Interim Tax Reporting Accuracy

Abstract

APB 28, Interim Financial Reporting, requires firms to report tax expense each quarter based on their estimated annual effective tax rate (ETR); however, due to both bias (e.g., downward manipulation) and estimation error, these estimates do not always accurately represent annual ETR. I exploit the requirements in APB 28 to examine the determinants of tax reporting accuracy and the effect of prior tax reporting accuracy on investor reaction to reported tax expense. Consistent with a monitoring role over financial reporting, I find that analyst following, institutional ownership, and auditor tenure are positively associated with interim tax reporting accuracy. I also document several firm characteristics that are negatively associated with interim tax reporting accuracy but have no association with bias, suggesting that these factors significantly contribute to estimation error within the tax accounts. Importantly, I find that estimated taxable income is more informative to investors as a performance measure for firms that have been more accurate in prior years, and that investors respond more positively to beating analysts’ forecasts using a decrease in the tax rate when the firm has a record of accurate tax reporting.