Impact of debt and taxes on earnings persistence of Portuguese SMEs.
| Autor | Pereira, Claudia |
Introduction
Accounting standards rely on flexibility in preparing financial reports in order to disclose the true and fair view of each firm. However, Kvaal and Nobes (2010) argue that accounting standards based on principles rather than rules may lead to different interpretations of financial information. In addition, the use of both fair value and estimates may lead to financial statement volatility and thus increase the potential for managerial discretion (Ball, 2006).
Given that accounting earnings are a fundamental source of information for decision making (Francis et al., 2004), entities with high earnings quality and good economic performance tend to promote efficient resource allocation (Healy & Wahlen, 1999). Therefore, it is important to investigate the factors that may affect managers' decisions regarding the financial statements to be prepared. Indeed, managers may not defend the interests of owners, so it is fundamental to regulate their performance, as agency theory shows. Several studies analyze the incentives that drive discretion. In particular, debt covenants are analyzed in studies on accounting choices, as reported by Fields et al. (2001).
In this context, information quality indicators are essential to increase transparency and gain the trust of stakeholders. However, as the quality of results is not directly observable, the literature has developed several indicators that allow the perception of earning management activities (Dechow et al., 2010; Schipper & Vincent, 2003).
In the specific case of SMEs, which have a large presence in most economies, they have an incentive to reduce tax payments, but they also have very high levels of indebtedness. Thus, while entities report lower earnings in order to pay less tax, they have an incentive to increase earnings in order to obtain additional bank financing at a reasonable cost, as mentioned by Khuong et al. (2022). This helped to motivate our research.
Previous literature highlights the effect of earnings quality for stakeholders. For example, Cerqueira and Pereira (2020) mention that shareholders and creditors demand high quality financial information. In the same sense, Francis et al. (2004) point out that earnings persistence is a desirable attribute and contributes to reducing the cost of debt. Therefore, given that earnings persistence is a measure of earnings quality, we propose that creditors will tend to value sustainable earnings because they reduce the risk of default. In this sense, the objective of this paper is to investigate the impact of debt and taxes on the earnings persistence of Portuguese SMEs in the period from 2015 to 2020.
Our empirical evidence shows that debt is significantly and negatively associated with earnings persistence. Thus, when debt increases, earnings persistence tends to be lower, which is inconsistent with the need to respond to creditors' demand to reduce default risk. This result deserves the attention of managers, investors, creditors and regulators from the perspective of the level of indebtedness of Portuguese SMEs, which is a contribution of the study. The result can be explained by the level of indebtedness of the sample firms and their exposure to the lack of liquidity in the markets during the Covid-19 pandemic. In the case of SMEs, income tax, analyzed together with debt, it has a significant negative effect on earnings persistence, in line with Hanlon (2005) and Blaylock et al. (2012), according to whom entities have less earnings persistence to avoid paying taxes. Moreover, our results suggest that the tax effect is more relevant than the debt effect for earnings persistence. This may be explained by the relatively small size of Portuguese SMEs, their high average debt and the huge weight of taxes. Furthermore, we find evidence that size positively affects earnings persistence, which may be due to these entities being subject to different economic and social pressures.
The insignificant number of scientific papers on the Portuguese market, the high representativeness of SMEs in the national economy and the high average debt level of the sample, on the one hand, and the evidence that firm size affects earnings persistence, on the other hand, justify the choice of this sample.
This paper is useful for researchers and various economic agents, namely, firm managers, bank decision makers and academics. On the one hand, it shows that earnings persistence is an indicator of the quality of accounting results, and on the other hand, it highlights the possibility that earnings persistence is a mechanism to control the activity of managers in order to gain the confidence of creditors. Moreover, the results of the paper may contribute to the responsible alignment of managers with stakeholders' expectations, especially since Portuguese SMEs have high levels of indebtedness. Finally, the tax administration may also benefit by knowing the impact of tax policy on earnings persistence and, thus, on earnings quality.
