Malaysian Listed Firm s Tax Avoidance: Another Earnings Management Strategy?

Transcription

1 Malaysian Listed Firm s Tax Avoidance: Another Earnings Management Strategy? Mohd Waliuddin Mohd Razali, Pong Xiang Yi, Rayenda Khresna Brahmana, and Akmal Hisham Tak To Link this Article: DOI: /IJARBSS/v9-i2/5597 Received: 11 Jan 2019, Revised: 21 Feb 2019, Accepted: 26 Feb 2019 Published Online: 02 March 2019 In-Text Citation: (Razali, Yi, Brahmana, & Tak, 2019) To Cite this Article: Razali, M. W. M., Yi, P. X., Brahmana, R. K., & Tak, A. H. (2019). Malaysian Listed Firm s Tax Avoidance: Another Earnings Management Strategy? International Journal of Academic Research in Business and Social Sciences, 9(2), Copyright: 2019 The Author(s) Published by Human Resource Management Academic Research Society ( This article is published under the Creative Commons Attribution (CC BY 4.0) license. Anyone may reproduce, distribute, translate and create derivative works of this article (for both commercial and non-commercial purposes), subject to full attribution to the original publication and authors. The full terms of this license may be seen at: Vol. 9, No. 2, 2019, Pg JOURNAL HOMEPAGE Full Terms & Conditions of access and use can be found at 643

2 Malaysian Listed Firm s Tax Avoidance: Another Earnings Management Strategy? Mohd Waliuddin Mohd Razali, Pong Xiang Yi, Rayenda Khresna Brahmana, and Akmal Hisham Tak Faculty Economics & Business, Universiti Malaysia Sarawak (UNIMAS) Kota Samarahan, Sarawak, Malaysia Abstract This study examines the role of tax avoidance on firm s earnings management for a sample of 149 listed public firms in Malaysia over Beneish M-score is used to measure the earnings management and effective tax rate to measure the tax avoidance. After controlling firm size, growth, leverage and profitability, the result shows that only two variables which tax avoidance and growth are positively significant towards the earnings management. The result implies that firms may manage their earning to enjoy tax advantages. Moreover, management in growth firms tend engages better earnings performance and thus it may affect the firm investment strategies. Background of Study Tax receipts are still one of main income for Malaysia. According to the data obtained from CEIC database, the tax revenue of Malaysian government was RM1840 millions in year 1970 and this amount kept on increasing steadily to RM21244 millions in year 1990 and RM millions in year The tax receipts have increased % in year 2013 since year The changes in tax revenue for Malaysian government are shown in the figure1 below: 644

3 RM millions RM millions Figure 1: Tax Receipts of Malaysian Government, Source: CEIC database, Years Among the taxes collected by Malaysian government, corporate tax is given attention in this study. Corporate tax refers to the levy placed on the profit of a firm, with different rates used for different levels of profits. Corporate taxes are normally charged on the net income earned by businesses within a given taxable period. Revenues collected from the corporate tax are also a crucial source of income for Malaysian government. Companies in Malaysia has contributed RM489 millions to the government in year 1970 by paying the corporate tax. The amount then increased to RM4497 millions in year 1990 and RM58175 millions in year The changes of corporate tax revenues are presented in the figure 2 below. Figure 2: Corporate Tax Revenue in Malaysia, Corporate Tax Revenues in Malaysia Source: CEIC database, Years 645

