A Fiscal “Big Brother”

By Kevin Tankersley

The premise seems simple enough: If there is a high probability the IRS is going to audit a company's taxes, then that company's financial records are going to be clean across the board. After all, if the IRS is sniffing around the books and stumbles across fraudulent reporting within the financials—even if those financials do not have anything to do with tax reporting—the IRS has the ability to alert the Securities and Exchange Commission to what it has found.

The thing is, however, there does not seem to be a record of that ever happening. So, does an IRS audit actually affect financial misreporting? This question was posed in a recent study co-authored by Paul Mason, assistant professor of Accounting and Business Law at Hankamer School of Business.

According to the study, "Does IRS Monitoring Deter Managers from Committing Accounting Fraud?," a financial manager might have incentive to inflate a company's numbers, because that manager's yearly or quarterly bonus is often based on the firm's net income.

"If I am running a firm, if I hit a certain benchmark, my bonus might be double. And then I might have a propensity, I might have a desire, to inflate my accounting numbers so that I get a bigger bonus," Mason said.

That misreporting can take a couple of directions, Mason said. Sometimes, future income could be "accelerated" into the current reporting period, or the reported numbers could be totally fictitious, but that only happens in the most egregious cases, Mason said. Regardless, these actions can lead to an SEC enforcement against the firm.

But why would the IRS inhibit financial misreporting when conducting a tax audit?

"They would be concerned with the tax line, but books and records for taxes start with financial reporting records," Mason said. "They are not directly auditing the financial statements, but they start from a similar spot. You start with financial records, then make a bunch of adjustments to it, to get to the tax return. When the IRS comes in and audits that company, they are looking at the tax return, but the tax return, if you keep digging down, started with the financial statements, but they do not directly audit the financial statements."

Each year, the IRS releases its audit rates, which give a company a pretty good idea of the probability of it facing an audit. Generally, the larger an organization, the higher the chance of it experiencing a visit from the tax agency. But that visit is not always a bad thing.

"If I think that the IRS has a higher likelihood of auditing my firm, from a tax standpoint, then I am less likely to misreport my financial statements," Mason said. "My records across the company are going to be better."

The IRS' effect on financial misreporting is known as a spillover effect, Mason said, "because they are not directly looking for fraud cases in the financial statements."

Using data collected from 1992 to 2010, Mason, along with his co-author, Brian Williams, assistant professor of Accounting at Indiana University, found that firms are less likely to engage in financial misreporting when the probability of being audited by the IRS is higher. And even though the threat of the IRS reporting financial malfeasance to the SEC might be hanging over a company in the midst of an audit, the reality is that a report will probably never be made. As a result, the threat of an IRS audit is more likely to have a spillover effect due to firms enhancing financial record-keeping, generally, in anticipation of a potential tax audit.

"[The research] has policy implications for how we view IRS enforcement and the value of that enforcement," Mason said. "It also has a component for governance of firms if we think about who is monitoring the managers. And it sheds light on an external factor, the IRS, which is also helping monitor managers."