Material Weaknesses in Tax-Related Internal Controls and Last Chance Earnings Management

ABSTRACT: We investigate the consequences of tax-related internal control material weaknesses (ICMWs) for financial reporting. We hypothesize that the presence of ineffective controls over the tax function makes earnings management through the income tax accrual (both income increasing and income decreasing) easier to implement relative to firms with effective controls. We also predict that the remediation of tax-related ICMWs has the effect of constraining earnings management through the tax accrual. The results provide support for our predictions. We also find that last chance earnings management via tax-related ICMWs is concentrated in the early years of our sample, during the initial SOX implementation period. Our results suggest that tax-related ICMWs were initially associated with greater tax-expense management but that SOX internal control assessments subsequently improved the quality of financial reporting by reducing opportunities for tax-expense management.