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CH 1

Capital market research (CMR)


Understand the role of accounting and other financial information in
equity markets
Examine statistical relations between accounting and/or other financial
information and share prices
Underlying assumption of CMREfficient Market Hypothesis
Efficient market defined as a market that adjusts rapidly to fully
impound information into share prices when the information is released
Weak form: prices reflect information about past prices and trading
volumes
Semi-strong form: all publicly available information is rapidly and fully
impounded into share prices in an unbiased manner when released
Strong form: security prices reflect all information (public and private)
If markets are efficient they will use information from various sources
when predicting future earnings
Share prices have been found to react not only to earnings data but also to
such news e.g.,
News about senior executive resignations
Takeover rumours posted to internet discussion sites
Which raises possible issues about the regulation of
information provided on such sites
Concerns raised by auditors,
Share prices are the sum of expected future cash flows from dividends,
discounted to their present value using a rate of return commensurate
with the companys risk
Total or actual returns can be divided into
normal (expected) returns given market-wide movements
abnormal (unexpected) returns due to firm-specific share price
movements
Abnormal returns used as an indicator of information content of
announcements
Research examined relationship between the magnitude of unexpected
changes in earnings (EPS) and magnitude of abnormal returns
Earnings persistence depends on proportion of accruals relative to cash
flows
firms with large accruals relative to actual cash flows unlikely to have
persistently high earnings
Earnings announcements by one firm also results in abnormal returns to
other firms in the same industry
Firms with more disclosure policies have
larger analyst following and more accurate analyst earnings forecasts
increased investor following
reduced information asymmetry

reduced costs of equity capital


Earnings announcements found to have a greater impact on share prices
of smaller firms than larger firms
Share prices are considered as benchmark measures of firm value
Share returns are considered as benchmark measures of firm
performance
Benchmarks are then used to compare usefulness of alternative
accounting and disclosure methods
Market reactions to information often found to be longer than would be
anticipated from an efficient market. Also market found to sometimes
under-react to particular announcements

CH2
Agency Relationship
a contract under which one or more persons
(the principal(s)) engage another
person (the agent) to perform some service on their behalf which involves
delegating some decision making authority to the agent
Monitoring costs e.g., auditing, Internal control systems, budget control,
performance review, and incentive compensation systems etc.
Bonding costs e.g., Preparing financial statements and contractual limitations
on the managers decision making power etc.
Residual loss e.g, company resources or facilities are heavily used for
personal purpose etc (Jensen and Meklcing, 1976)
Firm is defined as a legal fiction which serves as a focus for a complex process in
which the conflicting objectives of individuals (some of whom may represent other
organizations) are brought into equilibrium within a framework of contractual
relations
Firm with and without High Shareholding Concentration (HSC Firm and NonHSC Firm)
HSC is present when an entity or private individual holds directly or indirectly
(via an entity) substantial equity ownership (large shareholding) and can
thereby significantly influence the financial and operating policy decisions of
the firm. 20 per cent or more
Agency Problem I
In a firm that does not have HSC, small shareholders cannot all represent themselves
on the board of directors and the size of their shareholding is insufficient to justify the
costs of monitoring managers
Conflicts of interest are more likely to arise between the board of directors and
shareholders.
Agency Problem II
In a firm that does have HSC, conflicts of interest are more likely to occur between
large shareholders (e.g. directly via their appointed directors and their position on the
board) and other shareholders.

Private Benefits of Control


For example, large shareholders (via their appointed directors and their own
position on the board) can expropriate the firms wealth by using the firms
resources to acquire their own firms or business units without proper
independent valuation.
Proponents of HSC
Proponents of HSC argue that large shareholders can align the interests of directors
and shareholders, and provide more effective monitoring of directors than in non-HSC
firms
This suggests that the interests of large shareholders are aligned with other
shareholders.

