The Regulator over Your Shoulder

Fearing visits by the Securities and Exchange Commission, companies engage in fewer accounting tricks when state tax investigators are cracking dow...
David KatzApril 8, 2011

The increased tax enforcement that often follows state tax amnesties may well deter financial-reporting fraud, according to a new study. Large public companies “are significantly less likely to intentionally misreport their financial statements in the two years following state tax amnesty programs,” says Nathan Sharp, an assistant professor of accounting at Texas A&M and one of four authors of the study, which is currently under peer review for possible journal publication.

The reason for the decreased tendency to engage in accounting tricks, earnings management, and other forms of financial misreporting? “We hypothesize [that it] relates to stepped-up enforcement that usually follows tax amnesty programs,” says Sharp. Amnesties are one-to-six-month periods in which state tax authorities forgive civil or criminal penalties or interest from previous tax liabilities. They are often followed by increased state tax audits.

The odds of a company launching a period of intentional misreporting are 38.9% lower in the first year following amnesty and 36.0% lower in the second year for firms headquartered in amnesty-granting states compared with all other “firm years” in the study sample, according to Sharp. The study, which covers the years 1995 through 2008, is based on 60,300 firm years, defined as the total number of yearly observations by the companies studied. The companies had an average of $1.4 billion of assets on their balance sheets.

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The researchers used three measures of financial-reporting irregularities for the study: Securities and Exchange Commission enforcement actions, shareholder lawsuits related to accounting wrongdoing, and restatements attributed to accounting irregularities. “We do not find evidence that firms are more likely to engage in financial reporting irregularities in the period preceding an amnesty,” they write in their paper, “Are State Tax Amnesty Programs Associated with Financial Reporting Irregularities?” “However,” they add, “we find that firms headquartered in states offering amnesties are significantly less likely to engage in misreporting in the post-amnesty period relative to all other firms and periods in our sample.”

That may be because they know a crackdown may be coming. “Anytime you’ve got another set of eyes looking over your shoulder and monitoring your behavior as a manager, we believe that can influence the reporting behavior of that manager,” says study co-author Jaron Wilde, a Ph.D. student at Texas A&M’s Mays Business School. (The other authors are David Wood of Brigham Young and Neal Buckwalter of Indiana University.)

Further, state tax authorities have information-sharing agreements with the Internal Revenue Service, which in turn shares information with the SEC, the researchers point out. With state tax authorities becoming “increasingly more desperate,” CFOs should make sure their companies are scrupulous about paying state taxes, says Wilde. “And I’m also going to be concerned about making sure my financial-reporting numbers are in order, because I don’t want to potentially have another monitor coming in and looking at what else is going on.”