Sep 6, 2007 - of income tax reporting (Audit Analytics database; KPMG 2006, 23-24). Prior to SOX, corporate tax departments primarily focused on minimizing ...
Material Weaknesses in Tax-Related Internal Controls and Earnings Management
Cristi Gleason Tippie School of Business University of Iowa Morton Pincus Merage School of Business University of California, Irvine and Sonja Olhoft Rego Tippie School of Business University of Iowa
September 6, 2007
Preliminary and incomplete. Please do not quote without permission from authors.
Material Weaknesses in Tax-Related Internal Controls and Earnings Management I. Introduction As mandated by the Sarbanes-Oxley Act (SOX) of 2002, publicly traded companies must disclose material weaknesses in their internal controls for financial reporting. Initial disclosures indicate that one of the most common areas reflecting material internal control weaknesses is that of income tax reporting (Audit Analytics database; KPMG 2006, 23-24). Prior to SOX, corporate tax departments primarily focused on minimizing effective tax rates and tax liabilities, and companies often lacked meaningful internal controls over their tax function. This changed with the enactment of SOX. Firms have expanded the scope and documentation of their internal controls in the tax area (KPMG 2006, 15), and the presumption is that such actions will lead to more accurate and reliable financial reporting.1 In this study, we examine the impact of material weaknesses in tax-related internal controls on financial reporting. First, we investigate whether earnings management using the income tax accrual is more prevalent for firms reporting material tax-related internal control weaknesses relative to peer firms having no internal control deficiencies, and whether the extent of such earnings management decreases once the material weaknesses are disclosed. We employ the tax-accrual earnings management methodology introduced by Dhaliwal et al. (2004). Dhaliwal et al. argue, and provide support for the claim, that a firm’s “last chance” to manage reported earnings is through manipulation of the income tax expense accrual. We conjecture that the presence of material weaknesses in the system of internal controls over the tax function makes such last chance earnings management relatively easy to implement, and that the
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SOX seeks to improve the accuracy and reliability of financial reporting, and Li et al. (forthcoming) document that the rhetoric surrounding its passage suggests Congress and the Securities and Exchange Commission (S.E.C.) believed SOX would lead to higher quality earnings. Also see DeFond and Francis (2005).
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disclosure and remediation of tax-related material weaknesses has the effect of constraining earnings management using the income tax accrual. Second, we explore whether reported income tax expense is less useful in predicting future earnings for firms with material weaknesses in tax-related internal controls relative to tax expense reported by firms without internal controls deficiencies. Prior research documents an association between material internal control weaknesses and lower earnings persistence (Ashbaugh-Skaife et al. 2007; Doyle et al. 2007). Schmidt (2006) investigates whether the annual tax change component of earnings is useful in predicting future earnings, where the tax change component of earnings reflects the change in effective tax rates from one year to the next, and shows that the tax change component of earnings is highly persistent. Building on these findings, we test whether material tax-related internal control weaknesses impair the ability of the tax change component to predict future earnings. Our study provides evidence on whether material weaknesses in tax-related internal controls are associated with greater tax-accrual earnings management and with reduced usefulness of tax rate changes in predicting future earnings. Further, we investigate whether there are reductions in tax-accrual earnings management and improvements in the ability of tax rate changes in predicting future earnings when firms disclose material tax-related internal control weaknesses as a result of the SOX-mandated internal control reviews. Evidence of relatively more earnings management associated with material weaknesses in tax-related internal controls would help to explain how last chance earnings management occurs. More importantly, evidence of a reduction of tax-accrual earnings management for firms disclosing tax-related material weaknesses would be consistent with the effectiveness of SOX-mandated internal control reviews, as would an improvement in the predictability of earnings based on effective tax
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rate changes. In contrast, evidence to the contrary would call into question the utility of the SOX-imposed internal control reviews. It can be argued that the degree of information asymmetry between management and financial statement users with respect to income taxes makes tax-related earnings management more likely, even when internal controls over the tax function are deemed sufficient. However, the relative lack of internal controls in the tax area in the pre-SOX era, combined with the high frequency of subsequently disclosed material tax-related internal control weaknesses and their remediation suggest that, compared to other areas of accounting controls, the tax function is likely to have experienced a significant shift in reporting practices for a relatively large number of firms in the post-SOX period. Hence, the tax function is a powerful setting to investigate whether disclosures of material internal control weaknesses reduce the prevalence of earnings management and increase the usefulness of current earnings in predicting future earnings. We find evidence that firms with material tax-related internal control weaknesses engaged in tax-accrual earnings management to meet or beat earnings targets (i.e., avoiding reporting a loss in the full sample, and meeting or beating analyst forecasts in the subsample having analyst data) in the year prior to the firms disclosing their material weaknesses, relative to firms without internal control deficiencies. In contrast, the results indicate that such firms reduced their tax-accrual earnings management in the year of and in the year after disclosing their tax-related internal control weaknesses. These results suggest that SOX-mandated internal control reforms successfully reduced tax-accrual earnings management. We also find that firms with material tax-related internal control weaknesses have less persistent earnings for all three years of our investigation, but that the tax change component of earnings is less persistent for these firms only in the year before they disclosed their tax-related
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material internal control weaknesses. These results suggest that disclosures of material taxrelated internal control weaknesses prompt firms to improve their internal controls over the tax function, which in turn improves the usefulness of tax rate changes in predicting future earnings. We organize the remainder of the paper as follows. In section II we provide background and develop our research hypotheses. Section III discusses the empirical methods we use to test the hypotheses, section IV describes sample selection and the resulting samples, section V reports the results, and section VI concludes.
II. Background and Prior Research Background Together, Sections 302 and 404 of SOX require management to establish and maintain effective internal controls over financial reporting (ICFR), regularly evaluate the effectiveness of the firm’s ICFR, and report information about ICFR in the firm’s Form 10-K filings. In addition, Section 404 mandates that auditors attest to the adequacy of a company’s internal controls. These provisions of SOX reflect the concern that material weaknesses in internal controls increase the likelihood of material misstatements in firms’ financial statements. Consistent with weak internal controls resulting in an increase in material misstatements in financial reports, Ashbaugh-Skaife et al. (2007) and Doyle et al. (2007) find that material control weaknesses reported under SOX Sections 302 and 404 are associated with lower accruals quality, decreased earnings persistence, and restatements. There is evidence, however, that credit rating agencies do not expect that all internal control weaknesses will increase the likelihood of material financial statement misstatements.
