As the onset of the new tax accounting reporting standard approaches, external stakeholders are anticipating getting new insights into corporations’ tax planning activities. However, what all external stakeholders may not be aware of is that there is another new rich source of information that may provide fruitful insights. In this article, I discuss recent academic research that sheds light on the informativeness and usefulness of the expanded audit report when tax matters are being discussed.
The New Expanded Audit Report
In 2019, the PCAOB introduced requirements that external auditors must provide an expanded audit report. In this report, the auditor must report critical audit matters, the auditor’s tenure, and other relevant information, according to the Harvard Law School Forum on Corporate Governance. The goal of these new requirements was to move beyond the traditional pass/fail and boilerplate style of audit report and transition into a scenario where auditors can provide more value by shedding additional light on their clients.
Notably, the critical audit matters (or key audit matters, as referred to in the international community) that auditors disclose offer additional insights into the key risks that their clients face. For example, like Apple’s 2019 Annual Report, their auditor, Ernst & Young, disclosed an entire paragraph about the uncertainty Apple is facing over a 12.9 billion euro multinational tax dispute.
However, what many US investors and external stakeholders may not realize is that many members of the international business community have already been providing an expanded audit report. Starting in 2016, those countries under the guidance and regulation of the IAASB began providing very similar expanded audit reports. As data has been available longer for non-US companies, researchers have turned to these observations outside of the US to help shed light on the impacts of the expanded audit report.
A Look At Tax Key Audit Matters
Recent research in the Review of Accounting Studies explores the impacts of the expanded audit report. In a study titled “The consequences of expanded audit reporting: implications of tax key audit matters for tax attribute valuation and auditor-provided tax services,” researchers examined key audit matters of a sample of 3,063 firm-year observations from 601 unique firms from the London Stock Exchange premium segment over the 2013 to 2019 time period. This article is co-authored by Dan Lynch of the University of Wisconsin–Madison, Aaron Mandell of the University of Wisconsin–Milwaukee, and Linette Rousseau of the University of Houston. Their study aims to investigate whether key audit matters affect investor or auditor outcomes.
In discussing the key motivation for examining their research question, Lynch states, “Regulators introduced expanded audit reporting to increase the usefulness of the audit report to investors by requiring the auditor to discuss the most challenging issues. However, Prior research generally finds that key audit matters do not influence investor perceptions of audited companies.” Lynch continues to state, “We believed that examining tax key audit matters, a specific sub-topic related to material financial statement amounts that is important to regulators and investors and where auditors are permitted to provide certain non-audit services might yield more nuanced insights. Specifically, if investors perceive tax key audit matters negatively, then we believe managers would have an incentive to avoid having the auditor disclose these key audit matters and one way to do so would be by purchasing more tax services from their auditor.”
The study finds, in fact, that tax key audit matters influence investor and audit outcomes. Mandell specifically highlights, “We find that tax key audit matters attenuate the positive valuation investors place on the tax avoidance and deferred tax assets of firms. In most cases, investors no longer place a positive valuation on these tax attributes.” Thus, these findings have significant implications for the capital markets.
Perhaps, even more striking were the second set of analyses related to auditor-provided tax services. “The biggest surprise was probably that firms increase their purchases of tax services from auditors to avoid tax key audit matters, which potentially represents a threat to auditor independence,” states Rousseau. She continues, “We find that firms that receive a tax key audit matter reduce tax services purchased from their auditor by about 32% or $63,000. We find that firms that stop receiving tax key audit matters increase the purchase of tax services from their auditor in the year following this resolution by 104% or about $208,000.” Consequently, there is evidence that clients recognize the value of not having a tax key audit matter, and this notion is seen as a transactional opportunity to work with their external auditor.
Lynch concludes, “It would be interesting to see if these results generalize to the U.S. expanded audit report setting and to other common critical/key audit matters topics.” Thus, even though this research examined an international setting, it is possible that the results may also apply to the US setting. Importantly, as US firms prepare to provide more tax insights through their new tax disclosure requirements under Accounting Standards Update 2023-09, it is essential to remember that numerous other sources may provide fruitful and valuable information, such as the expanded auditor report.