Monitoring roles of auditors and tax authorities in tax-induced downward earnings management

In this study we examine how external auditors and tax authorities separately and jointly constrain corporate tax incentives to manage earnings downward through discretionary accruals. We find that stricter tax authority scrutiny limits these accruals to a greater extent. We also find that although the monitoring effect of auditors is in general insensitive to income-decreasing accruals, higher-quality auditors are more effective than their lower-quality counterparts in constraining such accruals when tax enforcement is stricter. We interpret the results as being consistent with the different monitoring foci of auditors and tax authorities, and with the penalty risk argument that auditors will behave more conservatively so as to avoid regulatory costs arising from the failure to detect managerial misconduct that is discovered ex-post by the tax authority.