Double Trouble: An Analysis of IRS Attention and Financial Reporting

Existing research provides limited insight into what draws the attention of tax authorities to public information and how that information is used in the process of examining corporate tax positions.  For publicly traded firms in the U.S., the Internal Revenue Service (IRS) has access to both public and private information from the publicly mandated disclosures required by the Securities and Exchange Commission (SEC) and the IRS’ own private disclosures submitted via a corporate tax return.  The use of public information provides additional data to the IRS that can be used in the enforcement process to complement private information provided on the corporate tax return.

The IRS, as well as other taxing authorities, face increasing resource constraints.  The Transactional Records Access Clearinghouse (TRAC) publishes data concerning the amount of audits conducted by the IRS relative to corporations filing annual tax returns.  They show that the IRS audit rates for large companies fell by almost 38 percent from 2010 to 2017.  In this constrained environment, the need for informative signals to better deploy limited resources is greater than ever.  In our study, we investigate whether the IRS uses public information to obtain qualitative signals about the integrity of management or of firms’ information quality that could help the IRS  assess firms’ tax filings.

A recent study by Bozanic, Hoopes, Thornock, and Williams (2017) provides the first evidence that the IRS does acquire and use public disclosures. They find the use of public information increased following the implementation of Financial Accounting Standards Board (FASB) 2006, ASC 740-10, (FIN 48), requiring firms to disclose tax reserve information.  Their results are consistent with the IRS obtaining these public disclosures to scrutinize tax related reserves. We build on their analysis to test whether the IRS also uses public disclosures to obtain more qualitative signals about a firm to assist in the examination process.  Specifically, we examine financial restatements and reports of internal control weaknesses (ICWs) as potentially useful signals to the IRS of an aggressive corporate culture or poor information quality.

We argue that financial restatements are likely to draw the attention of the IRS for three reasons that are not mutually exclusive.  First, in some instances, restatements can have direct implications for tax returns.  In these cases, the inaccurately reported information consists of tax-conforming restatements that will likely directly affect previously filed tax returns and may necessitate those tax returns being amended.  Second, financial misreporting could indicate an aggressive corporate culture that is also aggressive in tax planning. Third, the IRS may observe fraud, a misapplication of GAAP, or another kind of error that leads it to question the quality of the firm’s financial information more generally and whether those quality issues extend to tax filings. The second and third reason for IRS interest in restatements fit under the cockroach theory:  Where one problem surfaces,  more problems will probably follow.

Our research question is not without some tension. Despite the arguments for why the IRS may obtain more public information following a restatement, there are reasons to expect that the IRS might not notice restatements. First, restatements most often arise due to accounting misapplications that are unlikely to directly affect taxes. Second, most restatements related to fraud cause firms to restate earnings downward, which potentially reduces the taxes owed by the firm (assuming it reported the inflated earnings on its original tax return). Third, the restatement may carry no tax implications simply because the firm did not report inflated earnings for tax purposes or only used non-tax conforming methods to adjust its earnings. In either case, the IRS does not stand to collect more taxes because of the restatement.

We measure the level of IRS attention by applying an approach similar to that used in Bozanic et al. (2017).  Specifically, we use a dataset that tracks IRS acquisition of financial filings or forms hosted by the SEC’s EDGAR servers.  EDGAR provides the public with all SEC filings and forms from all public companies.  For those interested in access to the information, a server log file tracks the the Central Index Key (CIK) of the company whose information was requested, the IP address of the user accessing the information, the date and time of the request, and a link to the form or filing being requested.  There is a log of all downloads  for any given day.  Using this information, we are able to locate instances of IRS downloads and the filings or forms being requested for download on a daily basis. We use downloads of all available public information to measure the level of IRS attention to each firm and aggregate the total downloads for a given month during the sample period. We identify the months following a restatement announcement as the restatement window.  The windows examined are one, two, and three months.  This approach allows us to include all restating firms during the sample period and to examine whether IRS attention increases during the restatement window.  As expected, we find IRS attention is positively affected by restatement announcements.

Since IRS attention is likely to vary according to the type of restatement, we next identify the types of restatements most likely to draw increased scrutiny.  Because the majority of restatements arise from a misapplication of GAAP, we use those restatements as the base group to test the incremental effect of restatements stemming from fraud and errors. We expect that restatements occurring due to errors to be the least informative, and that restatements arising from fraud will be the strongest sign of an aggressive culture.  We find that IRS attention increases for restatements caused by the misapplication of accounting rules in all tests, which supports the argument that restatements signal possible tax misreporting and merit additional inspection.  A restatement attributable to fraud results in an incremental increase in attention relative to restatements stemming from the misapplication of GAAP.  We do not find an increase in IRS attention around restatements stemming from errors.

Apart from restatements, there are other public signals about the quality of a firm’s information  or the integrity of management that may lead to increased IRS attention.  In our next set of tests, we investigate IRS attention following a firm’s disclosure of material weaknesses.  Gallemore and Labro (2015) and Feng, Li, and McVay (2009) both argue that disclosure of material weaknesses indicates poor information quality that management must rely on for tax planning or management guidance.  To the extent that internal control weaknesses (ICWs) provide a signal about information quality, we investigate whether IRS attention increases after a firm discloses ICWs.  We find evidence consistent with increased downloads of firms’ public information following an ICW disclosure.  This result is particularly interesting because, unlike some restatements that involve conforming tax elements, the receipt of an ICW does not have a direct connection to previously filed tax returns.

In additional analyses, we consider whether IRS attention to a restatement leads to an increase in the amount of future tax settlements.  Although it is difficult to directly attribute an increase in settlements to increased scrutiny following a restatement, we find evidence suggesting that firms report higher settlement amounts to tax authorities in the period after these restatements.  Finally, we consider whether the need for qualitative signals is related to the decrease in IRS enforcement rates.  We find that as enforcement rates decrease, restatements become more relevant in explaining IRS attention.

Our results suggest that the IRS focuses on not only tax disclosures but also other aspects of public filings that may contain signals about corporate culture and information quality that are likely useful in the risk assessment process. Further, we find the IRS appears to rely more on those signals when enforcement rates are lower. In showing IRS attention increases following a restatement, we broaden the implications of financial misreporting to another important stakeholder of the firm, the tax authorities. This study also adds to the debate about the connection between aggressive tax and financial reporting. Wilde and Wilson (2018) note that evidence of that connection is mixed. We contribute to the debate by finding that the IRS responds as if aggressive tax and financial reporting are linked.

This post comes to us from Zackery D. Fox, a PhD candidate at the University of Oregon, and Ryan J. Wilson, a professor at the university. It is based on their recent article, “Double Trouble: An Analysis of IRS Attention and Financial Reporting,” available here.