The Changing Role of Auditors in Corporate Tax Planning
by Edward L. Maydew and Douglas A. Shackelford

The headline is familiar: “XYZ Corporation confirmed that it is under investigation by the SEC for alleged accounting irregularities.” After the Enron and WorldCom scandals, numerous companies have seen themselves the focus of such inquiries, and no industry seems immune from accounting problems. Once considered the hum-drum province of bean counters, accounting now provides a steady-stream of controversy. Never before have accountants been subject to so much attention, scrutiny and, ironically, demand for their services.

Much attention has focused on accountants’ capacity as outside auditors. Congress responded to the scandals with the Sarbanes-Oxley Act of 2002, which, among other things, created the Public Company Accounting Oversight Board (PCAOB) to supervise accounting firms. The PCAOB is the auditor of the auditors. What is less well-known is that the accounting scandals and responses to them are making profound changes to the relationship between auditing and corporate tax planning.

Before these events occurred, most companies obtained outside tax services from the same firms that conducted their audits. Good reasons for this practice included operational and cross-selling synergies between the audit and tax practices of accounting firms. We estimate that as recently as 2001, the average S&P 500 firm paid as much to its outside audit firm for tax advice as it did for the audit, and by 2004, the average S&P 500 firm paid its auditor nearly four times as much for the audit as for tax services. Two factors account for this shift:

1. Audits fees have increased dramatically in the past several years as audits have become more intensive.
   
2. Regulatory and market pressures caused many companies to change their practice of obtaining tax services from the same firm doing their audits to obtaining their tax services from any firm other than the one doing their audits.

Yet there is no evidence of a general decline in spending for tax services. Total revenue of the tax practices of the largest accounting firms has held steady. Rather, evidence indicates a decoupling of the longstanding link between audit and tax services, with firms shifting their tax services purchases away from their auditor and toward other providers.

These changes will have major consequences for corporate tax planning. While the future is hazy, we hazard a few predictions.

1. Although high audit fees provide a short-term incentive for tax partners to stay in auditing firms, if trends continue we anticipate long-run instability and the eventual sale or spin off of significant portions of the Big Four tax practices. At the very least some non-trivial amount of tax work could migrate to non-audit firms (law and consulting firms, investment and commercial banks).
   
2. Decoupling tax and audit services means that the auditor reviewing the tax expense number in the public financial statements is no longer judging tax strategies developed by his own firm. Consequently, auditors will be much more conservative about allowing tax benefits to be recorded in financial statements when there is uncertainty about the tax strategy’s ultimate success. (A proposed change to accounting standards will have a similar effect.)
   
3. Increasingly, auditors require detailed work papers to back up the tax numbers in financial statements. This documentation will be the IRS’s roadmap in subsequent audits and could significantly deter aggressive tax planning. Ultimately, auditors at public accounting firms could prove to be a more effective deterrent of aggressive corporate tax planning than the IRS.

The far-reaching effects of the scandals and the responses to them will, we suspect, play out for years to come.

This summarizes a study by UNC accounting professors Maydew and Shackelford that will appear in Taxing Income in the 21st Century. Contact Maydew at (919) 843-9356, or Shackelford at (919) 962-3197, .