M41 Accounting
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Fair value and audit fees
(2012)
This paper investigates the effect of fair value reporting and its attributes on audit fees. We use as our primary sample the European real estate industry around mandatory IFRS adoption (under which reporting of property fair values becomes compulsory), due to its unique operating and reporting characteristics. We document lower audit fees for firms reporting property assets at fair value relative to those employing depreciated cost―a difference that appears driven (in part) by impairment tests that occur only under depreciated cost. We further find that audit fees are decreasing in firm’s exposure to fair value, and increasing both in the complexity of the fair value estimation and for recognition (versus only disclosure) of fair values. We corroborate our findings in two alternative settings: contrasting UK and US real estate firms; and using UK investment trusts. Overall, the results suggest that fair values can lead to lower monitoring costs; however, any reductions in audit fees will vary with salient characteristics of the fair value reporting, including the difficulty to measure and the treatment within the financial statements.
A growing body of literature investigates the interaction of changes in accounting standards with institutions such as investor protection laws and corporate governance mechanisms. We examine the unintended consequences of fair value accounting in determining mandated preferred dividends. We study the case of Russian energy conglomerate UES, which had a good corporate governance track record and a consistent dividend history. Following its adoption of fair value accounting, UES reported the highest quarterly profit in world corporate history, but it subsequently omitted dividends for all its shareholders. The case analysis suggests that the transitory nature of fair value adjustments and the interaction with the investment policy were important considerations in justifying the dividend omission. The reduction in preferred dividends was not offset by any capital gains, and led to a wealth transfer from preferred to ordinary shareholders. Thus, requiring the use of fair value accounting when determining the dividend distribution base can lead to unintended consequences, and increase agency costs for minority shareholders.
This study investigates why countries mandate accruals in the definition of corporate taxable income. Accruals alleviate timing and matching problems in cash flows, which smoothes taxable income and thus better aligns it with underlying economic performance. These accrual properties can be desirable in the tax setting as tax authorities seek more predictable corporate tax revenues. However, they can also make tax revenues procyclical by increasing the correlation between aggregate corporate tax revenues and aggregate economic activity. We argue that accruals shape the distribution of corporate tax revenues, which leads regulators to incorporate accruals into the definition of taxable income to balance the portfolio of government revenues and expenditures. Using a sample of 26 OECD countries, we find support for several theoretically motivated factors explaining the use of accruals in tax codes. We first provide evidence that corporate tax revenues are less volatile in high accrual countries, but high accrual countries collect relatively higher (lower) tax revenues when the corporate sector grows (contracts). Critically, we then show that accruals and smoother tax revenues are favored by countries with higher levels of government spending on public services and uncertain future expenditures, while countries with procyclical other tax collections favor cash rules and lower procyclicality of corporate tax revenues.
This study revisits prior research on the valuation of dividends in an accounting-based valuation framework. Using a battery of tests, we show that market value deflation is essential in market-based tests of dividend displacement and signaling because it controls for ‘stale’ information in addition to scale (size) differences across firms. For U.S. firms, we show that after controlling for ‘stale’ information, the empirical association between dividends and market values switches from positive to negative. This switch is not explained by scale differences across firms. Further, we show that after controlling for staleness, the valuation of dividends remains positive for European firms. This result is explained by the relatively stronger association of dividends with future earnings in these settings (i.e., signaling). Lastly, our country-specific estimates of dividend valuation provide a potentially valuable index for studies aimed at examining the effects of accounting and securities regulation on information asymmetries in an international context.
This paper examines pricing differences across recognized and disclosed fair values. We build on prior literature by examining two theoretical causes of such differences: lower reliability of the disclosed information, and/or investors’ higher related information processing costs. We examine European real estate firms reporting under International Financial Reporting Standards (IFRS), which require that fair values for investment properties, our sample firms’ key operating asset, either be recognized on the balance sheet or disclosed in the footnotes. Consistent with prior research, we predict and find a lower association between equity prices and disclosed relative to recognized investment property fair values, reflecting a discount assigned to disclosed fair values. We then predict and find that this discount is mitigated by lower information processing costs (proxied via high analyst following), and some support that it is also mitigated by higher reliability (proxied via use of external appraisals). These latter results are documented using subsample analyses to test one attribute (either information processing costs or reliability) while holding the other constant. Overall, these findings are consistent with fair value reliability and information processing costs providing complementary explanations for observed pricing discounts assessed on disclosed accounting amounts.
The paper studies the effect of uncertainty in firm-speciffic tax avoidance on firm value. We first show in a clean surplus valuation model that expectations about future profitability interact with corporate tax avoidance. Two dimensions of corporate tax avoidance strategies matter for valuation: uncertainty and level of expected future tax rates. We confirm the importance of level and uncertainty of tax avoidance for forecasts of future tax rates using a small sample of analyst tax rate forecasts. Consistent with the model and the implications from analyst forecasts, we derive a tax signal-to-noise ratio based on historical tax information. In our sample of 2,820 firms, we show empirically that this tax signal-to-noise ratio amplifies the effect of pre-tax earnings on firm value. Pre-tax earnings have a stronger effect on firm value for firms with effective and persistent tax avoidance. Firms with volatile effective tax rates receive a discount on their earnings.
Does legality matter?
(2015)
Previous research argues that law expresses social values and could, therefore, influence individual behavior independently of enforcement and penalization. Using three laboratory experiments on tax avoidance and evasion, we study how legality affects individuals’ decisions. We find that, without any risk of negative financial consequences, the qualification of tax minimization as illegal versus legal reduces tax minimization considerably. Legislators can thus, in principle, affect subjects’ decisions by defining the borderline between legality and illegality. However, once we introduce potential negative financial consequences, legality does not affect tax minimization. Only if we use moral priming to increase subjects’ moral cost do we again find a legality effect on tax minimization. Overall, this demonstrates the limitations of the expressive function of law. Legality appears to be an important determinant of behavior only if we consider activities with no or low risk of negative financial consequences or if subjects are morally primed.
This study examines the relation between executives’ inside debt holdings and corporate tax risk. As executives’ inside debt holdings are unsecured and unfunded, they should align executives’ interests with those of outside debtholders and incentivize executives to act more conservatively toward risk. Hence, inside debt should also reduce the risk of tax avoidance activities. Consistent with this prediction, we find that executive inside debt holdings are negatively related to tax risk. Further, this relation becomes stronger at higher levels of tax risk. We also find that the relation between insider debt and tax risk is stronger for firms that are not facing liquidity constraints and among well-governed firms. The latter result implies that institutional ownership and inside debt compensation are substitutes in reducing tax risk. Overall, our results suggest that part of the observed cross-sectional difference in tax avoidance can be explained by a reduction in tax risk that is related to executive inside debt holdings.