Is Aggressive Financial and Tax Reporting Related to the Organization and Orientation of the Corpora

1
Is Aggressive Financial and Tax Reporting Related
to the Organization and Orientation of the
Corporate Tax Function?

• John R. Robinson
• Stephanie A. Sikes
• Connie D. Weaver

2
ABSTRACT

• Research question
• Is the growing book-tax gap accelerating
  because of more aggressive financial reporting
  and/or more aggressive tax reporting?
• Objective
• This study investigates whether the recent
  tendency of corporations to organize their tax
  functions as profit centers, rather than as cost
  centers, is related to the magnitude of the
  book-tax gap and aggressive reporting behaviors.
• Data
• We begin by using survey data to derive an
  indicator variable representing corporate tax
  functions organized as profit centers and
  oriented toward planning (rather than
  compliance).
• Method
• We then test whether this motivation variable is
  positively associated with the book-tax gap.
• Findings
• firms with motivated corporate tax functions
  (profit centers oriented to tax planning) are
  associated with larger book-tax gaps, more
  aggressive tax reporting, and less aggressive
  financial reporting.
• Which demonstrates the inherent conflict between
  aggressive tax reporting, which seeks to reduce
  taxable income, and aggressive financial
  reporting, which seeks to increase book income.

3
1. INTRODUCTION

• Motivation
• Despite the increased attention, however, little
  is known about the extent of aggressive financial
  and tax reporting among financially sound
  corporations.
• We investigate two features of the corporate tax
  function that evolved during the 1990s
• organization of the function as a profit center
• the extent to which the tax function is oriented
  toward planning versus compliance.
• Study stages
• Contribution
• identifying a potential and previously untested
  determinant of tax and financial reporting
  aggressiveness, the corporate tax function
• provide evidence that the combination of the tax
  functions organization as a profit center
  (rather than a cost center) and the orientation
  of the tax function toward planning (rather than
  compliance) contributes to the book-tax gap
• find evidence that the combination of these two
  aspects of the tax function is positively
  associated with measures of aggressive tax
  reporting and negatively associated with measures
  of aggressive financial reporting
• Summary of rest of the paper

4
2. PRIOR LITERATURE AND HYPOTHESES DEVELOPMENT
(P5)

• Literature Context
• Page 5 -6
• Hypothesis
• we expect that firms that designate the tax
  function as a profit center (rather than as a
  cost center) and orient the tax function toward
  planning (as opposed to tax compliance) will have
  larger book-tax gaps.
• we posit that firms with the motivation (profit
  centers) and ability (resources devoted to tax
  planning) will be positively associated with tax
  reporting aggressiveness.
• we do not make a directional prediction of the
  effect of organization of the tax function as a
  profit center combined with orientation of the
  tax budget towards planning on financial
  reporting aggressiveness.

5
3. RESEARCH DESIGN

• 3.1 Survey Data
• Question 9A from the 1997 and 1999 surveys asked
  Overall, would you say that your tax department
  is managed and measured as more of a cost center
  or as more of a contributor to the bottom line?
• Question 5A from the 1999 survey asked Thinking
  now of your total tax department budget, what
  proportion is spent on tax planning activities
  and what percentage on compliance?
• 3.2 Stage one the Book-Tax Gap
• SPREAD U.S. Domestic Income U.S. Taxable
  Income (current federal tax expense, divided by
  the statutory maximum corporate tax rate) - State
  Income Taxes Other Income Taxes Equity in Net
  Loss (1)

6

• 3.2.1 Measurement of Independent Variables Go
  back to Table 3
• SPREADit ß0 ß1MOTIVATEDi ß2Xkit eit (2)
  
• where
• MOTIVATEDi equals one if a firm manages and
  measures its tax department as a profit center
  and allocates over 32 percent of its tax budget
  to planning, and equals zero otherwise,
• Xit a vector of k explanatory variables
  representing the characteristics of firm i in
  year t that control for variations in SPREAD.
• 3.3 Stage two Evaluating Reporting
  Aggressiveness we follow Frank et al. (2006) and
  estimate the following system of equations using
  two-stage least squares Go back to Table 5
• TAXit a0 a1MOTIVATEDi a2FINit
  aSCONTROLSit eit (3)
• FINit ?0 ?1MOTIVATEDi ?2TAXit
  ?SCONTROLSit eit (4)

7

• 3.3.1 Measurement of Dependent Variables
• PERMDIFFit a0 a1INTANGit a2UNCONit a3MIit
  a4CSTEit a5LAGPERMit a6LAGMTBit
  a7INCR_EPSit a8DEBTit eit (5)
• where
• PERMDIFFit Total book-tax differences less
  temporary differences measured as
  BIit-(CFTEitCFORit)/STRit-(DTEit/STRit),
• BIit Pre-tax book income less income
  attributable to minority interest,
• CFTEit Current federal tax expense,
• CFORit Current foreign tax expense,
• DTEit Deferred tax expense,
• STRit Statutory tax rate,
• INTANGit Goodwill and other intangibles,
• UNCONit Income (loss) reported under the
  equity method,
• MIit Income (loss) reported to minority
  interest,
• CSTEit Current state income tax expense,
• LAGPERMit One-year lagged PERMDIFF,
• LAGMTBit Prior year market to book measured as
  stock pricecommon shares outstanding/book
  value of equity,
• INCR_EPSit Number of consecutive years in the
  five years preceding year t in which firm i
  experienced a positive change in earnings per
  share,
• DEBTit Long-term debt, and
• ite Discretionary permanent book-tax
  difference (TAXit).3

