The Effect of Financial Factors On Firms' Financial and Tax Reporting Decisions Edited

Asian Review of Accounting
The effect of financial factors on firms’ financial and tax reporting decisions
Yunsung Koh, Hyun-Ah Lee,
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ARA
23,2
The effect of financial factors
on firms’ financial and tax
reporting decisions
110 Yunsung Koh
Received 27 January 2014
School of Business, Hankuk University of Foreign Studies,
Revised 27 April 2014 Seoul, Republic of Korea, and
Accepted 6 May 2014
Hyun-Ah Lee
School of Business, Gachon University, Gyeonggi-do, Republic of Korea
Abstract
Purpose – The purpose of this paper is to investigate the effect of financial factors on firms’ financial
and tax reporting decisions. Firms often face the difficulties of accomplishing both financial and
reporting goals. The extent to which reporting they put more value depends on the differential
weighting of firms’ financial reporting and tax costs. The authors incorporate various financial factors
as a source of cross-sectional differences in the weighing of both financial reporting and tax costs.
Design/methodology/approach – To examine firms’ decisions when fulfilling both the purposes
of financial and tax reporting is difficult, the authors use a large set of firms in Korea, where book-tax
conformity is high and aggressive tax shelters are restricted. The authors develop a new measure that
can specify firms’ decision making between financial and tax reporting by considering both earnings
management and tax avoidance.
Findings – The findings show that debt ratio affects firms’ financial and tax reporting decisions
non-monotonically depending on the level of the debt ratio. The authors also find that firms with more
long-term debt financing are more likely to be aggressive in financial reporting, while firms with higher
financing deficit or better access to the capital market are more likely to be aggressive in tax reporting.
Research limitations/implications – Thus, the findings provide more compelling evidence of firms’
decision making between two conflicting strategies, particularly when fulfilling both the purposes of
financial and tax reporting is difficult. The authors expect that the results provide practical implications
to standard setters, auditors and financial statement users who are interested in the ongoing debate over
book-tax tradeoffs.
Originality/value – This paper fulfills an identified need to study how firms’ decision making between
two conflicting reporting strategies are affected by the various financial factors, which are closely linked
to a firm’s financial reporting and tax costs.
Keywords Earnings management, Tax avoidance, Financial factor
Paper type Research paper
Nomenclature
EMTM 1 if a firm is classified as LTDEBT1 (long-term debt + bond)/debt,
aggressive financial where debt ¼ short-term
reporting firm, and 0 if a firm debt+long-term debt + bond
is classified as aggressive LTDEBT2 (change in long-term debt
tax reporting firm +change in bond − change
LEV1 debt/total asset, where in short-term debt)/debt
debt ¼ short-term debt DEFICIT1 (capital expenditures + net
Asian Review of Accounting +long-term debt+bond increase in working capital
Vol. 23 No. 2, 2015
pp. 110-138
LEV2 debt/(debt+equity), where + dividend + current portion
© Emerald Group Publishing Limited debt ¼ short-term debt of long-term debt at start of
1321-7348
DOI 10.1108/ARA-01-2014-0016 +long-term debt + bond period − operating cash
flows)/asset, where net ICM debt from related parties/ Firms’
increase in working total asset financial and
capital ¼ increase in COLLRATIO (tangible asset+inventory)/
accounts receivables change total asset
tax reporting
− increase in inventories ADJMBT (liability–debt from related decisions
− increase in account parties+market value of
payables equity)/equity 111
DEFICIT2 (capital expenditures+net SIZE log(asset)
increase in working capital ROA net income/total asset
+dividend + current REV change in sales/total asset
portion of long-term MTR Manzon’s (1994) marginal
debt at start of tax rate modified for Korean

period − operating tax laws
cash flows)/asset, OWN proportion of common
where net increase shares held by major
in working shareholders
capital ¼ increase in asset FOR proportion of common
from operating activities shares held by foreigners
− increase in debt from BIG 1 if the auditor is one of the
operating activities Big 4 auditors, and 0
+ increase in cash otherwise
ECM (liability + market value of YR year dummy
equity)/total asset IND industry dummy
1. Introduction
Corporate managers have an incentive to manage book income upward for financial
reporting purposes and taxable income downward for tax reporting purposes. However,
in real business practices, they often face circumstances where book-tax conformity is
high and tax shelter activities are restricted. They cannot be aggressive in both financial
and tax reporting because earnings management leads to higher taxable income and tax
avoidance leads to lower book income (Hunt et al., 1996; Jenkins and Pincus, 1998; Johnson
and Dhaliwal, 1988; Klassen, 1997; Guenther et al., 1997; Erickson et al., 2004). Thus,
rational managers generally compromise one strategy over the other based on the
differential weighting of financial reporting and tax costs. To be specific, they would place
more emphasis on financial reporting by managing book income upward when the
financial reporting cost is greater than the tax cost. On the other hand, they would put
more emphasis on tax reporting by managing taxable income downward when the tax
cost is greater than the financial reporting cost.
This study investigate as to which strategy firms place more emphasis between
two conflicting strategies by incorporating various factors regarding the financing
activity of firms as a source of cross-sectional differences in the weighing of financial
reporting and tax costs. Financing is an important activity that supports firms’
continuous operations and strategic investments because capital is essential in order to
make investments on working capitals and equipment. The lack of capital financing
induces firms to be exposed to liquidity risk and further, jeopardize their ability to
remain a going concern. Accordingly, financing is one of the most critical activities that
affect corporate managers’ overall decision-making process. Furthermore, financial
factors are closely linked to the firms’ financial reporting and tax costs. Thus, we
ARA explore how various financial factors including the level of debt ratio, debt maturity,
23,2 financing deficit and access to the capital market influence the firms’ decision making
between earnings management and tax avoidance.
First, debt ratio of a firm is associated with its financial reporting costs because
debt financing increases the risk of violating accounting-based debt covenants. Many
prior studies suggest that firms with higher debt ratios have an incentive to manage
112 book income upward in order to decrease the financial reporting costs (Watts and
Zimmerman, 1986; Duke and Hunt, 1990; DeFond and Jiambalvo, 1994; Sweeney, 1994;
Beneish, 2001). Debt ratio is also related to the tax cost as debt financing basically
allows firms to enjoy tax deduction effects of interest expenses, which implies that the
tax cost decreases as a firm’s debt ratio increases (Mackie-Mason, 1990; Collins and
Shackelford, 1992; Dhaliwal et al., 1992).

However, unlike the US, Korean tax law specifies that interest expenses relevant
to debt above a certain limit cannot be tax deductible for the purpose of preventing
excessive debt financing. This unique Korean tax law provides an interesting research
setting, where excessive debt financing rather increases a firm’s tax costs because the
relevant interest expenses are included in the taxable income and as a result, a firm’s
tax deduction effect disappears ( Jeon, 1997; Koh, 2007; Kweon et al., 2009).
Accordingly, increasing the debt ratio above a certain level, where interest expenses
become non-deductible, raises both financial reporting and tax costs, whereas
increasing the debt ratio within the level raises financial reporting cost but lowers tax
costs. Because the effects of the debt ratio on financial reporting and tax costs differ
with regard to the threshold of debt ratios, a firm’s decision may vary depending on the
level of its debt ratio. We expect that earnings management is likely to take priority
over tax avoidance as the debt ratio increases, when a firm’s debt ratio is below a
certain level. On the other hand, when a firm’s debt ratio is at or above a certain level,
it would be an empirical question as to which strategy they are likely to pursue because
both financial reporting and tax costs increase as the debt ratio increases.
Second, debts are divided into short- and long-term debts based on their maturity.
Increase in short-term debt financing raises a firm’s financial reporting costs because early
repayment or lack of renewals of short-term debts increases firms’ liquidity risk and even
cause bankruptcies. Thus, firms with more short-term debt financing have incentives to
manage earnings for the purpose of easy debt contract renewal (Gupta et al., 2008; Fung
and Goodwin, 2013). Meanwhile, long-term debt financing is closely related to firms’ tax
costs because the cost of issuing a long-term debt is less expensive compared to that
of rolling over short-term debts when aiming to achieve the same duration. Prior studies
show that a firm with high tax costs has tax-based incentives to make long-term debt
commitments that minimize refinancing costs (Scholes and Wolfson, 1992; Newberry and
Novack, 1999; Harwood and Manzon, 2002). Taken together, firms with more long-term
debt financing are expected to have a greater tax cost than financial reporting cost. Thus,
we anticipate that tax avoidance is likely to take priority over earnings management
as firms’ long-term debt financing increases.
Third, internal financing deficit is one of the most important financial factors to
induce firms to borrow money from a bank or issue stocks or bonds (Shyam-Sunder
and Myers, 1999; Frank and Goyal, 2003). If firms report a loss or appear unprofitable
in the financial statements, it will be difficult for them to borrow money from a bank
or even further, they may not be able to issue stocks or bonds at adequate prices.
Therefore, financing deficit leads to managers’ opportunistic behavior to make firms look
profitable to the capital market, implying that financing deficit raises a firm’s financial
reporting costs. Meanwhile, the tax cost would be lower than the financial reporting Firms’
cost for firms with a financing deficit. We hypothesize that firms with higher financing financial and
deficit are likely to engage in earnings management rather than tax avoidance in order to
minimize total costs.
tax reporting
Lastly, firms can raise funds from either the external capital market (ECM) or internal decisions
capital market; the former includes stock/bond markets, banks and finance companies,
whereas the latter includes business group firms. Firms with better access to the ECM 113
may have a lower financial reporting cost because they have less incentive to make the
firm look more worthy for external financing. On the other hand, access to the ICM can
also diminish a firm’s incentive for financial reporting. If firms can raise funds from
affiliated firms, they have less pressure to finance from the ECM and are less restricted
to the accounting-based debt covenants with third parties. Moreover, they can even relax
their debt contract constraints with internal capital providers. Hence, firms with easier
access to external and ICMs are expected to face a relatively lower financial reporting
cost, and thus they may place less emphasis on earnings management. We assume that
they are likely to engage in tax avoidance rather than earnings management in order
to minimize their total costs.
To test firms’ decision making between two conflicting strategies, we investigate a
large set of samples in the Korean setting because Korea provides an appropriate
research setting that allows researchers to empirically explore the management’s
decision making between two conflicting strategies. This is largely due to Korea’s
relatively high accounting-tax alignment and aggressive tax shelters, such as tax
havens or transfer pricing, which are utilized to a very limited extent[1]. The managers
of Korean firms encounter more serious tension between financial and tax reporting
compared to other countries and thus, they attempt to make an efficient decision by
considering both financial reporting and tax costs affected by financial factors.
To assess the inclination of a firms’ strategy between financial and tax reporting,
we estimate firm-level earnings management and tax avoidance by using the modified
Jones discretionary accruals and Desai and Dharmapala’s (2006) tax avoidance,
respectively. However, the original Desai and Dharmapala’s (2006) model inadequately
allows the structural book-tax difference (BTD) and non-discretionary accruals to be
assumed as tax avoidance. Thus, we modify the original model by adopting Tang’s (2006)
abnormal BTD and discretionary accruals in order to calculate the tax avoidance more
accurately. We classify firms to put more emphasis on financial reporting if they have a
higher level of earnings management and a lower level of tax avoidance than the
respective median values. On the contrary, we classify firms to put more emphasis on tax
reporting (EMTM ¼ 0) if they have a higher level of tax avoidance and a lower level
of earnings management than the respective median values. The former group is defined
as aggressive financial reporting firms and the latter as aggressive tax reporting firms.
Our study makes several contributions. First, it contributes to the literature of book-tax
tradeoffs by analyzing the firm-level decision making between financial and tax reporting.
While previous researches also examine the strategies to resolve the tradeoffs, they
focus mostly on the accounting choices for specific accounts or transactions. Unlike
prior studies, we specify the firms’ overall decision making, estimated by the level of
earnings management and tax avoidance. Second, our study shows that firms’ financial
and tax reporting decision making can be varied depending on the differential weighting
of financial reporting and tax costs. More specifically, we explore various financial factors,
such as the level of debt ratio, debt maturity, financing deficit or access to the external/
ICM, which have not been often demonstrated in book-tax tradeoffs studies. We further
ARA examine the non-monotonic effect of debt ratio on firms’ decision making based on unique
23,2 Korean tax laws, which specify non-deductible interest payments of excessive debt
financing. Lastly, our analysis is performed in a setting where book-tax conformity is high
and tax shelters are utilized to a very limited extent. Thus, our findings provide more
compelling evidence of firms’ decision making between two conflicting strategies,
particularly when fulfilling both the purposes of financial and tax reporting is difficult. We
114 expect that our results provide practical implications to standard setters, auditors and
financial statement users who are interested in the ongoing debate over book-tax tradeoffs.
The rest of the paper proceeds as follows. Section 2 describes the previous research
and lays out the hypotheses. Section 3 suggests the research method and model in
order to prove the hypotheses. Empirical evidence is provided in Section 4. In Section 5,
we summarize and conclude.
2. Previous research and hypotheses development

