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Auditor-Provided Tax Services: The Effects of a Changing Regulatory Environment
Author(s): Thomas C. Omer, Jean C. Bedard and Diana Falsetta

Source: The Accounting Review , Oct., 2006, Vol. 81, No. 5 (Oct., 2006), pp. 1095-1117
Published by: American Accounting Association
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THE ACCOUNTING REVIEW
Vol. 81, No. 5
2006
pp. 1095-1117
Auditor-Provided Tax Services:

The Effects of a Changing
Regulatory Environment
Thomas C. Omer
Texas A&M University
Jean C. Bedard
Bentley College
Diana Falsetta
University of Miami
ABSTRACT: This study investigates auditor-provided tax services from 2000 to 2002
during which fees paid to auditors for nonaudit services (NAS) were disclosed, but
separate disclosure of tax service fees was voluntary. We examine changes in t
market for tax NAS in 2002, as Congress debated possible prohibition of these ser-
vices. Using the Heckman MLE procedure to control for selection bias in tax fee dis
closure, we find that a strong pre-2002 positive association between tax fees an
higher than expected audit fees weakened significantly in 2002, suggesting that so
companies paying high audit fees reduced or terminated auditor-provided tax service
in 2002. Our findings also suggest that auditor-provided tax services were reduced
among new or short-tenure clients. Controlling for tax complexity, we also find som
evidence that early "returns" (i.e., tax rate reductions) to companies from auditor-
provided tax services were reduced in 2002. Finally, results of our selection model imp
that the decision to voluntarily disclose fees paid to the auditor for tax services is
positively associated with tax complexity and auditor tenure, and negatively associate
with the proportion of NAS fees to total fees. Overall, our findings imply significan
change in auditor-provided tax services prior to 2003, when separate disclosure
auditor-provided tax service fees was mandated.
Keywords: tax fees; tax consulting; audit fees; auditor independence.
The authors are grateful to Dan Dhaliwal and two anonymous reviewers for their helpful comments
John Graham for providing marginal tax rate data used in this study. We also thank Elizabeth Conn
Dunbar, Julie Hertenstein, Ganesh Krishnamoorthy, LeAnn Luna, Mario Maletta, Jim Maroney, Lillian Mi
Phillips, George Plesko, Tim Rupert, Marjorie Shelley, Pete Wilson, Arnie Wright, and participants of
forums at Australia National University, Boston College, Texas A&M University, and the University of W
as well as those attending the University of Oklahoma Accounting Research Conference and the 2005
Region and American Accounting Association Annual Meetings, for comments on earlier versio
manuscript.
Editor's note: This paper was accepted by Dan Dhaliwal.

Submitted March 2005
Accepted May 2006
1095

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1096 Omer, Bedard, and Falsetta
Data Availability: The data used for this study a

in the text, with the exception of the m
by John Graham of Duke University.
I. INTRODUCTION
his study examines the market for auditor-provided tax services durin
a period in which Congressional debate on possible prohibition of thes
likely contributed to fundamental changes in this market. In general, nonaud
(NAS) provision by auditors is controversial due to potential positive and neg
In particular, joint provision of audit and tax services may be beneficial due t
achieved by having a single professional services firm serve as both auditor
sultant. However, potentially damaging outcomes of joint service provision
promising audit quality and risking shareholder value.
Our study period represents a crucial time in the audit and tax services ind
scale financial frauds focused the attention of the Securities and Exchange
(SEC), and ultimately the U.S. Congress, on the issue of audit quality. One im
in the ensuing debate was whether provision of NAS, including tax services
auditor would be allowed or prohibited. Following extensive discussion rega
provision of various NAS, the final version of the Sarbanes-Oxley Act o
allowed auditor-provided tax services, but disallowed other specific NAS.
We study three basic issues during the limited period that immediately
includes the Congressional debate over SOX in 2002, which may under-repr
implementation of changes in service relationships resulting from SOX legisla
sequent regulations. However, this period does provide an initial look at firm
expected changes in auditor-provided tax services coincident with the SOX
we examine whether the association between tax fees and audit fees change
period of increased pressure on corporations to separate their audit and tax s
ers. Second, we investigate whether the association between tax fees and the
client/auditor relationship changed over the same period. This question is imp
SOX specifically includes auditor tenure as a factor relevant to auditor indep
(Section 207). While using separate tax and audit service providers shoul
association between tax fees and auditor tenure, limited prior research (Bec
finds no association between auditor tenure and tax service fees. Third, we exa
the association between tax service fees and their benefits (as measured by
decline in tax rates) changed during this period. We expect that increasing
impending regulatory change likely altered the product mix in the tax servi
2002, reducing the association between tax fees and tax savings. In studying
we address a specific type of NAS that is interesting and important due to
characteristics. First, in contrast to other NAS (e.g., systems development), ta
have a direct and immediate impact on client income and cash flows throug
reduction.2 Second, tax services may also affect public policy in terms of t
impact on tax equity. Thus, our service-specific approach complements oth
In this paper, "nonaudit services" (NAS) refer to services, other than the financial statement a
a company's auditor. "Tax fees" refers to fees paid to auditors for tax services.
2 Phillips et al. (2003) examine earnings management through deferred tax expense. They docum
tax expense is incrementally useful over total accruals and discretionary accruals in detecting ear
ment to avoid an earnings decline or loss. Their results suggest that deferred tax expense i
earnings management.
The Accounting Review, October 2006

