A Negative Effect To Discretionary Accrual Accounting Essay

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Tax is defined as an obligatory levy made by public authorities for, which nothing is received directly in return. From the definition we may notice three elements that we may characterize a tax. It is a compulsion, made by public authorities, and from which no direct return can be expected by the payers. Taxation is basically one of the methods of transferring funds from the private to the public sector. There are other means such as direct charges (e.g. retribution). Tax is an important issue in economic system. Consequently, there has been broad discussion on the fundament of its impact which in turn leads to the criteria of a good tax. These criteria have been developed ever since Adam Smith's four cannon of taxation to the improvement of optimal taxation theories. In the book entitled Taxing Ourselves, Joel Slemrod and Jon Bakija provide useful intuitions on how the tax system should be developed from the economic point of view, while some important criteria, such as efficiency and equity, as well as simplicity and enforceability are discussed within the framework of the US Tax System (Slemrod and Bakija, 2000).

The criteria of good taxation should be analyzed in line with the development stages in which a country is going through. The idea is that a particular stage of development may require or, on the contrary, may not suitable with, certain types of taxation. Specifically, for a certain stage of development with certain infrastructure condition, particular types of taxation will be more efficient than the others. For instance, in a less developed country, a social security system or wealth taxes may not be easily implemented, and thus can be inefficient in creating revenue or even may mislead the economy.

Identifying the correlation between a country's stage of development and its appropriate tax system is very important to analyze what is needed and should be done in country's tax reform. The development of Japanese taxation system is a good example of relationship between tax system and country's phase of development (Ishi, 2001). During the high growth period, the Japanese tax system was aimed at promoting more exports and investments from foreign source. When the economy achieved a certain level, and the domestic sources of production input were decreasing, the taxation policy was redirected to encourage more capital from domestic source to be invested outside the country. At this point we can see that a tax can not only become a basis of revenue but also might use as a device to support economic policy in a country.

Mostly, an important issue related to tax in developing countries is tax reform. Tax reform is basically needed when the current tax system does not perform optimally and there is a demand for basic alteration in the system so that the system may perform better conforming to the general economic policies and condition. Therefore, the issue of tax reform is linked very closely to developing economies, because it is the case either such changes are needed to meet the dynamic changes in the overall economy or that developing countries usually have less developed systems that may need to be improved to perform better. Tax reform program was aimed to maximize tax revenue by reducing the tax gap (the difference between potential tax collections and voluntary tax collections) and expanding the tax base; to increase voluntary compliance by providing excellent services and clear, consistent law enforcement (such as simplifying the tax laws); to create a good image and high public trust on the competent tax officers; to implement efficient administration systems and applicable information technologies and to build organizational culture which is conducive for the implementation of good governance (Brondolo, Silvani, Le Borgne, and Bosch, 2008).

In The Wealth of Nations, Adam Smith set out four canons that lead to better taxes. In modified form, they still influence the formal thinking until present times. Those four axioms are (Morse et. al., 1996):

People have to contribute taxes according to their incomes and wealth;

Taxes should be certain, not arbitrary;

Taxes should be imposed in a way that most convenient;

The costs of imposing and collecting taxes must be kept at a minimum level.

Meanwhile, with the similar idea, Joseph E. Stiglitz (2000) in the Economics of Public Sector mentions "five desirable characteristics for any tax system" (p. 457). Those five accepted properties of a good tax system are:

Economic efficiency: the tax system must not disturb efficient resources allocation;

Administrative simplicity: the tax system must be easy and relatively inexpensive to manage;

Flexibility: the tax system must be able to respond easily (in some cases automatically) when economic conditions are changed;

Political responsibility: the tax system must be designed in such a way so that everyone can confirm what they pay, and evaluate how the system reflects their preferences accurately;

Fairness: the tax system should be fair enough in treatment relative to different persons.

Still concerning the principles of good taxation, there is an important concept of optimal taxation. Optimal taxation try to find the tax structure that provides a balance between the objectives of efficiency and equity. In a nutshell, the optimal taxation theory is searching the best tax that can maximize the goal of having the criteria of good taxation. Nevertheless, this normative point of view may not always in accordance with what we see in the real word. Tax reform, on the other hand, deals with real problem in a particular tax system (e.g. implementation and institutional aspects of tax system), which may not be the scope of the theory of optimal taxation.

