This study investigates how real activities management (RAM) by employees to meet internal targets set by managers affects their performance, and how managers' awareness of employees' opportunity to engage in RAM moderates this effect. Using two experiments, we predict and find that when managers are unaware of employees' RAM opportunity, employees who face miscalibrated targets use RAM to restore their own incentives to work hard, resulting in increased employee performance. Counter to conventional wisdom, we also predict and find that making managers aware of employees' RAM opportunity hurts employee performance. Such managers overestimate employees' RAM and adjust targets aggressively such that they become more difficult to achieve, leading to lower employee motivation and less trusting employee-manager relations. Overall, our findings show that the opportunity to engage in RAM can have the indirect benefits of motivating higher employee performance, but increasing managers' awareness of this has negative performance and relational effects.
Many tax-exempt hospitals generate substantial profits. At the same time, regulations governing tax-exempt status prohibit these organizations from issuing equity or operating for the benefit of private owners, leaving managers with unusual discretion over retained resources. This combination makes them especially prone to agency problems. Because hospitals play a central role in the U.S. economy, the costs of weak governance extend beyond the sector itself. We find that tax-exempt hospitals spend more on administrative wages and capital investments than comparable taxable hospitals. At the same time, weaker financial performance accompanies greater mission-related activity. A novel, hand-collected measure of additional state-level oversight reveals that stronger oversight disciplines finances without crowding out mission-related activity.
Theory suggests that changes in corporate tax rates can alter the dispersion of after-tax project payoffs, thereby altering the exposure of firm-level risk transmitted to executives through compensation. Using state tax changes, we observe firms shifting away from option-based compensation following state corporate tax rate increases. This result is concentrated in compensation contracts that lack relative performance evaluation (RPE) features, which filter common shocks to performance and influence the type of risk executives are incentivized to take. We also find that firms are more likely to initiate RPE shortly after a state tax rate increase and that firms that adjusted compensation through reductions in equity risk incentives or used RPE were less likely to experience a subsequent increase in systematic risk following a state tax rate increase. Overall, our findings provide novel insight into how taxes can influence CEO compensation design and the transmission of firm-level risk to executives.
Using IRS tax return data for private C corporations, we examine the relation between GAAP audits and IRS enforcement outcomes. Among IRS-audited tax returns, we find that those with audited GAAP financial statements have fewer and smaller proposed deficiencies. These effects persist after controlling for tax preparers. Furthermore, we estimate that the explanatory power of audited GAAP financial statements is comparable to that of external debtholders. Audited GAAP financial statements are also associated with a higher likelihood of unagreed proposed deficiencies, more detailed tax return disclosures, and fewer IRS audit hours, all of which are consistent with more defensible tax positions. Tax returns with audited GAAP financial statements exhibit greater initial voluntary compliance and generate smaller proposed deficiencies per IRS audit hour. These results inform private firms as they weigh the costs and benefits of financial statement audits and the IRS as it allocates enforcement resources.
Using PCAOB data, we examine variation in auditor-employed tax experts' involvement to assist the audit team. Tax expert hours average 5 percent of total audit hours and are positively associated with several proxies for the complexity of tax estimates. Greater tax expert involvement correlates with a higher detection rate of tax-related internal control material weaknesses (ICMWs) and a greater frequency of subsequent tax-related restatements. However, earlier tax expert involvement is associated with fewer ICMWs, although it is not significantly associated with subsequent restatements. Overall, our findings provide new evidence on how the timing and intensity of tax expert involvement relate to audit outcomes. Although involving tax experts is a typical response to auditing complex estimates, their involvement alone does not fully mitigate restatement risk. Importantly, timely coordination between the audit team and tax experts plays a critical role in ensuring high audit quality.
