Examination on Tax Avoidance Measures and Earnings Management: Focusing on Effective Tax Rates and Discretionary Accruals

In this study, we examine the effects of earnings management on effective tax rates (ETR) which is one of the most widely used tax avoidance measures in tax accounting research. We also test whether an alternative tax avoidance measure of operating cash flow-based effective tax rate (CFO ETR) is more robust from the effects of earnings management than ETR. We lastly recommend the ways to identify the overestimating issue of ETR caused by earnings management when measuring tax avoidance in an empirical analysis. Our analysis using non-financial listed firm-year observations for the period of 2001-2019 yields the following findings. First, we observe the evidence of earnings management from the group of firms that are considered to achieve low ETR due to the increasing denominator (pretax earnings). Second, among components of pretax earnings, operating cash flow is found to have a stronger relationship with taxes paid than accruals, supporting the robustness of CFO ETR. Lastly, based on the re-examination of the previous literature on tax avoidance, we find that the empirical estimates or results could be biased by the effects of earnings management on ETR measures. In this regard, we specifically address the need to identify and control for these effects by using both ETR and CFO ETR, and either eliminating or partitioning the group of observations considered to be affected by earnings management when conducting empirical analysis.