Separation of the tax and audit function Motivation and consequences
SEPARATION OF THE TAX AND AUDIT FUNCTION: MOTIVATION AND CONSEQUENCES by Bradrick M. Cripe A DISSERTATION Presented to the Faculty of The Graduate College at the University of Nebraska In Partial Fulfillment of Requirements For the Degree of Doctor of Philosophy Major: Interdepartmental Area of Business (Accountancy) Under the Supervision of Professor Paul A. Shoemaker Lincoln, Nebraska August, 2006 UMI Number: 3214106 3214106 2006 UMI Microform Copyright All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, MI 48106-1346 by ProQuest Information and Learning Company. SEPARATION OF THE TAX AND AUDIT FUNCTION: MOTIVATION AND CONSEQUENCES Bradrick M. Cripe, Ph.D. University of Nebraska, 2006 Advisor: Paul A. Shoemaker This study examines companies choosing to separate the tax and audit function prior to and subsequent to the passage of the Sarbanes-Oxley Act (“the Act”). While the provision of tax services is not currently prohibited by the Act, some companies have separated these two functions. An examination of the relationship between tax function separation and audit quality, financial statement visibility and tax minimization proxies is performed for two different samples: (1) a matched pair design for companies engaging their audit firm for tax work in 2001 (2 years before the Sarbanes-Oxley Act was placed in effect) and then separating the tax and audit function by 2003 (the effective year of the Sarbanes-Oxley Act), and (2) a logistic regression analysis on all companies in the Russell 2000, a major market index, for 2002-2004. The data used in this study is compiled from proxy statements filed with the Securities and Exchange Commission and commercially available information from I/B/E/S, COMPUSTAT and AuditAnalytics. After controls for size, industry and growth are added to the model, the results reveal that in some years separation companies pay significantly less for their audit and, as a consequence, have higher instances of financial statement restatement. These results support the idea that the integration of audit and tax provide a better quality audit, supporting prior empirical work of Kinney et al. (2004) and anecdotal evidence from accounting firms. Some evidence for 2004 exists that separation companies are actually becoming less visible in the capital markets. Given that audit quality, analyst following, share turnover and management ownership are decreasing, this implies that these companies are less concerned with financial reporting quality. Overall, these findings suggest that tax service separation may be motivated by factors beyond merely shopping for the best tax provider. ACKNOWLEDGEMENTS I dedicate this dissertation to my wife, Rochelle, who has brought so much happiness and joy to my life. Thank you for your love, unwavering support, encouragement and your abundant laughter, which has carried me through so much of this process. I am blessed to have met you, and you have made me the luckiest man in the world. I will always be happy surrounded by the love that we have for each other. You are such an important part of this work, from the nights we sat together inputting data to the times you lifted me up and asked me to carry on. Your name will always be associated with this project and with all the wonderful things we will accomplish together. I pledge to you my love and my heart forever. I would not have been the person I am today without the support of my parents, Michael and Jacqueline Cripe. Thank you for always believing that I could accomplish great things, even when I did not believe in myself. Your constant support, encouragement and your commitment to me all these years is directly responsible for the completion of this work. I have always known only abundant love from the two of you, and I can never express to you how much I appreciate all that you have done. My greatest contribution to this world will be to continue in your tradition of being an outstanding parent and a loving partner. I would also like to thank the faculty of the University Of Nebraska School Of Accountancy for all of your help to prepare me for a successful scholarly career. I wish to acknowledge the significant contribution of my dissertation committee: Dr. Paul A. Shoemaker (chair), Dr. Renée A. Price, Dr. Rafael DeAyala, and Dr. John E. Anderson. Thank you for reading all the drafts, catching the mistakes, suggesting alternative measures and models, and for being patient with me. Their efforts contributed significantly to the quality of this paper, and any remaining errors or omissions are my responsibility alone. I am particularly thankful to Paul Shoemaker for being a terrific chair and a great mentor. Any errors I