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Moody’s Investment Services categorizes material internal control weaknesses into more severe and less severe categories. Moody’s describes the more severe internal control weaknesses as weaknesses in “company-level controls such as the control environment or the financial reporting process” that are brought to the attention of its ratings committee and “call into question not only management’s ability to prepare accurate financial reports but also its ability to control the business” (Dos and Jonas 2004, 1). On the other hand, less severe weaknesses generally involve account-specific or transaction-level internal controls. Moody’s does not expect these weaknesses to result in any ratings-related action, under the assumption that management will take corrective action on a timely basis to address such weaknesses. Moody’s asserts “that the auditor can effectively ‘audit around’ these material weaknesses by performing additional substantive procedures in the area where the material weakness exists” (Dos and Jonas 2004, 1). Doyle et al. (2007) follow Moody’s classification scheme and partition their sample of material internal control weaknesses into account-specific and company-level groups. They find no significant association between account-specific internal control deficiencies and accruals quality and conclude that their overall finding of a relation between material control weaknesses and accounting quality is driven by company-level internal control weaknesses. While finding no relation between account-specific control weaknesses and accounting quality may be due to auditors’ ability to ‘audit around’ any account-specific weaknesses, an alternative explanation is that the broad measures of accruals that Doyle et al. use lack the power to detect fine degrees of earnings management that are concentrated in a specific account. A significant fraction of material internal control weaknesses disclosed between 2004 and 2006 have involved the income tax area, and these are included in Moody’s less severe, account-
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specific internal control weakness category (Dos and Jonas 2004; Doyle et al 2007). Of the nearly 1,000 company-year reports indicating material weaknesses in internal controls (both account-specific and company-level) in SEC filings included in the Audit Analytics database as of June 2007, more than one-third reflect income tax-related weaknesses. The prevalence of weak internal controls in the income tax area likely reflects the high degree of complexity and judgment required in income tax reporting coupled with a lack of adequate documentation of the tax reporting function. Moreover, the same characteristics that contribute to weak internal controls in the tax area also make income tax reporting a likely area for earnings management, and prior research points to several ways in which tax expense may be used to manage earnings. Complexity of tax law is one factor that would seem to make the financial reporting of income tax expense an area ripe for earnings management. For example, foreign operations significantly increase the complexity of estimating income taxes for financial reporting purposes. APB Opinion No. 23 permits managers to avoid recording deferred tax expense on (low-tax) foreign earnings if they designate those earnings as permanently reinvested. Krull (2004) examines firms’ decisions to repatriate foreign earnings to the United States, and finds evidence that changes in the amount of permanently reinvested earnings are related to incentives to meet analysts’ forecasts of earnings. Estimating an income tax reserve (a.k.a. a “tax cushion”) for uncertain tax positions also requires substantial judgment. Hence, this may represent another opportunity to manage earnings, and Blouin and Tuna (2007) provide evidence that companies use tax reserves to smooth earnings. During our sample period, SFAS No. 5 was the standard governing the amount of contingent liability that companies record for ongoing or expected audits by tax authorities of tax positions reflecting permanent tax rate effects. Under SFAS No. 5, corporations record
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probable and estimable liabilities for additional taxes the firm expects to owe after the tax audit and any appeals are completed.2 Firms make estimates of the probability of audit and detection as well as the likelihood of prevailing against the IRS on challenged positions (see Gleason and Mills 2002). Because audit outcome probabilities are difficult to gauge and the resolution of disputes may stretch over a decade or more, estimating tax reserves involves substantial discretion. Until recently, disclosures about tax reserves were limited (Gleason and Mills 2002; Blouin and Tuna 2007), and this lack of transparency may increase the likelihood of earnings management using tax reserves. Another example of the discretion available in the accrual of tax expense is the considerable judgment inherent in recording deferred tax asset valuation allowances. Each reporting period, companies estimate whether they are “more likely than not” to realize the book value of deferred tax assets. Frank and Rego (2006) present evidence that firms use the discretion permitted in estimating the valuation allowance to smooth earnings toward analysts’ consensus forecasts (also see Schrand and Wong 2003). However, they find little evidence that managers use the valuation allowance to manage earnings to achieve other earnings incentives, including reporting positive earnings or positive earnings changes, or avoiding debt covenant violations. Dhaliwal et al. (2004) present evidence that income tax expense is managed to meet analysts’ annual earnings forecasts. They focus on changes in total tax expense from the third to the fourth fiscal quarter and argue that because the tax accrual is typically determined just prior to the announcement of annual earnings but after most other accounts are closed, tax expense
In July, 2006, the FASB announced Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48), which governs accounting for uncertain tax benefits. FIN 48 uses a “more likely than not” threshold to determine when benefits should be recognized in earnings. As FIN 48 was not in effect until January 2007, it does not affect our analysis. 2
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presents a last chance for firms to manage earnings. Their results suggest that firms that would not meet analysts’ earnings forecasts using reported third quarter effective tax rates reduce income tax expense in the fourth quarter to meet or beat the forecast. They estimate that tax expense-related earnings management enables firms to increase earnings by an average of 1.6 cents per share. Hypotheses In summary, prior research finds that firms manage income tax expense in a variety of ways to achieve financial reporting objectives. The inherent complexity and judgment associated with income tax reporting and the relatively limited disclosure about income taxes in shareholder financial reports have been identified as factors that make earnings management of the income tax expense accrual likely. We add to this set of factors the generally limited scope of internal controls surrounding the income tax function that existed in the pre-SOX era. We conjecture that earnings management in the tax area is related to the occurrence of material weaknesses in internal controls over income tax reporting. Accordingly, we hypothesize the following: H1: Among firms achieving earnings benchmarks, the proportion of firms reporting lower effective tax rates in the fourth fiscal quarter relative to the third quarter is higher for firms that disclose material tax-related internal control weaknesses in the following year than it is for firms without internal control deficiencies. There is also evidence in the literature that suggests detection and remediation of internal control weaknesses lead to an improvement in accruals quality (Ashbaugh-Skaife et al. 2007; Altamuro and Beatty 2007; Bedard 2007). Accordingly, our second hypothesis is:
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H2: Among firms achieving earnings benchmarks, the proportion of firms reporting lower effective tax rates in the fourth fiscal quarter relative to the third quarter is not different for firms that disclose material tax-related internal control weaknesses in the current year or in the previous year than it is for firms without internal control deficiencies. H2 assumes that firms substantially correct material weaknesses in tax-related internal controls in the year they disclose such weaknesses. As noted above, prior research also documents an association between material weaknesses in internal controls and lower earnings persistence (Ashbaugh-Skaife et al. 2007; Doyle et al. 2007). Following Schmidt (2006), we explore whether material tax-related internal control weaknesses are associated with lower persistence of the tax change component of earnings, which is based on the change in effective tax rates from one year to the next. If the existence of material internal control weaknesses makes it easier for firms to manipulate reported earnings, then for firms with tax-related material internal control weaknesses the tax change component of earnings should be less useful in predicting future earnings as compared to firms without such weaknesses. We formulate two hypotheses: H3: In the year prior to disclosing material tax-related internal control weaknesses, firms report changes in annual effective tax rates that are less useful in predicting future earnings than firms with no internal control deficiencies. H4: In the year firms disclose material tax-related internal controls weaknesses, and in the following year, such firms report changes in annual effective tax rates that are as useful in predicting future earnings as those reported by firms with no internal control deficiencies.