2.1 Previous research
2.1.1 Research on book-tax tradeoff. A large body of literature has discussed the
tradeoff that managers encounter when making financial and tax reporting decisions.
Scholes and Wolfson (1992) establish a framework on such tradeoffs by demonstrating
that effective tax avoidance requires the planner to recognize all costs arising in the tax
avoidance process. Shackelford and Shevlin (2001) review extant studies that extend
Scholes and Wolfson (1992) by empirically investigating the tradeoffs between
financial and tax reporting. Most of the studies provide evidence that firms choose
accounting methods that are favorable for either financial or tax reporting by focussing
on the accounts or transactions in which the accounting principles and tax laws
conform. For example, Jenkins and Pincus (1998) report that firms with higher tax costs
tend to adopt LIFO for the inventory costing method because LIFO lowers the present
value of corporate taxes albeit at the cost of lower earnings. Johnson and Dhaliwal
(1988) examine the LIFO abandonment decision, which increases taxes and lowers
financial reporting costs. They confirm that abandonment firms are more leveraged,
closer to violating working capital covenants and have larger NOL carryforwards.
Klassen (1997) examines the major asset divestures and finds that firms with lower
levels of inside ownership concentration, which is a proxy of high financial reporting
cost, realize larger gains or smaller losses.
Several studies utilize a small sample in order to investigate the tradeoff between
financial and tax reporting. Guenther et al. (1997) use a sample of 66 firms which were cash
basis taxpayers before TR86. As a result, they find that firms reduce their taxable income
and save taxes at the cost of lower reported earnings after they become mandated accrual
basis taxpayers. On the other hand, Erickson et al. (2004) analyze a sample of 27 firms
accused of accounting fraud in order to examine whether they are willing to sacrifice
taxes in order to inflate earnings. The evidence indicates that allegedly accounting fraud
firms overpay their taxes in the process of inflating their reported earnings.
On the other hand, recent literatures pay attention to the area of book-tax non-
conformity. They suggest that firms do not always tradeoff financial and tax reporting
decisions, because non-conformity between the accounting principles and tax rules
provide firms with opportunities to report higher earnings and lower taxable income
during the same period (Desai, 2002; Manzon and Plesko, 2002; Mills et al., 2002;
Hanlon, 2005). Frank et al. (2009) suggest that aggressive financial reporting firms
are also aggressive in tax reporting by engaging in tax shelter activities. They analyze
the relationship between earnings management and permanent discretionary BTD and Firms’
find that there is a positive association between these two measures, which are proxies financial and
for aggressive financial and tax reporting. Ko et al. (2012) also address firms’
willingness to simultaneously engage in aggressive financial and tax reporting
tax reporting
behavior; however, they report that financial reporting aggressiveness is negatively decisions
related to tax reporting aggressiveness for Korean firms. Furthermore, they conjecture
that such contradicting result is due to the unique characteristics of the Korean setting. 115
According to Atwood et al. (2012), the level of tax reporting aggressiveness varies
across countries depending on corporate tax rates, book-tax conformity and the
law system (code-law or common-law). Based on the results of Atwood et al. (2012),
Ko et al. (2012) suggest that aggressive financial reporting firms have difficulties
engaging in aggressive tax reporting in Korea, where corporate tax rates are lower,
book-tax conformity is higher and the code-law is adopted.
In consideration of mixed evidence on whether aggressive financial reporting firms
exhibit more or less tax reporting aggressiveness, Lennox et al. (2013) attempt to
resolve this issue by analyzing the association between aggressive tax planning and
the frequency of alleged accounting fraud. They mainly find that tax aggressive US
firms are less likely to commit accounting fraud and do not support arguments and
evidence of Frank et al. (2009).
2.1.2 Research on financial factors. According to the positive accounting theory’s debt
covenant hypothesis, ceteris paribus, the closer a firm is to violating accounting-based
debt covenants, the more likely it is that such firms will make income-increasing
accounting choices (Watts and Zimmerman, 1986). This theory implies that firms with a
high debt ratio attempt to manage earnings upward in order to avoid breaching covenants
in the debt contracts. However, the empirical evidence on the relation between debt ratio
and earnings management is mixed. Some studies find a positive relation between the debt
ratio and earnings management by investigating accounting choices such as depreciation
methods, inventory valuation or discretionary accruals (Duke and Hunt, 1990; DeFond
and Jiambalvo, 1994; Sweeney, 1994; Beneish, 2001). In contrast, other studies note that the
debt ratio is negatively related to earnings management measured by discretionary
accruals (Becker et al., 1998; Frankel et al., 2002; Wang, 2006).
Research has also been conducted on the relation between debt ratio and tax avoidance.
Debt financing allows firms to enjoy tax deduction effects because interest payments
are typically tax deductible. In Modigliani and Miller’s (1963) theorem, firm value is a
function of leverage due to the tax deduction effect of debt financing. DeAngelo and
Masulis (1980) demonstrate that firms use not only debt, but also non-debt tax shields such
as depreciation and tax credits, in order to reduce their taxes. Moreover, there is a
substitution effect between the level of debt and non-debt tax shields. Graham and Tucker
(2006) support the substitution effect hypothesis by demonstrating that firms use less debt
when they engage in tax sheltering. However, studies in Korea provide inconsistent results;
the debt ratio is positively related to the level of tax avoidance. One possible explanation for
such result is that the interest expenses of debt above a certain level specified by tax laws
cannot be tax deductible, unlike in the USA. ( Jeon, 1997; Koh, 2007; Kweon et al., 2009).
Their results suggest that using debt above a certain limit rather increases firms’ tax costs
and thus, firms with high debt ratio are likely to avoid taxes.
Researches on debt financing also pay attention to the relationship between tax and
debt maturity. Scholes and Wolfson (1992) posit that transaction costs make it more
expensive to issue a sequence of short-term debt than to issue one long-term debt.
ARA They predict that firms with high marginal tax rates (MTRs) are more likely to use
23,2 long-term debt because they can use the ongoing tax shields provided by the long-
term debt cost-effectively. Newberry and Novack (1999), and Harwood and Manzon
(2002) empirically test Scholes and Wolfson’s (1992) tax clientele prediction;
according to their finding, firms with high MTRs use more long-term debt than do
firms with low MTRs.
116 A few studies examine the relation between debt maturity and earnings
management, which are motivated by the mixed empirical evidence on the relation
between debt ratio and earnings management. Short-term debt increases a firm’s
liquidity risk because firms may be denied the renewal of loans or even more,
repayment may be required before the maturity of their projects (Flannery, 1986;
Diamond, 1991; Johnson, 2003). Thus, Gupta et al. (2008) and Fung and Goodwin (2013)
expect that short-term debt financing may lead to managers’ opportunistic behavior to
make their firms look more worthy to lenders. Their empirical evidences reveal that
firms with a large amount of short-term debt are more likely to manage earnings
upward, which is consistent with their expectation.
In capital structure literature, internal financing deficit is considered as one of the
important factors affecting firms’ external financing. Shyam-Sunder and Myers (1999),
and Frank and Goyal (2003) include the financing deficit ratio as one of the explanatory
variables to explain firms’ financing behavior. They re-examine the pecking order
theory of capital structure by adding the financing deficit ratio estimated from the
financial statements. As a result, they point out that information in the financing deficit
appears to be factored in along with many other things that firms take into account.
Edwards et al. (2013) investigate whether financial constraints have a significant
impact on the firms’ tax avoidance behavior. However, unlike previous studies, they focus
on external financing constraints measured by change in GDP, bank lending, Altman
Z-score and financial constraint index, instead of internal financing deficit. Given
that constrained firms, by definition, struggle to access external funding, they predict that
these firms attempt to increase cash flows through tax planning. Consistent with their
prediction, they find that firms facing external financial constraints exhibit lower cash
effective tax rates.
A firm’s market value is also regarded as one of the critical factors influencing firms’
capital structure. It is widely documented that the market-to-book ratio, a measure of
growth opportunities, is negatively related to the leverage ratio because firms are more
likely to issue equity when their market values are high and repurchase equity when their
market values are low. Baker and Wurgler (2002) demonstrate that market valuation,
measured by the market-to-book ratio, affects the capital structure through net equity
issues (Market timing theory). On the other hand, Chen and Zhao (2006) indicate that the
relation between the market-to-book ratio and leverage ratio is not monotonic. They find
that debt financing increases when the market-to-book ratio rises from low to medium,
because firms with higher market-to-book ratio face lower debt financing cost. Thus, the
market-to-book ratio can be used as a proxy for access to the ECM because firms with high
market-to-book ratio, evaluated as ones with a growth opportunity and/or profitability, can
easily raise their funds through equity or debt financing.
With regard to the provider of capital, a great amount of literature in corporate
finance primarily focusses on the ECM, e.g., the bond market, stock market, banks
and finance companies. However, another stream of literature sheds light on the ICM,
where business group firms transfer financial resources among affiliated firms.
Some examples of empirical studies in this line of research are Lamont (1997) and Shin Firms’
and Stulz (1998), which study conglomerates. They confirm that the ECM is imperfect financial and
and that firms rely on the ICM.
tax reporting
2.2 Hypotheses development decisions
In general, firms attempt to report higher earnings and lower taxable income in order
to minimize financial reporting and tax costs. However, under circumstances where 117
book-tax conformity is high and tax shelters are utilized to a limited extent, firms
face difficulties of accomplishing both goals at the same time. Thus, it is highly likely
for rational managers to choose a strategy that can manage income (in which they also
put more emphasis on) by sacrificing the other income (Scholes and Wolfson, 1992).
The extent to which income they put more value depends on the differential weighting
of firms’ financial reporting and tax costs, which are varied across firms and time.
Thus, by accessing the relative weighting of financial reporting and tax costs, they can
decide to focus on the strategy that reduces the cost relatively higher than the other.
To examine a firms’ decision making between financial reporting and tax reporting,
we incorporate various financial factors as a source of cross-sectional differences in the
weighing of both financial reporting and tax costs. As described in the substantial
stream of research in accounting and finance, financial factors, such as the debt ratio,
influences firms’ financial and tax reporting decisions. In this study, we explore more
various financial factors in detail, including the level of debt ratio, debt maturity,
financing deficit and access to the capital market.
First, many previous papers report that the debt ratio is positively related to
earnings management because according to the debt covenant hypothesis, debt
financing increases firms’ financial reporting costs. The violation of accounting-based
debt covenants requires an early redemption of debt or increases the borrowing rates.
Thus, firms with higher debt ratios make income-increasing accounting choices in
order to avoid breaching covenants in their debt contracts (Watts and Zimmerman,
1986; Duke and Hunt, 1990; DeFond and Jiambalvo, 1994; Sweeney, 1994; Beneish,
2001). However, some studies do not provide the empirical evidence of a positive
relation between debt ratio and earnings management (Becker et al., 1998; Frankel
et al., 2002; Wang, 2006).
Because debt financing is closely linked to not only financial reporting costs but also
to tax costs, we conjecture that the relation between debt ratio and earnings
management may not be simple and monotonic. Normally, debt financing offers tax
advantages to firms because the interests paid on loans are generally tax deductible.
Thus, firms with a high debt ratio have lower tax costs and less incentive to use
non-debt tax shields (Mackie-Mason, 1990; Collins and Shackelford, 1992; Dhaliwal
et al., 1992; Graham, 1996). However, excessive debt financing rather increases tax costs
because, in Korea, if firms use debts above the limit specified by the tax law, relevant
interest expenses cannot be tax deductible. Jeon (1997) shows that firms with excessive
debt financing have higher effective tax rates and moreover, Koh (2007) finds that these
firms actively engage in tax planning.
Taken together, firms’ financial reporting and tax costs are graphed in Figure 1.
When firms’ debt financing is below a certain level, the financial reporting cost
increases; however, the tax cost decreases in the debt ratio. On the other hand,
both financial reporting and tax cost increase in proportion to the increase in the debt
ratio when firms’ debt financing is above a certain level. Thus, firms with a lower level
of debt ratios than the threshold have more incentives to decrease financial reporting
ARA cost in order to maximize firm value and are more likely to engage in aggressive
23,2 financial reporting. However, firms with a higher level of debt ratio than the threshold
have incentives to decrease both costs, and which cost is chosen over the other remains
as an empirical question. Hence, we cautiously conjecture that lowering the tax cost
may be an easier way for firms with a higher level of debt ratio to maximize firm value
because their financial reporting cost is already too high relative to the tax cost. Our
118 first hypothesis is developed as follows:
H1. Firms with a lower level of debt ratios are likely to be more aggressive in financial
reporting as the debt ratio increases; however, firms with a higher level of debt
ratio are likely to be more aggressive in tax reporting as the debt ratio increases.
Second, the maturity structure of debt is another significant financial factor that firms
should consider for their tax costs. Scholes and Wolfson (1992) propose that due to
refinancing costs, taxes affect firms’ preferences for long-term vs short-term debts.
Because issuing one long-term debt is less expensive than issuing a sequence of
short-term debts in terms of transaction costs, firms that are expected to use the
ongoing tax shields prefer long-term debt to short-term debt. Newberry and Novack
(1999) and Harwood and Manzon (2002) empirically find that firms with high MTRs
use more long-term debt. Thus, firms with more long-term debts would have the
propensity to avoid taxes due to their tax burden.
On the other hand, debt maturity is also closely related to financial reporting costs
because short-term debt comes with an inherent liquidity risk (Flannery, 1986;
Diamond, 1991). Firms with significant short-term debt financing have a higher
liquidity risk because they may be denied renewals of short-term debt or repayment
may be required prior to the maturity of their projects (Gupta et al., 2008). If firms have
trouble in the renewal of their debt contract, they may suffer from the lack of funding
and have difficulties of operating their businesses. Thus, such firms have more
incentives to make their financial reporting look worthy for the purpose of easy debt
contract renewal than firms with long-term debt financing. In sum, firms with more
long-term debt financing are likely to engage in aggressive tax reporting based on
the relatively greater tax cost than the financial reporting cost:
H2. Firms with more long-term debt financing are likely to engage in aggressive
tax reporting.
Third, when firms’ internal cash flows are inadequate for capital expenditure, net
increase in working capital and dividend payment, firms should raise funds by issuing
debt and/or equity. Shyam-Sunder and Myers (1999) and Frank and Goyal (2003) define
such inadequate operating cash flows as financing deficit. From the perspective of firms
with a financing deficit, financial reporting becomes more important than tax reporting
Financial reporting cost Tax cost
Figure 1.
Debt ratio and
financial reporting
and tax costs
Debt ratio Debt ratio
because their financing activity can be restricted if they report a loss or appear Firms’
unprofitable. Banks are reluctant to lend money to loss firms or unprofitable firms. Also, financial and
these firms may not be able to issue stocks and/or bonds at adequate prices. Thus,
financing deficit is one of the factors that lead to managers’ opportunistic behavior in
tax reporting
order to make firms look more profitable to the ECM, rather than to avoid taxes. Hence, decisions
we predict that firms with a financing deficit are likely to perform aggressive financial
reporting based on the relatively greater financial reporting cost than the tax cost: 119
H3. Firms with financing deficit are likely to engage in aggressive financial reporting.
Lastly, firms with better access to the ECM find it easier to raise funds. Thus, they would
be less motivated by financial reporting purposes in order to make them look worthy to the
ECM than those with limited access to the capital market. Accessibility to the ECM can
differ according to the firms’ growth opportunity because, ceteris paribus, banks, finance
companies or stock/bond investors prefer firms with a growth opportunity. Prior studies
reveal that firms with a high market-book ratio, which is a proxy of growth opportunity,
issue equity or borrow more (Baker and Wurgler, 2002; Chen and Zhao, 2006).
Access to the ICM may also reduce a firm’s propensity to manage earnings. If firms
can raise funds from affiliated firms, they have less pressure to raise funds from the
ECM. Further, they can even relax their debt covenant constraints in their favor when
contracting with internal capital providers. Eventually, firms with better access to the
external or ICMs face alleviated financial reporting cost and thus, they place more
emphasis on tax reporting in order to minimize their total costs. Thus, we hypothesize
that firms with better access to external or ICMs are likely to undergo aggressive tax
reporting in order to maximize their firm values:
H4. Firms with better access to external/ICMs are likely to engage in aggressive
tax reporting.
3. Research method and sample selection

