Vague disclosures by public companies in the footnotes to their financial statements about how much they’re paying in taxes don’t appear to be deterring investors, according to a new academic study.
The study, by Kerry K. Inger of Auburn University, Michele D. Meckfessel of the University of Missouri – St. Louis, Mi Zhou of Virginia Commonwealth University, and Weiguo Fan of Virginia Polytechnic Institute, found that shareholders seem to reward companies that are avoiding taxes and doing little to show their hand by using practically unreadable disclosures in the notes to their financial statements. The study appears in the spring issue of The Journal of the American Taxation Association, published by the American Accounting Association.
“Since the tax footnote could be a useful source of information, investors may believe that decreased tax footnote readability hinders the tax authority’s ability to use the footnote as a ‘roadmap’ for audit purposes,” said the study. “Managers of firms with high levels of tax avoidance write less straightforward tax footnotes, and investors value these efforts to conceal tax planning from the tax authority.”
The researchers analyzed tax footnotes from financial annual reports of multinational companies included in the SP 1500 from 2000 to 2014, a sample comprising approximately 11,700 company years. To assess the readability of tax footnotes, the researchers used a standard linguistic index that, they said, “captures readability or syntactic complexity as a function of syllables per word and words per sentence.” Text with an index score greater than 18 is rated as virtually unreadable, 14 to 18 as difficult to read, and 12 to 14 as ideal for the average reader. The mean index score for tax footnotes, the researchers found, was 15.29, meaning it was difficult to read but easier than the text of the annual reports as a whole, which, at 18.96, bordered on unreadable.
The study used Tobin’s Q, a measure of companies’ appeal to investors based on the ratio of market value to book value. Among companies rated to be above-average tax avoiders, the biggest avoiders in this group saw a 12.4 percent boost in their Tobin’s Q compared to companies near the avoidance median, provided, that is, their tax footnotes were low in readability. On the other hand, if the tax footnotes were comparatively clear and straightforward, the investor premium enjoyed by top tax avoiders turns into a 3.4 percent discount. “These results are consistent with investors preferring firms with relatively high tax avoidance to have less straightforward tax footnotes,” said the paper.
However, investors reacted in opposite ways when companies were below-average tax-avoiders. In those instances, their Tobin’s Q received a boost from increased avoidance if tax-footnote readability was high. “When tax avoidance is relatively low, firms are likely not engaging in a substantial degree of aggressive tax planning,” said the paper. “Since there is not a lot of tax avoidance to conceal from the tax authority and the avoidance that is occurring is likely on the benign end of the spectrum … investors will prefer straightforward disclosures when tax avoidance is low.”
“Research has shown that IRS downloading of company annual reports becomes more likely as tax avoidance increases,” Inger explained. “Presumably that reflects a heightened interest in the tax footnotes of those reports, so it is not surprising that managers who are adept at tax avoidance would be reluctant to make those notes models of clarity. And while it is widely assumed that investors favor clarity, we find that they’re even more appreciative of management efforts to minimize taxes, even if this means footnotes that are hard to decipher.”
White Paper
Finance Pros Share Tips for Evaluating ERP
Partner Insights
Sponsor Content From: