Does audit regulation improve corporate decision making? Evidence from the disclosure of tax‐related key audit matters

Abstract

AbstractOur study examines changes in corporate cash tax savings around the disclosure of tax‐related key audit matters (tax KAMs). We expect publicly disclosed tax KAMs to increase the visibility of a firm's tax complexity and uncertainty, thereby motivating the firm to improve its tax function. In turn, we expect to observe increased cash tax savings as an outcome of improvements to corporate tax functions. As predicted, we document that firms exhibit lower cash effective tax rates in the period after their auditors disclose tax KAMs. Additional tests suggest that disclosure of tax KAMs does not increase the likelihood of firms being aggressive in cash tax planning and increased cash tax savings are primarily driven by firms that adjust toward their optimal levels of cash tax savings. Cross‐sectional analyses support our expectation that post‐disclosure increases in cash tax savings are less pronounced when investors were better informed about firms’ tax strategies in the pre‐disclosure period and when firms faced stronger tax enforcement in the pre‐disclosure period. Collectively, our results highlight the role of KAM disclosure requirements in prompting firms to improve their internal operational decisions.