The PCAOB Part II Inspection Report Disclosure of Income Tax Deficiencies and Auditor-Provided Tax Services

We examine whether publicly disclosed quality control deficiencies in auditing income tax accounts in Deloitte’s 2007 PCAOB Part II report impose costs on Deloitte’s auditor-provided tax services (APTS). We document that audit clients reduce reliance on APTS upon the disclosure of Deloitte’s income tax-related audit deficiencies. This suggests that publicly revealed audit deficiencies in the Part II report have a spillover effect on the inspected firm’s non-audit services. We find that the decision of terminating APTS is predominantly evident in clients relying more on Deloitte’s non-audit, non-tax services, and in those excessively increasing deferred tax valuation allowance and reserve for uncertain tax benefits. This result is consistent with reduced demand for Deloitte’s APTS driven by stakeholders’ concern about auditor independence and by clients’ concern about APTS quality. We also find that reported earnings and income tax expenses are more value relevant for Deloitte’s audit clients dropping APTS. This finding suggests that the PCAOB Part II inspection report on overall audit quality control influences investors’ perception of financial reporting quality.