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

Abstract

This paper examines the relation between tax enforcement and financial reporting quality. The government, due to its tax claim on firm profits, is de facto the largest minority shareholder in almost all corporations. Therefore, the government, like other shareholders, has an interest in the accurate reporting of (taxable) income and preventing insiders from siphoning corporate funds to obtain private benefits. We hypothesize and find evidence that higher tax enforcement by the tax authority has a positive association with financial reporting quality. Further, we find that this association is generally stronger when other monitoring mechanisms are weaker. Our evidence is consistent with the predictions from the Desai, Dyck, and Zingales (2007) theory that the tax authority provides a monitoring mechanism of corporate insiders. Our paper also adds to the literature on the determinants of financial reporting quality and how the relation between accounting standards and reporting outcomes depends on country level institutions.

Are State Tax Amnesty Programs Associated with Financial Reporting Irregularities?

“…First, it contributes to a literature that examines the tax effects and patterns of tax amnesties (e.g., Alm, McKee, and Beck 1990;Christian, Gupta, and Young 2002;Luitel and Sobel 2007;Mikesell and Ross 2012) by examining the relation between tax amnesty programs and non-tax firm-level behavior (financial reporting irregularities). Second, it contributes to the emerging literature that considers the role tax authorities play in monitoring managerial behavior (e.g., Dyck and Zingales 2004;Desai, Dyck, and Zingales 2007;Hanlon, Hoopes, and Shroff 2012;Hoopes, Mescall, and Pittman 2012) and the relation between financial reporting quality and various tax-related activities (Frank, Lynch, and Rego 2009). Finally, the findings suggest that state tax authority enforcement efforts may have broader implications than previously anticipated, an insight that is particularly relevant given states' increased use of tax amnesties.…”

Is the risk of product market predation a cost of disclosure?

“…For example, there are virtually no outside sources of information that reveal a private firm's financing characteristics, which is information critical to evaluating a rival's financial constraint and, therefore, vulnerability to predation. Third, financial statement filings of German private firms are generally reliable, as these filings form the basis of tax returns in Germany, 4 so publicly disclosed financial statement information is effectively under the scrutiny of tax authorities (Hanlon et al, 2014). 5 I hypothesize that the probability of disclosure avoidance prior to the enforcement change is increasing in financial constraint at an increasing rate.…”

Is the Risk of Product Market Predation a Cost of Disclosure?

“…For example, there are virtually no outside sources of information that reveal a private firm's financing characteristics, which is information critical to evaluating a rival's financial constraint and, therefore, vulnerability to predation. Third, financial statement filings of German private firms are generally reliable, as these filings form the basis of tax returns in Germany, 4 so publicly disclosed financial statement information is effectively under the scrutiny of tax authorities (Hanlon et al, 2014).…”