Does the Content of PCAOB Part II Reports Influence Client Financial Reporting? Evidence from Tax Accounts

Transcription

1 Does the Content of PCAOB Part II Reports Influence Client Financial Reporting? Evidence from Tax Accounts Katharine Drake Nathan Goldman Stephen Lusch University of Arizona April 10, 2014 Deloitte Foundation/University of Kansas Auditing Symposium May 2014 ABSTRACT: We investigate how the PCAOB inspection process impacts audit client financial reporting. In particular, we investigate whether auditors respond to the particular account related deficiencies identified in PCAOB Part II reports as evidenced by client changes in reporting of the deficient account. We examine this question in the setting of Deloitte s 2008 Part II inspection report, which specifically identifies weaknesses in the auditing of tax accounts. In particular, we test for changes to financial reporting of income taxes for Deloitte s clients in response to a change in auditor scrutiny resulting from PCAOB Part II reports related to audits of income tax accounts. We observe no change in GAAP effective tax rate (ETR) associated with a tax-related PCAOB Part II inspection report, but we find an estimated decrease of % in the reported reserve for unrecognized tax benefits (UTB) associated with the PCAOB Part II report. We find this change is concentrated in firms that use auditor provided tax services (APTS). We also find that firms that terminate APTS do not reduce the amount of reported UTBs after a change in auditor scrutiny. Our study provides initial evidence about audit clients specific financial reporting outcomes of changes in auditor scrutiny resulting from the PCAOB inspection process. *We would like to acknowledge Matthew Erickson, Nicholas Hallman, Sandy Klasa, Michael Mowchan, Robert Whited, and the University of Arizona Tax Readings Group for their valuable contributions and considerations in the development of this study.

2 I. INTRODUCTION We investigate how the Public Company Accounting Oversight Board (PCAOB) inspection process impacts client reporting, and whether the changes in financial reporting are associated with the particular accounts identified as deficient in the PCAOB Part II reports. Specifically, we examine whether increased auditor scrutiny over tax accounts, resulting from an unsuccessful Part II remediation, affects the auditor s clients financial reporting for income taxes. Deloitte & Touche LLP s (Deloitte) 2008 Part II inspection report identifies, among other items, firm-wide deficiencies in audits of income tax accounts. Using this unique setting, we investigate whether the changes Deloitte made after the issuance of the 2008 Part II report impacted financial reporting of tax accounts among Deloitte clients. The prevalence of fraudulent corporate financial activity in the early 2000s led to the passage of the Sarbanes-Oxley Act of 2002 (SOX). The impact of SOX was significant to auditors and firms. One provision of SOX subjects auditors of United States public companies to external and independent oversight. This led to the creation of the PCAOB, a nonprofit corporation under the authority of the Securities and Exchange Commission. Specifically, the PCAOB is responsible for upholding the quality of external audits through a rigorous inspection process. Prior and concurrent research of PCAOB inspections examines the effects of the publicly disclosed inspection findings on auditor turnover (Abbott et al. 2013; Nagy 2014), audit quality (Buslepp and Victoravich 2014; Carcello et al. 2011; Church and Shefchik 2012; Gunny and Zhang 2013), auditor competition (DeFond and Lennox 2011), auditor reporting decisions (Gramling et al. 2011; Lamoreaux 2013), auditor-client relationships (Acito et al. 2013), and investor reaction to PCAOB reports (Muriel 2013). 1

