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The Nexus between Aggressive Tax Planning and Earnings Management in different Political Systems and the Moderating Role of Corporate Governance
Soufiene Assidi
ISIGK, University of Kairouan, Tunisia Email: [email protected]
Omar Al Farooque UNE Business School
University of New England, Armidale, NSW 2351, Australia
Email: [email protected]
Khaldoon Albitar Faculty of Business and Law University of Portsmouth, UK Email: [email protected]
Abstract
The purpose of this paper is to explore the relationship between aggressive tax planning and earnings management in European listed companies. In addition, this study compares different political systems of the sample European countries when studying this relationship. Further, this study examines the moderating role of governance characteristics on the relationship between aggressive tax planning and earnings management. We use panel data models based on data of 105 companies listed on the EURONEXT 100 and NEXT 150 during the period 2011 to 2018. We also apply additional analysis and a robustness check to alleviate the endogeneity concern. The results show that there is a significant positive relationship between aggressive tax planning and earnings management. The results also reveal that firms which tend to use earnings management practices have a lower effective tax rate (ETR). This relationship is more pronounced in countries with a Presidential system compared to Parliamentary or Quasi- parliamentary system countries. Also, the findings relating to the moderating role of governance variables show that the interaction between each of board size and board independence with the
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effective tax rate is negative and significant. These findings suggest that the board plays an effective role in weakening the relationship between the effective tax rate and earnings management. That is, more members on the board of directors and more independent directors on the board along with the effective tax rate deters earnings management practices. Future research may extend this work by covering other attributes of corporate transparency including accounting conservatism and considering other proxies of aggressive tax planning. The findings help corporate stakeholders to better understand the relationship between aggressive tax planning and earnings management by highlighting the role of the political system and board governance and take the necessary actions to reduce these behaviors.
Keywords: Aggressive tax planning; Earnings management; Effective tax rate; political system;
European.
1. Introduction
With the recent political and economic changes in the world and the different scandals resulting from some accounting changes or manipulations of companies such as Enron and WorldCom, the reliability of financial reporting has gained much attention from regulators and practitioners (Chen et al., 2021; Chen et al., 2014). One of the main causes of these scandals is the involvement of companies in aggressive tax practices to reduce their taxes. Recent media reports have focused on the capability of multinational companies working in Australia to operate loopholes in tax legislation to minimize their international tax obligations (the Australian Financial Review, 2012). In the name of tax transparency, the giant technology companies (Facebook, Apple, and Google) paid just 200 million dollars tax in Australia compared to revenue of 11 billion dollars between 2018-2019 (Australian Financial Review, 2020). These reports indicate that most companies in the world adopt aggressive tax practices in one way or another. Although this practice is legitimate but possibly unethical, in the US context, some politicians encourage firms to relocate and avoid the US tax burden (Arnold and Wilson, 2014).
Taxes are a charge which affects the profits of the company on the one hand and the management of those profits on the other hand (Elemes et al., 2021). The tax represents a percentage of income that can be calculated using various methods via financial statements.
Indeed, managers usually make different decisions for tax matters. Shackelford and Shevlin
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(2001) provide evidence that financial reporting choices are affecting tax. Often times, politicians and academics have questioned whether it would be wise to minimize the gap between accounting books and taxation and move to a high compliance system in which income from accounting books is more equal to taxable income (Chen et al., 2021). The minimization of taxable income is the main objective included in tax planning. Tax planning (TP) is an act that aims to reduce tax expense and increase after tax earnings. Tax planning that maximizes the firm's expected discounted after-tax cash flows requires managers to consider their decisions on after-tax consequences (Shackelford, 2001). This may be considered as an investment for companies and shareholders (Chen et al., 2010). Nevertheless, investors may not encourage tax planning activities because of their overpricing. Frank et al. (2009) outline tax aggressiveness as a management technique for reducing taxable income through various tax planning activities. The practice of these techniques needs global strategies including management strategies and compensation strategies. Assidi and Hussainey (2020) find that external tax preparers are more tax aggressive than internal ones which explains that the choice and discretion of the tax preparers is substantial in tax management. In fact, aggressive tax planning may be potentially ambiguous to the real performance and affect the information content of taxable income (Ayers et al., 2009).
