Study Shows No Better Reporting After Auditors Cut Tax Services

U.S. auditor independence rules targeted at tax work have done nothing to improve financial reporting quality, according to new academic research out of Singapore.

Clive Lennox of Nanyang Technological University studied filings from 2002 through 2009 to see the effect before implementation, during transition, and after adoption of auditor independence rules written by the Public Company Accounting Oversight Board. Rules 3521, 3522, and 3523 bar audit firms from providing services on a contingent-fee basis, from providing aggressive tax planning services that are not likely to hold up under tax examination, and from providing tax services to individuals who have roles in financial reporting with audit clients.

The study found a big shift in non-audit services provided by audit firms, leading to a significant drop in auditor-provided tax services, especially among firms that had been accused of selling aggressive tax schemes meant to avoid taxation. Lennox says companies with the biggest drops in auditor-provided tax services were more likely to misstate their tax accounts before the rules were introduced. And comparing those companies with others that had less entanglement of audit and tax services to unravel, they showed no improvement in their likelihood of misstatements in tax accounts after the rules took effect either.

“Companies that significantly reduced their auditor-provided tax services purchases do not exhibit a subsequent improvement in financial reporting quality,” Lennox wrote. “To the contrary, these companies have relatively poor reporting quality for their tax accounts in the periods before, during, and after the introduction of the PCAOB restrictions.”

The PCAOB and the Securities and Exchange Commission continue to remind auditors to pay attention to conflicts of interest that compromise their independence. The PCAOB’s auditor independence rules focused on tax services took effect in 2006 to establish a general obligation on auditors that they remain independent of the companies they audit throughout the engagement period.

The PCAOB saw the provision of certain tax services to audit clients or to individuals involved in the financial reporting process as compromising that independence. The Lennox study says the rules met resistance by some who argued they might make financial reporting worse by decreasing the sharing of information across audit and tax staff.