corporate tax compliance: the role of internal and external
TRANSCRIPT
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Corporate Tax Compliance: The Role of Internal and External Preparers
Kenneth Klassen University of Waterloo [email protected]
Petro Lisowsky University of Illinois at Urbana-Champaign [email protected]
Devan Mescall University of Saskatchewan [email protected]
April 5, 2012 Abstract: Using a survey of tax executives and proprietary data on who signs the corporate tax return, we investigate tax reporting strategies to understand how firms are managing this challenging task, and what effect tax preparers have on corporate tax positions. Specifically, we investigate whether tax preparer type—internal, external auditor, or external non-auditor—is related to tax aggressiveness. Using IRS data on who signs a firm’s tax return, we find that (1) firms using internal and external non-auditor preparers exhibit greater tax aggressiveness than external auditor preparers; and (2) publicly disclosed tax fees paid to a firm’s auditor do not provide information sufficient to replicate this result. In our survey, tax executives report that their firms outsource only 30% of their compliance and planning work, and seldom utilize their auditor exclusively for such work. Applying conventions in tax fee research to infer preparer type, we estimate that tax fees incorrectly classify between 20 and 62 percent of firms into tax preparer types that do not match those reported on a firm’s tax return. Our findings are important given that the paucity of archival research on tax preparers and the importance of tax advisors to the tax-related decisions made by companies in the U.S. economy. Keywords: paid preparer, auditor, FIN 48, tax reserve, tax aggressiveness ______________________________________________________________________________ We obtain confidential tax return data from the Internal Revenue Service (IRS) Large Business & International Division’s (LB&I); these data are not publicly available. Because tax return data are confidential and protected by data non-disclosure agreements under the Internal Revenue Code, all statistics are presented in the aggregate; no statistics with fewer than three observations are disclosed. Any opinions are those of the authors and do not necessarily reflect the views of the IRS. The authors thank William Ciconte, Julie Coffey, Howard Engle, Gary McGill, Sean McGuire, Pat O’Brien, Devin Williams, and workshop participants at the University of Waterloo and University of Florida for helpful comments. The authors thank Stephen Powers for excellent research assistance.
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1. Introduction
The current corporate tax environment is characterized by a high degree of uncertainty.
Uncertainty in the tax law can create opportunities for planning, but can also create challenges in
compliance. To evaluate the compliance responsibilities and implications surrounding business
transactions, companies employ internal tax specialists and/or hire external advisory firms. The
effect of the tax advisor in compliance decisions of corporations is very important, but has not
been subject to much archival empirical research due to the lack of available data. This paper
begins to overcome that shortcoming by using survey responses of 170 tax executives, as well as
large-sample proprietary data from the Internal Revenue Service (IRS) on who signs the
corporate tax return, to examine the effect of the tax service provider on the compliance of tax
positions claimed by corporations. In doing so, we also evaluate the ability of publicly disclosed
tax fees to correctly reveal the identity of the corporate tax return preparer.
An extensive literature has examined the relation between auditors providing tax services
and their effect on the audit process.1 There continues to be a debate over whether auditors
providing tax services impair independence, create knowledge spillover, or both. For example,
Davis, et al. (1993) find no evidence of a knowledge spillover, while 43% of CFOs surveyed by
Cripe and McAllister (2009) identify knowledge spillover as their primary reason for integrating
their choice of auditor and tax preparer. Despite this lack of resolution, a majority of studies in
the accounting literature continues to look at the decision to choose the auditor as the firm’s tax
service provider through the lens of the audit and auditor-related consequences. The literature
remains mostly silent on the role of a broader set of tax preparers—including internal tax
departments and non-auditors—and their effect on corporate tax-related decisions.
1 For example, see Davis et al. (1993); DeFond et al. (2002); Abbott et al. (2003); Kinney et al. (2004); Francis and Ke (2006); Pittman and Fortin (2008); Lim and Tan (2008); and Zamar et al. (2011).
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Examining the relation between tax preparers and corporate tax aggressiveness is
important for several reasons. First, overall tax service work is economically significant yet
vastly under-studied due to data limitations. Our sample firms alone pay over $815 million in
total to their auditors for tax work; surely the number is higher if one could observe the costs
related to internal or external non-auditor tax work. Second, the Internal Revenue Service has
long been interested in the effect of tax preparers on compliance. However, the focus has mostly
been on individual tax compliance (e.g., see Slemrod and Sorum 1984 and Slemrod 1989).
For example, Long and Caudhill (1987) and Christian, et al. (1993) archivally examine
the determinants of individuals’ choice in hiring a paid preparer, while Hite and McGill (1992)
experimentally examine whether individuals retain or dismiss their paid preparer if they disagree
with the preparer’s recommendation to report a tax position conservatively or aggressively. More
recently, Neuman et al. (2011) explore the not-for-profit sector where the identity of the
preparers is disclosed in publicly available tax returns.2 In testing the effect of paid preparer type
on donations (their measure of credibility), they find that external preparers are positively
associated with donations. They interpret this evidence to suggest that the public views self-
prepared returns as less credible. Although they infer that their results generalize to the for-profit
sector, direct evidence on the role of tax preparer type in a corporate setting remains elusive. Our
objective is to fill this void. In particular, our research questions ask whether tax preparer type is
associated with tax aggressiveness; and how accurately public data on tax fees paid to a firm’s
auditor capture the actual tax return preparer type.
To answer these questions, we use confidential data from the Internal Revenue Service
(IRS) on who signs the tax return for 1,533 firm years during 2008 and 2009. The tax return data
allow us to focus on whether the compliance activities of the firm are primarily administered by 2 In particular, IRS Form 990 is required for tax-exempt entities and is available for public examination.
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the internal tax department, the firm’s financial statement auditor, or an external non-auditor
preparer. Until now, researchers have only been able to observe the dichotomous choice of a
corporation using or not using its auditor for tax services (e.g., Lassila, et al. 2011); and even so,
it remains unclear whether the “tax services” pertain to tax compliance or planning.
To set the context for this analysis, we survey 170 tax executives from the Tax
Executives Institute (TEI) who disclose their use of external firms for compliance work. Our
survey reveals that 20% of the respondents do not use any external firm for compliance work,
16% use their auditors only, 52% use another type of consultant (either an accounting firm that is
not their auditor, or another type of provider), and 12% use both their auditor and other
providers. However, when external providers are used, on average they perform only 30% of the
corporation’s compliance work and 30% of its tax planning work; the remaining work stays in-
house. Finally, companies who do not outsource their tax compliance work, and to a somewhat
lesser extent those who use accounting firms that are not their auditor, are generally larger firms.
With this background, we employ the theoretical model of Phillips and Sansing (1998) to
form predictions around the relation between the type of tax preparer and the observed
aggressiveness of the company’s tax-related decisions. As described in Section 3, we predict that
internally-prepared tax returns are more aggressive than externally prepared returns, on average,
because theory suggests that companies who do not hire an external preparer tend to have a high
tolerance for reassessment and are willing to claim aggressive tax positions.3 Phillips and
Sansing (1998) also predict that, in equilibrium, companies’ aggressiveness will be increasing in
their preparer’s quality. Because Cripe and McAllister (2009) find that non-auditor preparers are
more costly than auditor preparers, then to make the decision rational, it is likely that for that
3 We acknowledge that the choice of preparer is likely endogenous and account for this possibility in our empirical tests.
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firm, hiring a non-auditor preparer yields higher quality advice, thus making the taxpayer more
likely to claim aggressive tax positions with the non-auditor than the auditor preparer when tax
law ambiguity is present.
Using FIN 48 tax reserves as our proxy for tax aggressiveness, and linking them to the
tax preparer identity from the tax returns, our empirical tests support these hypotheses. In
particular, we find that external auditor-prepared tax returns are the least aggressive compared to
returns prepared by internal tax departments or other external preparers. Including proxies for
both internally prepared returns and non-auditor prepared returns in our models, their
coefficients are similar, and both types of companies have tax returns that are more aggressive
than auditor-prepared tax returns. Furthermore, reflecting our survey results, we find that 55%
our sample firms prepare their tax returns in-house and they are large, 25% use non-auditor
preparers, and 20% use their auditors for tax preparation work. The distribution indicates that in-
house tax departments are well-resourced and able to claim aggressive tax positions.
In a final analysis, we examine how accurately tax preparer type can be inferred from
public data on tax fees paid to a firm’s auditor. We do so to assess whether the signal available to
investors and researchers in financial reports on tax services is useful to infer tax compliance
work. We find that more than 80% of our sample firms publicly disclose tax fees paid to their
auditor, but only 20% of tax returns are in fact prepared by the auditor. Using a variety of proxies
using tax fee data to infer preparer type, we attempt to replicate our main results based on actual
tax return preparer identities, but are unable to do so. We estimate that tax fees incorrectly
classify between 20 and 62 percent of firms into tax preparer types that do not match those
reported on firms’ tax returns. This finding suggests that tax fees have limited use in correctly
identifying the tax preparer, and thus the primary tax compliance advisor of the company.
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Given the paucity of archival research on tax preparers generally, our study makes a
significant contribution to understanding their important role in the U.S. tax system. Specifically,
our research is the first to document the identity of tax return preparers for a large sample of U.S.
companies, reports its links to tax aggressiveness, and evaluate how tax fees mostly do not
accurately capture tax compliance activity that is observed directly from the tax return.
The paper proceeds as follows. Section 2 describes our setting of tax preparers by
reporting results of our survey of tax executives at TEI. Sections 3 and 4 develop hypotheses
and describe the research design. Section 5 reports the results of tests using large-sample tax
return data. Section 6 explores the accuracy of public fee data in the context of testing our
research questions. Section 7 concludes.
2. Institutional Setting
2.1 SURVEY OF TAX EXECUTIVES ON TAX COMPLIANCE
To gain an understanding of the general use of external tax advisors in a corporate
compliance environment, we surveyed a sample of the Tax Executives Institute (TEI)
membership on this topic. The survey was conducted online between October and December,
2010, and members were contacted directly by TEI in two emails. Both the original email and
the second follow-up email were sent to tax executives at 2,700 multinational firms. We
received responses from 218 tax executives resulting in a response rate of 8.1%.4 The response
rate is comparable to previous surveys of senior executives, including the 8.8% response rate in
4 Of the respondents, 40% identified themselves as their firm’s Tax Director, 39% identified themselves as VP Tax or CTO, 19% as Tax Manager, and 2% as CFO.
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Graham and Harvey (2001) and 9% in Slemrod and Venkatesch (2004), although it is lower than
the exceptional 26.6% rate in Hanlon, et al. (2010).5
Pursuant to our agreement with TEI, participation in the survey was optional. Therefore,
we evaluate whether our inferences suffer from non-response bias. The survey was conducted
by sending out the request for participation by TEI leadership to its members, and followed up
by a second request 42 days later. This approach allows us to test for evidence of a non-response
bias on the overall survey using Wallace and Mellor’s (1988) method (see also, for example,
Graham and Harvey, 2001). Our results show no statistical difference in the characteristics of the
early versus late respondent firms in terms of size, industry, or geography, suggesting the effect
of any non-response bias is likely minimal.