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Auditor-Provided Tax Services 1097
NAS fees in general, and on the ass

quality.
To conduct our investigation, we use data on tax fees paid to auditors, disclosed in
company proxy statements beginning in 2000. Although the SEC did not mandate separate
reporting of tax service fees paid to auditors until 2003, numerous firms voluntarily
disclosed this information in their proxies from 2000 to 2002. Because firms selectively
disclosed fees paid for auditor-provided tax services we use a maximum likelihood esti-
mation (MLE) approach to the Heckman two-step estimation process (Heckman 1979) to
control for potential selection bias. Our results suggest that higher abnormal audit fees were
positively associated with higher tax fees early in our study period, but this positive asso-
ciation significantly weakened in 2002. This apparent shift in demand for auditor-provided
tax services from 2000 to 2002 suggests a preemptive response by firms to separate audit
and tax service provision, based on expectations that the impending SOX provisions related
to NAS would prohibit or substantially limit auditor-provided tax services.
On the association between tax fees and the length of the auditor-client relationship,
we find that higher tax fees were not associated with longer auditor tenure early in the
study period (consistent with prior research), but longer tenure was positively associated
with higher tax fees in 2002. Although this finding seems to support concerns about NAS
affecting auditor independence for longer tenure clients, the longer relationships are also
likely to be those in which the client receives higher value. We find a negative associa-
tion between tax fees and subsequent changes in tax rates prior to 2002 but the association
weakened in 2002, suggesting a reduced return on tax-planning investments. In sum, our
results are consistent with a change in the fundamental economics of tax service provision
to corporations by their auditors in the period leading up to and including the passage of
SOX. Also, we infer from the results of our selection model that firm size (assets) and
auditor size (Big 5/4) are associated with the decision to purchase tax services from the
auditor, but not with the decision to disclose tax fees paid to the auditor. Factors positively
associated with voluntary disclosure of tax fees include tax complexity (e.g., foreign tax
payments), auditor tenure, and auditor change; voluntary disclosure is negatively associated
with the proportion of NAS fees to total fees.
II. BACKGROUND AND HYPOTHESIS DEVELOPMENT

Background: Auditor-Provided Tax Services
When the assurance market reached saturation levels in the 1970s, audit fir
their revenue base by providing consulting services in taxation, systems, and
From the 1970s into the 1990s, audit firms' gross revenues from consulting
ceeded those from assurance services. For example, according to reports prov
(2003, 269), in 1990, Arthur Andersen generated 44 percent of its gross fee
sulting, 35 percent from assurance, and 21 percent from tax. In 2000, Price
Coopers generated 49 percent of gross fees from consulting, 33 percent fro
and 18 percent from tax. During this period, tax partners experienced increa
to generate revenue by cross-selling tax-related services to audit clients,
develop creative tax strategies.
In response to the major corporate financial failures in late 2001 and early
gress debated and passed SOX, which imposed greater regulation on audit firm
restrictions on services provided to clients. To promote auditor independence
audit quality, SOX prohibits auditors from performing several specific NAS f
statement audit clients, and requires audit committee approval of permissible

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tax services were not among the NAS prohibited

was under discussion during 2002. Purcell and
proposed rules prohibited "formulation of tax st
a firm's tax obligations" due to a concern about
However, because tax services can provide benefi
and increased after-tax earnings), the final rule
to audit clients, "except for transactions with n
(unless consistent with applicable tax laws)." Thu
period provided pressure on public companies a
provided audit and tax services.
Debate continues among regulators regarding
impairs auditor independence. The Public Comp
published a briefing paper on this issue (PCAOB
adopted new rules on July 25, 2005. In the roun
provision argued that as with other NAS, tax s
They argued that large revenues and relatively h
auditors' judgments on crucial aspects of financi
auditors cannot objectively judge the appropria
sold to audit clients by their own firm (Rankin
perform tax services argued that shared know
improve audit quality as well as the firm's tax
because issues associated with the firm's tax return
more likely to be identified, and identified earli
Prior Research on Nonaudit Services

Prior studies have mainly examined two aspects of NAS: (1) the level of NAS pur
chased, and (2) the possible effects of NAS provision on financial reporting quality. Mo
tivated by longstanding concern about potential effects of economic bonding on audito
objectivity (e.g., Simunic 1984; Beck et al. 1988), recent studies examining the level of
NAS purchased (e.g., Dopuch et al. 2003; Brandon et al. 2004) find that financial market
participants recognize auditor independence issues associated with NAS and alter their
financial decisions accordingly. One specific issue addressed in prior research is whethe
NAS are associated with higher audit fees. Such an association implies that clients seek
either obtain the benefit of knowledge spillovers between these services, or to influenc
auditor judgment. While a number of studies document a positive association between NA
fees and audit fees (e.g., Simunic 1984; Simon 1985; Palmrose 1986; Davis et al. 1993
Bell et al. 2001; Antle et al. 2002; Alam and Baez-Diaz 2005), others report no association
(Abdel-khalik 1990; O'Keefe et al. 1994; Whisenant et al. 2003).3
The length of the auditor-client relationship might also suggest reduced auditor objec
tivity. Increasing NAS investment with longer auditor tenure may occur due to the auditor
greater client-specific experience and expertise, and/or because greater access to client
management improves the ability to identify and sell services to existing clients. While a
concern about possible detrimental effects of auditor tenure on audit quality is noted i
SOX, recent research (e.g., Myers et al. 2003) finds that earnings quality is actually highe
3 As noted by Firth (2002), a positive association of audit and NAS fees need not imply auditor independence
concerns if this association is due to firm-specific factors that increase the cost of both services. However,
these characteristics are controlled for and the association remains strong, auditor-client economic bonding
suggested.

