conditional effects can systematically differ across firms. We encourage researchers to provide nuanced discussion of potential in-
teractive effects when p-values for interaction coefficients are outside the conventional significance ranges but appear to be eco-
nomically significant.
For accounting research in general, the use of interactions will likely become more common as streams of research mature. After
identifying an unconditional effect, a next step is to understand whether there are systematic differences or limitations related to the
effect across firms or circumstances. The insights provided in this study are intended to help researchers better utilize and understand
interactive models in accounting research.
Acknowledgements
We appreciate the helpful comments from the editor and two anonymous referees, participants at the ATA Mid-Year Meeting, and
from Erik Beardsley, Stephen Lusch, Dan Lynch, Tom Omer, Terry Shevlin, and Ryan Wilson.
Appendix A
Simulation Analysis for Detecting Trade-Offs
This Appendix explains the simulations to investigate how noise affects inferences from a trade-off regression model. The in-
teractive model, as specified in Eq. (2), serves as the basis for the simulations. It regresses income shifted in dollars (denoted IS), on a
tax benefit variable, T, a cost of shifting variable, CF, and an interaction between T and CF. We follow Randolph et al. (2005) (RSS) in
defining T as continuous and CF as binary.32 This allows us to use the analytical modeling in RSS to set true values for the coefficients
that are internally consistent and to set realistic ranges for the variables. Consistent with RSS, we express T as a percentage of dollars
shifted and it represents the present value of the tax savings associated with reducing current period taxable income.
The modeling in RSS assumes that the tax benefit T is constant per dollar of income shifted regardless of the amount of
income shifted, and that the cost associated with shifting income to future periods increases at an increasing rate. Given this
assumption of increasing marginal costs, the total cost of shifting income is modeled as a quadratic function of the amount of
income shifted (IS), i.e., total cost = l(IS)+ q(IS2). The values of the linear (l) and quadratic (q) parameters of the cost function
differ across the high-cost (CF = 1) and low-cost (CF = 0) firm types. RSS then conduct a standard optimization for each firm
type that equates the marginal cost of shifting (∂Total shifting cost/∂IS) to the marginal tax benefit of shifting (∂T/∂IS). The
result is an expression for optimal dollars shifted, denoted IS*, as a linear function of T, CF, and a T × CF interaction as in Eq. (2).
The coefficients in (2) are functions of the linear (l) and quadratic (q) parameters of the cost function for each firm type (RSS,
318-20).
To generate a sample for the simulation we specified a mean tax benefit level, T, and an average amount of income shifted, IS, for
both high- and low-cost firms. We set the mean T at 7.0 percent for both types of firms.33 We chose the linear and quadratic
parameters of the cost function for each firm type such that the low-cost firms shift twice as many dollars as the high-cost firms at a T
of 0.07. Although this choice is ad hoc, some empirical support for this difference is provided in Albring et al. (2011, 76) which finds
that discretionary total accruals for firms with a tax incentive to accelerate loss recognition is 97 percent greater than that for control
firms. We operationalize this difference by having the low-cost (high-cost) firm type shift $30 ($15) when T equals its average of
0.07.34 With the average T and IS established for each firm type, we then chose the linear and quadratic parameters for the two cost
functions such that the coefficients in Eq. (2) are economically significant and have the signs normally expected in tax trade-off
32
Thus our simulation is similar to research that uses dichotomous variables to classify firms as facing either high or low non-tax incentive (e.g.,
Dhaliwal et al., 1994 (high/low pre managed financial earnings), Mills & Newberry, 2001 (public vs. private companies), Rego, 2003 (multinational
vs. domestic companies), Klassen & LaPlante, 2012a (high/low nontax costs).
33
This mean level is consistent with the range of estimates for income shifting incentives found in Guenther (1994), Maydew (1997), and
Randolph et al. (2005) and is close to the 8.2 percent mean tax incentive reported in Klassen and Laplante’s (2012a) study of cross-jurisdictional
income shifting.
34
One could think of the scale of these dollar values as being in millions (i.e., $30 million and $15 million), as is the convention in Compustat. We
do not further scale the income-shifting variable (IS) by a size scalar such as total assets, as is common in trade-off research, because this would only
affect coefficient magnitudes, not sign or statistical significance. Statistical inferences in a real setting could be affected, however, if the scaling is
done with error. We simulate the effect of random scaling error (and any other form of random variation in the dependent variable) by system-
atically varying the standard deviation of the regression model’s residual error term.
74
studies: a positive coefficient on T and negative coefficients on CF and T × CF.35 The resulting true model is:
IS = −0.5 + 435.7 × T − 7.5 × CF − 107.1 × T × CF (A1)
Having established the true model, we then estimate the coefficients using samples generated from the true model with error.
Each sample consists of 1000 hypothetical independent firms, with half of the firms assigned as low-cost (CF = 0) and half assigned as
high-cost (CF = 1). To create cross-sectional variation in the tax benefit T, we randomly assign each firm a level of T, where T is
normally distributed with a mean of 0.07 and standard deviation of 0.025. Because in reality negative T’s are infrequently observed,
we winsorize negative values of T to zero.
After assigning values of T and CF to each of the 1000 sample firms, we plug those values into the true model. We then add noise
to the true model by including a residual error term, denoted e, which is normally distributed with mean zero and standard deviation
