Financial Statement Readability and Tax Aggressiveness

Abstract

This study investigates whether firms with aggressive tax planning strategies have less readable financial reports. In theory, tax-planning increases firm value through tax savings but can lead to a discount if applied too aggressively. Therefore, managers have an incentive to obfuscate their aggressive tax planning activities. One means of doing so is to make financial statements less readable and thus make aggressive tax planning activities more difficult to interpret for outsiders. Consistent with the information-based agency problem perspective of complex financial statements, we find a robust negative relation between financial statement readability and various proxies for tax aggressiveness. We further show that the negative association between financial statement readability and tax aggressiveness is weakened after the installation of Schedule M-3, a regulatory requirement for a detailed reconciliation of book income to tax income intended to make firms' aggressive tax planning activities more apparent to the Internal Revenue Service (IRS). Collectively, this evidence suggests that managers apply complex financial reporting strategies when the benefits of hiding tax aggressive policies exceed the costs, but rely less on obfuscation through such complexity when the benefits of obfuscation attempts are small.