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2012 International Conference on Engineering and Business Management

The Motivation for Tax Avoidance in Earnings


Management
Shiwei WANG, Siyu CHEN
School of Business, Renmin University, China, 100872
Email: wangshiwei@ruc.edu.cn

Abstract: Among listed companies, earnings management and tax avoidance are both specific operations for
enterprise interest, following the same development strategy planning. Examining data from Chinese A share
listed companies during 2004-2006, we find a significant positive correlation between earnings management
and tax avoidance and the long-term business performance weakens this positive correlation. In particular, for
state-backed companies, their business performance has little influence on the motivation of earnings
management. This paper aims to provide advises to interest groups like regulatory authorities, investors and
executives.
Keywords: Earnings management; tax avoidance; business performance; state-backed enterprise

1 Introduction

2 Research Hypothesis

Accompanying
the
further
reforming
and
marketization, China has achieved fast economic
development, and the capital market gradually matures.
To prevail over competition, public companies
whitewash their performance index by earnings
management, thus they gain benefits via misleading
decision-makings of information users. Based on its
extensive of existence, earnings management has become
an important subject of western scholars from 1980s, and
now is drawing growing attentions. Existing researches
discuss the purposes and means of earning management
with empirical or normative analysis, and reach an
agreement on some conclusions.
Scholars including Burgstahler and Dichev (1997) and
Mills and Newberry (2001) raise that earnings
management can be detected by empirical model based
on deferred income tax expense. This research results
provide reference for the detecting of earnings
management behavior related to income tax.
Dhaliwal, Gleason and Mills (2003) study whether
corporations will manipulate income tax expense when
manipulate earnings to achieve the gold for certain
business results. This study shows that corporations
achieve the goal for certain business results firstly by
means of manipulating non-taxable items. However,
when the earning management of non-taxable items
cannot bring enough profit to achieve that goal,
corporations will through certain means reduce income
tax owed to realize the profit target. This research
provides theoretical support for realizing earnings
management by tax means.

Firstly, according to economic man, enterprises


operations and decision-makings are guided by the total

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978-1-61896-007-8 2012 SciRes.

2012 International Conference on Engineering and Business Management

value maximization of themselves, and they try to


reduce tax expense in order to avoid the outflow of
economic benefits.
During a certain accounting period, discretionary
accruals may be adjusted by accounting manipulation,
which results in differences between cash flows and
profit. Cash flow has become a crucial factor that
manager should consider when making decisions. The
tax expenditure has its rigidities and therefore when
profit is defined, tax expense calculated by profit will
lead to cash outflow.
The analyses above show that in enterprises under
heavy tax burden, tax avoidance will be the motivation
of earnings management. This yields
Hypothesis 1: Tax avoidance is one of the
motivations of earnings management.
Enterprises on one side do profit manipulation
through earnings management, on the other side prevent
benefits from outflowing by reduce tax expense.

978-1-61896-007-8 2012 SciRes.

But for enterprises that have long-term good business


performance, the primary issue faced is further
development when tax expense is not a critical restriction
factor. At that time, the influence of capital market
motivation, contract motivation and political motivation
exceed tax avoidance motivation in business decisionmaking. Then it weakens the tax avoidance motivation in
earnings management. This yields
Hypothesis 2: Good operating performance weakens
the tax avoidance motivation.
For some other listed companies, implementation of
tax avoidance, as an edge behavior, is risky. But when
facing bad business performance, enterprises have strong
tax-avoidance motivation in order to survive. Hence, for
listed-companies lack of government support, the
business performance holds a greater influence on taxavoidance motivation. This yields
Hypothesis 3: The relation between government and

448

enterprises weaken the relation of earnings management


and tax avoidance.

3 Sample selection and construction of


variables
This study use the data of Chinese A share nonfinancial listed companies from annual reports during
2004-2006. The implementation of
The

st

Accounting Standards for Enterprises from Jan 1 , 2007


st
and The Income Tax Law for Enterprises from Jan 1 ,
2008 adjust accounting treatment and tax rate, which
have an effect on the empirical study. Thus this study do
not use data during 2004-2006.
To test the Hypothesis 1 and 2, we introduce
regression models as below.

