The effect of disclosing audit quality control deficiencies on non-audit tax services: Evidence from Deloitte’s 2007 PCAOB Part II inspection report

We examine whether public disclosure of Deloitte 2007 PCAOB Part II report, which identifies quality control deficiencies related to audits of income tax accounts, affects Deloitte’s auditor-provided tax services (APTS). Using a difference-in-differences model, we document a 17 percent lower likelihood of Deloitte’s audit clients employing APTS relative to clients of other annually inspected firms when the report is made public. We also find that the dampening effect of publicly disclosing the Part II report on Deloitte’s APTS is more evident among audit clients paying higher non-audit fees to auditors and those with more complex tax planning. These results suggest that revealing income tax-specific quality control deficiencies prompts audit clients to revise upward (downward) their expected costs (benefits) of perceived auditor independence impairment (knowledge spillover) stemming from APTS. Overall, our study suggests that public disclosure of audit firm-wide quality control deficiencies pertaining to audits of income tax accounts imposes a collateral damage to the inspected firm’s non-audit tax services, thereby providing a more complete understanding of the consequences of the PCAOB’s communications about quality control deficiencies in Part II reports.     

Audit quality effects of the PCAOB's 2006 tax service restrictions

In 2004 and 2005, use of aggressive tax services provided by a company's auditor had become so broadly concerning that it was the focus of a PCAOB roundtable and discussed in a Congressional subcommittee investigation report (PCAOB, 2004 and US Senate, 2005). Although auditor provision of these and other nonaudit services to issuer audit clients was restricted in 2006, research on the effectiveness of these restrictions finds that they did not impact audit quality (Notbohm, Paterson and Valencia, 2015 and Lennox, 2016). We reexamine this issue with a focus on the audit quality effects for the engagements most impacted by the restrictions-Big 4 audit clients with pre-restriction tax service fees of at least $100,000 that fell by at least 75% following the restrictions. Using a difference-in-difference framework and two proxies for audit quality, we find evidence of the effectiveness of the PCAOB's 2006 restrictions among those clients. Additionally, we find these results are sensitive to the level of pre-restriction tax service fees, with the restatement (going concern) effect of the restrictions strengthening (weakening) in the pre-restriction tax service fee level. We also find that the effects of these restrictions are concentrated among clients of Big 4 auditors rather than clients of the 2nd tier or 3rd tier auditors. Results of additional analyses indicate that audit quality, as measured by the probability of restatement, was lower in the pre-restriction period for purchasers than for non-purchasers. Our results are robust to a barrage of sensitivity tests. Our findings contribute to the continued regulator discussion about the proper level and types of allowable tax nonaudit services.     

An Empirical Investigation Into the Audit Engagement Letter: Use, Content and Effectiveness

The Engagement Letter documents the scope of the audit and the responsibilities of both auditor and client, and thus is both contractual and informative in nature. A survey of 600 auditors and 300 listed public company managers investigated the use and effectiveness of a broad range of Engagement Letter items. Findings show that public company managers regard Engagement Letter items as significantly less important than do auditors. Differences between auditors and their clients in their assessment of the importance of these items might suggest misunderstanding. Consistent with the expectation gap literature, it is likely that auditors can improve their communication, perhaps through expanding on and clarifying the importance of particular items to clients.     

Taxing audit markets and reputation: An examination of the U.S. tax shelter controversy

From 2002 to 2007, the nation's largest CPA firms faced allegations of illegal activity related to the sale of tax shelters: EY, KPMG and PwC paid fines; KPMG was investigated by a federal grand jury; and EY faced a criminal inquiry. These shelter events occurred shortly after the 2002 collapse of Arthur Andersen, when policy makers were concerned about audit market concentration. This is the first paper to provide a chronological summary of how the tax shelter controversy started and ended. We investigate the stock market reaction to tax shelter news developments between 2003 and 2005 to make inferences about the market's view of audit competition and CPA firm reputation. Our results are consistent with market concern over large audit firm concentration, evidenced by large negative returns for clients of all audit providers upon the KPMG grand jury investigation announcement. We also find that tax shelter activities impact both the reputation of the accounting profession and the individual CPA firms marketing tax shelter products.     

