Audit quality effects of the PCAOB's 2006 tax service restrictions
Introduction
Announcements of high-profile corporate tax reporting investigations (e.g., Caterpillar, Hewlett Packard) involving nonaudit tax services provided by the company's auditor have renewed discussions about the types of tax services auditors should provide their clients (Mclaughlin, 2017; Novak, 2012b). Lawmakers investigating these companies have expressed concern about potential conflicts of interest when the auditing firm designs and sells questionably aggressive tax structures to audit clients and subsequently audits the financial reporting for these structures (U.S. Senate, 2012, U.S. Senate, 2014). The Public Company Accounting Oversight Board (PCAOB) and Securities Exchange Commission (SEC) also expressed interest in reexamining the potential independence effects of tax and other nonaudit services (Harris, 2014; PCAOB, 2015; Tysiac, 2013).
In the early 2000s, the PCAOB, SEC and many in practice had similar concerns about the auditor independence effects of auditor provision of personal tax services and aggressive tax consulting services to audit clients (PCAOB, 2004). In 2006 the PCAOB restricted these types of auditor-provided tax services by implementing rules 3521, 3522, and 3523 (PCAOB, 2021; Securities Exchange Commission, 2006).1,2 These rules reaffirmed the existing restrictions on contingent fees and added further restrictions on the auditor provision of certain aggressive tax consulting services and certain personal tax preparation services for audit clients. The key purpose behind these restrictions was to improve auditor independence by restricting certain nonaudit services that may impair independence.
However, recent empirical research finds little evidence of these rules' effectiveness (Lennox, 2016; Notbohm, Paterson, & Valencia, 2015). If the 2006 restrictions on tax nonaudit services had little or no effect on audit quality, then some may question if further restrictions on tax nonaudit services should be considered. Our study reexamines this research question with a focus on the engagements that were likely most impacted by the restrictions. Based on comments in a 2004 PCAOB Roundtable discussion, U.S. Senate Subcommittee Investigation Report, U.S. Department of the Treasury Investigation Report, and a financial press article on the subject, we expect that the aggressive tax strategy services restricted by Rule 3522 were provided primarily by the largest auditing firms (U.S. Department of the Treasury, 1999; Novak, 1998; PCAOB, 2004; U.S. Senate, 2005). Additionally, because auditor-provided tax services that generate large fees likely create greater conflicts of interest than if the same services were provided for small fees, we expect the restricted tax services created the greatest conflicts of interest when the services generated large fees. Using both financial statement restatements and going concern modified wording audit opinions as indicators of audit quality, we estimate difference-in-difference regressions, similar to those estimated in Lennox (2016), to test the audit quality effects of these restrictions on suspected purchasers of the restricted services.
We find that the probability of restatement (going concern opinion) was significantly reduced (increased) by the 2006 restrictions among Big 4 audit clients that significantly reduced their tax service fees. Additionally, we find that the restatement result gets stronger as the level of pre-restriction tax service fee increases. However, we also find that the going concern result fades in the level of pre-restriction tax service fee. We expect this fading going concern result is due to the inability of financially distressed companies to benefit from expensive tax nonaudit services. In additional analyses we find that prior to implementing the 2006 restrictions the probability of restatement was higher for suspected purchasers than for non-purchasers, and we also find that the audit quality effects of the restrictions were concentrated among Big 4 firms. Our results are robust to alternative definitions of the treatment variable, matched pairs balanced sample analysis, exclusion of clients audited by KPMG, inclusion of financial firms, and are partially robust to an alternative control for internal control strength.
The primary difference between our study and Lennox (2016) is that our study focuses on the engagements that are likely most impacted by the 2006 restrictions. This alternate focus impacts our analyses in two significant ways. First, we focus our sample on audit clients of the Big 4. We impose this condition because many practitioner, regulator, and legislator comments about the “promoters” of the services that were restricted by PCAOB Rule 3522 are consistent with only the largest public accounting firms. Second, in our main tests we limit our treatment firms to those with at least $100,000 of pre-restriction period tax nonaudit fees. This condition ensures that we focus our tests on only purchasers of significant levels of aggressive tax services, contingent fee services, and/or personal tax services.
