Tax Internal Control Quality: The Role of Auditor-Provided Tax ...

Tax Internal Control Quality: The Role of Auditor-Provided Tax Services and Tax Department Integration

Lisa De Simone University of Texas at Austin

[email protected]

Matthew Ege* University of Texas at Austin

[email protected]

and

Bridget Stomberg University of Texas at Austin

[email protected]

July 2012

Early Draft. Please do not cite without permission of the authors.

*Corresponding author

Abstract

We propose that auditor-provided tax services (tax NAS) improve tax internal control quality by combining knowledge of business operations and tax reporting. Consistent with predictions, we find a positive and economically significant association between tax NAS and tax internal control quality from 2004-2010; moving from the 25th to the 75th percentile of tax fees decreases the probability of a tax material weakness by 29 percent. This effect is strongest when companies pay less attention to tax such as in the years preceding the adoption of FIN 48 or when companies lack tax experts in top management or audit committee roles. We also provide evidence that tax NAS improve overall financial reporting quality through tax internal controls. Our research informs shareholders, boards, regulators, and auditors about the benefits of tax NAS and the mechanism through which tax NAS affect financial reporting quality.

Acknowledgements: We thank Patrick Badolato for providing tax expertise data. We also appreciate helpful comments from Greg Capps, Dain Donelson, Tracie Majors, John McInnis, Lillian Mills, Jaime Schmidt and Laura Wang. All authors gratefully acknowledge support from the Accounting Doctoral Scholars Program as well as the Red McCombs School of Business.

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I. Introduction

Joint consideration of business operations, tax law and financial reporting for income

taxes is crucial to maintaining effective internal controls over tax reporting. By providing tax

services to their clients, audit firms combine their tax knowledge with knowledge of client

business operations, allowing them to identify both audit and tax related risks. Therefore, we

propose that auditor-provided tax non-audit services (tax NAS) improve tax internal control

quality by facilitating the joint consideration of tax reporting and business operations within the

client. Further, we predict the benefits of tax NAS on tax internal control quality are strongest in

situations where the client is not already routinely paying attention to tax issues when making

operating and financial reporting decisions. Companies with a high level of attention to tax at the

director and officer level are more likely consider how operational changes affect tax risk and

reporting. As such, we expect these companies to benefit less from tax NAS.1

Demonstrating that tax NAS improve internal control quality has broad implications.

First, Kinney et al. (2004) present evidence that tax NAS are associated with a reduced

likelihood of financial restatements. We propose that improving tax internal control quality could

be the mechanism through which tax NAS improve financial reporting quality. Gleason et al.

(2011) document a link between tax internal control quality and tax financial reporting quality by

providing evidence that tax material weaknesses facilitate earnings management through the tax

expense. Although not specific to tax, Donelson et al. (2012) demonstrate that poor internal

control quality is associated with an increased likelihood of future fraud revelation. Therefore,

understanding the determinants of effective internal controls has implications for improving

financial reporting quality. Additionally, prior to the passage of the Sarbanes-Oxley Act of 2002

1 Throughout this paper, we use “client” and “company” to refer to the entity being audited or receiving tax NAS. We use “audit firm” to refer to the financial statement audit or tax NAS provider.

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(SOX) regulators and legislators extensively debated whether to allow NAS (Romano 2005;

Caplan et al. 2009). Ultimately, regulators banned most NAS but specifically allowed tax NAS

(U.S. Congress 2002). Identifying benefits of tax NAS with respect to internal control quality

and financial reporting quality is of interest to shareholders, boards of directors, regulators, and

auditors.

Company personnel must be aware of how significant business transactions will affect

tax reporting to ensure that tax-related internal controls are designed appropriately and operating

effectively. If the income tax function is isolated from other departments, tax personnel may not

be aware of issues that materially affect taxes.2 Similarly, directors and officers may not be

aware of the tax ramifications of business decisions. In these situations, having the financial

audit firm provide tax services increases the likelihood that the company will jointly consider tax

and business matters in the financial reporting process. This makes the company better able to

identify potential tax risks, and design and implement appropriate tax internal controls. For

example, the audit firm would become aware of a company’s intention to expand operations into

new countries during audit planning meetings. The audit firm can communicate potential tax

implications of expansion to the company, such as the need to file tax returns in new

jurisdictions, and prompt the company to ensure that adequate internal controls are in place to

manage the new tax risks. 3

2 An informed tax function can itself be a control. For example, in a 2005 management report on internal controls Vetro, Inc. disclosed a material weakness of “insufficient controls over the preparation of the income tax provision” and stated that to improve internal controls over the calculation of the income tax provision they will “include quarterly meetings between our tax and accounting team members to formalize communication between the two functions (Vetro 2006, 58).” 3 Auditor independence rules prohibit the auditor from assuming the role of management or auditing their own work (PCAOB 2007). Although the tax team cannot design tax internal controls over financial reporting, the tax team can identify tax internal control risks and assess the design and operating effectiveness of tax internal controls over financial reporting throughout the year. The types of discussions and information exchange contemplated in this paper are within the scope of permissible auditor behavior and do not violate independence rules.

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Tax NAS increase the likelihood that the company jointly considers tax and business

matters by (1) fostering a strong relationship between the audit firm tax partner and company

personnel, and (2) broadening the tax partner’s knowledge of both client-specific tax and audit

risks. First, relative to a tax partner on the audit team who does not provide any tax NAS, a tax

partner who provides tax NAS develops a better relationship with the client through more

frequent interactions and his or her role as client advocate on consulting projects. This

relationship increases the likelihood that the tax partner shares information from discussions with

company management or other audit team members with the client’s tax personnel to prevent

material weaknesses from arising. More frequent communications throughout the year also

increase the likelihood that any potential material weaknesses are identified early in the reporting

period and resolved by year-end.4

Second, through involvement in both tax NAS and audit work, the audit firm’s tax

partner is more cognizant of both tax and audit risks than a tax provider who is not involved in

the financial statement audit. The tax partner brings a deep knowledge of the client’s tax issues

to the audit as well as an understanding of potential audit risks when conducting tax NAS. Audit

firm involvement during the year helps companies avoid surprises during the annual provision

review by increasing the auditor’s awareness of transaction details and audit risks early in the

year (Larsen 2011). By being actively involved in the client’s audit and tax functions, the tax

partner is well-positioned to identify new tax issues that arise during the year and discuss them

with the client. Therefore, we predict a positive association between tax NAS and tax internal

control quality.

4 Auditor internal control opinions are “as of” a specific date, as opposed to covering an entire period. Accordingly, if a material weakness is discovered, but subsequently remediated and validated by the auditor prior to the “as of” date on the report, then the material weakness does not have to be disclosed.

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We expect the benefits of tax NAS on tax internal control quality will be greatest when

the company does not routinely pay attention to tax issues at the director and officer level when

making business and financial reporting decisions. We test this prediction in two ways. The

period immediately following the adoption of FIN 48 is our first proxy for attention to tax. From

2004-2006, the years preceding FIN 48, tax departments were charged primarily with monitoring

tax compliance (Robinson et al. 2010). As a result tax risks were not well integrated into the

overall risk assessment of the company. For example, a 2005 survey published by the Tax

Executives Institute (TEI) reports that only 27 (43) percent of tax executives made presentations

to the board (audit committee) in that year (Larsen 2011). This anecdotal and survey evidence

supports our proposition that directors and officers, on average, did not pay much attention to

taxes when making business and financial reporting decisions from 2004-2006.

Since that time, however, companies have increased their attention to income taxes,

largely in response to SOX and the passage of FASB Interpretation No. 48 Accounting for

Uncertainty in Income taxes – An interpretation of FASB Statement No. 109 (FIN 48). We

believe that both regulatory changes made tax issues more salient to directors and officers.5 A

2011 TEI survey confirms this assertion, reporting that 81 percent of surveyed executives made

presentations to the board or audit committee – a threefold increase from 2005 (Larsen 2011).

Additionally, over 58 percent of companies report that the implementation of FIN 48 was at least

somewhat beneficial to improving the company’s understanding of tax uncertainties (Deloitte

2007). Therefore, we predict that directors and officers are more cognizant of tax issues, on

average, in recent years, and we use the period from 2007 through 2010 as our first proxy for

attention to taxes in business and financial reporting decisions.

5 FIN 48 became effective for fiscal years beginning after December 15, 2006. The standard provides complex rules for measuring and recognizing tax benefits in financial statements and requires detailed annual disclosures of reserves related to uncertain tax positions.