Costs Associated With Going-Concern-Modified Audit Opinions: An Analysis of the Australian Audit Market

This article examines the potential costs to Australian auditors and their clients from the issuance of first-time going-concern-modified audit opinions. We examine the population of Australian companies receiving a first-time going-concern-modified audit opinion during the period 1994–97 and a matched sample of financially distressed firms receiving a clean audit opinion. Results indicate that auditor switching is positively associated with receipt of a going-concern-modified opinion. However, we find no empirical evidence that there is a self-fulfilling prophecy of increased probability of company failure following the issuance of a going-concern-modified opinion for the Australian companies in our study. Our analyses of lost audit fees indicate that auditors issuing first-time going-concern-modified audit opinions lost proportionately more fees by losing clients (through switching or company failure) than firms not issuing a going-concern-modified opinion to financially stressed clients.     

企业集团统一审计能降低审计收费吗

审计收费是审计研究的重要问题。已有审计研究文献通常关注的是对单个公司的审计收费,本文则关注在同一实际控制人控制下的企业集团中,多家上市公司选择同一家会计师事务所审计,即集团统一审计对审计收费的影响。研究发现,集团统一审计不但不能降低审计收费,反而会增加审计收费;选择大所进行统一审计可以降低审计费用,而小所执行统一审计则可能存在牺牲独立性以获得更多审计收费的情形。此外,事务所尤其是小规模事务所,在招揽集团客户时存在激烈的低价竞争。     

Using machine learning to predict auditor switches: How the likelihood of switching affects audit quality among non-switching clients

In this paper, we utilize machine learning techniques to identify the likelihood that a company switches auditors and examine whether increased likelihood of switching is associated with audit quality. Building on research that finds a deterioration in audit quality associated with clients that engage in audit opinion shopping, we predict and find lower audit quality among companies that are more likely to switch auditors but remain with their incumbent auditor. Specifically, we find that companies more likely to switch auditors have a higher likelihood of misstatement and larger abnormal accruals. These results are consistent with auditors sacrificing audit quality to retain clients that might otherwise switch. Our findings are especially concerning because there is no public signal of this behavior, such as an auditor switch. Our methodology is designed such that it could be implemented by investors, audit firms and regulators to identify companies with a higher probability of switching auditors and preemptively address the deterioration in audit quality.     

Public Attention and Auditor Behavior: The Case of Hurun Rich List in China

Adverse client publicity can entail regulatory scrutiny over audited financial statements and impose political costs on auditors. We use the changes in client publicity caused by their controlling owners’ presence on the Hurun Rich List (the rich listing) in China to test the hypothesis that auditor conservatism increases with client publicity. Our evidence indicates auditors issue more adverse audit opinions to clients and charge higher fees following the rich listing events. Moreover, we observe that auditors strategically respond to clients with different attributes—for clients whose owners accumulated wealth in a more questionable manner, auditors choose more stringent audit reporting to better defend themselves from regulatory scrutiny; for clients without such attributes, auditors primarily rely on increasing audit fees to cope with any post-listing increase in audit risks. Our analyses also suggest the impacts of rich listings tend to be concentrated among large audit firms with stronger reputation concerns or among engagement auditors with more conservative reporting styles. By showing how auditors manage political risks associated with heightened public scrutiny, we contribute to both the auditing and political cost literature.     

Valuation of tax loss carryforwards

Tax loss carryforwards (TLC) are a valuable asset because they can potentially reduce a company’s future tax payments. However, there is often a great deal of uncertainty regarding the probability and timing of these tax savings. We propose a contingent-claim model to value this asset. The value is determined primarily by the size of accumulated carryforwards relative to earnings. We show that, for poorly performing firms with large TLC, (1) the realizable (or fair) value of the tax losses can be significantly smaller than the book value, and (2) the tax losses can account for a significant fraction of the company’s equity value. The model is illustrated by calibrating it to a couple of companies with large carryforwards. Finally, we show how the model can be used to compute the marginal tax rate of a company with carryforwards.     

Public Disclosure of Audit Fees and Bargaining Power between the Client and Auditor: Evidence from China

Before the public disclosure of audit fees was mandated, it was unlikely for an audit client to have accurate information about how much other companies were charged by their auditors. Public fee disclosure decreases the cost of auditees' access to audit fee information for the auditor's portfolio of clients and is thus likely to increase the relative bargaining power of auditees over auditors when they negotiate audit fees. Using both proprietary and public audit fee data before and after public fee disclosure was mandated in China, we provide evidence consistent with the preceding conjecture. We find that public fee disclosure reinforces the magnitude of audit fee decreases for overcharged clients and weakens auditors' ability to raise audit fees for undercharged clients. These findings suggest the existence of unintended consequences of public fee disclosure regulation, the original rationale of which was a concern about audit pricing practices that could undermine auditor independence.     

