Tax Consulting and Reported

Weaknesses in Internal Control

Randy Elder
Syracuse University

David Harris
Syracuse University

Jian Zhou
SUNY-Binghamton
 Outline

Broad perspective on nonaudit services

Previous literature and motivation
Hypotheses
Data and results
 Why Examine Tax Consulting?
PCAOB considered prohibiting tax consulting
– Tax consulting issues at E&Y with Sprint, and KPMG
tax shelters
– PCAOB restricted provision of abusive shelters and
consulting for key executives

Tax consulting is a significant type of nonaudit

service and the effect of nonaudit services
remain unresolved
 Background
SOX codifies existing provisions
– Not all services are prohibited
– Only applies to public company audit clients

Big 4 are still in the game

– Deloitte still has a consulting practice
– KPMG advisory revenues grew 30% last year
– PwC will likely expand services after non-compete
expires
– Tax still a significant revenue source
 Background Theory
Audit Quality (DeAngelo 1981) – joint
probability that auditor
will:
– Detect a misstatement (technical ability)
– Report the misstatement (independence)

Tests have focused on independence

– This has been especially true of effect of
nonaudit services
Arguments for/against consulting
Pro – Consulting services provide
knowledge spillovers
– Reduces cost of auditing and/or consulting
(efficiency)
– Provides knowledge useful to performance of
auditing and/or consulting
Con – Consulting revenues increases the
auditors economic dependence on the
client, reducing auditor independence
 Consulting and Independence
Enron famously paid Andersen $52 million in 2000
- $25 million for audit and $27 million for consulting
However, preponderance of research does not find
that non-audit services impairs independence
Why this doesn’t matter
– Concern is with both independence in fact and
appearance
– Consulting created appearance that independence was
impaired
– Therefore, finding of non-impairment probably not
sufficient to change status quo
Independence evidence: earnings
management
Conflicting results on the relationship between
non-audit service and auditor independence
measured by earnings management
– Frankel et al. (2002) find a positive relation between
non-audit services and earnings management
– Ferguson et al. (2004) also find for U.K. Firms.
– Several U.S. studies find no relation
Ashbaugh et al. (2003)
Chung and Kallapur (2003)
Reynolds et al. (2002)
Francis and Ke (2002)
 Independence evidence: other
aspects
No evidence that nonaudit services
affected propensity to issue going concern
opinions (DeFond et al. 2002)

Little evidence that restatements are

related to nonaudit services (Kinney et al.
2004)
Knowledge Spillovers - Performance

Audit firms argue that non-audit services:

– Can be performed at lower cost
– Also allows for more effective performance of
both services
Performance data (or evidence of lower
fees) will be necessary to justify change in
status quo
 Knowledge Spillovers and Fees
Simunic (1984) identifies various plausible relations
between audit and nonaudit service fees
Audit Fee Consulting Fee

Fixed cost Fixed cost

Variable cost Variable cost
Knowledge Spillovers and Fees
Key Points
– Early studies found positive relation between audit
and nonaudit fees
– Whisenant et al. (2003) find no significant relation
using simultaneous equations of audit and nonaudit
fees, indicating no knowledge spillovers
– Little evidence that using your auditor for consulting
results in lower fees, although this is counterintuitive
– Studies do not consider acquisition costs to client
Evidence from Tax Services
Kinney et al. (2004) find some evidence
that restatements are negatively related to
tax services
Gleason and Mills (2007) find that auditor-
provided tax services are associated with
more accurate estimates of tax expense
– Consistent with knowledge spillover and
contrary to concerns about independence
failure
 Internal Control Reporting
Section 404 reports on internal control
provide a new reporting environment to
test for potential lack of independence and
knowledge spillovers

H1: There is no association between tax

consulting and tax-related ICWs
H2: There is no association between tax
consulting and other ICWs
 Possible Patterns of Results
Effect of Tax Consulting on ICWs
Tax non-Tax
ICWs ICWs Interpretation