We also compare our respondents to the overall population of TEI member firms. In
Table 1, we compare the size and industry of our sample to the 2005 survey that TEI required its
total membership to answer. Our sample of surveyed firms is generally comparable to slightly
larger in revenue, total assets, and tax budget. For example, we find 17% and 4% of our sample
are in the largest two revenue categories of $10-$50 billion and greater than $50 billion,
respectively, while the 2005 population had 11% and 2%, respectively. This may suggest our
responses come from larger firms than the overall TEI membership.
[Insert Table 1 about here]
The respondents to our survey and the TEI membership have a similar industry
composition with the exception of a higher concentration of manufacturing firms; i.e., 49%
compared to 36% in the 2005 survey, and 11% in industries not identified in the 2005 survey.
Although we could not identify any obvious bias stemming from this difference in industry 5 To allow the researchers to ask the questions of interest and to insure the responding members of TEI felt comfortable responding, it was agreed that all questions would be optional and members should feel free to skip any questions. As a result, the response rate varies across questions.
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composition or the somewhat larger respondents, we cannot rule out a bias of unknown severity
that may affect our inferences. Nevertheless, the survey data provide additional context against
which we can evaluate the different types of tax preparers used by U.S. corporations.
Summary statistics of survey questions are presented in Table 2. One question asked
respondents to identify who they use to provide assistance with tax compliance. Possible
responses include the company’s auditor, other accounting firms, and/or non-accounting firms
such as lawyers, consultants, etc. Respondents indicated that they use one, two, or all three of
these alternative providers. Of the seven possible combinations listed, the exclusive use of one
accounting firm other than the company’s auditor was the most common response at 41%.
Twenty percent do not outsource any compliance work. Interestingly, only 16% of the
respondents outsourced their compliance work exclusively to their auditor. Seventeen percent
indicate that they use more than one type of outside firm to perform compliance work.
[Insert Table 2 about here]
The next column of statistics summarizes the amount of compliance work that is
outsourced. Overall, only approximately 30% of compliance work is outsourced. However,
when only the company’s auditor or another accounting firm is used, approximately 40% of
compliance work is outsourced. On the other hand, only 22% of compliance work is outsourced
when only a non-accounting firm is used.
Using more than one type of provider does not dramatically increase the proportion of
work outsourced. Column 5 lists the percentage of planning work that is outsourced.
Comparison of columns 4 and 5 reveals that on average, the same proportion of work is
outsourced, 30%, but in almost all categories, the average amount of planning work outsourced
is smaller (for example, for auditor only, 40% of the compliance work is outsourced, but only
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31% of planning work is outsourced). The only group for which planning work is a higher
percentage is when only a non-accounting firm is used for compliance work. Overall, these
statistics suggest that much of the typical companies’ tax work is done in-house, and that if
anything, planning work is even more commonly done in house too. They provide some
validation that firms with internal tax departments are well-resourced, indicating an ability to
pursue advantageous tax positions.
The last two columns of Table 1 provide some summary statistics on respondent size in
terms of the number of internal tax personnel employed and total assets. On average, the firms
who do not outsource any compliance, i.e., “in-house,” are on average the largest in asset size,
while the group that does not use its auditors (both non-auditor accounting firms and non-
accounting firms) for compliance work has the largest internal tax personnel. Firms using only a
non-auditor accounting firm are, on average, large, and also have sizable tax departments. Those
firms that use only a non-accounting firm are the smallest, on average, but have a large number
of internal tax personnel, suggesting that firms generally use internal personnel, then supplement
with specialists (such as lawyers) as necessary. Those who use only their auditor are both small
in size and have the fewest internal tax personnel (though on a size-adjusted basis these firms
may also have sizable tax departments).
Overall, our analysis reveals that survey respondent-firms generally do not outsource the
majority of either their compliance or planning work. It also shows that while many firms
choose a single type of firm for compliance, there is a noteworthy percentage that uses more than
one type. Firms using only their auditor tend to be small while firms using only a non-audit
accounting firm or not outsourcing at all tend to be large in terms of asset size and tax personnel.
Other than those who do not outsource any compliance, other categories generally outsource a
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smaller proportion of their planning than the proportion of their compliance work. In the next
section, we describe tax return information on the party primarily responsible for the tax
compliance work of the corporation, which we later employ in our empirical tests.
2.2 SIGNATURE INFORMATION ON THE TAX RETURN
To our knowledge, there is no archival research on the importance of a specific type of
tax preparer in a corporate setting.6 Studies such as Christian, et al. (1993), Hite and McGill
(1992), and Long and Caudhill (1987) investigate various aspects of the decision by individual
taxpayers to use paid tax preparers, and Neuman, et al. (2011) examine tax preparer use in the
non-profit sector. Although some factors identified in the individual tax preparer literature, such
as time, cost, and complexity (Christian et al. 1993) may impact corporate decisions to seek
external tax advisors as well, the tax compliance environment for corporations is certainly
different from individuals and non-profits along other dimensions. For example, differences in
audit probabilities, penalty exposure, agency and reputational costs, litigation risk, resource
availability, and profit-motive, all create a unique environment in which corporations evaluate
and implement tax compliance activities.
The main challenge facing external parties interested in assessing corporate tax
compliance is observing its qualitative input. For example, one cannot observe the set of
transactions available to the corporation; design details of the transactions; or the labor, time, and
management talent required to implement the transactions. To overcome this shortcoming,
interested parties are forced to utilize noisy observable outputs to infer unobservable inputs. For
example, disclosures in securities documents of fees paid to corporate auditors for tax services
are sometimes used as proxies for tax planning activities (e.g., Cook, et al. 2008). However, it is
6 We discuss related theoretical research in Section 3.
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unclear whether tax fees (a) in fact represent compliance-related activities at all; (b) accurately
reflect the auditor’s relative role and importance in the context of all the corporation’s tax
compliance activities, and (c) appropriately describe how much the corporation also uses its
internal tax department or other external non-auditor parties to prepare and report the tax return
to the tax authorities. Unfortunately, these issues only become more opaque when tax fees paid
to auditors are not disclosed at all.
One avenue toward obtaining a clearer picture of a corporation’s tax compliance
activities is by observing the identity of the party that signs the tax return. Although this
information is not publicly available for corporations, it is for the first time made available to one
of the authors on a limited, confidential basis for purposes of this study. Importantly, by using
tax returns, the signature’s observability is not conditional on the corporation using its auditor for
tax services. Also, the tax return preparer’s identity provides a more direct signal of compliance
work in particular than do tax fees that aggregate all “tax services” into one value.7
Most notably, Internal Revenue Code (IRC) Section 6694 outlines penalties related to
external preparers signing tax returns containing unreasonable positions that result in an
understatement of tax liability.8 The related penalty regime for non-compliance requires the
preparer to pay the greater of $1,000 or half of the income derived (or expected to be derived)
with respect to preparing the tax return (§6694(a)(1)). Clearly this latter explicit penalty, coupled
with related litigation and indirect reputational costs (e.g., lost future business), can be
economically significant for large external paid preparers, such as those in our sample. 7 We thank a tax partner at a large accounting firm for extensive input on this subject. We also conduct various tests on whether tax fees are informative for tax compliance. We report those results in Section 6. 8 An unreasonable position is one that (a) the tax preparer knew or reasonably should have known of the position; (b) there was not a reasonable belief that the position would more likely than not be sustained on its merits; and (c) the position was not disclosed or there was no reasonable basis for the position (§6694 (a)(2)). Separately, the Statement on Standards for Tax Services No. 1, issued by the AICPA, provides strict guidelines on paid preparers for reporting and properly disclosing their clients’ tax positions to the tax authorities. Other penalties may include §6662 related to accuracy (i.e., under-reporting) and non-disclosure of tax positions.
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The effect of the penalty regime is that an external preparer will not sign the tax return
unless it is confident it has obtained enough information to properly defend the underlying tax
positions and advocate for the client in the event of a dispute with the tax authority. Therefore, if
the external advisor does not sign the tax return, it is either because it did not provide any tax
work at all, or it only provided limited, focused compliance work on a particular transaction
(e.g., calculated the foreign tax credit only). A narrow scope of work does not require the
external advisor to sign the tax return. In fact, the advisor will prefer not to sign the return in this
situation because it has not adequately evaluated the merits underlying the rest of the tax return
and thus does not want to incur additional risks by claiming material responsibility over that tax
return. If there is no other external party claiming responsibility over the tax return compliance
work, then the tax return is only signed by the corporation, typically the senior tax officer (e.g.,
the Tax Director or Vice President of Tax).
However, if the corporation would like the external party to sign the tax return, the §6694
penalty regime provides strong incentives for the external preparer to require a much larger
scope of work (and thus more fees) to gather adequate documentation and support underlying the
entire tax return. If an external party reasons that through the additional work, its compliance-
related requirements are met, it signs the tax return (in the “Paid Preparer” section) alongside the
corporation’s tax officer.9 In fact, if the work by the external advisor is substantial, the external
party is required to sign the tax return; conditional on the work performed, the signature itself is
not an election.10,11 In all, the strict regulatory regime underlying §6694, which exposes an
9 Although technically the corporation must always sign the tax return, the absence (presence) of a paid preparer signature implies that the compliance work is predominantly executed internally (externally). We use this fact in our research design. 10 The tax partner at a large accounting firm stated to one of the authors that if a client wants his firm to sign the tax return, his firm has to be “comfortable that it has substantially impacted the development of the return. If we are signing the return, we have to feel in good conscience that the return is properly prepared. We will not sign a return
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external preparer to substantial business and reputation risk if sufficient support is not gathered
in preparing the return, provides strong institutional incentives that ensure the signature
information on the tax return represents the party most substantially associated with the
corporation’s tax compliance work. In the next section, we develop hypotheses regarding the
links between tax preparer type and aggressive tax transactions.
3. Hypothesis Development
3.1 USING AN EXTERNAL TAX RETURN PREPARER
The effect of a company’s tax preparer on its tax positions is an important, but under-
studied area of corporate decision making. To guide our predictions as to when corporations
choose among preparing their tax return internally or engaging their auditor or another external
provider, we explore the theoretical model of Phillips and Sansing (1998) (hereafter PS). PS
analyze the effects of external tax preparers in the tax compliance of a firm. The focus of their
study is on the effects of requiring a fixed fee for compliance work rather than a contingent fee
based on the filing position. PS conclude that a fixed fee contract, relative to a contingent fee
contract, raises the expected cost of tax return preparation, and leads to more taxpayers filing a
favorable (aggressive) tax position, increasing under-compliance overall. They also note that the
use of a higher quality preparer will lead to greater observed tax aggressiveness.13
While not discussed in their paper, the PS model can also provide predictions for the
relation between using an external preparer and the aggressiveness of firms’ tax positions. In
that we have not substantially worked on, and similarly, if we have substantially worked on the return, we cannot duck the responsibility by not signing the tax return.” 11 If the paid preparer performs substantial work, but disagrees with a taxpayer taking an aggressive tax position, the paid preparer is still required to sign the tax return as long as it discloses the issue to the IRS. 13 Tax preparer quality is defined as the ability of the preparer to use specialized tax knowledge to help taxpayers resolve tax law uncertainty, thereby allowing taxpayers to make a more informed reporting decision and minimize their expected tax costs relative to the tax benefits claimed (see Phillips and Sansing 1998).
