Tax Consulting and Reported Weaknesses in Internal Control
Randy ElderRandy ElderSyracuse UniversitySyracuse University
David HarrisDavid HarrisSyracuse UniversitySyracuse University
Jian ZhouJian ZhouSUNYSUNY--BinghamtonBinghamton
OutlineOutline
Broad perspective on Broad perspective on nonauditnonaudit servicesservicesPrevious literature and motivationPrevious literature and motivationHypothesesHypothesesData and resultsData and results
Why Examine Tax Why Examine Tax ConsultingConsulting??
PCAOB considered prohibiting tax consultingPCAOB considered prohibiting tax consulting–– Tax consulting issues at E&Y with Sprint, and KPMG Tax consulting issues at E&Y with Sprint, and KPMG
tax shelterstax shelters–– PCAOB restricted provision of abusive shelters and PCAOB restricted provision of abusive shelters and
consulting for key executivesconsulting for key executives
Tax Tax consulting consulting is a significant type of is a significant type of nonauditnonauditserviceservice and the eand the effect of ffect of nonauditnonaudit servicesservicesremainremain unresolvedunresolved
BackgroundBackgroundSOX codifies existing provisionsSOX codifies existing provisions–– Not all services are prohibitedNot all services are prohibited–– Only applies to public company audit clientsOnly applies to public company audit clients
Big 4 are still in the gameBig 4 are still in the game–– Deloitte still has a consulting practiceDeloitte still has a consulting practice–– KPMG advisory revenues grew 30% last yearKPMG advisory revenues grew 30% last year–– PwC will likely expand services after nonPwC will likely expand services after non--compete compete
expiresexpires–– Tax still a significant revenue sourceTax still a significant revenue source
Background TheoryBackground Theory
Audit QualityAudit Quality ((DeAngeloDeAngelo 1981) 1981) –– joint joint probability that auditor probability that auditor
will:will:–– Detect a misstatement (technical ability)Detect a misstatement (technical ability)–– Report the misstatement (independence)Report the misstatement (independence)
Tests have focused on independenceTests have focused on independence–– This has been especially true of effect of This has been especially true of effect of
nonauditnonaudit services services
Arguments for/against consultingArguments for/against consulting
ProPro –– Consulting services provide Consulting services provide knowledge spilloversknowledge spillovers–– Reduces cost of auditing and/or consulting Reduces cost of auditing and/or consulting
(efficiency)(efficiency)–– Provides knowledge useful to performance of Provides knowledge useful to performance of
auditing and/or consultingauditing and/or consultingConCon –– Consulting revenues increases the Consulting revenues increases the auditors economic dependence on the auditors economic dependence on the client, reducing auditor independenceclient, reducing auditor independence
Consulting and IndependenceConsulting and IndependenceEnron famously paid Andersen $52 million in 2000 Enron famously paid Andersen $52 million in 2000 -- $25 million for audit and $27 million for consulting$25 million for audit and $27 million for consultingHowever, pHowever, preponderance of research does not find reponderance of research does not find that nonthat non--audit services impairs independenceaudit services impairs independenceWhy this doesn’t matterWhy this doesn’t matter–– Concern is with both independence in fact and Concern is with both independence in fact and
appearanceappearance–– Consulting created appearance that independence was Consulting created appearance that independence was
impairedimpaired–– Therefore, finding of nonTherefore, finding of non--impairment probably not impairment probably not
sufficient to change status quo sufficient to change status quo
Independence evidence:Independence evidence: eearnings arnings mmanagementanagement
Conflicting results on the relationship between Conflicting results on the relationship between nonnon--audit service and auditor independence audit service and auditor independence measured by earnings management measured by earnings management –– Frankel et al. (2002) find a positive relation between Frankel et al. (2002) find a positive relation between