Because of the importance given by managers to taxation, the role of tax and its relationship with earnings management (EM) practices has increased (Neifar and Utz, 2019). While there is a perception that firms manipulate earnings for tax reasons (Mills et al., 1998; Mills, 1998;
Dhaliwal et al., 2004; Marques et al., 2011), there is a lack of empirical studies on the association between aggressive tax planning activities and earnings management behaviour of firms. This study fills the gap in the literature by providing empirical evidence in support of such a proposition. We explore the level to which variations in the effective tax rate (ETR) relates to earnings management through aggressive tax planning strategies. Given that the ETR has a powerful impact on earnings management practices, Mills et al. (1998) propose that investments in tax planning may result in a decreased ETR. Dhaliwal et al. (2004) hypothesize whether firms change their ETR between the third and fourth quarters as their objective is to manage earnings and provide evidence that reported taxes are used to manage earnings. The authors argue that any modification to the ETR is associated with earnings management. This is because, in practice, earnings are linked to the tax expense amount that allows managers to take the last decision about the level of earnings management. Companies are often reluctant to limit tax burdens too much to avoid suspicion of the tax authorities and investors (Armstrong
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et al., 2019). The debate between the costs and benefits of aggressive tax planning and earnings management continues. It can be argued that a better tax record decreases the uncertainty of financial reporting. Managing upward profits increases taxes and reduces tax shelters because downward tax management minimizes rising profits reported to shareholders (Blaylock et al., 2015). Based on the above discussion, this study examines the association between aggressive tax planning and earnings management of a sample of listed companies in European countries with different political systems. In addition, this study explores the moderating role of governance characteristics on the relationship between aggressive tax planning and earnings management.
This paper contributes to the literature in several ways. First, this study enhances the understanding of the relationship between aggressive tax planning and earnings management.
Secondly, to the best of our knowledge, this is the first paper that compares countries with different political systems when studying the relationship between earnings management and aggressive tax planning. Thirdly, this paper also highlights the moderating role of governance characteristics on the relationship between aggressive tax planning and earnings management.
The remainder of the article is organized as follows. In Section 2, we review prior research on earnings management and taxation and we develop the hypotheses. In Section 3, we describe the research methodology and data and, in Section 4, we report and discuss our empirical results. Finally, in Section 5, we provide the conclusions and implications of the study and give further insight about future research.
2. Literature review and hypothesis development
2.1 Aggressive tax planning activities and earnings management
The association between taxation and accounting is not as straightforward as one might imagine (Hsu et al., 2021). This is a much more complex relationship due to the sometimes contradictory objectives assigned to the two topics (Nobes, 2004; Formigioni et al., 2009). To understand corporate tax avoidance, it is necessary to know the managerial incentives. To minimize tax burdens or avoid paying government tax, firms use specific strategies or steps to meet their objectives (Assidi and Hussainey, 2020). Aggressive tax planning may result from agency conflicts between managers and shareholders (Desai and Dharmapala, 2006). In this case, managers remain careful to provide reliable information which could lessen the problem of information asymmetry which usually motivates and leads to earnings management practices
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(Healy and Wahlen, 1999). However, to protect their interest, managers avoid exposing their motivation for tax strategies (Hanlon et al., 2014). Similarly to other agency conflicts, managers own private information about the aggressiveness of the firm’s tax positions and can become involved in risky tax strategies where shareholders will bear the costs if detected (Bauer et al., 2018).
Drawing on behavioral theories, the literature gives more insights into investor behavior. It also causes managers to take actions and decisions to manage the profits or to increase them through income smoothing in order to protect their personal interest (Kasipillai and Mahenthiran, 2013).
Aliani et al. (2017) argue that CEO overconfidence is positively related to tax planning.
Managers have used their own discretionary power to manage accounting results without influencing income tax (Mills and Newberry, 2001). To realize the advantage of aggressive tax planning, managers tend to decrease accounting income and avoid paying extra taxes. Thus, managers engage in corporate tax avoidance for their own interest, not for the interest of shareholders.