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their model, taxpayers are endowed with an exogenous, unobservable aversion to enduring a tax
audit adjustment (that is, an aversion to having a tax position reversed on audit). This parameter
affects whether the taxpayer is willing to file the favorable position if the correct tax position is
uncertain—more averse companies will not file a favorable position if the perceived cost of an
audit adjustment and penalties is too large.
In Appendix A, we summarize the model and show that for very low levels of aversion to
audit adjustments, the company will not use the external expert because they will always file the
favorable (aggressive) position when they are uncertain, and the fees to hire the advisor exceed
the benefit of certainty generated by the preparer’s research. The analysis also demonstrates that
more companies find it value maximizing to self-prepare with lower audit probabilities or lower
tax benefit to the favorable position are also associated with not hiring an external advisor. 14 In
all cases, however, the company will file the favorable position in equilibrium.
When the company uses an external advisor, its research may provide certainty regarding
the correct filing position and the taxpayer will use that position in equilibrium. The filing
position will either be favorable (aggressive) or unfavorable (conservative), depending on the
results of the research and the company’s aversion of audit adjustments. Thus, in equilibrium, an
external advisor is sometimes associated with a favorable tax position and sometimes associated
with an unfavorable tax position. Thus we conclude, the external advisor is associated with less
aggressive reporting, on average. This leads us to our first hypothesis:
H1: Tax returns filed without the assistance of an external preparer will be more aggressive than tax returns filed with the assistance of an external preparer, on average.
14 Anecdotal discussions with tax directors at two large publicly traded companies confirm this analysis. One reason their companies do not employ external preparers is because their transactions are complex enough that the cost of educating and managing a team of external preparers is not worth the potential benefit that the team might provide a better understanding of the merits of the company’s positions, i.e., the effect on the company’s tax uncertainties.
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Hypothesis H1 arises from the model of Phillips and Sansing (1998) using the
assumption that the choice to hire an external preparer is endogenous to the model (that is,
depends on the company’s aversion to an audit adjustment). However, it remains possible that
the firm decides to hire a preparer for other reasons, and this decision is independent of the
firm’s tax preferences.15 Whatever the other dimensions involved in the choice to self-prepare or
to use an external preparer, it continues to be reasonable to assume that the external preparer is of
higher quality than the internal staff (to justify the fees). If the decision to hire an external
preparer is independent of tax preferences and the external preparer is of higher quality than the
internal staff, then Phillips and Sansing (1998) conclude that the use of a higher-quality advisor
would raise the threshold value of aversion of audit adjustment needed to claim aggressive tax
positions. In this setting, conditional on hiring an external preparer, the taxpayer will, on
average, be aggressive more often with an external preparer, contrary to hypothesis H1.
3.2 ROLE OF NON-AUDITOR PROVIDERS
As described in the introduction, the use of auditors as tax advisors has been the subject
of much research. This research suggests that firms choose to use, or not use, their auditor as a
tax preparer for a variety of reasons (see, for example, Omer et al., 2006, and Lassila et al.,
2010). Cripe and McAllister (2009) survey 42 CFOs about their decisions to use their auditor as
a tax preparer. When asked for their primary reason why a firm would choose their auditor as
their tax preparer, the most common response, at 48%, was lower cost. Alternatively, when firms
who used a non-auditor external preparer were asked about the effect of this choice on fees, 31%
identified that they pay higher fees by foregoing their auditor as tax preparer. So if, on average, 15 Firms that internally prepare tax returns might include those that are less sophisticated and resource constrained, such that they will not have the capability or talent to develop and execute aggressive tax planning strategies, resulting in less aggressive reporting overall, than for firms that engage an external preparer.
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using a non-auditor for tax compliance is more costly, then to make this choice rational, the
benefits of the external non-auditor preparer must exceed the incremental cost.
One of the benefits will be that the external non-auditor preparer will be of higher quality,
on average. Respondents to the Cripe and McAllister (2009) study identified non-auditor tax
preparer quality as the second most popular reason for choosing to acquire their audit and tax
preparer services from separate providers.16 Even if this is not the main reason to choose another
preparer, when choosing among the alternative firms, we assume that the highest quality preparer
is most likely to be chosen. Thus, given that an external, high quality preparer is chosen, on
average, the non-auditor external preparer will be of higher quality than the auditor.17
If we consider non-auditor preparers to generally have greater ability, the threshold
between what Phillips and Sansing (1998) refer to as “aggressive taxpayers” versus those labeled
“conservative taxpayers” is increasing in the ability of the tax preparer. In their model, the higher
quality preparers allow marginal taxpayers to report aggressively because reducing the likelihood
that the filing position is uncertain allows more taxpayers to overcome the trade-off between
receiving the expected benefits of the favorable (aggressive) reporting position and suffering the
expected cost of being overturned on audit.
Because we can directly observe the compliance work through the tax return signatures,
we classify a tax preparer as high quality if the external preparer is not the auditor, as suggested
by Cripe and McAllister (2009). Thus, we extend our analysis by further delineating the external
tax preparers into auditors and non-auditors, while still estimating the effects of internally 16 Auditor independence was the most popular response which is not surprising as the survey was conducted in early 2007 shortly after new PCAOB rules on auditor provided tax services were introduced. 17 For example, assume that there are four preparers possible, denoted A, B, C, and D in order of quality for a given industry, location, etc. For each taxpayer, one is the auditor. If the taxpayer does not use the auditor, we assume it always chooses the highest quality preparer among the remaining three choices. In this case, only audit clients of A will choose a non-auditor preparer that is of lower quality (that is, B). However, clients of all other firms will choose A, a higher quality tax preparer than their auditor. Given the relatively even distribution of companies among the major audit firms, on average, the non-auditor preparer will be of higher quality than the auditor.
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preparing the tax returns. Thus, assuming non-auditors are high quality on average, the
predictions of Phillips and Sansing (1998) lead to the hypothesis below:
H2: Tax returns filed with the assistance of an external preparer who is not the firm’s auditor will, on average, be more aggressive than tax returns filed with the assistance of the firm’s auditor.
4. Method
4.1 RESEARCH DESIGN
We design our empirical tests to examine whether tax returns filed without an external
preparer or with a non-auditor external preparer will be more aggressive than tax returns filed
with the assistance of an auditor external preparer. We alternately estimate regressions of the
logged FIN 48 tax reserve ending balance (Log_UTB_EB) on INTERNAL_PREP,
OTHER_PREP, and control variables for firm i at time t as follows:18
Log_UTB_EBit =
β0 + β1 INTERNAL_PREPit + β2 OTHER_PREPit + β3 LOG_ASSETSit + β4 PRETAX_ROAit + β5 FOR_INCOMEit + β6 NOLit + β7 R&Dit
+ β8 LEVERAGEit + β9 YR2008it + βkIndit + eit
(1)
We define the model variables in Appendix B.
We use the tax reserve, or unrecognized tax benefit (Log_UTB_EB) obtained from
publicly available FIN 48 disclosures, as our proxy for tax aggressiveness for several reasons.
First, it clearly captures both the magnitude and uncertainty related to tax positions reported on
18 Since our sample period is short (2008-2009), we follow Petersen (2009) and cluster the standard errors by firm and include a 2008 time indicator variable in all of our regressions. All regressions also include industry fixed effects at the one-digit SIC code level. We winsorize continuous variables at the 1st and 99th percentiles to mitigate the effect of outliers. We employ both OLS and Tobit to ensure that the 154 firms with zero values in the dependent variable do not alter our inferences.
∑=
16
9k
17
the tax return, yet not recognized for financial reporting purposes as a reduction in tax expense.19
In other words, the tax reserve reflects both the expected tax benefits as well as managerial self-
assessment of tax uncertainty, or aversion to having the position overturned. Both inputs make
the tax reserve a direct proxy for testing the theory in Phillips and Sansing (1998).20
Second, Lisowsky, Robinson, and Schmidt (2011) find that it is a reliable proxy for
corporate tax aggressiveness, namely tax shelters disclosed as reportable transactions (obtained
from the tax return). A key reason underlying their finding is that both tax shelters and the FIN
48 tax reserve (UTB) contain information on tax benefits at the extreme end of the tax avoidance
continuum, regardless if the transactions conform or do not conform between financial and tax
reporting. Supporting this notion, they find that the UTB is the only key variable from the tax
avoidance literature that contains information on tax shelter use because the other measures
focus on a set (or even sub-set) of non-conforming transactions only. In particular, Lisowsky, et
al. (2011) compare the explanatory power of the logged UTB to the GAAP effective tax rate
(Rego 2003), cash effective tax rate (Dyreng, et al. 2008), total book-tax differences (Mills
1998), permanent book-tax differences, and discretionary permanent book-tax differences
(Frank, et al. 2009), and find that the non-UTB measures—either alone or together, and with or
without the UTB—are not associated with tax shelter use.21
19 FIN 48 (or ASC 740-10-25 under new codification) governs the recognition, derecognition, and measurement of uncertain tax benefits. In a two-step process, the firm must first recognize the financial statement benefit of a tax position after determining it is more-likely-than-not to be sustained upon audit by the taxing authorities. Second, the amount recognized should be the largest benefit that has a greater-than-50% likelihood of being realized upon settlement with the taxing authorities. The amount that remains unrecognized is the unrecognized tax benefit (UTB), and is recorded as a contingent tax liability (FASB, 2006). 20 Note that under FIN 48, managers must ignore the probability the position will or will not be audited by the tax authority, which ensures the reserve reflects the underlying uncertainties of the tax positions as opposed to whether jointly the positions are uncertain and will be audited. 21 We are not interested in tax shelter transactions per se. However, tax shelter data from the IRS are a useful non-financial statement benchmark against which Lisowsky, et al. (2011) infer the nature of transactions underlying the FIN 48 tax reserve, i.e., those not meeting the more-likely-than-not threshold. The resulting inference is that the FIN 48 tax reserve should accurately reflect aggressive tax positions more generally as well. Along similar lines, the
18
Finally, Lisowsky, et al. (2011) demonstrate that the information on tax aggressiveness
contained in the UTB is not eliminated due to reporting discretion arising from non-tax factors,
such as financial reporting preferences (Hanlon and Heitzman 2010), corporate governance
mechanisms (Desai and Dharmapala 2006), independent auditor certification process (Gleason
and Mills 2011), capital market incentives to manage earnings (Gupta, et al. 2011), and tax
director compensation (Armstrong, et al. 2011). They conclude that the tax reserve itself, even if
subject to managerial discretion about reporting aggressiveness or conservatism, is a reliable
proxy for the aggressiveness of the underlying tax position claimed on the firm’s tax return.