4 Furthermore, Malaysia tax systems include the Self-Administered System (SAS). On 1 January 2005, the Inland Revenue Board Malaysia (IRBM) has applied the self-assessment tax system (SAS) on individual taxpayers to encourage voluntary tax fulfillment. Based on the SAS, individual who has income accruing in or derived from Malaysia are obligatory to compute tax payable correctly, disclose taxable income truthfully, file tax return form and pay tax on a timely manner. In short, under SAS, the responsibility to charge the tax liability is on the taxpayers. Tax planning or tax avoidance is knowledge of tax laws and agreement with tax requirements. The objective of tax avoidance or tax planning is to eliminate, reduce, minimize or defer income tax within the field of law. Furthermore, it also minimizes or defer the amount of taxes that have to be paid, maximize non-refundable income and consider of and employ different strategies in order to minimize or defer the amount of taxes paid during a period (Phillips, 2003; Dyreng et al, 2010). When company doing tax avoidance or tax planning activities, as a result in reducing or deferred tax liability, reduce climate change effort, thus more money to enjoy for donating, investing, spending, and saving. Tax avoidance is an action to minimize the amount of tax payable within the ambit of laws, which is legal and acceptable within the framework given by the agencies. It is non-trivial for the corporations to practice tax avoidance. The companies try to reduce their tax liability by making full use of the benefits offered by the government especially for the corporations, such as the exemptions, reductions, allowances and rebates (Institute of Business Ethics, 2013). They aim to lower the total tax payable and increase the after-tax profits. However, the practice of tax avoidance has created a business ethics issue. There are some parties argue that it is immoral to avoid tax. They argue that it is a social responsibility for the companies to pay taxes which in turns helps the government in improving the public services such as healthcare, education and infrastructures of that country. Then again, the corporations that practice tax avoidance argue that it is normal to do so as it is allowed by the law. Yet, studies such Phillips et al (2003), Marques et al (2011) and Desai and Dharmapala (2006) conclude that firm may use tax for earnings management. This means that managers manage earnings to achieve some threshold (e.g., to avoid an earnings decline or executive compensation) by exploiting the greater discretion they have for financial reporting purposes vis-ai-vis tax reporting. The relationship between tax avoidance and earnings management lies on agency problem tenet. For example, managers can manage earnings by engaging in a limited set of transactions that create permanent book-tax differences. Managers also can make accrual decisions or take actions that change operating cash flows that affect both book and taxable income simultaneously. In developed countries, Enron is the good example how firm uses tax avoidance in manipulating earnings report. The case is famous with the name Project Steele where Enron had already guaranteed that it would not pay taxes well into the future through previous tax shelters; this transaction was motivated by the fact that it would create $133 million in pretax financial accounting income. Yet, in order to generate favorable tax treatment, Enron admitted that its purported principal business purpose for the transaction was to generate financial accounting income. In Malaysia, there are also earnings management cases. For example, is Transmile Group Berhad which have overstated its consolidated revenues by US$157 million dollars (RM 530 million) over the accounting period of 2005 and Yet, the auditor found that Transmile had overstated 646

5 its earnings through invoices and deferred tax. Transmile s 2006 unaudited report released to Bursa Malaysia on Feb 15, and reported an 80% surge in revenue to RM989.2mil from RM550mil a year earlier. Net profit more than doubled to RM157.5mil against RM74.8mil in 2005, and it made transmile s has artificially good performance. Hence, there are three important points from the explanation above. First, corporate tax is important for Malaysia government. Second, managers can use tax avoidance to manage firm s earnings. Third, there are dossiers showing real example of manager uses tax avoidance to manager earnings. These facts show that the relationship between tax avoidance and earnings management is intriguing yet interesting. Therefore, this study aims to investigate the association between tax avoidance and earnings management. Prior Studies Note that tax avoidance or tax planning is different from tax evasion. In legal point of view, tax avoidance is legal, however tax evasion is illegal (see Slemrod, & Yitzhaki, 2000; Aumeerun et al., 2016). Tax evasion is illegal practice, where a person, organization or corporation deliberately, intentionally or willfully to hide income and reduce tax liabilities (Slemrod, & Yitzhaki, 2000; Aumeerun et al., 2016). For instances deliberate omission of income from a tax return, making false statement or entry in a return or giving false answer. Besides that, tax evasion will lead to result in penalties, fines, interest charges and a possible jail sentence. Tax planning or tax avoidance is legal utilization by taxpayer, it also knowledge of tax laws and compliance with tax requirements. For instances tax relief and incentives provided by in the tax laws. The purpose of tax avoidance or tax planning is to eliminate, reduce, minimize or defer income tax within the tax law (Slemrod, & Yitzhaki, 2000; Choong 2013). Whilst company doing tax avoidance or tax planning activities, it leads to reduce or deferred tax liability, reduce climate change effort, therefore reap more money and benefit of sound donating, investing, spending, and saving. How tax avoidance relates to earnings managements? Plesko (2002) describe by using the loopholes in national GAAP. Because current GAAP allows managers greater discretion in determining the amounts of income and expense in each period than does the tax system. This is not to mention due to the difference of accounting report period. The easy example of using tax to manipulate earnings is bad debts provisions. GAAP allows flexibility in estimating the provision for bad debts, while tax rules allow a deduction only for accounts receivable actually written off. Depreciation, and revenue recognition are other tax avoidance modes that managers can use for earnings management. Empirical findings have proven how managers use tax avoidance for earnings management. For instance, Desai and Dharmapala (2006) who develop a conceptual framework for understanding agency cost regarding tax avoidance activities. In particular, they explore the managerial decision to divert rents from shareholders, as in the literature on private benefits of control. There are also Dyreng et al (2010) who indicate that individual executives play a significant role in determining the level of tax avoidance. The structure of executive compensation that increase the weight placed by managers on firm value lead to reduced levels of tax sheltering activity. This is consistent with the existence of strong positive feedback effects between sheltering and diversion 647