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Tax expertise of company managers and audit committee members is our second proxy

for attention to tax. Top managers (i.e., CEOs and CFOs) are directly responsible for establishing

and maintaining internal controls, and audit committees are charged with overseeing the

accounting and financial reporting processes, which includes internal controls (U.S. Congress

2002). Top managers or audit committee members with tax expertise are more likely to have the

requisite knowledge and experience to identify tax risks. Therefore, these individuals not only

have the directive to maintain an effective internal control environment, but also have the tax-

related knowledge and expertise to evaluate internal controls over taxes and effectively

communicate with tax department personnel about the income tax provision. Accordingly, we

predict that companies with tax experts pay more attention to income taxes and benefit less from

joint consideration of tax and business matters facilitated by tax NAS.

Overall, results support our predictions that tax NAS improve internal control quality.

Using pooled logistic regressions we find tax NAS are negatively associated with the disclosure

of tax material weaknesses, our proxy for poor tax internal control quality, from 2004 to 2010.

The marginal effect of moving from the 25th to the 75th percentile of the natural log of tax fees

represents a 29 percent decrease in the likelihood of disclosing a tax material weakness, holding

all other variables at their means. We also find that the benefits of tax NAS on tax internal

control quality are weaker when the company is more likely to routinely pay attention to taxes

when making business and financial reporting decisions. We find no association between tax

NAS and tax material weakness from 2007-2010 or for company-years where management or

audit committee members have tax expertise. Together, these findings support our conjecture

that tax NAS increase the likelihood that tax and business matters are jointly considered within

the company, enabling companies to improve tax internal control quality. However, these

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benefits are muted when the company routinely pays attention to tax at the director and officer

level.

Combined with evidence from prior literature that internal control quality affects

financial reporting quality, our finding that tax NAS improve internal control quality motivates

us to re-examine the negative relation between tax NAS and restatements documented in prior

studies. We find the negative relation between tax NAS and all restatements becomes

insignificant after controlling for tax material weaknesses. These results suggest that tax NAS

improve financial reporting quality indirectly through tax internal control quality. In contrast, we

find that the negative relation between tax NAS and tax-only restatements weakens but remains

significant after controlling for tax material weaknesses. This suggests that tax NAS provide

direct benefits to tax financial reporting quality incremental to those provided through tax

internal control quality.

This study makes several important contributions to the literature. First, although prior

literature provides evidence that tax NAS improve financial reporting quality, there is limited

research examining the link between tax NAS and internal control quality. Our findings that tax

NAS are associated with enhanced tax internal control quality should be of interest to

shareholders and audit committees assessing the costs and benefits of tax NAS, as well as to

regulators. Further, our findings that tax NAS are less beneficial for companies with tax expertise

in top management or on the audit committee can inform boards of directors and managers when

establishing criteria for hiring top executives and appointing audit committee members.

Second, this study extends the literature examining the determinants of financial

reporting quality by highlighting a previously unexamined mechanism through which tax NAS

improve financial reporting quality. Additionally, our finding that tax NAS benefit tax internal

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control quality most in companies with little attention to tax extends the line of research

examining the consequences of tax NAS. Despite the lack of evidence that tax NAS impair

independence, auditor-provided tax fees declined sharply after the passage of SOX (Maydew and

Shackelford 2005) and have not returned to the pre-SOX level.6 We help reconcile these

seemingly conflicting facts by demonstrating that increased attention to tax at the director and

officer level reduces the beneficial effects of tax NAS. Finally, our study uses new data that

allow us to directly test how tax expertise affects the relation between tax NAS and tax internal

control quality.

The remainder of the paper proceeds as follows. Section II discusses related literature

and develops hypotheses. Section III provides sample selection and research. Section IV

provides results of tests, Section V describes additional supplemental analyses and results, and

Section VI concludes.

II. Related Literature and Hypothesis Development

In July 2002, Congress passed SOX Section 201, which banned many auditor-provided

NAS. However, tax NAS remain permissible as long as the audit committee pre-approves fees.

Prior literature demonstrates that tax NAS are positively associated with financial reporting

quality. Kinney et al. (2004) find a negative association between tax NAS and restatements, which

supports the theory that tax NAS increase the information available to the auditor and lead to

higher quality audits and improved financial reporting quality. The authors conclude that

improved financial reporting quality outweighs any threat to independence created by the

economic bond tax NAS generate. Paterson and Valencia (2011) extend Kinney et al. (2004) but

6 Maydew and Shackelford (2005) present evidence that auditor-provided tax fees as a percentage of audit fees decreased from 100 percent in 2001 to 25 percent in 2004. Based on our sample data, auditor-provided tax fees averaged $334,000 in 2004; this average declines to $278,000, or 12 percent of total audit fees, in 2010.

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differentiate between recurring and nonrecurring tax NAS. Recurring tax NAS tend to

encompass work that deepens the audit firm’s knowledge of business operations. The authors

find recurring tax NAS drive the negative relation between tax NAS and restatements. Gleason

and Mills (2011) provide evidence that companies purchasing tax NAS more accurately estimate

income tax expense, specifically when accruing reserves for potential future tax liabilities. Their

results offer a direct link between tax NAS and tax financial reporting quality.

Collectively, these studies suggest that tax NAS enhance financial reporting quality.

However, to our knowledge, no published paper addresses the relation between tax NAS and tax

internal control quality, which is a significant determinant of financial reporting quality. In

unpublished work, Elder, Harris and Zhou (2008) examine the relation between tax NAS and

reported material weaknesses in internal controls from 2004-2005. The authors find that tax NAS

are associated with fewer reported tax and non-tax material weaknesses, and attribute the result

to a lack of auditor independence. This interpretation is somewhat unexpected given the limited

evidence from prior studies that NAS are detrimental to auditor independence. For example, in

addition to the literature cited above, Francis (2006) concludes there is “no smoking gun

evidence linking the provision of non-audit services with audit failures”. We therefore propose

and test an alternative explanation for the link between tax NAS and tax internal control quality.7

We posit that tax NAS facilitate the joint consideration of tax and business operations

creating a positive association between tax NAS and tax internal control quality. Because

financial statement auditors are knowledgeable about the company’s overall business

organization and operations, they are well positioned to understand how general business risks

7 In an untabulated robustness test, we find no relation between tax NAS and the likelihood that a clean internal control opinion is subsequently restated. If tax NAS cause independence concerns, we would expect a positive association between tax NAS and clean internal control opinions that are subsequently restated, reflecting the auditors’ initial reluctance to issue a material weakness opinion due to economic incentives.

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affect income tax reporting. In the course of providing tax compliance or consulting services,

the audit firm can share this information with the tax department, whether through informal

communications or directly through a specific tax engagement. For example, if a company

intends to expand operations into new countries, the audit team – which often includes the tax

partner – will be made aware of these plans during audit team meetings. The tax partner can

communicate potential implications for tax reporting to the client’s tax personnel, such as the

need to file tax returns in new jurisdictions. This information could prompt tax personnel to

ensure that adequate internal controls are in place to manage these risks. One such control might

involve verifying with the legal department the nature and extent of each entity’s activities to

establish filing requirements.

Additionally, increased interactions with the tax partner make it more likely that the

client will become aware of potential control problems earlier in the year, which the client can

remediate prior to year-end to avoid disclosure of a material weakness. These interactions are

especially salient for the tax function, which according to Deloitte (2011), was not traditionally

integrated with the rest of the organization or involved with the audit committee. We predict that

tax NAS assist companies in identifying and mitigating potential internal control risks and

therefore improve the client’s internal controls over reporting for income taxes. We formally

state this prediction in the alternative form below.

H1: There is a negative relation between tax NAS and the probability of reporting a material weakness in internal controls over taxes.

We expect the benefits of tax NAS will be greater for companies that are less likely to

routinely pay attention to tax at the director and officer level. Companies that pay attention to tax

are more likely to integrate tax considerations into changes in operations, general business risks,

and strategic planning. A company that pays attention to tax “acknowledges tax as a common

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thread running through and impacting many business risks” and incorporates tax risks into the

overall risk framework of the company (Deloitte 2011). For these companies, the possibility for

tax NAS to facilitate incremental consideration of tax matters is limited. Thus, we predict any

positive association between tax NAS and tax internal control quality will be weakest for

companies that are more likely paying attention to tax at the director and officer level. We

formally state this prediction in the alternative form below.

