Why Investors Like Unreadable Tax Footnotes

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Frustrated by indecipherable tax footnotes? Investors like them that way for low tax-paying firms, study finds

Twenty years ago, when the Securities and Exchange Commission issued its “plain English handbook,” a guide, it said, to “writing disclosure documents in a language investors can understand,” Warren Buffett prefaced it with the complaint that in his many years of studying company documents, “too often I’ve been unable to decipher just what is being said or, worse yet, had to conclude that nothing was being said.”


See 2017 Hedge Fund Letters.

His complaint is hardly unique. Widely viewed today as among the highest of corporate virtues, transparency has few, if any, public detractors.

It may bring some measure of comfort, then, to those who craft corporate financial documents that investors do not invariably share Warren Buffett’s – and regulators’ – yearning for transparency. Indeed, when it comes to tax footnotes – the most publicly available source of company tax activities, given the proprietary nature of tax returns – investors often favor notes that are difficult to decipher.

Explains a paper in the current issue of the Journal of the American Taxation Association, a peer-reviewed publication of the American Accounting Association, “Since the tax footnote could be a useful source of information, investors may believe that decreased tax footnote readability hinders the tax authority’s ability to use the footnote as a ‘roadmap’ for audit purposes…Managers of firms with high levels of tax avoidance write less straightforward tax footnotes, and investors value these efforts to conceal tax planning from the tax authority.”

Collaborating on the study were Kerry K. Inger of Auburn University, Michele D. Meckfessel of the University of Missouri – St. Louis, Mi Zhou of Virginia Commonwealth University, and  Weiguo Fan of Virginia Polytechnic Institute.

Comments Prof. Inger, “Research has shown that IRS downloading of company annual reports becomes more likely as tax avoidance increases. Presumably that reflects a heightened interest in the tax footnotes of those reports, so it is not surprising that managers who are adept at tax avoidance would be reluctant to make those notes models of clarity. And while it is widely assumed that investors favor clarity, we find that they’re even more appreciative of management efforts to minimize taxes, even if this means footnotes that are hard to decipher.”

Indeed, the study reveals investors’ appreciation to be considerable, as indicated by Tobin’s Q, a common measure of companies’ appeal to investors based on the ratio of market value to book value. Among firms that are above-average tax avoiders, the biggest avoiders in this group enjoy a 12.4% boost in Tobin’s Q compared to firms near the avoidance median – provided, that is, tax footnotes are low in readability.  In contrast, if tax footnotes are relatively clear and straightforward, the investor premium enjoyed by top tax avoiders turns into a 3.4% discount. As the authors explain, “These results are consistent with investors preferring firms with relatively high tax avoidance to have less straightforward tax footnotes.”

Yet, investors react in opposite ways if firms are below-average tax-avoiders. In those cases, Tobin’s Q gets a boost from increased avoidance if tax-footnote readability is high. As the authors explain, “When tax avoidance is relatively low, firms are likely not engaging in a substantial degree of aggressive tax planning. Since there is not a lot of tax avoidance to conceal from the tax authority and the avoidance that is occurring is likely on the benign end of the spectrum…investors will prefer straightforward disclosures when tax avoidance is low.”

The study’s findings are based on an analysis of tax footnotes from financial annual reports of multinational firms included in the S&P 1500 over the period 2000 through 2014, a sample comprising about 11,700 firm-years. To assess the readability of tax footnotes, the researchers used a standard linguistic index that, they write, “captures readability or syntactic complexity as a function of syllables per word and words per sentence.” Text with an index score greater than 18 is rated as virtually unreadable, 14 to 18 as difficult to read, and 12 to 14 as ideal for the average reader. The mean index score for tax footnotes, the professors find, is 15.29 – difficult to read but easier than the text of the annual reports as a whole, which, at 18.96, border on unreadable.

Asked for examples, the authors provide this excerpt from a tax footnote with a gargantuan index score of 50.35 from a company that ranks high in tax avoidance:

“The change in the valuation allowance reflects the recording by the Company in 2010 and 2009 of an income tax expense credit of approximately $30 million and $36 million, respectively, resulting from the Company’s elections under applicable sections of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 and the Housing and Economic Recovery Act of 2008 (as extended by the American Recovery and Reinvestment Act of 2009), allowing corporations to accelerate utilization of certain research and alternative minimum tax (AMT) credit carryforwards in lieu of applicable bonus depreciation on certain qualifying capital investment.”

The professors analyzed the relationship between tax avoidance of companies (how their effective tax rates compared with the medians in their industries) and the readability of both their annual reports as a whole and the tax footnotes therein, controlling for varied factors that might affect readability. They then probed how readability and tax avoidance and the two in combination related to firms’ value as measured by Tobin’s Q.

Analysis revealed the readability of tax footnotes, but not of the annual report as a whole, to be significantly related to tax avoidance, with the biggest avoiders having the least readable footnotes. Thus does the readability of tax footnotes have a special relationship to tax avoidance, providing a ready clue to companies’ tax status for investors and regulators alike. As Prof. Inger observes, “Despite the frustration an investor feels in trying to make sense of virtually indecipherable tax footnotes, this may not be a totally wasteful exercise. More likely than not, it’s providing a quick read of a company’s tax avoidance.”

As for investors’ response to tax footnotes, the professors find that “investors’ preference for footnote readability varies with the level of tax avoidance.” As a general matter, investors reward increased tax avoidance, but the extent they do so varies considerably, depending on the way it is presented in tax footnotes – most amply when reported straightforwardly by firms where tax avoidance is low or when reported in “textually complex” ways where tax avoidance is high.

In sum, “the tax footnote is one of the most detailed and costly footnotes to produce [owing to] transactions that are governed by a vast set of tax legislation, administrative rules, and judicial decisions. The tax footnote is also unique in that the tax authority can use the information to constrain tax avoidance. Managers must weigh the cost of providing disclosures that could inform the tax authority against the usefulness of the information to stakeholders…Investors positively value tax avoidance when the tax footnote is contextually complex [in the] belief that decreased readability of the tax footnote will hinder the tax authority’s ability to use the tax footnote to identify tax avoidance strategies.”

Entitled “An Examination of the Impact of Tax Avoidance on the Readability of Tax Footnotes,” the study is in the spring issue of The Journal of the American Taxation Association, a peer-reviewed, semiannual publication of the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. The American Taxation Association, founded in 1974, joined the American Accounting Association in 1978. Other journals published by the AAA and its specialty sections include The Accounting Review, Accounting Horizons, Auditing: A Journal of Practice and Theory, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, Journal of FinanciaSl Reporting, and Journal of Forensic Accounting Research. 

Article By American Accounting Association

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