Tax avoidance, financial experts on the audit committee, and business strategy

• DOI: http://doi.org/10.1111/jbfa.12352
• Date: 01 October 2018
• Published date: 01 October 2018

DOI: 10.1111/jbfa.12352

Tax avoidance, financial experts on the audit

committee, and business strategy

Pei-Hui Hsu1Jared A. Moore2Donald O. Neubaum3

1Collegeof Business, California State University,

EastBay, Hayward, CA, 94542-3067, USA

2Collegeof Business, Oregon State University,

443Austin Hall, Corvallis, OR, 97331-2603, USA

3Collegeof Business, Florida Atlantic University,

777Glades Road, Boca Raton, FL, 33431, USA

Correspondence

JaredA. Moore, College of Business, Oregon

StateUniversity, 443 Austin Hall, Corvallis, OR

97331-2603,USA.

Email:jared.moore@bus.oregonstate.edu

JELClassification: H25, H26, M41, G3, L19, L21

Abstract

We examinewhether financial expert audit committee members tai-

lor their approach to overseeing the corporate tax planning process

according to the firm's business strategy. We predict and find that

such directors encourage defender-type firms (characterized par-

tially byhigh risk aversion) to engage in more tax avoidance activities

and prospector-type firms (characterizedpartially by innovation and

risk seeking) to scale back on tax avoidance, relative to the opposing

strategy type. We also find that both accounting experts and non-

accounting financial experts on the audit committee contribute to

our results to some extent, although the effects of non-accounting

financial experts present more consistently.Overall, our results sug-

gest that financial experts on the audit committee tend to play more

of an advising role for defenders and more of a monitoring role for

prospectors, relative to one another.

KEYWORDS

audit committee, board of directors, business strategy, financial

experts, tax aggressiveness,tax avoidance

1INTRODUCTION

This study investigates whether the advising and monitoring roles of the board of directors (Adams & Ferreira,2007)

vary with a firm's business strategy in the context of tax avoidance. Specifically,we examine how financial expertise

on the audit committee and the firm's strategy type (Higgins, Omer,& Phillips, 2015; Miles, Snow, Meyer, & Coleman,

1978) interact to influence the firm's tax planning activities. Audit committees have come to play an increasingly

vital role in firms’ tax planning and tax risk management processes (Deloitte, 2011, 2013, 2014; Richardson, Taylor, &

Lanis, 2013). The importance of financial expertise on the audit committee has also increased as the scope of the audit

committee's oversight has evolvedto include areas such as tax issues, information technology, and globalization, each

carrying their own complexities and risks (KPMG, 2012, 2015, 2017).

In a prior study, Robinson, Xue, and Zhang (2012) examine the impact on tax avoidance of financial expertiseon

the audit committee generally, finding a positive association between financial expertiseand levels of tax avoidance

(consistent with directors’ advising role) but a negative association between financial expertise and the use of risky

tax planning strategies (consistentwith directors’ monitoring role). What is not revealed from these findings, however,

is the extent to which board, specifically audit committee, members vary their application of these roles based on

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1294 HSU ET AL.

contextual factors or conditions, such as the strategic profile of the firm. We explorethis question, thereby helping to

provide a richer understanding of how board members approach oversightof the corporate tax planning process.

Prior studies argue that there is an optimal level of tax avoidance for each firm that maximizes firm value

(Armstrong, Blouin, Jagolinzer,& Larcker, 2015; Chen, Chen, Cheng, & Shevlin, 2010; Slemrod, 2004). Recent empirical

evidence by Cook, Moser, and Omer (2017) supports this argument; they find that firms’ ex-ante cost of capital

increases with the degree to which their level of tax avoidance deviates from investorexpectations in either direction.

From an agency theory perspective, in the absence of sufficiently strong incentive alignment and/or monitoring,

managers may choose to engage in more or less tax avoidance than would maximize shareholder value (e.g., Desai

& Dharmapala, 2006; Rego & Wilson, 2012). While Fama and Jensen (1983) emphasize the general importance of

the board of directors as a monitoring body, Adams and Ferreira(2007) characterize the board as serving dual roles

as both monitors of and advisors to management, providing expert counsel to managers for optimal decision making

while also constraining managers’ actions to the extentthat they do not benefit shareholders.

Themixed extant evidence linking tax avoidance with board characteristics is indicativeof the presence of both roles

in the corporatetax planning process. For example, in the context of noncompliant tax avoidance, Lanis and Richardson

(2011) and Richardson et al. (2013) find that a higher proportion of independent directors on the board is negatively

associated with tax aggressiveness, consistent with the monitoring role.1However,Minnick and Noga (2010) find no

relationbetween board independence and either generally accepted accounting principles (GAAP) or cash effective tax

rates(ETRs) but a negative association between director pay-performance-sensitivity and GAAP ETRs, more reflective

of the advising role at some level. More recently,Armstrong et al. (2015) find that more independent and more sophis-

ticated boards appear to encourage more (less) aggressive tax positions for firms at the lower (upper) extreme of the

tax avoidance continuum, consistent with both roles.

As noted previously,Robinson et al. (2012) also find evidence highlighting both the advising and monitoring roles of

board members in influencing firms’ tax avoidance, specifically those on the audit committee with accounting-specific

financial expertise.Their evidence that financial expertise on the audit committee is important to the tax planning pro-

cess is consistent with the increased role of the audit committee in managing tax risk (e.g., Deloitte, 2011, 2013, 2014;

Richardson et al. 2013) and the growing importance of financial expertiseon the part of audit committee members due

to risks associated with emerging areas of audit committee oversight(e.g., tax issues, information technology, and glob-

alization). Given the complexity surrounding tax issues, audit committee members with financial expertiseare indeed

in a unique position to monitor and advise executives’decisions concerning their firms’ tax planning activities and the

related risks. Similar to Robinson et al. (2012), our analyses explore how audit committee members, specifically finan-

cial experts, fulfill their dual advisory and monitoring roles with respect to tax planning.2However,our study differs

from theirs in that we investigate how a firm's business strategyconditions financial expert audit committee members

to tailor how they deliver on these roles.

Miles et al. (1978) develop a typology of four business strategy types, namely defenders, analyzers, prospectors,

and reactors, each with different approaches to competing in the marketplaceand propensities toward innovation and

risk-taking. Higgins et al. (2015) examine the association between tax avoidance and firm strategy type, finding that

(more risk seeking) prospectors engage in more tax avoidance and do so in more risky and uncertain ways than (more

risk averse) defenders. These findings suggest (as expected) that the different characteristics of each strategy type,

such as strategicfocus, risk tolerance, and organizational structure, influence the manner in which managers weigh the

costs and benefits of tax planning.

The board of directors, of which the audit committee is a subset, plays a keyrole in establishing and maintaining the

business strategy of the firm and the general premise of managerial decision making (Baysinger & Hoskisson, 1990;

Mizruchi, 1983). The board accomplishes this partially through the implementation of decision control systems chosen

1Richardsonet al. (2013) also find the same association using the proportion of independent directors onthe audit committee.

2Wefollow the final definition adopted by the SEC, under which an audit committee member can be deemed a financial expert if the member has: (a) account-

ing expertisefrom work experience as a certified public accountant, auditor, CFO, financial comptroller, financial controller,or accounting officer; (b) finance

expertisefrom work experience as an investment banker,financial analyst, or any other financial management role; or (c) supervisory expertise from supervis-

ingthe preparation of financial statements (e.g., CEO or company president).