Did PCAOB rules on ethics, independence, and tax services influence financial reporting for income taxes?
Introduction
Prior literature has well documented the significant role that taxes have on corporate decisions (Graham, 2003, Desai and Dharmapala, 2006). Shareholders often view taxes as additional business costs that reduce distributable profits and therefore may even incentivize managers to consider active tax planning strategies and maximize firm value (Rego and Wilson, 2012). However, aggressive tax-planning strategies are usually frowned on since they could lead to significant negative consequences like litigation and a lower stock price upon discovery (Hanlon and Slemrod, 2009, Hanlon and Heitzman, 2010). Moreover, aggressive tax-planning increases financial and organizational complexity, and managers may not fully communicate the company’s tax planning strategies to financial statement users and may engage in actions that obscure the underlying intent of the transaction to guarantee the tax benefit (e.g., McGill and Outslay, 2004, Balakrishnan et al., 2019, Chung et al., 2019, Bauer et al., 2020). Such obfuscation can simultaneously provide a shield for managers engaging in a variety of diversionary activities that would not align with the interests of shareholders (e.g., Desai and Dharmapala, 2009).
Prior research has shown that regulatory authorities can serve as monitoring mechanisms and positively influence a company’s financial and tax reporting decisions (e.g., Desai et al., 2007, Hanlon et al., 2014, Kubick et al., 2016, Towery, 2017). However, the literature provides little evidence on the effect of scrutiny by government agencies other than the Internal Revenue Service (IRS) or the Securities and Exchange Commission (SEC). The Public Company Accounting Oversight Board (PCAOB) Rules on Ethics, Independence, and Tax Services prohibit registered public accounting firms from providing contingent fee-based and highly aggressive tax services to their SEC-regulated audit clients (PCAOB, 2005, PCAOB, 2006). This study exploits this tax-induced setting to examine whether and how restricting aggressive auditor-provided tax services (APTS) affects companies’ financial reporting for income taxes as well as tax-aggressive decisions.
The PCAOB plays an important role as a market monitoring mechanism for protecting investors’ interest in accurate financial reports and reliable audits (e.g., Gramling et al., 2011, Petherbridge and Messier, 2016, DeFond and Lennox, 2017, Aobdia, 2018, Gipper et al., 2020, Shroff, 2020). The SEC and the PCAOB focus on the financial reporting of tax information, but it is of immense interest to the PCAOB that the audits of income tax accounts are conducted independent of the company’s influence. An auditor’s provision of services in favor of aggressive tax-position transactions likely compromises the auditor’s independent judgement in the performance of auditing income tax accounts, due at least to two types of conflicts of interest. First, providing aggressive tax avoidance strategies places the auditors in the position of auditing their own firm’s work. This can be problematic because tax-motivated transactions could generate sizable financial accounting benefits (e.g., Desai and Dharmapala, 2009). Second, opining in favor of the tax treatment of an aggressive tax-position transaction causes the auditor to have an inappropriate mutuality of interests with the client, since the results of the transaction are less “likely than not to be allowable under applicable tax laws” (PCAOB, 2004, PCAOB, 2005, PCAOB, 2006).
The PCAOB 2006 rule is unique in being the first major rule-making initiative to specifically restrict auditors’ involvement in aggressive tax-position transactions. Of about 800 letters sent to the PCAOB commenting on the new rule, 740 were from individual investors expressing strong support for the proposal with the financial statement impact of tax aggressive transactions being a major concern of the investor groups. As a result, the PCAOB has a major focus on improving the quality of financial reporting for income taxes. The restriction on auditors’ involvement in aggressive tax-position transactions eliminates the conflict of interest that might make an auditor reluctant to upset management. Furthermore, increased regulatory scrutiny is likely to discourage intentional obfuscation and diversion by managers, and thus improves companies’ financial reporting of tax information (e.g., Desai et al., 2007, Hanlon et al., 2014). Additionally, the PCAOB regulation could positively affect other agencies that focus on tax avoidance (e.g., the IRS).1 Companies may subsequently decrease their tax avoidance behavior due to an increase in expected tax costs (e.g., Kubick et al., 2016, Towery, 2017). Therefore, the PCAOB 2006 regulation could affect: (1) financial reporting for income tax accounts, as well as (2) tax-aggressive decisions among companies potentially subject to the regulation.
