The results of this study are important to policymakers as the PCAOB considers whether tax and audit services should be provided by different firms. The results of this study indicate that auditor-provided tax services may actually decrease the tax aggressiveness of companies, especially those serviced by the Big 4. Based on the representative who signs the tax return, tax aggressiveness is higher for internally prepared and non-auditor externally prepared tax returns than auditor-prepared tax returns. Additionally, accounting professionals may be interested in the findings of this study as it provides insights into how tax compliance changes in the presence of an audit. The authors suggest that signing a tax return with aggressive positions is costly to auditors because of reputation risk and financial reporting restatement risk in the tax accounts. As accounting professionals seek to perform effective audits and accurate tax returns, it may be beneficial to consider how tax compliance decisions could be impacted by the same firm providing both services.

Klassen K. J., P. Lisowsky, and D. Mescall. 2016. The role of auditors, non-auditors, and internal tax departments in corporate tax aggressiveness. The Accounting Review. 91(1): 179-205.

Corporate tax returns may be prepared by management, an external party who does not perform the audit, or the company’s auditor. There is little evidence to suggest how the type of tax preparer impacts corporate tax decisions. In particular, it is unclear how the dual role of auditor-tax preparer may impact tax compliance outcomes. This study seeks to provide insight into how tax preparer type influences corporate tax aggressiveness. Specifically, the authors:

• Examine the relationship between the tax return preparer type and corporation tax aggressiveness. 
• Examine whether tax fees as a representation of tax planning supports the findings of prior academic research.
• Examine the link between tax aggressiveness and tax preparer type for Big 4 firms.

The authors were able to obtain confidential data from the Internal Revenue Service (IRS) for 2008 and 2009. The data provided by the IRS Large Business & International Division included tax return preparer identities and FIN 48 disclosures. Financial statement data were obtained from Compustat, and auditor identity, tax fees, and audit fees were obtained from the Audit Analytics database. The authors’ proxy for tax aggressiveness using the current-year increase in the tax reserve from FIN 48 disclosures on each company’s tax return. They use the tax return preparer identities in combination with the auditor identities to identify the tax return preparer type for their analysis. Based on the availability of the data, the final sample consisted of 1,533 firm-years (804 firms in 2008 and 729 in 2009).

• The authors find that tax returns that are internally prepared by management claim more aggressive tax positions than auditor-prepared returns. Tax returns that are prepared by a non-auditor external party also claim more aggressive tax positions than auditor-prepared returns.
• The authors find that less tax aggressiveness occurs for clients when the tax preparer is also the auditor and a Big 4 firm than when the tax preparer and auditor are different Big 4 firms.
• The authors corroborate prior academic research that suggests tax fees represent the level of tax planning by the audit firm. The authors find that even after considering the tax return preparer type which accounts for tax compliance costs, higher tax fees paid to the auditor are indicative of more tax aggressive behavior.

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An implication of the findings from experiment one is that restricting the auditor’s provision of NAS may lead to fewer lawsuits and, importantly, a reduction in the deadweight costs associated with litigation. But such restrictions mean that companies forgo the potential benefits (e.g., knowledge spillovers) of acquiring NAS from the auditor. Based on the findings from experiment two, participants perceive that the potential benefits of NAS outweigh the potential costs, notably when performing a conventional assessment of asset value. The net benefits are lost when the auditor is prohibited from providing NAS. The authors encourage future study to examine the net effect of restricting the auditor’s provision of NAS on social welfare.

Church, B. K., and P. Zhang. 2011. Nonaudit Services and Independence in Appearance: Decision Context Matters. Behavioral Research in Accounting 23 (2): 51-67.

Following the Enron and WorldCom scandals, the Sarbanes-Oxley Act of 2002 (SOX) prohibited the auditor’s provision of many nonaudit services (NAS). The passage of SOX suggests that regulators and legislators believe that certain NAS impair auditor independence and, in turn, lower financial reporting quality. Archival data, however, provide scant evidence of a relation between NAS and audit quality (independence in fact). Notwithstanding, auditors must still maintain independence in appearance for their reports to be credible.

The fundamental question is whether users’ perceptions of NAS differ across decision contexts; that is, whether NAS are viewed as detrimental in one context and beneficial in another. By examining the effect of decision context on users’ assessments, the authors seek to identify an important factor that may account for some of the mixed findings documented elsewhere. The authors suggest that decision context influences users’ motives, such that the auditor’s provision of NAS is interpreted opportunistically—in a manner that best suits users’ self-interest. If that is the case, then users’ assessments of independence are malleable, which can be problematic for regulators; the challenge of prescribing rules to ensure independence in appearance becomes quite daunting. Because auditor independence is a cornerstone of auditing, regulators may opt to err on the side of caution and mandate strict rules. Yet, such rules may not be socially optimal.