- None Knowledge Spillovers

- - Loss of independence
or
Self-selection by high
quality firms
 Sample
4289 observations for 2004-2005 from Audit
Analytics with necessary data
– 13.4% have an ICW
– 4.8% have a tax-related ICW
 ICW Model
ICW Model is based on previous work by
Doyle, Ge and McVay (2007) and
Ashbaugh-Skaife, Collins and Kinney (2007)

ICW = α0 + α1TAXCSLT + α2TAXFEER +

α3ABSDARK + α4SIZE + α5LOGAGE +
α6AGG_LOSS + α7ZSCORE + α8LOGSEG +
α9GROWTH + α10FOR_TRAN +
α11RESTR_CHG
 Variables
ICW: 1 if the firm has a material internal control weakness; 0 otherwise.
OTHICW: Non-tax-related ICW.
TAXICW: Tax-related ICW.
TAXFEER: Ratio of tax-related fees to total fees.
TAXCLST: 1 if tax-related fees are reported; 0 otherwise.
ABSDARK: Decile rank of the absolute value of discretionary accruals.
SIZE: Most recent three years average market value
LOGAGE: Log of the number of years that the company has CRSP data
AGG_LOSS: 1 if the sum of earnings before extraordinary items for year t and
year t-1 is less than zero, 0 otherwise.
ZSCORE: Altman Z-score measure of financial distress
LOGSEG: Log of number of operating and geographic segments
GROWTH: Most recent three years’ sales growth
FOR_TRAN: 1 if the company has non-zero foreign currency translation in
year t, 0 otherwise.
RESTR_CHG: Aggregate restructuring charges in year t and t-1 scaled by
market capitalization in year t.
 Table 1 – Descriptive Statistics

Variable Mean Std Dev Median

ICW 0.134 0.341 0.000
OTHICW 0.114 0.317 0.000
TAXICW 0.048 0.213 0.000
TAXFEER 0.090 0.099 0.058
TAXCSLT 0.822 0.383 1.000
ABSDARK 5.499 2.872 5.000
SIZE 3713.270 9846.350 739.746
LOGAGE 2.483 0.953 2.485
AGG_LOSS 0.244 0.429 0.000
ZSCORE 4.649 5.860 3.233
LOGSEG 1.317 0.961 1.386
GROWTH 0.211 0.408 0.117
FOR_TRAN 0.337 0.473 0.000
RESTR_CHG 0.005 0.016 0.000
 Table 3 – Basic ICW Model
Variables Expected ICW Tax ICW Other ICW
Sign Coef. p-value Coef. p-value Coef. p-value

INTERCEPT ? -2.051 <.0001 -3.416 <.0001 -2.099 <.0001

ABSDARK + 0.033 0.042 0.015 0.562 0.042 0.017
SIZE - -0.0001 <.0001 -0.00004 0.017 -0.0001 0.000
LOGAGE - -0.071 0.166 -0.006 0.940 -0.115 0.036
AGG_LOSS + 0.711 <.0001 0.438 0.010 0.731 <.0001
ZSCORE - -0.024 0.005 -0.044 0.009 -0.025 0.007
LOGSEG + 0.079 0.114 0.196 0.014 0.045 0.400
GROWTH + -0.129 0.234 -0.390 0.095 -0.089 0.419
FOR_TRAN + 0.282 0.004 0.608 <.0001 0.136 0.196
RESTR_CHG + 1.665 0.483 5.370 0.096 -0.237 0.927
Pseudo R- 7.02% 5.64% 6.55%
square

# of 4289 4289 4289

observations
 Table 4 – Tax Consulting all ICWs
Variables Expected ICW ICW ICW
Sign Coef. p-value Coef p-value Coef. p-value