Do corporate payouts signal going-concern risk for auditors? Evidence from audit reports for companies in financial distress

We examine the association between payout policy changes and going-concern decisions for financially distressed clients. Extant auditing standards indicate that payout reductions, which offer a prospect of short-term cash relief, can potentially mitigate going-concern uncertainty, whereas economic theory suggests payout decreases (increases) convey mixed but mostly negative (positive) signals about a company’s future financial status. We find that, compared with a bankruptcy prediction model over short (not to exceed 1 year) and long (2–3 years) horizons, auditors seem to significantly underreact to payout decreases (i.e., negative signals) but react appropriately to payout increases (i.e., positive signals) in their going-concern decisions. Moreover, auditors are three times more likely to make Type II misclassification errors in payout-decreasing firms than in payout-increasing and no-change firms. We also find that auditors take longer to determine the appropriate opinion for clients with payout changes, especially for those who cut their payouts. Overall, our findings suggest that auditors respond differently to positive and negative signals about companies’ future prospects, reflecting the mixed nature of payout decreases relative to payout increases and the professional standards’ emphasis on the prospect of short-term cash relief from payout reductions.     

Evidence of the effect of domicile on corporate average effective tax rates in the European Union

We estimate (worldwide) corporate average effective tax rates (ETRs) from financial statements for companies domiciled in European Union (EU) member states during 7 years from 1990 to 1996. Our objective is to compare the tax rate effectively experienced by each company with the corporate statutory tax rate (STR) in the EU country in which each company is domiciled. The difference between the corporate statutory tax rate and the financial statement-based corporate average effective tax rate provides information on the magnitude of tax incentives provided by governments within the EU. These tax incentives come on top of the directly observable differences in statutory tax rates between EU member states. We find (1) that the use of tax incentives, over and above differences in STRs, differs substantially between EU member states (corporate domiciles) and (2) that the provision of tax incentives does not have the effect of equalizing corporate ETRs between EU member states (corporate domiciles).     

Indirect tax harmonization and global public goods

This paper identifies conditions under which, starting from any tax-distorting equilibrium, destination- and origin-based indirect tax-harmonizing reforms are potentially Pareto improving in the presence of global public goods. The first condition (unrequited transfers between governments) requires that transfers are designed in such a way that the marginal valuations of the global public goods are equalized, whereas the second (conditional revenue changes) requires that the change in global tax revenues, as a consequence of tax harmonization, is consistent with the under/over-provision of global public goods relative to the (modified) Samuelson rule. Under these conditions, tax harmonization results in redistributing the gains from a reduction in global deadweight loss and any changes in global tax revenues according to the Pareto principle. And this is the case independently of the tax principle in place (destination or origin).     

Local tax rebates,corporate tax burdens,and firm migration: Evidence from China

Conflicts of interest between local governments and the central administration in China have yielded many local policies that only serve the interests of local governments. The policy of first levying and then rebating taxes is an example of how local governments eschew the national tax regulations to boost local economies rather than national interests. In 2001, the Chinese government announced the termination of local tax rebates, which had some expected outcomes. We find that local governments complied with the new tax policy even though it no longer allowed local governments to grant tax incentives. However, some companies found ways to avoid the greater tax burdens by moving their business registration locations to tax havens. We also find that firms controlled by local governments were less likely to change registration locations. Our study examines the national tax regulation in China and explores how tax rules influence company decisions. In addition, we show that non-tax incentives, such as local economic development, may also influence company decisions.     

The interplay between mandatory country-by-country reporting,geographic segment reporting,and tax havens: Evidence from the European Union

We investigate whether mandatory public country-by-country reporting (CBCR) by European Union (EU) banks affects geographic segment reporting. We find no significant change in the reported number of geographic segments, country segments, or line items per geographic segment disclosed in segment reporting notes after the introduction of CBCR. Consistent with the notion that EU banks may aggregate geographic segments to obfuscate tax haven activities, we find a positive association between tax haven intensity and geographic segment aggregation. Further, we document the location of banks’ operations and the extent of their economic presence in tax havens. We find that EU banks report significantly higher profit margins, turnover per employee, and profit per employee, and lower book effective tax rates for operations located in tax havens, relative to non-tax havens. Our evidence suggests that mandatory public CBCR has limited impact on geographic segment reporting. Nevertheless, CBCR provides additional information to better identify the existence and scale of tax haven involvement. Our results should be informative for EU policymakers currently considering the expansion of public CBCR to all industries. They might also be relevant to researchers considering the decision usefulness of CBCR for financial statement users in estimating after-tax profitability and tax enforcement risk.     