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among longer-tenure clients. Evidenc

provided by Beck et al. (1988), who
tenure in 1978-1979. They conclud
longer tenure for some types of ser
tenure.
Research on the association between NAS and indicators of financial reporting quality
yields inconsistent findings, with some studies (Frankel et al. 2002; Ferguson et al. 2004
Reynolds et al. 2004) suggesting that NAS provision is associated with lower earning
quality, while others studies find no association between earnings quality (or earnings re-
statements) and NAS provision (e.g., Ashbaugh et al. 2003; Chung and Kallapur 200
Raghunandan et al. 2003; Kinney et al. 2004). In contrast, Larcker and Richardson (2004)
find that higher audit and NAS fees are associated with higher earnings quality, concludin
that reputation effects constrain auditors from allowing clients to manage earnings. Thu
recent research is mixed on whether NAS compromise auditor independence.
Research in the Tax Service Context and Hypothesis Development

The research reviewed in the previous section provides mixed evidence regarding fac-
tors associated with investment in NAS, and the role of NAS in auditor independence.
Further research in the specific context of tax services is motivated by several reasons. First,
tax services can provide a direct impact on client income and cash flows, in contrast to les
directly measurable impacts of other NAS. Supporting differential effects of tax services
Kinney et al. (2004) find that greater investment in tax NAS is associated with a lower
incidence of earnings restatements (while finding no association between overall NAS fees
and earnings restatements). They suggest that this finding implies a possible net benefit i
earnings quality from auditor-provided tax services.4 Second, studies in the U.S. market
generally use pre-2001 data, and thus they do not consider the possible preemptive change
in auditor-provided tax services brought about by the SOX debate. Third, Mills et al. (199
provide a basis for removing variance in tax service fees associated with client complexity
potentially improving the power of hypothesis tests. This study responds to these motivating
features of prior research, examining factors associated with investment in tax NAS, and
the association of this investment with subsequent changes in tax rates.
We first consider the association between investment in tax fees and the auditor-client
relationship during our study period. Hypothesis la considers the association between tax
fees and audit fees, testing whether the positive association found by some prior studies
(e.g., Bell et al. 2001; Antle et al. 2002) holds for auditor-provided tax services during our
study period. Of the studies that separately address this issue in the tax context, Palmrose
(1986) finds that tax fees are associated with higher audit fees in 1980-1981, while O'Keefe
et al. (1994) find no association between tax services and audit fees or hours. Thus, we
expect a positive association in Hla; however, we propose in Hlb that the association
between tax fees and audit fees weakens in 2002, as the approach of new legislation placed
pressure on client management and auditors to loosen ties suggesting compromised auditor
independence.
Hla: Tax fees paid to auditors are positively associated with audit fees that are greater
than expected given client size and risk characteristics.
HIlb: The association of tax fees with audit fees will weaken in 2002.
4 However, some concern is raised by Favere-Marchesi (2006), who finds that auditors providing tax services to
clients assess a lower risk of fraud than auditors who do not.

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We also examine the association between ta

relationship. While longer relationships cou
pendence (as implied in SOX), the only direct
are aware is Beck et al. (1988), who find no
auditor tenure. Thus, we propose the followi
H2a: Tax fees paid to auditors are associa

relationship.
H2b: The association of tax fees with the length of the auditor-client relationship will
change in 2002.
Hypotheses 3a and 3b consider the association between investment in tax NAS and
subsequent reductions in tax rates, and changes in this association in 2002, respectively.
Mills et al. (1998) find that investment in tax services (performed by auditors, nonauditors,
and in-house personnel) among large corporations in 1991 is positively associated with tax
complexity and negatively associated with tax rates. Consistent with this research, H3a
proposes that companies invest in tax planning to reduce future tax liabilities. Thus, higher
tax fees should be associated with declining future tax rates, as the effect of the purchased
tax strategies becomes evident. Hypothesis 3b proposes a weakening of this association in
2002, due to increasing attention by regulators and the financial press on auditor indepen-
dence, audit quality, and questionable tax positions.
H3a: Higher tax fees paid to auditors are associated with reductions in future tax rates.
H3b: The association of tax fees with reductions in future tax rates will weaken in
2002.
III. METHODS
Description of the Sample and Variable Definitions
Sample Derivation and Dependent Variable
Data for this study are obtained from Standard & Poor's Audit Fee Data (2
Compustat Annual Industrial 2003, and Graham's (1996a, 1996b) estimated ma
rates (1980-2003). During our study period, registrants were required to repo
to auditors in three categories: audit, audit-related, and other. The latter catego
tax services as well as other NAS. Many firms provided an additional fee categ
ically noting tax fees paid to the auditor. Others provided detail on the compo
"other" category in notes accompanying the proxy statement disclosure. Our
variable, lnTAXFEE, is the natural log of tax fees paid to auditors, as reporte
sources.
Table 1 summarizes the derivation of the sample. Table 1 indic

firm-years with complete data, tax fees are identified in 2,405 ca
percent). For our analyses, firms providing tax fee information a
closers." "Nondisclosers" are firms that provide no tax fee inform
information was available on all of the independent variables.
Independent Variables-Auditor Relationship Variables

Hypothesis la proposes a positive association between tax fees a
greater than expected, given client characteristics. We employ an
measure as our independent variable for testing this hypothesis,

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TABLE 1
Derivation of the Samplea
Firms Repor
Tax Fee Inform
Total Sample (Disclosers
Firm-Years Firms Firm-Years Fi
Initial Sample Based on Standard & Poor's 14,434 6,945 5,68

Audit Fee Data 2000-2002
Sample after Combining with Compustat 12,890 5,946 3,2

Annual Industrial 2003c
Sample after Combining with Graham's 8,044 3,686 3,54
Marginal Tax Rate Data 2000-2003c
Adjusting for Change in Marginal Tax Ratec 5,727 2,925 2,4
a This table presents the derivation of the sample used in the hypothesis test
z bThe numbers do not sum to the first column because some firms did not
S cFirms must have at least two years of available marginal tax rate informa
0o

