Use of Financial Ratios in Selecting Entities for Tax Audit Purposes - Empirical Study in Albania

WSEAS TRANSACTIONS on ENVIRONMENT and DEVELOPMENT DOI: 10.37394/232015.2021.17.30 Rezarta Shkurti, Elena Myftaraj, Elsia Gjika Use of Financial Ratios in selecting entities for Tax Audit purposes - empirical study in Albania. REZARTA SHKURTI (PERRI) Professor, University of Tirana, Albania Orcid ID: 0000-0002-2126-2339 ELENA MYFTARAJ (TOMORI) Professor, University of Tirana, Albania ELSIA GJIKA Tax Directorate, Albania Abstract: Information from financial statements and reported financial ratios have long been used to detect common phenomenon such as fraudulent financial statements, earnings management, and the relation between financial ratios and the level of tax risk of an entity. The focus of this study is to research the use of financial ratios that entities declare, in the detection of the magnitude of tax avoidance. In this paper we apply a binary logistic regression to detect which financial statement ratios differentiate between tax evading and non-tax evading entities. We analyse data from 183 tax audited Albanian entities for 2015 and 2016 accounting years and calculate several financial ratios to determine the level of tax risk based on the tax evasion magnitude found by the tax audit of these entities. We apply univariate and multivariate analysis and find several important ratios that can indicate quite accurately the high risk of tax audit of an economic entity. We suggest including these ratios as risk indicators or “red flags” in the selection procedures employed by the tax auditors. As tax reporting and financial reporting have similarities across countries of the region, our findings may be useful for other Southern Eastern European Countries as well. Keywords: tax audit, tax risk, financial ratios Received: March 10, 2021. Revised: April 8, 2021. Accepted: April 12, 2021. Published: April 14, 2021. 1. Introduction income and indirect taxes). To mitigate the overall level of the tax risk, the Tax The accurate assessment of the tax risk levels Administration employees, (the tax auditors), of economic entities is an important focus of engages in tax audits, whose primary focus is the tasks of any Tax Administration. It is the examination of an organization's or extremely important for the tax authorities to individual's tax return to verify that financial be able to manage the scarce tax audit information is being correctly reported. resources with effectiveness and efficiency, Usually, tax audits represent a considerable hence the special focus on determining the time demand for tax auditors as they imply tax risk which in turn would orient the scarce on-site controls and inspections for the tax audit resources towards the entities with a audited companies what is a major hassle for high tax risk. The tax risk from the them. Therefore, carefully selecting the tax perspective of the Tax Authorities is the risk audit subjects represents a major purpose in that companies may calculate, report, or pay effectively managing Tax Administration incorrect amount of taxes (including both resources and minimizing the probable false E-ISSN: 2224-3496 297 Volume 17, 2021 WSEAS TRANSACTIONS on ENVIRONMENT and DEVELOPMENT DOI: 10.37394/232015.2021.17.30 Rezarta Shkurti, Elena Myftaraj, Elsia Gjika identification of either tax evading or non-tax procedures of manually selecting the tax evading entities. audited companies. There have been attempts to link the To manually select the entities tax risk level of an entity with risk indicators which will be subjected to a tax audit, the tax (red flags) extracted from its financial auditors usually rely on continually statements and filed and reported monitoring the performance and activity of information. Therefore, this study aims to the companies such as the amount of the contributing towards a stream of research that reported revenues, the amount of declared uses financial ratios and reported financial and paid Value Added Tax and other taxes information to detect high tax risk entities. payable. During this process they are also Usually, the selection procedures of oriented and guided by some Risk Indicators the companies that will be subjected to a tax which are traditional financial ratios easily audit go in two stages. In the first step the calculable from reported financial statements Risk Module of the Information System of – current ratio, acid test ratio, total debt ratio, the Tax Administration, based on indicators debt to equity ratio, times interest earned and red flags derived by its internal Business ratio, return on assets, return on equity and Intelligence algorithms, selects up to a certain operating profit margin. percentage of entities that will be audited. On a closer review of the Risk The remaining entities are manually selected Indicators, we observe two aspects which, by the tax auditors based on a close follow up given the high reliance that the tax auditors of the activities of the entities (in Albania this have on these indicators, can be considered