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

By Michelle Hanlon, Jeffrey Hoopes, and Nemit Shroff @ HLS Forum.

Abstract: 

We examine the relation between tax enforcement and financial reporting quality. We proxy for financial reporting quality using the extent to which accruals map into cash flows and the magnitude of discretionary accruals. We measure tax authority monitoring in the U.S. using data on the probability of IRS audits. In addition, we use a regime shift in tax enforcement in Russia as an alternative test setting. The data provide evidence that higher tax enforcement is associated with higher financial reporting quality and that the relation is generally stronger when other monitoring mechanisms are weaker. Overall, we interpret our evidence as being 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.

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