σ, and refer to this added noise as classic error. The classic error represents random measurement error in IS, scaling error (if the
researcher scales IS), or the exclusion of other explanatory variables that affect IS. All of these sources of noise are assumed to be
uncorrelated with the explanatory variables of interest (i.e., T, CF, and T × CF).36
We manipulate σ to systematically vary the level of classic error across samples. We simulate six different levels of classic error.
Each level corresponds to a percentage: the expected unsigned magnitude of the classic error, e, as a percentage of expected dollars
shifted (IS), i.e. E(|e|)/E(IS). For example, to achieve a classic error level of ten percent, we would choose σ such that the mean
unsigned value of e, E(|e|), is ten percent of E(IS). The six levels of classic error we choose are 0, 10, 25, 50, 75, and 100 percent of E
(IS). Appendix B shows how we choose σ to achieve these desired levels of classic error. Because E(IS) is heavily conditional on firm
type, we add classic error to each firm type separately, basing σ on an E(IS) of 15 for high-cost firms and on an E(IS) of 30 for low-cost
firms. This allows each firm type to have the same classic error percentage.
After generating the sample values of IS using the true model coefficients, true values of T and CF, and the random error term, e,
we impart the final two sources of noise: measurement error in T and misclassification error in CF. We impart measurement error in T
by adding a normally distributed random error term φ (mean = 0, standard deviation = ω) to the true T values. As with classic error,
we simulate six levels of measurement error in T by manipulating ω. The levels again represent the expected unsigned error in T as a
percentage of expected T, i.e. E(|φ|)/E(T). We initially target the same six levels of measurement error that we did for classic error.
However, because we do not allow T to fall below zero, the effect of the error term φ becomes truncated, and the actual levels of
measurement error in T turn out to average 0, 10, 25, 45, 61, and 71 percent of E(T).
We impart misclassification error in CF by randomly choosing a certain number of CF = 1 firms and re-coding them as CF = 0,
and randomly choosing the same number of CF = 0 firms and re-coding them as CF = 1. We create four levels of misclassification
error in CF as a percentage of expected CF: 0, 10, 25, and 50 percent. Appendix B describes how these levels are achieved.
We generate 500 samples for each combination of classic error, measurement error in T, and misclassification error in CF (144
combinations in total: 6 × 6 × 4). We then estimate Eq. (A1) for each sample using OLS regression and determine how the three
sources of noise affect the ability to make correct inferences about the coefficient signs of T, CF, and T × CF. We also estimate a
linear-additive model (i.e. drop the interaction term) and examine the ability to make correct inferences about the unconditional
effects of T and CF.
Table A1 shows, for each combination of classic error, measurement error in T, and classification error in CF, the rate of correct
inference across the 500 regressions. There is a black outline around those cells with noise combinations that resulted in mean
regression R-squareds of 20 percent or less. We selected this R-squared cut-off because many trade-off studies have relatively low R-
squared values. The cells where the rate of correct coefficient inference is below fifty percent are shaded. The leftmost columns of
Table A1 show the rates of correct inference for the coefficient on T from the interactive model, with correct inference defined as a
positive estimated coefficient sign (consistent with the true model) that is statistically significant at the five percent level (one-tailed).
The correct inference about the T coefficient is made 92 percent of the time (untabulated) and never falls below 50 percent in any
cell.
The interactive model (leftmost columns) and linear-additive model (center columns) exhibit similar rates of correct inference
about the T coefficient, as long as the measurement error in T is at or below the 45 percent level. However, for higher levels of
measurement error in T, the interactive model yields a lower rate of correct inferences. The lower rate of correct inferences for the
interactive model is counterintuitive because in this model the coefficient on T theoretically reflects the firms that are most responsive
to T (because the coefficient captures the effect of T for low-cost firms only, i.e. firms where CF = 0). Thus, one might expect correct
inferences about the T coefficient to be lower in the linear-additive model because the less responsive (i.e. high-cost) firms dampen
the estimate on T.
An explanation for the linear-additive model’s higher rate of correct inferences is that it has the advantage of utilizing data for the
entire set of 1000 sample firms to estimate the average effect of T; in contrast, the coefficient estimate on T in the interactive model is
based on only the 500 firms considered low cost. An implication of this finding is that if researchers suspect high levels of mea-
surement error in the tax variable, then they might be limited to making inferences that can be made from the linear-additive model.
35
The linear and quadratic parameters for the high-cost firm type are 0.024347826 and 0.001521739, respectively. The low-cost firm type has a
value of 0.001147541 for both parameters.
36
It is well known that estimated coefficients are biased when the explanatory variables are correlated with sources of noise. The degree of the
bias depends on the degree of the correlation in each particular setting, and there is little insight we can add through a simulation. Thus, we focus on
uncorrelated sources of noise.
75
Table A1
Percentage of Samples with Correct Inference.
Each cell in the table above represents the percentage of samples in which the estimated regression coefficient is significantly different from zero in
the predicted direction (5 percent confidence level, one-tailed). Cells with mean R-squareds of 20% or less in Table 1 are outlined in black. Cells with