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demonstrates that audit fees are highly associated

client characteristics that also appear as indep
we estimate an OLS model of the log of audit
receivables plus inventory to total assets, leve
segments, year, Big N/Non-Big N, and indust
variance in audit fees, which is consistent wit
is actual logged audit fees minus forecasted a
Hypothesis 2a predicts that the length of t
with investment in auditor-provided tax servi
length. TENURE is a continuous variable, repres
auditor has performed the financial statement
retaining auditors from prior years will have
provided tax services, relative to firms swi
AUDITOR CHANGE equals 1 if the firm switc
otherwise. Hypotheses lb and 2b, which propo
auditor relationship variables weakens in 2002
relationship variables with the dichotomous v
Hypothesis 3a proposes a negative association
tax services in a given year and subsequent yea
of tax rates is Graham's estimated after-finan
ulations of firms' future taxable income (She
test the sensitivity of our results using changes i
We rely primarily on MTR because ETR may
minimization strategies in the short term, after
ronment and capital structure. We compute E
minus Deferred Taxes (Compustat item #50)
#170). Hypothesis 3b, which proposes that th
changes weakens in 2002, is tested through th
2002.
Control Variables
One advantage of studying tax services as a specific NAS is the ability to control for
firm characteristics affecting investment in tax services, to improve the power of our hy-
pothesis tests. We use several variables to measure the tax complexity of our sample firms.
First, firms with relatively higher deferred taxes are likely to pay higher fees for advice
successful in deferring liabilities to future periods. DEFTAX is a continuous variable mea-
suring the relative amount of Deferred Taxes (Compustat item #50) to Total Tax Expense
(Compustat item #16). Second, firms involved in mergers or acquisitions are likely to need
advice on the tax implications of changes in their firm structure and limitations imposed
on effectively using the tax attributes of the merging entities or the acquired firm. MERGER
is a dichotomous variable equal to 1 if the firm engaged in a merger, acquisition, or other
corporate restructuring, and 0 otherwise. Third, firms doing business in foreign jurisdictions
likely need the assistance of tax professionals in preparing multiple jurisdiction tax returns
as well as determining appropriate timing of repatriation of earnings. FOREIGN is equal
to 1 if taxes were paid to a foreign jurisdiction (Compustat item #64), and 0 otherwise.
5 Plesko (2003) questions the Graham marginal tax rate measure because of its limited distribution characteristics.
We acknowledge this possible limitation but note that the Graham measure is used extensively in the literature
and is one of the only available sources of these estimates.

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Fourth, firms with a net operating lo

uling and valuing the related deferred
loss carryforward (Compustat item #
- 0), and 0 otherwise. Fifth, firms w
Segments) are likely to have more co
planning strategies. Finally, firms th
higher tax advisory fees to accomplis
et al. 2003; Desai and Hines 2002; Seid
variable equal to 1 if Cloyd et al. (2003
to an offshore tax haven, and 0 other
Our model also includes control var
(InASSETS, the natural log of total as
minus stockholder equity, divided by
Pretax ROA (pretax income divided by
controls for all of the possible interest
activity regardless of source. While w
Pretax ROA, the appropriate sign on
2002 measures the intercept shift ass
audit fee models, we control for varia
series of dichotomous variables based
dichotomous variables representing B
still providing services during part of
Empirical Models
The discussion above suggests the f
InTAXFEE = xo + oxUNEXPECT
+ o2UNEXPECTED AUDIT F
+ O4TENURE X YEAR 2002
+ ot6AUDITOR CHANGE X
+ "sCHANGE MTR(ETR) X
+ a" oMERGER + aoqFOREIG
+ "14EXPATRIATE + as5YEA
+ oa21nASSETS + a22LEVERA
+ o24-87INDUSTRY + u. (1)
Because of the selective disclosure of auditor-pro

MLE approach to Heckman's two-step estimation pr
MLE procedure controls for selection bias through
explaining selection of firms into the group of firm
The Accounting Review, O

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selection model), with the empirical

selection model in our full sample is
series of management decisions. Firs
an external provider. Research in th
proposes that the decision to outsou
relating to human-asset specificity,
the outsourcing of tax compliance is
complexity should be associated with
Second, the firm must choose the audit
affects this decision as well as the le
relationship between auditors and cl
and greater access to decision-maker
model includes tax complexity and au
The third decision is that the firm
auditors. While we are aware of no
disclosure, Healy and Palepu (2001) n
communication of knowledge about
formance for contracting, political, a
literature, our selection model inclu
(LEVERAGE) as agency variables, as
political sensitivity of some aspects
status) and close auditor relationship
dition to tax complexity variables, w
relative level of NAS fees (NAS/T
6 The Heckman MLE method tests for correlati

of the inverse Mills ratio and its coefficient
errors for multiple observations on individual
An anonymous reviewer raised two issues rela
in tax rates. The first is our choice to use t
independent variable, in contrast to prior st
several reasons why our specification is appro
multiple hypotheses centered on the level of t
model provide controls for differences in ta
model is the most parsimonious way to achie
selection bias in the voluntary disclosure of ta
the ability to use the Heckman procedure to c
The second issue raised by the reviewer is
(in particular, simultaneous endogeneity). Prio
problem exists and, if so, whether it is poss
Selection bias and simultaneity are both end
likely the more serious problem in our anal
specific source of endogeneity. To address pos
than contemporaneous tax rates as used in p
geneity, if it exists.
In additional untabulated analysis, we instr
nonaudit service fees. The R2 for the instrum
constructed. We then test for endogeneity u
both tests fail to reject the null hypothesis th
that, at least in our setting, using change in t
issue. This supports our use of the Heckma
greater concern.

