Center for Financial Markets & Policy Assessing Tax Accrual Quality

This paper develops a measure of income tax expense accrual quality. Following the framework of Dechow and Dichev (2002), we examine the extent to which the financial statement accrual for book tax expense maps into tax-related cash flows. We argue that the quality of a firm’s tax accrual is decreasing in the magnitude of estimation error associated with the accrual, and that tax accrual quality has implications for earnings quality over and above working capital accruals quality. We estimate tax accrual quality (TaxAQ) as the standard deviation of the residuals from firm-specific regressions of a firm’s tax expense accrual on past, present, and future cash taxes paid. We next evaluate the construct validity of our new measure. We find that lower tax accrual quality is associated with higher pre-tax earnings volatility, greater uncertain tax positions, discontinued operations and extraordinary items, option grants, and the presence of tax-related internal control weaknesses, consistent with our expectations. We conclude by providing an application of our new measure, documenting that firms with lower tax accrual quality have lower overall earnings quality.