Does Tax Enforcement Have a Spillover Effect on Qualitative Disclosure? Evidence from Tone Management in the MD&A

Synopsis The research problem Our study explores the association between tax enforcement and tone management in the Management's Discussion and Analysis (MD&A). Motivation Prior studies have shown that tax enforcement influences financial reporting due to the tax authority's scrutiny of financial statements to detect tax evasion, which deters financial reporting manipulation. However, the spillover effect of tax enforcement on qualitative disclosures remains unexplored. Motivated by the relevance of MD&A as a comprehensive discussion of a firm's conditions and a target for manipulation, we investigate the association between tax enforcement and tone management. The test hypotheses We test two competing hypotheses: increased tax enforcement is associated with more tone management, and it is associated with lesser tone management. Target population Our study should be of interest to corporate stakeholders, including managers, investors, regulatory authorities, and policymakers. Adopted methodology Ordinary least squares regressions, staggered difference-in-differences model, and path analysis. Analysis Our study explores a sample of Chinese A-share listed firms from 2008 to 2020. We measure tone management using Huang et al.'s [(2014). Tone management. The Accounting Review, 89(3), 1083-1113. https://doi.org/10.2308/accr-50684] model, which regresses the tone level in MD&A on firm fundamentals, and use the discretionary tone portion as a proxy. Tone level is calculated as the difference between the number of positive and negative sentiment words divided by their sum. Findings We find that increased tax enforcement is associated with lesser tone management. Path analysis shows that this effect is driven by constraints on earnings management and enhanced accounting conservatism, suggesting that tax enforcement improves financial reporting quality, which in turn disciplines disclosure tone. Cross-sectional tests further indicate that the effect of increased tax enforcement varies with tax compliance levels, managerial incentives to influence investor perceptions, and external monitoring.