Corporate tax rates are going down

But…the tax basis is being expanded

Anti-abuse rules being introduced

Transparency required

Governments are becoming more aggressive

New and high-growth markets are tough

Substance required in tax planningFigure 2.1. Global Tax Trend

Source: www.KPMG.com

As we can see from the Table 2.1 the global trend of taxation is reducing the corporate tax rate but expanding the tax basis. Therefore, the government should aggressively doing reformation which was considered as comprehensive, with the aims of increasing revenues, better income distribution, improved economic efficiency and better administration and compliance. In the policy aspect of the reform, the strategies were: revenue neutral, broader base and lower rates. Other strategies include eliminates many tax incentives arrangement which are hard to manage and only beneficial for particular sectors or persons (e.g. tax holidays, accelerated depreciation, investment allowances, tax incentives to encourage the emergence of stock market and the use of public accountants). The elimination of those provisions is expected to support a reduction of the tax rate, which would create advantage to all taxpayers (Erata, 1998).

An effective tax planning requires the tax planner to consider all the parties to the transaction, all taxes and all costs to the transactions (Scholes and Wolfson, 1992). Shackelford and Shevlin state in their paper: "The three themes -all parties, all taxes, and all costs- offer a structure for tax management that accomplishes organizational objectives, such as profit or wealth maximization. The themes suggest that tax minimization is not necessarily the purpose of effective planning. Instead, the efficient design of organization and a contractual perspective adoption must evaluate the effective tax planning. The implicit paradigm assumes that if all contractual parties, all taxes and all non-tax costs can be identified and controlled, then the rational and predictable tax behavior is discovered." (Shackelford and Shevlin, 2001 p. 323)

2.2. Earnings Management

The corporate tax rates' changes affect the behavior of the firm in managing their financial report. This gives an incentive for firms to shift earnings to periods of lower tax rates to save tax (tax shifting). Several studies indicate that earnings contain more information rather than primitive constructs like operating cash. Lev. B (1989, p. 155) states: "Earnings, the "bottom line," are widely believed to be the premier information item provided in financial reports." They show the extent to which a firm involved in value-added activities. They give signal that supports resource allocation in capital markets optimally. In reality, the theoretical value of the stock company is the present value of its future earnings. When earnings increase it means the company value is also increase, while decreased earnings indicate a decrease in that value. That is, the correlation between earnings and future stock revenue, earnings and future performance are greater than the correlation between operational cash flows and these variables (Gomez and Okumura, 2000). Such improvement in information content is obtained by the use of accruals. In this sense, accruals contain the accounting adjustments needed to cancel variations related to the operating cash cycle. However, since Generally Accepted Accounting Principles (GAAP) tolerates certain discretion in reporting accounting figures, there is a possibility that accruals contain management's expectation about future cash flows or management's intention or both of them, to manipulate information. The accrual method of accounting for financial statement purposes requires expense recognition in the accounting date when the expense is incurred. In addition, under the matching principle some expenses (e.g. warranty claims) are estimated and recorded before they are incurred, in order to match them against the revenue that was generated by the expense.

The focus of prior study on earnings management is mainly on detecting whether earnings management exists and occurs. It is also focused mostly on what are called accounting accruals, which are the differences between accounting earnings and cash flows from operations. According to the early work of Healy (1985), accruals modify the timing of reported earnings and are composed of discretionary accruals that allow a manager to transfer earnings between periods. A discretionary accrual is an expense that the company is not compulsory to pay, such as management bonuses. The expense is recorded over period in the company's accounting report, although it has not yet been paid. This benefits the company for spreading equal expense over time and smooth earnings. Discretionary accruals are used as a device to improve the accuracy of financial estimates.

There are several empirical studies about earning management in response to the tax rate reductions. Guenther (1994) investigates earning management in response to The Tax Reform Act in United States in 1986. Guenther finds evidence that firms which are expected to decrease financial report income to gain tax savings are large firms, and firms with low levels of long-term debt. There is no relation between accruals and manager ownership and the fiscal year-end of the firm is not related to the magnitude of earnings management. Cloyd, Pratt, and Stock (1996) examine that both public and private firms have incentives to avoid corporate tax, but private firm managers are more aggressive than public firms because the consequences of tax avoidance from reporting lower income are less essential for them. Maydew (1997) uses a random walk model to estimate tax-induced income shifting by firms with net operating loss (NOL) carrybacks and finds that these firms managed recognition of revenues and expenses to increase their NOL carrybacks in response to declining tax rates and thereby increase the refund of prior years' taxes at the old higher tax rates. In contrast, Lopez et al. (1998) do not find significance on leverage, ownership, and firm size in relation with discretionary accruals in the year prior to tax rate changes.

Further research by Yin and Cheng (2004) find that tax rate reductions have little impact on tax-minimizing behavior of loss firms. Non-tax incentives, such as earnings pressure and management ownership explain more variations in loss firms' discretionary current accruals. The results suggest that managers of loss firms who involve in tax-induced earnings management face higher financial reporting costs and minimizing tax may not be the most efficient choice. They may be less opportunistic tax planners because they are more sensitive to financial reporting costs. The contractual relationships with shareholders, lenders, and other interested stakeholders may discourage the tax-minimizing strategy.

Yamashita and Otogawa (2007) examine that there are significantly negative discretionary accruals for the year prior tax rate reduction. This result shows that Japanese firms manage their book income to minimize tax costs. In Indonesia, empirical results of earnings management in response to tax reduction have done by several researchers. For example, Hidayati and Zulaikha (2001) investigate on the impact of the amendment of Income Tax Law No. 17 year 2000 to management behavior in reporting earnings. They find that managers do not respond the change in the tax rate to manage their earnings through discretionary accrual.

Subagyo and Oktavia (2010) who also used discretionary accruals to identify earnings management try to obtain empirical evidence. Their findings indicate that profit firms are more likely to engage in earnings management to take advantage of tax benefits. They also find profit firms was influenced by both tax and non-tax incentives to examine earnings management, but in loss firms it shows that non-tax incentives are more important considerations. Furthermore, Wijaya and Martani (2011) identify that profit firms and loss firms are induced earnings management to save tax.

2.3. Conceptual Framework

Tax Reform:

Corporate tax rate changes

Earnings Management

Increase current income at the expense of income in later years

Decrease earnings in the current year with the intension of increasing the future income

Non-discretionary Accruals

Accounting Accruals

Discretionary Accruals

Enable the manager to transfer earnings between periods

Mandated by accounting standard-setting bodies

Firms reduced reported financial income to minimize taxes

Figure 2.2 Conceptual Framework construct from Guenther (1994)

Earnings management is operationalized using discretionary current accruals. We define current accruals as change in current assets (other than cash) minus change in current liabilities (other than the current portion of long-term debt and income taxes payable). We classify only current accruals that are highly correlated with tax reporting requirements and omit accruals that have little effect on taxable income to improve the power of test of tax motivated earnings management. Non-current accruals, such as financial depreciation and amortization expense, are likely to have little correlation with tax (Yin and Cheng, 2004). Since taxable income cannot be directly detected, the main point of this study is the management of financial statement earnings. The concern is whether managers defer or accelerate revenues or expenses, or both, in order to shift earnings from one period to another. Therefore, if managers use accounting accruals to defer taxable income in anticipation of a reduction in tax rates, discretionary current accruals in the year immediately prior the year of the tax reduction will be negative.

This leads directly to the first hypothesis:

H1: Firms will have more negative discretionary accruals in the year preceding the tax rate reduction.

H2: Tax Planning has a negative effect to discretionary accrual

Given the opportunity of possible tax savings, firms are constrained by their tax planning abilities to minimize tax costs. An aggressive tax-planning firm is more likely to take advantage of the opportunity of the tax reduction and more likely to use income-reducing discretionary accruals (take greater negative discretionary accruals) to take advantage of the tax cut (Yin and Cheng, 2004).

H3: Discretionary accruals of firms at the year before declining corporate tax rate tend to be positively related to the net deferred tax liability.

A Deferred Tax Liability is created by temporary differences between when revenue and expense items are recognized for tax and financial reporting purposes. In other words, a deferred tax liability represents the increase in taxes payable in future years as a result of taxable temporary differences existing at the end of the current year (Kieso, 2009). Net deferred tax liability will increase as firms accelerate revenue or defer expense for accounting purpose relative to their tax reporting which results future taxable amounts (Yulianti, 2005).

Earnings management decisions are also affected by nontax incentives. In this case, three additional variables are included in the regressions to control for nontax effects, such as: earnings pressure, debt, and stock.

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