What is the Effect of the PCAOB Part II Inspection Report Disclosure - PowerPoint PPT Presentation

What is the Effect of the PCAOB Part II Inspection Report Disclosure of Income Tax Deficiencies on Auditor-Provided Tax Services? Jaehan Ahn, University of Oklahoma Herita Akamah, University of Nebraska – Lincoln Sydney Shu, San Diego State University

Research question  Broad : Are PCAOB inspection reports impactful?  Specific : Did Deloitte’s Part II report impose Costs on Deloitte? - Does Deloitte’s Part II report have a spillover effect (i.e., decrease in demand) on Deloitte’s auditor-provided tax services (APTS)? - What factors drive the demand for Deloitte’s APTS following Deloitte’s Part II report ?

Motivation  Long-standing debate on the usefulness of PCAOB inspection reports. - Independence vs. Expertise  Deloitte’s 2007 Part II report provides a great setting to address the issue. - The first PCAOB Part II report, and out of all firms inspected in 2007, Deloitte was the only firm with a Part II report (Hence, we expect a significant response isolated to only Deloitte) - Includes PCAOB’s concern over Deloitte’s quality control over auditing income tax account (Compelling link between auditing the tax account and auditor-provided tax services)

Literature  PCAOB inspection part II report - Change in auditors for triennially inspected firms (Buslepp and Victoravich 2014) - Lower audit fees (Johnson 2015) - Decrease in market share (Nagy 2014)  Deloitte’s 2007 PCAOB inspection part II report - Once publicly disclosed, dismissals of Deloitte in high litigation industries and long auditor tenure (Muriel 2013). - After PCAOB’s determination of Deloitte’s unsatisfactory remediation in quality control in auditing income taxes, Deloitte heightens scrutiny over auditing income tax (e.g., higher valuation allowance on DTA, and higher reserve for uncertain tax benefits) (Drake et al. 2016)

Literature (continued)  Auditor-provided tax services (APTS) - Perception of independence impairment  Shareholders are less likely to vote for auditor ratification when APTS fees are high (Mishra et al. 2005)  AS non-tax NAS fees increase, clients are less likely to retain APTS (Lassila et al. 2010) - Knowledge spillover  A negative relation between APTS fees and accounting misstatements (Kinney et al. 2004; Paterson and Valencia 2011)  APTS are associated with more accurate estimates of tax expense (Gleason and Mills 2011)

Hypotheses development  Audit committee acknowledges the cost and benefits of APTS, and makes decision to hire APTS or not based on cost/benefit analysis .  Deloitte’s 2007 Part II report is the first and only report pertaining to the PCAOB’s concerns about the firm’s audit procedures of income tax accounts .  This unique incidence is likely to amplify the “cost” side of Deloitte’s APTS .  Open empirical question: Amplified cost of APTS is greater than the benefit of APTS? - The controversy over PCAOB’s expertise also blurs the prediction. H1: The PCAOB Part II Report quality control deficiencies related to the auditing of income tax accounts do not affect audit clients’ reliance on Deloitte’s APTS.

Hypotheses development (continued)  What could drive audit clients to reduce reliance on Deloitte’s APTS? Deficiencies in auditing income tax accounts elicit stakeholders’ concern over 1) compromised auditor independence, raising greater doubt about the financial reporting quality  To bolster the appearance of audit independence  To alleviate stakeholders’ adverse perception Deloitte exercised greater scrutiny over auditing tax-related accounts after a failure of 2) remediation related 2007 PCAOB part II report (Drake et al. 2016). And, tax reserve is influenced by APTS (Gleason and Mills 2011).  APTS might forgo riskier tax position (cash saving opportunities).  To restore APTS reputation  To accede audit team’s position H2a: The effect of quality control deficiencies related to the auditing of income tax accounts on audit clients’ reliance on Deloitte’s APTS is more pronounced when stakeholders have greater concern about impaired auditor independence. H2b: The effect of quality control deficiencies related to the auditing of income tax accounts on audit clients’ reliance on Deloitte’s APTS is more pronounced when clients have greater concern about APTS quality.