H2: The negative relation between tax NAS and the probability of an internal control weakness over income tax is weaker for companies more likely to pay attention to tax at the director and officer level.

We test the effect of attention to tax on the benefits of tax NAS in two ways. First, we

predict that the benefits of tax NAS on tax internal controls are more significant in the early

years of SOX, when many companies assessed internal controls over taxes for the first time. We

submit that companies, on average, pay more attention to tax subsequent to SOX. After the

disclosure of a significant number of tax material weaknesses under SOX, boards of directors

increased oversight of the tax function and companies committed resources to improve internal

control quality (Larsen 2011). As a result, disclosed tax material weaknesses declined

significantly, decreasing monotonically from 2005 through 2010. Additionally, we posit that

the implementation of FIN 48 in 2007 fundamentally changed the way companies view tax risks

and increased the visibility of income tax reporting. Prior to FIN 48, companies typically

accrued contingent liabilities for uncertain tax positions, but little guidance existed governing the

calculation of reserves and no separate disclosure was required.8 FIN 48 provided new rules for

the measurement and recognition of uncertain tax benefits and requires specific disclosures of

the magnitude of tax uncertainties. This increased transparency of tax risk prompted

7 Because FAS 109 is silent on accounting for income tax contingencies, most companies followed the guidance in FAS 5 and recorded contingent liabilities for tax matters only when the likelihood of payment was probable.

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management and boards of directors to increase their monitoring of income tax risk and

reporting. Therefore, we expect companies pay more attention to tax, on average, in recent years

and that there are fewer benefits of tax NAS in 2007-2010 as compared to 2004-2006.

Second, we test our attention to tax hypothesis using information about the tax expertise

of the CEO, CFO and audit committee members. Managers and audit committee members

experienced in tax matters have more awareness of potential tax risks and can conduct more

detailed analyses of tax amounts reported on the financial statements. For example, managers

and audit committee members with tax expertise are likely able to ask probing questions about

the measurement and recognition of tax contingencies, leading to more frequent communications

between tax personnel and top management. In sum, we submit that management or audit

committee tax expertise improves communications between the tax department and other

company departments, and results in greater involvement from management and the board of

directors in identifying and implementing controls over financial reporting for income tax. We

therefore predict that having a tax expert in top management or an audit committee role weakens

the positive relation between tax NAS and tax internal control quality.

III. Sample and Research Design

a. Tests of H1 To test H1, we begin with all SOX Section 302 and 404 internal control disclosures

included in the Audit Analytics database from 2004 through 2010.9 Next, we require each

observation to have data available from both CRSP and Compustat to calculate control variables

9 We begin our sample in 2004 because the Public Company Accounting Oversight Board did not issue guidance defining levels of internal control severity until it released Auditing Standard No. 2 on March 9, 2004. This standard included formal definitions of material weakness, significant deficiency, and control deficiency. As a result, the completeness of material weakness disclosures prior to 2004 is questionable. For example, the number of material weaknesses reported in 2004 significantly increased compared to 2002 and 2003. In our sample, the number of disclosed tax material weaknesses jumped from nine in 2003 to 184 in 2004. We find it unlikely that the material weaknesses reported in 2004 did not exist in earlier years.

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shown in prior literature to affect the probability of a company (or its financial statement auditor)

disclosing a material weakness. Finally, in the event of restated internal control reports, we retain

only the most recently issued internal control report for each fiscal year. We do this because we

are interested in whether or not a material weakness existed in a year, not in when the material

weakness was disclosed. The full sample consists of 26,089 observations from 5,524 unique

companies. Panel A of Table 1 provides descriptive statistics for the sample. All continuous

variables are Winsorized at one and 99 percent. Nearly 72 percent of the sample purchases tax

services from their auditor. The average (median) amount of tax fees paid to auditors is over

$270,000 ($37,000), compared to average (median) audit fees of over $2.1 million ($851,000).

[Insert Table 1 here.]

H1 predicts a negative relation between tax NAS and the probability of a tax material

weakness disclosure. To test H1, we estimate the following logistic regression from 2004

through 2010.

Prob (ICW_TAX=1) = F(β0 + β1TAXNAS + β2LNAUDIT + β3LNMKTCAP + β4AGGLOSS + β5SHUMWAY + β6LSEGCOUNT + β7FORTRANS + β8MERGER + β9EXTREMESG + β10RESTRUCTURE + β11BIG4 + β12AUDITOR_RESIGN + β13PCTFORSALES + β14TAXLOSS + Year FE) (1)

We define all variables in detail in Appendix A, with references to Compustat variable

names. ICW_TAX is a company-year indicator variable equal to one if a company discloses a

material weakness in internal controls over income taxes in that year, and zero otherwise. We set

ICW_TAX equal to one for a given company-year regardless of whether the material weakness

was disclosed by the company in a SOX Section 302 or 404(a) disclosure, or by the financial

statement auditor in a SOX Section 404(b) disclosure.

We estimate equation (1) using two different measures of tax NAS: LNTAXNAS is the

natural logarithm of tax fees reported in Audit Analytics in that year, and TAXNASIND is an

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indicator variable equal to one if the company purchased tax NAS in that year, and zero

otherwise. In equation (1), β1 is the coefficient of interest. H1 predicts that β1 is negative.

Because audit fees increased dramatically after SOX and are positively associated with the

probability of a material weakness disclosure (Hogan and Wilkins 2008), we avoid scaling tax

fees by audit fees or total fees.10 Instead we control for the natural logarithm of total audit fees

LNAUDIT and expect the coefficient β2 to be positive.

We also include several control variables shown in Ashbaugh-Skaife et al. (2007) and

Doyle et al. (2007b) to be significant determinants of material weaknesses. LNMKTCAP controls

for size, as smaller companies exhibit an increased likelihood of material weaknesses. We

therefore predict that β3 will be negative. We include AGGLOSS and SHUMWAY as controls for

financial distress. AGGLOSS is an indicator variable equal to one if earnings before

extraordinary items in years t-1 and t sums to less than zero, and zero otherwise. SHUMWAY is

the decile rank of the percentage probability of bankruptcy from the default hazard model

prediction based on Shumway (2001). Higher scores indicate higher probability of bankruptcy.

We expect companies in greater financial distress to be more likely to disclose material

weaknesses and, therefore, β4 and β5 to be positive.

Next we include variables to control for financial reporting complexity, all of which have

been shown to increase the likelihood of material weaknesses. LSEGCOUNT captures the natural

logarithm of the number of operating and geographic segments the company reports in the

Segments database of Compustat in year t. FORTRANS is an indicator variable equal to one if

the companies has non-zero foreign currency translation in year t, and zero otherwise. MERGER

is an indicator variable equal to one if the company has non-zero acquisition expense in year t-1

10 Additionally, prior research shows a negative association between company size and material weakness disclosures (Ashbaugh-Sakife et al. 2007; Doyle et al. 2007b), so we do not consider measures of tax NAS that scale tax fees by total assets or market capitalization.

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or year t-2, and zero otherwise. Consistent with prior literature, we expect β6, β7 and β8 to be

positive.

EXTREMESG and RESTRUCTURE control for rapid growth, which increases the

likelihood of reporting a material weakness. EXTREMESG is an indicator variable equal to one if

the year-over-year, industry-adjusted sales growth is in the top quintile of the sample.

RESTRUCTURE is the aggregate restructuring charges in years t-1 and t, scaled by the

company’s market capitalization in year t. We expect the coefficients on both of these variables

to be positive. We also include control variables to capture auditor quality. BIG4 equals one if

the financial statement auditor in year t is KPMG, Ernst and Young, Deloitte,

PricewaterhouseCoopers or one of their predecessors, and zero otherwise. AUDITOR_RESIGN is

an indicator variable equal to one if the company experienced an auditor resignation during the

year as reported by Audit Analytics. We expect both of these variables to increase the likelihood

of disclosing a material weakness, and expect β11 and β12 to be positive.

Because we are examining tax material weaknesses specifically, we include two

additional variables to control for income tax reporting complexity. PCTFORSALES is the

percentage of total sales attributable for foreign segments as reported in the Compustat Segments

database. As international operations expand, companies are more likely to face complex tax

issues in multiple jurisdictions. Accurately calculating an income tax provision is more difficult

as for multinational entities due to complex financial reporting issues such as permanently

reinvested foreign earnings (APB 23 assertions), foreign tax credit calculations, foreign currency

translation issues, valuation allowances in multiple jurisdictions and intraperiod tax allocations

issues (e.g. related to other comprehensive income). Therefore, we expect β13 to be positive.