3.1 Measuring earnings management and tax avoidance
In this section, we estimate the level of a firm’s earnings management and tax avoidance in
order to assess firms’ financial and tax reporting strategies. First, we use discretionary
accruals from the Modified Jones model in order to estimate the level of earnings
management. Earnings are decomposed into two components: cash flows and accruals.
In particular, the discretionary portion of accruals is considered to be easier in managing
earnings because managers can exercise their discretion. In order to explain the total
accruals, Jones (1991) calculates the discretionary accruals portion driven by the
unexplained portion of accruals when firms’ operational factors are deployed. Later,
Dechow et al. (1995) modify the original Jones model by adjusting changes in the
receivables for the discretionary portion. We estimate the following equation by fiscal year
and industry, where all variables are scaled by the beginning of the year total assets:
1 DADJ REV i;t PPE i;t
TACC i;t ¼ a1 þ a2 þ a3 þ ei;t (1)
TAi;t1 TAi;t1 TAi;t1
where TACCi,t is the total accruals for firm i in year t; TAi,t the total assets for firm i in
year t; ΔADJREVi,t the changes in sales minus changes in receivables for firm i from
year t-1 to year t; PPEi,t the gross property, plant and equipment for firm i in year
t; εi,t the error term for firm i in year t.
ARA Second, we follow Desai and Dharmapala’s (2006) approach to estimate the level
23,2 of a firm’s tax avoidance. Desai and Dharmapala (2006) construct a tax avoidance
measure by regressing the total BTD on total accruals. As a result, the component of
BTD, which cannot be explained by earnings management, is interpreted as a tax
sheltering activity. However, the accounting-tax misalignment that is less likely to
relate to the firms’ opportunistic behavior, such as earnings management or tax
120 avoidance, also results in BTD. Thus, Desai and Dharmapala’s (2006) model has a
limitation, that accounting-tax misalignment can be captured by the residual in the
following equation, which is erroneously considered as tax avoidance:
BTDi;t ¼ a1 TACC i;t þ ei;t (2)
where BTDi,t is the book-tax difference for firm i in year t; TACCi,t the total accruals for
firm i in year t.
To estimate tax avoidance more precisely, we modify the original Desai and
Dharmapala’s (2006) model by employing Tang’s abnormal BTD. Tang and Firth
(2011) regresses BTD on non-discretionary permanent items in order to exclude the
normal BTD, which is a result of the differences between accounting and tax laws.
The residual in the following equation, an unexplained portion of BTD, is the measure
of abnormal BTD (ABTD):
BTDi;t ¼ a1 I NV i;t þ a2 DREV i;t þ a3 N OLi;t þ a4 TLU i;t þ ei;t (3)
where BTDi,t is the book-tax difference for firm i in year t; INVi,t the change in investment
in gross property, plant and equipment and intangible assets from year t-1 to t; ΔREVi,t
the changes in revenues for firm i in year t; NOLi,t the value of net operating losses for
firm i in year t; TLUi,t the value of tax losses utilized for firm i in year t.
Because ABTD is composed of earnings management and tax avoidance, we exclude
earnings management by regressing ABTD on discretionary accruals. The modified
version of Desai and Dharmapala’s (2006) model is the following equation. The adjustments
relative to Desai and Dharmapala’s (2006) model is that BTD and TA are replaced
by ABTD and DA, respectively. In doing so, the accounting-tax misalignment and
non-discretionary accruals is no longer considered as tax avoidance:
ABTDi;t ¼ a1 DAi;t þ ei;t (4)
where ABTDi,t the abnormal book-tax difference for firm i in year t; DAi,t the
discretionary accruals for firm i in year t.
Unlike prior studies, we develop a new measure that can specify firms’ decision
making between financial and tax reporting by considering both earnings management
and tax avoidance. Without considering both earnings management and tax avoidance
contemporaneously, it is hard to fully understand the firms’ decision making to minimize
the sum of financial reporting and tax costs. Based on the level of earnings management
and tax avoidance driven by Equations (1) and (4), we determine as to which strategy
firms place more importance over the other. We consider firms to put more emphasis
on financial reporting (EMTM ¼ 1) if they have a higher level of earnings management
and a lower level of tax avoidance than the respective median values. On the contrary,
we consider firms to put more emphasis on tax reporting (EMTM ¼ 0) if they have a
higher level of tax avoidance and a lower level of earnings management than the
respective median values. The former group is defined as aggressive financial reporting
firms and the latter as aggressive tax reporting firms.
3.2 Research models Firms’
We analyze the effects of financial factors on a firm’s decision making between financial and
financial and tax reporting by using the following logistic regressions:
tax reporting
EM TM i;t ¼ b0 þ b1 ðLEV 1 or LEV 2 Þi;t þ b2 ðLEV 1 or LEV 2 Þ2 i;t decisions
þ b3 SI Z E i;t þ b4 ROAi;t þ b5 REV i;t þ b6 M TRi;t þ b7 OW N i;t
121
þ b8 FORi;t þ b9 BI Gi;t þ b10 SY R þ b11 SI N D þ ei;t (5)
EM TM i;t ¼ b0 þ b1 ðLTDEBT1 or LTDEBT2 Þi;t þ b2 LEV i;t þ b3 SI Z E i;t