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INCOME, NAS fees scaled by pretax i

of disclosure.8 The resulting selection
DISCLOSE = 80 + ?1 UNEXPECTE
+ 83AUDITOR CHANGE + 8
+ 86FOREIGN + s7NOL + 8,
+ "8olnASSET + 8s1SEGMEN
+ "13LEVERAGE + 814NAS/
+ 816YEAR 2002 + u.
(2)
We view the selection model as preliminary to our primary goal of testing hypotheses
on the association of the level of tax fees with other variables. Thus, we provide only a
brief discussion of its results in the next section, prior to providing results of our outcome
model (Model (1)). As an alternative to the full sample analysis, we apply Heckman MLE
to a subsample, containing only disclosers and a smaller sample of nondisclosers that paid
the auditor for tax services. Thus, in the subsample model, selection bias is narrowed to
the disclosure decision only. This approach conforms to advice by Wooldridge (2002), who
notes complications introduced by multiple possible sources of selection bias. To accom-
plish this, we use the S&P 2003-2004 Audit Fee File to identify firms that paid tax fees
to auditors in 2002, but did not report those fees in that year.9 The subsample contains 300
nondisclosing firms that paid tax fees to their auditor in 2002, combined with 2,405 firm-
years disclosing tax fees paid. This procedure specifically addresses the issue of selection
bias regarding the decision to disclose fees rather than the combined decision to purchase
tax services from the auditor and disclose.
IV. RESULTS
Descriptive Statistics
Table 2 reports descriptive statistics for our sample. Table 2, Panel A, indicat
the mean (median) fee paid by firms reporting auditor-provided tax services appr
$787,000 ($173,000). Comparing tax fees reported by disclosing firms for each y
tabled), we find that the median fee declines significantly through the sample p
($256,880 in 2000, $191,000 in 2001, and $145,150 in 2002; Pearson Chi-square
8 The addition of relative NAS fees to the selection model accomplishes the frequently cited need to
additional variables not contained in the outcome model, in order to avoid multicollinearity. Madd
and Wooldridge (2002) note that it is not technically necessary for the selection equation to contain
variables, and caution that adding inappropriate variables to the selection equation can leave the issu
selection unaddressed. Stolzenberg and Relles (1997) note that independent variables in the two mo
often identical in the sociology literature, and show that the Heckman procedure may not be superi
even with a large sample size. Based on this caution, we estimate our models several different way
Heckman approach with the addition of relative NAS fees, which might affect disclosure but have low
with the outcome equation dependent variable; (2) the Heckman approach using only the variables re
tax complexity, auditor relationship, and controls, which we theorize are related to both selection and
(3) censored normal regression, which assumes a random selection process; and (4) OLS regression. W
inferences across the three approaches remain unchanged, control for selection bias using both Heckma
produces some changes in model coefficients, including increased significance of tax complexity. T
similarity of results across these approaches supports the validity of our findings.
9 Identification is possible because with mandatory disclosure in 2003, firms were also required to r
payments.

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TABLE 2
ao Descriptive Statistics
Firms Reporting F
ch
a
Tax Fee Reporting T
Information (Ful
cz Full Sample (Disclosers) Nondisc
Variable Description (n = 5,727) (n = 2,405) (n = 3
Panel A: Continuous Variablesa
t,
1\
TAX FEE Fee paid to auditor for tax NA 787 (2
services (thousands) 173
AUDIT FEE Fee for financial statement 848 (2,110) 1,127 (2,824) 64
audit (thousands) 285 334
TENURE Number of years financial 8.98 (9.30) 9.92 (9.45) 8.3
statement audit performe
by the current auditor
CHANGE MTR Percentage change in estimated -1.41% (12.3) -1.38% (12.4) -1
marginal tax rates in the 0%
following period (Graham)
CHANGE ETR Percentage change in effective -1.91% (5.92) -2.19% (6.00) -1
tax rates in the following -0.45% -0.94%
period
DEFTAX Current deferred tax expense 0.53 (23.4) 0.45 (18.5)
divided by total tax expense 0.14 0
SEGMENTS Number of business segments 4.63 (3.16) 4.84 (3.29) 4
4 4 4
ASSETS Total assets (in millions) 6,199 (40,425) 9,311 (57,429) 3,948
433 523 3
LEVERAGE Total liabilities + Total assets 0.56 (0.44) 0.56 (0.34) 0
0.55 0.56 0.
Pretax ROA Pretax income - Total assets 0.01 (0.76) 0.01 (0.33) 0
0.05 0.04 0.

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TABLE 2 (Continued)
Panel B: Dichotomous Variablesb
AUDITOR = 1 if changed auditor in the 9%

CHANGE current year, 0 otherwise
MERGER = 1 if merger or acquisition, 0 17% 1
otherwise
FOREIGN = 1 if foreign taxes paid, 0 42% 46

otherwise
NOL = 1 if a carryforward exists 15% 14

and no pretax income exists,
O otherwise
EXPATRIATE = 1 if firm was reincorporated 0.3%

h3
;sl
outside the U.S. (Cloyd et
(h al. 2003), 0 otherwise
C: aThe table reports the mean (standard deviation) and median fo

O
x
b The table reports the percentage equal to 1 for dichotomous
~Zf;
$j
decimal changes in the hypothesis testing models.
CIO
Ch
O
O

83.253.247.117 on Wed, 26 Apr 2023 09:05:09 UTC
p = 0.00). Regarding auditor relationship var

paid by firms in the full sample is $848,000,
Overall, the mean of the annual change i
garding control variables, the mean ratio of
the mean number of business segments is 4
sample is about $6.2 billion (median, $433 m
mean pretax ROA is 1 percent. Table 2, Pan
about 9 percent of the total firm-years, the
occurred in 17 percent of the firm-years, ta
42 percent of sample observations, 15 perce
percent have expatriate tax status. Correlat
are low, with the highest correlation (0.40) betw
of business segments.
Selection Model Results, Full Sample, and

Prior to discussing our outcome model (Mod
of the selection model (Model (2)) presented
has acceptable discrimination (Hosmer and L
area value of 0.71. The coefficient for the s
significant (p = 0.00). The full sample select
significant are TENURE (p = 0.00); AUDIT
= 0.02); InASSETS (p = 0.00), FOREIGN (p
findings are consistent with large, complex ent
disclosure in this context. Similar results hav
Carcello et al. [2002], for disclosures about a
for disclosures of financial information on corp
model results also indicate that the coefficie
icant (p = 0.00). This implies that firms pur
were likely exposed to greater political cost
voluntarily disclose separate fees for auditor
Because there are multiple sources of poss
subsample selection model may better indica
that the firm has decided to purchase tax s
value for the subsample selection model is 0
selection bias parameter A for the subsamp
positive and significant coefficients in the su
sample model, with the exception of the co
remain positive but are not significant. Thes
worthy of note, as they imply that firm siz
purchasing auditor-provided tax services (a p
sample), but not the likelihood of disclosing
of bias present in both samples).
Outcome Model-Full Sample Results

