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Though regulators frown on accounting firms doing taxes of companies they audit, study finds they shun tricky ploys

Returns signed by auditors claim 30% less in aggressive tax benefits

Corporate tax avoidance being a hot issue in the U.S. and Europe these days, it comes as no surprise that a recent 130-million-lb. settlement for taxes going back to 2005 between the British government and Google has proved highly contentious, with members of the political opposition denouncing it as "derisory" and a " sweetheart deal." 

Yet, even as corporate taxation has moved to the political front burner, European regulators are in the midst of banning an accounting arrangement which, new research suggests, inhibits corporate tax aggressiveness of the kind brought to light in the Google case.

Under EU rules to go into effect later this year, and likely being monitored closely by regulators across the Atlantic, auditors of corporate financial statements will be prohibited from providing a whole variety of tax-related services to their clients, including preparation of company tax returns. This occurs just as research published in the current issue of the American Accounting Association journal The Accounting Review suggests that 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? In the words of the study, based on data from firmsin the S&P 1500, "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."

As the paper goes on to explain. "There are at least two types of risk that are absent in other preparer types: (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.  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."

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

Comments Petro Lisowsky of the University of Illinois at Urbana-Champaign, a co-author of the study with Kenneth J. Klassen of the University of Waterloo and Devan Mescall of the University of Saskatchewan, "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. By a wide margin most 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. Specifically, how far do companies push the envelope of tax aggressiveness when it is their external auditor that signs the tax form?

"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."

The research takes advantage of unique access to confidential Internal Revenue Service data on who signed corporate tax returns, information made available to Prof. Lisowsky on the condition that corporate anonymity be preserved in the paper and in any discussion by the professor of the research. The authors analyzed the relationship of tax-preparer identity (whether the signer was the company auditor, another accountant, or an officer of the firm) 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.

Still, the professors asked, was it possible that the smaller amounts held in reserve by firms filing auditor-prepared returns were due not to less aggressiveness but simply to greater confidence on the part of auditor-preparers that the tax benefits they claimed would pass muster? To explore that possibility, the authors checked on further measures of tax aggressiveness, including whether firms reported the use of a tax shelters to the IRS or located subsidiaries in tax havens. In the words of the study, "the results support our interpretation that tax returns prepared by someone other than the company's auditor contain more aggressive tax positions."

While acknowledging that the main thrust of the study was to explore tax aggressiveness, the professors see their findings as relevant to overall corporate financial probity, which regulators tend to see as compromised when auditors provide tax services. As Prof. Lisowsky puts it, "Our findings suggest that auditor-prepared tax returns take less aggressive positions than those prepared by others, which, given the importance of taxes in company finance, should enhance the reliability of the company financial reporting. In this sense, the study should be of value to investors as well as to corporate managers and 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, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Auditing: A Journal of Practice and Theory, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, and The Journal of the American Taxation Association.