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Finally, TAXLOSS is a binary variable set equal to one if the company reports a tax net

operating loss carryforward (NOL) in year t.11 We make no prediction for the sign of β14. On one

hand, tax losses may reflect overall financial distress; companies with tax losses may not

consider income tax reporting to be a priority and, therefore, be more likely to disclose material

weaknesses. Additionally, companies must regularly evaluate NOLs to determine if they are

realizable and establish a valuation allowance as contra asset to offset the benefit of any tax

NOLs that are expected to expire unused. The rules governing accounting for valuation

allowances are complex. Therefore, TAXLOSS could be positively associated with ICW_TAX.

Conversely, companies with extensive tax losses may have simpler tax provisions, especially if

the NOLs are completely offset with a valuation allowance, resulting in a zero tax provision.

b. Tests of H2 i. By Period

H2 predicts that attention to tax attenuates the negative relation between tax NAS and tax

internal control weaknesses. Based on anecdotal evidence that SOX and FIN 48 prompted

companies to better increase their focus on tax matters, our first proxy for attention to tax is the

period from 2007-2010. Our first test of H2 re-estimates equation (1) on the full sample

separately from 2004 through 2006 and from 2007 through 2010. Panel B of Table 1 presents

statistics for the sample period that pre-dates the adoption of FIN 48 (2004 through 2006), and

Panel C presents statistics for the period subsequent to the effective date of FIN 48 (2007

through 2010).

Consistent with a decline in tax NAS since the passage of SOX, mean and median tax

fees are significantly lower in the later period although mean and median audit fees are higher.

Sample companies have lower average market capitalization in the later period. The frequency of

11 We acknowledge the limitations of tax net operating loss data from Compustat. See, for example, and Kinney and Swanson (1993) and Guenther (2011).

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aggregate losses is greater in the later period while the frequency of foreign transactions, mergers

and restructuring are all significantly lower in the later period. Both trends likely reflect

consequences of the economic downturn in 2008 and 2009. From 2007 through 2010 companies

report a higher percentage of foreign sales and greater net operating losses. Sample companies

are also less likely to use a Big 4 auditor in the later period. Table 1, Panel D presents the

frequency of internal control weaknesses over tax by year. Disclosures of internal control

weaknesses over income taxes peak in 2005 at 237 disclosures then decrease monotonically over

the remaining sample period. In total, sample companies disclose 628 tax material weaknesses in

the early period and 461 in the later period.

As in our tests of H1, we use two measures of tax NAS: LNTAXNAS and TAXNASIND to

test H2. Our coefficient of interest is β1. We expect β1 to be negative and significant in the early

period (2004-2006), but less significant in the late period (2007-2010). Our predictions for

control variables are consistent with our discussion of H1 above.

ii. By Tax Expertise Our second proxy for attention to tax is top management or audit committee member tax

expertise. We begin with the full sample detailed above and match company-year observations to

Boardex, a professional business network database. Boardex provides biographical information

and employment history for corporate directors and officers.12 We utilize Boardex to search for

employment titles that convey tax expertise. See Appendix B for a list of titles we consider

representative of tax expertise. We set MGMT_EXPERT equal to one if a tax expert serves as the

CEO or CFO during the year, and zero otherwise. Similarly, AC_EXPERT is an indicator

variable set equal to one if a tax expert serves on the audit committee during the year, and zero

otherwise. EXPERT equals one if either MGMT_EXPERT or AC_EXPERT equals one. 12 A t-test on average LMARKETCAP suggests that average company size does not significantly differ between our main sample and the Boardex sample (p-value =0.8870).

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Table 2 provides descriptive statistics for the Boardex sample. All continuous variables

are Winsorized at one and 99 percent. Panel A presents statistics for the entire sample, Panel B

presents statistics for company-years that do not have a top manager or audit committee member

with tax expertise (EXPERT=0), and Panel C presents statistics for company-years that have a

top manager or audit committee member with tax expertise (EXPERT=1). Observations with tax

expertise in top management or on the audit committee report significantly higher tax and audit

fees. Expert company-years also have greater average market capitalization. Not surprisingly,

these observations also reflect characteristics indicative of organizational and tax complexity

such as more operating segments, and greater foreign transactions, foreign sales and mergers.


Our second set of tests of H2 estimate equation (1) on the Boardex sample. We estimate

the regression separately where EXPERT equals zero or one. To investigate whether

management or audit committee expertise differentially affects the association between tax NAS

and tax internal controls, we further split the sample by MGMT_EXPERT and AC_EXPERT, re-

estimating equation (1) separately where each indicator variable equals one.

In these tests of H2, we restrict our tax NAS measure to LNTAXNAS. We do this because

we do not have sufficient variation in the EXPERT subsamples to evaluate the effect of

TAXNASIND on the probability of a tax material weakness disclosure. β1 is the coefficient of

interest. H2 predicts that β1 will be negative and significant for company-years lacking tax

expertise in a top management or audit committee position, but less significance for company-

years with tax experts in these roles. Our predictions for control variables are consistent with our

discussion of H1 above. In alternative specifications, we also control for MGMT_EXPERT or

AC_EXPERT, making no prediction on these control variables.

18

IV. Results

a. Tests of H1

The first two columns of Table 3 provide results of testing H1 using two measures of

auditor-provided tax services: LNTAXNAS and TAXNASIND. Results are consistent with our

hypothesis that auditor-provided tax services decrease the probability of a tax internal control

weakness, on average. Specifically, we find negative and statistically significant coefficients on

LNTAXNAS and TAXNASIND over the full period, suggesting that the probability of disclosing

an internal control weakness over income taxes is decreasing in purchases of non-audit tax

services. Additionally, these results are economically significant. The coefficient of -0.0299 for

LNTAXNAS in the first column corresponds to a marginal effect of approximately -1.3 percent.

This marginal effect represent an approximate 29 percent decrease in the probability of

disclosing a tax material weakness when moving from the 25th to the 75th percentile of

LNTAXNAS, holding all other variables constant at their means. The economic significance of

TAXNASIND is similar, representing a 25 percent decrease in the probability of disclosing a tax

material weakness when moving from TAXNASIND equals zero to one. We interpret this

evidence as supporting our theory that tax NAS improve tax internal control quality.


The effects of control variables are mostly in line with predictions. We find positive and

significant coefficients on LNAUDIT, AGGLOSS, FORTRANS, AUDITOR_RESIGN and

PCTFORSALES across both measures of tax NAS. We also find a negative and significant

coefficient on LMARKETCAP across both specifications. Contrary to predictions, we find

negative and significant coefficients on SHUMWAY and BIG4. The coefficient on TAXLOSS, for

19

which we had no directional prediction, is significantly negative across both specifications. The

remaining coefficients are not significantly different from zero.

b. Tests of H2

i. By Period

The remaining columns of Table 3 provide results for the first test of H2, which predicts

that as companies increase their attention to tax following the passage of SOX and FIN 48, the

benefits of tax NAS diminish. We find a negative and significant relation between both measures

of tax NAS and tax material weaknesses in the early period, but an insignificant relation in the

later period. We interpret these results as consistent with our theory that, in a period in which

directors and officers paid little attention to taxes, the benefits of tax NAS on tax internal control

quality were greater than in a period characterized by increased attention to tax . The

coefficients on control variables are similar to those reported in testing H1 above.

As in tests of H1, the coefficients in the early period are economically significant for both

measures of tax NAS. The coefficient of -0.0427 for LNTAXNAS in the third column corresponds

to a marginal effect of approximately -0.4 percent. This marginal effect represents an

approximate 16 percent decrease in the probability of disclosing a tax material weakness when

moving from the 25th percentile to the 75th percentile of LNTAXNAS, holding all other variables

constant at their means. We estimate the marginal effect of TAXNASIND to be more than twice

as large; moving from TAXNASIND equals zero to one is associated with an estimated 33 percent

decrease in the probability of disclosing a tax material weakness.

ii. By Tax Expertise

Table 4 provides results for our second set of tests of H2. We estimate equation (1)

separately by EXPERT, MGMT_EXPERT, and AC_EXPERT to investigate whether tax expertise

20

in a top management or audit committee position attenuates the negative relation between tax

NAS and ICW_TAX.13 Panel A presents results from bifurcating the sample by EXPERT. The

first column of Panel A estimates equation (1) on the entire Boardex sample as a baseline;

consistent with tests of H1 above, we find a negative and significant coefficient on LNTAXNAS

when estimating equation (1) on this smaller sample. The second and third columns of Panel A

present results by EXPERT.