6 the improved alignment of incentives induces the manager to divert less, and this in turn increases the marginal cost of sheltering, and so reduces the equilibrium level of tax avoidance activity. Meanwhile, there is Adhikari, Derashid and Zhang (2005) who found positive and significant association between average effective rates in the periods before the possible change in tax policy and the change in deferred tax expenses during the period of possible change in tax policy. Phillips et al (2003) also investigate the role of tax avoidance on earnings management. Their results provide evidence consistent with deferred tax expense generally being incrementally useful beyond total accruals and abnormal accruals earnings model in detecting earnings management to avoid an earnings decline and to avoid a loss. Note that there is not much research about tax avoidance and earnings management. So far, there is Maydew (1997), Phillips et al (2003), and Adhikari et al (2005) findings which investigate the association in developed market context. This research aims to investigate the tax-earnings management link in developing market countries, specifically, in Malaysia context. Data and Methodology This research collected the data directly from firm s audited annual report to avoid the data reliability of DataStream. The annual report is downloaded from Bursa Malaysia. The number of firm is 149 and the period is started from 2009 to 2013 implying our data is set in panel. We exclude financial services firms because they might have different nature of taxation and regulation. We also exclude utilities from our sampling frame because of the regulation and business nature (extensive government-controlled industry). Estimation Model Following the study of Maydew (1997) and Phillips et al (2003), we employ the same estimator for earnings management. Earnings management is calculated in accrued mode, where we use Beneish M Model of Beneish (1999). The model is as follow. EM = β 0 + β 1 DSRI + β 2 GMI + β 3 AQI + β 4 SGI + β 5 DEPI Where, EM is Beneish M-Score or Earnings Management; DSRI is Days Sales Receivables Index; GMI is Gross Margin Index.; AQI is Asset Quality Index; SGI is Sales Growth Index.; and DEPI is Depreciation Index. By looking at the calculated M-score, an M-score value of lower than indicates that that particular firm is not an earnings manipulator. Meanwhile, a firm is suspected as a manipulator if the M-score is greater than The basic factors that affecting the practice of earnings management are firm size, firm s profitability, growth and leverage. (see Phillips et al, 2003; Desai and Dharmapala, 2006;2009). These factors are set as the control variables in determining the level of earnings management in the sample firms. The basic relationship between earnings management and the control variables are written in a functional form as follows: Earnings Management = f(size, Profitability, Level of Investments, Leverage) 648

