The effects of tax law on financial reporting

In an article from Bloomberg Tax, Assistant Professor Financial Accounting at Erasmus School of Economics Jochen Pierk and Saskia Kohlhase of Rotterdam School of Management show the findings from a recently published paper. In this paper, they show that tax laws have an effect on financial reporting.

When implementing policy, it is important to be aware of the possible consequences of the measures. This is logical, since adverse behaviour could lead to the negative effects outweighing the positive effects of an action. Firms seek to minimise the amount of taxes they have to pay, to maximise their profits after taxes. By reporting depreciation and amortization at strategical moments for instance, companies can lower their taxable income at favourable moments. However, these practices do not necessarily reflect reality. Even more so, it is loose from reality more often than not. This could endanger financial reporting to outside investors who attempt to get a clear picture of a company that they possibly want to invest in.

The usefulness of financial reporting

In order to offer investors financial reports which are comparable, the International Financial Reporting Standards (IFRS) have been put into place. From a theoretical perspective, taxes should have no effect on the financial reports that are published. However, as Pierk shows in his paper, there is an effect in practice. Because every country has different tax legislation, drawing comparisons is harder to do. For instance, in some countries losses can be carried backwards, in others it’s illegal. Tax loss-carryforwards are sometimes possible for up to twenty years, sometimes to infinity at different rates. When companies choose to postpone asset write-offs to maximise their profits, they have to choose between their financial reporting being less useful for investors and external parties becoming suspicious, since a bigger discrepancy between the reported profits in financial reports and fiscal reports can be an indicator of questionable practices.

The effects of a tax change concerning write-offs

In their research, Pierk and Kohlhase studies the possible effects of tax-loss offsetting rules on financial reporting. They did so by evaluating the change in behaviour of French and German companies after a tax change. The German companies, which had to put up with a change that made tax write-offs more expensive, reduced their reported write-offs by 0.61% of total effects in their financial reports. The French companies, which saw write-offs become cheaper, increased reported write-offs by 0.15% of total assets.

Assistant professor
More information

You can read the full article from Bloomberg Tax, 5 July 2021, here

You can read the paper by Pierk and Kohlhase here