An academic study finds that the corporate tax returns of companies that retain their financial statement auditor to prepare the return take less aggressive tax positions than do returns prepared by either the company itself or by other kinds of external advisers. The study, “Auditors, NonAuditors, and Internal Tax Departments in Corporate Tax Aggressiveness,” was conducted by Kenneth J. Klassen, University of Waterloo, Petro Lisowsky, University of Illinois at Urbana–Champaign Norwegian Center for Taxation, and Devan Mescall, University of Saskatchewan. It is based on a review of uncertain tax positions reported under FASB Financial Interpretation No. 48 (FIN 48) by companies in the S&P 1500 during 2008-2009, coupled with information obtained from the IRS regarding the signer of the corporate return.
The full text of the study appears in the January-February 2016 issue of the American Accounting Association’s publication, The Accounting Review (available here for purchase). The study’s abstract states:
“Using confidential data from the Internal Revenue Service on who signs a corporation's tax return, we investigate whether the party primarily responsible for the tax compliance function of the firm—the auditor, an external non-auditor, or the internal tax department—is related to the corporation's tax aggressiveness. We report three key findings: (1) firms preparing their own tax returns or hiring a non-auditor claim more aggressive tax positions than firms using their auditor as the tax preparer; (2) auditor-provided tax services are related to tax aggressiveness even after considering tax preparer identity, which supports and extends prior research using tax fees as a proxy for tax planning; and (3) Big 4 tax preparers, in particular, are linked to less tax aggressiveness when they are the auditor than when they are not the auditor.”
The authors explanation of their findings is that the auditor has more downside risk if tax positions underlying the return are rejected by the IRS than do other tax preparers, including the company’s tax staff. The auditor’s higher risk exposure stems from two sources: “(1) financial reporting restatement risk due to an audit failure related to the tax accounts; and (2) reputation risk, in that the auditor-preparer’s work is more visible and sensitive to the firm’s leadership.”
As to the later point, the authors argue that audit committee pre-approval of auditor tax services, required under the Sarbanes-Oxley Act, exposes the board to potential embarrassment if the company’s tax positions are rejected and that this risk incentivizes the auditor to be more cautious. “[I]f the firm employs its auditor for tax services, then its audit committee has explicitly sanctioned this relationship under the requirements of the Sarbanes-Oxley Act of 2002 (SOX). Therefore, the board of directors, as well as managers, may bear additional costs if negative tax outcomes result * * *, relative to the case if the tax work was conducted separately from the audit.” The authors also note that the PCAOB’s rules prevent the financial statement auditor from advising the company to use tax strategies that have tax avoidance as a significant purpose and do not meet the standard of “at least more likely than not to be allowable.” Other return preparers are not subject to this limitation.
Comment: Traditionally (i.e., since the early 2000s), non-audit services, including tax preparation, have been regarded as potential threats to auditor independence and therefore to audit quality. The theory behind this view is that the greater the aggregate fees the auditor is generating from the client, the less inclined the firm’s personnel will be to risk the relationship by challenging management’s views on financial reporting issues. This study looks at the issue from another perspective – promoting tax compliance – and suggests that, when viewed through that lens, auditor return preparation creates positive incentives. Of course, an audit committee considering whether to approve return preparation as a non-audit service would need to weigh a variety of factors, in addition to the auditor’s potential tax conservatism, including (1) cost of the service, relative to other options; (2) the level of in-house tax expertise; (3) the value, in the company’s circumstances, of having more than one perspective on the tax reserve; and (4) the risk of disagreements between the preparer and the auditor resulting in additional FIN 48 disclosures.