Separating Auditor Provided Tax Compliance and Tax Planning - - PowerPoint PPT Presentation

D’Amore-McKim School of Business

Separating Auditor Provided Tax Compliance and Tax Planning Services: Audit Quality Implications

James Chyz University of Tennessee Ronen Gal-Or Northeastern University Vic Naiker Monash University 2016 Deloitte/University of Kansas Symposium May 21, 2016

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Research Questions

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RQ1: Does knowledge spillover between tax and audit functions depend on the nature of tax service provided (i.e. planning or compliance) to audit clients? RQ2: Does knowledge spillover across tax and audit service lines arise between clients of the same office and does it depend on the nature of tax service provided? RQ3: Do office-level tax compliance and tax planning NAS capture audit offices’ allocation of resources and attention to the audit practice in ways that benefit or harm audit quality?

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Findings

• Yes…

Audit quality enhancing knowledge spillovers at the engagement level derive from the provision of tax compliance, but NOT tax planning non-audit services.

• Yes…

High levels of office level tax compliance (but not planning) NAS is associated with improved audit quality.

• High levels of office level tax planning NAS is associated with reduced audit

quality.

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RQ1: Does knowledge spillover between tax and audit functions depend on the nature of tax service provided (i.e. planning or compliance) to audit clients? RQ2: Does knowledge spillover across tax and audit service lines arise between clients of the same office and does it depend on the nature of tax service provided? RQ3: Do office-level tax compliance and tax planning NAS capture audit offices’ allocation of resources and attention to the audit practice in ways that benefit or harm audit quality?

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The Tax NAS Debate

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Continued regulatory/ congressional/ proxy advisor concerns surrounding tax NAS

• PCAOB Rule 3552 - prohibits audit firms from providing tax services that are

related to the marketing, p la nning or opining in favour of transactions that would be considered aggressive tax position transactions

• Institutional Shareholder Services (ISS) - propose “withholding” auditor

ratification and AC member vote if other non-audit fees (including fees paid for tax p la nning NAS) are excessive.

• Congressional (SEC) investigations regarding the tax p la nning services provided

by PWC (EY) to Caterpillar (HP).

Practitioners contend that efficiencies and knowledge spillovers arise when both services are jointly provided.

• “We believe that a strong and leading-edge consulting practice makes us smarter —

not only smarter as consultants, but also more knowledgeable as an overall firm regarding risks and challenges that affect our clients —audit and non-audit alike.” – PWC 2014 Audit Quality Report

TAX DIVISION OF AUDIT FIRM AUDIT CLIENT A TAX NAS

Kinney, Palmrose, and Scholz 2004; Paterson and Valencia 2011; Seetharaman, Sun, and Wang 2011; Gleason and Mills 2011; Krishnan, Visvanathan, and Yu 2013; Choudhary, Koester, and Pawlewicz 2014

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Engagement Level Tax NAS

TAX DIVISION OF AUDIT FIRM AUDIT CLIENT A D’Amore-McKim School of Business

Engagement Level Tax NAS

T.P NAS T.C NAS

Paterson and Valencia (2011)

Recurring tax NAS (Tax Compliance NAS )  Lower likelihood of restatement Non-recurring tax NAS (Tax Planning NAS ) Higher likelihood of restatement

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Hypothesis 1

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Engagement Level Tax compliance NAS

More likely to yield knowledge spillovers 1. Provided by local audit office

• 2. Promotes continuous contact with client and audit team
• 3. Knowledge transfers are more likely to be unbiased, relevant, and

high quality (cf. when knowledge is sourced from a third party)

• 4. Can better evaluate tax provisions, tax reserves, etc. but also…
• 5. Helps auditors to better understand corporate structure, state and

federal NOLs, foreign divisions/ subsidiaries, foreign tax credits, intercompany relationships, and information about specific accounts (i.e. capital expenditures and intangible assets)

H1: Engagement level tax compliance fees are positively associated with engagement level audit quality.

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Hypothesis 2

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Engagement Level Tax planning NAS

Could also lead to knowledge spillovers Higher margin work could increase the cost of an audit failure (Gleason and Mills 2011) Involved with less frequent interactions with clients Deal with specific projects Often outsourced from larger offices Providers less likely to have accounting backgrounds (e.g. tax lawyers, transfer pricing economists) Economic bonding concerns (if tax planning contracts more lucrative)

H2: Engagement level tax planning fees are not associated with engagement level audit quality.