þ b4 ROAi;t þ b5 REV i;t þ b6 M TRi;t þ b7 OW N i;t þ b8 FORi;t

þ b9 BI Gi;t þ b10 SY R þ b11 SI N D þ ei;t (6)
EM TM i;t ¼ b0 þ b1 ðDEFI CI T1 or DEFI CI T2 Þi;t þ b2 LEV i;t þ b3 SI Z E i;t

þ b4 ROAi;t þ b5 REV i;t þ b6 M TRi;t þ b7 OW N i;t þ b8 FORi;t
EM TM i;t ¼ b0 þ b1 ðECM or I CM Þi;t þ b2 LEV i;t þ b3 SI Z E i;t þ b4 ROAi;t

þ b5 REV i;t þ b6 M TRi;t þ b7 OW N i;t þ b8 FORi;t
The variables are defined as in nomenclature. Because the dependent variable is a
dummy variable that has a value of 1 if firms are classified as financial reporting
aggressive and 0 if firms are classified as tax reporting aggressive, we run logistic
regressions. In Model (5), the square value of the debt ratio (LEV12 or LEV22) examines
whether the effects of the debt ratio on financial or tax reporting is non-monotonic.
If the coefficient on LEV12 or LEV22 is a negative value, it implies that the likelihood
of aggressive financial reporting increases in the debt ratio below a certain level of debt
financing and subsequently, the likelihood of aggressive tax reporting increases in the
debt ratio over a certain level of debt financing.
In Model (6), LTDEBT1 or LTDEBT2 measures the long-term debt ratio. Firms
with more long-term debt financing have a higher tax cost than the financial reporting
cost. Thus, we expect to document a negative coefficient for LTDEBT1 or LTDEBT2.
In Model (7), DEFICIT1 or DEFICIT2 measures the level of internal financing deficit.
Financing deficit motives firms to make them look more profitable for successful
financing. Thus, we expect to document a positive coefficient for DEFICIT1
or DEFICIT2. In Model (8), ECM and ICM are proxies of access to the external
and ICMs, respectively. Firms that have access to the external or ICM have lower
incentives to manage earnings for financing. Instead, they are likely to avoid taxes
in order to minimize total costs. Thus, we expect to document the negative
coefficients for both ECM and ICM.
We include various control variables, such as firm size (SIZE), profitability
(ROA) and growth (REV), which are expected to affect the extent of earnings
ARA management (Beneish, 1999; DeFond and Park, 1997; Watts and Zimmerman,
23,2 1990). The MTR is meant to control for the other effects on tax avoidance
because firms with higher tax burdens are more likely to engage in tax
avoidance (Koh, 2007). We also control for major shareholder ownership (OWN),
foreign shareholder ownership (FOR) and big auditors (BIG) because earnings
management or tax avoidance can be mediated by firms’ governance characteristics or
122 audit quality (Becker et al., 1998; Desai and Dharmapala, 2006; Klassen, 1997). Finally, we
include the industry and year dummies in order to control for the industry and yearly
specific factors.
3.3 Sample selection
Our initial sample consists of firms listed on the Korea Stock Exchange (KSE)
during the period between 2003 and 2009. Financial firms are excluded from the
sample due to their unique nature of financial data. Non-December year-end firms
are also eliminated from the sample for homogeneity. The financial and stock data
are gathered from the TS2000 (www.kokoinfo.com) and KIS-VALUE (www.kisline.
com) databases[2]. We restrict our final sample to firms classified as aggressive
financial reporting or aggressive tax reporting, as described in Section 3.1, because
our interest is on firms’ decision making between two conflicting strategies. We
drop the sample firms with both a high (low) level of earnings management and tax
avoidance because it is vague as to which strategies they focus on. These
procedures resulted in the final sample comprising of 2,610 firm-years. To rule out
the effect of outliers, a winsorization process is performed for continuous variables
at the upper and below the 1 percent level.
4. Empirical results
4.1 Descriptive statistics and correlation analysis
Panel A of Table I presents the descriptive statistics for the variables used to
analyze firms’ decision making between aggressive financial reporting and
aggressive tax reporting, which are driven by the various financial factors. As
described in Section 3.1, we classify sample firms into aggressive financial firms
(EMTM ¼ 1) or aggressive tax reporting firms (EMTM ¼ 0) based on the median
values of discretionary accruals and tax avoidance. For the debt ratio, we measure
LEV1 by dividing debts by total assets, where debts consist of short-term debt,
long-term debt and bond which require the payment of interest. We measure LEV2
by dividing interest bearing debts by total capital, instead of using total assets. The
sample firms have approximately 20 percent of debt ratios to total asset or 26
percent to total equity.
We also measure the long-term debt ratio in two different ways: LTDEBT1 is the
level variable of the long-term debt scaled by total debts, where debt maturing after one
year is defined as long-term debt. LTDEBT2 is the change variable of the long-term
debt scaled by total debts. The sample firms’ long-term debt ratio is approximately
44 percent, and the issuance of long-term debt increases by 12 percent, on average.
For the financing deficit, we follow the equation developed by Shyam-Sunder and
Myers (1999). The financing deficit is constructed from an aggregation of dividends,
investment, change in working capital, current portion of long-term debt and internal
cash flows. More specifically, the financing deficit is measured in two different ways
based on the scope of working capital. DEFICT1 is computed by using working capital,
such as accounts receivable, inventory and accounts payable, while DEFICT2 is
Panel A: total samples (n ¼ 2,610)
Firms’
Variables Mean Median Median MIN Max SD financial and
GROUP 0.500 0.500 0.500 0.000 1.000 0.500 tax reporting
LEV1 0.202 0.190 0.190 0.000 0.599 0.162
LEV2 0.263 0.253 0.253 0.000 0.721 0.204 decisions
LTDEBT1 0.447 0.425 0.425 0.000 1.000 0.378
LTDEBT2 0.123 0.000 0.000 −1.357 3.917 0.620 123
DEFICIT1 0.027 0.022 0.022 −0.267 0.343 0.109
DEFICIT2 0.041 0.019 0.019 −0.187 0.355 0.096
ECM 0.939 0.815 0.815 0.285 3.250 0.485
ICM 0.000 0.000 0.000 0.000 0.027 0.003
SIZE 19.461 19.151 19.151 17.040 23.799 1.463