3 Although each of these studies provide evidence related to the effects the PCAOB inspections has on the audit firm, they do not directly address the consequences to the clients of the audit firms. One reason for this is that prior literature has primarily focused on either the PCAOB inspection program as a whole or specific Part I inspection reports. We suggest that while these settings are valid to address specific research questions, they may not be appropriate for examining the effects that PCAOB inspections may have on the inspected auditor s clients. In particular, the Part I report identifies deficiencies related to a particular audit issue on specific engagements, without disclosure of the name of the audit client. In contrast, a Part II report highlights identified deficiencies in the auditor s firm-wide quality controls, and we expect the auditor s response to broadly impact the firm s client base. The audit firm has 12 months to rectify all of the issues noted and respond to the PCAOB documenting remediation steps taken. Subsequent to the end of the remediation window, the PCAOB performs a review and determines whether the audit firm has appropriately addressed the noted deficiencies. In the event that the audit firm fails to adequately remedy the PCAOB s identified deficiencies, the report is publicly disclosed. 1 It was not until 2011 that the PCAOB publicly disclosed a Part II report for a major audit firm. 2 We believe the Deloitte Part II report, released in October 2011, provides us with an ideal setting to examine client specific effects related to PCAOB inspections because unlike the other publicly disclosed Part II reports the 2008 Deloitte report identifies weaknesses in quality controls over the audits of specific accounts (income taxes), and thus we expect Deloitte to increase scrutiny on these accounts in particular. 1 Subsequent to the end of the 12-month remediation window and prior to public disclosure, the audit firm may appeal to the SEC to overturn the PCAOB s ruling. As a result, many reports are publicly disclosed well after the end of the 12-month inspection window. 2 Consistent with the literature, we classify Big 4 and second tier firms as major firms. Thus our sample includes Deloitte & Touche, Ernst & Young, PricewaterhouseCoopers, KPMG, BDO, Grant Thornton, McGladrey, Crowe Horwath, and MaloneBailey. See additional discussion in the Section II. 2

4 We examine client-specific effects of the PCAOB inspections through publicly disclosed Part II reports. As of the end of 2013, the PCAOB has publicly issued five Part II reports to major audit firms, indicating the auditors failed to adequately address the PCAOB s concerns within the 12-month remediation window. Deloitte s 2008 PCAOB Part II inspection report identifies deficiencies surrounding its auditing of tax accounts and tax based estimates. In contrast, the remaining four publicly issued Part II reports do not identify deficiencies related to the auditing of tax accounts. Rather, those reports focus only on general deficiencies relating to audits of management estimates, use of specialists, supervision and review, and professional skepticism. This difference allows us to examine the effect of the inspection reports on audit clients, given that we expect the auditor will substantially change the audit approach to these accounts. We use the term auditor scrutiny to encompass the potential audit changes in response to the PCAOB report. We use the construct of auditor scrutiny to encompass effort, diligence, and professional skepticism. Further, our study examines whether the increased auditor scrutiny in response to Part II inspection reports result in a change in client financial reporting. We investigate our research question using firms that are clients of auditors in the year after the auditor s 12-month remediation window expired. 3 Specifically, we examine how the audit client s financial reporting of income taxes is differentially impacted depending on the content of the PCAOB Part II inspection report. 3 During the fiscal year subsequent to the expiration of the 12-month response window, the audit firm is aware that it did not appropriately respond to comments within the inspection report and it will therefore be publicly disclosed pending an appeal to the SEC. Any comments that appear in this report and do not appear in a subsequent report or a lack of a subsequent report suggests that they were appropriately addressed during the year after the expiration of the 12-month response window. As a result, we use this to model our selection window. See additional discussion below and Figure 1. 3

5 Companies have an incentive to manage tax accounts to achieve financial reporting goals. In particular, we focus on two financial accounting-based measures to determine whether there were changes to financial reporting of income taxes, GAAP effective tax rate (ETR) and the reserve for unrecognized tax benefits (UTB). In a survey of tax executives, Graham et al. (2014) find that public firms focus on GAAP ETR as a performance measure. In addition they find that the impact of tax strategies on earnings per share is an important metric in evaluating whether to implement a particular tax strategy or not. Accordingly, Armstrong et al. (2012) document that tax director incentive compensation is negatively associated with the firm s GAAP ETR. Furthermore, Dhaliwal et al. (2004) find that the tax accounts are used as a last ditch effort to meet earnings targets. Similarly, Cazier et al. (2011) find that firms use discretion over the UTB liability to meet consensus analyst forecasts. Thus, changes to auditor scrutiny may impact financial reporting for income taxes. However, increased auditor scrutiny over a firm s tax accounts might also alter a firm s incentives related to the selection of the tax transactions undertaken. In their survey, Graham et al. (2014) also inquire why tax executives decide not to engage in a particular tax strategy. Among the factors that provide a disincentive for tax planning, executives identify the possibility of having to later restate financial statements, the tax benefit not being recorded for GAAP, whether the transaction has a business purpose, and reputational concerns as important. 4 To the extent that the additional auditor scrutiny over tax accounts from Deloitte s PCOAB Part II report increases these disincentives for tax planning, audit clients of Deloitte may engage in less and/or different types of tax planning. 4 Among public firms surveyed, 42-88% of respondents identified these items as important disincentives for tax planning. 4

