Economic growth and financial statement verification

We use a proprietary data set of financial statements collected by banks to examine whether economic growth is related to the use of financial statement verification in debt financing. Exploiting the distinct economic growth and contraction patterns of the construction industry over the years 2002–2011, our estimates reveal that banks reduced their collection of unqualified audited financial statements from construction firms at nearly twice the rate of firms in other industries during the housing boom period before 2008. This reduction was most severe in the regions that experienced the most significant construction growth. These trends reversed during the subsequent housing crisis in 2008–2011 when construction activity contracted. Moreover, using bank‐ and firm‐level data, we find a strong negative (positive) relation between audited financial statements during the growth period, and subsequent loan losses (construction firm survival) during the contraction period. Collectively, our results reveal that macroeconomic fluctuations produce temporal shifts in the overall level of financial statement verification and temporal shifts in verification are related to bank loan portfolio quality and borrower performance.Accepted manuscrip

The economic effects of special purpose entities on corporate tax avoidance

This study provides the first large‐sample evidence on the economic tax effects of special purpose entities (SPEs). These increasingly common organizational structures facilitate corporate tax savings by enabling sponsor‐firms to increase tax‐advantaged activities and/or enhance their tax efficiency (i.e., relative tax savings of a given activity). Using path analysis, we find that SPEs facilitate greater tax avoidance, such that an economically large amount of cash tax savings from research and development (R&D), depreciable assets, net operating loss carryforwards, intangible assets, foreign operations, and tax havens occur in conjunction with SPE use. We estimate that SPEs help generate over $330 billion of incremental cash tax savings, or roughly 6% of total U.S. federal corporate income tax collections during the sample period. Interaction analyses reveal that SPEs enhance the tax efficiency of intangibles and R&D by 61.5% to 87.5%. Overall, these findings provide economic insight into complex organizational structures supporting corporate tax avoidance.Accepted manuscrip

Economic Growth and Financial Statement Verification

We use a proprietary data set of financial statements collected by banks to examine whether economic growth is related to the use of financial statement verification in debt financing. Exploiting the distinct economic growth and contraction patterns of the construction industry over the years 2002–2011, our estimates reveal that banks reduced their collection of unqualified audited financial statements from construction firms at nearly twice the rate of firms in other industries during the housing boom period before 2008. This reduction was most severe in the regions that experienced the most significant construction growth. These trends reversed during the subsequent housing crisis in 2008–2011 when construction activity contracted. Moreover, using bank- and firm-level data, we find a strong negative (positive) relation between audited financial statements during the growth period, and subsequent loan losses (construction firm survival) during the contraction period. Collectively, our results reveal that macroeconomic fluctuations produce temporal shifts in the overall level of financial statement verification and temporal shifts in verification are related to bank loan portfolio quality and borrower performance.Sloan School of ManagementUniversity of Illinois at Urbana-Champaign (PricewaterhouseCoopers Faculty Fellowship

Do Smoothing Activities Indicate Higher or Lower Financial Reporting Quality? Evidence from Effective Tax Rates

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 associated with a lower likelihood of financial restatement and lower likelihood of tax-related financial reporting fraud. Further investigation reveals that such negative associations are stronger in firms with a higher level of discretion in tax reporting and when the demand and monitoring 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

The silent majority: private U.S. firms and the market for financial reporting

Please note: this work is permanently embargoed in OpenBU. No public access is forecasted for this item. To request private access, please click on the locked Download file link and fill out the appropriate web form.This study examines the financial reporting choices of medium-to-large private U.S. firms. Using a comprehensive panel of tax returns from private U.S. firms with assets of $10 million or more, we find that nearly two-thirds of these firms do not produce audited GAAP financial statements. Using an agency theory framework to motivate our tests, we find that size, ownership dispersion, external debt levels, and trade credit are positively associated with the choice to produce audited GAAP financial statements, while asset tangibility and internal debt are negatively related to this choice. The results also reveal that young, high-growth firms lacking tangible assets and raising outside equity find audited GAAP reporting particularly net beneficial. While the firms in our panel deploy over$9 trillion in capital and vastly outnumber public firms across all industries, even among firms with revenues exceeding $100 million, substantial unexplained variation in audited GAAP financial reporting remains. Collectively, we contribute new insights on financial reporting choices in this economically significant segment of the U.S. economy.First author draft2031-01-0