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III. Empirical Design Methods Used to Test H1 and H2 Following Dhaliwal et al. (2004), we use the change in the effective tax rate (ETR) from the third to the fourth fiscal quarter as our proxy for earnings management of reported income tax expense. The intuition for this measure stems from the requirement in APB Opinion No. 28 that firms apply their “best estimate of the effective tax rate expected to be applicable for the full fiscal year” in determining income taxes for interim quarters (APB Opinion No. 28, ¶ 19). Hence, third quarter ETR represents management’s best public estimate, as of the third quarter report date, of the ETR that will be reported for the entire fiscal year, and it is our proxy for the ‘unmanaged’ annual ETR. Prior literature identifies incentives for earnings management. One incentive is to meet or beat earnings benchmarks, and we consider three earnings benchmarks: zero earnings, the prior year’s earnings, and sell-side analysts’ consensus earnings forecasts (e.g., Degeorge et al. 1999; Brown 2001; Brown and Caylor 2005; Matsumoto 2002). Brown and Caylor (2003) provide evidence that analysts’ forecasts increasingly became a more important benchmark for firms to meet, and recent survey evidence (Graham et al. 2005) suggests that managers view avoiding reporting an earnings decline as important. In our sample, 47% of firms with material tax-related internal control weaknesses do not have analyst forecasts in the I/B/E/S database. It thus appears that material internal control deficiencies are somewhat more prevalent among smaller firms, for which there is frequently no analyst coverage. To retain smaller firms in our
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sample and thus increase the generalizability of our results, we consider all three earnings benchmarks in our analysis.3 H1 predicts that among firms that achieve a given earnings target (e.g., meeting or beating analyst forecasts), a higher proportion of firms that disclose material tax-related internal control weaknesses (hereinafter, tax ICW firms) report lower fourth quarter ETRs relative to third quarter ETRs in the year before they disclose their internal control weaknesses, compared to firms without internal control deficiencies. In contrast, H2 predicts no significant differences in third-to-fourth quarter ETR changes between tax ICW firms and firms without internal control deficiencies in the year of and the year after firms disclose their internal control weaknesses. We test H1 and H2 using both univariate and multivariate analyses. The univariate analyses focus on differences between the proportions of firms that have lower fourth quarter ETRs relative to the third quarter ETRs for two groups of firms – tax ICW firms and firms without internal control deficiencies. We include three different earnings targets in the analysis: avoiding negative earnings, avoiding a decline in earnings, and meeting or beating analysts’ forecasts. For the multivariate analysis, we estimate equation (1), a logistic regression, using all sample firms having positive pretax income and the Compustat data necessary to compute test and control variables (see below).4 We estimate equation (1) separately for the year prior to (t1), the year of (t), and the year following (t+1) the disclosure of a material weakness in taxrelated internal controls (firm-specific and time subscripts are suppressed):
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In untabulated analyses, we also consider incentives to manage earnings in connection with issuing securities (e.g., Teoh, Welch, and Wong 1998) and debt covenants (e.g., DeAngelo et al. 1994). We discuss our findings for these earnings management incentives later in the paper. 4 Consistent with Dhaliwal et al. (2004), we require that all sample firm-years have positive pretax income. Loss firms’ effective tax rates contain substantial measurement error because current tax expense does not accurately reflect current net operating losses. We include loss firms in our univariate analysis as a point of comparison.
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ETR_DOWN = β0 + β1TAX + β2POS_EPS + β3POS_EPS×TAX + β4POS_ΔEPS + β5POS_ΔEPS×TAX + β10Q3_ETR + β11FOR_DUM,
(1)
and we estimate equation (2) using the subset of firms for which we have analyst forecast data: ETR_DOWN = β0 + β1TAX + β2POS_EPS + β3POS_EPS×TAX + β4POS_ΔEPS + β5POS_ΔEPS×TAX + β12POS_AFE + β13POS_AFE×TAX + β10Q3_ETR + β11FOR_DUM + β14 I_CH_ETR,
(2)
where: ETR_DOWN = An indicator variable equal to 1 if the firm decreased its ETR from the third to the fourth quarter, and 0 otherwise; TAX =
An indicator variable equal to 1 if the firm had a material tax-related internal control weakness, and 0 otherwise;
POS_EPS =
An indicator variable equal to 1 if earnings per share at time t are greater than or equal to zero, and 0 otherwise;
POS_ΔEPS = An indicator variable equal to 1 if earnings per share at time t less earnings per share at time t-1 is greater than or equal to zero , and 0 otherwise; Q3_ETR =
Cumulative income tax expense for the first three quarters of the year divided by cumulative pretax income for the same period;
FOR_DUM = An indicator variable equal to 1 if the firm had foreign income, and 0 otherwise; POS_AFE =
An indicator variable equal to 1 if actual earnings per share (as reported on I/B/E/S) is greater than or equal to the median analyst forecast (as reported on I/B/E/S), and 0 otherwise;
I_CH_ETR = The induced change in the effective tax rate as computed in Dhaliwal, Gleason and Mills (2004).
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Our primary focus is on the interaction between incentives to manage earnings using the tax accrual and the occurrence of material tax-related internal control weaknesses. We expect a positive coefficient on the interactions between TAX and our incentive variables (POS_EPS, POS_ΔEPS, and POS_AFE). Following Dhaliwal et al. (2004), we include Q3_ETR and
FOR_DUM as controls for a firm’s opportunities to decrease the ETR during the fourth quarter. The higher (lower) a firm’s ETR through the first three quarters, the more (less) likely the firm is able to further decrease its ETR during the fourth quarter. In addition, firms with foreign operations and income generally face more uncertainty about final tax amounts during the year and also have more estimates involving judgment, which may increase the opportunities for earnings management. We expect a positive relation between ETR_DOWN and both Q3_ETR and FOR_DUM. When we estimate equation (2), which includes POS_AFE, we also include a measure of the induced change in ETR related to changes in income, I_CHG_ETR, as discussed in Dhaliwal et al. (2004). Method Used to Test H3 and H4 H3 predicts that changes in annual ETRs are less useful in predicting future earnings in the year before firms disclose material tax-related internal control weaknesses, relative to firms without internal control deficiencies. In contrast, H4 predicts no difference in usefulness in the year firms report material tax-related internal controls weaknesses and in the year following such disclosures. We adopt the research design in Schmidt (2006) to test the usefulness of the tax change component of earnings in predicting future earnings. His design is based on the notion that the total change in annual earnings can be decomposed into two components: the tax change component of earnings (TCC), and the after-tax change in earnings (ATE). ATE applies (one
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minus) last year’s ETR to the current year’s change in pretax earnings, and TCC captures the earnings generated by the change in annual ETRs. Equation (3) depicts our regression of future earnings on the ATE and TCC earnings components and the interactions of our TAX indicator variable with those components (firm-specific and time subscripts are suppressed): E = γ0 + γ1ATE + γ2TCC + γ3TAX + γ4ATE×TAX + γ5TCC×TAX + ν (3) where: E=
Next year’s earnings before extraordinary items;
ATE = Current year’s after-tax earnings = Pretax income × (1 – last year’s ETR); ETR = Current year’s effective tax rate = Current year’s total tax expense / Current year’s pretax income; TCC = Current year’s tax change component of earnings = Pretax income × (Last year’s ETR – Current year’s ETR). Schmidt (2006) finds that both after-tax earnings and the tax change component of earnings are highly persistent, with coefficients of 0.8106 and 0.7121, respectively (Schmidt 2006, Table 3). We extend his findings by investigating the persistence of TCC for firms that disclose material tax-related internal control weaknesses. In particular, we predict a negative coefficient (γ5) on TCC×TAX for the year prior to the material weakness disclosure. In contrast, we expect our sample of material weakness firms to improve their tax-related internal controls after their internal control weaknesses are disclosed such that the persistence of their tax change component does not differ from a control sample in the year of and the year after the material weakness disclosure (i.e., we predict that γ5 is insignificant in those years).