As predicted, we find a negative and significant relation between LNTAXNAS and

ICW_TAX for company-years lacking tax expertise in a top management or audit committee role,

but no statistically significant relation between LNTAXNAS and ICW_TAX for company-years

having a tax expert in top management or on the audit committee. Additionally, the coefficient

of -0.0330 for LNTAXNAS in column two (i.e., for company-years lacking tax expertise)

corresponds to a marginal effect of approximately -1.5 percent. This marginal effect represents

an approximate 32 percent decrease in the probability of disclosing a tax material weakness

when moving from the 25th percentile of LNTAXNAS, where the probability of disclosing a tax

material weakness is 0.0478, to the 75th percentile of LNTAXNAS, where the probability of

disclosing a tax material weakness is 0.0327, assuming all other variables equal their means. The

coefficients on control variables are similar to those reported in testing H1 above. We interpret

these results as supporting our theory that attention to tax attenuates the benefits provided by tax

NAS on tax internal control quality.

13 We choose to estimate Equation (1) on each subsample separately in lieu of reporting interactions because of the difficulty in interpreting interactions in logistic regressions.

21

Panels B and C of Table 4 report results of estimating equation (1) after bifurcating our

sample by MGMT_EXPERT or AC_EXPERT, respectively.14 We conduct these tests to shed

light on whether the relation between tax NAS and internal control quality differs based on who

in the company has tax expertise. The coefficient on LNTAXNAS is negative and significant for

company-years lacking tax expertise across all specifications, supporting the conjecture that both

top management and audit committee member tax expertise are important determinants of tax

internal control quality. The latter columns of Panels B and C additionally control for

AC_EXPERT or MGMT_EXPERT, respectively. The last column in Panel B indicates that

company-years having a tax expert in a top management position receive no incremental tax

internal control benefits from tax NAS, holding audit committee tax expertise constant. In

contrast, the last column in Panel C suggests that company-years having a tax expert on the audit

committee do receive incremental tax internal control benefits from purchasing tax NAS, holding

top management expertise constant. Together, these results provide some evidence that

management tax expertise may be more critical for mitigating tax internal control risks than audit

committee expertise.

We acknowledge that we cannot completely rule out the possibility that we find no

significant relation in the later period as a result of lower power. However, given that there are

still over 450 tax material weaknesses in the later period and that the magnitude of the

coefficients are much less negative in the later period, we believe the results are supportive of

our predictions that companies that are more likely to jointly consider business operations, tax

law and tax financial reporting in business decisions benefit less from tax NAS. Additionally, our

second set of tests of H2 related to tax expertise provides further support for our theory.

14 In the subsample for which MGMT_EXPERT=1, we drop the control variables BIG4 and AUDITOR_RESIGN due to lack of variation.

22

V. Additional Analyses on Tax NAS and Restatements

Our first set of supplemental analyses re-examines the negative association between tax

NAS and restatements documented in prior studies. Given our finding that tax NAS improve tax

internal control quality and the evidence in Donelson et al. (2012) that internal control

weaknesses are a significant determinant of restatements, we examine whether tax NAS are

associated with restatements after controlling for tax internal control quality. We estimate the

following logistic regression separately for all restatements and tax-only restatements.

Prob (RESTATE=1) = F(β0 + β1TAXNAS + [Β2ICW_TAX] + β3LNMKTCAP + β4AGGLOSS + β5EXTREMESG + β6MERGER + β7RESTRUCTURE + β8BIG4 + β9PCTFORSALES + β10TAXLOSS + β11BM + β12LEVERAGE + β13EXTERNALFINANCING + β14FREECASHFLOW + β15NICHANGE (2) We set RESTATE equal to one if the company misstated it financial statements in year t for any

issue (ALL=1). We first estimate the effect of tax NAS on RESTATE without controlling for

ICW_TAX. We then re-estimate equation (2) including ICW_TAX along with tax NAS to capture

the incremental benefit tax NAS provide after controlling for the effect of internal control

weaknesses. Following prior literature (e.g., Kinney et al. (2004); Seetharaman et al. 2011) we

use a tax NAS ratio, TAXNASRATIO, defined as the ratio of tax fees to the sum of audit and

audit-related fees in year t, as our measure of tax NAS.

We include control variables shown to be significantly associated with the likelihood of a

restatement. Several of the control variables overlap from equation (1); the predicted sign of

these coefficients are identical in both equation (1) and equation (2) with the exception of BIG4.

In equation (2), to the extent that BIG4 serves as proxy for audit quality, we expect the

coefficient on BIG4 to be negative. We include five control variables from the restatement

literature (e.g., Larcker et al. 2007, Carcello et al. 2011) that are unique to equation (2). BM

captures the company’s book-to-market ratio and controls for the possibility that rapidly growing

23

companies have higher incidences of restatements; thus, we expect β11 to be negative. The next

four variables capture pressure to manage earnings because of various financial constraints.

LEVERAGE represents the debt-to-asset ratio. EXTERNALFINANCING is total debt and equity

financing in year t, scaled by the market value equity at t-1. FREECASHFLOW is the difference

between operating cash flows in year t and average capital expenditures in years t, t-1 and t-2.

We expect the coefficients on these three variables to be positive. Finally, NICHANGE is the

percent change in net income from year t to t-1 and is intended to measure deterioration of

company profitability. We make no prediction for the sign of β15.


Table 5 presents results of this analysis. In the first two columns, we estimate equation

(2) on the entire sample. Consistent with prior literature, we find a negative association between

TAXNASRATIO and all restatements from 2004 through 2010. However, once we control for tax

material weaknesses, the coefficient on tax NAS is no longer significantly different than zero.

These results suggest that tax NAS improve financial reporting quality indirectly through its

effect on tax internal control. In the last two columns we estimate equation (2) using tax-only

misstatements (TAX=1). We use the taxonomy in Audit Analytics to determine if a restatement is

predominantly attributed to accounting for income taxes. In the third column, we find that

TAXNASRATIO is negatively related to tax-only restatements. The coefficient of -1.42 is more

negative and significant than the coefficient on TAXNASRATIO in the first column. This is not

surprising; tax NAS should have a more direct and significant effect on accounting for income

taxes than other accounts. In Column (d), we include ICW_TAX as a control variable and find

that the coefficient on tax NAS is less negative and less significant than in Column (c). These

24

results suggest that tax NAS improve financial reporting for income taxes both directly and

indirectly through its effect on tax internal controls.

VI. Conclusions

Prior tax NAS research has focused primarily on the relation between tax NAS and

financial reporting quality. We extend the literature examining the consequences of tax NAS by

testing the relation between tax NAS and tax internal control quality. We propose that tax NAS

improve tax internal control quality by facilitating the joint consideration of business operations,

tax law and financial reporting for income taxes. Further, we predict that the benefits of tax NAS

will be greatest in situations when companies do not routinely consider how operational changes

affect tax risk and reporting.

Consistent with predictions, we find a positive relation between tax NAS and tax internal

control quality from 2004 through 2010. In our sample, the marginal effect of moving from the

25th to the 75th percentile of the natural logarithm of tax fees represents a 29 percent decrease in

the likelihood of disclosing a tax material weakness, holding all other variables at their means.

This finding is important because tax material weaknesses can be detrimental to the quality of

reported earnings. Our findings suggest that by improving tax internal control quality, tax NAS

might indirectly improve financial reporting quality.

Additionally, we find little evidence that tax NAS provide benefits related to tax internal

control quality when companies pay attention to tax at the director and officer level. From 2007

through 2010, a time when income tax reporting is more salient to company executives and audit

committees, we find no association between tax NAS and tax internal control quality. Similarly,

we find no association between tax NAS and internal control quality when companies have top

managers or audit committee members with tax expertise.

25

Finally, we re-examine the negative relation between tax NAS and restatements

documented in prior studies. After controlling for tax internal control quality, we no longer find a

significant association between tax NAS and the likelihood of restatements in general. This result

suggests that tax internal controls are the mechanism through which tax NAS improve financial

reporting quality. In contrast, we continue to find a positive, although weaker, relation between

tax NAS and tax-only restatements after controlling for tax internal control quality, suggesting

that tax NAS provide incremental direct benefits to tax financial reporting quality.