made, whether in the classroom or on this project, were always corrected gently and with great care. Thank you for always being there when I needed to knock on the door and thank you for all of your counsel. I am also very grateful to those individuals who shared their time with me in the doctoral program here at Nebraska. I am honored to have shared this experience with my program counterparts: Jennifer Blaskovich, Brian McAllister, Piyaratt Jantadej, Myungsoo Son and Yijiang Zhao. Thank you all for your encouragement all these years! I am very grateful to Jennifer, Brian and Piyaratt for always listening and for all the advice and encouragement you provided throughout this long journey. There were times when the path was uncertain, and I always knew they would provide the answer that was true and in my best interest, even when it wasn’t what I wanted to hear! I also want to thank those who came after me in the program and whose wisdom and advice are important to me: Brenda Rees, Jurgen Sidgman, Roopa Chandrasekhar, Amy Fredin, and Matt Gleason. I thank you all for helping me throughout this process! I am also thankful to Dr. Arthur Allen and Dr. Linda Ruchala for providing the foundation in capital market and behavioral/managerial research that I will use in my career. I want to thank Carol Danielson and Susan Simpson for answering all of my questions, keeping me out of trouble, and for giving me cookies and cake all these years! You made my life so much easier! My friends and family contributed so much to the person I am today. First, I want to thank Brian McAllister for being such a great companion and officemate all these years. Brian, you are the wisest person I have ever had the privilege to work with, and also the most humble. Thank you for allowing me to be a part of your family, for giving me the opportunity to be Claire’s godfather, for standing with me on my wedding day, and for making me LAUGH! I will always remember our first AAA meeting…well, most of it! You and Kristin are wonderful people and I wish you the very best. I also want to thank Jennifer Blaskovich and Piyaratt Jantadej for helping me so much throughout this process. You both have done so much for me that I owe you a debt that will never be truly repaid. Jennifer, thanks for the recruiting updates for Nebraska football, for telling me the definition of multivariate analysis, and for sitting with me through all those statistics classes that sounded like Baptist revivals! OH YEAH! Jean, thank you for always listening to me, for helping me get through our comprehensive exams, and for getting Brian and I to the Penn State football game all those years ago. I hope I didn’t embarrass you! Next, I want to thank my extended family for all their support during my life. Dennis and Joyce Free, you have been like a second set of parents and I have felt less like your nephew and more like your son for all the time and love you have shown me. Thanks for all the meals and haircuts! Finally, I would like to thank Eric Free for being there for me when I needed it the most. You are such an amazing person: someone who is smart, incredibly successful, always positive and a true friend. I cannot count the number of times you and Tanya have invited me into your home and treated me so well. I will never be able to thank you for showing me what it must be like to have a brother. I pledge to always be there for you, through the best and the worst, a friend and brother to you forever! TABLE OF CONTENTS Page LIST OF TABLES iii SECTION 1 INTRODUCTION 1 1.1 Contribution of the Study 2 1.2 Research Methodology 2 1.3 Results of the Study 4 1.4 Organization of the Study 4 2 CURRENT ENVIRONMENT 5 2.1 Independence Under the Sarbanes-Oxley Act 5 2.2 Tax Services Marketing by Public Accounting Firms 7 3 HYPOTHESIS DEVELOPMENT 9 3.1 The Tax and Audit Separation Decision 9 3.2 Non-Audit Services, Auditor Independence and Audit Quality 10 3.3 Agency Costs 16 3.4 Financial Reporting Visibility 18 4 TAX MINIMIZATION AS AN ALTERNATIVE EXPLANATION 20 5 METHODOLOGY AND HYPOTHESIS TESTING 23 5.1 Variable Definitions 23 5.2 Matched Sample Design 27 5.3 Multivariate Prediction Model 28 6 PAIRED SAMPLE DESIGN RESULTS 29 6.1 Sample Selection Procedure 29 6.2 T-Test Assumptions 31 6.3 Descriptive Statistics 33 6.4 Univariate Analysis Results 33 6.5 Multivariate Analysis Results 35 6.6 Sensitivity Analysis 36 7.0 LOGISTIC REGRESSION DESIGN RESULTS 38 7.1 Sample Selection Procedure 38 7.2 Descriptive Statistics 38 7.3 Multivariate Analysis 41 7.3.1 Regression Diagnostics and Influential Observations 41 7.3.2 Model Robustness 42 7.3.3 Results 43 7.3.4 Sensitivity Analysis 44 8.0 SUMMARY AND IMPLICATIONS 45 9.0 LIMITATIONS 47 10.0 EXTENSIONS AND FURTHER RESEARCH 49 REFERENCES 50 TABLES 55 APPENDIX A—TAX SERVICE MARKETING 86 [...]