Thinking of Replacing Your Auditor’s Tax Services? Get Ready for a Higher Tax Bill
Updated: Aug 14, 2020
One of the concerns that lead to the Sarbanes-Oxley Act (SOX) was that the auditor’s provision of non-audit services to audit clients impairs independence. Nonetheless, SOX does not preclude auditors from providing tax planning and compliance services to audit clients. However, disclosure in a company’s proxy statement of the payment of significant non-audit fees to the auditor can be a red flag. Accordingly, audit committees sometimes retain a firm other than the financial statement auditor for tax services to minimize non-audit fees and promote the appearance of auditor independence.
A recent academic research paper looks at the tax liability impact of replacing the financial statement auditor with another tax services provider. In The Cost of Independence: Evidence from Companies’ Decisions to Dismiss Audit Firms as Tax-Service Providers in the June/August issue of Accounting Horizons (available here for purchase), Kirsten A. Cook (Texas Tech University), Kevin Kim (University of Memphis), and Thomas C. Omer (University of Nebraska-Lincoln) find that companies’ effective tax rates “increased by an economically significant 1.36 percentage points in the year after terminating or substantially decreasing purchases of tax services from their audit firms.” Cash tax payments increased by 1.63 percent, and the average additional first-year tax payment for the 419 companies in the study that changed tax service providers was $7.6 million. The authors conclude: “These tax-avoidance results suggest that companies dismissing or substantially reducing reliance on their audit firms as tax-service providers during our sample period incurred substantial costs to avoid the perception of impaired auditor independence.”
This finding is, as the authors point out, subject to some important qualifications.
The increase in taxes resulting from replacing the auditor as tax advisor is not permanent. “[O]ur results also suggest that these costs are relatively short-lived, as the decrease in tax avoidance lasted only for one year.” The authors note that the “temporary worsening of tax-avoidance outcomes likely reflects new providers’ lack of experience with clients’ current tax planning.”
The tax expertise of the firms involved affects the impact of switching from the auditor to another advisor:
“If a company uses its audit firm as its tax service provider and that audit firm is a tax expert, the decision by this company to dismiss or substantially decrease reliance on this tax expert due to SOX-related independence concerns is all the more costly for that company in terms of the foregone tax avoidance. In contrast, if a company uses its audit firm as its tax-service provider and the audit firm is not a tax expert, the decision by this company to dismiss or substantially decrease reliance on this non-expert appears to be without cost because the new tax-service provider is a tax expert or at least equally skilled as the outgoing tax-service provider.”
Switching to another tax services provider only appears to increase tax expense when the switch is motivated by the audit committee’s desire to improve the perception of auditor independence. Changes that have other motivations – e.g., to obtain higher quality tax services – do not result in increased tax costs. The study reaches this conclusion by comparing changes in tax providers during the years immediately following passage of SOX (when the alleged independence impact of non-audit services was widely discussed) with changes made in later years by companies that initially stayed with their auditor as tax services provider in the wake of SOX.
Comment: One might ask whether the additional tax costs found by Cook, Kim, and Omer are justified by improvements in either the fact or appearance of auditor independence. That question is outside the scope of the study, although the authors note that the literature on the impact of non-audit services on auditor independence “presents mixed results” and that “[r]esearch concerning the associations between the joint provision of audit and tax services and financial- and tax-reporting outcomes is sparse.” In any event, the study suggests that audit committees should be slow to replace their auditor as tax advisor merely for appearance reasons.