Decision making, Verbal protocol analysis, Decision processes

[In 1984, the U.S. Supreme Court ruled that the Internal Revenue Service (IRS) has the authority to summon the workpapers of independent auditors when those workpapers are relevant to the collection of taxes. The exercise of this authority may in some circumstances make the tax costs of corporate audit clients dependent on the disclosures they make to auditors regarding sensitive tax information. This is because such disclosures are documented in auditors' tax accrual workpapers. Many in the accounting profession have argued that clients would reduce disclosures of sensitive tax information to their auditors if the IRS were to routinely access audit workpapers and that this would lead to less accurate financial statements. Underlying this argument are assumptions about the relationships between a client's incentives to disclose tax information to an auditor, the diagnosticity of audit procedures that can serve as substitutes for client disclosures, and the quality of financial reporting. The purpose of this study is to obtain experimental evidence regarding these relations in a laboratory market experiment. A series of four laboratory markets was conducted, in which 32 under-graduates served as subjects. Each market consisted of eight participants, three "auditors" and five corporate audit "clients." There were two independent variables. The first was IRS access, which was operationalized as the effect of client-auditor communication on the likelihood that a contingent liability would become an actual liability. Under conditions of IRS access, client disclosure increased this likelihood. The second independent variable was the level of diagnosticity of an audit procedure that served as a substitute for client disclosure. The major dependent measures were client disclosures of specific contingent tax liabilities and the accuracy of the liability estimates made by clients. The results from the laboratory markets suggest several inferences regarding the effects of IRS access to auditors' workpapers. First, IRS access may reduce client disclosures regarding specific arguable tax return positions. Second, a decrease in client disclosure may not necessarily lead to a decrease in financial statement accuracy. Instead, the client's estimate of the tax liability may serve as a reliable substitute for disclosures regarding the specific arguable tax return positions underlying that estimate. Third, IRS access may reduce the number of arguable tax return positions that clients adopt. Taking fewer arguable positions reduces the need for client disclosure and may be an adaptive strategy for minimizing overall tax and audit costs. Fourth, for each of the three variables discussed above (i.e., disclosure, accuracy, and the adoption of contingent liabilities), the effect of IRS access may be contingent on the diagnosticity of any audit procedures that can serve as substitutes for client disclosure. For example, the clients in our laboratory markets were less inclined to withhold information regarding specific contingent liabilities in an environment where auditors could more easily detect this behavior. This result suggests that any inhibiting effect of IRS access on client disclosure may be smaller in situations where auditors have alternative means for assessing the accuracy of the tax provision. Thus, an important issue for future research is assessing the effectiveness of substitutes for client disclosure in real world audit settings.]

Abstract Reviews several books. "Secrets of the Tax Revolt," by James Ring Adams; "Financial Statement Analysis: Theory, Application, and Interpretation," 3rd ed., by Leopold A. Bernstein; "Perspectives in Auditing," 4th ed., by D.R. Carmichael and John J. Willingham; "Tax Shelter Alternatives: Measuring the Risks," by Michael N. Fitzerald.