Aggressive tax planning might be an instrument for earnings management because in managing accounting and taxation related issues together, managers take some decisions such as reportable accounting earnings before tax, timing of tax payment and deferred tax (assets/liabilities) (Assidi and Omri, 2017). Kasipillai and Mahenthiran (2013) reveal that managers use both accruals and loss allowances to achieve net deferred tax liabilities.
Generally, a firm’s involvement in various forms of tax planning to decrease expected tax liabilities is mirrored in its ETR. Therefore, the level of aggressive tax planning can be detected by the differences between the statutory tax rate (STR) and ETR. Ghardallou and Ftouhi (2020) contend that international/multinational firms do have aggressive tax planning through many complex techniques such as transfer pricing, loopholes in tax legislation etc. They argue that the existence of several complex techniques could be a reason for a paucity of studies not exploring aggressive tax planning. In fact, all tax planning decisions often require increased complexity in their management and motives to increase the firm value (Balakrishnan et al., 2019).
Exploring earnings management and aggressive tax planning is noteworthy in judging the earnings quality and detecting the managers’ behavior in the process through tax planning.
Frank et al. (2009) develop a proxy to measure tax reporting aggressiveness which identifies the activity of tax shelters. Using this proxy, the authors report that corporate culture and
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incentives have a significant impact on aggressive tax planning (Payne and Raiborn, 2018).
More precisely, firms that reveal aggressive tax planning and earnings management strategies at the same time tend to have strategies related to all the elements of the cash flow statement and managerial remuneration (Jia and Gao, 2021). This positive association between aggressive tax planning practices and aggressive financial management can be clarified through the companies having investment, operating and aggressive financing strategies (Frank et al., 2009). Balakrishnan et al. (2019) find that tax planning activity influences the business environment and decreases transparency and makes their management more complex. The aggressive tax strategy is characterized by an uncertain environment and variables that influence the calculation and estimates of the tax burden (Taylor and Richardson, 2014). The investment in tax planning activities can also be facilitated by the auditor’s services. Assidi and Hussainey (2020) reveal that external tax preparers are more tax aggressive than the internal preparers. Cook et al. (2008) show that auditor fees related to tax services may affect a firm’s third-to-fourth-quarter changes in ETR for the purpose of managing earnings forecasts and tax expenditure. They find the ETR technique is instrumental to earnings management after controlling for other types of accounting manipulation.
The difference between the accounting income and taxable income is considered as a tool to predict earnings management by tax planning activities. Tang and Firth (2011) examine the association between book–tax differences (BTDs) and earnings management, tax management, and their interactions in the Chinese context. They show that firms having several incentives in accounting profit and tax management usually demonstrate high levels of abnormal profit incentives and their tax management also exhibits high abnormal BTD levels. This finding indicates that BTDs can be used to detect accounting and taxation manipulation induced by managerial self-dealing motivations. Because managerial opportunism in tax evasion is legitimate, in some cases managers engage in disclosing bad information which increases firm risk and decreases stock price (Kim et al., 2010). Desai and Dharmapala (2006) examine the connection between earnings management and corporate tax avoidance and demonstrate how tax shelter products enable managers to manipulate reported earnings. Another stream of research suggests that multinational organizational structures are influenced by tax considerations and engage in the process of tax planning if the tax rate varies between 25% and 35% (Mahenthiran and Kasipillai, 2012; Blouin and Krull, 2016). We, therefore, develop the following hypothesis:
Hypothesis 1: Aggressive tax planning activities positively affect earnings management.
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2.2 Aggressive tax planning activities and earnings management under different political systems
Compulsory taxes are the main sources for financing public expenditure (Levaggi and Panteghini, 2021). The political system link is valuable, as governments control resources and set necessary taxes through legislation and economic policies (Ban et al., 2021). The political system helps managers to assist their firm and choose favorable treatments that can help the government (Wu et al., 2012). Therefore, the political system can support and protect businesses and influence tax burdens and firm profits (Li et al., 2008). This is explained by the political vision adopted by any system of government (Kim and Zhang, 2016).
