Abstract

     We investigate whether a firm’s financial statement comparability is associated with the firm’s tax strategy. We hypothesize that external observers (e.g. press, shareholders, analysts, and tax authorities) can better detect a firm’s atypical tax strategy when the firm has high financial statement comparability with its industry peers. Detection and its consequent penalties should restrain firm managers from choosing tax strategies that deviate significantly from those of industry peers. Using firms’ uncertain tax benefits (UTBs) as a proxy for tax avoidance, we find that the UTBs of firms with high financial statement comparability move toward their industry peers in subsequent periods. Results suggest that comparability reduces tax aggressiveness for high tax-avoidance firms and enhances tax aggressiveness for low tax-avoidance firms, in comparison with those of industry peers. Overall, these findings indicate a strong within-industry harmonization in tax avoidance for firms with high financial statement comparability.

Introduction

     Two sets of theoretical models motivate our hypothesis that firms’ financial reporting comparability is associated with their tax strategies. The first set of models proposes that external agents can improve their knowledge about a firm’s unique, unreported activities through comparison of peer firms’ financial reports (e.g. Cheynel & Levine, 2015; Kim & Verrecchia, 1997). This is because signals from peer firms’ financial reports could be complementary as well as substitutive. As such, external agents can interpolate and infer managers’ unobserved actions by combination and analysis of peer firms’ signals. The second set of models sets forth that external agents’ improved knowledge of managers’ actions can cause the managers to change their actions in subsequent periods (e.g. Dye, 1990). Despite the salience of these models, sparse research has been done on whether and how peer firms’ joint financial reporting quality affects firms’ real activities, such as tax avoidance (e.g. Armstrong et al., 2015). We fill this research gap by examining whether comparability is associated with reduction in peer firms’ tax distance, that is, the difference between the tax avoidance of a firm and those of its industry peers in the same year.

Conclusion

     We examine and find that financial statement comparability could, in some instances, affect firms’ tax planning activities. Our study is based on the idea that comparability reduces the information acquisition costs for external agents, thereby improving the agents’ knowledge about a firm’s atypical tax planning activities. This improved knowledge, in turn, could alter the costs and benefits of tax avoidance. The changed cost–benefit profile of tax avoidance could induce tax managers to change their tax strategies that are perceived negatively by external agents. Consistent with this idea, our results indicate that comparability moves firms’ UTBs toward those of industry peers and, thus, promotes greater harmonization of tax strategies among industry peers.