Earnings management induced by tax planning: The case of Portuguese private firms

In Portugal, a concept of taxable income associated closely with reported accounting income is used to determine the tax liability of firms. Recently, the Portuguese government legislated to introduce a system of “special payment on account” (SPA). Firms were required to pay an amount of income tax in advance that varied between a promulgated minimum and maximum. Although such a tax is unique to Portugal, other countries have tax arrangements that are similar in intent. Thus, Portugal's experience with the introduction of a SPA regime is likely to be instructive in fiscal policy deliberations in other settings.We assess the extent to which the SPA tax policy measure encouraged private Portuguese companies to manipulate earnings. We find that earnings manipulation appears to have been motivated by desire to minimize SPA. Firms whose estimate of SPA liability fell within the range of minimum and maximum limits of the SPA had higher levels of discretionary accruals than firms whose estimate was (equal to or) above the ceiling imposed by the new legislation. Firms with higher rates of income tax were found to reduce earnings to near zero. Firms with higher average income tax rates were more likely to manipulate their earnings than other firms.Our results reinforce the importance for auditors, stakeholders, and tax policy advisors to be alert to the close association between tax planning considerations and reported earnings in their monitoring, analysis, and policy advising activities.     

Interregional redistribution through tax surcharge

The paper considers a utilitarian federal government that levies a tax to finance a national public good or to effect a redistributive policy. Regions differ in their incomes and in their preferences for a local public good. First, we assume that the central government observes each region's public expenditures (and, hence, local tax revenues) but cannot perfectly observe revenues and preferences. We derive the (constrained) Pareto-efficient allocation and show how it can be implemented by a surcharge on local taxes. The level of redistribution that can be achieved is limited by the fact that it may be difficult, or even impossible, to distinguish low-income regions with a high preference for the public good from high-income regions with a low preference. Then we allow for the possibility that the central government can observe incomes through a costly audit. We examine the optimal audit policy and study the impact of audits on the optimal taxation scheme. Throughout the paper we focus on the properties of average and marginal tax rates and on the resulting under- or overprovision of regional public goods.     

Auditor-provided tax services and stock price crash risk

This paper examines whether auditor-provided tax services affect stock price crash risk: an important consideration for stock investors. Provision of tax services by incumbent auditors could accentuate or attenuate crash risk depending on whether such services give rise to knowledge spillover or impair auditor independence. The study investigates two channels through which tax services might affect crash risk: earnings management in tax expenses and tax avoidance. Also examined is whether the association between tax services and crash risk is moderated by the particular business strategy that organizations pursue. A two-stage model is used to control for the potential endogeneity inherent in the selection of auditors for tax services. Empirical findings reveal that auditor-provided tax services attenuate crash risk by constraining both earnings management in tax expenses and tax avoidance. Further evidence shows that auditor-provided tax services reduce crash risk for firms following innovator business strategies. Taken together, empirical findings reported in this study support knowledge spillover benefits, that is, insights gained from tax services can enhance audit effectiveness.     

Strategic pricing by Big 4 audit firms in private client segments

We examine how Big 4 auditors compete for new private clients. We find evidence suggesting that Big 4 auditors offer fee discounts to attract non‐Big 4 private clients to experience attributes of their brand name audit services. We also find that to attract clients from competing Big 4 suppliers, Big 4 auditors target fee discounts at clients in industries where they are the market leader. Our results further indicate that the Big 4 industry leaders target fee discounts to fast‐growing clients and are able to charge these clients significant price fee increases in the second mandate period (after 3 years).     

Do Publicly Disclosed Tax Reserves Tell Us About Privately Disclosed Tax Shelter Activity?

We examine whether public disclosures of tax reserves recently made available through Financial Interpretation No. 48 (FIN 48) reflect corporate tax shelter activities. Understanding this relation is important to corporate stakeholders and researchers keen to infer the aggressive nature of a firm's tax positions from its tax reserve accrual. Our study links public disclosures of tax reserves with mandatory private disclosures of tax shelter participation as made to the Internal Revenue Service's Office of Tax Shelter Analysis. We find strong, robust evidence that the tax reserve is positively associated with tax shelters, while other commonly used measures of tax avoidance are not. Based on out‐of‐sample tests, we also show that the reserve is a suitable summary measure for predicting tax shelters. The tax benefits of tax shelters are economically significant, accounting for up to 48% of the aggregate FIN 48 tax reserves in our sample.