Belghitar et al. (2019) argue that firms increase their accruals management when they have political connections. This shows that the political system does matter in a firm’s decision- making process. The political connection of firms and tax are examined by many researchers and their results are mixed. For instance, Kim and Zhang (2016) investigate the relationship between tax aggressiveness and the political connection of firms and find that politically connected firms are more tax aggressive than non-connected firms. Also, Adhikari et al. (2006) examine the relationship between political connection of firms and ETR and report that firms with political relations pay lower taxes compared to their counterparts. This explains the role of a political system in the taxation management of firms. Again, according to Pilcher (2011), a basic assumption is that politicians engage in opportunistic behavior to satisfy their self- interest when stakeholder pressure is intensive. Excessive pressure may exist in elections.
García-Sánchez et al. (2014) argue that elections give politicians a motive to behave opportunistically to satisfy their own interest to be re-elected. They also find that the proximity to an election may affect the financial position of local governments. Ferreira et al. (2013) show a relationship between the timing of the pre-election period and earnings management when political competition is very strong. Thus, following the previous discussion, we develop the following hypothesis:
Hypothesis 2: Different political systems can influence the relationship between aggressive tax planning activities and earnings management.
2.3 Aggressive tax planning activities and earnings management under corporate governance
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Earnings management is a practice used by firms to control their earnings and taxes (Krull, 2004). Since, earnings management deceives the users of financial reports by presenting false information about a firm's actual operational success, corporate governance plays a key role in controlling earnings management (Fan et al., 2021). As a result, corporate governance systems appear very important for investors to acquire accurate information from financial reports, as it can restrain a company's aggressiveness in earnings management. Lanis and Richardson (2013) contend that the main incentive/motivation and choice of managers for engaging in aggressive tax activity is to reduce the amount of tax owed by the firm which then has an impact on business profits both legitimately and unlawfully. Strong governance can help in providing objectivity in making decisions and also in preventing the counter-productive action of individuals (Widyaningsih et al., 2017). Therefore, governance will also help in limiting tax avoidance (Honggowati et al., 2017; Chouaibi et al., 2021). In this study, from the point view of the stakeholders, aggressive tax planning is a legitimate and legal activity for the firm which may have an impact on a firm's value. As a result, governance mechanisms may be able to mitigate this possible conflict of interest. Good governance is a control structure which ensures that the interests of both external and internal stakeholders are met. Thus, the tax planning procedures adopted is crucial in order to keep track of various actors’ interests (Borji, 2020).
Given the importance of governance in dealing with managerial self-interest and in protecting stakeholders’ interests, and in enhancing financial performance and firm value (Rossi et al., 2015), it is of interest in this study to observe the role of governance structures in aggressive tax planning decisions which includes managers' incentive-compensation contracts. As such, a number of governance variables (e.g. board size, presence of independent directors, board diversity and duality functions) are used to show interactions with ETR to find their joint effect on earnings management. Such moderation will indicate whether the relationship between aggressive tax planning activities and earnings management is strengthening (i.e.
complementary) or weakening (i.e. non-complementary) with the presence of governance variables. Accordingly, we develop the following hypothesis:
Hypothesis 3: Corporate governance moderates the relationship between aggressive tax planning activities and earnings management.
3. Research design
3.1 Sample and data
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The study sample is comprised of European firms listed on the EURONEXT 100 and NEXT 150. Our sample period spans from 2011 to 2018. We obtain data from the annual reports and websites of companies. The choice of the sample was based on the availability and recently published data. Financial sector firms and state companies are excluded because they use industry-specific accounting rules. We also eliminate firms that have negative tax burdens.
Table 1 reports the summary of the sample, indicating the final sample comprises 105 firms (840 firm-year observations) in four European countries.
3.2 Variables
3.2.1 Dependent variables
Both aggressive tax planning and earnings manipulation have a possible impact on accounting income and taxable income (Borkowski and Gaffney, 2021). Some researchers show that a higher marginal tax rate leads firms to reduce their incomes for tax considerations (Edwards et al., 2021). Also, it is predictable that firms may reduce their earnings to zero when their average ETR is higher (Guenther, 1994). In this study, we presume a positive relationship between aggressive tax planning (proxied by ETR) and earnings management. Earnings management is estimated as the total accruals scaled by total assets (Marques et al., 2011).
