Assessing the Quality of the Income Tax Accrual

Abstract

This paper develops and validates a measure of tax accrual quality. Tax accrual quality captures variation in the extent to which the income tax accrual maps into income tax-related cash flows, with lower variation indicating a higher quality tax accrual. Low tax accrual quality arises from (1) management estimation error and (2) financial reporting standards that lead to differences between income tax expense and income tax cash flows not captured by deferred tax assets and liabilities. We validate our tax accrual quality measure by showing it is associated with firm characteristics that capture both constructs and by demonstrating it predicts future tax-related restatements and internal control material weaknesses. We also illustrate the importance of our measure by showing that investors view tax expense as more informative in firms with better tax accrual quality. Our empirical results are incremental to controlling for working capital accruals quality and measures of tax avoidance, tax risk, and tax-related earnings management. Future researchers can use tax accrual quality to address questions related to estimation error in the income tax account.