Katharine D. Drake

Does Tax Risk Affect Investor Valuation of Tax Avoidance

We examine how investors value tax avoidance (measured as the level of cash ETRs) and tax risk (measured as the volatility of cash ETRs), and how these constructs interact to influence firm value. Our results suggest that investors positively value tax avoidance but negatively value tax risk and, most importantly, that greater tax risk moderates the positive valuation of tax avoidance. Results of tests in the post-FIN 48 period suggest that while disclosures of uncertain tax positions are informative to investors, they are generally associated with firm value incremental to (rather than as a substitute for) cash ETR-based measures of tax avoidance and tax risk. In additional analyses, we find that contemporaneous measures of tax avoidance and tax risk provide insight into future tax cash flows and that our results hold using GAAP ETR-based measures of tax avoidance and tax risk. Broadly, our findings provide new evidence on how taxes affect firm value and suggest that tax avoidance and tax risk should be considered jointly rather than in isolation.

Implementing Relative Performance Evaluation: The Role of Life Cycle Peers

The effectiveness of relative performance evaluation (RPE) in compensation contracts depends on a firm’s ability to identify peers that are subject to similar exogenous shocks with similar abilities to respond to such shocks. We expand the RPE literature by considering whether firms routinely select peers sharing a life cycle stage in RPE implementation. We argue that life cycle captures similarities in underlying economics and homogeneity along a number of dimensions relevant in filtering systematic performance. Using explicit peer firm disclosures and a peer selection model, we show that firms routinely select life cycle peers. Further, using implicit RPE tests, we document evidence of life cycle peers filtering common performance incremental to previously identified peer groups. We provide some of the first evidence that peer group composition differs with differing characteristics of the firm and its industry, highlighting that peer selection is a dynamic process evolving with the firm’s changing nature.

Compensation in the Post-FIN 48 Period: The Case of Contracting on Tax Performance and Uncertainty

Academic and anecdotal evidence indicates that incentive systems often provide short-term payouts without regard for long-term consequences. New detailed disclosures mandated by FIN No. 48, Accounting for Uncertainty in Income Taxes, enable us to use a tax setting to investigate whether boards adjust performance-based pay for uncertainty. We find managers’ bonus payouts are positively associated with tax performance; however, bonus payouts are lower when measures of ex ante tax uncertainty are higher. Our results are robust to tests of alternative explanations including financial reporting aggressiveness, overall firm risk, and other forms of compensation. Further, we document that the relation between bonus compensation and tax performance has changed in the post-FIN No. 48 period. Specifically, we identify a significant association between bonus payout and GAAP ETR only in the pre-FIN No. 48 period and a significant association between bonus payout and cash ETR only in the post-FIN No. 48 period, suggesting that the relation between compensation and tax avoidance should be examined carefully with particular attention to the post-FIN No. 48 period.

Money for Nothing? Using Expectations of Loss Persistence to Examine Cash Compensation in Loss-Making Firms

We investigate how boards use discretion in contracting to incorporate private information about managerial performance. Building from the literature documenting that loss firms’ publicly available valuation allowance (VA) disclosures contain value-relevant private information, we show the VA decision also provides contract-relevant private information. We develop an approach to capture a private firm-specific, time-varying signal of managerial performance by inferring a positive (negative) private signal when the VA decision suggests the firm expects the loss to be transitory (persistent). We show that variation in discretionary compensation payouts is consistent with the information conveyed in the private performance signal. We further find an association between the private performance signal and the weight placed on accounting performance in determining compensation payouts. We also document variation in the likelihood of CEO turnover consistent with the information conveyed in the private performance signal. Overall, our results suggest that extracting private information from the VA decision provides an innovative way to extend our understanding of how boards use discretion in contracting.