Diff 0 1DA 2 Performance 3DA* Performance 4Size 5 Level 6 FixedAss

11

i 7 Industryi

Goods

2006

t 1985Yeart

t2004

i1

Dependent variable: This study takes the difference


between accounting profit and taxable profit as proxy
variables (Diff) for tax-avoidance behavior.

avoidance, and hence negatively effects tax-avoidance


motivation in earnings management. So Hypothesis 2 is
valid.

Diff (Pr ofitAcc Tax / R) / Assetst 1


Tax is income tax. ProfitAcc is accounting profit.
R is nominal income tax rate.Assets t-1 is total
initial assets.
Independent variable: DA is discretionary
accruals, calculated by the Modified Jones
Model. Performance is the Long-term business
1
performance indices, dummy variable .
Control variables: Size is enterprise size,
represented by natural logarithm of total assets. Level
is liability-asset ratio, controlling financial leverage
level and debt tax shield. FixedAss is fixed assets
ratio, represented by fixed assets/total assets. Goods is
Goods/total assets. Industryi is dummy variable for
2
3
industry . Yeart is dummy variable for year .

4 Empirical results
According to the regression results of Diff, it shows
that there is a significant positive correlation between
Diff and DA, which identify with the correlation analysis,
illustrating the significant positive correlation between
earnings management and tax avoidance. So Hypothesis
1 is valid.
Meanwhile, the coefficient of DA*Performance passes
the notability test, whose value is negative, illustrating
the long-term business performance weakens the positive
correlation between earnings management and tax
1

The assignment rule: assign 1 when ROA in the both previous two
years exceeds industry average, otherwise 0.
2
Except financial industry, sample companies are sorted to 12 types
according to the China Securities Regulatory Commission (CSRC ),
thus 11 dummy variables are constructed. The sample companies are
Type 1 to Type 12 and when a certain sample is Type I, Industryi=1,

otherwise Industryi=0. When it is Type 12, the dummy variable for


industry equals 0.
3
The numeric area of t is 2004 to 2006. When selected data are from
year t, Yeart=1, otherwise Yeart=0. When data are from year 2006, he
dummy variable for year equals 0.

Table 1. Regression Test of Diff


Variables

Coefficient

Collinearity Statistics
t-value

Sig

Tolerance

VIF

Constant

-0.759

-11.820

0.000

DA

0.400

5.200

0.000

0.637

1.569

Performance

0.044

6.721

0.000

0.797

1.254

DA*Performance

-0.445

-3.358

0.001

0.643

1.556

Level

-0.018

-2.738

0.006

0.944

1.060

Size

0.035

11.726

0.000

0.849

1.178

FixedAss

-0.036

-2.029

0.043

0.734

1.363

Goods

-0.031

-1.268

0.205

0.741

1.350

Industry1
-0.043 -1.988 0.047
0.740
1.351
Dependent variable
Diff, R2=1.313, Adjusted
R2=0.125,
Industry2
2.730
0.006
0.826
1.211
the goodness-of-fit0.078
is acceptable
Industry3

0.037

2.992

0.003

0.209

4.776

Industry4

3.1773, it0.002
1.922the
When testing 0.055
hypothesis
need to 0.520
distinguish
-0.002
-0.067
0.947
0.805
1.243
stock rights of sample companies. This study divides
Industry6
2.979
0.003
0.581
1.720
them by the ratio0.053
of state-owned
shares in
total shares,
Industry5
Industry7

0.013

0.757

0.449

0.560

1.785

Industry8

0.016

1.060

0.289

0.487

2.054

Industry9

0.011

0.563

0.514

0.581

1.720

Industry10

0.043

2.305

0.021

0.630

1.587

Industry11

0.028

0.941

0.347

0.861

1.161

Year1

0.030

4.431

0.000

0.734

1.362

Year2

-0.005

-0.298

0.766

0.616

1.624

holding that ones with the ratio above 50% are statebacked, otherwise are not.
The regression results in Table 2 show that, when stateowned shares are in majority, there is still a significant
positive correlation between Diff and DA, illustrating
strong tax-avoidance motivation. Considering the
coefficient of DA*Performance is not significant, the
performance of these listed companies does not have a
significant effect on tax-avoidance motivation in earnings
management.

