Joint tax and audit services push up eps

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US investors have more faith in the audit when the external auditor has provided tax as well as audit services to the client

This surprising finding was thrown up by academic research published in the latest edition of the influential American Accounting Association journal.

According to professors Gopal Krishnan of American University, Gnanakumar Visvanathan of George Mason University and Wei Yu of the University of Tennessee, “Investors perceive the benefits of auditor-provided tax services (ie enhanced financial reporting quality due to knowledge spill over) to be greater than the cost (ie the likely threat to auditor independence associated with auditor-provided tax services)”.

“Everyone agrees that there are potential hazards and benefits to combining tax services with auditing; the question is which are greater?” Krishnan says. “The principal risk is that auditors who perform tax services will get too close to the client and lose a critical measure of independence and objectivity that the public has a right to demand.

“Certainly we've seen some flagrant examples of this. But doing tax services also provides lessons about a company, that we call knowledge spill over, which can enhance audit quality. What our study reveals is that investors, on the whole, consider the spill over benefit to outweigh the independence risk.”

He explained that the auditor’s knowledge of an audit client’s aggressive tax reporting could shed light on management’s mind set and point auditors in the right direction when devising ways of detecting and constraining earnings manipulation.

“For example, substantial differences in what a company reports on public financial statements and what it reports to the Internal Revenue Service in its tax returns can be a red flag to the auditor, signalling fraud or overly aggressive reporting.”

Spill over also means that potential financial reporting problems are picked up on a timely basis.

The three professors analysed thousands of US public companies between 2000-2008 which yielded around 28,000 years’ of data. In approximately two thirds of the cases, a single firm provided both tax and audit services.

They looked at how the interaction between the ratio of tax fees to total fees paid to the auditor and earnings per share affected the company share price. They discovered that, in general, the higher the ratio of tax fees to total fees, the more pronounced the effect of earnings on share price.

In other words, earnings results had more credibility when auditors provided both tax and audit services than when they didn’t, so much so in fact that 16% was added to the value of share prices, with the valuation increasing the higher the level of tax services provided.

Julia Irvine

 

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