3.2.2 Independent variables
Although it is challenging to measure the effectiveness/aggressiveness of tax planning, researchers who have studied this issue including Mills et al. (1998) and Phillips (2003), believe
Table 1: Summary of the sample
All firms listed in the EURONEXT 100 and NEXT 150 250
Less:
Financial firms (28)
Utility firms (7)
Negative effective tax rate (106)
Extreme effective tax rate 4
Final sample (number of firms) 105
Final sample (firm years) 840
Number of companies by country:
France 68
Belgium 12
Netherlands 19
Portugal 6
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that ETR closely reveals aggressive/effective tax planning compared to other proxies.
Therefore, if two companies show an equal amount of before-tax accounting profit, their tax liabilities could still be different depending on the levels of ETR. That is, the company that pays a smaller tax amount has a lower ETR and will be more effective with tax planning compared to other companies. Both Dyreng et al. (2008) and Robinson et al. (2010) argue that ETR is a proxy to capture corporate tax planning aggressiveness. In addition, manuals for practitioners frequently deal with specific technical tax planning to reduce ETR of companies (Ghardallou and Ftouhi, 2020). Following Assidi and Hussainey (2020) and Balakrishnan et al. (2019), we use two measures of ETR as a proxy for tax planning in our sample. First, we measure ETR1 as income tax expense divided by income before taxes. The income tax expense includes both current and deferred income taxes. Despite some limitations, this measure continues to be the best measure of tax planning activities available and the most popular measure of tax avoidance (Ftouhi and Ghardallou, 2020). Second, we measure ETR2 as total cash taxes paid divided by pre-tax income. Since this measurement focuses on the amount of cash expenditures used to measure strategies of tax avoidance (Dyreng et al., 2008).
3.2.3 Control variables
To control the relationship between ETR and earnings management, we add some variables to our regression model. Corporate size (SIZE) suggests that large companies can realize economies of scale through tax planning, and they also have the techniques, tools and motivations to optimize tax (Assidi et al., 2016). Leverage (LEV) indicates that firms with higher leverage have lower ETR and they are more efficient to optimize corporate taxes (Mills et al., 1998).Capital intensity (CAPINT) relates to fixed assets where the presence of higher fixed assets can affect the operational activities by increasing production volumes and thereby maximize a firm’s earnings (Kim and Sohn, 2013). Dividends (DIV) represents the best indicator for the relation between shareholders and managers because the amount of dividends can reduce the asymmetric information problem (Denis and Osobov, 2008). Growth of sales (GROWTH) specifies that firms with high sales growth along with highly concentrated share ownership are more likely to have their profits manipulated (He et al., 2017). Return on assets (ROA) is an indicator that describes the ability of the company to realize profits through its capacities and resources, as reflected in several policies and decisions taken by the company.
Inflation rate (INFL) captures the reaction of firms to macro-economic price changes.
3.3 Regression model
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To estimate the relationship between aggressive tax planning (i.e. ETR) and earnings management (i.e. EM), we construct the following regression models for testing the hypotheses:
0 1 2 3 4 5 6 7 8 (1)
it it it it it it it it it it
EM = + ETR + SIZE + GROWTH + ROA + INFL + DIV + CAPINT + LEV +
* 2 * 3 * 4 * 5 6
0 1
7 8 9 10 11
ETR Size Growth
ETR ETR
BSIZE INDR BDIV DUF
EMit ETRit it it it it it it it it it
ROAit INFLit Divit CAPINTit LEVit it
+ + + +
= + +
+ + + + + + (2)
where i represents the number of firms; t represents the year; earnings management (EM) is measured as the total accruals divided by total assets. The variable effective tax rate (ETR) is measured using total tax burden divided by profit before tax and SIZE is equal to the log of a firm’s total assets. LEV is measured by total debts over total assets and CAPINT is measured as tangible assets divided by total assets. DIV is measured by percentage of profit repatriation scaled per share on earnings per share and GROWTH is measured as one-year percentage growth of sales while ROA is measured by net income scaled by the total assets. Inflation rate (INFL) is measured by the annual inflation rate which captures the reaction of firms during higher inflation periods. Board size (BSIZE) is measured by the number of directors on the board and Independent directors (INDR) is measured by the percentage of independent directors on the board. Board diversity (BDIV) is measured by the percentage of female members of the board and the dual function (DUF) as chairman, and the CEO is a dichotomous variable that takes a value of 1 if the president of the board is, at the same time, the chief executive, and 0 otherwise.