IV. Sample and Descriptive Statistics
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Using Audit Analytics, we identify 349 firms that disclose a tax-related material internal control weakness for the first time in fiscal 2004, 2005, or 2006. We require annual and quarterly Compustat data to compute the variables we use in our analysis, and this reduces the sample to 315 material tax-related internal control weakness firms. Our tests examine the fiscal year that precedes the year (i.e., year t-1) firms first disclose their tax-related material internal control weaknesses, and also the fiscal year of the disclosure (year t) and the following year (year t+1). To reduce survivorship bias, we do not require firms to have data available in all three years. As shown in Table 1, the resulting sample is 827 observations with material taxrelated internal control weaknesses (denoted TAX = 1), comprised of 309 firms with data for year t-1, 302 firms with data for year t, and 216 firms with data for year t+1.5 In untabulated robustness tests, we limit the sample to firms that have data for all three years. INSERT TABLE 1 HERE We identify a sample of matched control firms (denoted TAX = 0) from the Compustat population. Control firm-years must be in the same three-digit NAICS industry and size quintile as the corresponding firm-year in the TAX = 1 sample. Importantly, control firms must not have reported any internal control deficiencies (under SOX Section 404) or ineffective disclosure controls (under SOX Section 302) during the 2003-2006 period per Audit Analytics. Our control sample includes 15,944 observations over the three years, t-1 to t+1. We compute all variables as defined in the note to Table 2. For our tests of H1 and H2, we constrain third and fourth quarter effective tax rates (Q3_ETR and Q4_ETR) to be between -1 and +1. We winsorize all continuous variables, except for ETR_DIFF, at the 1st and 99th percentiles to reduce the effect of extreme values. ETR_DIFF is the difference between
5
Data are available only through fiscal 2006.
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constrained values of Q3_ETR and Q4_ETR, and ETR_DOWN equals 1, if ETR_DIFF is positive (i.e., if third quarter ETR exceeds fourth quarter ETR), and 0 otherwise. Table 2 reports univariate statistics for the material weakness and control samples. For both samples of pooled observations, approximately one-half of the time firms decrease their ETR from the third to the fourth fiscal quarter, but the proportion of firms decreasing their fourth quarter ETRs is significantly higher for the material tax-related internal control weakness firms than for the control sample (0.536 vs. 0.502). Moreover, in untabulated results, the mean rate of ETR_DOWN in year t-1 is 0.595 for the TAX = 1 sample, which is statistically and economically larger than the ETR_DOWN mean rate of 0.491 for the TAX = 0 sample. In year t, mean ETR_DOWN is 0.483 for TAX = 1 firms and 0.508 for TAX = 0 firms, and in year t+1 the means are, respectively, 0.523 and 0.512; for both years t and t+1, the mean ETR_DOWN rates do not statistically differ. INSERT TABLE 2 HERE With regard to the magnitude of the decreases in ETRs, the decline in mean ETR (i.e., ETR_DIFF) is 5.8% for the TAX = 1 sample (pooled across three years) and 1.3% for the TAX = 0 sample (pooled across three years). The difference is significant. Untabulated results indicate a mean decline in ETR in year t-1 of 6.1% for the TAX = 1 sample versus a mean decline of 1.1% for the TAX = 0 sample, and the difference in mean and median ETR declines is significant. For year t, the respective mean declines in ETRs are 7.0% and 1.3%, which also reflects a significant difference, although the median declines are not significantly different. Lastly, for year t+1, neither the mean nor median ETR declines differ statistically. While descriptive, these results suggest the following: (1) In the year before the disclosure of material tax-related internal control weaknesses, tax ICW firms exploit those
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weaknesses to manage their income tax accrual down and thus manage reported earning up, relative to firms not reporting internal control deficiencies. (2) In the year following the disclosure of material tax-related internal control weaknesses, tax ICW firms are no different than firms without internal control deficiencies with regard to managing the income tax accrual. (3) In the year in which firms report a material tax-related internal control weakness, there is mixed evidence as to the frequency and extent to which tax ICW firms manage the income tax accrual relative to firms not reporting internal control deficiencies. This can also be seen in the ETRs shown in Table 2. Third quarter ETRs for the two samples are not significantly different in the sample pooled across the three years or for each of the three years (untabulated). On the other hand, the fourth-quarter mean ETR for tax ICW firms is significantly lower than that for firms without control deficiencies in the pooled samples, and this is also is the case for years t-1and t, but not for year t+1 (not shown). Further, overall and for each of the three years, tax ICW firms are, on average, smaller, are followed by fewer analysts, have lower EPS and less positive changes in EPS, are less likely to have had a string of non-decreasing EPS over the previous five years, and have significantly higher leverage and lower market-to-book ratios, except for year t-1. These firms are also significantly more likely to be audited by a Big 4 firm than are firms without internal control deficiencies in years t-1 and t, but that changes in year t+1 when there is no difference between the two samples in the proportion of firms having a Big 4 auditor. Table 3 presents correlations for the TAX = 1 and TAX = 0 samples between ETR_DOWN and each of the indicator variables reflecting earnings management incentives. ETR_DOWN is positive and significantly related to POS_EPS, POS_∆EPS, and POS_AFE in both samples, but more so with POS_∆EPS and POS_AFE for the TAX = 1 firms than the TAX = 0 firms.
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INSERT TABLE 3 HERE
V. Results Univariate Analysis of H1 and H2 We initially test hypotheses H1 and H2 using non-parametric comparisons of the proportions of TAX = 1 and TAX = 0 firms that report lower tax expense in the fourth fiscal quarter relative to the third quarter. Table 4 shows the results when we partition firms based on whether they report positive earnings for the given year and whether they have a tax-related material internal control weakness. Each cell shows the mean ETR_DOWN for a subset of firms. For example, in the TAX = 1 and POS_EPS = 1 cell in Panel A (i.e., the set of firms that report positive earnings in year t-1 and disclose material tax-related internal control weaknesses in year t), the proportion of firms that reduce their fourth quarter ETRs relative to their third quarter ETRs is 0.651 (or 65.1%). INSERT TABLE 4 HERE The results in Panel A indicate the following: First, irrespective of whether a firm is in the TAX = 1 or TAX = 0 sample, firms that report positive earnings (POS_EPS =1) are more likely to report an ETR in the fourth quarter that is lower than their third quarter ETR, relative to firms that fail to report positive earnings (i.e., POS_EPS = 0): 0.651 versus 0.468 in the TAX = 1 sample (p-value = 0.003), and 0.562 versus 0.310 in the TAX = 0 sample (p-value < 0.001). This result is consistent with Dhaliwal et al. (2004). Second, H1 predicts that among firms that achieve earnings benchmarks (in this case, among firms that report positive earnings), firms with material tax-related internal control weaknesses are more likely to decrease their ETR in the fourth quarter than firms without material control deficiencies. The results in the first row of
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Panel A support this prediction with a mean ETR_DOWN of 0.651 for TAX = 1 sample versus 0.562 for the TAX = 0 sample (p-value = 0.007). Panel B of Table 4 reports a similar analysis for year t, the year firms disclose their material tax-related internal control weaknesses. Among firms that report positive earnings, Panel B shows that TAX = 1 firms are not more likely to reduce their fourth quarter ETRs compared to TAX = 0 firms (0.492 versus 0.560). Panel C displays results for year t+1, the year after the material weaknesses are disclosed. Among firms that report positive earnings, tax ICW firms exhibit no significant difference in third-to-fourth quarter ETR changes compared to firms without internal control deficiencies. Table 5 reports a similar analysis where the benchmark is positive earnings growth. Among firms that report positive earnings growth in year t-1, we observe a higher proportion of fourth-quarter ETR decreases among TAX = 1 firms compared to TAX = 0 firms. However, in years t and t+1 the differences in fourth-quarter ETR changes between TAX = 1 and TAX = 0 firms is no longer evident. These results are consistent with the results in Table 4 and with H2, which predicts that the disclosure of material tax-related internal control weaknesses reduces opportunities for earnings management using income tax accounts.6 INSERT TABLE 5 HERE Our final benchmark is sell-side analysts’ consensus earnings forecasts. We limit our analysis to the TAX = 1 firms with I/B/E/S data and present the results in Table 6. Consistent with results for the positive earnings and earnings growth benchmarks, Panel A shows that for
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We also consider whether firms with material tax-related internal control weaknesses exhibit similar patterns of fourth quarter ETR decreases around two other incentives to manage earnings: securities issuances and debt covenants. In untabulated tests, we find a pattern similar to the results described above: in year t-1, TAX = 1 firms that issue securities or have higher leverage are more likely to decrease their fourth quarter ETR relative to TAX = 0 firms, but the significantly higher year ETR_DOWN disappears in years t and t+1.