... research question focuses on the motivations and consequences of separation of the tax and audit functions This study extends prior research on non -audit fees and auditor independence, 1 using a specific subset of non -audit fees: fees paid to audit firms for tax work This study is one of the first studies to examine the motivation for tax function separation using tax minimization and capital market visibility... related to the tax provision each quarter, rather than at year end By engaging the auditor to provide income tax services, the implications of tax laws and changes in the tax code for the audit and the tax return can be made simultaneously every three months, reducing the need to restate earnings in the future because of an IRS audit or because of a mistake within the financial statements Thus, the provision... current standard, companies are choosing to hire a different accounting firm to perform the tax compliance and research function instead of using the accounting firm engaged to perform the audit function The integration of the tax and audit function has been credited with providing a higher quality audit product, due to the synergy that is created when the audit company provides tax services Auditors... of the tax and audit function Section 4 presents tax minimization as an explanation for tax function separation Section 5 describes how the hypotheses will be tested and illustrates the models Section 6 gives the results of the matched pair design, and Section 7 gives the results of the logistic regression model Section 8 provides a summary analysis of the study, and implications of the results Section... Principles (GAAP) Auditors may charge more for audits of separation companies because they have no future expectation of additional non -audit fees in the form of tax work Because of the dual competing theories surrounding the issue of cost and quality, the following hypotheses are stated in the null form: H1(a): For similar sized companies in similar industries, audit fee (AUDIT) is equal for both separation. .. found that tax fees are viewed differently from other types of non -audit fees and that recent concerns relating to the provision of tax services by client companies to their audit firm are justified Contrary to this view, anecdotal and empirical evidence also suggests that the provision of non -audit services, and tax services in particular, increases the effectiveness of the audit process Gaver and Paterson... over the period 1.4 Organization of the Study This research is organized as follows The current section provides an introduction Section 2 illustrates the current environment facing both public 5 accounting firms and audited companies Section 3 discusses auditor independence and capital market visibility as motivations, and audit quality as a motivation and a consequence of the separation of the tax and. .. tax fees and restatements, giving support to the accounting firms’ claims that tax services increase the effectiveness of the audit process If the audit is more effective as a result of the provision of tax services, what is the impact of that effectiveness? A more effective audit should be of higher quality and should result in lower levels of restatement, as errors should have been uncovered by the. .. because of the claim that the provision of non -audit services is linked to specific events (merger/acquisition activity, for example) that compel the acquisition of outside expertise (Firth 2001) If the argument above is true, then as a consequence those companies choosing separation should have lower audit quality because of the absence of the 16 auditor’s performance of the tax function Separation. .. transactions Auditor independence is critical to investor confidence, and stakeholders become concerned when they detect any action that may impair, or appear to impair, auditor independence (Panel on Audit Effectiveness 2000) 3.0 Hypothesis Development 3.1 The Tax and Audit Separation Decision The purpose of this study is to examine the economically feasible reasons for separation of the tax and audit function . audit function. The primary research question focuses on the motivations and consequences of separation of the tax and audit functions. This study extends prior research on non -audit fees and auditor. firms and audited companies. Section 3 discusses auditor independence and capital market visibility as motivations, and audit quality as a motivation and a consequence of the separation of the tax. engaging their audit firm for tax work in 2001 (2 years before the Sarbanes-Oxley Act was placed in effect) and then separating the tax and audit function by 2003 (the effective year of the Sarbanes-Oxley