Accounting firms that prepare the taxes of companies they also audit tend to steer away from dubious tax deductions, according to a new study.

The study found that tax returns prepared by companies' external auditors claim roughly 30 percent less in questionable tax benefits than do those prepared by other outside accountants or by the firms' own tax officers. The study, written by Petro Lisowsky of the University of Illinois at Urbana-Champaign, Kenneth J. Klassen of the University of Waterloo and Devan Mescall of the University of Saskatchewan, appears in the January/February issue of the American Accounting Association journal The Accounting Review.

The researchers examined data from companies in the S&P 1500, noting, "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’s authors wrote, "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."

Having more to lose than other preparers, auditors tend to be less aggressive in advancing tax-benefit claims, according to the researchers.

"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,” said Lisowsky. “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 researchers received access to confidential Internal Revenue Service data on who signed corporate tax returns. The information was 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.

Approximately 55 percent of the companies in the sample (which consisted of more than 700 companies followed for two years, for a total of 1,533 company years) submitted tax forms signed by a company officer, while about 20 percent were signed by the company’s external auditor and the remaining 25 percent 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 percent less in aggressive tax benefits than those that relied on another accountant and about 28 percent less than those who prepared them internally.

The professors wondered whether it was possible 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, they checked on further measures of tax aggressiveness, including whether companies 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.

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