DA

0.389

5.814 0.000

0.674

1.483

Performance

0.040

6.833 0.000

0.812

1.232

DA*Performance

-0.582

-4.762 0.000

0.685

1.460

Level

-0.016

-3.015 0.003

0.941

1.063

Size

0.020

6.980 0.000

0.878

1.139

FixedAss

-0.025

-1.588 0.113

0.747

1.340

Goods

-0.012

-0.562 0.574

0.753

1.328

Industry1
Industry2

-0.072

-3.941 0.000

0.773

1.293

0.044

1.342 0.180

0.914

1.094

Industry3

0.036

3.566 0.000

0.252

3.968

Industry4

0.037

2.357 0.019

0.628

1.593

Industry5

0.018

0.733 0.464

0.878

1.140

Industry6

Collinearity Statistics

0.040

2.305 0.021

0.728

1.374

Industry7

0.004

0.308 0.758

0.590

1.694

Tolerance

Industry8

0.015

1.183 0.237

0.517

1.933

Industry9

0.006

0.426 0.671

0.601

1.665

Industry10

2.927 0.003

0.671

1.400

Indusry11

0.046
0.009

0.325 0.745

0.884

1.131

Year1

0.010

1.589 0.112

0.0774

1.292

Table 2. Regression Test of Diff (State Owned Share>50%)


Variables
Constant
DA

Coefficient t-value
s
-1.203
0.401

Performance

0.048

-7.768
1.967
2.999

Sig
VIF

0.000
0.050
0.003

0.552
0.759

1.813
1.318

DA*Performance

-0.381

-1.201

0.230

0.548

1.826

Level

-0.040

-1.811

0.071

0.917

1.090

Size

0.056

8.043

0.000

0.790

1.265

FixedAss

-0.050

-1.139

0.255

0.686

1.458

Goods

-0.050

-0.813

0.417

0.703

1.422

Industry1
Industry2

0.010

0.149

0.881

0.583

1.715

0.056

0.888

0.375

0.522

1.915

Industry3

0.032

0.745

0.457

0.103

9.754

Industry4

0.056

1.137

0.256

0.260

3.843

Industry5

-0.034

-0.563

0.574

0.529

1.891

Industry6

0.040

0.809

0.419

0.274

3.655

Industry7

0.016

0.286

0.775

0.429

2.329

Industry8

0.008

0.153

0.879

0.355

2.814

Industry9

0.034

0.593

0.553

0.478

2.090

Industry10

0.019

0.335

0.738

0.452

2.213

Industry11

0.066

0.794

0.427

0.738

1.354

Year1

0.066

3.684

0.000

0.607

1.647

Year2

-0.005

-0.298

0.766

0.616

1.624

Collinearity Statistics
Variables

Coefficients t-value Sig

There is a significant positive correlation between DA


and Diff with a significant negative coefficient of
DA*Performance, illustrating that for companies not
related to government, the long-term business
performance has a great effect on tax-avoidance
motivation in earnings management.
Table 3. Regression Test of Diff (State Owned Share50%)

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Year2

-0.0007

-1.185 0.236

0.0781

lower, weakening the tax-avoidance motivation in


earnings management. However, for state-backed
companies which are free of restrictions like taxavoidance risk, they receive benefits from tax avoidance
persistently and thus their business performance has little
influence on the motivation of earnings management.
Hence, for companies not have good relationship with
government, the tax-avoidance motivation gradually
reduce with the improvement of the business
performance.

1.280

5 Conclusions
In this paper, through an empirical study using the
data on exchange listed companies in China during
2004-2006, we draw the following conclusion.
Earnings management and tax-avoidance behavior are
common among Chinese listed companies, but they do
not present a consistency. In analyses related to
earnings management and tax avoidance, there is a
significant positive correlation between them, which
shows significant tax-avoidance motivation in earnings
management. Meanwhile, when companies have good
business performance, the tax burden will be relatively
Tolerance
Constant

-0.439

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