Managing earnings through tax expense : how effective are monitors and governance mechanisms at constraining last-chance earnings management?

Prior literature suggests that market participants struggle to understand changes in firms’ tax expense (Chen and Schoderbek 2000; Plumlee 2003; Weber 2009), making this account attractive for earnings management. Findings in the corporate governance literature suggest that monitors and disciplining governance mechanisms constrain earnings management at firms (Bushee 1998; Edmans 2009; Klein 2002). I join these literatures by examining whether traditionally effective corporate monitors and governance mechanisms also constrain tax expense management. I find little evidence that institutional investors, high quality auditors, or board independence constrain tax expense management, as measured by the change between the Q3 year-to-date GAAP effective tax rate (ETR) and annual ETR. However, consistent with Jensen and Meckling (1976), higher levels of CEO ownership deter tax expense management. These results contribute to our understanding of potential boundaries to monitoring by institutional investors and the effectiveness of disciplining corporate governance mechanisms and advance our understanding of the use of earnings management through tax expense.