Tax Aggressiveness and Accounting Fraud

• Published date: 01 September 2013
• Author: JEFFREY PITTMAN,PETRO LISOWSKY,CLIVE LENNOX
• DOI: http://doi.org/10.1111/joar.12002
• Date: 01 September 2013

DOI: 10.1111/joar.12002

Journal of Accounting Research

Vol. 51 No. 4 September 2013

Printed in U.S.A.

Tax Aggressiveness and Accounting

Fraud

CLIVE LENNOX,∗PETRO LISOWSKY,†

AND JEFFREY PITTMAN‡

Received 2 March 2012; accepted 3 December 2012

ABSTRACT

There are competing arguments and mixed prior evidence on whether firms

that are aggressive in their financial reporting exhibit more or less tax ag-

gressiveness. Our research contributes to resolving this issue by examining

the association between aggressive tax reporting and the incidence of alleged

accounting fraud. Relying on several proxies for tax aggressiveness to triangu-

late our evidence, we generally find that tax aggressive U.S. public firms are

less likely to commit accounting fraud. However, we caution that our results

are sensitive to how tax aggressiveness is measured. More specifically, four

(two) of the five (three) proxies for firms’ effective tax rates (book-tax dif-

ferences) load positively (negatively) during the 1981–2001 period, implying

that fraud firms are less tax aggressiveness. Our inferences persist when we

isolate the 1995–2001 period in which accounting impropriety steeply rose

and corporate tax compliance steeply fell. Moreover, we continue to find that

tax aggressive firms are less apt to fraudulently manipulate their financial

statements when we apply factor analysis to identify tax avoidance with a com-

mon factor extracted from the underlying proxies and match on propensity

∗Nanyang Technological University; †University of Illinois at Urbana-Champaign;

‡Memorial University of Newfoundland.

Accepted by Philip Berger. We appreciate constructive comments on an earlier version of

this paper from Andy Bauer,Paul Beck, Amy Dunbar, Scott Dyreng, Steve Gill, Jeffrey Hoopes,

Devan Mescall, Tom Omer, Stephen Powers, Casey Schwab, and participants at the ATA An-

nual Meeting and the AAA Annual Meeting. Hou Qingchuan and Franklin Hao provided ex-

cellent research assistance. Petro Lisowsky (Jeffrey Pittman) gratefully acknowledges generous

financial support from the PricewaterhouseCoopers Faculty Fellowship (Canada’s Social Sci-

ences and Humanities Research Council, the CMA Professorship, and the Chair in Corporate

Governance and Transparency).

739

Copyright C

, University of Chicago on behalf of the Accounting Research Center,2013

740 C.LENNOX,P.LISOWSKY,AND J.PITTMAN

scores to ensure that the fraud and nonfraud samples have very similar non-

tax characteristics.

1. Introduction

Recent research motivates our analysis of whether aggressive tax posi-

tions are associated with the incidence of accounting fraud allegedly per-

petrated by U.S. public companies. Several trends spanning the mid-1990s

to the early 2000s suggest that tax aggressiveness has begun to routinely ac-

company financial reporting aggressiveness. This apparent dynamic is evi-

dent in a steep rise in the frequency of accounting fraud and a fall in corpo-

rate tax compliance during this period. For example, the press highlights

that over 50 major U.S. public firms were under investigation for account-

ing fraud or other financial irregularities in 2002 alone (Stoller [2002]).

Although often less severe than accounting fraud, nearly 10% of all firms

listed on the NYSE, NASDAQ, and Amex announced at least one earnings

restatement between January 1997 and June 2002 with the number of com-

panies restating their earnings climbing by 145% in this short time frame

(General Accounting Office [2002]). In our own sample, the number of

companies engaged in accounting fraud increases monotonically between

1995 and 2000.

