Journal of Finance and Banking Review. Earnings Management, Corporate Governance and Tax Avoidance: The Case in Indonesia

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1 Journal of Finance and Banking Review Journal homepage: J. Fin. Bank. Review 2 (4) (2017) Earnings Management, Corporate Governance and Tax Avoidance: The Case in Indonesia Lulus Kurniasih a, Sulardi b, Sri Suranta c a Universitas Sebelas Maret, Surakarta, Indonesia b Universitas Sebelas Maret, Surakarta, Indonesia c Universitas Sebelas Maret, Surakarta, Indonesia ABSTRACT Objective This study aims to determine the effect of earning management and corporate governance mechanisms on corporate tax avoidance. Methodology/Technique Corporate governance mechanisms use institutional ownership, the size of the board of commissioners, the percentage of independent commissioners, auditing committees, and audit quality as proxies. Meanwhile, earnings management uses the modified Jones model. The sample of this study include non-financial companies that are listed on the Indonesian Stock Exchange (IDX) between 2014 and Findings Corporate tax avoidance can be detected by using the effective tax rate (ETR), which is the ratio of income to tax expenses. This sample was chosen using a purposive sampling method, resulting in 871 firms. The results suggest that earnings management has a significant impact on ETR. Novelty This study identifies that only independent commissioners and audit quality have a significant influence on ETR. Type of Paper: Empirical. Keywords: Tax Avoidance; Earnings Management; Corporate Governance; Effective Tax Rate; Audit Quality. JEL Classification: G3, G39, G Introduction Corporate entities are themselves taxpayers, and they therefore have an obligation to pay tax in accordance with the prevailing laws, which is calculated using their net income before tax, multiplied by the prevailing tax rate. Companies consider tax as a burdensome expense, that reduces the amount of potential profit to be generated. The main purpose of any company is to maximize the welfare of its shareholders, and this may contribute to some companies seeking ways to reduce their tax obligations. * Paper Info: Received: August 6, 2017 Accepted: December 2, 2017 * Corresponding author:lulus Kurniasih luluskurniasih@gmail.com Affiliation: Sebelas Maret, Surakarta, Indonesia ISSN Global Academy of Training & Research (GATR) Enterprise. All rights reserved.

2 As a result of differences in the basis of profit-making based on accounting and tax regulation, the amount of tax paid by various companies will vary (Plesko, 2004). Earnings management is one way that companies can achieve tax avoidance. Tax avoidance often involves identifying a gap in the prevailing taxation laws and the current Financial Accounting Standards Guidelines, with the aim of minimizing tax payments. Hanlon (2002) states that companies with a temporarily high tax obligation tend to undertake a persistent pre-tax income. A company s rules of corporate governance will affect the way that company fulfils its tax obligations and these structures may be used to manipulate the same (Friese, et.al, 2006). Friese, et.al (2006) explains how important it is to analyze the interaction between corporate governance and tax systems. Research conducted by Sartori (2010), relating to the influence of tax strategies on corporate governance, explains that if a company has well-structured corporate governance mechanisms, this will have a direct effect on the company's compliance to its tax obligations. Corporate governance is important for any company. To support those corporate governance mechanisms, the Indonesian government stipulates that all companies must have independent commissioners. One of the objectives of corporate governance mechanisms is to minimize the opportunistic behavior of management, particularly with respect to taxes. This study aims to examine the influence of corporate governance, and the occurrence of earnings management, on tax avoidance and to identify which elements of corporate governance contributes the most to reducing tax avoidance. 1.1 Hypothesis Development Agency Theory Agency theory arises where there is a contract between one or more people (the principal or principals) with another agent, for the provision of some service on behalf of the principal(s), involving the delegation of authority in terms of decision making by the agent (Jesen and Meckling, 1976). Agency theory recognizes the differences in interests between the principals and agents, and is a mechanism aimed at promoting those interests. Agents or directors need to be supervised in their performance. This supervision incurs a cost for the principal. One form to overcome agency costs is through providing a form of compensation to the directors when they achieve their goals (Jensen and Meckling, 1967). The board of directors decision with respect to tax planning actions, including lawful, aggressive, or unlawful actions, depends on the corporate governance system developed and implemented by the directors Earnings Management and Tax Avoidance The conflict that arises between agents and principal can sometimes affect the quality of earnings. Scott (2015) reveals that this is one of the encouragements for corporate managers to engage in earnings management, namely taxation motivation. Taxation is one of the most common reasons why corporate management seek to reduce the reported level of net income of a company. Desai and Dharmapala (2007) state that managers whose interests are aligned with its shareholders will act more aggressively with respect to tax avoidance. Further, Ball and Shivakumar (2004) state that one of the purposes of producing financial statements is for the determination of taxes. Profit reported by the company may depend on the company's efforts in managing its earnings for lower tax payments (Coppens and Peek, 2011). The use of accounting income as the basis for taxation encourages managers engage in earnings management (Coppens and Peek, 2011). Burgstahler and Dichev (1997), and Wang and Chen (2012) provide evidence on detecting earnings management behavior related to income tax. H1: Tax avoidance is a motive to engage in earnings management. 29

3 1.1.3 Corporate Governance and Tax Avoidance Corporate governance deals with earnings management and earnings quality (Klein, 2002; Givoly and Hayn, 2010). Tax planning depends on the dynamics of the corporate governance system within a particular company (Friese, et.al, 2006). Tax avoidance activities are often undertaken by the management of an enterprise, in an attempt to minimize their corporate tax liability (Khurana and Moser, 2009). Research conducted by Sartori (2010), relating to the influence of tax strategies on corporate governance, explains that when a company has a well-structured corporate governance mechanism, this will have a direct effect on the company s compliance with its tax obligations. Sartori (2010) concludes that the relationship between corporate governance and tax avoidance is positive, if and only if it is followed by low agency and transaction costs. Friese, et. al (2006) further explains that corporate governance interacts with taxation through various ways whilst Khurana and Moser (2009) argue that corporate governance has an impact on the way a company manages their tax affairs. Several studies have examined the effect of the board of commissioners on tax avoidance, stating that they have a negative and significant effect. Tax avoidance may be minimized by the presence of board supervision within a company. For instance, Vafeas (2010) found that board supervision has a significantly negative effect on tax avoidance within Fortune 500 companies. In addition, Lanis and Richardson (2011) documented evidence of board influence on tax avoidance with companies in Australia. Further, Annuar et al (2014) proposes an econometrics model for board composition to reduce tax avoidance. The Board of Commissioners is the organ of the company in charge of its day to day management, and they are collectively responsible for supervising and advising the company's management team, ensuring that the company carries out good corporate governance. Coles (2008) states that the optimal number of commissioners sitting on a board depends on the characteristics of each company. Research by Bhagat and Black (1999), and Minnick and Noga (2010) also found that fewer board members creates a better oversight function, with an increased focus on earnings management and taxation avoidance, conducted by management. Furthermore, Bhagat and Black (1999) conclude that an independent board of commissioners will achieve a more efficient level of supervision. Minnick and Noga (2010) also conclude that an independent board of commissioners will focus more on overall performance, where effective tax rates have an important role. Khurana and Moser (2009) argue that institutional ownership can effectively supervise and discipline managers, to reduce the prevalence of aggressive tax planning by management. Annisa and Kurniasih (2013) state that the long-term institutional investors can reduce the likelihood of management to engage in tax avoidance schemes. Halioui et al (2016) studied the corporate governance, CEO compensation and tax aggressiveness of American firms listed on the NASDAQ 100. Corporate governance was measured using the number of directors, CEO duality and independent commissioners, while tax aggressiveness was measured using ETR. The empirical results of that study show that there is a negative relationship between the size of the board of directors and the CEO's compensation to tax aggressiveness behavior. Jensen and Meckling (1976) further explain that auditing performed by independent auditors is one form of agency costs, which can supervise and control the financial statements and performance of the company. Based on the previous literature, the following hypotheses are proposed: H2: Institutional ownership decreases tax avoidance within a company. H3: The presence of independent commissioners decreases tax avoidance within a company. H4: The size of the board of commissioners decreases tax avoidance within the company H5: The size of the auditing committee decreases tax avoidance within the company. H6: Audit quality decreases tax avoidance within the company. 2. Research Method 30