nonnon--audit services and earnings managementaudit services and earnings management–– Ferguson et al. (2004) also find for U.K. Ferguson et al. (2004) also find for U.K. Firms.Firms.–– Several U.S. studies find no relationSeveral U.S. studies find no relation
AshbaughAshbaugh et al. (2003)et al. (2003)Chung and Chung and KallapurKallapur (2003)(2003)Reynolds et al. (2002)Reynolds et al. (2002)Francis and Ke (2002)Francis and Ke (2002)
IIndependence ndependence eevidencevidence: other : other aspectsaspects
No evidence that No evidence that nonauditnonaudit services services affected propensity to issue going concern affected propensity to issue going concern opinions (opinions (DeFondDeFond et al. 2002)et al. 2002)
Little evidence that restatements are Little evidence that restatements are related to related to nonauditnonaudit services (Kinney et al. services (Kinney et al. 2004)2004)
Knowledge Spillovers Knowledge Spillovers -- PerformancePerformance
Audit firms argue that nonAudit firms argue that non--audit services:audit services:–– Can be performed at lower costCan be performed at lower cost–– Also allows for more effective performance of Also allows for more effective performance of
both servicesboth servicesPerformance data (or evidence of lower Performance data (or evidence of lower fees) will be necessary to justify change in fees) will be necessary to justify change in status quostatus quo
Knowledge Spillovers and FeesKnowledge Spillovers and Fees
SimunicSimunic (1984) identifies various plausible relations (1984) identifies various plausible relations between audit and between audit and nonauditnonaudit service feesservice fees
Audit Fee Consulting FeeAudit Fee Consulting Fee
Fixed cost Fixed costFixed cost Fixed costVariable cost Variable costVariable cost Variable cost
Knowledge Spillovers and FeesKnowledge Spillovers and Fees
Key PointsKey Points–– Early studies found positive relation between audit Early studies found positive relation between audit
and and nonauditnonaudit feesfees–– WhisenantWhisenant et al. (2003) find no significant relation et al. (2003) find no significant relation
using simultaneous equations of audit and using simultaneous equations of audit and nonauditnonauditfees, indicating no knowledge spilloversfees, indicating no knowledge spillovers
–– Little evidence that using your auditor for consulting Little evidence that using your auditor for consulting results in lower fees, although this is counterintuitiveresults in lower fees, although this is counterintuitive
–– Studies do not consider acquisition costs to clientStudies do not consider acquisition costs to client
Evidence from Evidence from Tax ServicesTax Services
Kinney et al. (2004) find some evidence Kinney et al. (2004) find some evidence that restatements are negatively related to that restatements are negatively related to tax servicestax servicesGleason and Mills (2007) find that Gleason and Mills (2007) find that auditorauditor--provided tax services are associated with provided tax services are associated with more accurate estimates of tax expensemore accurate estimates of tax expense–– Consistent with knowledge spillover and Consistent with knowledge spillover and
contrary to concerns about independence contrary to concerns about independence failurefailure
Internal Control ReportingInternal Control Reporting
Section 404 reports on internal control Section 404 reports on internal control provide a new reporting environment to provide a new reporting environment to test for potential lack of independence and test for potential lack of independence and knowledge spilloversknowledge spillovers
H1: There is no association between tax H1: There is no association between tax consulting and taxconsulting and tax--related related ICWsICWs
H2: There is no association between tax H2: There is no association between tax consulting and other consulting and other ICWsICWs
Possible Patterns of ResultsPossible Patterns of ResultsEffect of Tax Consulting on Effect of Tax Consulting on ICWsICWs
Tax nonTax non--TaxTaxICWsICWs ICWsICWs InterpretationInterpretation
-- None Knowledge SpilloversNone Knowledge Spillovers