7 To empirically estimate the model above, the multiple regression model as below is estimated: EM i,t = β 0 + β 1 SIZE i,t + β 2 PROFIT i,t + β 3 INV i,t + β 4 LEV i,t + ε i,t Where, EM is Earnings management; SIZE is Log of assets which is used to represent firm s size; PROFIT is Operating-sales ratio; INV is level of investment; and LEV is Leverage ratio which is used to measure the ratio of debt to common share equity. The main objective of this research is to investigate the role of tax avoidance on firm s earnings management. Tax avoidance is measured by effective tax rates (ETRs) (Hanlon, 2002; Gupta & Newberry, 1997; Kern & Morris, 1992; Shevlin & Porter, 1992). According to Harris and Feeny (2000), a basic summary statistic of tax performance which describes the amount of taxes paid by a company relative to its gross profit is provided by the effective tax rate. In other words, effective tax rate measures the tax burden of a company as it expresses the rate of tax paid on the company income. The formula to calculate effective tax rate is: ETR = Income Tax Expense Earnings before Tax Hence, this tax avoidance is introduced in our earnings management model. The main estimation model is as follow. EM i,t = β 0 + β 1 SIZE i,t + β 2 PROFIT i,t + β 3 INV i,t + β 4 LEV i,t + β 5 ETR i,t + ε i,t Results and Discussion Descriptive Results Table 1 describes the summary statistics for our sample of 149 firms across the nine-year period ( ). Earnings management is measured by using Beneish M-score in this study. Based on the Table XX shown above, M-score for the chosen listed companies has a minimum value of and a maximum value of The index has a mean of and a standard deviation of The value of its standard deviation is quite large relative to the mean. Table1 Data descriptions Variable Mean Std. Dev. Min Max EM ETR SIZE INV PROFIT LEV N = 765 n = 149 T = 5 649

8 For the effective tax rate, it has a mean of and a standard deviation of The variable ranges from to Meanwhile, the firm size shown in the result has the amount between RM million and RM million. Then the average of firm size settles down at the value of RM million with a standard deviation of With regard to the growth of selected listed companies in this study, the result of the descriptive statistics shows that it has a mean of for the values ranging from to and standard deviation of On the other hand, Table 1 shows that the ratio representing leverage of the selected listed companies in this study has a minimum value of 0 and a maximum value of The ratio has an average of and standard deviation of The operating-sales ratio (OIS) which measures the profitability of the firms is also represented in the table. The result shows that the ratio ranges from to with a mean of and standard deviation of Baseline Model Table 2 presents the panel regression results for a few restricted variations of our baseline model. Note that based on the Breusch and Pagan LM test and Hausman test, the estimation model has to be run under fixed effect model. The estimation model passed the normality, multicollinearity test (Variance Inflation Factor test), and autocorrelation test (Wooldridge test), yet, it did not pass the heteroscedasticity test (Wald test). Hence, we run the model by controlling the standard errors under White robust fixed effect panel regression. It is noteworthy that the cut-off for earnings manipulator is -2.2 If a firm passes this threshold it indicates that firm did earnings management. This also implies that a positive relationship between one variable and earnings management indicates an inverse relationship in earnings manipulator. The higher the beta coefficient of that variable, the lesser is the probability of earnings management. Meanwhile, the negative relationship between one variable and earnings management indicates the alignment relationship. The higher the beta coefficient of that variable, the higher is the probability of earnings management. The findings in Table 2 show that all the control variables are not significant at any level of significance except for the growth variable which is significant at 1% level of significance when the firms are clustered with the industry effect or year effect. The baseline model estimates that firm size and growth (INV) have a positive relationship with the earnings management. This indicates that the earnings management will decrease when the firm size increases. Similarly, when the firms make investment such capital expenditure, the earnings management will also decrease. In contrast, the leverage and profitability variables are found to have negative relationship with the earnings management. The earnings management probability will increase when the two variables increase. Note also that Table 2 also shows that R2 of the estimation model is In detail, 52.29% of the dependent variable (Earnings management) can be explained by the independent variables. 650