ROA 0.041 0.043 0.043 −0.215 0.224 0.067
REV 0.082 0.065 0.065 −0.654 0.867 0.215
MTR 0.274 0.275 0.275 0.196 0.308 0.026
OWN 0.262 0.265 0.265 0.000 0.756 0.220
FOR 0.099 0.025 0.025 0.000 0.643 0.149
BIG 0.684 1.000 1.000 0.000 1.000 0.465
Panel B: groups
Aggressive financial reporting Aggressive tax reporting t-Test
firms (EMTM ¼ 1, n ¼ 1,305) firms (EMTM ¼ 0, n ¼ 1,305) Wilcoxon test
Variables Mean Median Mean Median t-stat z-stat
EM −0.059 −0.043 0.061 0.044 56.07*** 44.24***
TM 0.029 0.020 −0.033 −0.023 −51.62*** −44.24***
LEV1 0.185 0.160 0.219 0.214 5.46*** 5.86***
LEV2 0.243 0.220 0.283 0.283 5.08*** 5.47***
LTDEBT1 0.461 0.456 0.433 0.410 −1.89* −1.35*
LTDEBT2 0.167 0.020 0.078 0.000 −3.65*** −5.06***
DEFICIT1 0.012 0.004 0.043 0.039 7.32*** 8.62***
DEFICIT2 0.019 0.001 0.062 0.045 11.63*** 13.18***
ECM 0.977 0.837 0.900 0.802 −4.07*** −2.68***
ICM 0.001 0.000 0.000 0.000 −1.50 −1.13
SIZE 19.467 19.111 19.456 19.176 −0.20 1.29*
ROA 0.037 0.047 0.046 0.038 3.12*** −2.34***
REV 0.067 0.061 0.096 0.071 3.35*** 2.88***
MTR 0.274 0.275 0.274 0.275 −0.01 −0.63
OWN 0.263 0.265 0.261 0.264 −0.31 −0.37
FOR 0.108 0.023 0.089 0.026 −3.15*** −0.44
BIG 0.686 1.000 0.681 1.000 −0.25 −0.25 Table I.
Notes: The variables are defined as in nomenclature. *,***Significant at 10 and 1 percent levels, Descriptive statistics
respectively, based on two-tailed tests for variables
computed by using working capital, including assets or debt from operating activities.
The mean (median) values of DEFICIT1 and DEFICIT2 are 0.027 (0.022) and 0.041
(0.019), respectively, and are skewed to the right side.
The market-to-book ratio is used as a proxy of access to the ECM, and debt from
affiliated firms is used as a proxy of access to the ICM[3]. The mean (median) value of
ECM is 0.939 (0.815), indicating that firm value is generally underestimated compared
to book value. Also, the mean (median) value of ICM is 0.000 (0.000), indicating that
borrowings from affiliated firms do not take much portion in a firm’s total debt.
For the control variables, the mean (median) values of firm size (SIZE) and return
on assets (ROA) are 19.461 (1.151) and 0.041 (0.043), respectively. The sample firms’
ARA growth rate is about 8.2 percent and the MTR is about 27 percent. The proportion
23,2 of equity held by major shareholders is approximately 26 percent and the proportion of
equity held by foreign investors is about 10 percent. Lastly, 68 percent of the sample
firms are audited by one of the big auditors.
Panel B of Table I reports the descriptive statistics for aggressive financial reporting
and aggressive tax reporting firms in order to compare the financial factors of two
124 classified groups. As for the debt ratios (LEV1, LEV2), aggressive financial reporting
firms show higher mean (median) values than aggressive tax reporting firms. The
results of the t-test (t-stat ¼ 5.46 and 5.08, respectively) and Wilcoxon test (Z-stat ¼ 5.86
and 5.47, respectively) indicate that there is a significant difference between the two
groups. For the long-term debt ratio (LTDEBT1, LTDEBT2), aggressive financial
reporting firms have a lower mean (median) compared to aggressive tax reporting
firms. The results of the t-test (t-stat ¼ −1.89 and −3.65, respectively) and Wilcoxon test
(Z-stat ¼ −1.35 and −5.06, respectively) also show that there is a significant difference
between the two groups. Aggressive financial reporting firms have higher mean
(median) values for the level of financing deficit (DEFICIT) and lower values for
the ECM accessibility. Hence, the results of the t-test and Wilcoxon test support that
there are significant differences between the two groups. However, we cannot find an
apparent difference between the two groups in the mean (median) values of ICM.
Table II reports the result of the correlation analysis for the variables. While the debt
ratio (LEV) and financing deficit (DEFICIT ) are significantly correlated with
aggressive financial reporting, long-term debt ratio (LTDEBT ) and access to ECM are
significantly correlated with aggressive tax reporting. These results are consistent with
our expectations that firms with high debt ratio and/or financing deficit are likely to be
aggressive in financial reporting while firms with better access to the ECM are likely
to be aggressive in tax reporting. However, access to the ICM is not statistically related
to aggressive financial reporting or aggressive tax reporting. For the control variables,
ROA and firm growth (REV) are significantly related to aggressive financial
reporting, whereas foreign shareholder ownership (FOR) is significantly related to
aggressive tax reporting.
4.2 Logistic regression analysis

The results of estimating Equation (5) are presented in Table III. The value of Pseudo-R2
for Equation (5) ranges from 0.059 to 0.061 depending on the measures of debt ratios.
The coefficients on the two measures of debt ratios (LEV1, LEV2) are significantly
positive at 0.01 levels ( p-valueo0.01), while the coefficients on the square variables
of debt ratios (LEV12, LEV22) are significantly negative at 0.01 levels ( p-value ¼ 0.002
and p-valueo0.001, respectively). These results indicate that there is a non-linear
relation between the debt ratio and the firms’ decision making. To specify, for firms with
a debt ratio below a certain limit, firms are more likely to be aggressive in financial
reporting as the debt ratio increases. However, for firms with a debt ratio over a certain
level, they are more likely to be aggressive in tax reporting as the debt ratio increases.
This result is consistent with our expectation, that firms with excessive debt financing
place more emphasis on lowering the tax cost than the financial reporting cost although
both financial reporting and tax costs increases as the debt ratio increases. It is because
lowering the tax cost would be a more efficient way for firms to maximize the firm value
than lowering the financial reporting cost, particularly when the level is already too high.
Unlike prior researches, which assume the linearity between the debt ratio and earnings
management (or tax avoidance), our study provides interesting results: firms’ decision
EMTM LEV1 LEV2 LTDEBT1 LTDEBT2 DEFICIT1 DEFICIT2 ECM ICM SIZE ROA REV MTR OWN FOR BIG
EMTM 1.0000 0.1063 0.0989 −0.0369 −0.0714 0.1420 0.2221 −0.0795 −0.0293 −0.0039 0.0609 0.0654 −0.0001 −0.0060 −0.0616 −0.0049
( o0.0001) ( o0.0001) (0.0594) (0.0003) ( o0.0001) ( o0.0001) (o0.0001) (0.1348) (0.8416) (0.0019) (0.0008) (0.9956) (0.7592) (0.0016) (0.8007)
LEV1 1.0000 0.9685 0.2685 −0.0470 0.3669 0.4016 −0.0410 0.0952 0.1342 −0.3915 −0.0427 0.0236 −0.0120 −0.1978 −0.0275
( o0.0001) (o 0.0001) (0.0163) (o0.0001) ( o0.0001) (0.0364) ( o0.0001) ( o0.0001) ( o0.0001) (0.0294) (0.2281) (0.5398) ( o0.0001) (0.1607)
LEV2 1.0000 0.3085 −0.0377 0.3453 0.3817 −0.0245 0.0948 0.1822 −0.3904 −0.0179 0.0150 −0.0369 −0.1881 −0.0074
(o 0.0001) (0.0543) (o0.0001) ( o0.0001) (0.2109) ( o0.0001) ( o0.0001) ( o0.0001) (0.3603) (0.4449) (0.0593) ( o0.0001) (0.7046)
LTDEBT1 1.0000 0.2764 0.0676 0.0870 0.0504 −0.0528 0.3739 −0.0290 −0.0110 0.1056 −0.0201 0.0707 0.1589
( o0.0001) (0.0006) (o0.0001) (0.0100) (0.0070) (o0.0001) (0.1384) (0.5740) ( o0.0001) (0.3046) (0.0003) ( o0.0001)
LTDEBT2 1.0000 −0.1147 −0.1087 0.0555 −0.0340 0.0435 0.0336 −0.0407 −0.0046 0.0065 0.0150 0.0279
( o0.0001) ( o0.0001) (0.0045) (0.0824) (0.0263) (0.0860) (0.0374) (0.8144) (0.7389) (0.4437) (0.1547)
DEFICIT1 1.0000 0.7948 0.0703 −0.0006 0.0677 −0.2176 0.0473 −0.0583 −0.0414 −0.0685 −0.0058
( o0.0001) (0.0003) (0.9777) (0.0005) ( o0.0001) (0.0157) (0.0029) (0.0345) (0.0005) (0.7674)
DEFICIT2 1.0000 0.0793 −0.0088 0.0713 −0.2173 0.0466 −0.0818 −0.0366 −0.0786 −0.0165
( o0.0001) (0.6536) (0.0003) ( o0.0001) (0.0172) ( o0.0001) (0.0617) ( o0.0001) (0.3999)
ECM 1.0000 0.0014 0.2371 0.1999 0.0936 −0.2195 −0.0695 0.3838 0.1506
(0.9446) (o0.0001) ( o0.0001) ( o0.0001) ( o0.0001) (0.0004) ( o0.0001) ( o0.0001)
ICM 1.0000 −0.0371 −0.0440 0.0291 0.0246 0.0306 −0.0563 −0.0139
(0.0578) (0.0245) (0.1369) (0.2096) (0.1182) (0.0040) (0.4770)
SIZE 1.0000 0.1015 0.0197 −0.1010 −0.1121 0.4768 0.3314
( o0.0001) (0.3155) ( o0.0001) ( o0.0001) ( o0.0001) ( o0.0001)
ROA 1.0000 0.2985 0.0623 −0.0257 0.2572 0.1113
( o0.0001) (0.0014) (0.1898) ( o0.0001) ( o0.0001)
REV 1.0000 0.0792 −0.0536 0.0277 0.0302
( o0.0001) (0.0062) (0.1567) (0.1234)
MTR 1.0000 0.3481 −0.0207 0.0003
( o0.0001) (0.2902) (0.9861)
OWN 1.0000 0.0057 −0.0452
(0.7722) (0.0210)
FOR 1.0000 0.2318
( o0.0001)
BIG 1.0000
Note: The variables are defined as in nomenclature
tax reporting
decisions
Pearson correlations
financial and
for variables
Table II.
125
Firms’
ARA LEV1 (A) LEV2 (B)
23,2 Variables Estimate Wald χ2 (p-value) Estimate Wald χ2 ( p-value)
Intercept 0.349 0.140 (0.709) 0.347 0.138 (0.711)

