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Should Your Auditor do Your Taxes?

06.27.16

It’s not unusual for public companies to have the same firm perform their external audits and prepare their tax returns. But does this practice raise auditor independence issues?

Some believe that performing certain tax services for an audit client creates conflicts of interest that may impair auditor independence. The European Union, under rules that will take effect later this year, will soon prohibit public interest entity auditors from preparing their clients’ tax returns and providing a variety of other tax services. On the other hand, two recent studies show that companies whose auditors prepare their tax returns tend to take less aggressive tax positions and that many investors actually prefer that a company’s auditor do its taxes.

What’s permitted?

The Sarbanes-Oxley Act of 2002 enumerated certain prohibited services and relationships that are deemed to impair an auditor’s independence, including bookkeeping, financial information systems design and implementation, appraisal and valuation services, actuarial services and internal audit services. Notably absent from the list are tax services.

As a general rule, auditor-provided tax services don’t raise independence issues, so long as the company’s audit committee approves the arrangement. But that doesn’t mean the arrangements are always permissible. Even though tax services aren’t prohibited, they may violate SEC auditor independence rules if they create a conflict of interest — for example, if an auditor developed tax strategy results in sanctions against the company or some other legal liability. Under SEC rules, auditor independence may also be impaired if the auditor is placed in the position of auditing his or her own work or serving as an audit client’s advocate.

Also, the Public Company Accounting Oversight Board (PCAOB) prohibits auditors from providing tax services under certain circumstances. For example, tax services aren’t permitted if the auditor receives a commission or contingent fee for such services, advises the company regarding certain confidential or “aggressive” tax transactions, or provides tax services to someone in a financial oversight role with the company.

What are the benefits?

Despite these potential issues, there may be advantages to having your auditor do your taxes. According to a study published in the Spring 2013 issue of The Journal of the American Taxation Association, investors believe that the benefits of auditor-provided tax services — including enhanced financial reporting quality as a result of “knowledge spillover” — outweigh potential threats to auditor independence.

Another notable finding is that auditor-prepared tax returns tend to contain fewer aggressive tax positions. According to a study published in the January 2016 issue of The Accounting Review, corporate tax returns prepared by a company’s external auditors claim approximately 30% fewer questionable tax benefits than returns prepared in-house or by nonauditors.

The authors believe that the reason for this phenomenon is that auditors are exposed to certain risks — including financial reporting restatement risk and reputation risk — that are less of a concern for other types of tax preparers. As a result, auditors tend to avoid questionable tax positions.

Review your arrangements

Auditors in the United States aren’t strictly banned from providing tax services to audit clients, and having the same firm provide both audit and tax services offers certain advantages. But it’s critical for audit committees to review these arrangements carefully to assess their potential impact on auditor independence and ensure compliance with SEC and PCAOB rules.