Income Shifting under Losses

This paper examines the flexibility of multinational firms to use income-shifting strategies within a tax year to react to operating losses. We develop a theoretical model that considers how affiliate losses can be adjusted ex post (i.e., after financial outcomes are revealed) or ex ante (i.e., before financial outcomes are revealed) by using transfer prices and internal debt. Our model predicts that under ex-post income shifting, loss affiliates have lower transfer prices and internal leverage than profitable affiliates, whereas under ex-ante income shifting, affiliates feature the same transfer prices and internal capital structure, regardless of making losses. Using data on direct transfer payments and internal debt of Norwegian affiliates, we find empirical evidence that, under losses, transfer pricing provides flexibility to adjust income shifting ex post, while we do not find evidence for flexibility in the use of internal debt to shift income ex post. Our study extends prior literature on income shifting that focuses largely on profitable firms and does not consider transfer pricing and internal debt shifting concurrently

Measurement matters: financial reporting and productivity

Please note: this work is permanently embargoed in OpenBU. No public access is forecasted for this item. To request private access, please click on the locked Download file link and fill out the appropriate web form.We examine the relation between financial measurement practices and firm-level productivity. Using two proprietary data sets, including a comprehensive panel of firm tax returns, we find that financial measurement quality explains 10-20% of the intra-industry dispersion of total factor productivity (TFP), a magnitude similar to that of other structured management practices identified in prior studies. We provide evidence of two mechanisms for this result. First, cross-sectional and panel analyses are consistent with high-quality measurement as a management practice causing higher productivity. Second, using plausibly exogenous differences in misreporting incentives, we show that external auditors attenuate reporting biases in administrative data. Thus we show that a portion of measured productivity heterogeneity is the direct result of reporting differences across firms. While short of identifying causal treatment effects, the economic magnitude of our results suggests that firms’ accounting practices are an important area for explaining the vast heterogeneity in reported productivity.First author draft2031-01-0

Competitive externalities of tax cuts

Please note: this work is permanently embargoed in OpenBU. No public access is forecasted for this item. To request private access, please click on the locked Download file link and fill out the appropriate web form.We examine how tax cuts that benefit some firms are related to the economic performance of their direct competitors. Consistent with tax cuts decreasing the cost associated with initiating competitive strategies, we find that the decrease in the tax burden for only a certain group of firms in the U.S. economy has a negative economic effect on the performance of its direct competitors not directly exposed to the same tax cut. This negative externality is stronger when competitors face financial constraints, operate in more concentrated markets, and have similar products to their rivals. We also find that both investors and lenders price the negative externality manifested in these competitors’ economic performance.https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3265532First author draft2031-01-01First author draf

Tax aggressiveness and accounting fraud

There are competing arguments and mixed prior evidence on whether firms that are aggressive in their financial reporting exhibit more or less tax aggressiveness. Our research contributes to resolving this issue by examining the association between aggressive tax reporting and the incidence of alleged accounting fraud. Relying on several proxies for tax aggressiveness to triangulate our evidence, we generally find that tax aggressive U.S. public firms are less likely to commit accounting fraud. However, we caution that our results are sensitive to how tax aggressiveness is measured. More specifically, four (two) of the five (three) proxies for firms’ effective tax rates (book-tax differences) load positively (negatively) during the 1981–2001 period, implying that fraud firms are less tax aggressiveness. Our inferences persist when we isolate the 1995–2001 period in which accounting impropriety steeply rose and corporate tax compliance steeply fell. Moreover, we continue to find that tax aggressive firms are less apt to fraudulently manipulate their financial statements when we apply factor analysis to identify tax avoidance with a common factor extracted from the underlying proxies and match on propensity scores to ensure that the fraud and nonfraud samples have very similar nontax characteristics