LEV1 4.446 31.910*** (o0.001)
LEV1^2 −4.777 10.006*** (0.002)
LEV2 3.806 34.772*** ( o0.001)
126 LEV2^2 −3.767 13.939*** ( o0.001)
SIZE −0.037 1.108 (0.293) −0.036 1.020 (0.313)
ROA 4.245 32.929*** (o0.001) 4.051 29.885*** ( o0.001)
REV 0.226 1.236 (0.266) 0.184 0.814 (0.367)
MTR −0.633 0.075 (0.784) −0.696 0.091 (0.763)
OWN 0.060 0.076 (0.783) 0.070 0.101 (0.750)

FOR −0.809 5.778** (0.016) −0.812 5.807** (0.016)
BIG −0.020 0.047 (0.829) −0.023 0.058 (0.810)
YR Included Included
IND Included Included
χ2 122.870*** 118.070***
Pseudo-R2 0.061 0.059
n 2,610 2,610
Table III. EM TM i;t ¼ b0 þ b1 ðLEV 1 OR LEV 2 Þi;t þ b2 ðLEV 1 OR LEV 2 Þ2i;t þb3 SI Z E i;t þb4 ROAi;t þ b5 REV i;t
The results of þ b6 M TRi;t þb7 OW N i;t þ b8 FORi;t þb9 BI Gi;t þ b10 SY R þb11 SI N D þei;t
logistic regression Notes: The variables are defined as in nomenclature. **,***Significant at 5 and 1 percent levels,
for debt ratio respectively, based on two-tailed tests
making between financial and tax reporting can be non-linearly related to the debt ratio.
The results support our H1.
The results of estimating Equation (6) are presented in Table IV. The value of
Pseudo-R2 for Equation (6) ranges from 0.062 to 0.063, depending on the measures
of the long-term debt ratio. Consistent with our expectation, the coefficients on the two
measures of the long-term debt ratio (LTDEBT1, LTDEBT2) are both negative and
significant at the 0.01 level ( p-value o 0.001 and p-value ¼ 0.002, respectively). These
results indicate that firms with higher long-term debt ratios are more likely to be tax
reporting aggressive, which supports our H2.
Firms with more long-term financing have a lower liquidity risk and less incentive
to manage earnings for the renewal of short-term debt contract than firms with more
short-term debt financing. Also, firms with more long-term financing are expected to
have higher tax costs because they use the ongoing tax shields by issuing one long-
term debt, which can lower transaction costs, instead of using a sequence of short-term
debt. As they face a relatively higher tax cost than the financial reporting cost, they are
likely to place more emphasis on tax avoidance than earnings management.
The results of estimating Equation (7) are shown in Table V. The value of Pseudo-R2
for Equation (7) ranges from 0.074 to 0.107, depending on the measures of the financing
deficit. The coefficients on the two measures of the financing deficit (DEFICIT1,
DEFICIT2) are both positive and significant at the 0.01 level ( p-value o 0.001). The
results imply that firms are likely to be aggressive in financial reporting when the level
of financing deficit is high, thereby supporting our H3.
For firms with a financing deficit, the restriction on financing capital is a critical issue
because firms’ going concern can even be threatened by the failure of managing the
liquidity risk. If they report a loss or unprofitable figures, they cannot issue stocks or bonds
LTDEBT1 (A) LTDEBT2 (B)
Firms’
Variables Estimate Wald χ2 ( p-value) Estimate Wald χ2 ( p-value) financial and
tax reporting
Intercept −0.660 0.469 (0.493) 0.109 0.014 (0.907)
LTDEBT1 −0.466 14.044*** (o0.001) decisions
LTDEBT2 −0.217 9.935*** (0.002)
LEV1 2.414 62.078*** (o0.001) 2.116 50.574*** ( o0.001)
SIZE 0.016 0.186 (0.666) −0.020 0.317 (0.573) 127
ROA 4.397 35.009*** (o0.001) 4.349 34.223*** ( o0.001)
REV 0.216 1.124 (0.289) 0.206 1.024 (0.312)
MTR 0.373 0.026 (0.873) −0.409 0.031 (0.860)
OWN 0.044 0.040 (0.841) 0.058 0.071 (0.790)
FOR −1.002 8.949*** (0.003) −0.945 7.970*** (0.005)

BIG 0.006 0.004 (0.947) −0.007 0.005 (0.942)
χ2 127.042*** 123.238***
Pseudo-R2 0.063 0.062
n 2,610 2,610
EM TM i;t ¼ b0 þ b1 ðLTDEBT1 OR LTDEBT2Þi;t þ b2 LEV i;t þ b3 SI Z E i;t þ b4 ROAi;t þb5 REV i;t þ Table IV.
b6 M TRi;t þ b7 OW N i;t þ b8 FORi;t þ b9 BI Gi;t þb10 SY R þ b11 SI ND þ ei;t The results of logistic
Notes: The variables are defined as in nomenclature. ***Significant at 1 percent level, based on regression for
two-tailed tests long-term debt ratio
DEFICIT1 (A) DEFICIT2 (B)

Variables Estimate Wald χ2 ( p-value) Estimate Wald χ2 ( p-value)
Intercept 0.062 0.004 (0.948) 0.348 0.137 (0.711)

DEFICIT1 5.107 95.930*** (o0.001)
DEFICIT2 2.490 34.644*** ( o0.001)
LEV1 1.089 11.584*** (0.001) 1.629 27.534*** ( o0.001)
SIZE −0.035 0.969 (0.325) −0.034 0.921 (0.337)
ROA 5.238 45.677*** (o0.001) 4.883 41.574*** ( o0.001)
REV 0.060 0.082 (0.775) 0.129 0.397 (0.529)
MTR 0.442 0.035 (0.852) −0.486 0.044 (0.835)
OWN 0.099 0.196 (0.658) 0.082 0.138 (0.711)
FOR −0.919 7.274*** (0.007) −0.915 7.431*** (0.006)
BIG −0.009 0.010 (0.922) −0.014 0.023 (0.878)
χ2 218.794*** 148.524***
Pseudo-R2 0.107 0.074
n 2,610 2,610
EM TM i;t ¼ b0 þ b1 ðDEFI CIT1 OR DEFI CI T2Þi;t þ b2 LEV i;t þ b3 SI Z E i;t þ b4 ROAi;t þ b5 REV i;t þ Table V.
b6 M TRi;t þ b7 OW N i;t þ b8 FORi;t þ b9 BI Gi;t þb10 SY R þ b11 SI ND þ ei;t The results of
Notes: The variables are defined as in nomenclature. ***Significant at 1 percent level, based on logistic regression
two-tailed tests for financing deficit
at adequate prices to raise funds or further, financial institutions, such as banks, may deny
lending money. Therefore, they have strong incentives to manage earnings rather than to
avoid taxes. More specifically, firms with a financing deficit have relatively higher financial
reporting cost than tax cost and thus, they are likely to be aggressive in financial reporting.
ARA In this study, we measure financing deficit by following the approach adopted in pecking
23,2 order theory literature. In its simplest form, it is expressed as follows: capital
expenditure + net increase in working capital + dividend + current portion of long-term
debt – operating cash flows (Shyam-Sunder and Myers, 1999). Although two financing
deficit measures (DEFICIT1 and DEFICIT2) differ depending on the computation of
working capital, they basically measure the extent of inadequacy of internal cash flows for
128 its real investment and dividend commitments in common. Since all components of the
above expression pick up the portion of cash flows, the measures are expected to be rarely
affected by earnings management through discretionary accruals. However, it is still
doubtful whether tax planning lowers the internal financing deficit by increasing cash flows.
Thus, we further examine our H3 by including prior year’s tax avoidance and
earnings management described in Section 3.1 in Equation (7). Although it is limited

method to solve endogeneity problem, we try to control for the effect of a firm’s
accounting and tax decision on the financing deficit. The analysis provides similar
results even after including the prior year’s tax avoidance and earnings management in
Equation (7). More precisely, the coefficients on DEFICIT1 and DEFICIT2 are shown
as 5.644 ( p-value o 0.001) and 2.903 ( p-value o 0.001), respectively.
The results of estimating Equation (8) are reported in Table VI. The value of Pseudo-R2
for Equation (8) ranges from 0.059 to 0.070, depending on the measures of capital market
accessibility. The coefficients on ECM and ICM accessibility are both negative and
significant at the 0.01 level ( p-valueo0.001) and 0.05 level ( p-value ¼ 0.022), respectively.
According to these results, firms are likely to be tax reporting aggressive for better access
to the external or ICM, supporting our H4.
Firms with high market-to-book ratios have better access to the ECM and have less
incentives to appear worthy for the purpose of financing. If firms are able to finance
capital from affiliated firms and the portion of internal capital financing becomes large,
ECM (A) ICM (B)

Variables Estimate Wald χ2 (p-value) Estimate Wald χ2 (p-value)
Intercept 1.045 1.200 (0.273) 0.195 0.043 (0.835)