The authors design two experiments to investigate. For experiment one, the authors recruited 27 students from a large university to participate in the experiment. The authors recruited 37 students from a large university to participate in experiment two. All the students were in at least their third year, and all but one were pursuing a program of study in business or economics. The evidence was gathered prior to November 2011.

• The results of the experiments indicate that users’ perceptions of NAS differ across decision contexts.
• In the first experiment, participants initially perceive that NAS are associated with auditor fault—in the face of a bad outcome (loss in value), NAS are perceived negatively.
• In the second experiment, participants initially provide a higher assessment of asset value when the auditor supplies NAS—that is, the net effect of NAS on asset value is beneficial.
• In both experiments participants eventually decipher the experimental relations—that NAS are not associated with auditor fault or asset value.
• The findings indicate that decision context dramatically alters users’ perceptions of NAS and auditor independence.
• Undoubtedly accounting scandals, which create significant losses for owners and creditors, can lead users to question auditor independence.
• The findings suggest that users react in this manner for strategic reasons.
• In responding to public outcry, regulators may overreact, for political purposes, and enact laws/rules that are excessive, potentially sacrificing social welfare.

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The authors contribute by providing some of the first evidence of service bundling in the economics of auditing literature. In doing so, they broaden the notion that strategic pricing occurs around audit switches. This study contributes to prior mixed findings of the existence of industry specialist premiums in the small-client segment, suggesting an additional reason why these mixed findings might occur. Where opportunities to package services are attractive, auditors may strategically price and discount audits with bundling premiums in mind. Where potential for such bundling opportunities is less attractive, it is possible the auditor may instead seek to generate premiums in the audit service.

Ferguson, A., G. Pündrich, and A. Raftery. 2014. Auditor Industry Specialization, Service Bundling, and Partner Effects in a Mining-Dominated City. Auditing: A Journal of Practice & Theory 33 (3): 153-180.

This study examines auditor industry specialization effects in Perth, a remote mining town in Australia characterized by a large number of small, homogeneous firms. In this study, the authors consider whether an auditor industry specialist may strategically price a bundle of services in the small-client segment. They argue that the small company sector is a good environment to consider the existence of service bundling. The setting is the mining development stage entity (MDSE) market in Perth, the biggest industry and city in Australia by client numbers. This market is characterized by small (high-growth) firms where auditing is arguably of less importance to the client compared to tax advisory, the other primary service provided to them. Further, the firms are relatively homogeneous, an appealing feature of industry studies. Thus, the authors have arguably an attractive setting to observe service bundling by an industry specialist.

First, the authors examine whether industry specialist auditors earn audit fee premiums in the Perth MDSE segment. To do this, an audit pricing model is developed and includes controls likely to impact on audit fees in a mining industry context. Second, the authors redefine the dependent variable to consider the pricing implications of the bundle of services provided by industry specialists.

The authors utilize an OLS regression model to test for audit fee premiums with respect to brand name and industry leadership. A sample of 1,799 firms listed on the ASX as of December 31, 2009 is obtained. Of the 1,799 listed entities nationally, 668 (37.13 percent) are domiciled in Perth, making it the largest city-level market by client numbers in Australia. At the city-level, the market share of non-Big 4 firms is 70.1 percent in Perth.

The authors find no evidence of auditor industry leadership audit fee premiums accruing to either Big 4 (EY) or non-Big 4 (BDO) leaders. However, when the dependent variable is redefined to include non-audit services (NAS), the industry leader, BDO, obtains a total fee premium. This finding is of added interest given that the industry leader is a second-tier firm, implying that strategic audit pricing, such as service bundling, is not confined to Big 4 auditors. Nor is it confined to merely one location, since bundling premiums are observed at the national level. The authors argue MDSEs have little in the way of financial statement complexity, so they do not value specialist audits, but rather are willing to pay more for NAS. Last, in supplementary analysis, the authors find some evidence of partner-scale effects.

http://www.auditingresearchsummaries.org

The results of this study are important to audit regulators as they make decisions regarding policies, and to corporate governance officials as they make decisions regarding the audit firms they engage to provide tax nonaudit services. The evidence indicates that tax nonaudit services accelerate audit firm awareness of material transactions as these services are associated with a lower likelihood of a material weakness in internal controls. In addition, further evidence supports that this finding is not simply due to impaired auditor independence. Overall, this suggests that tax nonaudit services provided by the audit firm improve internal control quality. As regulators and companies evaluate the consequences of tax nonaudit services, the findings in this paper may impact their conclusions.