Therefore, following advice in Hanlon and Heitzman (2010) to carefully select the tax
aggressiveness proxy to suit the particular research question and empirical evidence in Lisowsky,
et al. (2011), we employ the ending balance UTB to examine the relation between preparer type
and tax aggressiveness. The favorable positions modeled in Phillips and Sansing (1998) are
those with material benefit and uncertainty, and we therefore view UTB as the closest
approximation of this construct.
Our first independent variable of interest is INTERNAL_PREP, equal to one if the firm
does not use an external tax preparer. Because hypothesis H1 seeks to examine the relative
aggressiveness of internal preparers over external ones, we specify INTERNAL_PREP as our test
variable. If tax returns filed without an external preparer are more aggressive than those filed
with the assistance of the auditor, β1 will have a significantly positive sign.22
other tax variables commonly used in the literature do not reflect managerial self-assessment of uncertainty and thus, do not map into the theory of Phillips and Sansing (1998). 22 Hypothesis H1 is motivated by internal versus external preparers, but to jointly test H1 and H2, we use the audit-prepared firm-years as the base group in both tests. In untabulated regressions without OTHER_PREP, the coefficient on INTERNAL_PREP is approximately 60% as large but continues to be statistically significant at the 5% level.
19
We are also interested in the relation between tax aggressiveness and other external
preparers, as specified in hypothesis H2. We include OTHER_PREP to examine the relation
between using an external preparer that is not the firm’s auditor, rather than the firm’s auditor, to
explain tax aggressiveness. To do so, we specify OTHER_PREP as equal to one if the external
tax preparer is not the firm’s auditor, zero otherwise. We expect the coefficient on
OTHER_PREP, β2, will have a significantly positive sign.
We draw on prior literature regarding investments in tax planning (Mills, et al. 1998),
auditor-provided tax services (McGuire, et al. 2011), and tax reserves (Lisowsky, et al. 2011) to
select our control variables. They include firm size (LOG_ASSETS), profitability
(PRETAX_ROA), foreign income (FOR_INCOME), existence of net operating losses (NOL),
research and development activities (R&D), and debt burden (LEVERAGE). We expect positive
coefficients on all the control variables.
In the hypothesis development, the choice to use an external preparer and the tax
positions taken by the taxpayer were both related to characteristics of the firm. Further, the
choice to use the auditor, versus other options (internally prepare or use another tax provider)
may relate to firm characteristics that also affect the aggressiveness of the firm’s tax positions.
Thus, to estimate equation (1), we explicitly model the endogeneity of this multiple-alternative
preparer choice. To do so, we employ a treatment-effects model (see, for example, Greene,
2008), as extended by Deb and Trivedi (2006) to a multinomial treatment. To summarize their
work, the firm has an indirect utility, EV*, associated with the jth choice of preparer:
EVij* = ′zi α j +δ j1 li1 +δ j2 li2 +ηij
is assumed to be zero for the base choice, j = 0, and zi are exogenous covariates with
parameters α. EV* includes latent factors lik which incorporate unobserved characteristics
EVi0*
20
common to firm i’s preparer choice and the outcome, yi (observed tax aggressiveness). η is an
i.i.d. error term. If dij are binary variables representing the observed choice of preparer of firm i,
then di = [di1, di2], with the probability of the choice represented as
g is a multinomial probability function. Finally, the outcome equation for firm i, formulated in
linear form, is
This model can be estimated, as described in Deb and Trivedi (2006), using maximum simulated
likelihood estimation.23
To implement this model in our setting, we identify the choices as 0 if the preparer is the
auditor (the base alternative), di = [1, 0] if the firm does not use an external preparer (i.e.,
INTERNAL_PREP = 1), and di = [0, 1] if the preparer is an external preparer other than the
auditor (i.e., OTHER_PREP = 1). In addition to the exogenous variables from equation (1),
namely firm characteristics (size, profitability, foreign income, NOL, R&D, and leverage), year,
and one-digit SIC industry code, we include NON_TAX_FEE as an additional variable in the
choice equation. NON_TAX_FEE is the fees paid to the auditor for services other than audit and
tax, deflated by the total non-tax fees paid to the auditor. NON_TAX_FEE is a measure of the
willingness of the firm to use the auditor for non-audit services and has been used in, for
example, McGuire et al. (2011) in a similar choice equation. We anticipate that the coefficient
on NON_TAX_FEE will be negative for both selection equations because greater reluctance to
23 Stata uses this estimation approach in its mtreatreg procedure. It is estimated using maximum simulated likelihood. We specify the routine using 100 Halton sequences that assume a normal density function.
Pr di zi ,li( ) = g ′ziα1 +δ11 l11 +δ12 l12, ′ziα2 +δ21 l21 +δ22 l22( )
yi = xi′ β + γ 1di1 + γ 2 di2 + λ1 li1 + λ2 li2 + εi
21
use the auditor for other services will lead to higher likelihood of internally preparing or using
another external preparer (i.e., not using the auditor for tax services).24
4.2 SAMPLE SELECTION
We obtain data from four sources: (1) FIN 48 tax reserve (UTB) data from the IRS Large
Business & International Division (LB&I);25 (2) tax return preparer identity from IRS-LB&I; (3)
financial statement data from Compustat; and (4) auditor identity, audit fee, and tax fee data
from Audit Analytics. We determine the sample used for our analysis in several steps. First, we
obtain the intersection of LB&I and Compustat data during 2008-2009, consisting of 10,881
firm-years.26 Second, we obtain IRS data on tax preparer identity from the face of the U.S.
corporate income tax return, Form 1120, for a restricted set of 805 calendar year-end firms in the
S&P 1500 as of the end of 2008.27 We are able to identify the tax preparer by name and tax
identification number (PTIN) in the “Paid Preparer” signature area; if preparer information is
missing, we assign the firm’s tax return as being internally prepared.28 We then merge the LB&I
FIN 48/Form 1120 data with Compustat and Audit Analytics over the same years, yielding a
24 We confirm that this variable does not have a statistically significant coefficient when also included in the main regression (equation (1)). We also included a variety of other variables in the first stage, including other aggressiveness measures such as Cash ETR; other firm attributes such as the corporate governance G-Score, stock exchange listing, and IRS audit probability; and auditor characteristics such as Big 4, each Big 4 firm individually, and audit fees. The coefficient on none of these variables were statistically significant, either when included alone or together. For parsimony, we only include NON_TAX_FEE in tabulated tests. 25 The UTB ending balance is also available to empirical researchers from a public data source (i.e., Compustat mnemonic TXTUBEND) or can be retrieved from financial statement footnotes. As in Lisowsky, et al. (2011), we use LB&I data because they undergo several layers of review, and are believed to be highly accurate. Confirming this point, Lisowsky, et al. (2011) report that the correlation between the authors’ hand-collected UTB ending balances and the amounts collected by LB&I (Compustat) is 0.96 (0.86). 26 Specifically, we obtain 5,539 (5,342) firms when intersecting LB&I and Compustat data for 2008 (2009). 27 Access to Form 1120 data is more restricted than access to the UTB data because the former is confidential while the latter can be obtained from other sources. Therefore, IRS non-disclosure agreements allowed us to only merge 805 (785) calendar year end S&P 1500 firms (excluding REITS) in 2008 (2009). 28 The IRS employee within LB&I supplying the tax preparer data confirmed that missing preparer information on the Form 1120 is consistent with internally prepared tax returns rather than the external tax preparer omitting its information for whatever reason. This fact reflects that a corporate officer must always sign the tax return, whether an external preparer is used or not. Therefore, the internal preparation of the tax return is determined by the absence of a paid preparer signature. See Section 2.2 for further details.
22
final test sample of 1,533 firm-years with non-missing observations for all of our multivariate
analyses.
5. Main Results
5.1 DESCRIPTIVE STATISTICS
Table 3 Panel A presents descriptive statistics for the tax preparers in our sample. In our
sample of 1,533 firm-years, 690 (45 percent) of the tax returns are externally prepared, of which
545 (145) are prepared by Big 4 (non-Big 4) accounting firms. The remaining 843 (55 percent)
are internally prepared. The proportions of externally and internally prepared returns are
consistent from 2008 to 2009, and reflect our survey results that most tax compliance work is
done in-house. Also consistent with the survey results is how large our sample firms are that
internally prepare their tax returns, with mean (median) assets of $24.8 ($5.9) billion, compared
to firms with externally prepared tax returns, either by Big 4 firms (mean [median] assets are
$8.9 [$1.8] billion) or non-Big 4 firms (mean [median] assets are $5.3 [$1.1] billion). The
descriptive statistics suggest that firms internally preparing their tax returns are well-resourced,
and likely sophisticated enough to not exhibit demand for outside tax preparer knowledge, even
if it is a Big 4 preparer.
[Insert Table 3 about here]
In Table 3 Panel B, we report the count of internally and externally prepared tax returns
by outside audit firm (note that each corporation in our sample is publicly traded and requires a
financial statement audit). The diagonal values (bolded) in this Panel highlight where the
corporation’s auditor is also its tax preparer. For example, of the 415 company financial
statements that Firm A audits during our sample period, 275 self-prepare their tax returns, 71
23
hire Firm A to also prepare the tax return (i.e., auditor-provided tax preparation service), and the
remaining 69 firms hire an external tax preparer that is not Firm A.29 Examining the data from a
different perspective, Firm A is the tax preparer for 128 firm-years in our sample, meaning that
they prepare tax returns for 57 non-audit firm-years (128 minus 71), of which 17 are audited by
Firm B, 25 by Firm C, 10 by Firm D, and 4 by Firm F.
In summary, Panel B reports that 312 firm-year tax returns are prepared externally by the
firm’s auditors (i.e., the sum of the bolded diagonal values); 378 firm-year tax returns are
prepared by an external preparer that is not the auditor (i.e., the sum of the non-bolded, off-
diagonal values, not including internally prepared); and 843 firm-year tax returns are prepared
internally, of which 829 use Big 4 firms as their auditor and 14 use non-Big 4 firms as their
auditors. These results are interesting in that we observe that auditor-provided tax preparation
services are by far the minority of prepared tax returns.
In Table 3 Panel C, we also report the industry composition for the three types of
preparers. In each industry, the internally prepared return is the most common. In five (three) of
the disclosed eight industries, the next most common combination is for the external preparer to
not be the auditor (to be the auditor). Again, the majority of firms do not employ their auditors to
provide tax preparation services.
Table 4 Panel A reports descriptive statistics for our dependent variable, control
variables, and other audit and tax fee-related data for the full sample. The mean (median) raw
UTB ending balance is $97.98 ($16.35) million, or 1.1% (0.60%) of total assets. The mean
(median) total assets for our sample is $17.4 ($3.4) billion, which is consistent with our sample
29 Due to confidentiality agreements, we are unable to name the paid preparer, so we use the more generic terms “Firm A,” “Firm B,” and so forth to denote the external preparers (who may or may not also be the corporation’s auditor). We are also unable to disclose counts that are less than three; we denote these values as “ND” in the tables. Although it would be interesting to examine the time-series trends in tax preparer use, especially before and after the passage of Sarbanes-Oxley (SOX), unfortunately our data are limited to analyzing cross-sectional relations only.