ECM −0.535 26.740*** (o0.001)
ICM −30.084 5.285** (0.022)
LEV1 2.376 61.758*** (o0.001) 2.213 55.036*** ( o0.001)
SIZE −0.022 0.395 (0.530) −0.029 0.675 (0.411)
ROA 4.924 41.126*** (o0.001) 4.234 32.787*** ( o0.001)
REV 0.321 2.445 (0.118) 0.249 1.498 (0.221)
MTR −2.261 0.921 (0.337) −0.145 0.004 (0.950)
OWN 0.095 0.189 (0.664) 0.067 0.093 (0.761)
FOR −0.364 1.087 (0.297) −0.924 7.634*** (0.006)
BIG 0.014 0.023 (0.880) −0.008 0.007 (0.934)
χ2 140.943*** 118.335***
Pseudo-R2 0.070 0.059
Table VI. n 2,610 2,610
The results of EM TM i;t ¼ b0 þ b1 ðECM OR I CM Þi;t þ b2 LEV i;t þ b3 SI Z E i;t þ b4 ROAi;t þ b5 REV i;t þ b6 M TRi;t þ
logistic regression b7 OW N i;t þb8 FORi;t þ b9 BI Gi;t þ b10 SY R þ b11 SI N D þ ei;t
for external/internal Notes: The variables are defined as in nomenclature. **,***Significant at 5 and 1 percent levels,
capital accessibility respectively, based on two-tailed tests
they are less motivated by earnings management to avoid violating debt covenants with Firms’
external capital providers. The coefficients show that firms attempt to maximize firm financial and
value by lowering the tax cost when they face a relatively lower financial reporting cost.
In this study, we use market-to-book ratio, a proxy of growth opportunity, as a measure
tax reporting
of the capital market accessibility because firms with higher growth opportunities enjoy decisions
lower borrowing cost in the capital market. It is well documented that market-to-book ratio,
which represents the market valuation of a firm’s growth opportunities, is one of the most 129
important determinants of capital financing (Baker and Wurgler, 2002; Chen and Zhao,
2006). However, book-to-market ratio is often interpreted as information asymmetry in
some papers, which assume that lower book-to-market ratio reflects greater information
asymmetry (Barclay and Smith, 1995; McLaughlin et al., 1998; Barth and Kasznik, 1999).
Since higher market-to-book value can be interpreted as greater information asymmetry,

it is hard to avoid criticism that our result may be driven by information asymmetry
instead of capital market accessibility.
Accordingly, we replace our measure with alternative proxy that is calculated by the
sum of tangible assets and inventories divided by total assets. Tangible assets and
inventories can be pledged as collaterals to lenders. Collaterals diminish the risk of lenders,
and lower interest rates charged upon loans. Therefore, the greater the proportion of
collateralizable assets, the more willing should lenders be to supply loans, and borrowers
raise debt more conveniently (Titman and Wessels, 1988; Rajan and Zingales, 1995). This is
largely supported by many corporate capital structure studies that find a positive
relationship between collateralizable assets and firm leverage (Mackay and Phillips, 2005;
Faulkender and Petersen, 2006). Thus, the ratio of tangible assets and inventories that can
be collateralized to total assets (the ratio of collateralizable assets) is a desirable measure to
capture the accessibility to the ECM. In specific, this ratio serves as an appropriate measure
of the accessibility to the debt financing capital market in Korea where mortgage financing
is very common. Table VII presents the result of re-estimating Equation (8) by replacing
ECM_COLLATIO (A) ECM_ADJMTB (B)

Variables Estimate Wald χ2 ( p-value) Estimate Wald χ2 ( p-value)
Intercept −0.142 0.023 (0.880) 0.572 0.366 (0.545)

COLLATIO −0.901 13.193*** (0.000)
ADJMTB −0.168 20.122*** ( o0.001)
LEV1 2.424 62.024*** ( o0.001) 2.740 69.796*** ( o0.001)
SIZE −0.010 0.079 (0.779) −0.008 0.058 (0.810)
ROA 4.223 32.543*** ( o0.001) 4.345 33.769*** ( o0.001)
REV 0.261 1.642 (0.200) 0.369 3.183* (0.074)
MTR 0.610 0.069 (0.793) −2.134 0.817 (0.366)
OWN 0.136 0.385 (0.535) 0.052 0.056 (0.813)
FOR −0.945 7.986*** (0.005) −0.642 3.569* (0.059)
BIG −0.027 0.081 (0.775) −0.001 0.000 (0.993)
χ2 126.158*** 133.907***
2
Pseudo-R 0.063 0.067
n 2,610 2,610 Table VII.
EM TM i;t ¼ b0 þ b1 ðCOLLATI O OR ADJM TBÞi;t þ b2 LEV i;t þ b3 SI Z E i;t þ b4 ROAi;t þ b5 REV i;t þ The results of
b6 M TRi;t þ b7 OW N i;t þ b8 FORi;t þ b9 BI Gi;t þ b10 SY R þ b11 SI N D þ ei;t logistic regression
Notes: The variables are defined as in nomenclature. *,***Significant at 10 and 1 percent levels, for external capital
respectively, based on two-tailed tests accessibility
ARA ECM accessibility with the ratio of collateralizable assets (COLLRATIO). As shown
23,2 in column (A), the coefficient on COLLRATIO is negative and significant at the
0.01 level ( p-valueo0.001), which is consistent with the main result reported in Table VI.
The result supports that firms with high ratio of collateralized assets are less motivated
by earnings management to make them look worthy because they can raise funds
conveniently in the ECM.
130 On the other hand, market-to-value ratio has the other limitation that it includes
internal debt financing. Thus, it is difficult to avoid the criticism that the result in
column (A) of Table VI cannot clearly show the effect of ECM accessibility on the firm’s
decision making. To eliminate the portion of ICM accessibility, we adjust the variable
by subtracting debt from related parties from total liabilities in the numerator
of market-to-book ratio (ADJMTB). Column (B) of Table VII presents the result of
re-estimating Equation (8) by replacing ECM accessibility with adjusted market-to-
book ratio (ADJMTB). The coefficient on ADJMTB is still negative and significant
at the 0.01 level ( p-value o 0.001), which implies that the result is robust after excluding
the effect of ICM accessibility. Overall, the results reported in Table VII with replaced
variables strongly support our expectation that firms with better access to ECM are
more likely to focus on the strategy of lowering tax cost because they face a relatively
lower financial reporting cost.
4.3 Additional analysis

In this section, we re-examine our hypotheses using a sample of newly classified
aggressive financial and tax reporting firms. We partition observations into deciles
based on the value of earnings management, which is measured using Equation (1).
We also partition the observations into deciles based on the value of tax avoidance,
which is measured using Equation (4). Then, we drop the observations which belong to
the mid-20 percent deciles for earnings management and tax avoidance, respectively.
In doing so, we exclude the firms which are ambiguous as to which strategy they
deploy with more emphasis over the other between two conflicting strategies. The
remaining observations are newly classified as aggressive financial or tax reporting
firms, following the procedure described in Section 3.1.
The results derived for the additional analysis are presented in Table VIII. The
coefficients on the two measures of debt ratios (LEV1, LEV2) are significantly positive at
the 0.01 level ( p-valueo0.01), while the coefficients on the square variables of debt ratios
(LEV12, LEV22) are significantly negative at the 0.01 level ( p-value ¼ 0.005 and
p-value ¼ 0.002, respectively). Further, the coefficients on the two measures of long-term
debt ratio (LTDEBT1, LTDEBT2) are both negative and significant at the 0.05 level
( p-value ¼ 0.014). The coefficients on the two measures of financing deficit (DEFICIT1,
DEFICIT2) are both positive and significant at the 0.01 level ( p-valueo0.001), whereas the
coefficients on ECM and ICM accessibility are both negative and significant at the 0.01
level ( p-valueo0.001) and 0.05 level ( p-value ¼ 0.033), respectively. In sum, all of the
results for firms’ financial and tax reporting decisions based on the various financial
factors are robust. This additional analysis confirms that our main results are not driven
by the misclassification and/or aspects of gray firms.
Furthermore, we conduct additional tests by including firms with higher level of
both earnings management and tax avoidance. In our main analysis, we exclude these
firms based on the assumption that they are vague as to which strategy they deploy
with more emphasis over the other between two conflicting strategies. However, they
can be viewed as firms adopting both strategies at the same time in rare occasions.
Panel A: the results of logistic regression for debt ratio
Firms’
LEV1 (A) LEV2 (B) financial and
Variables Estimate Wald χ2 (p-value) Estimate Wald χ2 (p-value) tax reporting
LEV1 4.930 25.864*** ( o0.001)
LEV12 −5.196 8.014*** (0.005)
decisions
LEV2 4.136 26.367*** (o0.001)
LEV22 −3.959 10.008*** (0.002) 131
χ2 107.029*** 102.379***
Pseudo-R2 0.080 0.077
n 1,720 1,720
Panel B: the results of logistic regression For long-term debt ratio

LTDEBT1 −0.380 6.011** (0.014)
LTDEBT2 −0.309 6.011** (0.014)
χ2 105.064*** 112.030***
Pseudo-R2 0.079 0.084
n 1,720 1,720
Panel C: the results of logistic regression for financing deficit
DEFICIT1 6.040 89.706*** ( o0.001)
DEFICIT2 3.001 35.014*** (o0.001)
χ2 201.500*** 135.490***
Pseudo-R2 0.147 0.101
n 1,720 1,720
Panel D: the results of logistic regression for external/internal capital accessibility
ECM (A) ICM (B)
ECM −0.565 20.123 ( o0.001)***
ICM −26.848 4.570** (0.033)
χ2 105.064*** 103.815***
Pseudo-R2 0.090 0.078
n 1,720 1,720 Table VIII.
Notes: The variables are defined as in nomenclature. **,***Significant at 5 and 1 percent levels, The results of
respectively, based on two-tailed tests additional analysis
Also, there is a possibility that depending on the criteria for the classification of the
sample firms they may fall into either aggressive financial reporting firms or
aggressive tax reporting firms. Thus, we conduct additional tests by including these
observations into the category of aggressive financial reporting firms (EMTM ¼ 1)
and the category of aggressive tax reporting firms (EMTM ¼ 0).
Table IX presents the result of the analyses after including the firms with higher
level of both earnings management and tax avoidance in the category of aggressive
financial reporting firms (EMTM ¼ 1). The coefficients on the financial factors of
interest are statistically significant and show consistent signs with the results of the
main analysis. On the other hand, Table X provides the result of the analyses after
including the firms with higher level of both earnings management and tax avoidance
in the category of aggressive tax reporting firms (EMTM ¼ 0). It shows that the results
are not materially different though coefficients on LEV12, LTDEBT1, LTDEBT2 and
ARA Panel A: the results of logistic regression for debt ratio
23,2 LEV1 (A) LEV2 (B)
LEV1 4.275 38.484*** (o0.001)
LEV12 −4.676 12.172*** (0.001)
LEV2 3.530 39.260*** (o 0.001)
132 LEV22 −3.517 15.534*** (o 0.001)
χ2e 214.020*** 205.014***
Pseudo-R2 0.076 0.077
n 3,809 3,809
Panel B: the results of logistic regression for long-term debt ratio

