Auditor’s Income Taxation and Audit Quality

Marcel Steller,Erich Pummerer

doi:10.1177/21582440211040833

Abstract

We use an analytical research model to analyze the effect of the auditor’s personal income tax on audit effort. We show that the auditor’s level of care crucially depends on the tax rate and amount of loss recognition. Taxes may cause paradoxical effects on the auditor’s effort, audit quality, and marginal audit fee if profits and losses are taxed differently or in case of risk-averse decision-makers. Therefore, compared with the pretax setting, taxes have distortional effects. Thus, common auditing standards (e.g., International Standards on Auditing framework) will imply diverse audit quality and marginal audit fees depending on the respective national tax law. Our results are relevant for standard setters, auditors, and financial statements’ addressees.

Highlights

In this study, we investigate the influence of auditors’ personal income taxation on audit quality using an analytical model
We focused on audit effort as a proxy for audit quality
Our key aspect was that we focused on after-tax instead of pretax outcomes as a basis for an auditor’s professional judgment The main results of the analysis were that optimal audit effort is mainly driven by the auditor’s risk aversion, the tax rate, and the level of fiscal’s loss participation in case of an audit failure

Summary

Introduction

We investigate the influence of auditors’ personal income taxation on audit quality using an analytical model. According to Equation 2, taxes solely influence the risk-neutral auditor’s optimal audit effort if the tax authorities do not fully participate in losses (l < 1) . If the tax authorities do not fully participate in the auditor’s damage-related losses, increasing tax rates are associated with increasing audit effort and audit quality.

Results

Conclusion