Financial Statement Audits of Private Firms and IRS Enforcement Outcomes

ABSTRACT

Using IRS tax return data for private C corporations, we examine the relation between GAAP audits and IRS enforcement outcomes. Among IRS-audited tax returns, we find that those with audited GAAP financial statements have fewer and smaller proposed deficiencies. These effects persist after controlling for tax preparers. Furthermore, we estimate that the explanatory power of audited GAAP financial statements is comparable to that of external debtholders. Audited GAAP financial statements are also associated with a higher likelihood of unagreed proposed deficiencies, more detailed tax return disclosures, and fewer IRS audit hours, all of which are consistent with more defensible tax positions. Tax returns with audited GAAP financial statements exhibit greater initial voluntary compliance and generate smaller proposed deficiencies per IRS audit hour. These results inform private firms as they weigh the costs and benefits of financial statement audits and the IRS as it allocates enforcement resources.

Data Availability: The IRS provided confidential tax information to Michele S. Mullaney pursuant to an agreement under the Intergovernmental Personnel Act of 1970 through the Statistics of Income Division’s Joint Statistical Research Program.

JEL Classifications: H25; H26; M41; M42; M48.