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Tax avoidance and firm value: does qualitative disclosure in the tax footnote matter?

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Abstract

This study examines whether qualitative disclosure in tax footnotes affects the market valuation of tax avoidance activities. We predict that more disclosures in tax footnotes mitigate investors’ concerns over the agency risk of managers engaging in potentially illegal tax avoidance and improve the transparency of firm performance, thus increasing firm valuation. Consistent with the prediction, we find that the market valuation of tax avoidance increases when firms’ tax footnotes disclose more qualitative information related to their tax avoidance activities. We provide several tests to show mechanisms underlying our main findings and mitigate concerns about alternative explanations. Overall, our study suggests that the tax-related disclosures in tax footnotes are useful for investors assessing the value of tax avoidance.

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Data availability

Data used in this study are available from the sources identified in the study.

Notes

  1. We choose these six factors because the disclosure of these factors is largely voluntary and under a firm’s discretion.

  2. We require all observations in our sample to have foreign operations.

  3. The extant literature provides mixed empirical evidence regarding whether investors react to quantitative information in tax footnotes. For example, Raedy et al. (2011) find that investors do not react to details about the composition of the book-tax difference disclosed in tax footnotes. However, Robinson and Schmidt (2013) suggest that “investors reward firms for low disclosure quality, especially small firms and firms with high proprietary costs” in a setting where there are proprietary costs associated with the disclosure of uncertain tax positions.

  4. Our definition of US multinational firms follows prior research (e.g., Dyreng and Lindsey 2009; Li and Ma 2022). Specifically, from the Compustat population, we first exclude non-US firms whose incorporation code “FIC” is not USA. Then, we further identify US multinational firms as those with non-missing “income taxes – foreign” (TXFO).

  5. Examples of headlines include “Income Taxes, Income Tax Matters, Taxes on Earnings, Income Tax Expense.”

  6. In untabulated tests, we show that our results are robust to excluding any one of these six factors from the construction of the variable.

  7. The frequency of tax holiday disclosure is higher in 2004 and 2005 than in 2003 but is not significantly higher than in the subsequent years. This is consistent with a recent study by Chow et al. (2018), which shows a significant increase in the percentage of US multinational firms that enjoy foreign tax holidays after 2005.

  8. Our proposition is consistent with Balakrishnan et al. (2019), who use the length of MD&A and conference call transcripts as their measures of disclosure quality. We support our proposition with anecdotal evidence from firms involved in recent high-profile tax scandals, e.g., Tyco. Desai (2005) suggests that Tyco’s managers’ rent extraction and resource diversion were facilitated and shielded by the complexity of Tyco’s tax avoidance strategies. Tyco’s income tax footnotes from 1997 to 2001 were very short—282, 123, 188, 187, and 186 words, respectively. Our sample’s lower quartile and median tax footnote lengths are 160 and 398 words, respectively. Thus, Tyco’s tax footnote length during 1997–2001 is below the sample median. The tax footnote of ADT in 1996, the year before it merged with Tyco, contains only reconciling tables with no verbal explanations. Thus, the length of ADT’s income tax footnote in 1996 is zero words.

  9. See the University of Virginia’s Research Data Services website at http://data.library.virginia.edu/using-and-interpreting-cronbachs-alpha/.

  10. In another famous tax scandal, Enron’s DisclosureScore was two in both 1998 and 1999.

  11. All subscripts are suppressed, as all these variables are from the same period.

  12. Book value of total assets and market value of common equity have been incorporated in the calculation of Tobin’s Q. To avoid documenting a mechanic association between size and firm value, we use total sales to measure firm size.

  13. In untabulated tests, our results are robust to controlling for the interactions of Length_10K and Opacity with tax avoidance or excluding TAX_VOL as a control variable.

  14. TRAC Reports Inc. provides data on the probability of IRS audits of income tax returns filed by corporations in different asset classes. See

    http://tracfed.syr.edu/index/index.php?layer=admin&ds=audit&tool=corptax&group=boxes&program= .

  15. The sample size is smaller than our main sample, because data on UTBs are available only for years after 2007.

  16. Inger et al. (2018) suggest that less readable footnotes increase the valuation of tax avoidance. In untabulated analysis, we find that firms tend to have less readable tax footnotes when they disclose more information in these footnotes. This negative association is likely because discussions in tax footnotes become longer and more complex when firms disclose more information related to tax avoidance. Therefore, while Inger et al. (2018) interpret this finding based on proprietary costs, we suggest that another possible explanation is that firms with less readable footnotes disclose more information, which mitigates investors’ perceived agency costs and improves transparency.

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Acknowledgments

We are thankful for comments from Jennifer Blouin, Editor, an anonymous reviewer, Jared Moore (Discussant), Jane Zhang (Discussant), and seminar participants at the American Tax Association (ATA) midyear meeting (Phoenix), the American Accounting Association (AAA) annual meeting (San Diego), Oregon State University, Huazhong University of Science and Technology, and Central University of Finance and Economics. Thomas Omer acknowledges support from the Delmar Lienemann Sr. Chair of Accounting. Le Luo acknowledges financial support from the National Natural Science Foundation of China (Grant No. 72272170).

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Authors and Affiliations

  1. School of Accountancy, Central University of Finance and Economics, Beijing, 100081, China

    Le Luo

  2. Katz Graduate School of Business, University of Pittsburgh, Pittsburgh, PA, 15260, USA

    Mark Shuai Ma

  3. School of Accountancy, University of Nebraska–Lincoln, Lincoln, NE, 68588, USA

    Thomas C. Omer

  4. Von Allmen School of Accountancy, University of Kentucky, Lexington, KY, 40506, USA

    Hong Xie

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  1. Le Luo
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Correspondence to Thomas C. Omer.

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Appendices

Appendix A

Table 9 Variable Definitions
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Appendix B

Table 10 Examples of Income Tax Footnotes
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Luo, L., Ma, M.S., Omer, T.C. et al. Tax avoidance and firm value: does qualitative disclosure in the tax footnote matter?. Rev Account Stud (2023). https://doi.org/10.1007/s11142-023-09773-w

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