Table 4 presents the results of estimating
first discuss the full sample results using M
(Column B), noting any differences arising
1o Because there is little guidance in the literature, selec

83.253.247.117 on Wed, 26 Apr 2023 09:05:09 UTC
TABLE 3
Selection Model Results: Heckman Maximum Likelihood Method
DISCLOSE = 80 + 8GUNEXPECTED AUDIT FEE + 82TENURE

+ 83AUDITOR CHANGE + 84DEFTAX + 8GMERGER
+ 86FOREIGN + 87NOL + 88Pretax ROA + 89EXPATRIATE
+ 8101lnASSET + 81,SEGMENTS + ,12BIG 5/4 + 813LEVERAGE
+ 814NAS/TOTALFEE + 615NAS/INCOME + G16YEAR 2002 + u (2)
A B
Variablea Full Sample Subsample
UNEXP. AUDIT FEE -0.00b -0.17
TENURE 0.01*** 0.01*
AUDITOR CHANGE 0.34*** 0.25**
DEFTAX 0.00 0.00
MERGER 0.01 -0.00
FOREIGN 0.18*** 0.26**
NOL 0.05 0.08
Pretax ROA -0.04 -0.09
EXPATRIATE 0.22 0.01
InASSET 0.08*** 0.04
SEGMENTS 0.01 0.02
BIG 5/4 0.18** 0.09
LEVERAGE -0.10 -0.06
NAS/TOTALFEE -1.57*** -1.15***
NAS/INCOME 0.00 0.00
YEAR 2002 0.58*** 0.07
Constant -0.63*** 1.00***
ROC Curve Area 0.71 0.62
n 5,727 2,705
This table presents

disclosing tax fees
results of the subsa
*, **, *** Indicate
a Variables are def
auditor fees), and
industry and for B
presentation.
b Values reported are the unstandardized regression coefficients.
effectiveness. Results of our hypothesis tests are as follows. Hypothesis la predicts that
investment in auditor-provided tax services is positively associated with audit fees that are
greater than expected in 2000-2001, given client characteristics. The positive and significant
coefficient (p = 0.00) on UNEXPECTED AUDIT FEE supports Hla. The negative and
significant coefficient on the interaction of UNEXPECTED AUDIT FEE with YEAR 2002
(p = 0.02) supports Hlb, which suggests that the positive association between tax-related
NAS fees and audit fees weakens in 2002. The marginal effects for these variables, con-
ditional on tax fee reporting, imply a 62.19 percent increase in tax fees for a one standard
deviation increase in unexpected audit fees prior to 2002, and a 37.79 percent increase

83.253.247.117 on Wed, 26 Apr 2023 09:05:09 UTC
TABLE 4
t`3
;sl
ca
Outcome Model Results: Heckman Maximum Likelihood Method
cs
cs
O InTAXFEE = ao + a-UNEXPECTED AUDIT FEE + 2%UNEXPECTED AUDIT FEE X
X
+ "4TENURE X YEAR 2002 + ot5AUDITOR CHANGE + u6AUDITOR CH
3t~
+ "X8CHANGE MTR(ETR) X YEAR 2002 + g9DEFTAX + ao0MERGER +
ch
N.
+ o"4EXPATRIATE + ,15YEAR 2002 + al6-20AUDITOR IDs + a211nASSE
+ a24-87INDUSTRY
O A
cs
Expected Full Sample

ca
u Variablea Sign MTR ETR M
O Constant -0.52b -0.51 0.6
O
0\
UNEXP. AUDIT FEE (Hla) + 3.38*** 3.42***
UNEXP. AUDIT FEE X YEAR 2002 (Hlb) - - 1.14** - 1.1
TENURE (H2a) +/- 0.00 0.00 -0
TENURE X YEAR 2002 (H2b) +/- 0.01* 0.01
AUDITOR CHANGE (H2a) +/- 0.38*** 0.39*
AUDITOR CHANGE X YEAR 2002 (H2b) +/- -0.39*** -0.40
CHANGE MTR (ETR) (H3a) - -0.33* -0.09** -
CHANGE MTR (ETR) X YEAR 2002 (H3b) + 0.34
DEFTAX + 0.00 0.00 0.00*
MERGER + 0.10* 0.10* 0.12
FOREIGN + 0.29*** 0.29*** 0.22
NOL + 0.06 0.07 0.0
SEGMENTS + 0.06*** 0.06*** 0.06
EXPATRIATE + 0.58** 0.59** 0
YEAR 2002 +/- 0.20*** 0.19*** -0.19
InASSETS + 0.55*** 0.55*** 0.53*
LEVERAGE +/- 0.19** 0.19** 0.23
Pretax ROA + 0.10* 0.10* 0.
Pseudo R2 0.11 0.11 0.
n 5,727 2,7

83.253.247.117 on Wed, 26 Apr 2023 09:05:09 UTC
TABLE 4 (Continued)
This table presents results of Heckman MLE outcome models, explaining the natural log of fees paid to auditors for
subsequent year change in marginal tax rates, tax complexity, and control variables. Column A presents results of t
tax rates as alternate measures of tax service effectiveness. Column B presents results of the subsample, which con
their auditor for tax services.
*, **, *** Indicate significance at 10 percent, 5 percent, and 1 percent, respectively, in a one-tailed test if directi
otherwise.
aVariables are defined in Table 2. Dichotomous variables for industry and for individual Big 5/4 audit firms are incl
efficiency of presentation.
b Values reported are the unstandardized regression coefficients.
Ch
~
O
X
;S
~=C.
;S
3t~
Ch
O
C,
Ch
Y
O
O
0\

