Do Smoothing Activities Indicate Higher or Lower Financial Reporting Quality? Evidence from Effective Tax Rates
55 Pages Posted: 3 Apr 2016 Last revised: 17 Apr 2019
Date Written: April 15, 2019
Prior literature is mixed as to whether smoothing through accruals indicates higher or lower financial reporting quality (Tucker and Zarowin 2006; Jayaraman 2008; Dechow et al. 2010). Motivated by the unique inter-temporal features and reporting incentives of tax expense, we provide new evidence on this debate by examining the link between smoothing of GAAP effective tax rates (ETRs) and the likelihood of financial restatements. Different from earnings smoothing’s insignificant relation with restatements, we find that ETR smoothing through tax accruals is strongly associated with a lower likelihood of financial restatement and tax-related financial reporting fraud. Further investigation reveals that these associations are stronger in firms with a higher level of discretion in tax reporting and when the demand for transparent reporting is higher. We also document corroborating evidence that smoothing through tax accruals increases the informativeness of GAAP ETRs for predicting future cash ETRs. Collectively, our results contribute to the financial reporting and tax literatures by providing evidence that smoothing activities pertaining to tax accruals are consistent with higher financial reporting quality.
Keywords: effective tax rates, financial reporting quality, smoothing, managerial discretion
JEL Classification: M41, M48, H26
Suggested Citation: Suggested Citation