Prior research finds that there is substantial variation in firms’ ability to avoid income taxes. One possible determinant of this tax avoidance variation is the influence of industry expertise of a firm’s external auditor.
In other words, the tax-specific expertise of the external auditing company a firm hires potentially makes a big difference in companies’ level of tax avoidance, and ultimately, net income.
Mays Business School faculty members and researchers Sean McGuire (an assistant professor in accounting), Thomas Omer (Ernst & Young Professor of Accounting) and Dechun Wang (assistant professor in accounting) set out to investigate the relationship between firms’ level of tax avoidance and the proficiencies of the external auditing companies those firms were hiring.
“We started this project because we were interested in the influence of the external audit firm on their clients’ tax avoidance activities,” says McGuire. “Many corporations hire their external audit firm to provide tax services in addition to their audit services. Accordingly, our goal was to investigate whether the tax expertise of audit firms that provide tax services to their client influences their clients’ level of tax avoidance.”
McGuire defines tax avoidance as “any strategy that reduces a firm’s tax liability, used by companies to generate cash savings and increase after tax earnings by reducing their tax expense.”
“Consistent with other academic research,” he explains, “we view tax avoidance as a continuum that ranges from clearly legal strategies, like investments in municipal bonds, to those of questionable legality, like tax shelters.”
The research relied on previous audit studies that define expertise in terms of industry and audit office fees. Two types of industry expertise were identified to measure the level of expertise in firms: overall expertise and tax expertise.
Both overall and tax expertise are designed to capture an audit firm’s tax expertise within a particular industry and city office. However, overall expertise includes audit expertise, rather than solely the firm’s level of tax proficiency.
To gather the information, McGuire says the researchers estimated companies’ tax-specific industry expertise based on an audit firm’s market share in a given industry and city. “We calculated market share using publicly available data from Audit Analytics,” McGuire shares.
The results of the research found that firms who hire industry experts exhibit higher levels of tax avoidance relative to firms that do not hire industry experts.
McGuire expounds upon the research results, saying, “I think the most interesting finding is that the clients of audit firms that have overall expertise, i.e. combined audit and tax expertise, exhibit high levels of tax avoidance. This finding suggests that the combined tax and financial reporting expertise of audit firms allows them to develop tax strategies that benefit their clients from both a tax and financial statement perspective.”
The research results provide a number of significant contributions to tax avoidance literature. Not only do the findings contribute to the stream of research investigating the variation in firms’ tax avoidance activities, but they also provide evidence on the association between the industry expertise of the firm’s external auditor and the firm’s tax activities.
According to McGuire, prior research documents substantial variation in firms’ level of tax avoidance. “Given that there are obvious benefits to avoiding income taxes (higher net income), it is important to understand why some firms are more successful than others in avoiding income taxes,” he says. “It is also interesting to examine whether the industry expertise developed by audit firms (in terms of tax-specific expertise and auditing expertise) influences the tax avoidance of their clients.”