83.253.247.117 on Wed, 26 Apr 2023 09:05:09 UTC
during 2002.1 The declining association between

were reducing their reliance on the auditor for
Hypothesis 2a proposes that the length of the
auditor-provided tax services, while H2b propo
The coefficient for TENURE, is insignificant; ho
TENURE and YEAR 2002 is positive and marg
no association prior to 2002 between tax fees and
However, this relationship changes in 2002, such
ships had a somewhat higher level of tax fees in
relationships. Conditional marginal effects imply
and, thus, for example, a ten-year auditor relat
tax fees.
We also test H2a and H2b using AUDITOR CHANGE to represent length of the auditor-
client relationship. Table 4 shows that the coefficient for AUDITOR CHANGE is positive
and significant (p = 0.00), and the coefficient on the interaction of AUDITOR CHANGE
with YEAR 2002 is negative and significant (p = 0.01).12 Conditional marginal effect com-
putations show that firms changing auditors prior to 2002 paid 46.03 percent higher tax
fees (ETR model: 47.01 percent), while those changing auditors in 2002 paid 1.41 percent
lower tax fees (ETR model: 1.00 percent). Taken together with results on TENURE, our
results suggest that clients with new auditors purchased more tax services prior to 2002.
However, in 2002 this positive association weakens, such that clients with short-tenure
auditors purchased less tax services from their auditors than clients with long-tenure
relationships.
Hypotheses 3a and 3b predict that the purchase of auditor-provided tax services is
associated with declining tax rates in the following year, but that this relationship weakens
in 2002. The negative and marginally significant coefficient on CHANGE MTR (p = 0.07),
supports H3a. While the positive coefficient for the interaction of CHANGE MTR and YEAR
2002 suggests that the relationship between tax fees and tax rate changes weakens in 2002,
the variable is not significant in the full sample model. For the MTR model, conditional
marginal effects imply that a 1 percent decline in tax rate is associated with 28 percent
higher tax fees prior to 2002.
The coefficients for several tax complexity variables are positive and significant, in-
cluding MERGER (p = 0.08), FOREIGN (p = 0.00), SEGMENTS (p = 0.00), and EXPA-
TRIATE (p = 0.05). Overall, these findings imply that firms with complex tax characteristics
paid higher fees to auditors for tax services, while controlling for client size and other
characteristics. For the remaining control variables we find positive and significant coeffi-
cients for InASSETS (p = 0.00), LEVERAGE (p = 0.03), and Pretax ROA (p = 0.09). The
YEAR 2002 intercept shift variable is also positive and significant (p = 0.01).
" We evaluate conditional marginal effects at the mean of the distribution. We report the conditional effects (i.e.,
only for firms reporting tax fees), as the economic impact is more meaningful among firms whose tax service
payments are known.
12 These results are obtained excluding firm-years that involved auditor changes from Arthur Andersen LLP in
2002 due to the possibility that measurement error is associated with the unusual circumstances surrounding the
"flight" from Andersen. When the 2002 Arthur Andersen switches are included in the sample, the results for
the AUDITOR CHANGE and AUDITOR CHANGE X YEAR 2002 are statistically unchanged although coefficients
and p-values are slightly different. However, the 2002 switches from Arthur Andersen to other auditors exhibit
greater reduction in tax fees paid to the new auditor than do other auditor switches.

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Outcome Model-Subsample Resu

As previously noted, interpretation o
sources of selection bias. This issue m
of tax service purchasers, shown in
for both the MTR and ETR models ar
results with two exceptions. First, th
YEAR 2002 is now negative and mar
for H3b. Marginal effects in the sub
fees associated with a 1 percent re
higher tax fees with a 1 percent tax
for AUDITOR CHANGE and the ne
CHANGE and YEAR 2002 are consis
significance in the subsample outcom
ditional marginal effects for firms
higher tax fees, while those changin
Other differences include the positiv
full sample outcome model but is si
coefficient for YEAR 2002, which is
model but is negative and significan
Supplementary Analyses
We perform two supplementary a
following the passage of SOX in 2002
ued to decline, or increased once it
prohibited. Either result is possible,
maintained during 2003, the final v
tax services by auditors. Using the
data for 1,124 of the 1,182 sample
The mean (median) tax fee paid by t
mean (median) tax fee reported in
(p = 0.00). This suggests that altho
factors such as the need for audit co
to depress this market.
Second, we investigate whether inve
with evidence of earnings managemen
is an association between tax fees an
test by first computing abnormal ac
ample, Francis et al. 2005).13 When
Model (1), we do not find a significa
and earnings management, either bef
on the possible effects of high tax
important to note that our results in
rates. This implies that firms buying
from the decline in tax rate, and th
in other ways. Further research shou
13 We estimate discretionary accruals using all

containing at least ten firms. This approach av
in the target sample.
The Accounting R