De Simone, L., M.S. Ege, and B. Stomberg. 2015. Internal Control Quality: The Role of Auditor-Provided Tax Services. The Accounting Review. 90(4): 1469-1496.

Audit regulators and companies’ corporate governance officials are charged with understanding and creating policies for auditor provided nonaudit services. To make informed decisions, it is important for these groups to know the benefits and costs of auditor provided nonaudit services. Previous research has reported a positive association between tax nonaudit services and financial reporting quality and audit quality. This paper investigates the relationship between tax nonaudit services and a specific component of financial reporting quality: internal control quality. Specifically, the authors:

• Examine the relationship between tax nonaudit services and the probability of a material weakness in internal controls (i.e. internal control quality).
• Examine whether tax nonaudit services are beneficial to companies experiencing a shock to their internal control environment.
• Examine how the relationship between tax nonaudit services and internal control quality is affected by audit firm tenure.

The authors also explain the process through which they propose tax nonaudit services affects non-tax financial reporting quality.

The authors collected auditor internal control opinions and data necessary to calculate control variables on publicly-traded companies that are subject to SOX Section 404(b). The information collected on these companies was for years 2004-2012.

• The authors find that companies that purchase tax nonaudit services are significantly less likely to disclose a material weakness. A one standard-deviation increase in tax nonaudit services is associated with approximately a 13% decrease in the rate of material weaknesses relative to the base rate. Further analysis indicates that impaired auditor independence does not account for this result.
• The authors find that when companies experience a significant shock to their internal control environment, tax nonaudit services incrementally benefit internal control quality relative to other companies.
• The authors find that the benefits of tax nonaudit services on internal control quality are greater in the early years of audit firm tenure.

http://www.auditingresearchsummaries.org

The results indicate that prior to the Sarbanes-Oxley Act, rewards to the auditor in the form of future additional nonaudit service fees from current-year high fee-growth-opportunity clients adversely affects audit quality. This effect is particularly strong among companies with powerful incentives to manage earnings. The findings indicate that regulators should consider the multi-period nature of the client-auditor relationship when contemplating policies that restrict nonaudit services, as well as the overall environment in which audit partners operate. This might include partner compensation arrangements that put pressure on audit partners to focus on increasing revenue at the expense of audit quality.

Causholli, M., D. J. Chambers, and J. L. Payne. 2014. Future Nonaudit Service Fees and Audit Quality. Contemporary Accounting Research 31 (3): 681-712.

Prior to the Sarbanes-Oxley Act of 2002, audit partners experienced economic pressure to grow revenue from the sale of nonaudit services to their audit clients. To an auditor who is highly rewarded for revenue generation and growth, nonaudit services may represent a particularly strengthened economic bond with the client. Prior research shows that, in general, nonaudit service fees received in the current period do not impair audit quality. The authors examine a different setting. Future nonaudit fees present an important source of career advancement and a source of particularly strengthened economic bond with the client. They propose that auditor independence can become impaired, and audit quality compromised, when clients that currently purchase relatively low amounts of nonaudit services, increase their purchases of nonaudit services from the auditor in the subsequent period. They test the prediction in the context of earnings management as a proxy for audit quality, measured by (a) performance-adjusted discretionary accruals and (b) classification shifting of core expenses.

The authors obtain the data on the Big-N clients’ audit and nonaudit fees from Audit Analytics, the data on client characteristics from COMPUSTAT, and the data on stock returns from CRSP for fiscal years 2000-2001. The Accruals Model has a sample of 4,078. The Classification-shifting Model has a sample of 3,361.

• The results show that earnings management is higher for high fee-growth-opportunity clients who increase their future nonaudit services (NAS) purchases from the auditor.
• Both forms of earnings management are higher for companies with relatively low NAS in the current year that simultaneously increase future NAS purchases from the auditor.
• The negative effect of future NAS is even more pronounced in companies that have greater incentives to manage earnings such as those that meet or just beat earnings forecasts or those that issue equity and less likely to occur in companies with strong corporate governance.
• When using the absolute value of discretionary accruals to proxy for earnings management, the authors find that future increases in NAS fees are positively associated with the absolute discretionary accruals for high fee-growth-opportunity clients. This association continues to hold when the authors separate total discretionary accruals into income-increasing and income-decreasing accruals.
• When using the association between unexpected core earnings and income-decreasing special items as the proxy for classification shifting, the authors find that the association becomes more positive, indicating greater classification shifting for high fee growth opportunity clients who increase future NAS purchases.

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