24
composition of large, publicly traded firms. On average, the sample firms are profitable (mean
[median] Pretax ROA of 4.7% [6.2%]), but with foreign operations in only a limited number of
firms (mean [median] scaled Foreign Income of 1.7% [0%]). A large share of firms—45%—
report net operation loss carryforwards, indicative of the economic crisis during the sample
period. R&D activities are, as typically the case, also concentrated in a limited number of firms
(mean [median] R&D of 2.4% [0%]), and debt levels show mean (median) values of 19.6%
(17.3%) of total assets.
[Insert Table 4 about here]
With respect to tax fee data disclosed by firms who engage their auditor for tax work,
80.6% of firms in our sample report positive tax fees paid to their auditors. Combined with our
tax return preparer information, it appears that many firms do not have their tax return prepared
by their auditor, although a vast majority of firms hire their auditor for some type of tax work,
perhaps limited consulting as consistent by our survey results. Tax fees account for a mean
(median) of $532,000 ($117,000), or 8.4% (4.8%) of total fees paid to auditors.
Table 4 Panel B reports related values, where pertinent, for each preparer grouping we
examine in our study. Most notably, the raw and logged UTB ending balances are significantly
higher for the internal tax department than for either of the external (is or is not auditor) groups,
while the scaled values for the internal tax department and external non-auditor preparer are
higher than the external auditor preparer.
Finally, the correlation table in Panel C reports a significantly positive (negative)
association between the UTB ending balance and the internally (externally) prepared tax returns,
providing initial support for hypothesis H1. We also find significantly positive correlations
between the UTB and OTHER_PREP suggesting support for hypothesis H2.
25
5.2 MULTIVARIATE RESULTS: HYPOTHESIS H1 AND H2
Table 5 presents the results of estimating Equation (1). We find significant results
supporting hypothesis H1 that tax returns prepared by the internal tax department are more
aggressive than tax returns filed with the help of an external auditor preparer, on average. In
particular, the coefficient on INTERNAL_PREP is positive and significant in all specifications.
In this setting, the OLS provides the most conservative estimates, in terms of the smallest
coefficients and the lowest t-values. The estimate for the coefficient on INTERNAL_PREP using
OLS is 0.29. This suggests that, relative to tax returns prepared by auditors, tax returns that are
internally prepared have uncertain tax benefits that are 29% higher. Second, the coefficient
estimate on INTERNAL_PREP using a Tobit estimation approach, which explicitly models the
truncation of the UTB balance at zero, is 0.35. Third, when the estimates explicitly control for
the endogeneity of the firm’s selection process using a multinomial treatment effect
specification, the coefficient on INTERNAL_PREP is 0.67. Overall, these tests provide evidence
that not using an external preparer, relative to using the auditor as the tax preparer, is associated
with an increase in UTB balance from between 29% and 67%.
[Insert Table 5 about here]
Table 5 concurrently presents the results of estimating whether an external non-auditor
preparer, rather than the auditor, is related to greater tax aggressiveness. We find evidence
supportive of H2 that tax returns filed with the assistance of a non-auditor external preparer is,
on average, more aggressive than tax returns filed with the assistance of auditor preparers. Using
both OLS and Tobit specifications, our tests yield significant and positive coefficients on
OTHER_PREP, suggesting that outside (and likely high quality) non-auditor preparers are
related to tax aggressiveness. The coefficient estimates on OTHER_PREP are smaller than those
26
on INTERNAL_PREP, and range from 0.22 using OLS to 0.55 using the multinomial treatment
effects model.30
The control variables, when significant, are in the expected directions; firm size
(LOG_ASSETS), the share of foreign income (FOR_INCOME), existence of net operating losses
(NOL), and research and development activities (R&D) are all increasing in the tax reserve,
while profitability and leverage are not significantly related to the FIN 48 tax reserve. In the
selection models, the non-tax fee ratio has a negative coefficient significant at the 10% level
using a two-tailed test. This result confirms that firms more willing to use their auditor for
services other than tax and audit are less likely to choose a non-auditor alternative preparer,
either internally prepare or use another firm. Size and foreign income are also positive related to
internal preparation, while R&D is negatively related. None of the equation (1) control variables
are related to the choice to use a tax preparer other than the audit firm for tax preparation.
The results on INTERNAL_PREP and OTHER_PREP are the first that provide empirical
evidence supportive of differences in tax aggressiveness across preparer type. Until now,
researchers have been unable to definitively observe the preparer type to examine whether tax
returns filed with the help of external preparers are more or less aggressive that those that are
internally prepared. Besides supporting the theoretical predictions of Phillips and Sansing
(1998), the results also triangulate with our survey of tax executives. In particular, the results
support that internally prepared firms are typically large and well-resourced, keeping most
compliance and planning work in-house. By doing so, these firms exhibit greater tax
aggressiveness as reflected in the FIN 48 tax reserve. In addition, the results support the findings
in Cripe and McAllister (2009) that external non-auditor preparers are more likely to be high
30 A test of differences between the coefficients on INTERNAL_PREP and OTHER_PREP reveals they are not significantly different (significance levels range from 21% to 51% using two-tailed tests).
27
quality. That is, to justify higher incremental fees over auditors as tax preparers, the non-auditor
preparers support positions with greater tax benefits in settings of uncertainty. Overall, our
results provide the first archival evidence of a significant relation between tax preparer choice
and tax compliance in a corporate setting.
6. Comparing Tax Return Data to 10-K Inferences on Tax Preparer Type
Because tax preparer type is only observable from confidential tax returns, we examine
the extent to which publicly available information can aid interested parties to infer preparer type
reported on the tax return. Specifically, we examine whether disclosures of auditor-provided tax
service fee data in financial statements can provide a window onto tax preparer identity, and
thus, the tax compliance activities of the corporation.
Since the Sarbanes-Oxley Act of 2002, firms are required to disclose in their financial
statements audit and non-audit fees paid to their auditor. Although firms must disclose tax fees
paid to their auditors, they are not required to disclose fees paid to non-auditors, or for that
matter, whether the tax return is prepared in-house and what resources are used to do so. Because
of this limitation, outside researchers can only observe the dichotomous outcome of whether the
firm’s auditor does or does not receive a fee for tax services. This information is then used to
analyze the propensity to engage, retain, or dismiss the auditor as the tax service provider (e.g.,
Lassila, et al. 2010; Omer, et al. 2006; and McGuire, et al. 2011). Of course, information on
whether the provider for tax services other than the auditor is either a non-auditor or the internal
tax department—and whether “services” have to do with compliance or planning—have until
28
now been unobservable in a corporate setting.31 Because we can observe the identity of the tax
preparer, we design an archival experiment that compares how the accuracy of preparer type
classification inferred from tax fees versus tax returns might affect our established inferences
about tax aggressiveness.
To begin, we re-specify Equation (1) by creating one variable, NONAUD_PREP_TR,
which combines the INTERNAL_PREP and OTHER_PREP firms into one proxy for non-audit
tax service provider that we can observe directly from tax returns. This re-specification of the
preparer variable of interest exactly mirrors the dichotomous specification using the tax fee data
as to whether the firm uses (or does not use) the auditor as the tax service provider. As in all of
our previous specifications, we leave the auditor tax service provider as the reference category
and continue to employ the same firm characteristics, year, and industry control variables.
Table 6 Panel A reports our replication of previous results using the modified Equation
(1). As expected, we continue to obtain a significantly positive sign on NON_AUD_PREP_TR,
indicating that tax service providers that are not the auditor (i.e., either external non-auditors or
internal tax departments) are linked to greater tax aggressiveness. These results in Panel A based
on tax return classification of preparer type serve as our benchmark case.
Using a similar approach when specifying our variable of interest, we then designate the
variable NON_AUD_PREP_10K as capturing whether the auditor does not provide tax services
to the client; this variable equals one if tax fees disclosed in the financial statements are equal to
zero; 0 otherwise. Put another way, this specification assumes that if a firm does not pay its
auditor any tax fees, then it uses either its own internal tax department or an external non-auditor
to prepare the tax return. As reported in Panel B as “Case 1,” we re-estimate our modified 31 As noted above, Neuman, et al. (2011) are able to observe the choice of non-auditor tax service provider for not-for-profit organizations because the IRS Form 990 is publicly available. However, data access limitations to corporate tax returns preclude them from evaluating the for-profit sector as we do here.
29
Equation (1), but find no significant relation between this financial statement-based variable of
tax preparer identity and tax aggressiveness.
[Insert Table 6 about here]
Because using a non-zero tax fee might unnecessarily designate firms that use their
auditor very little for tax services as similar to those that use their auditors for large amounts of
tax services, we designate several cut-off values on the size of the ratio of tax fees to total fees
paid to the auditor (or “tax fee ratio”). Specifically, we designate a new variable in “Case 2” of
Panel B as NON_AUDIT_PREP_10K_1% equal to one if the firm discloses a tax fee ratio of less
than or equal to 1%, zero otherwise. Put another way, this specification assumes that if a firm
pays its auditor an “immaterial” amount of tax fees, then it likely still uses either its own internal
tax department or an external non-auditor to prepare the tax return overall. We re-estimate the
modified Equation (1) and again obtain no significant results.
In successive specifications, we continue to increase the tax fee ratio cut-off at less than
or equal to 5%, 10%, 25%, and 50% when defining our non-auditor preparer variables of
interest. In every case, the results are either not significant (10% and 50% designations) or
significantly negative (5% and 25% designations). These results are in stark contrast to those
obtained from using tax preparer data directly observable from tax returns. We repeat these
specifications at levels less than or equal to 2%, 3%, 4%, 15%, 20%, 30%, 35%, 40%, 45%, and
55%, but to no avail (untabulated). Not once do the results using the presence or magnitude of
the tax fee yield inferences that are consistent with our original results that use actual tax
preparer identities from the tax return.
In Table 6 Panel C, we report error rates inherent in using public tax fee data in our
sample to classify the preparer type as either non-auditor (Non_Aud_Prep) or auditor
30
(Aud_Prep). Recall that our data report that 1,221 firm-years do not use their auditor to prepare
the tax return, while 312 do. Using these figures as benchmarks, we report for each tax fee ratio
cut-off the number and percent of firms that are correctly and incorrectly classified by preparer
type. For example, using NON_AUD_PREP_10K_1% derived from the tax fee data classifies
428 firm-years as having a non-auditor preparer, while 1,105 firm-years are classified as having
an auditor preparer. Of the 428, 412 indeed have a non-auditor tax preparer as reported on the tax
return. Of the 1,105, only 296 indeed have an auditor-preparer as reported on the tax return.
These figures illustrate that of the 1,533 total firm-year observations in our sample, only 708
(46.2%) are correctly classified into the two auditor and non-auditor preparer groups.
In particular, using the tax fees, sixteen firm-years are incorrectly classified as using non-
auditor preparers, since per the tax return, they are in fact using auditor preparers; and an
astonishing 809 firm-years are classified as having an auditor preparer, when in fact they use
non-auditor preparers as confirmed by the tax return. These figures illustrate that of the 1,533
firm-year observations, 825 (53.8%) are incorrectly classified. To be sure, the classification
accuracy improves as the cut-off values increase (because increasing sample sizes ensnare
enough correct tax preparer types). However, the fee data continue to incorrectly classify
between 20 and 62 percent of firm-year observations.