-- -- Loss of independence Loss of independence oror
SelfSelf--selection by high selection by high quality firms 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 ModelICW ModelICW Model is based on previous work by ICW Model is based on previous work by Doyle, Doyle, GeGe and and McVayMcVay (2007) and (2007) and AshbaughAshbaugh--SkaifeSkaife, , Collins and KinneyCollins and Kinney (2007)(2007)
ICW = ICW = αα00 + + αα11TAXCSLTTAXCSLT + + αα22TAXFEER + TAXFEER + αα33ABSDARK + ABSDARK + αα44SIZE + SIZE + αα55LOGAGE + LOGAGE + αα66AGG_LOSS + AGG_LOSS + αα77ZSCORE + ZSCORE + αα88LOGSEG + LOGSEG + αα99GROWTH + GROWTH + αα1010FOR_TRAN + FOR_TRAN + αα1111RESTR_CHG RESTR_CHG
VariablesVariablesICW: ICW: 1 if the firm has a material internal control weakness; 0 otherw1 if the firm has a material internal control weakness; 0 otherwise.ise.OTHICW:OTHICW: NonNon--taxtax--related ICW.related ICW.TAXICW:TAXICW: TaxTax--related ICW.related ICW.TAXFEER:TAXFEER: Ratio of taxRatio of tax--related fees to total fees.related fees to total fees.TAXCLST:TAXCLST: 1 if tax1 if tax--related fees are reported; 0 otherwise.related fees are reported; 0 otherwise.ABSDARK:ABSDARK: DecileDecile rank of the absolute value of discretionary accruals.rank of the absolute value of discretionary accruals.SIZE:SIZE: Most recent three years average market valueMost recent three years average market valueLOGAGE: LOGAGE: Log of the number of years that the company has CRSP data Log of the number of years that the company has CRSP data AGG_LOSS: AGG_LOSS: 1 if the sum of earnings before extraordinary items for year t a1 if the sum of earnings before extraordinary items for year t and nd
year tyear t--1 is less than zero, 0 otherwise. 1 is less than zero, 0 otherwise. ZSCORE:ZSCORE: Altman ZAltman Z--score measure of financial distress score measure of financial distress LOGSEG: LOGSEG: Log of number of operating and geographic segmentsLog of number of operating and geographic segmentsGROWTH:GROWTH: Most recent three years’ sales growthMost recent three years’ sales growthFOR_TRAN:FOR_TRAN: 1 if the company has non1 if the company has non--zero foreign currency translation in zero foreign currency translation in
year t, 0 otherwise. year t, 0 otherwise. RESTR_CHG:RESTR_CHG: Aggregate restructuring charges in year t and tAggregate restructuring charges in year t and t--1 scaled by 1 scaled by
market capitalization in year t.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 ModelICW Tax ICW Other ICW
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-square
7.02% 5.64% 6.55%
# of observations
4289 4289 4289
Variables Expected Sign
Table 4 – Tax Consulting all ICWsICW ICW ICW
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 observations
4289 4289 4289
Variables Expected Sign
TAX ICW TAX ICW TAX ICW
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. Sign
Other ICW Other ICW Other ICW Other ICW
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_CHG
+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 observations
4289 4289 4289 4289
Variables Exp. Sign
Results
The extent, but not the existence of tax The extent, but not the existence of tax consulting is associated with a reduced consulting is associated with a reduced likelihood of a taxlikelihood of a tax--related ICW related ICW (but not after controlling for other ICW)The extent, but not the existence of tax The extent, but not the existence of tax consulting is also associated with a consulting is also associated with a reduced likelihood of nonreduced likelihood of non--tax tax ICWsICWsResults are more consistent with reduced Results are more consistent with reduced independence than knowledge spilloversindependence than knowledge spillovers
PlansPlans
Gathering data on the nature of the tax Gathering data on the nature of the tax ICWsICWsFurther sensitivity analysis based on the Further sensitivity analysis based on the extent of the tax consultingextent of the tax consultingUse path analysis to test whether both Use path analysis to test whether both independence effects (for firmindependence effects (for firm--level level ICW) and spillover effects (for tax ICW) ICW) and spillover effects (for tax ICW) existexist
Top Related