represents a 70%1 to 30% ratio between both faulty: first, the Risk Indicators do not categories). In this paper we specifically represent a complete and comprehensive focus on the second step, the selection coverage of financial ratios from different procedures that tax auditors usually follow to perspectives of performance analysis; there select what they think should be the entities are liquidity ratios, debt ratios and that should be audited. To have a more profitability ratios, but no turnover ratios and objective framework to select the audited neither cash flow indicators. As a second companies, we propose to make use of observation, we find that the thresholds for indicators or red flags from the financial some of the ratios are far from the widely statements, hence the tax auditors will not be accepted optimal values for these ratios (for perceived as being subjective in their choices. instance, we see an optimal value of current According to the data published from the Tax ratio to be 0.42 times, which is quite far from Administration in Albania for 2017 the the optimal value of 1.50 times, widely amount of tax evasion discovered from accepted for this ratio). What we aim through entities manually selected from tax auditors this research is to “update” the list of is higher (23.274 Euro on average) than the financial ratios which could serve as red flags amount of tax evasion discovered in entities or risk indicators for the tax auditors, but not selected by the Risk Module of the only. The findings of this study also aim to Information System (20.558 euro on fill the gap that exists in the literature of average). This again supports the idea of how financial ratios use in earnings management, important it is having clear and unbiased fraudulent financial reporting and tax audit in 1 The ratio 70% to 30% in favor of selection from the Risk Finances of Albania and whether that rule is yielding the Module is a policy imposed from higher levels in decision- best results on the performance of the Albanian Tax making ranks of the Tax Administration and Ministry of Administration or not, it is a matter that goes beyond the scope of this study. E-ISSN: 2224-3496 298 Volume 17, 2021 WSEAS TRANSACTIONS on ENVIRONMENT and DEVELOPMENT DOI: 10.37394/232015.2021.17.30 Rezarta Shkurti, Elena Myftaraj, Elsia Gjika Albania and the South Eastern European incentives to engage in earnings management Region. Some relevant studies can be found in both dimensions, inflating earnings to in [1] and [2], but nevertheless we observe achieve the maximization of shareholders there is more to study in this regard. value and on the other hand deflating The rest of this paper is organized earnings to minimize the taxable income [3; as follows. In the following section we focus 4; 5; 6; 7; 8; 9; 10]. We find less studies, though on the literature review by adopting a having a specific focus on the connection relatively broad view. While studies focusing between financial ratios and tax risk. in finding linkages between audit risk (and Therefore, we adopt a broad approach in the especially tax audit risk) and financial ratios literature review section by considering all are very scarce, research in the broader studies about fraudulent financial reporting context of earnings management and and earnings management. Our special focus fraudulent financial reporting are more is on papers that reveal how we can use the common and offer rich insights as to the information in the reported financial probable indicators and variables that we statements to detect manipulated financial could use. Next, in the third section we statements. present the methodology by giving an For having a complete overview on overview of the sample selection procedures, previous results on this field we searched variables included, and the techniques used to through work from various authors, [11; 12; analyze the data. In the data analysis section, 13; 14; 15; 16; 17; 18; 19] whose research is we present the two analysis tools we have based on using financial ratios for detecting employed, the univariate and the multivariate manipulative financial statement. Their technique and the logistic regression models. findings suggest that some financial In the last section, we summarize the main statement figures are informative and that the findings of the study and come up with use of several financial ratios could be useful conclusions as to which are the most in detecting companies that might have been informative ratios regarding the tax risk level. involved in fraudulent activities and general Advantages of this study are the use of manipulation of financial statements. confidential information from Tax One study based on Finnish firms [20], which Authorities Database and Information are mostly known to manage earnings System (accessed via a Non-Disclosure downward (a similar situation as that of Agreement with this Institution) the use of Albania) suggested that fraudulent real cases and findings from recent tax companies in addition to managing earnings auditing processes.

Load more