values of less than 50% are shaded. We simulate 500 samples for each combination of% Misclassification Error in CF, % Measurement Error in T, and
% Classic Error, and estimate a regression on each sample. The interactive regression specification is E(IS) = β0 + βTT+ βCFCF+ βT × CFT × CF and
the linear-additive specification is E(IS) = α0 + αTT+ αCFCF, where IS is a continuous measure of income shifted, T is a continuous measure of the
tax benefit of shifting income into the future, and CF is a (0, 1) indicator variable capturing whether the cost of shifting income into the future is high
(1) or low (0). Each of the 500 simulated samples has 1000 observations. See Section 5.1 and the Appendix for description of how observations were
generated.
As noted earlier, such inferences are limited to identifying whether a trade-off exists rather than whether the trade-off is conditional
on the level of cost.37 Untabulated sensitivity analysis shows that this advantage of the linear-additive model in detecting the truly
positive coefficient on T lessens or reverses as the moderating effect of T × CF becomes stronger. For example, if high-cost firms are
truly completely unresponsive to T, as opposed to being moderately less responsive to T, then pooling high- and low-cost firms into a
linear-additive model may inhibit the model’s ability to detect whether a trade-off exists.
The rightmost columns of Table A1 focus on the estimated T × CF coefficients from the interactive model.38 Correct inferences
tend to be made about the T × CF coefficient much less often than is the case for the T constituent term. The ability to make the
correct inference is particularly low for the noise combinations that had mean R-squareds of 20 percent or below. The rate of correct
inferences for the T × CF coefficient across these noise combinations is only 17.6 percent. One cause of this low rate is that inter-
acting two variables measured with error magnifies the measurement error (Busemeyer & Jones, 1983). Again, this suggests that
researchers studying noisy settings may have to limit their research question to whether a trade-off exists rather than whether the
trade-off varies with levels of cost. At the same time, as explained in Section 4, we encourage researchers to provide nuanced
discussions of potential interactive effects so that readers appreciate that Type II error may be hiding systematic heterogeneity in this
effect across firms. Balanced discussion seems most appropriate when p-values are just outside of conventional significance ranges. In
untabulated analysis, we find that the ability to detect the negative coefficient on T × CF increases from 17.6 percent to 27.9 percent
when the Type I error rate is increased to 10 percent (one-tailed) and increases to 35.7 percent when the Type I error rate is increased
37
Recall that the existence of a trade-off is only established when T has a significantly positive coefficient and CF has a significantly negative
coefficient in a linear model. In untabulated analysis, we find that the linear model statistically detected the effects of both T and CF 98 percent of
the time among the cells that had R-squareds of 20 percent or less. The lowest trade-off detection rate was 77 percent in the cell that has the highest
levels of all three types of noise (the mean R-squared in this cell is 0.02).
38
We do not discuss the simulation results for the coefficient on CF because it is of little interest in the interactive model since it reflects the effect
of CF only when T = 0.
76
to 15 percent (one-tailed). Of course, this improvement in the Type II error rate comes at the cost of increasing the Type I error rate.
In additional simulations, we increased the magnitude of the true interaction effect but it only resulted in modest changes to the
ability to detect a significant interaction term when noise levels are high.
Given that Shackelford and Shevlin (2001) advocate an interactive model to assess trade-offs, it is important to know what can be
inferred from the estimated coefficients. A significant interaction term generally implies a differential trade-off but detecting an
interaction is subject to considerable type II error. The simulation indicates that there is a greater probability to detect the existence of
a trade-off via the linear-additive model than to detect a differential trade-off via the interactive model. However, in the absence of a
significant interaction term, the conditional effects derived from the interactive model could provide insights and evidence regarding
the existence of a trade-off beyond those from the linear-additive model. Consistent with the existence of a trade-off, both variables
might have statistically significant conditional effects within some range of the other variable. Thus, an interactive model could
provide insights regarding the segment of the sample firms subject to a trade-off and might detect the existence of a trade-off for a
segment of the sample even in cases where the linear-additive model fails to detect a trade-off. We caution researchers who present
segment-level results to be clear about how narrow or wide the segments are and to refrain from overstating the meaningfulness of
the results.
Appendix B
Systematically Inducing Error into Simulations
The simulations involve three variables to which we add noise: IS, T, and CF. Denote any of these variables by X. Our objective is
to add measurement error (ME) to X such that the expected value of the unsigned measurement error is a specified percentage of the
expected value of X. Refer to this percentage as ME% = E(|ME|)/E(X).
By definition, ME = X − Xtrue, where X is the value after ME has been added and Xtrue is the value before ME has been added. We
require that measurement error is added in an unbiased way: E(ME) = 0.
A. X is a continuous variable
To achieve a desired ME% for a continuous X, add a normally distributed noise term e ∼ N(0, σ2) to the continuous variable X,
where σ = (Desired ME%) × E(X)/sqrt(2/π).
Proof. The numerator of ME% can be expressed as
E(|ME|) = E(|X − Xtrue|) = E(|(Xtrue + e) − Xtrue |) = E(|e|) (B.1)
Given that e ∼ N(0, σ2),

