Information Sharing between Tax and Statutory Auditors: Implications for Tax Audit Efficiency

ABSTRACT

We examine whether tax audits become more efficient if tax auditors have access to information about statutory audit adjustments. To this end, we extend the standard tax compliance game by including a statutory auditor and analyze the strategic interactions among a firm issuing financial and tax reports, a statutory auditor, and a tax auditor. We show that granting the tax auditor access to information on statutory audit adjustments can, in some cases, increase tax revenues while simultaneously decreasing tax audit frequency. Thus, more information sharing between statutory and tax auditors could be a policy instrument to combat tax evasion and increase tax audit efficiency. However, the tax audit efficiency enhancing effect comes at the cost of a reduction in financial statement quality as the probability of overstated financial assets increases. Moreover, depending on the importance of firms' financial statement valuation, the additional information may also reduce tax revenues. The regulator must, therefore, carefully weigh the potential efficiency gains from information sharing on statutory audit adjustments that are derived in this study against the potential efficiency losses.

Keywords:

• Tax compliance game
• Tax audit
• Statutory audit
• Tax audit efficiency
• Strategic auditing

Acknowledgments

We thank Christian Hofmann (editor), two anonymous reviewers, Joachim Gassen, Laszlo Goerke, Kyungha Lee, Ulf Schiller, Barbara Schöndube-Pirchegger, Alfred Wagenhofer, participants of the ARFA – Workshop 2015, the GEABA – Symposium 2015, the EAA – Conference 2016, the VHB - Conference 2016, and the EISAM Workshop on Accounting and Economics 2016 for helpful comments.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Supplemental Data and Research Materials

Supplemental data for this article can be accessed online at http://dx.doi.org/10.1080/09638180.2022.2108094.

Notes

1 Our model is formulated such that it covers risky legal tax planning and (illegal) tax evasion. In the model, the difference is simply represented by the amount of penalties. In the case of risky legal tax planning, penalties are interest payments (above the market rate) that have to be paid on back tax payments after the audit. In the case of tax evasion, penalty payments include, in addition to interest payments, criminal penalties. In the paper, we often simply refer to incorrect tax reporting to cover both risky tax planning and illegal tax evasion.

2 We do not examine pure-strategy equilibria in which the tax auditor never or always audits and the taxpayer always or never evades taxes because these equilibria are rarely observed in real-world audit and reporting behavior.

3 See, for example, Zerni et al. (2012), Deng et al. (2014), and André et al. (2016).

4 To avoid having an excessively complex model, we exclude agency conflicts from the analysis. The effect of agency problems (among shareholders or between shareholders and managers) on corporate tax avoidance is analyzed, for example, in Chen and Chu (2005), Crocker and Slemrod (2005), and Jacob et al. (2021).

5 We do not address the taxpayer's uncertainty about the correct valuations in this paper. An analysis of tax uncertainty can be found, for example, in Graetz et al. (1986), Beck and Jung (1989), Beck et al. (1996), Mills et al. (2010), or De Simone et al. (2013).

6 This assumption is made for ease of exposition. The uniform distribution is sufficient to produce a variety of results that certainly hold under more general assumptions.

7 See, for example DeFond and Subramanyam (1998), Heninger (2001), Kim et al. (2003), Cahan and Zhang (2006), and Venkataraman et al. (2008).

8 See Watts (2003).

9 In section 4.2, we show that auditor conservatism simplifies the exposition of the equilibria in our game but is not critical for the efficiency results in propositions 1 to 3.

10 There are typically implicit incentives for assessing additional taxes during tax audits because the effectiveness of the tax audit staff is evaluated with respect to additional taxes ‘earned’ from tax audits (Alissa et al., 2014; Blaufus et al., 2022). In some countries, explicit incentives also exist (Kahn et al., 2001). However, we acknowledge that the legal function of a tax audit is to discover all relevant facts that are necessary to find the correct taxable income, even if this reduces the tax payment.

11 High tax auditor incentives would imply that tax auditors do not differentiate between reports with and without book–tax differences in their tax auditing decisions (Blaufus et al., 2020). This is not what one observes in reality (Mills & Sansing, 2000). Thus, high incentives do not seem to describe audit behavior in practice. Moreover, when tax auditor incentives are low, all taxpayers of type t = 1 report $\hat{z}=(\cdot ,0)$ when no information exchange takes place between the statutory and the tax auditor. Again, this is not consistent with observations in practice. Thus, the assumption that tax auditors have medium incentives remains the most reasonable assumption.

12 Gassen and Fülbier (2015) report an average debt ratio of 62% for European private firms.

13 The same problem of tractability would arise if we were to assume that the taxpayer is uncertain about the parameters of the auditors' objective functions. See Reinganum and Wilde (1988) for such an approach.

14 The timeline illustrates that we assume a traditional tax audit rather than a permanent or contemporary tax audit under a cooperative compliance regime.

15 It may be necessary to consider mixed- and pure-strategy equilibria when we compare the two information regimes. However, such a case does not appear in the following analysis because we do not consider extremely low tax auditor incentives.

16 Recall that ${\theta }_S=\frac{C_S}{{\delta }_S-C_S}$ and ${\theta }_T=\frac{C_T}{{\delta }_T-C_T}$.

17 In our model, this simply depends on whether ${\delta }_t$ is larger than, lower than or equal to one.

18 The properties discussed below hold generally. A proof is available upon request.