The Effect of Tax Aggressiveness and Corporate Governance on Audit Fees Evidences from Brazil

By Martinez, Antonio Lopo; Lessa, Rubem Cardoso | Journal of Management Research, January 1, 2014 | Go to article overview

The Effect of Tax Aggressiveness and Corporate Governance on Audit Fees Evidences from Brazil


Martinez, Antonio Lopo, Lessa, Rubem Cardoso, Journal of Management Research


Abstract

The study investigates the relationship between tax avoidance practices and audit fees. The literature has reported various factors that determine the amount of audit fees, among them the possible risks faced by the audit firm. This article focuses on the effect of tax avoidance by Brazilian companies on the fees charged by auditors. Based on audit fee data for the period from 2009 to 2011 and book-tax differences as an empirical proxy for tax avoidance, we find that tax avoidance practices are positively related to audit fees, i.e., companies that are more aggressive in their tax planning tend to be penalized by having to pay higher fees to their auditors. However, in the contextualized analysis, the results indicate that good corporate governance practices tend to minimize this relationship, attenuating the incremental effects on the remuneration of audit firms. This study also evidences the risk perception of independent auditors and identifies interactions of tax planning, independent auditing and corporate governance not usually perceived by the market.

Keywords: Audit fees, Tax avoidance, Audit risk, Corporate governance

1. Introduction

This article investigates the relationship between the level of tax avoidance of companies and the amount charged by audit firms. The concept adopted for tax avoidance is the simplified concept developed by Hanlon and Heitzman (2010), the reduction of explicit taxation, which leads to a broad vision of tax planning. The definition includes various tax planning strategies independent of the aggressiveness, so the definition covers both illegal tax evasion and legal tax avoidance (Hanlon & Heitzman, 2010).

External auditors play a key role in the representation of financial information, acting as intermediaries between the financial statements and their users (Hanlon, Krishnan & Mills, 2012). Krishnan and Visvanathan (2008) argued that the risk of corporate governance failure is highly relevant to auditors, because it increases the risk of reformulations, and consequently of auditing in general (Krishnan & Visvanathan, 2008). Therefore, audit fees can be expected to be higher to compensate the greater efforts and greater chance of losses due to the risk of litigation and/or harm to reputation (Hanlon et al., 2012).

The literature has reported evidence that highly elaborate structures to lower taxes can lead the market to believe that not only are the tax rules being circumvented, the financial statements are also being manipulated (Hanlon & Slemrod, 2009). There is also evidence that more complex tax avoidance structures permit companies to manage earnings (Desai & Dharmapala, 2006). Hence, an increase in audit fees would be expected as tax avoidance becomes more aggressive. Based on the foregoing, we examine the following research question: Is there a relationship between the level of tax avoidance and the audit fees paid by listing Brazilian companies?

For this purpose, we investigate if there is a relationship between the variation of external auditors' fees and the variation in levels of tax avoidance of Brazilian firms listed on the BM&FBovespa. We also verify if there is any relationship between audit fees and the level of corporate governance, represented by listing on one of the special trading segments of that exchange reserved for companies with enhanced governance structures. We do not attempt to judge the legality of tax avoidance, only its influence on the fees charged by independent auditors, since they are sensitive to situations that can pose risks to their reputation.

The results confirm the theoretical expectation, in harmony with the findings of other studies, indicating that auditors consider tax avoidance as a parameter to measure the audit risks. Another relevant finding is the inverse relationship between the interaction of being audited by one of the Big 4 and enhanced corporate governance and audit fees, according to which the largest audit firms interpret good corporate governance as a reducer of risks, leading to lower audit fees paid by firms listed for trading in one of the enhanced corporate governance segments. …

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