9 Table 2 Baseline Model Panel Regression Panel Regression Estimation of Model SIZE (0.9169) (0.9169) (0.9308) INV *** *** *** (0.0000) (0.0000) (0.0000) LEV (0.1202) (0.1202) (0.1424) For PROFIT (0.1984) (0.1984) (0.2601) the CONSTANT (0.4482) (0.4482) (0.4602) Firm Clustered Yes Yes Yes Year Effect No Yes Yes Industry Effect Yes No Yes N Adjusted-R R baseline model panel regression, we have four control variables size, investment, leverage, and firm s profitability. The regression is performed using panel regression with a fixed effects model. Heteroskedasticity errors are controlled using white robust standard errors; and firm clustering, year effect, and industry effect. The period of data taken is from 2009 to Note that SIZEit is firm size; LEVit is leverage; INVit is firm s expansion through capital expenditure investment; and PROFITit is profitability. The figures stated represent the coefficient values of the variables. On the other hand, the values in the parentheses stand for p-values. The levels of significance are denoted using the asterisk symbol with *, **, and *** which are equivalent to 10%, 5%, and 1% level of significance respectively. The Estimated regression model: EM = β 0 + β 1 SIZE i,t + β 2 PROFIT i,t + β 3 INV i,t + β 4 LEV i,t + ε i,t Full Model Table 3 reports the estimates of earnings management and tax avoidance. the R2 of the full model in this study is , indicating that the independent variables in this study explain 53.08% of the dependent variable. The results show that the control variables have no significant contribution to earnings management except investment. Investment has statistically significant effects on earnings management at 1% level. It contributes negatively with the coefficient value of This indicates that if one unit of investment increases, it would decrease the probability of earnings management by %. This result is consistent with the previous empirical research done 651

10 by Denis and Denis (1993) which claimed that a reduced managerial discretion over investment decisions increased the shareholders wealth. A company is said to be growing when the management expands the businesses. This means that when the company gains profit and owns the free cash flow, the management wants to use it to fund the investments so that the company grows. However, the shareholders normally prefer to receive dividends. This leads the management to manipulate the earnings on the balance sheet so that the extra funds can be used for investments and does not create any conflict with the shareholders. Meanwhile, firm s size has positive relationship but not statistically significant to earnings management. The coefficient value is The positive coefficient value indicates the larger the size, the lower the earnings management probability. This is consistent with Barton and Simko (2002), Nelson, Elliott and Tarpley (2002) and Myers and Skinner (2007). They found that larger firms are more likely to manipulate their earnings. Table 3 Full model panel regression Panel Regression Estimation Model ETR ** ** ** (0.0392) (0.0392) (0.0317) SIZE (0.9498) (0.9498) (0.8905) INV *** *** *** (0.0000) (0.0000) (0.0000) LEV (0.1380) (0.1380) (0.1693) PROFIT (0.1335) (0.1335) (0.1638) CONSTANT ** ** ** (0.0410) (0.0410) (0.0406) Firm Clustered Yes Yes Yes Year Effect No Yes Yes Industry Effect Yes No Yes N Adjusted-R R