(B.2) E(|ME|) = E(|e|) = σ × sqrt(2/π)
Substituting (A.2) into Desired ME%:
Desired ME% = E(|ME|)/E(X) = [σ × sqrt(2/π)]/E(X) (B.3)
Solving for σ in terms of the other quantities:
σ = (Desired ME%) × E(X)/sqrt(2/π) (B.4)
B. X is dichotomous variable
For dichotomous X (0,1), let n0 equal the number of sample observations where X = 0 and let n1 equal the number of sample
observations where X = 1. Let the total number of sample observations n = n0 + n1. In the special case of our simulations,
n0 = n1=.5n.
Re-coding rule: To achieve a Desired ME% of c, take 0.5 × c × n0 of the observations originally coded as X = 0 and re-code them as
X = 1. Take 0.5 × c × n1 of the observations originally coded as X = 1 and re-code them as X = 0.
For example, in a sample containing 500 low-cost firms and 500 high-cost firms, to achieve a Desired ME% of 10 percent, take 25
(= 0.5 × 0.10 × 500) low-cost firms and re-code them as high-cost, and take 25 high-cost firms and re-code them as low-cost.
Proof. After re-coding, the number of observations where |ME| = 1 is:
=.5 × c × n0 + .5 × c × n1
=.5 × c × .5n + .5 × c × .5n (B.5)
=.5 × c × n.
The percentage of observations where |ME| = 1 is (0.5 × c × n)/n = .5 × c. Likewise, the percentage of observations where
|ME| = 0 is 1 − 0.5 × c.
The numerator of Desired ME% is then given by:
E(|ME|) = (.5 × c) × 1 + (1-.5 × c) × 0 = .5 × c (B.6)
77
This means that the re-coding rule results in a Desired ME% of c:
Desired ME% = E(|ME|)/E(X) = (.5 × c)/.5 = c (B.7)
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Burks, J. J., Randolph, D. W., and Seida, J. A. (2019) - Modeling and Interpreting Regressions With

