Allison Koester

The Effect of Tax-Related Material Weaknesses in Internal Controls on the Market Valuation of Unrecognized Tax Benefits

This paper examines the effect of tax-related material weakness in internal controls on investors’ valuation of unrecognized tax benefits (UTBs). Firms are required to record a UTB when their uncertain tax positions are unlikely to be sustained upon tax return audit. While Koester (2012) finds that investors positively value UTBs, we posit that a tax-related material weakness in internal controls over financial reporting (MWIC) represents information risk in the tax account, reducing the value-relevance of UTBs. We predict that the positive relation between market value of equity and UTBs is attenuated when firms report a tax-related MWIC, and our empirical tests reveal that the relation is completely mitigated in the presence of a tax-related MWIC. Falsification tests confirm that non-tax related MWICs do not attenuate the positive relation between market value of equity and UTBs, consistent with tax-related MWICs capturing low information quality specific to the tax account.

Measuring Income Tax Accrual Quality

We develop and validate a measure of tax accrual quality. Tax accrual quality captures variation in the extent to which the income tax accrual maps into income tax-related cash flows, with lower variation indicating a higher quality tax accrual. Low tax accrual quality arises from (1) management estimation error and (2) financial reporting standards that lead to differences between income tax expense and income tax cash flows not captured by deferred tax assets and liabilities. We validate our tax accrual quality measure by showing it is associated with firm characteristics that capture both constructs and by demonstrating it predicts future tax-related restatements and internal control material weaknesses. We illustrate the importance of our measure by showing that investors view tax expense as more informative in firms with better tax accrual quality. Future researchers can use tax accrual quality to address questions related to estimation error in the income tax account.

Auditor-Provided Tax Services and Income Tax Estimation Error

This study examines the association between auditor-provided tax services (APTS) and financial reporting quality to determine if APTS impairs auditor independence or generates knowledge spillover. Lower (higher) financial reporting quality is generally viewed as evidence supporting auditor independence impairment (knowledge spillover). We use the quality of the income tax accrual estimate from Choudhary et al. (2013) as our measure of financial reporting quality because the tax account is where spillover should be most evident. We find a negative association between tax accrual quality and APTS, consistent with auditor independence impairment. Cross-sectional tests reveal that engaging an audit expert does not mitigate lower tax accrual quality for firms with APTS. Our findings are consistent with regulatory concerns that APTS have the potential to impair auditor independence. Acknowledgements: This paper has benefited from insightful comments by Michael Donohoe, Miguel Minutti-Meza, Katherine Schipper, and Georgetown University Accounting/Finance Brown Bag participants. http://finpolicy.georgetown.edu

Attracting Attention in a Limited Attention World: Exploring the Causes and Consequences of Extreme Positive Earnings Surprises

We investigate why extreme positive earnings surprises occur and the consequences of these events. We posit that managers know before analysts when extremely good earnings news is developing, but can have incentives to allow the earnings news to surprise the market at the earnings announcement. In particular, managers can use an extreme positive earnings surprise to attract investor attention when they believe their stock is neglected and future performance is expected to be strong. Analysts, who must allocate scarce resources across many firms, can also be inattentive and miss signals that suggest good performance is going to be announced. Using various proxies for extreme positive earnings surprises, management expectations for future performance and desire for attention, and analyst neglect, we find evidence that an extreme positive earnings surprise is a predictable event. These findings are incremental to controlling for a firms information environment, earnings volatility, and operating leverage. Finally, we show that extreme positive earnings surprises are a successful method for attracting attention, with significant increases in the number of institutional owners, the number of analysts, and trading volume during the subsequent three years. This paper was accepted by Mary Barth, accounting.

Political Connections and Government Subsidies: State-Level Evidence

We examine the role of political connections in US state government-awarded corporate economic incentives, and whether a role (if present) is cause for constituent concern. We find that companies are more likely to receive an incentive award in a politically connected state and this association is stronger when politicians’ motives appear to be self-serving. Although equity investors react more positively to announcements of incentives awarded to politically connected companies, politically connected awards are associated with lower local future economic growth. Our analyses suggest that government incentives awarded to politically connected firms are a less effective allocation of taxpayer funds.

Implications of the Time-Series Increase in the Relative Informativeness of Taxable Income for Future Earnings and Stock Returns

Prior research finds that taxable income is a more useful performance metric when book income quality is low (i.e., the “supplemental information role of taxable income”). We predict and find that taxable income’s supplemental information role for future earnings growth increases over time as book income quality declines over time. This time-series increase in the supplemental information role of taxable income is associated with temporal changes in the market pricing of book-tax differences. We find that mispricing disappears over time in firms where the supplemental information role of taxable income is less pronounced, but persists in firms where the supplemental information role of taxable income is more pronounced. Thus, the complexity of tax-based information and the time-series increase in the supplemental role of taxable income appear to be factors that limit investor learning. Investigating the increase in the supplemental information role of taxable income helps researchers and market participants better understand the time-series implications of two different performance metrics for predicting earnings growth and the equity valuation process as book income quality declines over time.