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

52 Pages Posted: 14 Oct 2010 Last revised: 26 Nov 2014

Michelle Hanlon

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Jeffrey L. Hoopes

University of North Carolina (UNC) at Chapel Hill

Nemit Shroff

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Date Written: May 14, 2014

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.

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

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

Suggested Citation

Hanlon, Michelle and Hoopes, Jeffrey L. and Shroff, Nemit, The Effect of Tax Authority Monitoring and Enforcement on Financial Reporting Quality (May 14, 2014). Journal of American Taxation Association, Vol. 36, No. 2, pp. 137-170, Fall 2014; MIT Sloan Research Paper No. 4849-10. Available at SSRN: https://ssrn.com/abstract=1691158 or http://dx.doi.org/10.2139/ssrn.1691158

Michelle Hanlon (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-668
Cambridge, MA 02142
United States
617-253-9849 (Phone)

Jeffrey L. Hoopes

University of North Carolina (UNC) at Chapel Hill ( email )

102 Ridge Road
Chapel Hill, NC NC 27514
United States

Nemit Shroff

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main St.
E62-679
Cambridge, MA MA 02142
United States
6173240805 (Phone)

HOME PAGE: http://mitsloan.mit.edu/faculty/detail.php?in_spseqno=51407&co_list=F

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