Overall, our findings suggest that on average tax NAS are an important determinant of

tax internal control quality. These results should be of interest to shareholders and audit

committees assessing the costs and benefits of tax NAS, as well as to regulators considering

potential further restrictions to tax NAS. Our findings that tax NAS are less beneficial when

companies lack tax expertise at the director or officer level can inform boards and managers

when hiring top executives and appointing audit committee members. These results also help

explain the reduction in tax NAS since SOX; as companies internally focus more on tax

reporting, the benefits of tax NAS to internal control quality diminish.

26

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Definition

ICW_TAX An indicator variable equal to one if the firm reported an internal control weakness related to tax in year t.

AUDITFEES Total audit fees in year t .TAXFEES Total auditor-provided tax fees in year t .

TAXNAS One of the following measures of auditor-provided tax services.LNTAXNAS The natural log of tax fees paid to the financial statement auditor in year t.TAXNASIND An indicator variable equal to one if the firm purchased auditor-provided tax services in year t ,

and zero otherwise.TAXNASRATIO The ratio of tax fees to the sum of audit and audit related fees in year t.

LNAUDITFEES The natural log of audit fees in year t .LMARKETCAP The natural log of market capitalization (PRCC_F*CSHO) in year t .AGGLOSS An indicator variable equal to one if earnings before extraordinary items (IB) in years t and t-1

sum to less than zero, and zero otherwise.SHUMWAY The decile rank of the percentage probability of bankruptcy in year t from the default hazard

model prediction based on Shumway (2001). Note: higher score translates to higher probability of bankruptcy.

LSEGCOUNT The natural log of the sum of the number of operating and geographic segments reported by the Compustat Segments database for the firm in year t .

FORTRANS An indicator variable that is equal to one if the firm has a non-zero foreign currency translation (FCA) in year t , and zero otherwise.

MERGER An indicator variable that is equal to one if the firm has a non-zero acquisition expense (AQP) in years t or t-1 , and zero otherwise.

EXTREMESG An indicator variable that is equal to one if year-over-year industry-adjusted sales growth (SALE) falls into the top quintile in year t , and zero otherwise.

RESTRUCTURE The aggregate restructuring charges (RCP * -1) in years t and t-1, scaled by the firm's year t market capitalization (PRCC_F*CSHO).

BIG4 An indicator variable that is equal to one if the firm engaged one of the largest four audit firms in year t as reported by Compustat (AU ). The largest four audit firms include Deloitte and Touche,

AUDITOR_RESIGN An indicator variable that is equal to one if the firm experienced an auditor resignation in year t as reported by Audit Analytics.

PCTFORSALES The percentage of foreign sales as reported in the Compustat Segments database as a percentage of total sales (SALE) reported in year t .

TAXLOSS Tax net operating loss carryforward reported in year t , scaled by total assets in year t (TLCF/AT).

Appendix A: Variable Definitions

Dependent Variable

Independent Variables of Interest - all data come from Audit Analytics.

Control Variables - data come from Audit Analytics, Compustat, and CRSP. Compustat variables names are in parenthesis.

Auditor Fees - all data come from Audit Analytics.

30

RESTATE One of the following measures of misstatement in year t.

ALL An indicator variable equal to one if the firm misstated its financials in year t.TAX An indicator variable equal to one if the firm misstated its financials for a tax-related issue in year

t.BTM The book value of common equity (CEQ ) divided by the market value of common equity

(PRCC_F*CSHO ) in year t .LEVERAGE The total debt (DLTT + DLC ) divided by total assets (AT ) in year t .EXTERNALFINANCING Equals net equity financing (SSTK - PRSTKC - DV ) plus net debt financing (DLTIS - DLTR +

DLCCH ) in year t, scaled by beginning of the year market value of equity.FREECASHFLOW The difference between operating cash flows (OANCF ) in year t and average capital

expenditures (CAPX ) over years t, t-1 , and t-2 .NICHANGE The difference between net income (NI) in years t and t-1 divided by net income in year t-1 .FIN48 An indicator variable that is equal to one if the reserve for uncertain tax positions (TXTUBEND )

reported in year t is positive, and zero otherwise.LNASSETS The natural log of total assets (AT) in year t .ROA Return on assets: operating income after depreciation (OIADP ) in year t divided by total assets

(AT ) in year t-1 . YE An indicator variable set equal to one if the company's year end is other than December 31, and

zero otherwise.NONSTANDARD An indicator variable set equal to one if a nonstandard audit opinion (AUOP ) was issued in year

t , and zero otherwise.INVREC The ratio of inventory (INVT ) and accounts receivable (RECT ) to total assets (AT ) in year t .QUICKRATIO The ratio of current assets (ACT ), less inventory (INVT ), to current liabilities (LCT ) in year t.ABSACC The absolute value of modified Jones discretionary accruals.

Appendix A (cont'd.): Variable Definitions

Additional Variables for Supplemental Analyses - data come from Audit Analytics, Compustat, and CRSP. Compustat variables names are in parenthesis.

31

Appendix B: Tax Expertise Search Terms

Director TaxHead of TaxManager TaxPresident Tax

TaxTax AccountTax AffairsTax CounselTax ManagerTax Officer

TaxationTaxes

VP Tax

32

N Mean Std Dev 25th Pctl Median 75th PctlFeesTAXFEES 26,089 270,267 923,880 0 37,167 175,784 AUDITFEES 26,089 2,106,273 4,621,645 342,000 851,270 1,940,500

Variables of InterestLNTAXNAS 26,089 8.205 5.336 0.000 10.523 12.077TAXNASIND 26,089 0.718 0.450 0.000 1.000 1.000

Control Variables - Internal Control QualityLNAUDIT 26,089 13.650 1.308 12.743 13.654 14.478LMARKETCAP 26,089 6.149 2.110 4.637 6.095 7.565AGGLOSS 26,089 0.355 0.479 0.000 0.000 1.000SHUMWAY 26,089 4.179 2.858 2.000 4.000 7.000LSEGCOUNT 26,089 1.094 0.699 0.693 1.099 1.609FORTRANS 26,089 0.334 0.472 0.000 0.000 1.000MERGER 26,089 0.114 0.318 0.000 0.000 0.000EXTREMESG 26,089 0.165 0.371 0.000 0.000 0.000RESTRUCTURE 26,089 0.011 0.048 0.000 0.000 0.004BIG4 26,089 0.749 0.433 0.000 1.000 1.000

AUDITOR_RESIGN 26,089 0.019 0.136 0.000 0.000 0.000PCTFORSALES 26,089 0.236 0.313 0.000 0.038 0.428TAXLOSS 26,089 0.389 1.246 0.000 0.000 0.119

Control Variables - Financial Reporting QualityBM 25,889 0.575 0.686 0.262 0.460 0.739LEVERAGE 25,889 0.205 0.214 0.006 0.157 0.327EXTERNALFIN 25,889 0.018 0.266 -0.050 -0.002 0.045FREECASHFLOW 25,889 200.880 843.356 -6.138 8.189 82.509NICHANGE 25,889 -0.147 3.934 -0.707 -0.017 0.447

Variable definitions are provided in Appendix A.