Evidence of the effectiveness of the 2006 PCAOB restrictions is important because it adds to the ongoing debate about the proper levels and types of allowable auditor-provided tax services. If the 2006 restrictions improved auditor independence with respect to purchasers of the restricted services, then other tax service restrictions may yield further independence improvements. Additionally, our results may benefit audit committees, boards of directors, owners, management and other decision makers charged with deciding which types of nonaudit services their company should purchase from their auditor. Evidence that the purchase of the restricted tax services harmed auditor independence and audit quality may caution these decision makers about approving the purchase of permitted tax services from their auditor.3
The remainder of the paper is organized as follows: Section Two discusses important background information related to the 2006 tax service restrictions and relevant prior research. In Section Three we motivate our hypothesis. Section Four includes our sample selection criteria, description of our data, and discussion of our research methodologies. In Section Five we discuss our results. In Section Six we present the results of our additional analyses. We conclude in Section Seven.
Section snippets
Background information
The use of abusive tax shelter services has been a long-standing concern to legislators. Excessive individual taxpayer use of aggressive tax shelters during the 1970s and early 1980s led Congress to pass the Tax Reform Act of 1986 (GAO, 2011). However, during the 1990s there was significant growth in the provision of these services to corporations (U.S. Department of the Treasury, 1999). Fueled by continued growth in aggressive tax services, a financial press article that detailed the types of
Hypothesis development
Three PCAOB rules restricting tax nonaudit services became effective on October 31, 2006 (Securities and Exchange Commission, 2006). Rule 3521 reiterated that contingent fees for any nonaudit service provided to an audit client violates auditor independence (PCAOB, 2021). Although contingent fee arrangements with audit clients were restricted before Rule 3521 (AICPA, 2021), the reiteration of this restriction may have highlighted the earlier rule in the minds of auditors and audit committee
Sample, methodology, and data
To test our hypothesis we use a difference-in-difference regression framework to estimate the impact of the 2006 tax service restrictions on firms suspected to have purchased the restricted services at significant levels. Consistent with Lennox (2016), we partition our sample companies into treatment and control groups based on their patterns of tax nonaudit service fees. We also partition our sample into pre-restriction period and post-restriction period observations based on when the
Results
We begin our multivariate analyses by replicating Lennox's (2016) results with an adjusted version of our sample and research design. Since Lennox's (2016) sample includes clients of the Big 4, second-tier, and other auditors, we add back fiscal year observations where the auditor was a non-Big 4 firm. This change added 4702 (1480 2nd tier and 3222 third tier) observations. Also, rather than truncating our sample period at 9-15-2009, we extended it to 12-31-2009, as in Lennox (2016).31
Additional analyses
The results of our analyses indicate there were audit quality improvements from the 2006 tax service restrictions among clients of the Big 4 auditors, and the audit quality improvements are sensitive to the magnitude of the pre-restriction tax nonaudit service fee. In this section we discuss the results of additional analyses performed to further investigate the nature and sensitivity of our primary results. These additional analyses include (1) tests for audit quality differences between
Conclusions
The purpose of the PCAOB's, 2006 tax service restrictions was to enhance auditor independence. Two prior studies (Lennox, 2016; Notbohm et al., 2015) find that the 2006 restrictions, overall, had no effect on audit quality. However, our study focuses on the audit quality effects of these rules for the engagements that were likely most impacted by these rules. This shift in focus affects our sample selection and treatment firm identification decisions.
We re-examine the question about the
Data availability
All data are available from public sources.
Author interests statement
Neither Matthew Notbohm nor Adrian Valencia has any financial or personal relationships with other people or organizations that could inappropriately influence (bias) this study. Professor Notbohm gratefully acknowledges receipt of the UND Accountancy Legacy Professorship. This professorship is not directly connected to the development or submission of this research.
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