Although many corporations use their audit firm to perform tax services, the practice runs counter to regulators’ professed preference for maintaining auditor independence. New research, however, shows that investors welcome the practice “because insight learned from providing tax services can enhance audit effectiveness and, in turn, the client’s financial reporting quality.”
On average, investors feel that the benefits of auditor-provided tax services outweigh the risks that the audit will not be performed independently enough, according to a study published in the spring edition of the American Accounting Association’s Journal of the American Taxation Association called “Do Auditor-Provided Tax Services Enhance or Impair the Value Relevance of Earnings?”
Authors Gopal V. Krishnan, a professor at American University; Gnanakumar Visvanathan, an associate professor at George Mason University; and Wei Yu, an assistant professor at the University of Tennessee looked at how the interaction between two variables – earnings per share and a measure of tax fees compared to total fees paid to the auditor— affected the stock prices of U.S. publicly traded companies between 2000 and 2008.
After 28,000 observations of company audits (some companies were observed a number of times in a year), the authors noted that the higher the ratio of tax fees to total fees paid to the auditor, the more pronounced the effect of earnings on a company’s stock price. Further, the authors found that when a number of firms switched their tax-services business away from their auditors, the effect of earnings on stock price was lower “in the year of the switch.”
Typically, companies benefit from discounted auditor fees by having the same auditor as their tax provider. They also get a boost in “overall audit effectiveness via better communication between the audit and tax sides,” according to the report. Investors seem to like that.
“For firms currently using their auditor for tax services, our findings indicate that investors are supportive of their decision,” Krishnan told CFO. For two-thirds of the sample, auditors also provided tax services; for a third, auditors did not.
But some companies separate the two functions even if there is a higher price for the services. Such companies make the separation to add credibility to their auditor services, notes Krishnan.
The study found that investors in companies that get tax services from their auditor do not benefit when a company splits up the tasks, however. When the auditor function was decoupled from the tax- service function in companies, the authors found, investors did not view that as a positive. “This finding is consistent with the potential loss of knowledge spillover when tax services are provided by someone other than the auditor,” noted the report.
Other research on this topic also shows evidence that more company knowledge is shared between the tax and audit functions when one firm is used rather than more than one. The spillover of knowledge that an auditor can receive from a tax professional working on the same company, according to Krishnan, is an important advantage to companies and auditors alike. “By doing the books and tax return, I see the whole picture,” he explains, speaking of the auditor.
Besides cutting audit and tax costs for the company, the practice also helps out the auditor’s bottom line, Krishnan told CFO. The tax function “is a recurring service. Tax returns have to be done every year. It creates a recurring source of revenue for the auditor,” he says.
Krishnan’s study raises important questions for CFOs, audit committees and regulators about what the benefits and risks that further restrictions or outright banning of auditor-provided tax services can bring to companies and their shareholders. As he puts it, more limitations “might have unintended consequences.”
CFOs and other corporate executives are allowed under Sarbanes-Oxley regulations to hire the same audit firm to perform both audit and tax services. Such allowable functions, however, must be approved by the company’s audit committee.
Regulators like the Public Company Accounting Oversight Board (PCAOB) have created some limitations for the practice over the years. Auditor-provided tax services are barred, for example, when confidential tax transactions are deployed by a company merely to avoid taxes; when an audit firm acting in a financial oversight role provides tax services; and when an audit firm provides tax services for which it receives a commission or contingent fee based upon a particular finding in their tax evaluation.
The European Union, in contrast, has openly cited disfavor of auditor-provided tax services and may ban the practice.