We examine the subsequent reporting behaviors of companies that significantly reduced APTS when the PCAOB regulation was introduced (from July 26, 2005 through October 31, 2006), compared to companies that did not significantly reduce APTS. We estimate two measures of financial reporting quality specific to the tax account: 1) the overall tax accrual quality measure developed following the approach in Choudhary et al. (2016), and 2) the reserve for uncertain tax positions following the methodology in Blouin and Tuna (2007). Prior research suggests that companies use the accrual for income taxes, including the reserves for tax contingencies, to manage earnings (e.g., Dhaliwal et al., 2004, Frank and Rego, 2006, Cazier et al., 2015). Furthermore, we employ four commonly used proxies to measure tax avoidance, viz., book and cash effective tax rates (Dyreng et al., 2008, Dyreng et al., 2019), total book-tax differences (Wilson, 2009), and discretionary permanent book-tax differences (Frank et al., 2009, Kubick and Masli, 2016).
Using a difference-in-differences research design, we find robust evidence that companies that significantly reduced APTS when the regulation was imposed (i.e., the treatment group) experienced a larger improvement in tax accrual quality after the change compared to companies that did not significantly reduce APTS (i.e., the control group). We show that this improvement is a function of the pre-regulation tax aggressiveness of the company’s tax positions. Furthermore, we find that companies that significantly reduced APTS also experienced a greater increase in financial reporting reserves for uncertain income tax positions, but only among pre-regulation aggressive tax-planning companies. Across different dimensions of tax avoidance, we find little evidence that the regulation influenced tax-aggressive decisions among companies potentially subject to scrutiny. These findings suggest that the regulation is associated with changes in financial reporting for income taxes without changing tax decisions and tax positions.
Our results are robust to matching of treated companies and controls based on propensity scores, using alternative matching choices, and using a placebo test in which we choose counterfactual treatment windows. Our results are also robust to using alternative measures of tax accrual quality, tax reserve, and tax avoidance. Specifically, we use tax sheltering as an alternative measure of tax aggressiveness (Wilson, 2009, Kubick and Masli, 2016) and find that the improvement in tax accrual quality for the treatment group is more pronounced for companies that have a greater probability of engaging in pre-regulation tax sheltering. Finally, we find that the improvement in tax accrual quality for the treatment group is statistically weaker when companies have more independent directors sitting on the audit committee, but is statistically more pronounced when the audit committee includes more financial experts. This provides some evidence that more independent audit committees preempt the monitoring benefits of the PCAOB rules likely due to their earlier actions to limit APTS, whereas audit committee financial experts ensure a better quality tax accrual in light of the fee reductions in meeting the rules. These cross-sectional results provide further support for the causal effect of the PCAOB scrutiny on companies’ reporting behaviors.
Our study contributes to the literature in three primary ways. First, we add to the literature linking APTS to financial reporting and audit quality. Extant research examines the effect of APTS on financial reporting and audit quality, and generally concludes that the joint provision of audit and tax services facilitates knowledge spillover, i.e., tax services allow auditors to obtain client information that improves financial reporting and audit quality (e.g., Simunic, 1984, Kinney et al., 2004, Gleason and Mills, 2011, De Simone et al., 2015, Alsadoun et al., 2018, Gleason et al., 2018). There is limited research on the financial reporting consequences of auditors’ involvement in aggressive tax-position transactions, the highly contentious type of APTS (e.g., Klassen et al., 2016, Dhaliwal et al., 2013). We utilize a natural setting of the PCAOB’s 2006 rule to investigate how significant restrictions on aggressive tax-position transactions affect the quality of a company’s financial reporting of its tax accounts. Lennox (2016) documents a chilling effect of the PCAOB 2006 rule on tax service fees but without a corresponding effect on audit quality. We distinguish our study from Lennox (2016) by focusing on the effect of regulatory scrutiny on companies’ reporting and tax decisions. Our findings are relevant to legislators and regulators who have viewed aggressive tax avoidance unfavorably and raised concerns in situations where auditors are involved in structuring aggressive tax-position transactions that generate specific financial accounting benefits.
