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Double trouble? IRS’s attention to financial accounting restatements

Abstract

We examine whether the Internal Revenue Service (IRS) uses public information to obtain qualitative signals regarding the quality of firms’ financial information or management integrity. Using the procurement of public information as a proxy for IRS attention, we test whether public signals of poor information quality (restatements) lead to an increase in IRS attention. To begin, we document that the IRS is both more likely and quicker to acquire public filings announcing a restatement than any other filing of the firm. Furthermore, we examine instances in which the IRS is more likely to learn of a restatement and find an increase in attention around both press releases and media coverage of the restatement. Next we examine the implications of increased IRS attention. Employing path analysis, we find that IRS attention is associated with both higher levels of future tax settlements and a greater likelihood of the mention of a tax audit. Overall our results are consistent with the IRS responding to signals of poor information quality or management integrity as if financial misreporting and tax reporting are related.

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Notes

  1. For the full article see: https://www.washingtonpost.com/news/powerpost/wp/2017/11/07/irs-chief-departs-blasting-congress-for-budget-cuts-threatening-tax-agency/?noredirect=on&utm_term=.b1c5d8e80968

  2. For more information regarding the audit enforcement data, see IRS SOI Tax Stats – Business Tax Statistics provided on https://www.irs.gov/statistics/soi-tax-stats-business-tax-statistics.

  3. Erickson et al. (2004) focus on firms that have restated their financial statements due to fraud allegations by the SEC. They find that managers of some firms are willing to pay taxes on overstated earnings. We note that financial restatements do not simultaneously trigger the data within a tax return to update. Following a restatement, three scenarios can occur. First, the IRS and the restating firm can do nothing and leave the tax return as filed. Second, the IRS can update its information through the new publicly available financial disclosures or through an audit. Lastly, the firm can amend prior tax returns directly affected by the financial restatement and, as a result, provide the IRS with the updated information.

  4. In informal discussions, IRS officials emphasized the fact that the agency’s staffers are not simply auditing the tax return itself but any information they can gather that is useful in assessing risk of tax noncompliance. The use of public information is an important component of enforcement and can be used to identify issues of concern or validate that tax reporting is being done correctly.

  5. Admittedly, examining the downloading of public filings indirectly measures the IRS’s interest in restatements. There are other measures to examine how other stakeholders respond to restatements (e.g., stock returns, interest rates, audit fees, etc.). However, when it comes to the IRS (and other tax authorities), the downloading of public filings provides a useful point of view.

  6. While Hennes et al. (2008) categorize restatements into intentional (fraud) and unintentional (errors) categories based on three criteria. We modify this approach by creating three separate categories for restatements as recorded by Audit Analytics: GAAP violations, clerical errors, and fraud. We posit that unintentional restatements from GAAP violations and clerical errors represent potentially different signals for the IRS and should therefore be considered individually.

  7. For more information see http://www.auditanalytics.com/blog/2016-financial-restatements-review/.

  8. Related studies include the work of Kinney Jr and McDaniel (1989), Guo et al. (2016), Armstrong et al. (2010), Burns and Kedia (2006), Efendi et al. (2007), Hennes et al. (2014), Swanquist and Whited (2015), Amel-Zadeh and Zhang (2015), Palmrose et al. (2004), Badertscher et al. (2011), and Karpoff et al. (2008a, b).

  9. We also searched the Internal Revenue Manual, an official compendium of internal guidelines for the IRS, for instances of the use of restatements in the examining process. The only reference to restatements came from the Compliance Assurance Process examinations, where restatements are used to help determine a firm’s eligibility to participate.

  10. In untabulated analyses, we also estimate Eq. (1) using a negative binomial regression. Results are available upon request.

  11. All variable measurements are defined in the appendix.

  12. There are several IP addresses linked to the IRS that do not contain the entire block of the final octet. Unfortunately, those IP addresses are not included into the sample because of our inability to verify that the download comes from the IRS.

  13. Our finding of 12 IP addresses for the IRS mirrors that of Bozanic et al. (2017). An example of a block of IRS IP addresses can be found here: https://whois.arin.net/rest/net/NET-204-62-146-0-1 (as of August 2017).

  14. IRS agents may have shifted how they acquire public filings. In informal discussions, officials at the IRS indicated that some resources, like that of Capital IQ or Bloomberg, are available to certain IRS offices, but that the access is not uniform across divisions or time. However, they did not provide us with further details.