2 Literature review
2.1 Earnings quality
Financial statements (FS) disclose useful information for various users to make their economic decisions (Dechow, 1994; Schipper & Vincent, 2003). The usefulness of financial information depends on its quality. In practical terms, earnings and metrics derived from these are used for debt contracts and managers' compensation (Penman & Zhang, 2002). Therefore, it is in the interest of all parties that FS exhibit high quality. In fact, entities with both good performance and high earnings quality contribute to an efficient allocation of resources (Healy & Wahlen, 1999).
Dechow and Schrand (2004) argue that quality is the ability of earnings to reasonably reflect the firm's current performance. However, given that earnings quality is not directly measurable, several estimates and approximations have been developed in the literature (Dechow et al., 2010; Schipper & Vincent, 2003). Indeed, Dechow et al. (2010) argue that estimates of earnings quality provide additional information about firm performance that is crucial in the decision-making process. Additionally, Dimitropoulos et al. (2013) point to the fundamental role of earnings quality, especially in controversial times, which underpins financial markets and allows investors to make more efficient and less risky decisions.
In general terms, the closer earnings are to future cash flows, the higher their quality. Hence, earnings management practices, which occur when managers use privileged information to mislead stakeholders about the true performance of the firm, tend to reduce earnings quality because they are no longer complete and transparent and may mislead users (Healy & Wahlen, 1999). Francis et al. (2004) divide measures of information quality into two groups: those based on accounting and those based on capital markets. The first includes parameters such as accruals, predictability, persistence, and smoothness, and the second includes conservatism, timeliness, and value relevance. The most used estimates of earnings quality in the literature are income smoothing, conservatism, more timely recognition of losses relative to gains, discretionary accruals, and earnings persistence (Dechow et al., 2010; Cerqueira & Pereira, 2019).
This paper focuses on the quality of earnings reported by accounting, considering the ability of entities to maintain earnings, through an analysis of their persistence. This measure indicates the extent to which current earnings persist and are repeated in the future, and thus it is used as a measure of earnings quality. Therefore, it is expected that higher levels of earnings persistence allow a more accurate estimate of the current and future performance of the firm (Dechow et al., 2010). In this context, persistence is interpreted as a measure of expected future cash flows. Its usefulness derives from the positive correlation between earnings persistence and stock returns (Schipper & Vincent, 2003). Consistently, Francis et al. (2004) point out that earnings persistence is a desirable characteristic that depends on firm performance. This does not prevent earnings from being volatile over time, as long as this volatility is directly related to changes in the firm's future performance.
In addition, earnings have two components, namely accruals and cash flows. Sloan (1996) observed that the performance of the accruals component is less persistent than the performance attributed to the cash flows component. The author also shows that stock prices act as if investors fix earnings and have serious difficulties in decomposing earnings into their different components.
In turn, Hanlon (2005) provides information that entities recognize losses in a timely manner in order to reduce taxes payable, and positive differences between book and tax earnings tend to increase earnings volatility and reduce their persistence. Demerjian et al. (2013) analyze earnings persistence as a proxy for earnings quality, and their results suggest that earnings persistence is greater when managers have more skills and higher ability.
2.2 Debt versus taxes and earnings management
Earnings management occurs when managers use inside information (information asymmetry between managers and outsiders) to modify the numbers expressed in certain items of FS, so that contracts based on accounting data are not breached, as argued by Healy and Wahlen (1999). In contrast, Bartov et al. (2002) and Scott (1997) mention that the management of financial information aims to maximize firm value. In this approach, firms engage in earnings management activities to avoid costs or generate benefits. In addition, earnings may be used as a regulatory mechanism, namely being useful for the definition of debt contracts, as argued by Dichev et al. (2013).
Business relationships are governed by contracts, where compliance with objectives is monitored through specific clauses (covenants), which sometimes appear in the...
Para continuar a ler
PEÇA SUA AVALIAÇÃOCOPYRIGHT GALE, Cengage Learning. All rights reserved.
