Tax Avoidance and the Implications of Weak Internal Controls

Abstract

I examine whether corporate tax avoidance is associated with internal control weaknesses (ICWs) disclosed under the Sarbanes-Oxley Act (SOX). ICWs disclosed under SOX are frequently related to a firm's tax function. When pervasive ICWs exist, the likelihood increases that these frequent tax-related ICWs spill over from financial reporting issues to tax avoidance objectives. Thus, my research helps corporate stakeholders understand the implications of internal controls beyond simply financial reporting objectives. Results indicate that, on average, firms with a tax-related ICW have a 4 percent higher three-year cash effective tax rate relative to firms without any such weaknesses. Further estimates reveal that this negative relation stems from pervasive, company-level tax ICWs. Analysis of remediation suggests a causal link. I find that after remediating tax-related ICWs, firms report higher levels of tax avoidance in the future. Broadly, these findings support that internal control quality represents a proxy for internal governance, and thus the strength of alignment between managers and shareholders. Furthermore, tax-related internal controls represent an important underlying determinant of tax avoidance with significant cash flow effects, and implications beyond financial reporting. * Accepted by Lillan Mills. I am grateful for the helpful advice and suggestions of my dissertation committee: Jee-Hae Lim, Alan Macnaughton, Anindya Sen and especially my chair, Ken Klassen. I am also indebted to Tim Bauer, James Chyz, Cristi Gleason and Louise Hayes for their wonderful insight and assistance. This paper has also benefited greatly from the comments of Lillian Mills and two anonymous refereescause a effet. L'auteur constate qu'apr es avoir rem edi e aux DCI li ees a la fonction fiscale, les soci et es affichent ult erieurement des niveaux d'optimisation fiscale sup erieurs. De fac ßon g en erale, ces observations viennent etayer le fait que la qualit e du contrôle interne est une variable de substitution a la gouvernance interne et confirment donc l'ad equation des int erêts des gestionnaires et des actionnaires. Plus encore, les contrôles internes li es a la fonction fiscale sont un important d eterminant de l'optimisation fiscale qui a des r epercussions importantes sur les flux de tr esorerie et dont les cons equences d epassent l'information financi ere. 450 Contemporary Accounting Research CAR Vol. 33 No. 2 (Summer 2016)trols (COSO 2011)-and include weak risk management, lack of key personnel, inadequate communication, "tone at the top," etc. 3 While related to financial reporting of tax provisions, valuation allowances, and other reserves specifically, these ICWs could translate into missed tax-avoidance opportunities. Conversely, they could also reflect inaccurate evaluation of tax jurisdictions and other planning inputs yet to be discovered by tax authorities, or opportunities for management to extract rents. Consequently, I hypothesize that taxrelated ICWs reflect a lack of internal governance for the tax f...

Internal Control and Operational Efficiency

“…While prior studies have shown that effective internal control mitigates information risk, our study extends this line of research by documenting that effective internal control can further improve firm operational efficiency. Our study hence adds to the emerging literature that examines the implications of internal control beyond financial reporting quality (e.g., Cheng et al ; Feng et al ; Bauer ). The evidence in this article contributes to the ongoing debate on the costs and benefits of SOX 404 reporting.…”

“…Cheng et al () find that material weaknesses lead to lower investment efficiency. Bauer () finds that tax‐related material weaknesses are associated with higher effective tax rates, suggesting that these material weaknesses reduce the effectiveness of firms' tax planning. Feng et al () investigate whether ineffective internal control over inventory affects inventory management.…”

“…We want to have the reader recognize more vividly the relevance and the opportunities to adopt the framework as it relates to operations and compliance” (Landsittel, as quoted in Tysiac ). Furthermore, the Internal Control—Integrated Framework issued by the COSO of the Treadway Commission (COSO , 3) explicitly states that one of the objectives of internal control pertains to the “effectiveness and efficiency of the entity's operations, including operational and financial performance goals, and safeguarding assets against loss.” However, there is little empirical evidence on this issue, with the exception of a few studies on individual corporate decisions such as investments, tax planning, and inventory management (Cheng et al ; Feng et al ; Bauer ) . This study fills this void in the literature by examining the effect of ICFR on firms' overall operational efficiency and the conditions under which this effect is stronger; such evidence can further inform the ongoing debate over the costs and benefits of SOX 404.…”

Material Weaknesses in Tax-Related Internal Controls and Last Chance Earnings Management

“…Alternatively, firms with tax-related ICMWs may lack sufficient understanding and/or control over the tax function to manage earnings. Consistent with this alternative, Bauer (2016) finds that firms with tax-related ICMWs are not effective tax planners because ineffective internal controls over the tax function inhibit management's understanding of tax positions and tax planning opportunities. These firms improve their tax planning effectiveness once the tax-related ICMWs are remediated.…”

Agressividade Tributária: Um Survey da Literatura

“…Trabalhos mais recentes têm destacado a influência de algumas características da empresa no seu perfil agressividade fiscal, são elas: a qualidade do ambiente informacional da empresa (Gallemore & Labro, 2015); a demora na publicação das demonstrações (Rodrigues, 2017); a predisposição para refazimento de demonstrações financeiras (Ramos, 2017); a eficiência dos mecanismos de controle interno (Martinez, Ribeiro & Funchal, 2015;De Simone, Ege & Stomberg, 2015;Bauer, 2016), a eficiência empresarial na utilização dos recursos (Paste Junior, 2017); as estratégias de negócios e os ciclos de vida das empresas (Higgins, Omer & Phillips, 2015;Silva & Rezende, 2017); as restrições financeiras as quais as empresas estão submetidas (Law & Mills, 2015;Edwards, Schwab & Shevlin, 2016;Da Silva & Martinez, 2017;Richardson, Taylor & Lanis, 2015); as transações com partes relacionas no exterior ; e a utilização dos paraísos fiscais como mecanismo para redução da tributação explícita (Lee, 2017;Dyreng & Lindsey, 2009;Dyreng, Lindsey, Markle & Shackelford, 2015;Taylor & Richardson, 2012). Esses estudos buscam identificar características das firmas que conduzem uma maior ou menor agressividade tributária.…”