Auditor-Provided Tax Services: The Effect of PCAOB Identification of Income Tax Related Deficiencies in the Part II Inspection Report

We examine whether quality control deficiencies in auditing income tax accounts publicly released in Deloitte’s 2007 PCAOB Part II report impose costs on the accounting firm’s auditor-provided tax services (ATS). We document that audit clients reduce reliance on ATS upon the public disclosure of Deloitte’s income tax-related audit deficiencies. This suggests that publicly disclosed audit deficiencies in the Part II report have a spillover effect on the inspected firm’s non-audit services. We also find that the decision of terminating ATS is predominantly evident in clients who rely more on Deloitte’s non-audit, non-tax services, and in those who excessively increase deferred tax valuation allowance and reserve for uncertain tax benefits. This is consistent with our expectation that reduced demand for Deloitte’s ATS is driven by stakeholders’ concern about independence impairment and by clients’ concern about ATS quality. In additional analyses, we find that Deloitte’s audit clients are less likely to retain ATS when the auditors lack sufficient tax expertise. We also find that PCAOB-identified income tax-related audit deficiencies are associated with reduced tax fees for clients that choose to retain ATS. Additionally, we document that reported earnings and income tax expenses are more value relevant for Deloitte’s audit clients that drop ATS in response to PCAOB-disclosed deficiencies in auditing income tax accounts. Collectively, our results are consistent with audit clients responding to the PCAOB Part II reports after they are publicly disclosed, suggesting that the PCAOB inspection on overall audit quality control has informational value. Specifically, this inspection report incentivizes audit clients to reconsider the benefits/costs of auditor-provided non-audit services and influences investor perception of financial reporting quality.