Positive Accounting Theory is defined as: [being] concerned with explaining


accounting practice. It is designed to explain and predict which firms will and
which firms will not use a particular method (Watts and Zimmerman
Positive Accounting Theory is based on the concepts of wealth-maximisation
and individual self interest
Role of Accounting in Agency Relationship (Agency Contract)
Accounting information can be used to minimise information asymmetry
(information gap) between the agent and the principal.
Higher Information asymmetry magnifies higher principals moral hazard and
adverse selection problems.
The adverse selection problem arises when investors are unable to make informed
investment decisions due to an information gap (Akerlof, 1970).
The moral hazard problem arises because investors are unable to predict with
certainty insiders future actions regarding the firm due to an information gap
Managers-Shareholders Contracting Relationship-Specific Agency Conflicts
Risk Aversion
Managers (the agents) are more likely to invest in low risky projects.
Low risk, low returns. Shareholders expect high returns on their investment in the
firm.
Dividend Retention
Managers (the agents) have less incentive to pay dividends to shareholders or
owners
(the principals). Shareholders expect high returns (e.g., high dividend) on their
investment in the firm.
Horizon Problem
Managers (the agents) tend to focus on firms short-term performance.
On the other hand, shareholders (the principals) are more concerned about
firms long term performance
Over consumption of perquisites
Using resources of the firm for their own benefit
CH3

Two theories frequently used in PAT literature to explain and predict managers
actions
Opportunism Hypothesis
-Managers act in their own best interest to maximize their
wealth at the expense of some other contracting parties
(Holthausen, 1990)
Efficiency Hypothesis
-Managers act in the best interest of the firm to maximize
the value of the firm (Holthausen, 1990)
Operational Discretion
For example, managers are likely to accelerate or defer recognition of revenue by
either expediting or delaying delivery of goods and services to customers in the
last month of the financial year in order to fit their reporting incentive and/or
interest
use flexibility in the goodwill rule to determine the recoverable amount of goodwill to
either increase or decrease goodwill impairment loss
use their discretion to increase or decrease depreciation expenses of non-current assets
by changing estimates of the useful life and/or by expediting or delaying the write off
of non-current assets
Managerial Opportunism
A bonus plan based on annual profits may cause managers to maximize
short-term profits rather than to invest in the long-term projects
find US managers inflate earnings in the pre-option-exercise period to
maximize option payoffs.
Extant studies find associations between buyback decisions and managerial
compensation
Fenn and Liang (2001) find that management share options are positively
related to on-market buybacks and negatively correlated with dividend
payments. In other words, large management share options are related to
high on-market buy-backs. Large management options are associated
with low dividend payments.
Leuz et al. (2003) assert that controlling shareholders are motivated to
manage the firms earnings upward to please outside shareholders and to
avoid any intervention by outsiders in the operational management of the
firm.
Are those managers actions efficient or opportunistic?
Importance of Strong Corporate Governance
A strong governance environment is expected to reduce agency costs
between managers and shareholders (investors) and therefore increase
shareholder value in the long run.
A non-executive chairperson of the board,
a majority of independent
directors on the board, and an audit committee can strengthen the
boards monitoring of the management team in presenting quality
financial information and acting in the shareholders' best interest (Arthur

et al., 2008, Ejzenberg, 2005).


