Linguistic Cues in Annual Reports Signal Aggressive Tax Avoidance

Companies that are financially constrained are more likely to use aggressive tax planning strategies in order to hold onto cash. Identifying those firms can be difficult, but research from McCombs shows that the negative words buried in a company’s annual report can reveal and predict tax avoidance.

The tone of a disclosure may matter just as much as the numbers a company reports, according to McCombs School of Business accounting Professor Lillian Mills and Tilburg University Assistant Professor Kelvin Law (McCombs Ph.D. ’12).

Mills and Law show that the negative words (such as “loss,” “against,” “claims,” “impairment,” and “adverse”) in a company’s annual report can reveal their strategy when it comes to taxes — namely, how likely the firm is to avoid paying them.

“If you pay a dollar less to the IRS, you’ve kept a dollar inside,” Mills explains. “When you think about a company facing financial constraints, that’s a company that might be facing a higher borrowing cost.” Company executives might decide that it’s cheaper to avoid paying a dollar to the IRS than it is to borrow a dollar (at a high interest rate) from the bank. That also means they’re willing to risk getting caught, which could result in fines, tax repayment with interest, and bad PR.

But for regulators, identifying firms that might be manipulating numbers to artificially reduce their tax obligation isn’t straightforward, particularly because corporate tax rules, says Mills, aren’t black and white. But analyzing the linguistic cues in a firm’s annual report can reveal companies with incentives to claim additional tax benefits.

Mills and Law looked at the 10-K filings for more than 5,000 firms between 1993 and 2011. They find that companies that use more negative words have:

  • Higher unrecognized tax benefits (UTB) of as much as $52 million per firm, per year;
  • Lower effective tax rates (ETR) by an average of 2-3%;
  • More tax havens for material operations; and
  • IRS audit adjustments amounting to as much as $200 million per company.

Just as important, the use of negative words also predicts which companies will avoid paying taxes in the future. Explains Mills, “The company might have the funds it needs to pay out this year’s dividends and other expenses, but by next year, they’re calculating that they’ll need that extra 1% on the ETR for the extra millions of dollars it’ll free up.”

Mills and Law write that these findings give shareholders, investors, and regulators — who may not have access to internal company data — a new way to identify which firms might be struggling and avoiding more tax to hold onto cash.

Their findings add to a growing body of research that shows the tone of a company’s reports predicts its policies and strategies. “Even after you’ve controlled for all of the numbers,” says Mills, “the words matter.”

Taxes and Financial Constraints: Evidence from Linguistic Cues

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