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year t-1, TAX = 1 firms are more likely to report decreases in fourth quarter ETRs than TAX = 0 firms. This higher proportion disappears in year t and is at best only weakly present in year t+1. In sum, we find consistent evidence in univariate analyses that TAX = 1 firms exploited internal control weaknesses to manage earnings up via the income tax accrual in the year prior to disclosure of internal control weaknesses. However, the disclosure and remediation of the material tax-related internal control weakness appear to have limited the amount of tax accrual earnings management in subsequent years. We now turn our attention to results for multivariate regressions. INSERT TABLE 6 HERE Multivariate Analysis of H1 and H2 In Table 7, we report the results of estimating logit regression (1) in which we regress the 0/1 indicator variable ETR_DOWN on TAX, the earnings management incentive variables (i.e., POS_EPS and POS_ΔEPS), interactions of TAX with each earnings management incentive variable, and control variables using the full sample of TAX = 1 and matched control firms.7 Our focus is on the coefficients for the interactive variables, and we predict positive coefficients in year t-1 and insignificant coefficients in years t and t+1. For year t-1, there is a significantly positive coefficient on POS_EPS×TAX (p-value = 0.023), suggesting that after controlling for the incentive to avoid reporting an earnings decline and other factors, TAX = 1 firms are more likely to exploit the material weakness in tax-related internal controls to manage income tax expense down and thus manage earnings up to report positive earnings. In years t and t+1, the coefficients on the interactive variables are not significant.8
7
We follow the research methodology in Dhaliwal et al. (2004) and delete firm-years with negative pretax income. In untabulated results that also include interactions of TAX with, respectively, 0/1 indicator variables for issuance of new securities and high leverage (i.e., NEW_SECS×TAX and HI_LEV×TAX), the year t+1 coefficients are significant at slightly better than the 0.10 level but are not significant in years t or t-1.
8
20
INSERT TABLE 7 HERE Table 8 displays the results from estimating logit regression (2), which is based on the reduced sample of firms having analyst forecast data. In year t-1, we simultaneously consider the three earnings targets and find that only the coefficient on POS_AFE×TAX is positive and significant (p-value = 0.082). The results suggest that firms with material tax-related internal control weaknesses manage the income tax accrual to meet or beat analyst earnings forecasts. In years t and t+1, none of the interactive variables is significant, consistent with the disclosure of material tax-related internal control weaknesses reducing the tendency of TAX = 1 firms to manage earnings via the tax accrual in a manner that differs from TAX = 0 firms. INSERT TABLE 8 HERE In untabulated robustness tests, we limit the tax ICW sample to firms with material weaknesses having data for all three years (i.e., t-1, t, and t+1), which restricts the sample to firms that disclosed their material internal control weaknesses in 2004 or 2005.9 For this restricted sample, we find that firms with material tax-related internal control weaknesses are more likely to beat earnings targets than firms without control deficiencies in year t-1, consistent with results reported in Tables 4-6. When we consider just the positive earnings (POS_EPS) and positive earnings growth (POS_ΔEPS) incentives to manage earnings, we also find results consistent with those reported in Table 7. However, the results for the analyst forecast analyses (POS_AFE), which correspond to Table 8, suggest a weak tendency for tax ICW firms to continue to reduce fourth-quarter ETRs to beat analysts’ consensus forecasts. In particular, the coefficient on POS_AFE×TAX is significant and positive in years t-1 and t, and marginally
9
We do not impose this restriction on firms in the control sample.
21
significant and positive in year t+1, when we constrain our sample to tax ICW firms with data available for three consecutive years. Analysis of H3 and H4 We test H3 and H4 by estimating equation (3). Our results, reported in Table 9, show that both the after-tax earnings component (ATE) and the tax-change component of earnings (TCC) are highly persistent in all three years, similar to Schmidt (2006). Consistent with H3, for firms with material tax-related internal control weaknesses, the tax change component of earnings is significantly less persistent for year t-1 in both the full sample and the I/B/E/S sample. However, once the material weaknesses are disclosed, the persistence of the tax-change component of earnings does not differ between firms with and without internal control deficiencies, which supports H4. We also observe that the after-tax component of earnings for tax ICW firms is significantly less persistent in all three years, relative to firms without internal control deficiencies (i.e., the coefficient on ATE×TAX is significantly negative and large in magnitude). We interpret this (unexpected) result as indicating that tax ICW firms generally have less persistent after-tax earnings. INSERT TABLE 9 HERE
VI. Conclusion We investigate whether firms with material tax-related internal control weaknesses (TAX = 1 firms) are more likely to manage earnings than peer firms with no internal control deficiencies. Our analysis has two main thrusts. First, we assess whether earnings management using the income tax accrual is more prevalent for TAX = 1 firms relative to peer firms, and whether the extent of such earnings management decreases once the material weaknesses are
22
disclosed. We conjecture that the presence of material weaknesses in internal controls over the tax function makes last chance earnings management (Dhaliwal et al. 2004) easier to implement, and that the disclosure and remediation of such material weaknesses has the effect of constraining earnings management using the income tax accrual. Our results support these conjectures. Second, we explore whether there is a link between the presence of material weaknesses in tax-related internal controls and changes in effective tax rates that are less useful in predicting future earnings relative to tax rate changes reported by firms without internal control deficiencies. Consistent with Schmidt (2006), we find that the tax change component of annual earnings is useful in predicting future earnings. We extend his result to document that TAX = 1 firms generally have less persistent after-tax earnings, while the tax change component of earnings is less persistent only in the year prior to disclosure of material weaknesses in taxrelated internal controls. These results suggest that disclosures of material tax-related internal control weaknesses prompt firms to improve their internal controls over income tax reporting. This has the effect of reducing earning management using the income tax accrual to meet earnings targets and improves the usefulness of tax rate changes in predicting future earnings. While our analysis does not consider the costs associated with the SOX-mandated internal control reviews and remediation, our results are consistent with the SOX-mandated internal control reviews being effective in constraining earnings management.