have a non-executive chairperson on the board
a higher proportion of independent directors on boards
An audit committee serves as a monitoring and control device to constrain
management opportunism and increase firm value
CH4
Two Ways of Measuring Earnings Quality
Market-based measures such as Earnings Response Coefficient (ERC) that measure
the quality of earnings by its association with stock-based measures such as price,
return or volume
Measures of the ability of current earnings to predict future cash flows and
earnings
Earnings Response Coefficient (ERC)
URit = a + b(ern-u)it + eit
where
UR
= the unexpected return
a
= the benchmark rate
b
= the earnings response coefficient
(ern-u) = the value of unexpected earnings,
e
= the random movement (error term)
i
= firm
t
= at time t or over period t
Accruals Quality
Accruals quality as the metric that best reflects the ability of current
earnings to reflect future cash flows
The extent to which current accruals are associated with current, previous,
and subsequent year cash flows
Total Accruals (TA) = Net Profit After Tax (NPAT) Net Operating Cash
Flows (NOCF)
Total Accruals (TA) = Discretionary Total Accruals (DTA) + Non
Discretionary Accruals (NDTA)
Discretionary Total Accruals (DTA) = Discretionary Current Accruals
(DCA) + Discretionary Long-term Accruals (DLA)
CH5
Price divergence from fundamental value and the value relevance of accounting
information
The usefulness of accounting information
A fundamental value of a firm = intrinsic value of a firm = fair value of a
firm
The ability to reflect the fundamental value of a firm
Measuring the fundamental value of firm
For example, using the following models:

-Discounted cash flow model;


-Dividend discount model; and/or
-Comparable price multiples from firms in the same
industry as sample firms
such as P/E (price earnings ratio) or P/S (price to sales ratio).
Measuring the value relevance of accounting numbers

Using R2s of the regressions of P (closing share price) or IV (intrinsic value)


on earnings and book values of equity

that the R2s from regression of share price on earnings and book values of equity (P
regression) significantly decline between 1984 and 2003 (coefficient = -0.012 and tvalue = -2.69), consistent with the prior literature
However, the R2s of the regressions derived using the two alternative value measures
(IV) do not exhibit a clear declining trend (the coefficient for Trend becomes
statistically insignificant with t-values of -0.85). This shows that the evidence of the
temporal decline in the value relevance of accounting information that has been
documented in prior studies is sensitive to the firm-value measures employed
read Fung et al. (2010) pages 849 to 851
When market price is replaced by two alternative measurements, we can see such
decline trend. So we can not conclude accounting information has lost its value. Such

decline may due to stock market inefficiency. Arbitrage or risk factors are also
associated with such inefficiency.
CH6
Objective of Fair Value Measurement
To estimate the price at which an orderly transaction to sell the asset or to transfer the
liability would take place between market participants at the measurement date under
current market conditions
The price that would be received to sell an asset or paid to transfer a liability in an
orderly transaction between market participants at the measurement date.
Principal Market
The market with the greatest volume and level of activity for the asset or liability.
Market participants
They are independent of each other
They are knowledgeable
They are able to enter into a transaction for the asset or liability.
They are willing to enter into a transaction for the asset or liability
Active Market
A market in which transactions for the asset or liability take place with
sufficient frequency and volume to provide pricing information on an
ongoing basis.
Valuation
Techniques
(If there is no active market)
Market approach
A valuation technique that uses prices and other relevant information
generated by market transactions involving identical or comparable (i.e.
similar) assets, liabilities or a group of assets and liabilities, such as a business.

Cost approach
A valuation technique that reflects the amount that would be required currently
to replace the service capacity of an asset (often referred to as current
replacement cost).
Income approach
Valuation techniques that convert future amounts (e.g. cash flows or income
and expenses) to a single current (i.e. discounted) amount. The fair value
measurement is determined on the basis of the value indicated by current
market expectations about those future amounts.
Fair Value Measurement: Advantage
If there is active market
Independent from management
Determined by market forces
Fair Value Measurement: Criticisms
Going concern (re-exit price)