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Journal of Accounting Literature 42 (2019) 61–79

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Journal of Accounting Literature

Modeling and interpreting regressions with interactions

ARTICLE INFO ABSTRACT

2. Conceptual issues and tax trade-offs

or trade off, competing incentives.

2.1. Regression model specification: linear-additive and linear-multiplicative models

IS = αo + αTT + αCFCF + εit. (1)

IS = βo + βTT + βCFCF + βT × CFT × CF (2)

From linear-additive model (1): ∂IS/∂T = αT, (3)

From interactive model (2): ∂IS/∂T = βT + βT × CFCF. (4)

Fig. 1. Linear-additive versus Interactive model.

3. Interactive models and conditional effects

3.1. Coefficient interpretation and conditional effects

3.2. Testing and presenting conditional effects

3.3. Interpretation issues in accounting research

hypotheses are not properly tested.18

(1) (2) (3)

Raw Raw Mean-centered

Panel B: Estimated coefficient variances and covariances from interactive model

INTS RIGHTS INTS*RIGHTS Intercept

INTS 0.516767 0.046637 −0.690837 −0.320847

Panel C: Analysis of conditional effect on RIGHTS for various INTS levels

10% 0.0000 0.0338 0.1890 0.18

where the slope on RIGHTS is significantly different from zero.23

4. Interactive modeling issues

4.1. Omission of constituent terms

4.2. Squared constituent terms

4.3. Mean-centered data: multicollinearity and coefficient interpretation

4.4. Converting a continuous variable to a binary variable

4.5. Statistical noise

Simulation Analysis for Detecting Trade-Offs

IS = −0.5 + 435.7 × T − 7.5 × CF − 107.1 × T × CF (A1)

Systematically Inducing Error into Simulations

E(|ME|) = E(|X − Xtrue|) = E(|(Xtrue + e) − Xtrue |) = E(|e|) (B.1)

Given that e ∼ N(0, σ2),

Desired ME% = E(|ME|)/E(X) = [σ × sqrt(2/π)]/E(X) (B.3)

Solving for σ in terms of the other quantities:

σ = (Desired ME%) × E(X)/sqrt(2/π) (B.4)

=.5 × c × .5n + .5 × c × .5n (B.5)

E(|ME|) = (.5 × c) × 1 + (1-.5 × c) × 0 = .5 × c (B.6)

This means that the re-coding rule results in a Desired ME% of c:

Desired ME% = E(|ME|)/E(X) = (.5 × c)/.5 = c (B.7)

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