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

Abstract:     
In this paper, we examine the relation between tax enforcement and financial reporting quality. The government, thanks 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 and monitoring by the tax authority has a positive spillover effect on financial reporting by improving reporting quality. Further, we find that this effect is generally stronger when other monitoring mechanisms are weaker. 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.

Number of Pages in PDF File: 51

Keywords: Enforcement, Financial Reporting Quality, Earning Quality, IRS Audit

JEL Classification: G3, H25, H26, K34, M40

working papers series