Ignores the assumption made in accounting that


the entity will continue in business
Subjectivity (re-valuation techniques)
If there is no active market, fair value is
measured using valuation techniques
-Based on predictions which may not be correct
CH7
Off-balance sheet financing refers to obtaining cash, goods or services without a
formal borrowing arrangement which requires recognizing a liability on the face of
the balance sheet.
It allows borrowers to lever up without recognizing liabilities on their balance
sheet; therefore, it can be used opportunistically to dilute the lenders claims.
In other words, it increases risks to lenders.
Off balance sheet Financing using Leas
es
Finance leases are ones where the lessee recognise assets in the balance sheet
and is responsible for the associated risks and rewards. These allow companies
to use and eventually own assets that they would not otherwise have the funds
to purchase completely up front.
Under operating leases, the lessor (not the lessee) bears the associated risks
and rewards since the lessor is the owner of the asset, e.g., the risk of over
estimating residual value. The lessor is also responsible for other costs such as
taxes, insurance, depreciation and amortisation.
When a company acquires an asset through debt financing, a liability
recognised in its financial statements informing investors about the claims
against the future income resulting from using the asset. In contrast, when the
asset is leased, no liability is created although the company is legally obligated
to make lease payments in the future.
Current standards require that operating leases must be disclosed in financial
statements, i.e. reported in notes.
Synthetic leases are common leases in the business world today treated as an
operating lease for accounting purposes and as a finance leases for tax
purposes.
These suggest that synthetic leases allow the parent company to get the tax
benefits of ownership (by recording interest and depreciation expenses) but to
conceal the liability (by not recording the debt). The use of operating and
synthetic leases for off balance sheet financing:
Increase earnings
misrepresent balance sheets,
but allow companies to maintain the ratios needed to satisfy debt
covenants which in turn lessens the influence of debt covenants, e.g.
keep their debt ratios low by misrepresenting the amount of debt they
are carrying.

Credit-constrained firms are more likely to use structured financing arrangements to


access lower cost financing sources or enhance their balance sheets.
Recent concerns of policy makers regarding firms use of financing arrangements
that are not reported as debt liabilities on their balance sheets stem from the
potential for these transactions to impose financial risks that are not adequately
disclosed to investors and creditors
Need changes in financial reporting requirements!
How do Firms Respond?
- Firms employing larger amounts of capital leases (i.e., more offbalance sheet debt financing) reported substantial declines in capital
leases and corresponding increases in operating leases (all leases not
classified as capital leases) around adoption of the standard.
- The volume of ABCP began to decline when the
requirements was first proposed, and that this decline is
primarily attributable to a reduction in North American
banks sponsorship of ABCP.
- Firms with bank debt covenants that are adversely
affected by this standard are more likely to redeem their
TPS.
- Issuers are more likely to restructure or redeem existing COCOs to
obtain more favourable accounting treatment when the financial
reporting impact on EPS is greater and when EPS is used as a
performance metric in CEO bonus contracts, i.e. managers are willing
to incur costs to retain perceived financial reporting and compensation
benefits.
accounting-based covenants see slides

When a debt covenant is violated by the borrower, the lender has a range of alternative
responses, including the following (non-exhaustive list):

Waive the violation and continue the loan

Waive the violation and imposition additional constraints

Require penalty payment

Increase interest rate


A debt covenant violation represents a breach of contract. Lenders response to the breach of
contract usually depends on the severity of the breach as well as the terms of the debt
agreement.

CH 8
What is Meant by Debt?
Public debt: bond issues by firms (the issuer) to the public (the
investors)

