Mandatory Book Tax Conformity and Its Effects on Strategic Reporting and Auditing

Abstract

This paper studies how mandating higher book-tax conformity influences a manager's strategy to misreport financial and taxable incomes in the presence of a financial auditor and subsequently a tax auditor. The main result is that allowing for some differences between GAAP and tax laws minimizes misreporting. The paper provides an explanation for why empirical research concerning how book-tax conformity affects misreporting finds mixed results: mandating higher book-tax conformity is a double-edged sword. It enables financial audits to resolve uncertainty about the source of a book-tax difference with higher precision. This reduces misreporting by complementing the deterrence effect of a subsequent tax audit. Contrarily, precluding all book-tax differences minimizes the probability of utilizing this precision effect and fosters misreporting because a manager optimally misreports both incomes to maintain conformity and avoid audit scrutiny. The paper provides further empirical predictions that depend on the relative strength of a manager's book-tax reporting incentives.