23
REFERENCES Altamuro and Beatty. 2007. “Do Internal Control Reforms Improve Earnings Quality? Working Paper. Ashbaugh-Skaife, Collins, Kinney. 2007. “The Discovery and Reporting of Internal Control Deficiencies Prior to SOX-Mandated Audits” Journal of Accounting and Economics. Ashbaugh-Skaife, Collins, Kinney LaFond. 2006. “The Effect of Internal Control Deficiencies on Firm Risk and Cost of Equity Capital” Working paper. Ashbaugh-Skaife, Collins, Kinney LaFond. 2006. “The Effect of Internal Control Deficiencies and Their Remediation on Accrual Quality” Working paper. Bedard, J. 2007. “Sarbanes Oxley Internal Control Requirements and Earnings Quality” University of Laval Working paper. Blouin, J. and I. Tuna. 2007. Tax Contingencies: Cushioning the Blow to Earnings? Working paper. Brown, L. 2001. A Temporal Analysis of Earnings Surprises: Profits Versus Losses. Journal of Accounting Research 39 (2): 221-241. Brown, L. and M. Caylor. 2005. A Temporal Analysis of Quarterly Earnings Thresholds: Propensities and Valuation Consequences. The Accounting Review 80 (2): 423-442. DeAngelo, H., L. DeAngelo, and D. Skinner. 1994. “Accounting Choice in Troubled Companies” Journal of Accounting and Economics 17 (January): 113-143. DeFond, M. and J. Francis. 2005. “Auditing Research after Sarbanes-Oxley” Auditing: J. of Practice and Theory. Degeorge, F., J. Patel, and R. Zeckhauser. 1999. Earnings Management to Exceed Thresholds. Journal of Business 72 (1): 1-33. Dhaliwal, Gleason and Mills. 2004. “Using Income Tax Expense to Achieve Analysts’ Targets” Contemporary Accounting Research. Dos and Jonas. 2004. Doyle, Ge and McVay. 2007. “Accruals Quality and Internal Control over Financial Reporting” The Accounting Review. Doyle, Ge and McVay. 2007. “Determinants of Weaknesses in Internal Control Over Financial Reporting” Journal of Accounting and Economics.
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Frank and Rego. 2006. “Do Managers Use the Valuation Allowance Account to Manage Earnings Around Certain Earnings Targets?” Journal of the American Taxation Association. Gleason, C. and L. Mills. 2002. Materiality and Contingent Tax Liability Reporting. The Accounting Review 77 (2): 317-42. Graham, J., c. Harvey, and S. Rajgopal. 2005. The Economic Implications of Corporate Financial Reporting. Journal of Accounting and Economics 40 (1-3): 3-73. KPMG LLP. 2006. “Assessing Internal Controls for the Tax Department,” presented at the American Tax Association mid-year meetings in San Diego. Krull, L. 2004. “Taxes and the Reinvestment of Foreign Subsidiary Earnings” The Accounting Review. Li, H., M. Pincus, and S. Rego. Forthcoming 2008. “Market Reaction to Events Surrounding the Sarbanes-Oxley Act of 2002 and Earnings Management” Journal of Law and Economics. Schmidt, A. 2006. The Persistence, Forecasting, and Valuation Implications of the Tax Change Component of Earnings. The Accounting Review 81 (3): 589-616. Schrand and Wong. 2003. “Earnings Management Using the Valuation Allowance for Deferred Tax Assets under SFAS 109” Contemporary Accounting Research. Teoh, Welch, and Wong. 1998. “Earnings Management and the Underperformance of Seasoned Equity Offerings” Journal of Financial Economics 50 (October): 63-99.
25
TABLE 1 Samples for the Year Prior to, the Year of, and the Year After Disclosure of Material TaxRelated Internal Control Weaknesses by Firms Having Such Weaknesses (TAX = 1 Firms) and Peer Firms Having No Internal Control Deficiencies (TAX = 0 Firms)
2003 2004 2005 Total
1 Year Prior to the Internal Control Weakness TAX = 1 TAX = 0 128 2691 115 2318 66 1559 309 6568
Total 2819 2433 1625 6877
2004 2005 2006 Total
Year of the Internal Control Weakness TAX = 1 TAX = 0 134 2403 112 2025 56 1201 302 5629
Total 2537 2137 1257 5931
2005 2006 Total
1 Year After the Internal Control Weakness TAX = 1 TAX = 0 126 2298 90 1449 216 3747
Total 2424 1539 3963
Grand Totals
827
15,944
26
16,771
TABLE 2 Descriptive Statistics for Firms with (TAX = 1) and without (TAX = 0) Tax-Related Material Internal Control Weaknesses, where TAX = 1 Firms are in Bold Percentiles N
Mean
Std Dev
Max
75th
50th
25th
Min
ETR_DOWN ETR_DOWN
827 15944
0.536** 0.502
0.499 0.500
1.0 1.0
1.0 1.0
1.0* 1.0
0 0
0 0
ETR_DIFF ETR_DIFF
827 15944
0.058*** 0.013
0.403 0.239
2.0 2.0
0.056 0.012
0.002** 0
-0.016 -0.004
-2.0 -2.0
Q3_ETR Q3_ETR
827 15944
0.207 0.209
0.348 0.253
1.0 1.0
0.383 0.359
0.295 0.288
0.007 0.001
-1.0 -1.0
Q4_ETR Q4_ETR
827 15944
0.150*** 0.196
0.424 0.276
1.0 1.0
0.377 0.355
0.248** 0.278
0 0
-1.0 -1.0
EPS EPS
827 15944
0.275*** 0.952
1.90 1.927
11.64 11.64
1.04 1.73
0.24*** 0.80
-0.31 0
-6.11 -7.50
ΔEPS ΔEPS
827 15944
0.002*** 0.238
2.338 1.780
16.27 16.27
0.57 0.50
0.06*** 0.12
-0.51 -0.18
-8.27 -8.27
AFE AFE
437 4910
-0.082* -0.054
0.340 0.321
0.66 0.88
0.04 0.04
0** 0.01
-0.07 -0.04
-2.28 -2.28
ASSETS ASSETS
827 15944
4128*** 6286
16031 21494
186192 219232
2081 2568
534.6** 628.3
189.5 146.3
1.601 1.278
MTB MTB
814 15234
2.425*** 2.825
2.800 3.520
18.92 21.491
3.134 3.438
2.004** 2.175
1.340 1.484
-18.43 -18.43
LEV LEV
827 15944
0.234*** 0.204
0.239 0.236
1.348 1.348
0.348 0.294
0.195*** 0.141
0.015 0.015
0 0
BIG_AUD BIG_AUD
805 14562
0.842*** 0.788
0.365 0.409
1.0 1.0
1.0 1.0
1.0*** 1.0
1.0 1.0
0 0
NUM_A NUM_A
437 4910
5.908*** 7.348
5.520 6.980
31 38
8 10
4*** 5
2 2
1 1
EPS_STRING EPS_STRING
817 15356
0.212*** 0.264
0.244 0.273
1.0 1.0
0.40 0.40
0.20*** 0.20
0 0
0 0
AFE_STRING AFE_STRING
403 4452
0.289 0.318
0.342 0.342
1.0 1.0
0.40 0.60
0.20** 0.20
0 0
0 0
Variable
27
***, **, * indicates significant difference in mean / median values between the TAX=1 and TAX=0 subsamples at the 0.01, 0.05, or 0.10 level or better (two-sided p-values).