Private debt: borrowings obtained by firms (the borrower) from


banks/financial institutions (the lenders)
The cost of debt is the rate of return that investors require on their debt
investment in a firm.
Investors assess the default risk of a firm based on all available information when
lending money to the firm.
several determinants for the costs of debt:
Firm-specific Characteristics
Size
Leverage
Profitability
Cash flow
interest coverage,
stock volatility,
analysts coverage, etc.
Debt Issue Characteristics
Issue size
Years to maturity
Callable debt
Senior/subordinated debt
Collateralized debt ,
Convertible debt, etc.
Accounting Practices
three motives for accounting choices/techniques :
Contracting (including debt contracts and management compensation
contracts),
Asset pricing, and
Influencing external parties (e.g., the Internal Revenue Service).
Covenant-based hypothesis:
Managers change accounting choices/techniques to circumvent accounting-based
restrictions found in debt agreements (Sweeney 1994).
Voluntary accounting changes: Borrowers can use these changes to avoid violating
accounting-based covenants, which increases the moral hazard and adverse selection
costs associated with the contracts. Previous studies find only limited support for this
behaviour
Mandatory accounting changes: Borrowers can use these changes to avoid violating
accounting-based covenants. Inclusion of these changes creates only limited moral
hazard problems on the contracting parties because standard setters impose mandatory
changes externally.
Excluding voluntary and mandatory accounting changes from the
calculation of covenant compliance:
- Covenants are included in debt contracts to restrict managerial opportunism
(Jensen and Meckling,1976). Borrowers can reduce their borrowing costs by
agreeing to restrict future opportunistic behaviour.

Borrowers face a trade-off between retaining the possibility of future


opportunistic behaviour and obtaining a lower interest rate.
Excluding voluntary accounting changes:
Including these changes (1) increase opportunistic actions by managers
to shift wealth from lenders to borrowers, and (2) increase the moral
hazard and adverse selection costs associated with the debt.
Excluding mandatory accounting changes:
Including these changes (1) impose cost to lenders to determine
whether covenant violations that arise after a mandated change are
indicative of a change in loan quality or a false warning, and (2)
increase contracting costs because they reduce the likelihood of a
violation occurring that predicts default.
Beatty et al. (2002) find that the exclusion of mandatory accounting
changes may reduce the expected renegotiation costs of the loan which
can benefit the borrowers through lower interest rates.
Theoretical argument: Timely and informative disclosures make more private
information publicly available. Investors therefore face lower uncertainty and
so charge a lower risk premium on their debt investment. Prior studies provide
strong support for this argument:

CH9
The cost of equity is the rate of return that a firm pays to its equity investors
for the risk they undertake by investing their capital.
Our emphasis is on whether firms financial reporting practices also influence
cost of equity
There are several views in prior literature on whether and how financial
information affects a firms cost of (equity) capital:
1. Stock market liquidity:
Information is linked to the cost of (equity) capital through stock
liquidity. This view suggests that providing more (i.e., quantity)
information increases stock liquidity which in turn reduces transaction
costs or increases demand for a firms securities. Either of these
consequences reduce cost of equity.
2. Estimation risk:
This risk arises from investors estimates of the parameters of an asset return
or payoff distribution.
Information is linked to the cost of (equity) capital through estimation risk.
That is, information asymmetry in the market affects estimation risk and
providing more (i.e., quantity) information can reduce the estimation risk;
therefore, providing more information will reduce the firms cost of (equity)
capital.
3. Information quality in the absence of estimation risk:

Information quality is linked to the cost of (equity) capital without


affecting estimation risk. The arguments is that poor information
quality either increases information asymmetry across investors or
reduces the investors average assessed precision of future cash flows.
Either of these consequences, however, induces a non-diversifiable
information risk which in turn increases the cost of (equity) capital as
investors will demand a higher rate of return for bearing such an
additional risk.
Botosan (1997)
The results for a full sample support no significant association between
greater disclosure and cost of cost of equity, BUT
For firms with low analyst following: greater disclosure is associated with
a lower cost of equity.
For firms with high analyst following: no significant association between
greater disclosure and cost of cost of equity.
Francis et al. (2008 at 93)
The results show that management forecast and conference call behaviour are
positively related to the cost of equity. That is, greater forecasting activity and
more conference calls are associated with higher cost of equity.
Determinants
of
Cost
of
Equity:
Firms Financial Reporting Quality
Academics use various measures to quantify earnings quality:
Accruals quality;
Earnings variability;
(Absolute) abnormal accruals (Francis et al., 2008)
Francis et al. (2008) examine the relations among voluntary disclosure,
earnings quality, and cost of capital and find that more voluntary disclosure
results in lower cost of (equity and debt) capital.
CH 10
(1) The association between international accounting standards and
accounting quality; and
(2) To the extent international accounting standards improve
accounting quality, is it priced by investors?
Arguments For
Objectives of IAS are to:
limit allowable accounting alternatives available to management; and
require accounting measurements that better reflect a firms economic position
and performance
Arguments Against
failure to capture regional differences reflected in domestic accounting
standards;
principles-based accounting standards inherently flexible;
lax enforcement

