Assessing Tax Risk: Practitioner Perspectives

Abstract

This study examines whether the tax risk determinants identified by practitioners are incrementally informative of firms’ tax risk, compared to other measures used by recent research. We develop an empirical estimate of tax risk, relying on insights from managers, practitioners, and revenue authorities to identify firm characteristics and activities that generate tax risk. Our validation tests indicate that our estimate of tax risk is associated with higher UTBs and other firm- and market-based risk measures, lower future cash ETRs, and less persistent ETRs, consistent with our estimate representing firms’ tax risk. Moreover, our practitioner-based tax risk measure has incremental explanatory power for future cash ETRs relative to other tax avoidance and tax risk measures. Consistent with practitioners reacting to the factors that they argue create risk, we also find that auditors charge higher audit fee premiums to firms with greater tax risk. Finally, further tests reveal that our tax risk measure explains a substantial portion of UTBs, after controlling for measures of earnings management. Our results indicate that our practitioner-based tax risk measure represents a different construct from that captured by academic tax avoidance and tax risk measures and is useful for examining manager and practitioner decisions regarding tax risk.