Complementary level of financial and tax aggressiveness and the impact on cost of debt: A cross-country study

Abstract

Managers can take advantage of the flexibility of accounting choices to act opportunistically through financial aggressiveness and/or tax aggressiveness. The higher the complementary level of financial and tax aggressiveness, the higher the risk arising from the levels of error or fraudulent reporting carried out by such firms (fraud risk). This study aims to examine the impacts of the complementary level of financial and tax aggressiveness on the cost of debt. We estimate these relationships with a two-stage estimator method using 7 200 firm-year samples from East Asia and Europe for the period 2014 to 2016. In the first stage, a binary logistics model is used to examine the factors that influence the complementary level of financial and tax aggressiveness. Then in the second stage, we use a regression model to examine the effect of the complementary level of financial and tax aggressiveness on the cost of debt. We find that the complementary level of financial and tax aggressiveness has a positive and significant effect on the cost of debt, meaning that the higher the complementary level of financial and tax aggressiveness, the higher the cost of debt faced by firms. Creditors perceive the practice of financial and tax aggressiveness as a significant firm risk, thus tending to increase the cost of the debt they provide.

Keywords:

• complementary level
• financial aggressiveness
• tax aggressiveness
• cost of debt

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 We use the complementary level of financial and tax aggressiveness (COMP) measure developed by Rachmawati, et al. (2019). COMP is measured via several stages. First, financial reporting aggressiveness (DFIN) and tax reporting aggressiveness (DTAX) are calculated following Frank et al. (2009). Second, DFIN and DTAX are classified into quintiles by country-year. Based on the quintile combination for DFIN and DTAX, we classify a firm into one of four groups: 1) If the quintile combination for DFIN and DTAX consists of firms that perform financial and tax aggressiveness at the same time, then the firms in this group are classified as having a high complementary level of financial and tax aggressiveness; 2) If the DFIN and DTAX quintile combination consists of firms that perform either financial or tax aggressiveness only, then the firms in this group are classified as having a low complementary level of financial and tax aggressiveness; 3) If the DFIN and DTAX quintile combination comprises firms that perform financial and/or tax aggressiveness, then the firms in this group are removed from the sample because the relationship between DFIN and DTAX is ambiguous; 4) If the quintile combination for DFIN and DTAX consists of firms that do not engage in financial and tax aggressiveness, then the firms in this group are removed from the sample.

2 Book-tax conformity (BTC) is measured using the root mean square error (RMSE) of the following equation: $CT{E}_{it}={\rho }_0+{\rho }_{1}PTB{I}_{it}+{\rho }_{2}FORPTB{I}_{it}+{\rho }_{3}DI{V}_{it}+{ϵ}_{it}$. Where CTE_it is current tax expense of firm i in the year t; PTBI_it is pre-tax book income of firm i in the year t; FORPTBI_it is estimated foreign pre-tax book income (foreign tax expense divided by total tax expense) of firm i in year t; and DIV_it is total dividend of firm i in the year t. To control for firm size, all of the variables are scaled by average total assets in years t–1 and t. [AQ8] This equation is estimated by country-year. The values of RMSE from this equation are sorted and descending ranked by each country and year, so that the highest RMSE in the year is ranked 0 and the lowest RMSE in the year is ranked n–1 (where n is the number of included countries in that year). The rank value is then divided by n–1 to scale the ranking between 0 and 1. This scale indicates that the greater the rating the higher the level of book-tax conformity in a country. The resulting scaled rankings are labelled BTC.

3 Law enforcement (ENFOR) is measured using three measures of law enforcement obtained from the Global Competitiveness Report: a) tax enforcement index; b) protection of minority investor index; and c) effectiveness of the capital market regulator index. These measures are combined using confirmatory factor analysis.

4 Financial constraint (FINCON) is measured using three measures combined using confirmatory factor analysis: a) net debt ratio; b) interest coverage ratio; and c) dividend payout ratio.