The unexpected information we can learn from the volatility of tax expense

How have you gauged the quality of a company’s financial report? Maybe you considered the audit report, whether the firm met earnings targets or how quickly the financial statements were filed. You could learn from each of these items, but not until after year-end. What if there were an easily-obtained metric providing information about the quality of the financial statements prior to year-end?

Public companies are required to issue quarterly financial statements to inform stakeholders and other interested parties about operating results as the year progresses. Most people are interested in the quarterly earnings numbers, which offer insight into the firm’s earnings trajectory for the year. But not all estimates in the quarterly report are created equal. Most estimates provided are simply the amount of income earned or expense incurred for that quarter. However, one value – the estimated tax rate – is an estimate of the annual tax rate for the company.

Financial accounting standards require companies to estimate their annual tax rate each quarter and include it in the interim report. Why is this important? To estimate annual tax expense, managers must estimate annual income. Thus, quarterly tax estimates serve as a signal of expected future earnings.

Because these estimates are partly based on management’s forecasts of taxable income, annual tax rate estimates could provide insight into financial reporting quality issues – specifically, the quality of systems that generate the reports. Because annual tax rates are estimated each quarter, we can see revisions to the estimate throughout the year. These revisions can signal one of two things – the company’s operations are changing or the company’s financial reporting systems are insufficient to generate accurate forecasts.

When controlling for changes in operations, Professor Stevie Neuman and her colleagues found that companies that significantly revised their annual tax rate estimates during the year were more likely to have internal control weaknesses and to subsequently restate their financial reports. Moreover, not only did this metric predict tax-related issues, it also predicted non-tax-related issues, pointing to the essential need to forecast income in order to forecast tax rates.

This finding is interesting because it suggests that financial statement users, and even managers themselves, can use a simple calculation – the standard deviation of quarterly tax estimates – to discern financial reporting quality prior to year-end. Thus, the resources of companies and audit firms could be deployed more cost effectively, and stakeholders, especially investors, could make better decisions regarding the reliability of the financial statements, improving their investment selection. The lesson here: powerful information can come from a single estimate.

For more information, please see the peer-reviewed study, “Interim Effective Tax Rate Estimates and Internal Control Quality.”