6 We find that Deloitte clients do not have significant changes in reported GAAP ETRs in the year after the PCAOB identified tax related audit quality issues. However, we find that on average Deloitte clients report a 10.7% decrease in UTBs in the year following the Part II report relative to the clients of auditors with non-tax related Part II reports. We find similar results (8.3% decrease in UTBs) comparing these Deloitte clients to audits performed in the same year by other annually inspected auditors 5 (none of which received Part II reports that year). We interpret these findings to suggest that the PCAOB inspection reports have an impact on the audit firm and that the changes to audit scrutiny impact the financial reporting of their clients. However, it should be noted that we cannot fully distinguish how much of the change in UTBs is associated with changes in financial reporting decisions versus changes in the underlying tax transactions. We interpret our findings that the overall decrease in UTBs suggests that the underlying tax transactions in which the clients are engaging are influencing the UTBs to a greater extent than changes in financial reporting decisions. 6 To further test our inferences, we examine cross-sections surrounding auditor provided tax services (APTS) and a change in auditor provided tax services. SOX altered the rules relating to auditor provided tax services to publicly traded companies. Specifically, any tax services provided by the audit firm to its audit client must be approved by the client s audit committee (PCAOB 2011). Similarly, audit partners often approve all services provided to a client as part of the oversight of the auditor-client relationship. As a result, APTS in the post-sox era now has multiple layers of acceptance that must be met prior to the formal approval of a tax project. If the 5 We choose to focus on the Big 4 and second tier auditors as these are the audit firms subject to annual inspection by the PCAOB and provide a more homogeneous sample of client firms. See additional discussion below. 6 On one hand, if Deloitte clients are engaging in the same tax transactions pre- and post- Part II then we would expect UTBs to increase as the auditor increases scrutiny over the tax accounts. On the other hand, if auditor scrutiny does not change, but tax management decreases then we expect UTBs to decrease. In our setting, auditor scrutiny and the tax strategies employed by the client are changing simultaneously so we cannot draw conclusions about the magnitude of the UTB change that is associated with financial reporting decisions versus tax strategy decisions. 5

7 PCAOB identifies weaknesses in the auditing of tax accounts, as with Deloitte in 2008, then the inspection process may have an effect on the types of projects or the risk profile of projects that are approved and presented to the client s audit committee. Prior studies provide evidence that firms that have APTS have more accurate tax reserves (Gleason and Mills 2011) and engage in less tax based earnings management (Cook et al. 2008). In our setting, we expect that when Deloitte provides tax services to clients, the oversight changes resulting from PCAOB Part II will differentially impact financial reporting as compared to clients that do not use Deloitte for tax services. Our results suggest that Deloitte clients with APTS have an incremental decrease in uncertain tax positions in the year following the Part II report. Further, we examine firms that previously engaged Deloitte for APTS and discontinued the services in the post-part II year. We find that firms that terminate APTS with Deloitte following the Part II report do not have a decrease in uncertain tax positions. These two results corroborate our initial findings that the effect of the PCAOB Part II inspection reports lead to a change in reported UTBs. This study contributes to the literature in a variety of ways. First, we provide initial evidence on the impact of PCAOB Part II inspection reports. DeFond and Francis (2005) call for research on the impact of SOX-related changes in oversight of the auditing profession. Many studies examine how the Part I inspection reports or the PCAOB inspection process as a whole impact the auditor and audit committee decision making (e.g., Abbott et al. 2013; Acito et al. 2013; Lamoreaux 2013; Carcello et al. 2011; Gramling et al. 2011; Church and Shefchik 2011), but to our knowledge no prior literature investigates the clientele reporting impact of a Part II inspection report. These Part II inspection reports are increasing in frequency of public disclosure. In the past three years, a total of five Part II inspection reports for major accounting 6

