The likelihood of being audited by the Internal Revenue Service has its strongest impact on laxly governed companies and fosters corporate truthfulness not just in confidential tax returns, but in public financial reports, according to new research.

The study, which appears in the September/October issue of the American Accounting Association’s journal Accounting Review, found that a lesser degree of auditing will translate into significantly less corporate taxes paid to the federal government.

Less auditing by the IRS is probably not only bad for federal tax coffers but for shareholders as well, according to the study. The paper’s findings, along with those of a related, unpublished study, reveal that the likelihood of being audited has its strongest effect on companies whose governance is lacking.

“The idea that shareholders benefit from having their companies audited by the IRS may seem strange to some investors,” said Jeffrey Hoopes of the University of Michigan, who co-authored both studies. “Our research, however, suggests that strict tax enforcement promotes good financial reporting and tends to check managers' proclivities to divert corporate resources for their personal use under the guise of saving taxes.”

As examples of corporate tax-saving efforts that harmed shareholders, Hoopes cites the case of Tyco, where tax management strategies based on relocating profits to low-tax countries permitted massive diversion of funds by top executives for their own personal use, and the more mundane case of Xerox, which had to restate several years’ (and billions of dollars’) worth of financials partly as a result of its pursuit of tax savings abroad.

Hoopes co-authored the Accounting Review paper, “Do IRS Audits Deter Corporate Tax Avoidance?” with Devan Mescall of the University of Saskatchewan and Jeffrey A. Pittman of Memorial University of Newfoundland and the still unpublished paper, “The Effect of Tax Authority Monitoring and Enforcement on Financial Reporting Quality,” with Michelle Hanlon and Nemit Shroff of the Massachusetts Institute of Technology.

The Accounting Review study, in which data from about 5,000 companies over 17 years were analyzed, found that companies’ effective tax rates increase an average of about two percentage points when the probability of being audited doubles. The researchers assessed the probability of IRS auditing from year to year through data from the Transactional Records Clearinghouse, a nonpartisan watchdog affiliated with Syracuse University that publicly releases statistics on the performance of federal agencies according to the government's own data. Quality of corporate governance was gauged by such measures as the number of companies' anti-takeover provisions and amount of share ownership by institutional investors.

While acknowledging that it is no surprise that tax payments rise with the increased probability of IRS audits, the researchers contend that this was anything but obvious in advance. As the study puts it, “There [were] several reasons to suspect that corporate tax avoidance is insensitive to IRS oversight,” one of which was that well-funded corporate tax departments might simply be able to outmaneuver the IRS, which is often described as being outgunned by sophisticated corporate taxpayers. Then there was the possibility that, in the study’s words, “firms may behave like wealthy individuals by increasing tax avoidance when IRS monitoring is stricter.”

While finding that, in fact, companies respond to the likelihood of IRS auditing much as less-than-wealthy people do, the paper’s authors stopped short of advocating stricter enforcement than there currently are, while noting a “clearly decreasing trend in audit coverage” over the 1992-2008 time span covered by the research. In the words of the study, its policy implications “require careful interpretation...Since tax enforcement consumes real resources and produces nothing—rather, it merely transfers private wealth to the state—the optimal enforcement policy often entails less enforcement than would be implied by maximizing tax revenue. Moreover, simply increasing the number of audits performed by the IRS may not constitute optimal tax policy given that less costly methods of inducing taxpayer compliance may be available, such as promoting cooperation between taxpayers and the IRS, requiring more corporate tax disclosure, and raising the penalty for committing tax evasion.”

As evidence that the IRS is getting smarter about corporate compliance, Hoopes cites the agency's Compliance Assurance Process, which he describes as “a relatively new and, by many accounts, popular program in which corporate taxpayers work with the IRS throughout the year on complicated and unclear tax issues, so that, when the return is filed, both the IRS and the corporation basically agree that it is accurate. This can avoid the need for a protracted audit and appeals process, such as the one I recently learned about from a corporate tax attorney whose company just concluded litigation with the IRS about an issue from the 1970s.”

Hoopes concluded, “The biggest group of companies in our sample, those with assets of $250 million or more, had a 27 percent probability of being audited in 2008, the last year covered by our data. If the likelihood had been 34 percent, as it was six years earlier, the Treasury would have collected an extra $7.1 billion in 2008. At a time of federal budgets in the trillions, that wouldn't have a major impact on the nation's fiscal situation, but it's certainly something worth considering as Congress mulls tax reform and the level of funding for the IRS. This is particularly true in view of the strong association our research finds between the likelihood of firms' being audited by the IRS and the quality of their public financial reporting.”