The analysis of the relationship between aggressive tax planning and earnings management involves the panel data regression method. The literature records panel data analysis as an efficient statistical approach with a structure that considers unobservable and consistent heterogeneity. Panel data regression can capture the heterogeneity of the variables by allowing either time-variant or time-invariant to be included in models (Law, 2018). Following the literature, this study applies the Fixed Effects method to control for the effect of time-invariant firm characteristics. The Fixed Effect method assumes that the time-invariant characters are unique for individual variables which are not correlated with each other. Fixed Effects also manages the omitted variable bias problems and provides robust estimates.
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4. Results and discussion
4.1 Univariate analysis
The descriptive statistics of the variables included can be seen in Table 2. Based on the results, the mean value of ETR is 0.28, with a minimum of 0 and a maximum of 0.844. The average EM is -0.001 ranging between minimum of -0.276 to a maximum of 0.479. Again, the mean firm leverage is 22%, suggesting that debt is not more than 25% in our sample of firms. Firm size has a mean of 3.53, with a maximum of 5.431. Average ROA, dividend (DIV) and sales growth (GROWTH) are 5.94, 1.05 and 0.07 respectively. Lastly, the mean value of capital intensity (CAPINT) is 0.227 and for inflation (INFL) is 1.81.
Table 2. Descriptive statistics
Variable Mean Std. Dev. Min Max
EM -.001 .073 -.276 .479
ETR .28 .111 0 .844
SIZE 3.537 .765 1.184 5.431
LEV .22 .25 0 2.428
ROA 5.943 5.245 -17.62 45.47
CAPINT .227 .213 0 .999
GROWTH .066 .168 -.954 .956
DIV 1.046 1.592 0 28
INFL 1.809 .853 -.836 4.487
Table 3 presents the correlations of the variables. As can be seen, ETR is negatively and significantly correlated with SIZE, ROA, DIV and INFL, while positively and significantly correlated with LEV, CAPINT and GROWTH. For our study, the results of the Variance Inflation Factor (VIF) are also presented in Table 3 which indicates that the values ranged between 1.02 and 1.15, all under 10, demonstrating that there is no sign of multicollinearity problems (Hair et al., 2010).
Table 3. Correlation matrix and VIF
Variables VIF (1) (2) (3) (4) (5) (6) (7) (8)
(1) ETR 1.025 1.000
(2) SIZE 1.154 -0.031 1.000
(3) LEV 1.017 0.075 0.059 1.000
(4) ROA 1.07 -0.068 -0.139 -0.022 1.000
(5) CAPINT 1.013 0.014 0.174 0.064 0.071 1.000
(6) GROWTH 1.112 0.014 -0.116 -0.022 0.048 -0.002 1.000
(7) DIV 1.062 -0.119 0.230 -0.022 0.125 -0.050 -0.049 1.000
(8) INFL 1.014 -0.048 -0.023 -0.023 0.080 0.072 0.029 0.011 1.000
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4.2 Multivariate analysis
To study the relationship between aggressive tax planning and earnings management, we examine ETR in a multivariate analysis framework as presented in Table 4, using the FE method. We find a significant positive relation between aggressive tax planning (through ETR) and earnings management (p < 0.01). Thus, Hypothesis 1 is supported. It means that managers aim to optimize the tax burden through the manipulation of financial statements. This result is reliable with the notion that firms with aggressive tax planning practices and aggressive financial management, tend to have investment strategies with active, operating and aggressive financing (Frank et al., 2009). More specially, firms use many strategies to manipulate their earnings. For example, if the firm tends to avoid reporting losses, it can manage their earnings upwards. In this case, the firm adopts accounting policies to optimize tax planning. In this sense, a tax expense is an opportunity to manage earnings (Dhaliwal et al., 2004). In other words, the ETR is positively associated with earnings management meaning that firms use ETR as a proxy for tax aggressiveness to manipulate earnings. This is consistent with the domain of idiosyncrasy between financial accounting and tax instructions. This result corroborates with the finding of Frank et al. (2009) who explain that firms have a possibility to increase book income and decrease taxable income at the same time. Our result, however, contradicts the findings of Kałdoński and Jewartowski (2020), showing a negative relation between earnings management and ETR.
