The Effect of Tax Authority Monitoring and Enforcement on Financial Reporting Quality

The following post comes to us from Michelle Hanlon of the Accounting Department at MIT, Jeffrey Hoopes of the Accounting Department at the University of Michigan, and Nemit Shroff of the Accounting Department at the University of Michigan.

In the paper, Uncle Sam Is Watching: The Effect of Tax Authority Monitoring and Enforcement on Financial Reporting Quality, which was recently made publicly available on SSRN, we examine the relation between tax enforcement and financial reporting quality. We proxy for financial reporting quality using the extent to which earnings map into cash flows and the magnitude of the absolute value of discretionary accruals. After controlling for firm level characteristics and industry membership, we find that accrual quality is positively associated with IRS audit probability and that discretionary accruals (unsigned) are negatively associated with IRS audit probability. These results collectively suggest that an increase in IRS enforcement leads to an improvement in financial reporting quality. We also find that IRS enforcement generally has a more prominent effect on financial reporting quality when agency problems are more severe.

Our paper makes several contributions to the literatures in financial accounting, taxation, and governance. First, we add to the literature on the determinants of financial reporting quality and on how the relation between accounting standards and reporting outcomes depends on country level institutions (e.g., Leuz, Nanda, and Wysocki [2003]; Lang, Raedy, and Wilson [2006]; Skinner [2008]; and others). Our paper builds on this literature by showing that tax enforcement may play a role in determining financial reporting outcomes.

Our paper also contributes to the literature arguing that tax enforcement serves as a corporate governance mechanism. Federal government is de facto the largest minority shareholder in almost all profitable corporations, and thus, has an interest in ascertaining the value produced by the company and getting its share of profits. Further, in most large corporations there is a separation of ownership and control, which provides opportunities for managers to act in their self-interest, perhaps diverting resources for private benefit. If managers choose to divert resources or otherwise seek private gain, they must often conceal such actions from shareholders, including the tax authority. Desai, Dyck, and Zingales [2007] put forth a theory of the game between the state, insiders, and outside shareholders and argue that stricter tax enforcement makes it harder for insiders to extract private benefits, and hence, active monitoring by tax authorities has a spillover effect by protecting the interests of outside shareholders. However, empirical tests of this theory are scarce – Guedhami and Pittman [2008] and El Ghoul, Guedhami, and Pittman [2010] show that greater tax enforcement is associated with lower cost of capital. We build on this literature by showing that tax enforcement affects the quality of financial reporting, and thus, is potentially the mechanism by which stricter tax enforcement leads to a reduction in the cost of capital.

While the theory in Desai, Dyck, and Zingales [2007] is new and intriguing, testing the theory empirically is difficult because measures of tax authority enforcement are not easily obtained. We use the TRAC data to obtain measures of IRS enforcement in the U.S., however, a concern with using the TRAC data is that the measure of IRS enforcement that is available for the longest period of time is classified such that it varies only by firm size and time. While we have conducted a variety of alternative tests to mitigate this concern, to the extent that we cannot control for any underlying factors that drive both IRS audit probability measures and financial reporting quality our results will be affected. However, our results using the TRAC data are supported by the use of data from Russia around the tax enforcement crackdown executed by Vladimir Putin in the year 2000 and by aggregate U.S. tax enforcement data. We note that our study does not address the efficiency of tax authority monitoring relative to other institutions, such as the SEC, in monitoring or strengthening financial reporting quality. Thus, we offer no normative prescription on whether tax authority monitoring should be strengthened. Rather, our research supports the view that there is a positive externality to tax authority monitoring.

In sum, our results are consistent with the theory proposed by Desai, Dyck, and Zingales [2007] and suggest that indeed the IRS provides a monitoring mechanism of insiders and their reporting choices. As a result, the strength and enforcement actions of the tax authority constitute another institutional country-level feature that affects financial reporting behavior beyond the existing accounting standards.

The full paper is available for download here.

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