4 The sample in this study is all non-banking companies listed on the Indonesian Stock Exchange between 2014 and Dependent Variable Tax Avoidance In this study, tax avoidance is measured by using the calculation of Effective Tax Rate (ETR) as follows: 2.2. Independent Variable The dependent variable in this research is earnings management (DA). Earnings management is measured through discretionary accruals, calculated by excluding total accruals (TA) with non disretionary accruals (NDA). In detecting earnings management (DA), the modified Jones model is used because the model can detect earnings management more effectively when compared to other models (Dechow et al. (1995); Healy model (1985); DeAngelo model (1986); Jones mode (1991), and the Industrial model developed by Dechow and Sloan (1991)). TAC = Nit CFOit TAt / At-1 = β1 (1/At-1) + β2 (ΔRevt / At-1) + β3 (PPEt / At-1) + e NDAt = β1 (1 / At-1) + β2 (ΔRevt / At-1 ΔRect / At-1) + β3 (PPEt / At-1) Furthermore, discretionary accruals (DA) are calculated as follows: DAt = TAt / At-1 NDAt Institutional Ownership The size of the Board of Commissioners is obtained from the number of boards of commissioners. Independent Board of Commissioners The Audit Committee is measured by the number of auditing committees. Audit quality is measured by the classification of public accounting firms into either big four or non big four. The controlled variable is firm size, obtained from the asset logarithm. The model of the research is as follows: 31

5 ETRit = β0 + β1 Dis_accrualit + β2 Inst_ownit + β3board it + β4ind_comit + β5aud_comit + β6 Aud_qualityit + β7sizeit + ε 3. Results The sample in this study was selected using a purposive sampling method, in order to be able to adjust the information needed based on the needs and interests of the researchers. The criteria used was: companies listed on the Indonesian Stock Exchange between 2014 and Based on this criteria, this study examined 290 companies as a sample with a total of 870 observations across the study period. The results show that the data passed the autocorrelation test, indicated by the value of the variance inflation factor, which is less than 10. The data also passes the autocorrelation test conducted using the Watson durbin test, and the heteroscedasticity test. Table 1. Anova and Adj R Square Model Sum of Squares df Mean Square F Sig. R Square Adjusted R Square 1 Regression Residual Total a. Predictors: (Constant), Size, Ind_com, Inst_own, Disc_accrual, Audit_com, Aud_quality, Board b. Dependent Variable: ETR The F test results show that this model is significant, where all independent variables together affect the dependent variable. However, the independent variable is only able to explain 3.1% of the variation in the dependent variable. Table 2. Hypotesis Testing Unstandardized Coefficients Standardized Coefficients Collinearity Statistics Model B Std. Error Beta t Sig. Tol VIF 1 (Constant) Dis_accrual Inst_own 2.350E Board Ind_com Aud_com Aud_quality Size

6 a. Dependent Variable: ETR The independent variable that had a significant influence on ETR is earnings management, whilst of the corporate governance variables, only independent commissioners and audit quality had a significant effect. The first hypothesis in this study explains that the higher the level of corporate EM, the higher the level of tax avoidance activities by management, which is marked by a high ETR value of the company. Based on the test results, the first hypothesis is accepted. Further, of the corporate governance variables, audit quality was the only factor that has a significant effect on tax avoidance. The results show that audit quality has a positive coefficient of 0.047, which means companies that are audited by the big four firms tend to have higher ETR values, thus indicating lower tendency to engage in tax avoidance. 4. Discussion Setiawan (2009) alleges that the performance of an independent board of commissioners in Indonesia is not comprehensively effective in hampering earnings management practices, including aggressive tax planning. Pradipta and Supriyadi (2014) further add that independent commissioners, who are responsible for supervising the management of a company when making decisions or devising strategies are often only put in place to satisfy some law or regulation, and may not truly achieve their supervisory goals. The Decree of the Board of Directors of PT. Jakarta Stock Exchange No. Kep-305 / BEJ / regarding rule number 1-A concerning Stock Listing and Equity Securities states that companies listed on the Indonesian Stock Exchange (BEI) must have independent board members making up at least 30% of the total board. The results of this study are consistent with research conducted by Annisa and Kurniasih (2012), which states that the number of board members within a company cannot significantly reduce tax avoidance activities. This is because the board of commissioners in most companies hold a share in the ownership of the company, which may contribute to bias in their management as members of the board. In addition, the quality of coordination among the board of commissioners also determines the quality of its supervisory function. Furthermore, institutional ownership is considered an effective means of supervising and disciplining management within a company, to ensure that investments in the company are safe, which in turn reflects efficient corporate governance mechanisms within the company (Khurana and Moser, 2009). These results are consistent with research conducted by Kharuna and Moser (2009) and Annisa and Kurniasih (2012) which indicates that a large percentage of institutional ownership has no significant effect on the prevalence of tax avoidance activity. Sefiana (2010) also explains that a lower quality of supervisory coordination conducted by the board of commissioners may give rise to opportunities for management to conduct earnings management activities, including tax avoidance. Sefiana (2009) states that corporate governance mechanisms, such as an auditing committee, is not significantly able to prevent earnings management practices conducted by management. The selection process of the auditing committee also affects the quality of the performance of the audit committee's oversight. The audit committee selection process is not in and of itself adequately transparent, and this may give rise to subjective selection of its members (Sefiana, 2009). The existence of subjectivity in the selection of the audit committee can create an opportunity for certain members of management to engage in earnings management activities. However, the results of this study are consistent with the results of research conducted by Winarsih, et.al (2014) and Dewi and Sari (2015) which explains that the size of an auditing committees has no effect on the company's engagement in aggressive tax activities. This is because the existence of an auditing committee within the company cannot be effective if it is not adequately supported from all sectors in a company. The results of this study are also consistent with research conducted by Annisa and Kurniasih (2012), Ain and Subardjo (2015), Dewi and Sari (2015) and Kanagaretnam, et. al (2016), which explains that audit 33

