Do Auditor‐Provided Tax Services Improve the Estimate of Tax Reserves?*

Abstract

Education fund for financial support. The Internal Revenue Service (IRS) provided confidential tax information to one of the authors pursuant to provisions of the Internal Revenue Code that allow disclosure of information to a contractor to the extent necessary to perform a research contract for the IRS. None of the confidential tax information received from the IRS is disclosed in this treatise. Statistical aggregates were used so that a specific taxpayer cannot be identified from information supplied by the IRS. 1.When we refer to independence throughout this paper, we mean independence in fact. We acknowledge that ATS also create a problem of independence in appearance. Several studies including Dopuch, King, and Schwartz 2003 and Khurana and Raman 2006 find investors perceive the disclosure of nonaudit services negatively. Dopuch et al. call for more evidence about the degree of correspondence between independence in fact and in appearance. 2.Joe and Vandervelde (2007) find a loss of independence could stem from auditors' subconscious actions even with no intent to conceal information.

Earnings Management through Tax Reserves and Auditor-Provided Tax Services

“…Furthermore, applying different data and different research designs, subsequent studies (e.g., Davis, Ricchiute, & Trompeter, 1993;Whisenant, Sankaraguruswamy, & Raghunandan, 2003) do not find such a positive relation between audit fees and non-audit fees. Using confidential data from the IRS, Gleason and Mills (2011) find that, in the pre-SOX period, corporations that purchase ATS are on average fully reserved for IRS disputes while other corporations are in general under-reserved (Note 9).…”

“…Part of the reason is that, except for Gleason and Mills (2011), most studies try to link NAS to the overall effectiveness and/or efficiency of audit. But it is possible that the production of NAS would not directly and materially impair or improve the effectiveness and/or efficiency of the audit of most accounts.…”

“…Knowledge spillover can be achieved by consulting with an informed internal tax professional. By discussing with tax and audit partners across the Big 4 audit firms, Gleason and Mills (2011) get to the understanding that tax partners generally believe that they have unique knowledge about tax risk by providing permissible services to audit clients and they are more forthcoming with information to the audit partner of the same firm than to the other audit firm. It is expected that the better understanding of tax reserves by the auditor, the less leeway the manager has to manipulate tax reserves.…”

“…Even though confidential data from the IRS offer a unique research setting, it limits the sample size at the same time. Gleason and Mills's (2011) Note 10. I also use the total change in tax reserves that would affect the effective tax rate if recognized, excluding settlements with tax authorities and statute of limitations expirations as a robustness check.…”

“…The tax reserve account represents an overlap between the external auditor's audit and tax services and offers a genuine opportunity to examine the independence impairment or the knowledge spillover between audit and tax services. Thus, this study tries to follow Gleason and Mills's (2011) approach to test the existence of independence impairment or knowledge spillover by studying whether ATS constrain or facilitate earnings management through tax reserves.…”