Auditors Who Prepare Tax Returns Tend to Be More Cautious

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Terry Sheridan
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Company tax returns done by outside auditors claim almost a third fewer questionable benefits than those prepared by outside accountants or company in-house tax preparers.

That’s the key finding of a new study, The Role of Auditors, Non-Auditors, and Internal Tax Departments in Corporate Tax Aggressiveness, published in the January/February issue of the American Accounting Association journal, The Accounting Review.

Why would external auditors be more cautious? Because they’ve got more to lose. By providing audit and tax services, they face greater costs compared to other preparers if an audit or court action overturns a position, the study states.

“Given regulators’ perennial distrust of auditors providing tax services to their clients, our study will probably come as a surprise, since 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,” study co-author Petro Lisowsky, associate professor of accountancy at the University of Illinois at Urbana-Champaign, said in a prepared statement.

Other preparers don’t face the risk of a restatement after an audit failure, nor the risk to their reputation, according to the study. The auditor-preparer’s work is more visible and sensitive to the board and C-suite.

“For example, if 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 [so that] the board of directors, as well as managers, may bear additional costs if negative tax outcomes result from joint provisioning relative to the case if the tax work was conducted separately from the audit,” the study states.

Lisowsky, along with taxation professor Kenneth Klassen of the University of Waterloo in Ontario and assistant professor Devan Mescall of the Edwards School of Business at the University of Saskatchewan, based their research on confidential IRS data about who signed corporate tax returns. The information was made available to Lisowsky on the condition that the corporations were not identified in the paper or in any talks.

Research involved analyzing the relationship of who the tax preparers were (i.e., the company auditor, an external nonauditor, or a corporate tax officer) to the amount of reserves set aside annually for unrecognized tax benefits (uncertain claims that likely would be accepted by the IRS or in court), annual financial statements, and auditor identity and fees, including tax fees.

The findings:

  • Companies whose taxes were prepared by their auditors claimed about 34 percent less in aggressive tax benefits than those that relied on another accountant and about 28 percent less than those who prepared them internally.
  • Firms preparing their own tax returns or hiring a nonauditor claim more aggressive tax positions than firms using their auditor as the tax preparer.
  • Tax services provided by the auditor are related to tax aggressiveness even after considering the identity of the preparer, which supports prior research using tax fees as a proxy for tax planning.
  • Big Four tax preparers were particularly linked to less aggressiveness when they are the auditor than when they aren’t.

“Our findings help policymakers and researchers better understand an important feature of tax-compliance intermediaries; particularly, how the dual role via audits is related to observable corporate tax outcomes,” the study states.

The findings should enhance the reliability of company financial reports, Lisowsky said.

“In this sense, the study should be of value to investors, as well as to corporate managers and directors, and tax and finance regulators,” he said.

Interestingly, European Union rules that take effect later this year will prohibit auditors of corporate financial statements from a variety of tax-related services to their clients. That includes preparing tax returns.

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