New Audit Rules Had Little Effect on Companies

When new financial auditing regulations went into effect in 2019, there were concerns the rules would affect publicly traded companies and, by extension, investors. A new study finds there was an effect – but it was a small one.

At issue are the audits that publicly traded companies are required to get each year. The auditors closely examine a company’s books and – if everything seems above board – sign off on a company’s financial statements, stating they believe the statements are accurate within a material margin of error.

However, starting in 2019, auditors are also required to disclose any aspects of the financial statement audit that they find particularly challenging or subjective, as well as why the auditors feel those issues are worth noting. These audits are governed by the Public Company Accounting Oversight Board, which issued the regulations – called “critical audit matters” (CAMs) – that define which things in a company’s financial statement merit a disclosure from auditors.

“CAMs that focus specifically on taxes are one of the areas where auditors are mostly likely to issue a disclosure,” says Nathan Goldman, co-author of a paper on the work and an associate professor of accounting in North Carolina State University’s Poole College of Management.

“Because these CAM regulations are so new, we wanted to see whether related tax disclosures were having an impact on how companies operate or how they report on their potential tax burden in financial statements. Ultimately, we wanted to see whether tax CAMs are changing corporate behavior in a way that could affect shareholders.”

To explore this issue, Goldman and his collaborators started by looking at data from 1,298 publicly traded companies for the years 2018 (just before the CAMs took effect) and 2019 (the first year of CAM disclosure requirements). While all of the companies received auditor disclosures due to the new CAM regulations, only 298 of the companies merited disclosures related to tax CAMs.

The researchers looked at whether there was a change between 2018 and 2019 for each company in three areas: tax-related financial reporting quality, tax avoidance and tax-related earnings management. More specifically, the researchers looked to see whether these differences were more pronounced for companies that had tax CAM disclosures, as compared to companies whose disclosures were not related to tax CAMs.

Financial reporting quality refers to how accurate the financial data in a company’s financial statement was. The researchers measured financial reporting quality by looking at whether the company received a comment letter from the SEC, subsequently restated its financial statements, or had an internal control weakness – meaning the auditors had concerns over whether the company had effective controls in place to mitigate a financial accounting misstatement. Tax avoidance refers to the extent to which a company was able to reduce its tax liability, relative to the baseline corporate tax rate. And tax-related earnings management refers to whether the actions a company took to reduce its tax liability moved the company from not meeting its earnings target to meeting its earnings target.

“We generally found very little change from year to year related to tax CAM disclosures,” Goldman says. “The only three changes we found that were associated tax CAMs were: a modest increase in the reserve for uncertain tax benefits, which is called a tax accrual; a modest increase in the quality of reporting on tax accruals; and a modest reduction in the likelihood of tax-related earnings management.”

The researchers then looked at data for all of the companies from 2020.

“We found that the numbers for 2020 essentially shifted back to the way things were in 2018,” Goldman says. “Basically, 2019 appears to have been a slight bump in the road as everyone adjusted to the tax CAM regulations, and things returned to normal very quickly.

“This is actually a very interesting finding,” Goldman says. “We used a multi-year window to monitor regulatory effects over time and found that there was an effect, but that things reverted to a norm very quickly. This is particularly valuable information for assessing potential unintended effects of the regulations.”

The paper, “Disclosure of Tax-Related Critical Audit Matters and Tax-Related Outcomes,” is published in the journal Contemporary Accounting Research. The paper was co-authored by Katharine Drake of the University of Arizona, Stephen Lusch of Texas Christian University and Jaime Schmidt of the University of Texas at Austin.

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Note to Editors: The study abstract follows.

“Disclosure of Tax-Related Critical Audit Matters and Tax-Related Outcomes”

Authors: Katharine D. Drake, University of Arizona; Nathan C. Goldman, North Carolina State University; Stephen J. Lusch, Texas Christian University; Jaime J. Schmidt, University of Texas at Austin

Published: Nov. 20, Contemporary Accounting Research

DOI: 10.1111/1911-3846.12920

Abstract: Given that tax-related critical audit matters (tax CAMs) were prevalent among accelerated filers (18.5 percent of observations) during the initial year of CAM disclosures, we examine whether an auditor’s disclosure of tax CAMs is associated with variation in tax-related financial reporting quality, tax avoidance, and tax-related earnings management. Finding an association between tax CAMs and one of these tax outcomes would indicate that the new auditor reporting standard has indirectly affected investors. Examining the first year of CAM disclosures, we do not find that tax CAMs are associated with broad proxies of tax-related audit or financial reporting quality (e.g., restatements, internal control weaknesses, comment letters) or tax avoidance (e.g., effective tax rates or book-to-tax differences). We do find that tax CAMs are associated with a modest increase in tax accrual quality, an increase in the reserve for uncertain tax benefits, and a reduction in the likelihood of tax-related earnings management. However, we do not find these tax CAM effects persist into the second year of CAM reporting. Our evidence is consistent with tax CAM disclosures having a modest but short-lived effect on companies’ reporting of tax accounts. Our findings should inform the PCAOB as they conduct their post-implementation review of the new audit reporting standard.

This post was originally published in NC State News.