7 quality can prevent or reduce the existence of aggressive tax planning activities. Annisa and Kurniasih (2012) state that when companies use external auditing services, it may decrease or prevent tax evasion altogether. Kanagaretnam et.al., (2016) agrees with the proposition that firms which are audited by high quality firms, such as the big four, are less likely to engage in aggressive tax activities. 5. Conclusion One of the motives behind earnings management activities is tax avoidance. Tax avoidance is conducted by a company with the objective of minimizing tax payments. To minimize this opportunistic behavior, adequate supervision is necessary, such as through various corporate governance measures. This study concludes that earnings management, as a motive for tax-avoidance, is common among companies listed on the Indonesian Stock Exchange. The precedeing analysis reveals that there is a significant positive correlation between the two, which shows significant tax-avoidance motivation in earnings management. Meanwhile, corporate governance mechanisms are more likely to reduce tax avoidance behavior when companies are audited by one of the Big Four auditing companies. References Ain, Q., & Subardjo, A. (2016). Pengaruh Tata Kelola Perusahaan Terhadap Tarif Pajak Efektif. Jurnal Ilmu dan Riset Akuntansi, 4(12). Annisa N.A., dan L. Kurniasih Effect of Corporate Governance on Tax Avoidance. Jurnal Akuntansi & Auditing, Vol. 8, No. 2: , (May). Annuar, H. A., Salihu, I. A., & Obid, S. N. S. (2014). Corporate ownership, governance and tax avoidance: An interactive effects. Procedia-Social and Behavioral Sciences, 164, Bhagat, S., & Black, B. (1999). The uncertain relationship between board composition and firm performance. The Business Lawyer, Burgstahler, D., & Dichev, I. (1997). Earnings management to avoid earnings decreases and losses. Journal of accounting and economics, 24(1), Cai, H., & Liu, Q. (2009). Competition and corporate tax avoidance: Evidence from Chinese industrial firms. The Economic Journal, 119(537), Chen, S., Chen, X., Cheng, Q., & Shevlin, T. (2010). Are family firms more tax aggressive than non-family firms?. Journal of Financial Economics, 95(1), Desai, M. A., & Dharmapala, D. (2009). Corporate tax avoidance and firm value. The review of Economics and Statistics, 91(3), Dewi, G.A.P, dan M.M.R. Sari Effect of Executive Incentives, Corporate Risk and Corporate Governance on Tax Avoidance. E-Journal Akuntansi Universitas Udayana 13.1, : Friese, A., S. Link, dan S. Mayer Taxation and Corporate Governance. Working Paper. Givoly, D., Hayn, C. K., & Katz, S. P. (2010). Does public ownership of equity improve earnings quality?. The accounting review, 85(1), Halioui, K., Neifar, S., & Ben Abdelaziz, F. (2016). Corporate governance, CEO compensation and tax aggressiveness: Evidence from American firms listed on the NASDAQ 100. Review of Accounting and Finance, 15(4), Hanlon, M The Persistence of Earnings, Accruals, and Cashflows when Firms have Large Book-Tax Differences. Doctoral Dissertation, University of Washington Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of financial economics, 3(4), Lanis, R., & Richardson, G. (2011). The effect of board of director composition on corporate tax aggressiveness. Journal of Accounting and Public Policy, 30(1), Kanagaretnam, K., Lee, J., Lim, C. Y., & Lobo, G. J. (2016). Relation between Auditor Quality and Tax Aggressiveness: Implications of Cross-Country Institutional Differences. Auditing: A Journal of Practice & Theory, 35(4), Klein, A. (2002). Audit committee, board of director characteristics, and earnings management. Journal of accounting and economics, 33(3),

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