Smoothing GAAP ETRs Through Tax Accruals And The Quality of Financial Reporting

Abstract

This study examines whether the smoothing of GAAP effective tax rates (ETRs) using tax accruals informs or obscures financial reporting quality. We develop a GAAP ETR smoothing measure that isolates variation in tax accruals from underlying variation in cash tax planning and performance reflected in GAAP ETRs. We find that smoothing ETRs through tax accruals is beneficial to financial statement users. Our tests show that GAAP ETR smoothing is associated with (1) greater ability of current-period ETRs to predict future cash ETRs; (2) analysts producing more accurate ETR forecasts; and (3) lower incidence of restatements and tax-related financial reporting fraud. We also find some evidence consistent with managers using their discretion to achieve these benefits, rather than our results being solely an artifact of GAAP rules. Our results suggest that accrual-based GAAP ETR smoothing informs financial statement users about tax outcomes and indicates enhanced financial reporting quality.

Keywords: effective tax rates, accrual management, financial reporting quality, smoothing, managerial discretion, ETR forecasts

JEL Classification: M41, M48, H26