TAX DIVISION OF AUDIT FIRM AUDIT CLIENT A

T.P NAS T.C NAS

Client B Client C Client E

T.P T.C T.P T.P T.P T.C T.C T.C

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Office Level Tax NAS

TAX DIVISION OF AUDIT FIRM AUDIT CLIENT A

T.P NAS T.C NAS

Client B Client C Client E

T.P T.C T.P T.P T.P T.C T.C T.C

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Office Level Tax NAS

TAX DIVISION OF AUDIT FIRM AUDIT CLIENT A

T.P NAS T.C NAS

Client B Client C Client E

T.P T.C T.P T.P T.P T.C T.C T.C

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Office Level Tax NAS

Knowledge Transfer

TAX DIVISION OF AUDIT FIRM AUDIT CLIENT A

T.P NAS T.C NAS

Client B Client C Client E

T.P T.C T.P T.P T.P T.C T.C T.C

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Office Level Tax NAS

Change in Strategic Focus

TAX DIVISION OF AUDIT FIRM AUDIT CLIENT A

T.P NAS T.C NAS

Client B Client C Client E

T.P T.C T.P T.P T.P T.C T.C T.C

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Office Level Tax NAS

Audit Firm/ Office Culture Changes

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Hypothesis 3 & 4

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Office Knowledge sharing/ spillover (O’Keefe et al. 1994,

McGuire et al. 2012, Bianchi et al. 2014)

Shifts in strategic focus/ culture Higher margin work (e.g.,

tax planning work) could lead to distractions from the audit and the audit firms “core values” – Former SEC Chief accountant (Paul Beswick),

PCAOB Member (Steven Harris)

Beardsley et al. 2015 –Increased focus on NAS associated with an increased likelihood of misstatements (in the presence of fee pressure).

H3: Audit office level tax compliance NAS fees are positively associated with audit quality at the engagement level. H4: Audit office level tax planning NAS fees are not associated with audit quality at the engagement level.

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Sample Selection

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Table 1 - Sample Selection Misstatement Non-Misstatementa Total Initial firm-year observations from Audit Analytics and Compustat 2,058 24,332 26,390 Firm-year observations with missing variables (410) (6,642) (7,052) MSA requirement (49) (482) (531) Base Sample (2007-2011) 1,599 17,208 18,807 1) No Disclosure of Tax Fee Breakdown 2) Disclose Tax Fee Breakdown 9,260 2,892 6,655 Final Sample 9,547

a - We require that non-misstatements firms do not restate their 2006-2012 financial statements

3) Firm-year

• bservations with no

Tax NAS Firm-year observations with positive Tax NAS

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Research Design

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RESTATE = β0 + β1 ENGAGE_TAXCOMP_RATIO + β2 OFFICE_TAXCOMP_RATIO + β3 ENGAGE_TAXPLAN_RATIO + β4 OFFICE_TAXPLAN_RATIO + βN Controls + Industry F.E. + Year F.E. + ε

H1  β1 (-) H2  β2 (?) H3  β3 (-) H4  β4 (?)

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Table 3 – Primary Regressions

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A One Stddev increase in ENG_TAXCOMP is associated with an 8.73% reduction in misstatement likelihood

Hypothesized (1) (2) (3) (4) DV = RESTATE Directional Expectation ENG_TAXFEES

• 0.789*
• 1.182*

(-1.95) (-1.71) ENG_TAXCOMP

• 1.911**
• 1.927**

(-1.78) (-1.80) ENG_TAXPLAN ?

• 0.089
• 0.151

(-0.07) (-0.11) OFF_TAXCOMP

• 0.115***

(-3.75) OFF_TAXPLAN ? 0.108** (2.56) ENG_LOG_AUDFEE + 0.174** 0.052 0.053 0.059 (2.39) (0.56) (0.57) (0.62) ENG_OTH_NAF + 1.076*** 1.327*** 1.338*** 1.372*** (3.41) (3.30) (3.33) (3.41) OFF_LOG_AUDFEE +

• 0.017

(-0.41) OFF_OTH_NAF +

• 0.010

(-1.03) Other Controls Yes Yes Yes Yes Industry and Year FE Yes Yes Yes Yes Constant

• 3.776***
• 2.396**
• 2.406**
• 2.144*

(-4.04) (-2.09) (-2.09) (-1.78) Observations 18807 9547 9547 9547 Pseudo R2 0.023 0.023 0.023 0.028

A One Stddev increase in OFF_TAXCOMP (OFF_TAXPLAN) is associated with an 16.78% reduction of (11.55% increase in) misstatement likelihood.

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Other Findings

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1. The office-level results persist even for firms purchasing no tax NAS. 2. Results persist after controlling for the office-level propensity to disclose the tax fee breakdown. 3. Results persist after controlling for the decision to purchase tax NAS (Heckman two-stage analysis). 4. Changes in office-level tax compliance NAS immediately manifest in a lower likelihood of misstatement; Changes in office-level tax planning NAS gradually increase misstatement likelihood. 5. High levels of national-level tax planning NAS positively associated with misstatement likelihood. 6. The office level results are more prominent at the larger offices. 7. High office-level tax compliance is more strongly associated with errors rather than irregularities.

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Conclusions

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Insights into the Tax NAS debate

Compliance (not planning) drives the positive audit quality association

Office level effects matter

Beneficial knowledge sharing Potential auditor distraction/ culture

Regulator/ legislator/ proxy advisor concerns may be valid but…

Focus should be on the office, not engagement

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Thank You