Variable Definitions: = 1 if ETR_DIFF > 0; 0 otherwise. ETR_DOWN = 3rd quarter ETR less 4th quarter ETR, where ETR is computed as cumulative ETR_DIFF total tax expense scaled by cumulative total pretax income through the 3rd and 4th quarter, respectively. = 3rd quarter ETR. Q3_ETR = 4th quarter ETR. Q4_ETR = Fully diluted earnings per share (Compustat #169). EPS = EPSt – EPSt-1. ΔEPS = Analyst forecast error = Actual EPS less the median analyst forecast from AFE I/B/E/S. = Total assets. ASSETS = Market-to-book = (Stock price x common shares outstanding) / Book value of MTB equity. = Current and long-term debt, scaled by total assets. LEV = 1 if firm employs a big 4/5/6 auditor; 0 otherwise. BIG_AUD = Number of analysts from I/B/E/S. NUM_A = Number of consecutive years of non-decreasing EPS in the 5 prior years, EPS_STRING scaled by 5. AFE_STRING = Number of consecutive years that actual earnings met or exceeded the median analyst forecast in the 5 prior years, scaled by 5.
28
TABLE 3 Pearson Correlations between 3rd- to 4th-Quarter ETR Changes (ETR_DOWN and ETR_DIFF) and Earnings Management Incentives for Firms with (TAX = 1) and without (TAX = 0) Tax-Related Material Internal Control Weaknesses Panel A: TAX = 1 Firm-Years (N = 827 / 437 for POS_AFE) ETR_DOWN ETR_DIFF ETR_DOWN ETR_DIFF POS_EPS POS_ΔEPS POS_AFE
0.457 0.117 0.058 0.103
-0.034 0.011 0.102
POS_EPS
POS_ΔEPS
0.283 0.219
0.135
Panel B: TAX = 0 Firm-Years (N = 15,944 / 4,910 for POS_AFE) ETR_DOWN ETR_DIFF POS_EPS ETR_DOWN ETR_DIFF POS_EPS POS_ΔEPS POS_AFE
0.319 0.204 0.027 0.025
0.000 0.010 0.014
0.211 0.106
Notes: Correlations in bold are statistically significant at the 0.10 level or better (two-sided test).
29
POS_ΔEPS
0.119
TABLE 4 Proportions of Firms that Decreased their Effective Tax Rates from the 3rd to the 4th Quarter (ETR_DOWN = 1) for Sub-Samples Partitioned Based on Tax-Related Internal Control Weaknesses (TAX) and the Positive Earnings Benchmark (POS_EPS) Panel A: 1 Year Prior to the Internal Control Weakness TAX = 1 Firm-Years
TAX = 0 Firm-Years
N
Mean ETR_DOWN
N
Mean ETR_DOWN
TAX = 1 vs. TAX = 0
POS_EPS = 1
215
0.651
4,719
0.562
p = 0.007
POS_EPS = 0
94
0.468
1,849
0.310
p = 0.001
POS_EPS = 1 vs. POS_EPS = 0
309
p = 0.003
6,568
p = < 0.001
Panel B: Year of the Internal Control Weakness TAX = 1 Firm-Years
TAX = 0 Firm-Years
N
Mean ETR_DOWN
N
Mean ETR_DOWN
TAX = 1 vs. TAX = 0
POS_EPS = 1
179
0.492
4,378
0.560
p = 0.072
POS_EPS = 0
123
0.472
1,251
0.329
p = 0.001
POS_EPS = 1 vs. POS_EPS = 0
302
p = 0.733
5,629
p = < 0.001
Panel C: 1 Year After the Internal Control Weakness TAX = 1 Firm-Years
TAX = 0 Firm-Years
N
Mean ETR_DOWN
N
Mean ETR_DOWN
TAX = 1 vs. TAX = 0
POS_EPS = 1
132
0.583
2,935
0.558
p = 0.563
POS_EPS = 0
84
0.429
812
0.345
p = 0.127
POS_EPS = 1 vs. POS_EPS = 0
216
p = 0.026
3,747
p = < 0.001
Notes: POS_EPS = 1 when EPS is greater than or equal to zero; 0 otherwise. See Table 2 for other variable definitions.
30
TABLE 5 Proportions of Firms that Decreased their Effective Tax Rates from the 3rd to the 4th Quarter (ETR_DOWN = 1) for Sub-Samples Partitioned Based on Tax-Related Internal Control Weaknesses (TAX) and the Positive Change in Earnings Benchmark (POS_ΔEPS) Panel A: 1 Year Prior to the Internal Control Weakness TAX = 1 Firm-Years
TAX = 0 Firm-Years
N
Mean ETR_DOWN
N
Mean ETR_DOWN
TAX = 1 vs. TAX = 0
POS_ΔEPS = 1
197
0.609
4,301
0.498
p = 0.002
POS_ΔEPS = 0
112
0.571
2,267
0.477
p = 0.051
POS_ΔEPS = 1 vs. POS_ΔEPS = 0
216
p = 0.518
6,568
p = 0.095
Panel B: Year of the Internal Control Weakness TAX = 1 Firm-Years
TAX = 0 Firm-Years
N
Mean ETR_DOWN
N
Mean ETR_DOWN
TAX = 1 vs. TAX = 0
POS_ΔEPS = 1
144
0.472
3,530
0.521
p = 0.251
POS_ΔEPS = 0
158
0.494
2,099
0.487
p = 0.879
POS_ΔEPS = 1 vs. POS_ΔEPS = 0
302
p = 0.711
5,629
p = 0.015
Panel C: 1 Year After the Internal Control Weakness TAX = 1 Firm-Years
TAX = 0 Firm-Years
N
Mean ETR_DOWN
N
Mean ETR_DOWN
TAX = 1 Vs. TAX = 0
POS_ΔEPS = 1
107
0.598
2,302
0.525
p = 0.140
POS_ΔEPS = 0
109
0.450
1,445
0.490
p = 0.416
POS_ΔEPS = 1 vs. POS_ΔEPS = 0
216
p = 0.029
3,747
p = 0.036
Notes: POS_ΔEPS = 1 when ΔEPS is greater than or equal to zero; 0 otherwise. See Table 2 for other variable definitions.
