Corporate tax disclosures and financial statements reveal different dimensions of a company's economic activities. Tax reporting reflects its obligations under tax law, while financial reporting presents its performance and financial position to investors. Yet the accounting choices and tax arrangements underlying these reports may be connected. Examining them separately can obscure reporting risks that become apparent when the information is considered together. For investors, this complicates assessments of corporate performance. For regulators and auditors, it raises a practical question: how can information already available be used more effectively to identify companies and transactions warranting closer scrutiny?
When Tax Planning Meets Earnings Management
Managers know more than outside investors and regulators about the tax arrangements and accounting judgements that shape a company's reported performance. This information gap can distort investment decisions and weaken oversight when external stakeholders cannot adequately assess the reporting choices made by management.
Tax avoidance and earnings management may complement each other when managers use tax and accounting discretion together to influence reported performance or limit external scrutiny. They may also substitute for each other when reductions in taxable income lower reported profits, potentially affecting valuations or financing conditions. These possibilities have different implications for oversight. A complementary relationship would make tax-related indicators potentially useful signals of financial-reporting risk, while a substitutive relationship would complicate assessments based on either set of information alone.
Tax Avoidance Leaves a Reporting Signal
Across 12,341 firm-year observations of non-financial companies listed on the National Stock Exchange of India between 2009 and 2022, greater tax avoidance is associated with higher levels of earnings management, measured through discretionary accruals. The estimated relationship is economically meaningful: a one-standard-deviation increase in the study's tax-avoidance measure is associated with a 0.0078 increase in discretionary accruals, equivalent to 6.8 percent of their standard deviation.
The association does not establish that tax avoidance causes earnings manipulation, nor does tax avoidance necessarily indicate unlawful conduct. It suggests, however, that tax-related information may provide useful signals of financial-reporting risk that are harder to identify from accounting outcomes alone.
When Reporting Risks Become More Pronounced
The relationship varies across corporate and institutional conditions. The positive association between tax avoidance and earnings management is stronger among firms with lower environmental, social and governance (ESG) performance and those facing fewer financial constraints. It is also stronger during periods of greater economic policy uncertainty and among firms where information asymmetry is higher.
Institutional ownership and board independence are associated with lower levels of earnings management, but neither consistently weakens the positive relationship between tax avoidance and earnings management. These findings suggest that governance mechanisms associated with better reporting outcomes overall may not adequately address risks arising from the interaction of tax and accounting decisions. Effective oversight therefore requires attention to both reporting behaviour and the conditions under which these decisions are made.
Making Tax Disclosures Count
India has an opportunity to use existing corporate tax information more systematically in financial-reporting oversight. Indian Accounting Standard (Ind AS) 12 already requires disclosures concerning tax expenses, their relationship with accounting profits, and deferred tax assets and liabilities. The immediate opportunity is to make more systematic use of these disclosures, particularly when assessing material differences between accounting profits, tax expenses and cash taxes paid. Where existing reporting does not adequately explain such differences, targeted improvements in clarity and comparability may be warranted.
Tax-related indicators could also strengthen existing financial-reporting surveillance. The Securities and Exchange Board of India and stock exchanges could examine whether unusual tax outcomes coincide with unexplained accounting adjustments or other reporting anomalies, while auditors could incorporate such patterns into their assessment of reporting risks. A low effective tax rate or a substantial difference between accounting profits and taxable income may have legitimate explanations, including tax incentives, timing differences and business circumstances. Such indicators warrant closer examination where appropriate, rather than an automatic presumption of manipulation.
Tax authorities, capital-market regulators, stock exchanges and auditors should also explore ways to identify reporting risks that become visible only when tax and financial information are considered together. Initial efforts could examine whether integrated analysis of existing disclosures improves risk identification before considering more extensive information-sharing arrangements. Any such arrangements would need to respect statutory mandates, confidentiality and due process.
Corporate reporting can appear consistent within individual disclosure frameworks while leaving important questions unanswered across them. The association between tax avoidance and earnings management makes a case for examining these connections more closely. For India, the next advance in corporate transparency may come less from requiring companies to report more information than from developing the capacity to interrogate what they already report.