8 firms were publicly disclosed. Buslepp and Victoravich (2014) examine whether the Part II reports signal both perceived and actual audit quality. They find that Part II reports distinguish audit quality (measured by likelihood of issuing an unqualified opinion in the presence of material misstatements) and foreshadow disciplinary actions and subsequent exits from the public company audit market for triennially inspected auditors, but not for annually inspected auditors. Additionally, concurrent research investigates whether these reports have a significant effect on the stock price and auditor turnover for these audit clients (Muriel 2013). Furthermore, Nagy (2014), who investigates publicly released Part II reports for annually inspected and triennially inspected firms, finds that auditors lose significant market share after the public release of a Part II report. Therefore, we expect the potential reputational damage might cause significant changes to the way both the audit firm and its clientele behave. Additionally, this study provides evidence on the impact of the content of PCAOB inspection reports. DeFond (2010) and Lennox and Pittman (2010) show that inspection reports have low signaling ability to the audit firm s clientele. Although that may be true for some inspection reports, our study suggests that it is not the case for Part II inspection reports. We find that these inspection reports lead to changes in the client reporting specific to the issues noted in the Part II report. This suggests that the content of the report may not only affect auditor scrutiny, but that the change in auditor scrutiny also influences the financial reporting of the inspected auditor s clients. Thus, our study also addresses the question posed in DeFond and Francis (2005) about whether auditor behavior can be inferred from client financial statements. The remainder of this paper is organized as follows. Section II discusses prior literature relevant to our hypothesis. Section III describes the research design including how variables are 7

9 measured and how the sample is comprised. Section IV presents the results of our analyses and Section V concludes. II. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT PCAOB Inspections and Reports Section four of the Bylaws and Rules of the PCAOB identifies the guidelines regarding inspection of public accounting firms. For the Big 4 and second tier firms, 7 the rules require annual PCAOB inspections to assess the degree of compliance with the PCAOB s rules and professional standards in connection with the firm s performance of audits and issuance of audit reports (PCAOB 2011). Each public accounting firm registered with the PCAOB is obligated to cooperate with the inspection process. Upon completion of the inspection, the PCAOB issues either a Part I Report (Inspection Procedures and Certain Observations) or both a Part I and Part II report (Issues Related to Quality Controls). The Part I report presents the findings of the specific engagements that the PCAOB inspected for that specific audit firm (PCAOB 2008) and summarizes the identified audit deficiencies. The Part I reports are made public for every inspected audit firm within several months of the completed inspection. The Part II report describes the PCAOB concerns about potential defects in the auditor s firm-wide quality control system. 8 The PCAOB examines the audit firm s stated quality control policies and procedures and concludes whether the firm has failed to assure quality (PCAOB 7 The Big 4 and second tier firms are often referred to as annually inspected firms. This includes Deloitte & Touche, Ernst & Young, PricewaterhouseCoopers, KPMG, BDO, Grant Thornton, McGladrey, Crowe Horwath, and MaloneBailey. The requirement to be considered an annually inspected firm is to audit 100 publicly traded companies (PCAOB 2011). All other audit firms are subject to triennial inspection. For the purpose of this study, we define these annually inspected firms as Major Firms. 8 PCAOB QC section describes that an audit firm s quality control system includes: (a) Independence, integrity, and objectivity, (b) Personnel management, (c) Client acceptance and continuance, (d) Engagement performance, and (e) Audit process monitoring. 8