Second, we contribute to the literature that examines the interactions between taxation and important external mechanisms of corporate governance such as regulatory agencies. Hanlon et al. (2014) suggest that stronger tax enforcement by the IRS has a positive spillover effect on the quality of a company’s financial reporting. Conversely, Kubick et al. (2016) find that regulatory scrutiny by the SEC of tax-related disclosure or accounts leads to lower levels of tax avoidance. While prior studies focus on the scrutiny by the tax authorities or the securities regulators, we add to this line of research by focusing on the PCAOB regulation of aggressive tax services. Our study complements existing research that argues that regulatory authorities could act as external governance mechanisms and improve a company’s financial and tax reporting behaviors.
Finally, we extend the stream of literature linking aggressive tax avoidance to corporate transparency and reporting quality (e.g., Frank et al., 2009, Donohoe and Knechel, 2014, Balakrishnan et al., 2019). We find that companies that engage in aggressive tax-planning experienced greater improvement in the tax aspects of earnings quality (i.e., higher tax accrual quality and more adequate tax reserves) following the restriction on auditors’ involvement in aggressive tax positions. Our findings are broadly consistent with tax aggressiveness having important implications for corporate transparency and reporting quality.
The next section develops the study’s hypotheses. Section 3 presents the research design. 4 Tax accrual quality analysis, 5 Tax reserve analysis report main empirical results. Section 6 presents additional analyses. Section 7 concludes.
Section snippets
Background and hypotheses development
The PCAOB 2006 rules are the first tax service fee regulations in the United States.2 The rules were prompted by concerns about auditor involvement in aggressive tax-position transactions as well as other arrangements
Matching procedures and sample selection
We intend to capture the change in income tax reporting and tax-aggressive decisions due to the reduction of APTS in response to the new PCAOB rules. The PCAOB announced the rules on July 26, 2005, and the SEC approved them on April 19, 2006. The new rules took effect on October 31, 2006 (PCAOB, 2006). Following Lennox (2016), we expect reductions in APTS fees likely occur during the transition period from July 26, 2005, to October 31, 2006 (referred to as the “event window”). Accordingly, the
Measuring tax accrual quality
Choudhary et al. (2016) develop a measure of tax accrual quality to capture variation in the extent to which the income tax accrual (difference between income tax expense and tax cash flow) maps into income-tax-related cash flows, in a manner similar to the approach used by Dechow and Dichev (2002) for estimating working capital accruals. Low tax accrual quality captures both intentional and unintentional management estimation errors in the income tax accrual. Following Choudhary et al. (2016),
Measuring tax reserves
Tax reserves (tax loss contingencies) are management’s estimate of potential future tax payments that could arise when tax authorities examine the firm’s tax positions, and they signal overall tax uncertainty. Managers update tax reserves based on the risk of legal uncertainty, IRS examination, detection, or litigation (Gleason and Mills, 2011). Since tax loss contingencies involve greater managerial discretion than other components of the income tax accrual, managers often use the change in
Measuring tax avoidance
To examine whether the PCAOB 2006 rules also resulted in changes in tax aggressiveness decisions, we estimate four separate measures of tax avoidance that represent a wide variety of tax avoidance activities (McGuire et al., 2012), including book effective tax rates ETR and cash effective tax rates CASHETR (Dyreng et al., 2008, Dyreng et al., 2019), book-tax differences BTD (Wilson, 2009), and permanent book-tax differences DTAX (Frank et al., 2009).
Regression model
Prior studies suggest similar regression
Conclusion
Several recent tax studies have examined the monitoring role of regulatory agencies like the IRS and the SEC and documented a positive effect of such oversight on a company’s financial and tax reporting decisions. The PCAOB Rules on Ethics, Independence, and Tax Services imposed restrictions on accounting firms’ provision of aggressive tax-position transactions to their audit clients. We exploit this natural experiment setting to examine the effect of the inquiry by the U.S. audit regulator on
Data availability
The data used in this study is available from public sources indicated in the paper.
Acknowledgements
We thank David Fang, Patrick Kastein, Mark Kohlbeck, Miguel Minutti-Meza, Ken Orbach, Joe Rakestraw, Divesh Sharma, Maya Thevenot, George Young, and participants at the 2019 PCAOB/TAR Conference on Auditing and Capital Markets, Western Michigan University, and the 2017 PhD Project Conference for helpful comments. Kellie Carr also thanks the KPMG Foundation Doctoral Scholarship and the AICPA Doctoral Fellowship for their financial support of her dissertation based on which this paper is
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