31
TABLE 6 Proportions of Firms that Decreased their Effective Tax Rates from the 3rd to the 4th Quarter (ETR_DOWN = 1) for Sub-Samples Partitioned Based on Tax-Related Internal Control Weaknesses (TAX) and Meeting or Beating Analysts’ Expectations (POS_AFE) Panel A: 1 Year Prior to the Internal Control Weakness TAX = 1 Firm-Years
TAX = 0 Firm-Years
N
Mean ETR_DOWN
N
Mean ETR_DOWN
TAX = 1 vs. TAX = 0
POS_AFE = 1
98
0.663
1,136
0.535
p = 0.015
POS_AFE = 0
67
0.537
749
0.557
p = 0.760
POS_AFE= 1 vs. POS_AFE = 0
165
p = 0.104
1,885
p = 0.359
Panel B: Year of the Internal Control Weakness TAX = 1 Firm-Years
TAX = 0 Firm-Years
N
Mean ETR_DOWN
N
Mean ETR_DOWN
TAX = 1 vs. TAX = 0
POS_AFE = 1
82
0.537
1,108
0.554
p = 0.758
POS_AFE = 0
80
0.475
720
0.488
p = 0.832
POS_AFE= 1 vs. POS_AFE = 0
162
p = 0.436
1,828
p = 0.005
Panel C: 1 Year After the Internal Control Weakness TAX = 1 Firm-Years
TAX = 0 Firm-Years
N
Mean ETR_DOWN
N
Mean ETR_DOWN
TAX = 1 vs. TAX = 0
POS_AFE = 1
61
0.656
756
0.549
p = 0.107
POS_AFE = 0
49
0.551
441
0.510
p = 0.589
POS_AFE= 1 vs. POS_AFE = 0
110
p = 0.267
1,197
p = 0.195
Notes: POS_AFE = 1 when actual earnings per share from I/B/E/S are greater than or equal to the median analyst forecast from I/B/E/S; 0 otherwise. See Table 2 for other variable definitions.
32
TABLE 7 Logistic Regressions of Third- to Fourth-Quarter ETR Changes on the Proxy for Tax-Related Internal Control Weaknesses (TAX), Incentives to Manage Earnings, and Other Control Variables for Firms with Zero or Positive Earnings ETR_DOWN = β0 + β1TAX + β2POS_EPS + β3POS_EPS×TAX + β4POS_ΔEPS + (1) β5POS_ΔEPS×TAX + β10Q3_ETR + β11FOR_DUM, 1 Year Prior to ICW Coeff Pr > χ2 Intercept TAX POS_EPS POS_EPS×TAX POS_ΔEPS POS_ΔEPS×TAX Q3_ETR FOR_DUM
-1.858 -1.738 1.410 1.963 0.065 0.467 2.290 0.221
N (ETR_DOWN = 1) N (ETR_DOWN = 0) Total N
2,769 2,063 4,832 60.2
% Concordant
< 0.001 0.053 < 0.001 0.023 0.333 0.164 < 0.001 < 0.001
Year of ICW Coeff Pr > χ2
1 Year After ICW Coeff Pr > |t|
-1.944 -0.701 1.502 0.502 0.065 -0.073 2.224 0.241
-2.234 -1.958 1.676 1.591 0.145 0.486 2.498 0.450
2,523 1,951 4,474 60.2
See Table 2 for variable definitions.
33
< 0.001 0.302 < 0.001 0.478 0.338 0.827 < 0.001 < 0.001
1,691 1,324 3,015 61.1
< 0.001 0.104 < 0.001 0.186 0.077 0.223 < 0.001 0.058
TABLE 8 Logistic Regressions of Third- to Fourth-Quarter ETR Changes on the Proxy for Tax-Related Internal Control Weaknesses (TAX), Incentives to Manage Earnings, and Other Control Variables for Firms with Zero or Positive Earnings and with Analyst Forecast Data Available on I/B/E/S ETR_DOWN = β0 + β1TAX + β2POS_EPS + β3POS_EPS×TAX + β4POS_ΔEPS + β5POS_ΔEPS×TAX + β12POS_AFE + β13POS_AFE×TAX + β10Q3_ETR + β11FOR_DUM + β14 I_CH_ETR, 1 Year Prior to ICW Coeff Pr > χ2 Intercept TAX POS_EPS POS_EPS×TAX POS_ΔEPS POS_ΔEPS×TAX POS_AFE POS_AFE×TAX Q3_ETR FOR_DUM I_CH_ETR
-1.806 -1.685 1.502 1.408 -0.073 0.331 -0.039 0.776 2.317 0.177 -0.174
N (ETR_DOWN = 1) N (ETR_DOWN = 0) Total N
973 695 1,668 59.5
% Concordant
< 0.001 0.199 < 0.001 0.280 0.531 0.468 0.720 0.083 < 0.001 0.093 0.627
Year of ICW Coeff Pr > χ2
1 Year After ICW Coeff Pr > |t|
-2.358 -1.693 1.708 1.464 0.144 -0.431 0.241 0.483 2.293 0.161 -0.338
-2.255 -1.487 1.608 1.564 0.296 -0.219 0.284 0.631 1.841 0.116 0.031
951 746 1,697 60.3
See Table 2 for variable definitions.
34
(2)
< 0.001 0.165 0.002 0.238 0.196 0.339 0.026 0.271 < 0.001 0.126 0.262
639 482 1,121 61.0
< 0.001 0.294 0.012 0.254 0.029 0.713 0.034 0.275 < 0.001 0.354 0.943
TABLE 9 Schmidt (2006) Tax Change Component Analysis for the Year Prior to, the Year of, and the Year after the Tax-Related Internal Control Weakness, Where the Dependent Variable is Net Income before Extraordinary Items in Year t+1 E = γ0 + γ1ATE + γ2TCC + γ3TAX + γ4ATE×TAX + γ5TCC×TAX + ν (3)
Panel A: Full Sample 1 Year Prior to ICW Coeff Pr > |t|
Year of ICW Coeff Pr > |t|
1 Year After ICW Coeff Pr > |t|
Intercept ATE TCC TAX ATE×TAX TCC×TAX
0.009 0.878 0.824 -0.026 -0.256 -0.693
0.012 0.823 0.673 -0.014 -0.456 -0.009
0.010 0.925 0.939 0.016 -0.347 0.193
N
6162 0.614
< 0.001 < 0.001 < 0.001 0.005 < 0.001 < 0.001
< 0.001 < 0.001 < 0.001 0.090 < 0.001 0.954
< 0.001 < 0.001 < 0.001 0.224 < 0.001 0.512
4068 0.526
2036 0.647
1 Year Prior to ICW Coeff Pr > |t|
Year of ICW Coeff Pr > |t|
1 Year After ICW Coeff Pr > |t|
Intercept ATEt TCC TAX ATE×TAX TCC×TAX
0.018 0.836 0.671 -0.016 -0.365 -0.665
0.011 0.902 0.736 -0.018 -0.450 -0.207
0.011 0.865 0.549 0.037 -0.331 0.285
N
1877 0.481
Adjusted R2
Panel B: Reduced IBES Sample
Adjusted R2
< 0.001 < 0.001 < 0.001 0.051 < 0.001 < 0.001
1417 0.596
< 0.001 < 0.001 < 0.001 0.049 < 0.001 0.239
606 0.617
Variable definitions: E= Next year’s earnings before extraordinary items; ATE = Current year’s after-tax earnings = Pretax income × (1 – last year’s ETR); ETR = Current year’s effective tax rate = Current year total tax expense / Current year’s pretax income; TCC = Current year’s tax change component of earnings = Pretax income × (Last year’s ETR – Current year’s ETR).
35
0.014 < 0.001 < 0.001 0.024 0.015 0.416
