The Importance of the Internal Information Environment for Tax Avoidance

Abstract

We show that firms' ability to avoid taxes is greatly affected by the quality of the firm's internal information environment, with effective tax rates (ETRs) substantially lower for high internal information quality firms. Furthermore, we show that firms that experience an internal information quality improvement (reduction) are reducing (increasing) their ETRs. The effect of internal information quality on tax avoidance is strongest for firms in which information is likely to play a more important role. First, firms with high coordination needs because of their dispersed geographical or business industry presence benefit more from the reduced information asymmetry and improved information coordination between their various business units, allowing for more effective tax planning. Second, firms that are operating in a more uncertain environment are able to offset some of the negative effect of uncertainty on their ETRs through the quality of their internal information system. Because lower ETRs are obtained through better internal information quality, they do not come at the cost of increased risk in the tax positions taken: unrecognized tax benefits and ETR volatility are lower in high quality information environments.

Allocation of Decision Rights Between the Parent Company and Its Subsidiaries

“…A good internal information environment can provide top management with timely information and improve the efficiency of management decisions (Horngren, Datar, Foster, Rajan, & Ittner, 2012). Previous studies have noted the importance of high-quality internal information and documented its effects on a variety of corporate decisions, such as management forecasts (Dorantes, Li, Peters, & Richardson, 2013) and tax avoidance (Gallemore & Labro, 2015). Our study extends this line of research and documents the relation between internal information and power structure.…”

“…Timely and accurate communication between top and low-level managers therefore becomes essential for centralization, which can be warranted by high-quality internal information. The quality of internal information determines the accessibility and accuracy of the data and knowledge collected, generated, and consumed within an organization (Gallemore & Labro, 2015). Top managers in a company with high-quality internal information have timely access to accurate information for better decision making (Hodge, Kennedy, & Maines, 2004).…”

The financial close process: Implications for future research

“…By definition, a company's internal information environment, including the financial close process, is private to the company and its quality is not publically observable (Gallemore and Labro, 2013). However, the output of the financial close process, the final financial statements and supporting material, is publically observable.…”

“…However, the output of the financial close process, the final financial statements and supporting material, is publically observable. Users often evaluate financial statement quality based on timeliness, reliability, accuracy, and quantity (Gallemore and Labro, 2013). These characteristics may result in participants including controllers, CFOs, compliance officers, and auditors making tradeoffs during the financial close process, particularly between producing the most accurate financial information and providing timely information (Ballou and Pazer, 1995;Keller, 2006;Gigler et al, 2012).…”

“…Third, audit standards (PCAOB, 2007) now identify the financial close process as a high risk area and several companies have disclosed internal control weaknesses related to the financial close process in recent SEC filings (Approva, 2006;Doyle et al, 2007;PCAOB, 2007PCAOB, , 2010Klamm et al, 2012). Finally, some academic researchers use the speed of the financial close process as a proxy for the quality of a company's internal information environment (Jennings et al, 2012;Gallemore and Labro, 2013). Accounting systems often vary by company size.…”