The Effect of Smoothing of GAAP ETRs on Audit Fees and Audit Hours
Asian Tax Journal Vol. 22 No. 3 (2021), pp. 89-131
Abstract
In this paper, we investigate whether auditors take into account smoothing of GAAP ETRs, a proxy for the audit risk associated with financial reporting quality. Recent study indicates smoothing of GAAP ETRs is associated with higher financial reporting quality (Demere et al. 2019). For example, Demere et al. (2019) document that GAAP ETR smoothing through tax accruals is strongly associated with a lower likelihood of financial restatement and tax－related financial reporting fraud. Therefore, managers are likely to use tax accruals to smooth out volatilities in GAAP ETRs to communicate a long－term sustainable tax rate (Demere et al. 2019). So from that point, we extends the prior literature by examining whether smoothing of GAAP ETRs’ information is associated with auditors’ assessment of their clients’ quality of financial information. An unexplored question, however, is whether GAAP ETR smoothing are association with higher or lower financial reporting quality influences auditors’ risk assessment of their clients. For analysis, following Demere et al. (2019), we measure GAAP ETR smoothing (hereafter GSMO), we also separate GAAP ETR smoothing measure into innate and discretionary factors. We use both audit fees and hours as a proxy for audit risk by auditor. Our sample covers KOSPI and KOSDAQ listed firms in non－financial industries with fiscal year－end in December from 2004 to 2018 period. Our main sample consists of 11,961 (11,574) firm year observations in audit fees (audit hours) data. We document several findings. First, after controlling for several factors as well as pre－tax earnings smoothing, tax avoidance, and opaque financial reports that affect audit fees and hours, we find evidence consistent with Demere et al. (2019)’s argument that there is a negative and significant association between GSMO and audit fees or audit hours. This suggests auditors assess their clients’ higher GAAP ETR smoothing as having lower audit risk. Therefore, our results suggest that GAAP ETR smoothing through tax accruals indicates higher financial reporting quality. Second, we also distinguish between GSMO driven by innate GSMO (i.e., economicfundamentals) and discretionary GSMO (i.e., management choices), we find that firms with a higher degree of innate GSMO affect auditors’ pricing decisions and decreasing their audit fees, whereas we also find that firms with a higher degree of discretionary GSMO affect auditors’ efforts and decreasing their audit hours. These results imply that auditors’ professional response varies with the source of GAAP ETR smoothing. Finally, we find that, within firm, a higher degree of GAAP ETR smoothing is associated with lower audit risk and such negative associations are more pronounced for firms is audited by a Big 4 auditor, lower information asymmetry (proxied by lower volatility of daily stock returns), and higher financial reporting quality (proxied by accruals quality, following Francis et al. (2005)). In sum, these results suggest that firms with higher GAAP ETR smoothing represent lower audit risk, which results in lower levels of audit fees and hours (i.e., effort) for the audit engagement. Thus, our results imply GAAP ETR smoothing reduces audit risk by enhancing clients’ quality of financial information. We contribute to the tax－related literature by showing that auditors reflect GAAP ETR smoothing strategy is related to higher financial reporting quality in their pricing decisions and auditing effort. In addition, our study contributes to the auditing and tax literatures by being the first to show that auditors’ pricing decisions and their auditing efforts are shaped by the information content of firms’ GAAP ETR smoothing policies and the information conveyance is attributable to reduced earnings manipulation risk surrounding the quality of the firm’s reported earnings. Therefore, we suggest that firms with higher smoothing of GAAP ETRs are likely the ones who commit to a more transparent earnings reporting strategy overall. Such a GAAP ETR smoothing strategy is a credible indicator for overall financial reporting quality. Furthermore, our results suggest that firms’ GAAP ETR smoothing status provides a relatively simple and observable cue to auditors as well as external information users (i.e., investors, creditors, regulators, tax authorities and policymakers etc.) when assessing a firm’s financial reporting quality.
Keywords
- Smoothing of GAAP ETRs
- Innate versus discretionary factors
- Financial reporting quality
- Audit fees
- Audit hours
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