Table 1, Panel AFull Sample Descriptive Statistics

33

N Mean Std Dev 25th Pctl Median 75th PctlFeesTAXFEES 11,785 287,562 954,780 3,000 43,000 191,000 AUDITFEES 11,785 2,036,948 4,610,703 304,423 793,000 1,885,820





Table 1, Panel BSample Descriptive Statistics, 2004-2006

34






Table 1, Panel CSample Descriptive Statistics, 2007-2010

Year ICW_TAX

2004 1632005 2372006 228

2007 1852008 1472009 742010 55Total 1,089

Tax Internal Control Weaknesses Table 1, Panel D

35


Variables of InterestLNTAXNAS 18,663 8.315 5.264 0.000 10.566 12.075TAXNASIND 18,663 0.729 0.444 0.000 1.000 1.000EXPERT 18,663 0.069 0.253 0.000 0.000 0.000MGMT_EXPERT 18,663 0.019 0.137 0.000 0.000 0.000AC_EXPERT 18,663 0.051 0.221 0.000 0.000 0.000

Control Variables - Internal Control QualityLNAUDIT 18,663 13.659 1.264 12.798 13.679 14.465LMARKETCAP 18,663 6.112 2.024 4.686 6.071 7.453AGGLOSS 18,663 0.337 0.473 0.000 0.000 1.000SHUMWAY 18,663 4.176 2.797 2.000 4.000 6.000LSEGCOUNT 18,663 1.072 0.683 0.693 1.099 1.609FORTRANS 18,663 0.295 0.456 0.000 0.000 1.000MERGER 18,663 0.097 0.296 0.000 0.000 0.000EXTREMESG 18,663 0.161 0.367 0.000 0.000 0.000RESTRUCTURE 18,663 0.011 0.047 0.000 0.000 0.003BIG4 18,663 0.753 0.431 1.000 1.000 1.000AUDITOR_RESIGN 18,663 0.018 0.134 0.000 0.000 0.000PCTFORSALES 18,663 0.211 0.287 0.000 0.025 0.375TAXLOSS 18,663 0.372 1.192 0.000 0.000 0.114


Table 2, Panel A

Boardex Sample Descriptive Statistics

36





Table 2, Panel B

Boardex Sample Descriptive Statistics, Expert=0

37

N Mean Std Dev 25th Pctl Median 75th PctlFeesTAXFEES 1,288 411,701 1,226,816 3,168 55,770 316,500 AUDITFEES 1,288 3,147,305 4,711,252 677,250 1,402,950 3,478,500




Table 2, Panel C

Boardex Sample Descriptive Statistics, Expert=1

38

Predicted Sign

TAXNAS - -0.0299 *** -0.2972 *** -0.0427 *** -0.4088 *** -0.0151 -0.1733(0.008) (0.095) (0.011) (0.124) (0.011) (0.128)

LNAUDIT + 1.2509 *** 1.2349 *** 1.4543 *** 1.4346 *** 0.9646 *** 0.9563 ***(0.071) (0.071) (0.089) (0.089) (0.107) (0.107)

LMARKETCAP - -0.7461 *** -0.7505 *** -0.8784 *** -0.8876 *** -0.5786 *** -0.5795 ***(0.052) (0.052) (0.066) (0.066) (0.075) (0.075)

AGGLOSS + 0.2505 ** 0.2542 ** 0.2112 0.2195 * 0.3258 ** 0.3264 **(0.103) (0.104) (0.131) (0.131) (0.154) (0.155)

SHUMWAY + -0.0685 *** -0.0693 *** -0.0840 *** -0.0858 *** -0.0479 -0.0480(0.022) (0.022) (0.028) (0.028) (0.035) (0.035)

LSEGCOUNT + -0.0733 -0.0770 -0.0931 -0.1017 -0.0317 -0.0315(0.087) (0.087) (0.111) (0.111) (0.125) (0.125)

FORTRANS + 0.1964 * 0.1979 * 0.1231 0.1248 0.2815 * 0.2833 *(0.102) (0.102) (0.128) (0.128) (0.147) (0.147)

MERGER + 0.0896 0.0874 -0.0011 -0.0007 0.1730 0.1713(0.129) (0.129) (0.189) (0.189) (0.162) (0.162)

EXTREMESG + 0.0699 0.0724 -0.0016 0.0017 0.1507 0.1513(0.096) (0.096) (0.133) (0.133) (0.133) (0.133)

RESTRUCTURE + -0.8949 -0.9147 -1.2836 -1.4833 -0.3549 -0.3545(0.558) (0.561) (1.971) (1.971) (0.575) (0.575)

BIG4 + -0.2060 * -0.2083 * -0.0971 -0.1013 -0.3273 ** -0.3253 **(0.114) (0.115) (0.151) (0.151) (0.159) (0.159)

AUDITOR_RESIGN + 0.9272 *** 0.9327 *** 0.8349 *** 0.8512 *** 1.1439 *** 1.1414 ***(0.164) (0.164) (0.207) (0.206) (0.270) (0.270)

PCTFORSALES + 0.2768 0.2694 0.2414 0.2272 0.3051 0.3036(0.188) (0.188) (0.244) (0.244) (0.261) (0.261)

TAXLOSS ? -0.2160 *** -0.2159 *** -0.3021 *** -0.3006 *** -0.1496 ** -0.1496 **(0.059) (0.059) (0.066) (0.066) (0.073) (0.073)

Obs. where ICW_TAX=1 1,089 1,089 628 628 461 461 Total Obs. 26,089 26,089 11,785 11,785 14,304 14,304

Likelihood Ratio 1,191.79 *** 1,186.20 *** 761.44 *** 754.08 *** 396.79 *** 396.80 ***

Variable definitions are provided in Appendix A. Standard errors clustered by firm in parentheses. *, **, and *** represent two-tailed statisticalsignificance at the 10%, 5%, and 1% levels, respectively. Our variable of interest is TAXNAS, measured in one of two ways. LNTAXNAS is the natural log of tax fees paid to the financial statement auditor in year t . TAXNASIND is an indicator variable equal to one if the firm purchasedauditor provided tax services in year t, zero otherwise. All specifications include year fixed effects.

Full Period (2004-2010)

LNTAXNAS

Early Period (2004-2006) Late Period (2007-2010)

Independent Variables LNTAXNAS LNTAXNASTAXNASIND

Table 3

Effect of Auditor Provided Tax Services on Tax Internal Control Weaknesses

Prob (ICW_TAX=1) = F(β0 + β1*TAXNAS + Controls + YearFE)

TAXNASIND TAXNASIND

39

Predicted Sign

LNTAXNAS - -0.0324 *** -0.0330 *** -0.0450(0.009) (0.009) (0.041)

LNAUDIT + 1.3197 *** 1.2899 *** 1.7282 ***(0.081) (0.085) (0.321)

LMARKETCAP - -0.7770 *** -0.7503 *** -1.0917 ***(0.057) (0.060) (0.202)

AGGLOSS + 0.3528 *** 0.3197 *** 0.8023(0.111) (0.115) (0.493)

SHUMWAY + -0.0833 *** -0.0801 *** -0.1158(0.024) (0.025) (0.095)

LSEGCOUNT + -0.0488 -0.0543 0.1049(0.096) (0.099) (0.417)

FORTRANS + 0.2242 ** 0.2797 ** -0.3975(0.113) (0.117) (0.424)

MERGER + 0.1485 0.1100 0.3554(0.146) (0.153) (0.478)

EXTREMESG + 0.0759 0.0488 0.5628(0.109) (0.113) (0.434)

RESTRUCTURE + -0.7502 -0.7098 -1.0796(0.672) (0.714) (2.041)

BIG4 + -0.2750 ** -0.3162 ** 0.6741(0.126) (0.129) (0.619)

AUDITOR_RESIGN + 0.8003 *** 0.7156 *** 1.9892 ***(0.192) (0.199) (0.720)

PCTFORSALES + 0.3458 0.2616 1.4896(0.215) (0.222) (0.964)

TAXLOSS ? -0.2644 *** -0.2657 *** -0.1614(0.068) (0.071) (0.235)

Obs. where ICW_TAX=1 873 810 63 Total Obs. 18,663 17,375 1,288

Likelihood Ratio 988.21 *** 878.43 *** 140.57 ***

Table 4, Panel A

Effect of LNTAXNAS and Tax Expertise on Tax Internal Control Weaknesses

Prob (ICW_TAX=1) = F(β0 + β1*LNTAXNAS + Controls + YearFE)

Variable definitions are provided in Appendix A. Standard errors clustered by firm in parentheses.*, **, and *** represent two-tailed statistical significance at the 10%, 5%, and 1% levels,respectively. LNTAXNAS is the natural log of tax fees paid to the financial statement auditor inyear t . EXPERT is an indicator variable equal to one for firm-years in which the CEO, CFO, ormember of the audit committee is a tax expert, zero otherwise. All specifications include year fixedeffects.