Overall, our archival experiment implies that using tax fee data to classify the tax
preparer as the auditor (or not the auditor) is not only materially inaccurate, it is inaccurate
enough to yield starkly different inferences from tests that are otherwise designed exactly the
same way. As a corollary, we demonstrate that using tax return data is materially beneficial in
our setting when drawing stable conclusions about links between preparer type and tax
aggressiveness. Admittedly, the original aim of this exercise was to provide guidance to
31
researchers when using tax fees to help them infer tax preparer type, and thus compliance
activities of the firm. However, the implication that tax fees are not informative of tax
compliance activities at all, namely the preparation of the tax return, suggests that researchers
must remain cautious when drawing inferences on the type of services supplied by tax providers
when tax fee data are used as the basis for such an analysis.
7. Conclusion
Our study examines companies’ choices regarding advisors for their tax compliance work
and how these decisions relate to companies’ tax positions. We survey 170 tax executives from
the Tax Executives Institute (TEI) to determine firms’ strategies for tax compliance. The survey
reveals that 20% of companies do not use any external firm for compliance work, 16% use their
auditors only, 52% use another type of consultant (either an accounting firm that is not their
auditor, or another type of provider), and 12% use both their auditor and other providers. The
survey also reveals that external providers perform only 30% of compliance work, and external
providers are used for a similar percentage of planning work.
We then test whether the choice of tax preparer type—whether internal, external auditor,
or external non-auditor—is related to the aggressiveness of positions claimed on a firm’s tax
return, as suggested by theory in Phillips and Sansing (1998). Using confidential data obtained
from the IRS on who signs a firm’s tax return, we find a positive and significant relation between
tax aggressiveness and not using an external tax preparer or using an external non-auditor
preparer, compared to using an auditor preparer. Finally, we find that tax fees paid to a firm’s
auditors as publicly disclosed in a firm’s securities filings are unable to reliably measure the tax
compliance and preparation activities of the firm, namely the identity of the tax preparer. In
particular, we estimate that the tax fee data incorrectly classify between 20 and 62 percent of
32
firms into tax preparer types that do not match those reported on a firm’s tax return. This finding
should caution other researchers when attempting to use the tax fee data to infer the tax
compliance attributes of firms.
Our findings are important given the paucity of archival research on tax preparers
generally. We make a significant contribution to the literature by better understanding this
important part of the U.S. tax system and companies’ decision making. Specifically, we are the
first to document the identity, distribution, and attributes of tax return preparers for a large
sample of U.S. companies. This analysis helps us evaluate the compliance responsibilities and
implications surrounding business transactions, and examine the extent to which companies
employ internal tax specialists and/or hire external advisory firms. We are also the first study to
provide empirical archival evidence in support of theoretical predictions in Phillips and Sansing
(1998) concerning the relation between tax preparers and tax aggressiveness. Documenting the
effect of the tax preparer in corporate tax compliance decisions with respect to tax
aggressiveness is of interest to tax authorities, tax service providers, corporate tax executives,
and tax researchers, as the archival literature remains largely silent on the role of the corporate
tax preparer and its effect on compliance.
33
APPENDIX A
The development of Hypothesis 1 is informed by the model of Phillips and Sansing
(1998). This model explores the role of contingent-fee versus fixed-fee contracts for tax
compliance services. In summary, the model involves a firm undertaking an uncertain tax
position. The treatment of the transaction can be either favorable or unfavorable to the taxpayer.
If the company is uncertain about the appropriate treatment, it trades off the benefit of the
uncertain treatment against the possibility of being audited, losing on audit, and incurring a
penalty. Based on the parameters of the position and the company, it chooses to either report
aggressively or conservatively. Both reporting approaches report the appropriate position when
the outcome is certain, based on a professional’s research, although even with research,
uncertainty sometimes remains. Aggressive reporting is defined as reporting the favorable
position when the outcome is uncertain, whereas conservative reporting is defined as reporting
the unfavorable position when the outcome is uncertain.
The key parameter is the company’s tolerance for being reassessed on audit; that is, the
company’s ‘cost’ of such an outcome, denoted λ. Higher tolerance leads to aggressive reporting.
Lacking information, the favorable tax position and the unfavorable tax position are assumed to
be equally likely. Using the notation of Phillips and Sansing (1998), the expected value of
reporting aggressively with the help of a tax professional is as follows:
𝜔2 𝐵 − 1− 𝜔 1−
𝛼2 𝐵 −
𝛼2 𝐵𝜆 − 𝐸 𝑦!
where ω is the probability that the position is certain after the professional completes the
research, ω/2 is the probability that the position is known to be favorable, (1 – ω) is the
probability that the position continues to be uncertain, B is the magnitude of the tax benefit that
is subject to uncertainty (e.g., the deduction amount times the tax rate, or the tax credit amount),
34
α/2 is the probability that the position is audited and found to be favorable to the company, λ is
the cost to the company from having the favorable position reversed upon audit, and E(yA) is the
expected fee to an aggressive company, denoted by the subscript A. E(yA) is not dependent on λ,
but is a function of ω, and the advisor’s research cost function, c(ω). The tax benefit to the
company from the unfavorable tax position is normalized to zero. When the position is
uncertain, it is assumed to be equally likely to be favorable or unfavorable.
The first term in the equation is the expected benefit from filing the favorable position
with certainty, the second term is the expected benefit from filing the favorable position when
the outcome is uncertain, and the third term is the expected fee to the professional.
Without the use of a professional, ω equals zero, and the first and third terms drop out
(i.e., there is no fee paid if no professional is used).32 Thus, the net benefit of using a
professional tax provider is as follows:
𝜔2 𝐵 − 1− 𝜔 1−
𝛼2 𝐵 −
𝛼2 𝐵𝜆 − 𝐸 𝑦! − 1−
𝛼2 𝐵 −
𝛼2 𝐵𝜆
Thus, the company will hire an external tax professional if this expression is positive, or if
𝜔2 𝐵 − 𝜔𝐵 1−
𝛼2 −
𝜆𝛼2 − 𝐸 𝑦! > 0
or if
𝜆 > 𝜆∗ =1𝛼
2 𝐸 𝑦!𝐵𝜔 + 1 − 1
From this analysis, we discover that for low values of λ, firms will forego the use of a
professional. The basic intuition is that without advice, companies with low λ will report the
32 We assume that the taxpayer, in the absence of a paid preparer, has no tax knowledge on the issue at hand; however, the analysis holds for internal tax staff that is less knowledgeable than the external preparer. If the internal staff has some ability to discern the legitimacy of the position, the company will choose the favorable position except in the rare cases the internal analysis shows that the position will not withstand audit.
35
favorable (aggressive) position because this is value-maximizing when they are uncertain. With
a paid advisor, the company will continue to report the favorable position unless the advisor’s
research determines that the unfavorable position is correct, but the additional fee to avoid the
resolution of uncertainty and alter the reporting position is not sufficiently to overcome the fee
when the cost of having the tax position reversed on audit is very low.
For higher values of λ, Phillips and Sansing (1998) demonstrate that the firm will choose
the unfavorable position when they are uncertain. In this case, with a paid preparer, the value to
the firm is as follows, where subscript C denotes the conservative taxpayer:
𝜔2 𝐵 − 𝐸 𝑦!
The company will report the favorable position if the advisor’s research reveals that the
favorable position is correct and otherwise will report the unfavorable position. This expression
is not a function of λ because the company never takes on the risk of having the position
overturned. If the company were to not hire a professional, they would never report the
favorable position, and the expected value is zero. Thus, in the more conservative companies,
the external advisor is always hired unless the professional prices itself out of the market (i.e.,
the fee exceeds the company’s expected benefit). We assume this to be rare.
In equilibrium, companies that are the least averse to audit adjustments do not seek
professional assistance and file the favorable position. Somewhat less averse companies hire the
professional and either file the favorable or unfavorable tax position. Thus, if the preparer
choice is observed, not using an advisor will be associated with favorable filing only, whereas
using an advisor will sometimes be associated with a favorable filing and sometimes with an
unfavorable filing, depending on λ and the outcome of the research. Therefore, on average, using
an external advisor will yield less aggressive reporting than internally preparing.
36
APPENDIX B Variable Definitions
Variable
Definition
Dependent Variable Log_UTB_EB = The natural log of (1 + UTB), where UTB = Ending balance (in
$millions) of the FIN 48 unrecognized tax benefit (UTB). Source: IRS-LB&I.
Tax Preparer Measures INTERNAL_PREP = 1 if the firm’s Form 1120 tax return is not signed by an external
preparer; 0 otherwise. Source: IRS-LB&I. OTHER_PREP = 1 if the firm’s Form 1120 tax return is signed by an external preparer
that is not the firm’s external auditor; 0 otherwise. Source: IRS-LB&I, Audit Analytics.
Control Variables LOG_ASSETS = The natural log of Total Assets (AT). Source: Compustat. PRETAX_ROA = The ratio of Pretax Income (PI) / Total Assets (AT). Source:
Compustat. FOR_INCOME = The ratio of Foreign Pretax Income (PIFO) / Total Assets (AT).
Source: Compustat. NOL = Indicator variable equal to one if Tax Loss Carry Forward (TLCF) is
non-zero; 0 otherwise. Source: Compustat. R&D = The ratio of R&D Expense (XRD) / Total Assets (AT). Source:
Compustat. LEVERAGE = The ratio of Long-Term Debt (DLTT) / Total Assets (AT). Source:
Compustat. NON-TAX FEE RATIO = The ratio of fees paid to the auditor for services other than tax or
audit, divided by fees paid to the auditor for services other than tax. Source: Audit Analytics.
37
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41
TABLE 1
Descriptive Statistics for Survey Respondents and Comparison to TEI Membership Population
Total Assets
TEI membership
Survey respondents
Industry
TEI membership
Survey respondents
<$10M 1% 1%
Mining and resources 6% 2% $10M-$500M 24% 22%
Utilities 4% 0%
$500M-$1 Billion 17% 15%
Construction 1% 1% $1 Billion- $5 Billion 32% 29%
Manufacturing 36% 49%
$5 Billion-$50 Billion 21% 26%
Wholesale and retail 11% 8% $50 Billion-$500 Billion 4% 5%
Transportation 3% 2%
> $500 Billion 1% 2%
Information and telecomm 5% 8%
100% 100%
Financial and Insurance 10% 6%
Real estate 2% 1%
TEI Survey
Professional services & Education 6% 6%
Total Revenues membership respondents
Health 6% 2% < $500 Million 24% 25%
Media and Entertainment 3% 1%
$500 Million - $1 Billion 17% 10%
Food and Accommodation 7% 3% $1 Billion - $5 Billion 37% 34%
Other 0% 7%
$5 Billion - $10 Billion 10% 10%
None of the above 0% 4% $10 Billion - $50 Billion 11% 17%
100% 100%
Greater than $50 Billion 2% 4%
100% 100%
TEI Survey Tax Budgets membership respondents < $250,000 15% 10% $250,000-$500,000 21% 18% $500,000- $1 Million 26% 16% $1 Million - $5 Million 32% 40% >$5 Million 5% 16%
100% 100%
These data are drawn from the Tax Executives Institute’s (TEI) mandatory survey of its membership in 2005 and from our Tax Survey conducted in 2010.
