Internal Control Deficiencies in Tax Reporting: A Detailed View

Prior research, using data from Sarbanes-Oxley Act Sections 302/404 (SOX, U.S. House of Representatives 2002) disclosures, finds that material weaknesses (MWs) in internal controls over financial reporting of taxes are more frequent and consequential than other account-specific MWs. Understanding internal control deficiencies (ICDs) in tax reporting is important but public information is limited, as MWs comprise only control flaws remaining unremediated at year-end and few details on their nature are available from SEC filings. We supplement prior studies by providing a detailed look at all Section 404 control deficiencies in tax reporting in a proprietary sample of engagements in 2004-2005 from several large auditing firms. We find that tax ICDs are less likely to be remediated between discovery and fiscal year-end, more likely to be severe, and more likely to have caused a financial misstatement. Remediation failure for tax ICDs is greater when management missed detecting the problem, and more prevalent for poorly designed controls, controls over the tax provision, and monitoring control activities. Auditors' severity classifications imply that ICDs relating to the tax provision and deferred taxes, and those that failed in operation, have higher potential for producing misstatements. Overall, our results underscore the importance of auditor involvement in internal control reporting in the tax area.