INTERCEPT ? -1.790 <.0001 -1.887 <.0001 -1.806 <.0001

TAXCSLT ? -0.373 0.001 -0.146 0.239

TAXFEER ? -2.652 <.0001 -2.329 <.0001

ABSDARK + 0.034 0.036 0.035 0.032 0.035 0.031
SIZE - -0.0001 <.0001 -0.0001 <.0001 -0.0001 <.0001
LOGAGE - -0.065 0.208 -0.068 0.186 -0.066 0.202
AGG_LOSS + 0.682 <.0001 0.662 <.0001 0.657 <.0001
ZSCORE - -0.025 0.004 -0.023 0.007 -0.024 0.006
LOGSEG + 0.083 0.098 0.092 0.067 0.092 0.067
GROWTH + -0.133 0.224 -0.134 0.222 -0.135 0.219
FOR_TRAN + 0.302 0.002 0.314 0.001 0.318 0.001
RESTR_CHG + 2.289 0.336 2.375 0.320 2.542 0.288
Pseudo R-sq. 7.47% 8.07% 8.12%

# of 4289 4289 4289

observations
Variables Exp. TAX ICW TAX ICW TAX ICW
Sign Coeff. p-value Coeff. p-value Coeff. p-value

INTERCEPT ? -3.314 <.0001 -3.369 <.0001 -4.204 <.0001

?
TAXCSLT 0.091 0.659 0.216 0.321
TAXFEER ? -1.636 0.049 -1.805 0.049 -0.642 0.494
?
OTHICW 2.531 <.0001
ABSDARK + 0.016 0.543 0.016 0.543 -0.004 0.871

SIZE - -0.00004 0.020 -0.00004 0.019 -0.00002 0.126

LOGAGE - -0.003 0.970 -0.004 0.956 0.027 0.742
AGG_LOSS + 0.407 0.017 0.411 0.016 0.092 0.614
ZSCORE - -0.043 0.010 -0.043 0.010 -0.038 0.038
LOGSEG + 0.205 0.010 0.205 0.011 0.200 0.016
GROWTH + -0.398 0.090 -0.397 0.091 -0.471 0.066
FOR_TRAN + 0.629 <.0001 0.626 <.0001 0.605 0.000
RESTR_CHG + 5.769 0.074 5.663 0.081 5.772 0.108

Pseudo R-square 5.94% 5.95% 22.82%

# of observations 4289 4289 4289
Variables Exp. Other ICW Other ICW Other ICW Other ICW
Sign
Coeff. p-value Coeff. p-val. Coeff. p-value Coeff. p-value

INTERCEPT ? -1.805 <.0001 -1.893 <.0001 -1.833 <.0001 -1.916 <.0001

TAXCSLT ? -0.426 0.001 -0.123 0.346 -0.174 0.204
TAXFEER ? -3.527 <.0001 -3.222 <.0001 -3.016 <.0001
TAXICW ? 2.517 <.0001
ABSDARK + 0.043 0.014 0.045 0.011 0.045 0.011 0.045 0.016
SIZE - -0.0001 0.000 -0.0001 0.000 -0.0001 0.000 -0.00004 0.003
LOGAGE - -0.108 0.050 -0.111 0.044 -0.109 0.005 -0.136 0.018
AGG_LOSS + 0.699 <.0001 0.670 <.0001 0.666 <.0001 0.650 <.0001
ZSCORE - -0.025 0.006 -0.024 0.009 -0.024 0.009 -0.019 0.048
LOGSEG + 0.049 0.360 0.062 0.254 0.062 0.256 0.020 0.732
GROWTH + -0.092 0.405 -0.093 0.405 -0.093 0.402 -0.038 0.743
FOR_TRAN + 0.158 0.134 0.175 0.099 0.179 0.092 0.040 0.727
RESTR_CH +
G 0.487 0.851 0.675 0.796 0.817 0.755 -1.227 0.668
Pseudo R-
square 7.13% 8.13% 8.17% 18.40%
# of 4289 4289 4289 4289
observations
 Results
The extent, but not the existence of tax
consulting is associated with a reduced
likelihood of a tax-related ICW (but not
after controlling for other ICW)
The extent, but not the existence of tax
consulting is also associated with a
reduced likelihood of non-tax ICWs
Results are more consistent with reduced
independence than knowledge spillovers
 Plans

Gathering data on the nature of the tax

ICWs
Further sensitivity analysis based on the
extent of the tax consulting
Use path analysis to test whether both
independence effects (for firm-level
ICW) and spillover effects (for tax ICW)
exist