In our analysis, we provide evidence that aggressive tax planning is a substantial factor in earnings management. Taxpayer companies habitually apply earnings management to avoid high tax payment and to regulate the timing of payment. This result is consistent with Guenther (1994), Yamashita and Otogawa (2008) and Slamet and Wijayanti (2012) demonstrating the sign of earnings management in response to corporate income tax rate increase/decrease. In the same vein, Assidi and Omri (2017) find that the timing of tax payments is also a technique for minimizing the tax burden. Moreover, our finding supports the idea of controlling tax planning as a legitimate and essential strategy to realizing the purposes of earnings management (Omer et al., 2006).
Table 4. Earnings management and aggressive tax planning Fixed effect
Variables Model 1
ETR 0.065***
14 (0.000)
SIZE 0.004
(0.714)
LEV 0.030**
(0.031)
ROA 0.004***
(0.000)
CAPITN -0.054
(0.164)
GROWTH 0.051***
(0.000)
DIV 0.001
(0.632)
INFL 0.007***
(0.000)
Industry Dummies Included
Year Dummies Included
Constant -0.035
(0.414)
F- stat 22.14***
R-squared 0.42
Observations 840
Note: ***, ** and * indicate statistical significance at the 1%, 5% and 10% thresholds, respectively.
The inclusion of the control variables is designed to capture observable aggressive earnings management. One possibility is that modifications in features of the firm contribute to the increase of earnings management practices. It is noteworthy that sales growth (GROWTH) is significantly positive with EM. Our result shows that high-growth firms are related to high earnings management. This result can be explained by the flexibility of earnings management in the growing stage of firms compared to mature firms, since it is not easy to detect the business activities of fast growing firms. Therefore, managers of high growth firms probably have strong incentives to reach earnings benchmarks. Again, ROA is significantly positive with earnings management. This result can be explained by the role of managers in the manipulation of current earnings (either an increase or a decrease). We also find that leverage (LEV) is positive and significant with earnings management, indicating that firms have a higher motivation to engage in earnings management when they have a higher leverage ratio that minimizes their tax burden.
Finally, a positive and significant coefficient of inflation (INFL) with earnings management suggests that inflation sometimes can lead to higher earnings management.
4.3. Additional analysis and robustness tests
To analyze the sensitivity of the results, we have divided the sample into two sub-groups categorized by their political system. The first sub-sample includes firms with the Presidential system in the country and the second sub-sample includes firms with the Parliamentary or
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Quasi-parliamentary system. This division is within the framework of the political connection between the enterprise and its system. Based on sub-sampling according to the political system, Table 5 presents the regression results obtained using the Fixed Effect method. Overall, the coefficients of variable of interest maintain the same sign and statistical significance as those obtained using the Fixed Effect method in Table 4. This evidence supports the robustness of the findings presented here. In particular, ETR shows a positive and significant effect on earnings management in the Presidential system countries as well as in Parliamentary or Quasi- parliamentary system countries at p < 0.05, and p < 0.10 levels of significance. Therefore, the positive relationship between ETR and earnings management is more pronounced in Presidential system countries compared to Parliamentary or Quasi-parliamentary system countries. Thus, Hypothesis 2 is also supported. Regarding the control variables, all of them show similar findings in Presidential system countries as reported in Table 4. In addition, SIZE is also shows a positive effect on earnings management, albeit weakly significant. In Parliamentary or Quasi-parliamentary system countries, only ROA and GROWTH demonstrate a positive and significant effect on earnings management.