(1) Earnings management


Lower earnings management associated with higher earnings
quality and, thus, higher accounting quality;
(2) Value relevance
Higher value relevance associated with higher accounting
quality
(3) Timely loss recognition
Higher timely loss recognition associated with higher
accounting quality
Model see slides

Barth et al (2008) examine whether the application of IAS is associated with


higher accounting quality
Their results show that firms applying IAS generally evidence
less earnings management, more timely loss recognition,
and more value relevance of accounting amounts than do
firms not applying IAS

To the extent international accounting standards improve accounting quality,


does this effect investor perceptions?

They use cross-sectional estimation to assess the overall


investors reaction to IFRS adoption events and find.
an incrementally positive reaction for firms with lower
quality pre-adoption information, which is more
pronounced for banks, and with higher pre-adoption
information asymmetry.
an incrementally negative reaction for firms domiciled
in code law countries
a positive reaction to IFRS adoption events for firms
with high-quality pre-adoption information.

Daske (2006)
during the transition period the expected cost of equity capital
appear to have rather increased under non-local accounting
standards
Daske et al (2008) examine the effects of mandatory IAS reporting on market
liquidity, cost of capital, and Tobins q in 26 countries. They find:
On average, market liquidity increases around the time of the
introduction of IFRS
A decrease in firms cost of capital and an increase in equity
valuations, but only if we account for the possibility that the
effects occur prior to the official adoption date
Week 11

Objective of Executive Compensation


Separation of ownership and control creates agency conflicts, as interests of
management and shareholders are not aligned
Executive compensation attempts to align the interests of management and
shareholders:
Bonuses for meeting performance hurdles;
Short and long-term (equity) incentives
Who Sets Executive Compensation?
a sub-committee called the remuneration committee
the board of directors
Remuneration committees often hire compensation consultants
Determinants of Executive Compensation
Economic determinants
Firm size; firm performance; investment opportunities
CEO-specific characteristics
CEO experience, including age and tenure
Governance (board of director) characteristics
Board size; outside directors; director age and busyness
CEO Power
CEOs earn greater compensation when the effectiveness of the board
to monitor the CEO is weak (i.e., CEO power is high):
CEO is board chair
Outside directors have been appointed by the CEO
Remuneration Committee
The authors argue outside CEO directors relate to and sympathise with
the company CEO and, as a result, recommend higher CEO
compensation
The authors find that outside CEOs serving on the remuneration
committee are associated with higher CEO compensation
Role of Compensation Consultants
Compensation consultants provide expertise on compensation-related issues
including (Cadman et al., 2010; Murphy and Sandino, 2010):
Recommendations on appropriate pay levels and pay composition (salary vs.
bonus; short-term vs. long-term incentives);
Proprietary benchmarking information on industry and market pay practices;
and
Regulatory requirements (e.g., accounting; tax) related to executive pay
Many compensation consultants also provide other services to firms
(Cadman et al., 2010; Murphy and Sandino, 2010):
Non-executive compensation advice;
Actuarial services;
Human resources advice
The decision to engage consultants in these other services often rests with