42
TABLE 2
Survey Statistics of Compliance Outsourcing
Compliance Work Outsourced To: N Percentage
Average Percentage Of Compliance
Work Outsourced
Average Percentage Of
Planning Work Outsourced
Average Number of
Internal Tax Personnel
Total Assets ($ Billion)
Not outsourced 34 20% 0% 16%
13
37.9
Auditor only 27 16% 40% 31%
5
2.2
Non-auditor accounting firm only 70 41% 39% 35%
14
29.5
Non-accounting firm only 9 5% 22% 37%
18
1.8
Auditor and non-auditor accounting firm 11 6% 27% 24%
16
7.4
Auditor and non-
accounting firm 3 2% 52% 17%
9
2.8
Non-auditor accounting
firm and non-accounting firm
11 6% 40% 38%
21
15.2
All three types 5 3% 37% 28%
12
7.5
Totals 170 100% 30% 30% 13 22.2
These data are drawn from our Tax Survey. Respondents are classified according to their responses to the question "If your tax compliance is outsourced, to whom is it outsourced?" Tabulations in columns 4, 5, and 7 are based on the mid-point of categorical responses given in 11 categories; and column 6 are based on the mid-point of categorical responses given in 5 categories. The highest, open-ended category is not considered. Column 4 is based on responses to the question, "What percentage of overall tax compliance work (both transfer pricing and non-transfer pricing) is outsourced?" Column 5 is based on responses to the question, "What percentage of overall tax planning work (both transfer pricing and non-transfer pricing work) is outsourced?" Column 6 is based on responses to the question, "How many full time tax personnel are employed company wide?" Column 7 is based on responses to the question, "My company's asset size as of the most recent annual fiscal period is." While only 120 responses to this last question were received, the distribution across classifications is almost identical to that shown in column 2 (for example, 25 of 120 response, or 21%, are in category 1-not outsourced; 18 of 120 responses, or 15%, are in category 2-auditor only; etc.).
43
Panel A. Distribution of Sample and Assets by Tax Return Preparer and Year
n% of Total
mean Assets
median Assets n
% of Total
mean Assets
median Assets n
% of Total
mean Assets
median Assets
Big 4Firm A 69 8.6% 8,366 1,754 59 8.1% 15,106 2,662 128 8.3% 11,473 2,346Firm B 73 9.1% 8,462 2,018 63 8.6% 5,712 1,920 136 8.9% 7,188 1,988Firm C 89 11.1% 10,663 1,417 90 12.3% 9,581 1,661 179 11.7% 10,119 1,585Firm D 51 6.3% 5,811 1,439 51 7.0% 6,703 1,636 102 6.7% 6,257 1,506 Total Big 4 282 35.1% 8,654 1,670 263 36.1% 9,336 1,955 545 35.6% 8,983 1,834
Non-Big 4Firm E 7 0.9% 2,958 1,420 7 1.0% 2,544 631 14 0.9% 2,751 1,067Firm F 16 2.0% 3,527 629 11 1.5% 4,031 833 27 1.8% 3,732 702Other 57 7.1% 3,832 1,679 47 6.4% 8,808 1,857 104 6.8% 6,081 1,761 Total Non-Big 4 80 10.0% 3,695 1,138 65 8.9% 7,325 1,352 145 9.5% 5,322 1,146
InternalTax Dept. 442 55.0% 24,158 5,544 401 55.0% 25,680 6,143 843 55.0% 24,882 5,884
TOTAL 804 100.0% 16,684 3,215 729 100.0% 18,147 3,601 1,533 100.0% 17,379 3,380Asset values are in $Millions.
Panel B. Count of Sample Firms by Tax Return Preparer Type and Auditor
A B C D E F TOTALFirm A 71 17 25 10 ND 4 ND 128Firm B 21 54 27 19 ND ND 10 136Firm C 19 17 103 32 4 ND ND 179Firm D 10 11 16 56 ND 6 ND 102Firm E 0 0 5 0 7 ND ND 14Firm F 5 3 7 7 ND 5 ND 27Other 14 23 24 18 6 3 16 104Internal 275 190 211 153 4 7 3 843TOTAL 415 315 418 295 25 30 35 1,533
Bolded numbers on the Diagonal represent that the outside Tax Preparer is also the AuditorND = Not disclosed to do small sample sizes.
SummaryExternal Tax Preparer: Is the Auditor 312 Is Not the Auditor 378Total External 690
Internal Preparer Uses: Big 4 Auditor 829 Non-Big 4 Auditor 14Total Internal 843
Total Sample 1,533
Auditor Firm
Other
Tax
Prep
arer
Totals
TABLE 3Descriptive Statistics on Firms by Tax Return Preparer Type and Year
2008 2009 Total By Preparer
44
Panel C. Distribution of Sample Firms by Tax Return Preparer Type and Industry
Preparer Type SIC0 SIC1 SIC2 SIC3 SIC4 SIC5 SIC6 SIC7 SIC8 SIC9Internal Preparer ND 58 166 217 136 37 122 61 39 NDExternal Preparer is Auditor ND 11 31 74 40 29 76 34 16 NDExternal Preparer is not AuditorND 25 48 104 38 30 68 50 14 ND
ND TotalTotal ND 94 245 395 214 96 266 145 69 ND 9
Panel D. Distribution of Sample Firms by Tax Return Preparer Type, Firm, and Industry
Preparer Type SIC0 SIC1 SIC2 SIC3 SIC4 SIC5 SIC6 SIC7 SIC8 SIC9Internal Preparer ND 58 166 217 136 37 122 61 39 NDExternal Preparer is Auditor ND 11 31 74 40 29 76 34 16 ND Firm A ND 5 6 20 11 ND 18 4 5 ND Firm B ND ND 10 ND ND ND 6 15 4 ND Firm C ND ND 9 33 13 15 18 8 5 ND Firm D ND ND 3 11 10 6 18 4 ND ND Non-Big4 ND ND 3 ND ND 4 16 3 ND NDExternal Preparer is not AuditorND 25 48 104 38 30 68 50 14 ND Firm A ND ND 6 ND 7 6 6 10 5 ND Firm B ND ND 7 31 12 ND 14 9 ND ND Firm C ND 7 15 21 ND 10 11 9 ND ND Firm D ND 7 12 ND ND ND 9 7 ND ND Non-Big4 ND 5 8 31 15 8 28 15 7 ND
ND TotalTotal ND 94 245 395 214 96 266 145 69 ND 9
ND = Not disclosed to do small sample sizes.SIC 0 = AgricultureSIC 1 = ConstructionSIC 2 = ChemicalsSIC 3 = ManufacturingSIC 4 = TransportationSIC 5 = RetailSIC 6 = FinancialSIC 7 = Business ServicesSIC 8 = HealthSIC 9 = Diversified/Other
311
TABLE 3 (continued)
Total836
311
3779
1,533
Total836
377
69351015226
1,533
407373351179
45
TABLE 4 Descriptive Statistics for Regression Variables Panel A. Summary Statistics
Full Sample
Variable n Median Mean STD Dependent Variable UTB Ending Balance ($M) 1,533 16.347 97.982 199.177 UTB EB / Total Assets 1,533 0.006 0.011 0.017 Log_UTB_EB 1,533 2.853 2.912 1.953
Control Variables
Total Assets ($M) 1,533 3,379.889 17,379.490 44,622.450 LOG_ASSETS 1,533 8.126 8.217 1.725 PRETAX_ROA 1,533 0.062 0.047 0.143 FOR_INCOME 1,533 0.000 0.017 0.042 NOL 1,533 0.000 0.450 0.498 R&D 1,533 0.000 0.024 0.055 LEVERAGE 1,533 0.173 0.196 0.170
Tax Fee Data
Tax Non-Audit Fees > 0 (0/1) 1,533 1.000 0.806 0.396 Tax Non-Audit Fees / Total Assets 1,533 0.0000 0.0001 0.0002 Tax Fee Ratio (Tax Fees / Total Fees) 1,533 0.048 0.084 0.096 Tax Non Audit Fees ($M) 1,533 0.117 0.532 1.129 Log(1+Tax Fees) 1,533 0.111 0.298 0.431
Non-Tax Fee Ratio (Non-Audit Fees - Tax Fees)/(Total Fees - Tax Fees)
1,533 0.050 0.082 0.098
Categories
Preparer Type
External Preparer 1,533 0.000 0.450 0.498 is Auditor (AUD_PREP) 1,533 0.000 0.204 0.403 is not Auditor (OTHER_PREP) 1,533 0.000 0.247 0.431 Internal Preparer (INTERNAL_PREP) 1,533 1.000 0.550 0.498
Notes: UTB EB is the total value (ending balance) of uncertain tax benefits recorded by the IRS Large Business & International Division. LOG_ASSETS is the natural logarithm of total assets. PRETAX_ROA is pretax income deflated by total assets. FOR_INCOME is the ratio of the company's disclosure of foreign pretax income, deflated by total assets. NOL is an indicator variable if the firm has a loss carryforward. R&D is research and development expenses, deflated by total assets. LEVERAGE is the ratio of long-term debt to total assets. Tax Non-Audit Fees and Total Fees are the fees disclosed by the company that are paid to the auditor for tax services and all services, respectively. AUD_PREP is an indicator variable that takes on the value 1 if the tax return is signed by the company's audit firm; NONAUD_PREP is an indicator variable that takes on the value 1 if the tax return is signed by a preparer who is not the firm's auditor; and INTERNAL_PREP is an indicator variable that takes on the value 1 if the firm's tax return is not signed by an external preparer. AUD_PREP, OTHER_PREP and INTERNAL_PREP are mutually exclusive and jointly exhaustive.