Table 5. Earnings management and aggressive tax planning in presence of political system
Presidential system Parliamentary or quasi-parliamentary system
ETR 0.045**
(0.014)
0.061*
(0.072)
SIZE 0.025*
(0.052)
-0.014 (0.605)
LEV 0.042***
(0.001)
-0.006 (0.911)
ROA 0.008***
(0.000)
0.002***
(0.000)
CAPITN -0.013
(0.815)
-0.057 (0.332)
GROWTH 0.027**
(0.011)
0.074***
(0.000)
DIV 0.000
(0.974)
0.006 (0.415)
INFL 0.009***
(0.000)
0.002 (0.424)
Industry Dummies Included Included
Year Dummies Included Included
Constant -0.142***
(0.004)
0.036 (0.669)
F- stat 26.70*** 31.07***
R-squared 0.45 0.43
Observations 840 840
Note: ***, ** and * indicate statistical significance at the 1%, 5% and 10% thresholds, respectively.
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Further, we have also included the interaction between each corporate governance variable (BSIZE, BDIV, INDR and DUF) and ETR to explore the moderating role of each governance factor on the relationship between ETR and earnings management. As can be seen from Table 6, we apply the Fixed Effect method and find that the interaction between board director size (BSIZE) and ETR is negative and significant (p < 0.10). This finding suggests that board size plays as a moderator between the ETR and earnings management relationship. That is, more members on the board of directors along with ETR reduces the company earnings management slightly. Similarly, we also find a significant and negative association (p < 0.05) interaction of independent directors (INDR) and ETR on earnings management. This result explains that the existence of independent directors massively reduces company earnings management. In summary, both board size and independent directors can effectively monitor the firm’s behavior and constrain earnings management practices. However, board diversity (BDIV) and dual function (DUF) do not show any moderating effect. Thus, Hypothesis 3 is partially supported.
It should be noted here that among these four governance variables, board size and independent directors remain dominant governance factors, compared to board diversity and dual function.
Therefore, we can conclude that governance factors are generally non-complementary to the positive relationship between ETR and earnings management that can effectively deter earnings management behavior of firms.
Table 6. Interaction between ETR and corporate governance and their effect on earnings management
Variables Model 2
ETR*BSIZE -0.005*
(0.058)
ETR *BDIV 0.015
(0.101)
ETR * INDR -0.137**
(0.016)
ETR * DUF -0.011
(0.254)
SIZE 0.006
0.651
LEV 0.033**
0.021
ROA 0.004***
0.000
CAPITN -0.052
0.193
GROWTH 0.048***
0.000
DIV 0.000
0.781
INFL 0.007***
0.000
17
Industry Dummies Included
Year Dummies Included
Constant -0.044
0.319
F- stat 29.43***
R-squared 0.47
Observations 840
Note: ***, ** and * indicate statistical significance at the 1%, 5% and 10% thresholds, respectively.
5. Conclusion
Firms are often involved in numerous practices and techniques of aggressive tax planning to reduce predictable tax liabilities. To achieve this goal, we explore earnings management as a previously unexamined instrument for tax purposes. Using 105 companies listed on the EURONEXT 100 and NEXT 150 during the period 2011 to 2018, our multiple regression analysis shows evidence consistent with the developed hypotheses. We provide empirical evidence that tax related income diversion is positively related to earnings management. We also find empirical support that the effects of managerial opportunism comes from other characteristics of companies. This result is partially consistent with the outcome of Frank et al.
(2009)which shows that aggressive tax planning can be related to aggressive reporting. The practice of aggressive tax planning is important for investors and increases their benefit.
The findings show that the relationship between earnings management and effective aggressive tax planning is positive and significant for the whole sample as well as for the sub-samples. The results confirm our finding and show that the political system can be a determinant to explain the relation between aggressive tax planningand earnings management. Also, importantly, the results suggest that corporate governance can be an effective vehicle to minimize the effect of aggressive tax planning and earnings management practices. Our findings have several implications for managers, regulators, investors politicians and other stakeholders. The findings help regulators to understand more why companies engage in aggressive tax planning through profit management with a tax saving perspective. Policy makers and politicians can consider these results when planning new legislation to tackle this practice. Firms and managers who are engaged in aggressive tax planningand earnings management practices need to try and reduce the agency cost stemming from private benefits of earnings management. Finally, future research may extend this work by covering other attributes of corporate transparency including accounting conservatism and considering other proxies of aggressive tax planning.
18
Acknowledgments
We thank the anonymous reviewers and the editor for helpful comments.
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