those top executives that the consultant recommends their pay levels
consultants who are advising on executive pay are simultaneously
receiving millions of dollars from the corporate executives whose companies
they are supposed to assess (Waxman, 2007)
How do the CEOs of firms with weak corporate governance justify their pay
to the board of directors and/or shareholders?
Through claiming that CEO pay was determined by an expert compensation
consultant
Armstrong et al. (2012) argue that firms with weak corporate governance are
more likely to hire compensation consultants
Findings:
CEO pay is higher in firms with weaker governance and that firms with
weaker governance are more likely to use compensation consultants
CEO pay is higher in firms using consultants compared to firms not using
consultants
There is no significant pay differences in consultant users and nonusers when
controlling for governance strength
Does equity-based compensation provide an incentive for managers to manage
earnings?
Managers holding stock or options to purchase stock gain from increased
stock prices
Investors react positively to good earnings announcements, causing stock
prices to increase
As a result, managers with equity-based compensation have an incentive to
manipulate earnings to increase their wealth
The authors find that managers with high equity incentives are:
more likely to report earnings that meet or just beat analysts forecasts;
less likely to report large positive earnings surprises; and
report higher abnormal accruals
The authors found equity-based compensation was associated with
misreporting:
Firms are more likely to misreport when the CEOs stock option portfolio is
more sensitive to stock price movements
The magnitude of misreporting is also higher when the CEOs stock option
portfolio is more sensitive to stock price movements
Week 12
What is Tax Avoidance?
Aggressiveness tax reporting is a downward tax manipulation of taxable income
through tax planning.
Benefits
Primary benefit is the increased after-tax cash flows due to tax savings
Costs
Increased costs associated with tax planning strategies;

Internal tax staff costs; and


External tax service providers
Increased likelihood of tax audit by authorities:
Audit costs; penalties and/or interest on unpaid taxes
Increased agency costs associated with aggressive tax avoidance
Information asymmetry
How is Tax Avoidance Measured?
(1) Effective tax rates (ETRs)
Income-based ETRs (ETR1, ETR2, ETR3); and
Cash-based ETRs (ETR4, ETR5, CASH_ETR, CETR)
(2) Book-tax differences (BTDs)
Total BTDs (BTD1, BTD);
Temporary BTDs
Permanent BTDs (BTD2)
Discretionary permanent BTDs (DTAX; BTD3)
(3) Probability of tax sheltering activity (SHELTER)
(4) Tax reserves (TAX_RES)
Does Tax Avoidance Help Explain Accounting Manipulation/Quality?
The authors suggest there are two contrasting views on this association:
(1) There is a growing gap between accounting profit and taxable income, as
firms use opportunities provided by substantial discretion available in GAAP
and also tax planning that creates a permanent wedge between financial and
taxable incomes to:
manage their book earnings upward without affecting their taxable income;
and also
manage taxable income downward (without affecting their book income)
(2) Managers face trade-offs when making tax and financial reporting decisions:
Increasing financial reporting income (profit) may incur tax costs (e.g., tax
payable)
Lowering taxable income may incur financial reporting costs (e.g., reporting
lower income to the market)
Increasing the gap between accounting profit and taxable income results in
greater scrutiny from regulators and auditors
(1) Based on agency theory, aggressive tax avoidance facilitates managers
diverting resources from the firm
Use of complex tax transactions (e.g., setting up tax shelters) increases
information asymmetry as managers suppress information on their tax
planning strategies
Concealing such information provides an opportunity for managers to
manipulate earnings
(2) Managers may willingly have their firms pay taxes on the earnings
overstatements to avoid raising the suspicion of investors and regulators.
Do Investors Price Tax Avoidance?

The level of a firms reserve for income taxes is significantly positively


associated with the cost of equity capital
Indicates investors perceive the benefits of more aggressive tax avoidance
are outweighed by the costs
However, not all measures of highly aggressive tax avoidance are
associated with the cost of equity capital
Goh et al. (2013) examine the association between corporate tax avoidance and cost
of equity
Findings:
Less aggressive forms of tax avoidance significantly reduces a firms
cost of equity
Indicates investors perceive the benefits of less aggressive tax avoidance
outweighs the costs

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