Should Your Auditor Prepare Your Tax Return?

While regulators frown on a company's auditor handling its taxes, new research suggests that such concern is unwarranted.
David McCannFebruary 1, 2016
Should Your Auditor Prepare Your Tax Return?

With corporate tax avoidance a hot issue in the United States and Europe these days, it’s no surprise that a recent $185 million settlement for taxes going back to 2005 between the British government and Google has proved highly contentious. Members of the political opposition have denounced it as “derisory” and a “sweetheart deal.”

AAA 2Yet European regulators are set to ban an accounting arrangement that, new research suggests, actually inhibits corporate tax aggressiveness of the kind brought to light in the Google case.

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Under new European Union rules slated to take effect later this year, and likely to be monitored closely by regulators across the Atlantic, auditors of corporate financial statements will be prohibited from providing a variety of tax-related services to their clients, including preparation of company tax returns.

But, according to research published in the current issue of the American Accounting Association journal The Accounting Review, tax returns prepared by companies’ external auditors claim roughly 30% less in questionable tax benefits than do those prepared by other outside accountants or by the firms’ own tax officers.

Why is this the case? The study, based on data from S&P 1,500 companies, offers a rationale: “With the joint provision of audit and tax services, auditor preparers bear greater costs, relative to other preparer parties, if a position is overturned due to a tax audit and court action.”

The study notes that auditors bear at least two types of risk that do not apply to other preparer types: (1) the risk of a financial reporting restatement due to an audit failure; and (2) reputation risk, in that an auditor’s work is more visible and sensitive to the firm’s leadership.

In short, having more to lose than other preparers, auditors tend to be less aggressive in advancing tax-benefit claims.

“Ever since the turn-of-the-century accounting scandals involving Enron, WorldCom, and others, regulators have consistently expressed concern over companies’ purchasing both audit and tax services from the same accounting firm,” says Petro Lisowsky, a University of Illinois at Urbana-Champaign professor and a co-author of the study along with Kenneth Klassen of the University of Waterloo and Devan Mescall of the University of Saskatchewan.

Lisowsky notes that the vast majority of research on this issue has focused on whether this arrangement reduces audit independence and thereby compromises corporate financial reporting. But relatively little attention has been paid to the question of how this arrangement affects tax reporting.

“Given regulators’ perennial distrust of auditors providing tax services to their clients, our study will probably come as a surprise,” Lisowsky says. “It finds that company taxes prepared by the external auditor tend to shun questionable tax breaks — so-called unrecognized tax benefits — considerably more than those prepared by another accountant or by a firm’s tax department.”

The research takes advantage of unique access to confidential Internal Revenue Service data on who signed corporate tax returns, information made available to Lisowsky on the condition that corporate anonymity be preserved.

The authors analyzed the relationship of tax-preparer identity to three variables: (1) the amount of reserve companies set aside each year (as footnoted in their financial statements) for unrecognized tax benefits — that is, claims that are uncertain but are deemed more likely than not to pass muster with the IRS or in court; (2) data from annual financial statements; and (3) auditor identity and fees, including tax fees.

About 55% of the companies in the sample (which consisted of more than 700 firms followed for two years, for a total of 1,533 firm-years) submitted tax forms signed by a company officer, while about 20% were signed by the firm’s external auditor and the remaining 25% by another accountant.

After controlling for size, profitability, and other factors, the authors estimate that companies whose taxes were prepared by their auditors claimed about 34% less in aggressive tax benefits than those that relied on another accountant, and about 28% less than those who prepared them internally.

While the study’s main thrust was to explore tax aggressiveness, the professors see their findings as relevant to overall corporate financial integrity, which regulators tend to see as compromised when auditors provide tax services.

As Lisowsky puts it, “Given the importance of taxes in company finance, [this study] should enhance the reliability of companies’ financial reporting. In this sense, the study should be of value to investors as well as to corporate managers, directors, and tax and finance regulators.”

The new study, entitled “The Role of Auditors, Non-Auditors, and Internal Tax Departments in Corporate Tax Aggressiveness,” is in the January/February issue of The Accounting Review, published every two months by the American Accounting Association.

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