The Setting  PCAOB inspects audit firms annually for those having more than 100 public clients, and triennially for those having less than 100 public clients.  Audit firms subject to annual inspections: 9 audit firms  Inspection reports - Part I: audit firm’s deficiencies at engagement level (publicly available) - Part II: audit firm’s overall quality control deficiencies

Timeline of the Part II Inspection Process for Deloitte’s 2007 Report Adapted from Drake, Goldman, and Lusch (2016)  Sample - Four-years (2009-2012) around the event date of 10/17/2011 - Limit to annually inspected audit firms - Non-auditor switchers  10,118 firm-year observations

Research design for H1  Empirical models APTS i,t = α 0 + α 1 DT i,t + α 2 POST + α 3 DT i,t ×POST + β n Controls i,t + Ԑ i,t - APTS = 1 if client uses its auditor as APTS provider (i.e., tax fees>0), and 0 otherwise. - DT = 1 if auditor is Deloitte, and 0 otherwise. - POST = 1 if fiscal year is ending after 10/17/2011, and 0 otherwise. If α 3 < 0  Clients are less likely to retain DT as APTS provider after the disclosure of Part II report (H1)

Testing H1 Dependent variable = APTS APTS_STOP APTS_START DT –0.092 –0.065 –0.132 (–0.547) (–0.373) (–0.854) POST –0.103 –0.300** –0.551 (–0.575) (–2.286) (–1.525) DT x POST –0.142*** 0.545*** 0.037 (–3.364) (4.351) (0.358) Constant –6.450*** 1.886*** –7.312*** (–8.418) (2.700) (–8.090) Control Yes Yes Yes Year FE Yes Yes Yes Industry FE Yes Yes Yes N 10,050 7,012 2,848 Pseudo R 2 0.096 0.055 0.082

Research design for H2a  Proxy for perceived auditors’ independence impairment  NTAFEE = Non-tax NAS fees / Audit fees  Two subsamples divided on median value of NTAFEE ( HNTAFEE = 0 for below median, and HNTAFEE = 1 for above median)  Empirical models APTS i,t = α 0 + α 1 DT i,t + α 2 POST + α 3 DT i,t ×POST + β n Controls i,t + Ԑ i,t - α 3 on subsample of high NTAFEE ( HNTAFEE = 1) is less than on subsample of low NTAFEE ( HNTAFEE = 0)  support H2a

Testing H2a Dependent variable = APTS HNTAFEE = 0 HNTAFEE = 1 (1) (2) DT –0.231 –0.007 (–1.430) (–0.034) POST –0.106 –0.233* (–0.475) (–1.885) DT x POST 0.086** –0.337*** (2.212) (–4.974) Constant –4.442*** –8.841*** (–4.523) (–10.859) Control Yes Yes Year FE Yes Yes Industry FE Yes Yes N 4,999 4,999 Pseudo R2 0.079 0.121

Research design for H2b  Proxy for APTS quality (excessive conservatism)  Abnormal changes in deferred tax valuation allowance (HIGHVA) and reserve for uncertain tax benefits (HIGHUTB)  HIGHVA = 1 for above median of changes in deferred tax valuation allowance  HIGHUTB = 1 for above median of change in reserve for uncertain tax benefits  Empirical models APTS i,t = α 0 + α 1 DT i,t + α 2 POST + α 3 DT i,t ×POST + β n Controls i,t + Ԑ i,t - α 3 on subsample of high changes in tax provisions ( HIGHVA = 1 or HIGHUTB = 1) is less than on subsample of low changes in tax provisions  support H2b

Testing H2b Dependent variable = APTS HIGHVA = HIGHUTB = 0 1 0 1 (1) (2) (3) (4) DT −0.229 0.716*** −0.154 0.347 (−1.444) (4.904) (−0.955) (1.081) POST 0.052 −0.163 −0.134 0.637** (0.202) (−0.420) (−0.486) (2.508) DT x POST 0.250*** −0.411* 0.239*** −0.306* (3.181) (−1.862) (3.828) (−1.887) Constant −7.426*** −1.450 −4.053*** −6.752*** (−6.131) (−0.806) (−4.220) (−3.056) Control Yes Yes Yes Yes Year FE Yes Yes Yes Yes Industry FE Yes Yes Yes Yes N 3,678 1,208 3,650 1,141 Pseudo R 2 0 102 0 092 0 112 0 173

Additional analysis 1. Auditor’s tax-specific industry expertise  Idea: The costs of terminating APTS are lower for clients whose auditors are not tax specific industry experts.  TAXSPEC = 1 for the audit firm’s APTS market share is greater than 30%  APTS i,t = α 0 + α 1 DT i,t + α 2 POST + α 3 DT i,t × POST + β n Controls i,t + Ԑ i,t  Finding: α 3 on subsample of auditors’ low tax expertise ( TAXSPEC = 0) is less than on subsample of high tax expertise ( TAXSPEC = 1) 2. APTS fees  Idea: Are there further costs imposed on Deloitte conditional on Deloitte is retained as APTS provider?  Restrict sample to clients retaining APTS provider over the sample periods.  APTS_FEES i,t = α 0 + α 1 DT i,t + α 2 POST + α 3 DT i,t × POST + β n Controls i,t + Ԑ i,t  Finding: α 3 is negative and significant, implying the reduced market power.