46
TABLE 4 (continued)
Panel B. Summary Statistics by Tax Preparer Type
External Tax Preparer:
Auditor (AUD_PREP = 1)
Not the Auditor (OTHER_PREP = 1)
Internal Tax Department (INTERNAL_PREP = 1)
Variable n Median Mean STD n Median Mean STD n Median Mean STD Dependent Variable
UTB Ending Balance ($M) 312 5.79 46.86 127.66 378 6.65 46.77 134.40 843 37.30 139.87 232.75 UTB EB / Total Assets 312 0.00 0.01 0.02 378 0.01 0.01 0.02 843 0.01 0.01 0.01 Log_UTB_EB 312 1.19 2.10 1.79 378 2.03 2.23 1.70 843 3.65 3.52 1.91
Control Variables
Total Assets ($M) 312 1,956 9,472 28,610 378 1,339 7,175 18,697 843 5,884 24,882 55,116 LOG_ASSETS 312 7.58 7.71 1.58 378 7.20 7.42 1.61 843 8.68 8.76 1.63 PRETAX_ROA 312 0.06 0.04 0.15 378 0.04 0.02 0.19 843 0.07 0.06 0.11 FOR_INCOME 312 0.00 0.01 0.03 378 0.00 0.01 0.04 843 0.00 0.02 0.04 NOL 312 0.00 0.45 0.50 378 0.00 0.49 0.50 843 0.00 0.43 0.50 R&D 312 0.00 0.02 0.06 378 0.00 0.04 0.07 843 0.00 0.02 0.04 LEVERAGE 312 0.13 0.17 0.17 378 0.11 0.16 0.18 843 0.21 0.22 0.16
Panel C. Correlation Table
1. 2. 3. 4. 5. 6. 7. 8. 9. 1. Log_UTB_EB 2. AUD_PREP -0.21 3. OTHER_PREP -0.20 -0.29 4. INTERNAL_PREP 0.34 -0.56 -0.63 5. LOG_ASSETS 0.63 -0.15 -0.26 0.35
6. PRETAX_ROA 0.06 -0.01 -0.13 0.12 0.11 7. FOR_INCOME 0.28 -0.09 -0.11 0.16 0.14 0.38 8. NOL 0.07 0.00 0.05 -0.04 -0.19 -0.07 0.09 9. R&D 0.04 0.00 0.13 -0.12 -0.21 -0.13 0.11 0.13 10. LEVERAGE 0.18 -0.08 -0.12 0.16 0.18 -0.02 -0.09 0.09 -0.16
This Panel reports Pearson correlation coefficients. Correlations in excess of 0.04, in absolute value, are generally statistically significant at a
5% level.
47
Dependent Variable: Log_UTB_EB
VariablePred. Sign
INERNAL_PREP + 0.287 ** 0.353 *** 0.667 ***(2.49) (2.73) (4.31)
OTHER_PREP + 0.216 * 0.274 * 0.550 **(1.70) (1.89) (2.21)
LOG_ASSETS + 0.917 *** 0.963 *** 0.663 *** -0.129 0.897 ***(27.82) (27.13) (7.99) (-1.32) (22.11)
PRETAX_ROA + -0.463 -0.536 -0.335 -0.881 -0.414(-1.39) (-1.49) (-0.43) (-1.13) (-1.25)
FOR_INCOME + 3.476 *** 3.481 ** 5.147 * -0.182 3.265 **(2.72) (2.55) (1.77) (-0.06) (2.55)
NOL + 0.276 *** 0.301 *** -0.257 0.083 0.279 ***(3.23) (3.25) (-1.11) (0.34) (3.26)
R&D + 2.501 ** 2.542 * -5.055 * 2.512 2.598 **(2.13) (1.93) (-1.69) (1.02) (2.26)
LEVERAGE + 0.084 0.113 0.800 -0.078 0.054(0.25) (0.32) (1.14) (-0.10) (0.16)
NON-TAX FEE RATIO -1.635 * -2.067 *(-1.69) (-1.88)
Constant + -4.986 *** -5.448 *** -2.581 * 0.734 -5.150 ***(-10.55) (-10.72) (-1.68) (0.45) (-10.20)
Year ControlIndustry Controls≅_INTERNAL_PREP -0.432 ***
(-3.34)≅_OTHER_PREP -0.359
(-1.47)ObservationsAdjusted R2 60.1%Model F-Stat 84.92 *** 78.81 ***Model Chi-Square 1,845.67 ***Pseudo-R2 20.5%Log Pseudo-LikelihoodTests between Coefficients:INTERNAL_PREP vs.EXT_ISNT_AUD
≅≅ = 1.54p= 0.21
YES YES YES YES
-2,534.04 -3,838.08
YESYES
378
All models use robust standard errors clustered by firm. Continuous variables are winsorized at the 1 and 99 percentile levels. *, **, and *** denote significance at the p < 0.10, 0.05, and 0.01 levels (all two-tailed), respectively. See Appendix B for full variable definitions.
YES YES YES YES
1,533 1,533 843 1,533
≅ 1 = ≅ 2
F = 0.43p =0.514
≅ 1 = ≅ 2
F = 0.43p =0.513
≅ 1 = ≅ 2
Coefficient Coefficient Coefficient Coefficient(t-statistic) (t-statistic) (z-statistic) (z-statistic)
Coefficient(z-statistic)
OLS TobitINTERNAL_
PREP
TABLE 5Multivariate Regression Results on the Link between Tax Aggressiveness and Tax Preparer
Type
Stage 1OTHER_
PREP
Multinomial Self-Selection Model
Stage 2
48
Dependent Variable: Log_UTB_EB
VariablePred. Sign
NONAUD_PREP_TAXRET + 0.259 ** 0.323 ***(2.41) (2.64)
All Controls YES YESObservationsAdjusted R2 60.1%Model F-Stat 90.14 *** 83.57 ***Pseudo-R2 20.5%Log Pseudo-Likelihood
Panel B. Using Tax Fee Data to Classify Preparer as (Internal or External) Non-Auditor
Case 1: Non-Auditor Preparer as Zero Tax Fees Case 2: Non-Auditor Preparer as <1% Tax/Total Fee RatioDependent Variable: Log_UTB_EB Dependent Variable: Log_UTB_EB
VariablePred. Sign Variable
Pred. Sign
NONAUD_PREP_10K + -0.012 -0.025 NONAUD_PREP_10K_1% + -0.059 -0.060(-0.11) (-0.21) (-0.61) (-0.56)
All Controls YES YES All Controls YES YESObservations ObservationsAdjusted R2 59.8% Adjusted R2 59.8%Model F-Stat 89.74 *** 83.03 *** Model F-Stat 90.11 *** 83.25 ***Pseudo-R2 20.3% Pseudo-R2 20.3%Log Pseudo-Likelihood Log Pseudo-Likelihood
Case 3: Non-Auditor Preparer as <5% Tax/Total Fee Ratio Case 4: Non-Auditor Preparer as <10% Tax/Total Fee RatioDependent Variable: Log_UTB_EB Dependent Variable: Log_UTB_EB
VariablePred. Sign Variable
Pred. Sign
NONAUD_PREP_10K_5% + -0.141 * -0.144 NONAUD_PREP_10K_10% + -0.127 -0.133(-1.69) (-1.53) (-1.52) (-1.46)
All Controls YES YES All Controls YES YESObservations ObservationsAdjusted R2 59.9% Adjusted R2 59.9%Model F-Stat 91.12 *** 84.12 *** Model F-Stat 92.80 *** 85.25 ***Pseudo-R2 20.3% Pseudo-R2 20.3%Log Pseudo-Likelihood Log Pseudo-Likelihood
OLS Tobit
Coefficient Coefficient(t-statistic) (t-statistic)
-2,534.41
1,533 1,533
TABLE 6
OLS Tobit
Coefficient CoefficientCoefficient Coefficient
OLS Tobit
1,533 1,533
1,533 1,533
-2,540.67
Sensitivity Test Summary Results: Classifying Type of Preparer from Tax Returns vs. from Financial Statement Disclosures
(t-statistic) (t-statistic)
-2,540.91
(t-statistic) (t-statistic)
Coefficient Coefficient(t-statistic)
OLS Tobit
Coefficient Coefficient(t-statistic) (t-statistic)
Panel A. Benchmark Case - Using Tax Returns to Classify Preparer as (Internal or External) Non-Auditor
(t-statistic)
-2,538.93
OLS Tobit
1,533
-2,539.49
1,533 1,533 1,533
49
Case 5: Non-Auditor Preparer as <25% Tax/Total Fee Ratio Case 6: Non-Auditor Preparer as <50% Tax/Total Fee RatioDependent Variable: Log_UTB_EB Dependent Variable: Log_UTB_EB
VariablePred. Sign Variable
Pred. Sign
NONAUD_PREP_10K_25% + -0.301 ** -0.351 *** NONAUD_PREP_10K_50% + 0.858 1.171(-2.42) (-2.63) (1.39) (1.39)
All Controls YES YES All Controls YES YESObservations ObservationsAdjusted R2 59.9% Adjusted R2 59.8%Model F-Stat 91.67 *** 84.78 *** Model F-Stat 90.06 *** 83.13 ***Pseudo-R2 20.4% Pseudo-R2 20.3%Log Pseudo-Likelihood Log Pseudo-LikelihoodAll models use robust standard errors clustered by firm. Continuous variables are winsorized at the 1 and 99 percentile levels. *, **, and *** denote significance at the p < 0.10, 0.05, and 0.01 levels (all two-tailed), respectively.
OLS Tobit
Coefficient Coefficient
OLS Tobit
Coefficient Coefficient
TABLE 6 Panel B (continued)
1,533 1,533
(t-statistic)(t-statistic)(t-statistic)
-2,539.96
(t-statistic)
1,533 1,533
-2,537.37
50
NONAUD_PREP
AUD_PREP Total Total
Tax ReturnNON_AUD_PREP_TAXRET 1,221 312 1,221 312 1,533 0 0 0 0.0%
10-KNON_AUD_PREP_10K 298 1,235 288 302 590 10 933 943 61.5%NON_AUD_PREP_10K_1% 428 1,105 412 296 708 16 809 825 53.8%NON_AUD_PREP_10K_2% 538 995 510 284 794 28 711 739 48.2%NON_AUD_PREP_10K_3% 640 893 601 273 874 39 620 659 43.0%NON_AUD_PREP_10K_4% 718 815 668 262 930 50 553 603 39.3%NON_AUD_PREP_10K_5% 777 756 717 252 969 60 504 564 36.8%NON_AUD_PREP_10K_10% 1,055 478 933 190 1,123 122 288 410 26.7%NON_AUD_PREP_10K_15% 1,203 330 1,025 134 1,159 178 196 374 24.4%NON_AUD_PREP_10K_20% 1,320 213 1,104 96 1,200 216 117 333 21.7%NON_AUD_PREP_10K_25% 1,417 116 1,159 54 1,213 258 62 320 20.9%NON_AUD_PREP_10K_30% 1,471 62 1,190 31 1,221 281 31 312 20.4%NON_AUD_PREP_10K_35% 1,496 37 1,206 22 1,228 290 15 305 19.9%NON_AUD_PREP_10K_40% 1,514 19 1,216 14 1,230 298 5 303 19.8%
NONAUD_PREP_TAXRET = 1 if tax return does not report the firm's auditor as its tax preparer; 0 otherwise.NONAUD_PREP_10K = 1 if firm does not report in its 10-K any tax fees paid to its auditor; 0 otherwise.NONAUD_PREP_10K_1% (_2% , _3% …) = 1 if firm reports in its 10-K any tax fees paid to its auditor less than or equal to 1% (2%, 3%..., respectively) of total fees paid to the auditor; 0 otherwise.
# as NONAUD_
PREP
# as AUD_PREP
TABLE 6 (continued)
Is not NONAUD_PREP but
10-K implies it is
Is NONAUD_PREP but
10-K implies it is not
# correctly classified% Sample Incorrectly Classified
# incorrectly classifiedPanel C. Analysis of Accuracy in Classifying Preparer Type from Financial Statement Disclosures of Tax Fee Data