Many countries are reforming their audit regulations by removing mandatory audit requirements. In private firms, tax considerations play an important role in financial reporting decisions. Public interest in private firms is limited and owners can more directly observe firm performance. Private (particularly smaller) firms don’t have the same pressure as public firms to report superior financial performance. Instead, private firms have a higher incentive to understate their financial performance as a means of reducing the corporate tax bill, leading them to engage in tax avoidance. As a result, an obvious tension emerges between the firm and the state which relies on fair financial and tax reporting in the state’s revenue collection activities.

Although auditors do not have direct responsibility for tax reporting outcomes, previous research based on firms under a mandatory audit regime suggests that auditors limit aggressive tax behaviour by ensuring fair representation of the financial statements. In this paper, Ting Dong, Milda Tylaite and their co-author Ryan Wilson investigate whether auditors demonstrate the same limiting effect on corporate tax avoidance behaviour when audits become voluntary. They find that voluntarily audited firms exhibit a 19% decrease in total income tax paid relative to firms subject to mandatory audit following the regulatory change.

Prior studies had not considered the potential change in auditor–client dynamics when the financial statement audit becomes voluntary, a factor that may have consequences for auditor independence and corporate reporting outcomes. A disruption of the incumbent auditor–client relationship does not necessitate the hiring of a new auditor. For private firms without capital market concerns, the cost of leaving their incumbent auditor can be lower than in the mandatory regime, thereby reducing auditors’ bargaining power. Auditors arguably have a high incentive to compromise with their clients to retain them. The researchers argue, then, that the shift from a mandatory to a voluntary audit regime may impair auditor independence, leading to an increase in tax avoidance in voluntarily audited firms. It indicates, among others, that voluntarily audited firms exhibit similar levels of tax avoidance to firms with no audit at all.

"Financial statement audit is typically perceived as a quality-stamp, a signal important for private firms’ external stakeholders. However, many countries globally move towards the removal of the mandatory audit regime for private firms. It is therefore important to understand how the type of audit regime, i.e., whether audit is voluntary or mandatory, affects the audited firms’ and, equally importantly, their stakeholders’ outcomes."

Milda Tylaite

The study contributes to the debate over the costs and benefits of removing mandatory audit requirements for private companies. To read about the study in detail, you can access the article here.

About the researchers

Ting Dong and Milda Tylaite are affiliated to the Accounting Frameworks research platform at Misum and the Department of Accounting at the Stockholm School of Economics.

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