How Do Auditors Respond to Corporate Tax Enforcement?

I examine whether financial statement auditors respond to corporate tax enforcement by changing their audit fees. I argue that tax enforcement affects audit fees in two non-mutually exclusive ways. First, tax enforcement could decrease audit fees due to spill over effects from the tax inspector’s monitoring activities on audit risk (spill over effect mechanism). Second, tax enforcement could increase audit fees due to an increased probability that the tax inspector reports a managerial action that implies bad monitoring of the auditor (penalty risk mechanism). To explore which of these effects dominates, I develop a new measure that proxies for IRS district specific tax enforcement, by exploiting variation in effective tax rates across IRS districts. I find that audit fees are negatively associated with tax enforcement, which is consistent with the hypothesis that corporate tax enforcement generates spill over effects on audit risk. In additional analyses, I examine cross-sectional variation in the expected strength of both mechanisms. I find that the empirical effect becomes 1) more negative if tax compliance is high, 2) less negative when the overlap of the monitoring activities between the tax inspector and the auditor decreases, and 3) more positive when auditors become more concerned about their reputation.

This seminar is organised by the Erasmus Accounting Research Group.