11 For the full model panel regression, we have four control variables size, investment, leverage, and firm s profitability, and our main variable tax avoidance (ETR). The regression is performed using panel regression with a fixed effects model. Heteroskedasticity errors are controlled using white robust standard errors; and firm clustering, year effect, and industry effect. The period of data taken is from 2009 to Note that ETRit is effective tax rate which is measurement for tax avoidance. SIZEit is firm size; LEVit is leverage; INVit is firm s expansion through capital expenditure investment; and PROFITit is profitability. The figures stated represent the coefficient values of the variables. On the other hand, the values in the parentheses stand for p-values. The levels of significance are denoted using the asterisk symbol with *, **, and *** which are equivalent to 10%, 5%, and 1% level of significance respectively. The Estimated regression model: EM = β 0 + β 1 SIZE i,t + β 2 PROFIT i,t + β 3 INV i,t + β 4 LEV i,t + β 5 ETR i,t + ε i,t The other control variables such leverage and profitability do not have the statistically significant effect, and coefficient value is negative. The coefficient values are and for leverage and profitability, respectively. The findings are in line with previous result such Stulz (1990), Maloney, McCormick and Mitchell (1993) and Jelinek (2007). They suggested that the needs to repay debts reduced the cash available to the management, leading to a lower probability of engaging in earnings management. The increase in leverage of a company indicates that the company is using a higher degree of debt to finance its business operations. Then, any free cash flow left for the company has to be paid to the creditors. In terms of profitability, the negative coefficient value is in line with Saleh, Iskandar and Rahmat (2005) who claimed that the losses making company is more likely to be involved in earnings management activities. Table 3 documented that tax avoidance (ETR) has statistically significant effects on earnings management. It contributes negatively where the coefficient value is This means that there is a negative relationship between tax avoidance and earnings management. One unit of tax avoidance increases, the earnings management would increase %. This finding is in line with the empirical research done by Adhikari, Derashid and Zhang (2005) where they found that tax avoidance was used for earnings management. This means that when the companies are required to pay their corporate taxes, they will try to plan for tax benefits. This desire may motivate the companies to manipulate their earnings so that it appears to be lower on the financial statement, hence to have lower tax obligations. Therefore, the higher the desire of the companies to lower their tax obligations, the higher is the degree of earnings management. Conclusion Our study addresses the phenomenon of accounting fraud through taxation engaged by Malaysian firms. The motivation is mainly because there is lack of attention given to these deserving emerging countries despite their growth and accounting fraud cases. This paper by all means might become the foundation for any further research in this topic on emerging countries with more focus on country-specific characteristics. Note that taxation report in Malaysia is self-administered system which allows managers to employ tax avoidance. Tax avoidance is important for firms to increase earning which increase their shareholders wealth. 653

12 This paper extends further the nexus studies of earnings management and taxation. Prior studies such as Phillips et al (2003), Desai and Dharmapala (2006, 2009), have shown the earnings management prediction using taxation approach. Therefore, we adopted their model and definition, and tested it in Malaysia context. Our result shows that tax avoidance has a positive significant relationship with earnings management at 1% level of significance. This result is supported by Adhikari, Derashid and Zhang (2005) where they found that there was positive and significant association between average effective rates and the change in earnings management. Our results bring implication for corporate governance and accounting reporting frameworks. First, we found that earnings management-taxation link does not only apply in advanced countries, but it also applies in emerging markets. This explains the WorldCom and Enron cases in US happened also in Malaysia (for example is the case of Transmiles). However, all our findings need to be validated by further research on other emerging countries in order to verify some facts about certain common characteristics embedded in the emerging markets as compared to advanced markets. Note that this research is limited on its earnings management measures. Earnings management measures are divided into accrual accounting earnings management and real income earnings management. This paper focuses only on accrual accounting earnings management as the national GAAP is closer to accrual accounting approach rather than cash basis. However, investigating the taxation-earnings management by using cash-basis model might be useful as a robustness test. Another limitation of this study is the measurement of earnings management is solely based on Beneish (1999) model. Even though Phillips et al (2003) surmise the beneficial of using Beneish (1999) model, further research can use other models such as Jones (1991) model. References Adhikari, A., Derashid, C., & Zhang, H. (2005). Earnings management to influence tax policy: Evidence from large Malaysian firms. Journal of International Financial Management and Accounting, 16(2), Barton, J., & Simko, P. J. (2002). The balance sheet as an earnings management constraint. The Accounting Review, 77(s-1), Beneish, M. D. (1999). The detection of earnings manipulation. Financial Analysts Journal, 55(5), Denis, D. J., & Denis, D. K. (1993). Managerial discretion, organizational structure, and corporate performance: A study of leveraged recapitalizations. Journal of Accounting and Economics, 16(1), Desai, M. A., & Dharmapala, D. (2006). Corporate tax avoidance and high-powered incentives. Journal of Financial Economics, 79(1), Desai, M. A., & Dharmapala, D. (2009). Earnings management, corporate tax shelters, and book-tax alignment. National Tax Journal, Dyreng, S. D., Hanlon, M., & Maydew, E. L. (2010). The effects of executives on corporate tax avoidance. The Accounting Review, 85(4), Gupta, S., & Newberry, K. (1997). Determinants of the variability in corporate effective tax rates: Evidence from longitudinal data. Journal of Accounting and Public Policy, 16(1),

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