LTDEBT1 −0.474 19.161** (o0.001)
LTDEBT2 −0.151 7.633** (0.006)
χ2 221.160*** 209.589***
Pseudo-R2 0.078 0.074
n 3,809 3,809
DEFICIT1 5.388 126.215*** (o0.001)
DEFICIT2 2.633 46.003*** (o 0.001)
χ2 341.588*** 249.509***
Pseudo-R2 0.119 0.088
n 3,809 3,809
Table IX.
The results of Panel D: the results of logistic regression for external/internal capital accessibility
additional analyses ECM (A) ICM (B)
after including firms Variables Estimate Wald χ2 (p-value) Estimate Wald χ2 (p-value)
with higher level of ECM −0.486 31.616*** (o0.001)
both earnings ICM −22.396 4.204** (0.040)
management tax χ2 99.901*** 206.068***
avoidance in the Pseudo-R2 0.036 0.073
category of n 3,809 3,809
aggressive financial Notes: EMTM ¼ 1. The variables are defined as in nomenclature. **,***Significant at 5 and 1 percent
reporting firms levels, respectively, based on two-tailed tests
ICM have p-values at lower significance level than those in the main analyses. Taken
together, the results continue to hold even after considering the firms with higher level
of both earnings management and tax avoidance in each category. It implies that these
observations do have traits of both categories, and thus do not have significant effect to
the results of our main analysis. The additional analyses support that our results are
not driven by the criteria for the classification of sample firms or exclusion of certain
group of firms with ambiguous strategies.
5. Conclusion
This study explores the effects of various financial factors on firms’ decision between
earnings management and tax avoidance. Because financial factors are closely linked
to firms’ financial reporting and tax costs, they influence the firms’ effective decision to
minimize total costs. However, firms often face difficulties to become aggressive in both
Panel A: the results of logistic regression for debt ratio
Firms’
LEV1 (A) LEV2 (B) financial and
Variables Estimate Wald χ2 (p-value) Estimate Wald χ2 (p-value) tax reporting
LEV1 2.431 12.634*** (o0.001)
LEV12 −2.540 3.745* (0.053)
decisions
LEV2 2.296 16.580*** (o0.001)
LEV22 −2.325 6.934*** (0.009) 133
χ2 90.585*** 91.357***
Pseudo-R2 0.033 0.032
n 3,809 3,809
Panel B: the results of logistic regression for long-term debt ratio

LTDEBT1 −0.246 5.100** (0.024)
LTDEBT2 −0.148 6.057** (0.014)
χ2 91.954*** 93.155***
Pseudo-R2 0.033 0.033
n 3,809 3,809
DEFICIT1 2.635 40.653*** (o0.001)
DEFICIT2 1.437 15.813*** (o0.001)
χ2 128.242*** 102.736***
Pseudo-R2 0.046 0.037
n 3,809 3,809
Table X.
Panel D: the results of logistic regression for external/internal capital accessibility The results of
ECM (A) ICM (B) additional analyses
Variables Estimate Wald χ2 (p-value) Estimate Wald χ2 (p-value) after including firms
ECM −0.322 12.494*** (o0.001) with higher level of
ICM −19.311 2.713* (0.099) both earnings
χ2 99.901*** 89.699*** management tax
Pseudo-R2 0.036 0.032 avoidance in
n 3,809 3,809 category the
Notes: EMTM ¼ 0. The variables are defined as in nomenclature. *,**,***Significant at 10, 5 and aggressive tax
1 percent levels, respectively, based on two-tailed tests reporting group
financial and tax reporting due to book-tax conformity and restrictions of tax shelters;
therefore, they tend to place more importance on one over the other. In this study,
we examine how firms make decisions between financial and tax reporting by
considering various financial factors, such as the level of debt, debt maturity, financing
deficit and accessibility to capital markets.
First, we find that the debt ratio affects firms’ financial and tax reporting decisions
non-monotonically depending on the level of the debt ratio. When firms’ debt ratio is
relatively low, they are more likely to be aggressive in financial reporting as the debt ratio
increases. This practice is consistent with the results of many prior studies, which
demonstrate that debt financing leads to firms’ opportunistic behavior to manage book
income upward because the financial reporting cost is greater than the tax cost. On the
other hand, when firms’ debt financing is above a certain level, firms are more likely
to be aggressive in tax reporting as the debt ratio increases. We conjecture that this is
ARA because excessive debt financing cannot provide a tax advantage and thereby raises the
23,2 tax cost. Although the debt ratio raises both financial reporting and tax cost for firms with
excessive debt financing, empirical evidence shows that they focus on lowering the tax
cost instead of the financial reporting cost in order to maximize firm value.
Second, we find that firms using more long-term debt are more likely to be aggressive
in tax reporting because the tax cost is relatively greater than the financial reporting cost.
134 Because the transaction cost makes it more expensive to roll over short-term debts than to
issue one long-term debt, firms that are expected to use tax shields cost-effectively prefer
a long-term debt. In addition, long-term debt alleviates firms’ motives to manage book
income upward for the renewal of debt, because long-term debt emerges for renewals less
frequently than short-term debt.
Third, firms with a financing deficit are more likely to be aggressive in financial
reporting because the financial reporting cost is relatively greater than the tax cost.
For firms with a financing deficit, successful financing is a critical issue. Thus,
financing deficit engenders firms’ opportunistic behavior to manage book income
upward in order to raise funds successfully in the capital market.
Lastly, firms with better access to the external or ICM are more likely to engage in
aggressive tax reporting. Firms with better access to the ECM have less incentive to
make them look worthy for financing. Firms with better access to the ICM also have
less pressure to finance in the ECM and/or to avoid violating the debt covenant. Thus,
we find that firms rather avoid taxes in order to reduce the tax cost for firm value
maximization because the financial reporting cost is relatively small for those firms.
This study contributes to the extant literature in at least three ways. First, the extant
literature examining firm’s decision making between financial reporting and tax
reporting focus mostly on the accounting choices for specific accounts or transactions.
In this study, we extend this literature and investigate firm-level decision making by
employing the measures that capture firm-level earnings management and tax
avoidance. Second, this study is one of the first to investigate whether various financial
factors can impact on the firms’ decision making on financial and tax reporting. The
financial factors of interest in this study include the level of debt ratio, debt maturity,
financing deficit or access to the external/ICM. Lastly, compared with earlier studies,
our findings based on the data from Korean firms provide clearer and more compelling
evidence of firm’s decision making between two conflicting strategies because our
research is performed in a unique setting where fulfilling both the purposes of financial
and tax reporting is difficult. Hence, we believe that the results of this paper can be
helpful for policymakers, auditors, financial statement users and researchers who have
interest in firms’ opportunistic behaviors for financial and tax reporting.
Notes
1. Relatively high accounting-tax alignment is mostly due to different treatments for
allowances and the depreciation in accounting standards and tax laws. In Korea, allowances
for uncollectible accounts or pensions are tax deductible as long as they are within the limit
specified by tax laws, while they are not tax deductible at all in the USA, Korean tax law also
prohibits faster tax depreciation deduction than book depreciation expense (Choi et al., 2009).
In addition, there are less number of multinational firms that opportunistically utilize the
aggressive tax planning such as tax havens or transfer pricing in Korea than the USA.
2. TS2000 and KIS-VALUE databases systems are Korean equivalents of COMPUSTAT
or CRSP in the USA, providing financial and stock price data for firms listed on the KSE
(Choi and Lee, 2013).
3. Debt from affiliated firms which is used as a proxy of access to the ICM captures the actual Firms’
end result of the firm’s effort to raise capital from ICM. Meanwhile, the earnings, returns
or cash flows of affiliated firms can be a good proxy of ICM because such variables measure
financial and
the potential source of capital from ICM. Unfortunately, the above variables are generally not tax reporting
available to the public, and thus we are left with no other option than to use the debt from the decisions
affiliated firms as a proxy for ICM. Due to the limited access to the database, our study is
subject to the limitation that we do not conduct more extensive analyses adopting other
alternative proxies of ICM. 135
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About the authors

Dr Yunsung Koh is an Associate Professor at the Hankuk University of Foreign Studies.
This work was supported by Hankuk University of Foreign Studies Research Fund of 2015.
Dr Hyun-Ah Lee is an Assistant Professor at the Gachon University. Her Academic and
Professional experience includes: an Assistant Professor at the Gachon University (2015-Present),
PhD at the Yonsei University (2014). Dr Hyun-Ah Lee is also a member of Korean Institute
of Certified Public Accountants (2002-Present). Dr Hyun-Ah Lee is the corresponding author and
can be contacted at: halee@gachon.ac.kr
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School of Business, Gachon University, Gyeonggi-do, Republic of Korea

debt at start of tax rate modified for Korean

Shackelford, 1992; Dhaliwal et al., 1992).

we summarize and conclude.

2. Previous research and hypotheses development

Financial reporting cost Tax cost

3. Research method and sample selection

EM TM i;t ¼ b0 þ b1 ðLTDEBT1 or LTDEBT2 Þi;t þ b2 LEV i;t þ b3 SI Z E i;t

þ b4 ROAi;t þ b5 REV i;t þ b6 M TRi;t þ b7 OW N i;t þ b8 FORi;t

EM TM i;t ¼ b0 þ b1 ðDEFI CI T1 or DEFI CI T2 Þi;t þ b2 LEV i;t þ b3 SI Z E i;t

EM TM i;t ¼ b0 þ b1 ðECM or I CM Þi;t þ b2 LEV i;t þ b3 SI Z E i;t þ b4 ROAi;t

SIZE 19.461 19.151 19.151 17.040 23.799 1.463

4.2 Logistic regression analysis

Intercept 0.349 0.140 (0.709) 0.347 0.138 (0.711)

OWN 0.060 0.076 (0.783) 0.070 0.101 (0.750)

FOR −1.002 8.949*** (0.003) −0.945 7.970*** (0.005)

DEFICIT1 (A) DEFICIT2 (B)

Intercept 0.062 0.004 (0.948) 0.348 0.137 (0.711)

earnings management described in Section 3.1 in Equation (7). Although it is limited

ECM (A) ICM (B)

Intercept 1.045 1.200 (0.273) 0.195 0.043 (0.835)

Since higher market-to-book value can be interpreted as greater information asymmetry,

ECM_COLLATIO (A) ECM_ADJMTB (B)

Intercept −0.142 0.023 (0.880) 0.572 0.366 (0.545)

4.3 Additional analysis

LTDEBT1 (A) LTDEBT2 (B)

LTDEBT1 (A) LTDEBT2 (B)

LTDEBT1 (A) LTDEBT2 (B)

Vol. 26, pp. 189-210.

The Accounting Review, Vol. 65 No. 1, pp. 131-156.

About the authors

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FOR −1.002 8.949* (0.003) −0.945 7.970* (0.005)