  15. We restrict our analyses to 2007, as the control variable UTB begins in this year and is an important determinant of IRS attention, as documented by Bozanic et al. (2017).

  16. The restatement types may not be mutually exclusive. Some restatements stem from a combination of errors, GAAP violations, or fraud. As a result, we assign those observations according to severity. If a restatement stems from both an error and fraud, we categorize that restatement as fraud (one instance). Likewise, if a restatement stems from both a GAAP violation and fraud, we categorize that restatement as fraud (18 instances). Finally, if a restatement stems from both a GAAP violation and an error, we categorize that restatement as a GAAP violation (22 instances). The sample contains no observations where a restatement is a combination of all three restatement types.

  17. We also present the mean number of total downloads surrounding a restatement by firms with total assets above and below $20 billion in the online appendix.

  18. We lose 282 restatements announced via press releases for which there is no accession number or filing on EDGAR to determine the number of downloads by the IRS for that announcement.

  19. We lose another 694 restatements of which the IRS does not download.

  20. If announcing a restatement via the Schedule M-3 on the firm’s corporate tax return is triggering the downloads of public filings by the IRS, we would expect a spike in downloads around either or both March and September, as these are the due dates for corporate tax returns to be filed for calendar year-end firms. Figure OA2 in our online appendix documents the average number of downloads by month over the calendar year for calendar year-end firms within our sample during the year of restatement. There appears to be no meaningful spike in information acquisition by the IRS around either March or September.

  21. In the online appendix, we find an increase of 29.8% from the mean in expected downloads (counts) in the restatement month when using a negative binomial regression.

  22. This result is also subject to potential measurement error of IRS DOWNLOADS in the month of the restatement. The exact date a restatement is revealed varies within months so that downloads we pick up in the announcement month may occur before the restatement announcement itself. To address this issue, we shift the restatement window to the second month following the restatement and continue to find a significant relation for the second month following a restatement announcement for both samples (results not tabulated). This result suggests that the IRS responds relatively quickly to an announcement of a restatement through its information acquisition and that our measure of IRS DOWNLOADS correctly captures IRS attention.

  23. In the online appendix, we test whether tax related restatements lead to increased IRS attention but fail to find a significant incremental effect.

  24. We exclude the control variables 10-K, 10-Q, and FORMS, as those variables capture firm-month variation.

  25. Bozanic et al. (2017) test for an association between IRS 10-K downloads and an indicator variable equal to one if a firm disclosed a decrease in the UTB balance related to settlements with a tax authority and references to a tax audit in the firm’s 10-K. They find that the probability of a decrease in the settlement line item and mention of a tax audit increases in the number of downloads. Our analysis differs in that we attempt to identify how an increase in IRS attention is connected to future settlements and a reference to being under IRS audit using a path analysis.

  26. Following Bozanic et al. (2017), we seek references to a tax audit by identifying audit related words (“audit,” “exam,” “investigation,” or “inspect”) that occur within 20 characters of “IRS,” “I.R.S.,” or “Internal Revenue Service.”

  27. We acknowledge there may be valid reasons for these organizations to be interested in restatements, but we are at least unaware of what those reasons would be.

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Acknowledgments

We are grateful for the helpful feedback from Jake Thornock (EIASM discussant), Jeffrey Hoopes, Terry Shevlin, Mollie Mathis (ATA Mid-Year Meeting discussant), Ted Christensen, Jane Song, Erin Towery, Paul Demere, Enrique Gomez, Christian Paparcuri, David Kenchington, Jenny Brown and workshop participants at the University of Oregon, Arizona State University and University of Georgia. We also thank Josh Cutler, Aaron Nelson, Adam Olson, Sonja Rego and other conference participants at the BYU Accounting Research Symposium, the ATA Mid-Year Meeting and the EIASM Conference.

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Appendix

Appendix

Table 9 Variable Definitions

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Fox, Z.D., Wilson, R. Double trouble? IRS’s attention to financial accounting restatements. Rev Account Stud (2022). https://doi.org/10.1007/s11142-022-09680-6

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Keywords

  • Restatements
  • Financial misreporting
  • Internal control weaknesses
  • IRS attention
  • Tax enforcement
  • Political costs
  • Regulatory interaction

JEL codes

  • G28
  • H20
  • H25