The purpose of this paper is to investigate the empirical research on the relationship between GAAP ETR smoothing and the cost of capital. In particular, this study investigate whether firms with GAAP ETR smoothing is associated with a lower cost of capital. Demere et al. (2019) document that GAAP ETR smoothing through tax accruals is strongly associated with a lower likelihood of financial restatement and tax-related financial reporting fraud. Evidence in the prior research shows that managers using tax accruals to smooth out volatilities in GAAP ETRs seem to also be committed to not using tax accruals in earnings manipulation. Rather, GAAP ETR smoothing could be associated with higher financial reporting quality and the ability of GAAP ETR smoothing for predicting future cash (or GAAP) ETRs. This is, GAAP ETR smoothing improves the prediction of future cash (or GAAP) ETRs and also outside investors put a greater emphasis on the stability of ETR reporting than on other costs. Therefore, managers are likely to use tax accruals to smooth out volatilities in GAAP ETRs to communicate a long-term sustainable tax rate and GAAP ETR smoothing strategy is a credible indicator overall reporting quality (Demere et al. 2019).

An unexplored question is whether the information of GAAP ETR smoothing as an indicator of higher financial reporting quality is association with a lower cost of capital after controlling for pre-tax income smoothing, tax avoidance, and earning quality. For analysis, following Demere et al. (2019), I measure GAAP ETR smoothing (hereafter GSMO) as the variance of the GAAP ETR and the cash ETR over prior five years (i.e., t－4～t), then I subtract the variance of the cash ETR from the variance of the GAAP ETR, and multiply this measure by negative one so that higher levels represent smoother GAAP ETRs relative to cash ETRs. Following Demere et al. (2019), I also separate my measure of GAAP ETR smoothing into its two sources of innate and discretionary components. I employ WACC (i.e., WACC consists of both the cost of debt and the cost of equity capital) as a measure of the cost of capital (hereafter COC) comes from KISVALUE databases. This study sample covers KOSPI and KOSDAQ listed firms based on the test variable from 2003 to 2017 period.

Empirical findings reveal the following. First, after controlling for several variables as well as pre-tax income smoothing, tax avoidance, and earning quality that affect the dependent variable (COC), I find evidence of a negative and significant association between GSMO and COC, which suggests that firms with GAAP ETR smoothing tax strategies have a significantly lower cost of capital. This results suggest that smoothing of GAAP ETRs through tax accruals serves as a credible indicator of higher financial reporting quality. Second, I further document that the impact GAAP ETR smoothing on the cost of capital and hence should lead to a lower cost of capital effect is mostly driven by the innate components (i.e., innate GSMO). Lastly, when I divided the full sample into KOSPI and KOSDAQ listed firms, I find that the first and second results mostly is more pronounced for KOSDAQ listed firms, which relatively when the demand for transparent reporting is higher. Their evidence is consistent with Demere et al. (2019)’s argument.

Collectively, my results contribute to the financial reporting and tax literatures by providing evidence that GAAP ETR smoothing activities pertaining to tax accruals are consistent with higher financial reporting quality. This is the first paper to address the relation between GAAP ETR smoothing and the cost of capital. Therefore, my findings can provide additional and novel evidence to the related GAAP ETR smoothing tax strategies. Overall, these results suggest that the smoothing of GAAP ETRs as a proxy for the higher financial reporting quality as well as its does capture underlying indicator for predicting future cash ETRs and/or GAAP ETRs.

▶ Key Words： GAAP ETR smoothing, pre-tax income smoothing, tax avoidance, financial reporting quality, cost of capital

** Published on May 2020
** Full article available in Korean only
** Download here → 21-7 The Effect of Smooting of GAAP Effective Tax Rates on Cost of Capital.pdf