In time-series evidence, Plesko [2000] finds that pretax book income

grew at a faster rate than current or deferred tax expense from 1994 to

1998. He suggests that increased participation in tax shelters is one poten-

tial explanation for this divergence, although financial reporting aggres-

siveness may play a role as well. Similarly, Desai [2005] reports that in the

mid-1990s actual book income began to seriously deviate from both taxable

income and simulated book income—essentially, what book income should

have been given genuine differences between financial accounting and tax

reporting. Although actual marginal corporate tax rates were quite stable

over this period, Yin [2003] estimates that the effective tax rates of compa-

nies in the S&P 500 slid from 28.9% in 1995 to 24.2% in 2000. In the same

time frame, the GAO [2003] reports that the fraction of large companies

paying no income taxes jumped from 32.7% to 45.3%. Finally, Desai [2003]

finds that the explanatory power of annual regressions of book income on

taxable income subsides over time.

Notwithstanding that aggregate time-series trends indicate that tax ag-

gressiveness has begun to coincide with aggressive financial reporting,

firm-level empirical research seldom examines this issue.1However, there

are two important exceptions, albeit with conflicting results. First, in an

extensive analysis of 27 firms censured by the Securities and Exchange

Commission (SEC) for overstating earnings that were later restated,

1Shevlin [2002] cautions against drawing conclusions about aggregate trends in aggressive

tax reporting stemming from book-tax differences, reinforcing the contribution of our firm-

level evidence to extant research.

TAX AGGRESSIVENESS AND ACCOUNTING FRAUD741

Erickson, Hanlon, and Maydew [2004] conclude that these firms, on av-

erage, deliberately overpaid their taxes by 11 cents to legitimize each dollar

of fraudulently inflated earnings. Their small-sample evidence implies that

some firms orchestrating accounting fraud rely on exaggerating their tax

obligations to help disguise their deceit.2

In the other direction, Frank, Lynch, and Rego [2009] estimate a posi-

tive relation between financial reporting aggressiveness and tax aggressive-

ness, consistent with firms concurrently managing book income upward

and taxable income downward. This evidence provides some support for

arguments in Desai [2005] and Desai and Dharmapala [2006] that man-

agers exploit complex tax avoidance strategies—under the pretext that

lowering taxes benefits shareholders as the residual claimants—to divert

corporate resources, which they later hide by distorting the firm’s financial

statements (e.g., La Porta et al. [1998], Dyck and Zingales [2004]). De-

spite that Frank, Lynch, and Rego [2009] highlight the recent watershed

accounting scandals when developing their predictions, they quantify ag-

gressive financial reporting with general earnings management, a construct

that is notoriously difficult to measure (e.g., Dechow, Sloan, and Sweeney

[1995], Dechow, Ge, and Schrand [2010], Guay, Kothari, and Watts [1996],

Healy and Wahlen [1999], Hribar and Collins [2002], Wysocki [2004]).3In-

deed, Ball [2009, p. 281] calls for more evidence on fraudulent financial re-

porting given the limitations inherent with earnings management research

using discretionary accruals:

The advantages of focusing on negligent and fraudulent reporting in-

clude: a proven case of negligent or fraudulent financial reporting is an

institutional “fact,” as distinct from an error-prone academic estimate; re-

porting negligence and fraud have been shown to have substantial adverse

effects on firm values (Palmrose, Richardson, and Scholz [2004]); and the

sight of executives being led away in handcuffs under indictment for re-

porting fraud created more scandal than a whole literature of Jones-model

discretionary accrual estimates.

Similarly, DeFond [2010, p. 9] stresses that:

Earnings restatements and SEC Accounting and Auditing Enforcement

Releases (AAERs) are potentially attractive alternatives to abnormal

2Ettredge et al. [2008] find that the disclosure of corporate tax details under SFAS No.

109 facilitates distinguishing firms that commit accounting fraud from a control sample of

nonfraud firms, implying that some companies neglect to cover their tracks through book-tax

conformity.

3Hanlon and Heitzman [2010] raise some concerns about the regression variables used in

Frank, Lynch, and Rego [2009] that are derived from discretionary accruals models. Moreover,

Blaylock, Shevlin, and Wilson [2012] provide evidence inconsistent with that of Frank, Lynch,

and Rego [2009] that aggressive financial reporting firms are more likely to pursue aggressive

tax reporting strategies.