The Effect of Smoothing of GAAP Effective Tax Rates on Credit Ratings and the Cost of Debt
Asian Tax Journal Vol. 21 No. 5 (2020), pp. 9-57
Abstract
In this study, we investigate whether credit rating agencies and debtholders take into account smoothing of GAAP effective tax rates (ETRs) (hereafter, GSMO), indicates higher or lower financial reporting quality. Demere et al. (2019) develop a new measure of GSMO as the inverse difference in volatilities of GAAP ETRs and cash ETRs over prior three years (i.e., t－2,t), suggest that smoothing of GAAP ETRs through tax accruals is associated with higher overall financial reporting quality. Thus, they insist that managers are likely to use tax accruals to smooth out volatilities in GAAP ETRs to communicate a long－term sustainable tax rate, and also they are restrained from using accruals for earnings manipulation. Therefore, Demere et al. (2019) assure that such a GAAP ETR smoothing serves as a credible indicator for overall reporting quality. But prior research do not investigate on the market response. An open question in the market participants is whether GAAP ETR smoothing activities are associated with higher or lower financial reporting quality. To fill this void, our study investigates whether credit rating agencies and debtholders perceive GSMO to be a financial reporting risk increasing or decreasing factor. We also distinguish between GSMO driven by economic fundamentals (innate GSMO) versus management choices (discretionary GSMO). For this purpose, our sample covers KOSPI and KOSDAQ listed firms based on the test variable from 2003 to 2018 (the dependent variable from 2004 to 2019), then final sample includes 10,415 firm－year observations. The empirical results are as follows. First, after controlling for several variables as well as pre－tax earnings smoothing, tax avoidance, and opaque financial reports that affect credit ratings, we find that a significantly negative association between credit rating and GSMO, as well as we find that both innate and discretionary factor has the potential to influence credit rating. These results indicate that credit rating agencies perceive GSMO to be associated with managerial opportunism, which leads them to downgrade credit ratings accordingly. Second, we also find no relation between the cost of debt and GSMO, only find that a significantly positive association between the cost of debt and innate GSMO. Third, we include interactive terms between GSMO and agency cost (e.g., the largest shareholder’s holdings), between GSMO and monitoring effects (e.g., foreign shareholder’s ownership) in the model, we find that the interactive terms are significant positive associated with credit ratings, respectively. Contrastively, we find that the interactive terms on the agency cost are significantly positive associated with the cost of debt, while we find that the interactive terms on the monitoring effect are significantly negative associated with the cost of debt. Thus, we observe a systematic differences between credit rating agencies and debtholders perceive GSMO to be associated with the financial reporting quality. Lastly, when we divided the full sample into KOSPI and KOSDAQ listed firms, we find that the first results obtain similar between the two subsamples. Whereas the second results vary in different market type. For example, GSMO is negatively (positively) associated with the cost of debt in the KOSPI (KOSDAQ) sample. In sum, our study contributes to the financial reporting and tax literatures by being the first to examine the economic consequence of GAAP ETR smoothing in the context of credit ratings and the cost of debt. Collectively, our results show that GAAP ETR smoothing perceive higher or lower financial reporting quality, which is different from the market participants. In that respect, our findings is inconsistent with Demere et al. (2019)’s argument and evidence. Therefore, our results contribute to related literature by providing additional and new evidence.
Keywords
- GAAP ETR smoothing
- Pre－tax earnings smoothing
- Tax avoidance
- Credit ratings
- Cost of debt
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