83.253.247.117 on Wed, 26 Apr 2023 09:05:09 UTC
V. CONCLUSION AND LIMITATIONS
Conclusions
This study examines factors associated with investment in auditor-provided tax services
during 2000-2002, a period of change in the regulatory climate for NAS and for tax servi-
ces specifically. While there has been research directed toward joint audit/NAS provision
since disclosure of U.S. audit and NAS fees in 2000, there is little evidence on tax services
specifically, despite its importance to companies, providers, and the public interest. Thi
issue is important because while the tax services are not among prohibited NAS, thi
exemption has not been adequately examined in light of the concerns over auditor inde-
pendence.14 Research findings on the association between total NAS and auditor indepen
dence are mixed, with some evidence provided by Kinney et al. (2004) that tax services
may differ from other types of NAS in this regard. Our research provides three main
findings.
First, we find a strong positive association between tax fees and unexpected audit fees
during 2000-2001 and a significant reduction in the strength of this positive association in
2002. We also find that that during 2000-2001, new clients paid significantly greater
tax fees than continuing clients; however, in 2002, shorter-tenure clients paid lower tax
fees. Overall, these findings suggest that the reduction in association between audit and
tax service fees in 2002 was due to new and relatively short-tenure clients terminating tax
services (or not initiating new services), while services provided by longer-tenure auditors
were maintained despite growing pressure by regulators to seek tax services elsewhere. Two
prior studies are important in interpreting this result. Kinney et al. (2004) find that higher
tax fees paid to auditors are associated with fewer earnings restatements. In addition, Myers
et al. (2003) find that longer auditor tenure is associated with higher earnings quality.
Combining these results with ours, the evidence suggests that service quality is the main
driver of joint audit/tax service provision, rather than attempts by clients to "buy" the
auditor's acquiescence. This finding supports the PCAOB's decision not to ban auditors
from performing all tax services for their clients, but to limit the prohibition to certain tax
services likely to be more problematic. Our supplemental comparison of 2003 tax fees paid
by the 2002 reporters in our sample shows a continued decline in this market, even after
the final version of SOX did not prohibit auditors from providing tax services to clients.
Our second main finding relates to the association between tax fees and subsequent
changes in tax rates. Our results imply that during 2000-2001, higher tax fees were asso-
ciated with greater reductions in future tax rates. However, we find some evidence that this
association weakened during 2002, in which tax fees paid were not associated with future
declines in tax rates (controlling for firm size, income, and tax complexity), implying no
or reduced "return" to those expenditures. Although we cannot directly observe the nature
of tax services provided, our interpretation of these findings is that the services provided
in 2002 were less likely to produce reduction in tax rates.
Our third main set of findings is derived from our selection model (Model (2)). The
significant selection bias parameter provides evidence that the voluntary disclosure of tax
fees during the early 2000s was not a random event. As has been found in other financial
disclosure contexts, the disclosure decision varies depending on firm-specific and auditor-
specific factors. For instance, the difference in significance of the effects of firm size and
14 At this writing the PCAOB has proposed further restrictions on the provision of tax services by auditors, which
have yet to be ratified by the SEC. See http://www.pcaobus.org/News andEvents/News/2004-12-14.asp for
further discussion of the proposed ban.

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auditor size on disclosure between ou

factors are positively associated with th
but not with the decision to disclose th
the PCAOB hearings on tax services, com
(e.g., to prepare the tax provision). Once
fee amount is strongly associated with f
the relationship is unaffected. However,
other variables in the model) firms with
likely to voluntarily disclose the amoun
period provides a unique view of volun
investigate these issues in greater depth
Limitations
Our findings are limited by features of our data and method. First, reporting of tax fees
paid to auditors was voluntary during our sample period, and disclosure of tax fees paid to
nonaudit providers was not required. We attempt to control for this selection bias using the
Heckman procedure. While control may not be complete, one of the significant contribu-
tions of the current study is to show that during a period of regulatory uncertainty, the
provision of tax services by auditors changed from previous patterns. Thus, use of voluntary
disclosure data is necessary in order to address our research questions, and this study
provides a foundation for further studies of tax fees under mandatory reporting. Second,
while we measure tax rate changes over a single year, tax-planning effects are likely to
occur over longer horizons. This implies that the observed relationship between change in
tax rates and current tax fees may understate the tax benefit of fees paid, especially for
effective tax rates. Finally, we observe the tax services market over a limited period, and
thus may not fully observe the implementation of changes in service relationships resulting
from SOX legislation and subsequent regulations.
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Auditor-Provided Tax Services: The Effects of a Changing Regulatory Environment

Author(s): Thomas C. Omer, Jean C. Bedard and Diana Falsetta

Stable URL: https://www.jstor.org/stable/4093099

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Auditor-Provided Tax Services:

Keywords: tax fees; tax consulting; audit fees; auditor independence.

Editor's note: This paper was accepted by Dan Dhaliwal.

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Data Availability: The data used for this study a

The Accounting Review, October 2006

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NAS fees in general, and on the ass

II. BACKGROUND AND HYPOTHESIS DEVELOPMENT

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tax services were not among the NAS prohibited

Prior Research on Nonaudit Services

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among longer-tenure clients. Evidenc

Research in the Tax Service Context and Hypothesis Development

The Accounting Review, October 2006

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We also examine the association between ta

H2a: Tax fees paid to auditors are associa

Table 1 summarizes the derivation of the sample. Table 1 indic

Independent Variables-Auditor Relationship Variables

The Accounting Review, October 2006

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Initial Sample Based on Standard & Poor's 14,434 6,945 5,68

Sample after Combining with Compustat 12,890 5,946 3,2

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demonstrates that audit fees are highly associated

The Accounting Review, October 2006

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Fourth, firms with a net operating lo

Because of the selective disclosure of auditor-pro

The Accounting Review, O

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selection model), with the empirical

6 The Heckman MLE method tests for correlati

The Accounting Review, October 2006

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INCOME, NAS fees scaled by pretax i

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Panel B: Dichotomous Variablesb

AUDITOR = 1 if changed auditor in the 9%

FOREIGN = 1 if foreign taxes paid, 0 42% 46

NOL = 1 if a carryforward exists 15% 14

EXPATRIATE = 1 if firm was reincorporated 0.3%

C: aThe table reports the mean (standard deviation) and median fo

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p = 0.00). Regarding auditor relationship var

Selection Model Results, Full Sample, and

Outcome Model-Full Sample Results

1o Because there is little guidance in the literature, selec

The Accounting Review, October 2006

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DISCLOSE = 80 + 8GUNEXPECTED AUDIT FEE + 82TENURE

This table presents