Independent Variables Boardex Sample Expert=0 Expert=1

40

Predicted Sign

LNTAXNAS - -0.0335 *** 0.0939 -0.0336 *** 0.0310(0.009) (0.160) (0.009) (0.106)

AC_EXPERT ? 0.1588 8.3257(0.202) (8.372)

LNAUDIT + 1.3064 *** 5.8046 *** 1.3048 *** 11.8389 *(0.082) (1.269) (0.082) (6.758)

LMARKETCAP - -0.7642 *** -3.7065 *** -0.7648 *** -7.6120 **(0.057) (0.965) (0.057) (3.384)

AGGLOSS + 0.3344 *** 4.4470 *** 0.3352 *** 6.2700(0.111) (1.673) (0.111) (3.874)

SHUMWAY + -0.0809 *** -0.7072 -0.0809 *** -1.3620 **(0.024) (0.629) (0.024) (0.626)

LSEGCOUNT + -0.0386 -2.8021 -0.0393 -4.8151 *(0.096) (1.932) (0.096) (2.647)

FORTRANS + 0.2335 ** 3.3480 0.2351 ** 7.4661 *(0.114) (3.244) (0.114) (4.352)

MERGER + 0.1638 -3.9734 0.1595 -9.6481(0.148) (2.695) (0.147) (6.930)

EXTREMESG + 0.0720 -2.5256 ** 0.0735 -5.8002(0.109) (1.224) (0.109) (4.587)

RESTRUCTURE + -0.7108 10.3043 -0.7093 45.6192(0.673) (9.093) (0.673) (41.034)

BIG4 + -0.2819 ** -0.2786 **(0.126) (0.126)

AUDITOR_RESIGN + 0.8130 *** 0.8156 ***(0.194) (0.194)

PCTFORSALES + 0.2961 6.9647 ** 0.2952 17.2998(0.217) (3.006) (0.217) (12.194)

TAXLOSS ? -0.2666 *** -0.0377 -0.2657 *** -0.3414(0.069) (0.727) (0.069) (2.679)

Obs. where ICW_TAX=1 861 12 861 12 Total Obs. 18,307 356 18,307 356

Likelihood Ratio 954.67 *** 71.43 *** 955.67 *** 79.75 ***

Variable definitions are provided in Appendix A. Standard errors clustered by firm in parentheses. *, **, and *** representtwo-tailed statistical significance at the 10%, 5%, and 1% levels, respectively. LNTAXNAS is the natural log of tax fees paidto the financial statement auditor in year t . MGMT_EXPERT is an indicator variable equal to one for firm-years in whichthe CEO or CFO is a tax expert, zero otherwise. AC_EXPERT is an indicator variable equal to one for firm-years in whichan audit committee member is a tax expert, zero otherwise. All specifications include year fixed effects.

Mgmt_Expert=0 Mgmt_Expert=1Independent Variables Mgmt_Expert=0 Mgmt_Expert=1

Table 4, Panel B

Effect of LNTAXNAS and Management Tax Expertise on Tax Internal Control Weaknesses

Prob (ICW_TAX=1) = F(β0 + β1*LNTAXNAS + Controls + YearFE)

41

Predicted Sign

LNTAXNAS - -0.0319 *** -0.0663 -0.0320 *** -0.0688 *(0.009) (0.041) (0.009) (0.042)

MGMT_EXPERT ? -0.6512 1.2077(0.440) (0.906)

LNAUDIT + 1.3037 *** 1.5884 *** 1.3081 *** 1.6053 ***(0.084) (0.367) (0.084) (0.376)

LMARKETCAP - -0.7649 *** -0.9378 *** -0.7631 *** -0.9420 ***(0.059) (0.208) (0.060) (0.212)

AGGLOSS + 0.3257 *** 0.8636 * 0.3262 *** 0.8540 *(0.115) (0.523) (0.114) (0.513)

SHUMWAY + -0.0810 *** -0.0878 -0.0804 *** -0.0803(0.025) (0.099) (0.024) (0.097)

LSEGCOUNT + -0.0644 0.3404 -0.0627 0.3648(0.099) (0.441) (0.099) (0.435)

FORTRANS + 0.2755 ** -0.6330 0.2765 ** -0.6274(0.117) (0.461) (0.117) (0.455)

MERGER + 0.0982 0.3851 0.1011 0.4380(0.152) (0.510) (0.152) (0.502)

EXTREMESG + 0.0562 0.5857 0.0535 0.6173(0.112) (0.409) (0.112) (0.412)

RESTRUCTURE + -0.7263 -0.9058 -0.7190 -0.8046(0.710) (2.023) (0.708) (2.022)

BIG4 + -0.3109 ** 0.7192 -0.3117 ** 0.7153(0.129) (0.646) (0.129) (0.650)

AUDITOR_RESIGN + 0.7020 *** 2.5071 *** 0.7101 *** 2.5262 ***(0.197) (0.790) (0.197) (0.798)

PCTFORSALES + 0.3127 1.0034 0.3069 1.0305(0.220) (1.150) (0.221) (1.172)

TAXLOSS ? -0.2621 *** -0.1951 -0.2622 *** -0.1864(0.069) (0.264) (0.069) (0.268)

Obs. where ICW_TAX=1 820 53 820 53 Total Obs. 17,705 958 17,705 958

Likelihood Ratio 912.33 *** 396.80 *** 916.56 *** 103.00 ***

Table 4, Panel C

Effect of LNTAXNAS and Audit Committee Tax Expertise on Tax Internal Control Weaknesses

Prob (ICW_TAX=1) = F(β0 + β1*LNTAXNAS + Controls +YearFE)

AC_Expert=1

Variable definitions are provided in Appendix A. Standard errors clustered by firm in parentheses. *, **, and *** represent two-tailed statistical significance at the 10%, 5%, and 1% levels, respectively. LNTAXNAS is the natural log of tax fees paid to thefinancial statement auditor in year t . MGMT_EXPERT is an indicator variable equal to one for firm-years in which the CEO orCFO is a tax expert, zero otherwise. AC_EXPERT is an indicator variable equal to one for firm-years in which an audit committeemember is a tax expert, zero otherwise. All specifications include year fixed effects.

AC_Expert=0 AC_Expert=1 AC_Expert=0Independent Variables

42

Predicted Sign

TAXNASRATIO - -0.2939 * -0.2125 -1.4219 ** -1.2001 *(0.164) (0.158) (0.704) (0.681)

ICW_TAX + 1.1623 *** 1.8563 ***(0.096) (0.246)

LMARKETCAP - -0.0072 -0.0020 0.0377 0.0566(0.022) (0.022) (0.072) (0.074)

AGGLOSS + 0.1565 ** 0.1162 0.1599 0.0697(0.072) (0.073) (0.276) (0.269)

MERGER + 0.0270 0.0067 0.1458 0.1086(0.102) (0.898) (0.317) (0.684)

EXTREMESG + 0.0179 0.0276 -0.1604 -0.1436(0.928) (0.072) (0.774) (0.226)

RESTRUCTURE + 0.6857 0.3946 0.1041 -0.4051(0.497) (0.529) (1.311) (1.535)

BIG4 - -0.0568 -0.0751 -0.3414 -0.3851(0.086) (0.086) (0.275) (0.276)

PCTFORSALES + 0.2548 ** 0.1964 * -0.0900 -0.2521(0.112) (0.114) (0.352) (0.371)

TAXLOSS ? -0.0934 *** (0.077) ** -0.9917 *** (1.032) ***(0.032) (0.031) (0.313) (0.364)

BTM - 0.048 0.0545 0.036 0.0564(0.044) (0.045) (0.099) (0.103)

LEVERAGE + 0.5568 *** 0.5457 *** 0.5613 0.5914(0.154) (0.155) (0.471) (0.485)

EXTERNALFINANCING + -0.0031 0.0411 -0.5947 *** -0.5234 ***(0.094) (0.093) (0.143) (0.146)

FREECASHFLOW + -0.0002 ** -0.0002 ** -0.0005 ** -0.0005 *(0.000) (0.000) (0.000) (0.000)

NICHANGE ? -0.0053 -0.0041 -0.0352 * -0.0334(0.007) (0.007) (0.021) (0.021)

Obs. where Restate=1 1,989 1,989 168 168 Total Obs. 25,889 25,889 25,889 25,889 Likelihood Ratio 790.13 964.20 76.19 137.85

Variable definitions are provided in Appendix A. Standard errors clustered by firm in parentheses. *, **, and *** represent two-tailed statistical significance at the 10%, 5%, and 1% levels, respectively. Our variables of interest are TAXNASRATIO and ICW_TAX . TAXNASRATIO is the ratio of tax fees to the sum of audit and audit related fees in year t . ICW_TAX is an indicator variable equal to one if the firm reported an internal control weakness related to tax in year t, and zero otherwise. All specifications include year fixed effects.

Table 5

Effect of LNTAXNAS on Restatements

Prob (RESTATE=1) = F(β0 + β1*TAXNASRATIO + Controls + YearFE)

Independent Variables All Restatements Tax Restatements

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