8

• TACCit d0 d1(?REVit ?ARit) d2PPEit ?it
  (6)
• where
• TACCit Total accruals (EBEIitTTEit)-(CFOitIT
  Pit)-EIDOit,
• EBEIit Earnings before extraordinary items
  from the statement of cash flows,
• TTEit Total tax expense,
• CFOit Cash flow from operations,
• ITPit Income taxes paid from the statement of
  cash flow,
• EIDOit Extraordinary items and discontinued
  operations from the statement of cash flow,
• ?REVit Change in sales from year t-1 to year
  t,
• ?ARit Change in accounts receivable from year
  t-1 to year t,
• PPEit Gross property, plant, and equipment,
  and
• ?it Discretionary accruals before adjusting
  for performance.

9

• 3.3.2 Measurement of Independent Variables
• We include several variables in equations (3) and
  (4) to control for other incentives to report tax
  and financial income aggressively.
• We also include variables in the financial
  reporting aggressiveness model (equation (4)) to
  control for incentives to engage in aggressive
  financial reporting.

10
4. EMPIRICAL RESULTS

• 4.1.1 Sample Descriptives and Univariate Tests
• 4.2 Book-Tax Gap Regression Results
• Panel A of Table 2 presents the descriptive
  statistics for regression variables used in the
  book-tax gap analysis for 266 firm-year
  observations between 1996 and 2000.
• Panel B of Table 2 presents descriptive
  statistics across the sample of 266 firm-year
  observations used in the stage one analysis,
  divided between observations for firms that
  organize their tax function as a profit center
  and orient their tax budget towards planning and
  all other firms.
• Table 3 presents the results of estimating
  equation (2) for our sample firms for the period
  1996 through 2000.
• The regression results for the control variables
  are largely consistent with Manzon and Plesko
  (2002)
• Go to Equation 2

Table 1
Table 2
Table 3
11

• 4.3 Financial and Tax Reporting Aggressiveness
  Regression Results
• Table 4 presents descriptive statistics for
  regression variables used in the analysis of tax
  and financial aggressiveness using a pooled
  sample of 424 firm-year observations from 1996
  through 2000.
• While most of the comparisons are not
  statistically significant, MOTIVATED firms have
  significantly larger mean and median lagged
  market-to-book ratio, significantly larger
  discretionary permanent book-tax differences, and
  are more likely to have positive foreign pretax
  income than other firms.
• Table 5 reports the results of estimating
  equations (3) and (4) via two-stage least
  squares, and coefficient estimates are presented
  with absolute values of test statistics estimated
  using robust standard errors as adjusted for
  clustering across industry (2-digit SIC) and
  fiscal year. Go to Equation 3 and 4
• The positive and significant coefficient on FIN
  (3.66, p-value
  equation (3) indicates that firms who report
  aggressively for financial purposes also report
  aggressively for tax purposes.
• Likewise, the positive and significant
  coefficient on TAX (1.68, p-value
  two-tailed test) in equation (4) suggests that
  firms who report aggressively for tax purposes
  also report aggressively for financial reporting
  purposes.
• However, operating the tax department as a profit
  center and orienting the tax budget towards
  planning significantly reduces financial
  reporting aggressiveness (measured as the level
  of performance-matched discretionary accruals)
  (-0.04, p-value
• The regression results suggest that providing the
  tax function with an incentive to contribute to
  the bottom line and the means to do so increases
  tax reporting aggressiveness. In the case of
  conforming activities, tax functions choose
  reducing taxable income and thereby reducing cash
  outflows over increasing financial income.
• 4.4 Limitations
• First, due to the high growth that occurred
  during our sample period, our results may not
  generalize to periods with little or no growth.
• Second, we base our analysis on a small sample of
  large firms and our results may not generalize to
  the larger population of firms which includes
  smaller firms.

Table 4
Table 5
12
5. CONCLUDING COMMENTS

• CONCLUDING Review (See Abstract)
• Regulators and researchers alike have speculated
  whether the growing difference between corporate
  book income and taxable income (the book-tax
  gap) is accelerating because of more aggressive
  financial reporting or more aggressive tax
  reporting.
• This study investigates whether the organization
  and orientation of the corporate tax function are
  related to the magnitude of the book-tax gap and
  contribute to aggressive reporting behavior. In
  our first stage, we test whether the recent
  tendency of corporations to organize their tax
  function as profit centers, rather than as cost
  centers, and orient the tax function budget
  toward planning (rather than compliance) is
  associated with the book-tax gap.
• We find, as expected, that the organization of
  the corporate tax function as a profit center
  combined with the orientation of the tax function
  budget to planning is associated with larger
  book-tax gaps, increases aggressive tax
  reporting, and reduces aggressive financial
  reporting.
• We conclude that organizing the tax function as a
  profit center and orienting the tax budget to
  planning has a positive effect on the spread
  between a firms taxable income and book income.
• We contribute to the literature by identifying a
  potential and previously untested determinant of
  tax and financial reporting aggressiveness, the
  corporate tax function. (See Contribution)

13
The End

• Thank you!