10 2008; PCAOB 2009A; PCAOB 2009B; PCAOB 2010A; PCAOB 2010B). According to the PCAOB inspection guidelines: With respect to any final inspection report that contains criticisms of, or potential defects in, the quality control systems of the firm under inspection, the firm may submit evidence or otherwise demonstrate to the Director of the Division of Registration and Inspections that it has improved such systems, and remedied such defects no later than 12 months after the issuance of the Board's final inspection report. After reviewing such evidence, the Director shall advise the firm whether he or she will recommend to the Board that the Board determine that the firm has satisfactorily addressed the criticisms or defects in the quality control system of the firm identified in the final inspection report and, if not, why not (PCAOB 2011, p. 70). The auditor may respond to the PCAOB criticisms via a Rule 4009 submission documenting the ways in which the audit firm has addressed the PCAOB s quality control issues (PCAOB 2006). Thus, if the audit firm appropriately addresses the criticism (in the eyes of the PCAOB) within the year, then the results are not conveyed publicly. Accordingly, any unremediated portions of a Part II inspection report are not publicly disclosed until a full year after the audit firm is notified of its deficiencies. If however, the auditor has failed to demonstrate substantial, good faith progress toward achieving the relevant quality control objectives, then the report is made public (PCAOB 2006, p. 6). In addition, the auditor is allowed to appeal the findings to the SEC, and thus the public release of any Part II report is typically several years after the initial inspection. 9 Part I and Part II Reports Our study examines changes in audit client financial reporting in response to the issuance of these PCAOB Part II inspection reports and more importantly the content of the reports. We contend an audit firm that has a Part II inspection report publicly disclosed (indicating the audit firm was made aware of quality control concerns and failed to adequately respond to the 9 For example, the 2008 Deloitte inspection report was published on May 19, 2008 and therefore the remediation period ended on May 18, Although the Part I findings were publicly disclosed on May 19, 2008, the Part II results were not publicly disclosed until October 17, See additional detail in Table 1 Panel A. 9

11 concerns within the 12-month remediation period) undergoes significant changes to its organizational behavior during the audit period subsequent to failing to remediate the related issues. In contrast, a Part I inspection report is always publicly disclosed, and relates to specific deficiencies identified in specific engagements inspected by the PCAOB. However, the PCAOB considers the issues noted in these engagements as isolated to those engagements and not necessarily persistent throughout the entire audit firm. The Part II report identifies widespread quality control issues the PCAOB identified throughout the audit firm which demands a more significant response from the audit firm, especially given the remediation period and subsequent opportunities to appeal to the SEC before the reports are publicly released. 10 While we expect the audit firm takes corrective actions during the remediation window itself, the fact that the report has been publicly disclosed suggests that the PCAOB did not consider the actions within the remediation window to be sufficient to correct the deficiencies. Therefore, we expect that the audit firm will take further measures to correct the deficiencies after the public disclosure of the Part II report in order to avoid receiving a Part II report on the same issues the following year. This notion is substantiated anecdotally by Deloitte in its Advancing Quality through Transparency Report (Deloitte 2010). This report includes Deloitte s process improvements in response to PCAOB inspections and internal inspection processes, including implementing a new audit methodology, developing new training, and enhancing engagement review and feedback procedures. 11 Similarly, Ernst & Young s response to their 2010 PCAOB Part II inspection report states: 10 The PCAOB guidance suggests that the non-public issuance of Part II of the inspection report to the audit firm does not require a firm to address the quality control criticisms to the Board s satisfaction, it merely provides a specific incentive to do so, the threat of public release of Part II of the inspection report (PCAOB 2006, p. 2) 11 Interestingly, this document was released by Deloitte in January 2010, after the remediation period for the 2008 Part II report had ended, but prior to public issuance by the PCAOB. 10

12 We have provided our audit professionals with new audit tools, additional training and expanded technical guidance. These efforts have been beneficial generally and continue to improve our execution. Overall, we have invested thousands of partner and staff hours on these issues and believe we approached each board criticism seriously and responsibly (PCAOB 2010A, p. 3). Given that the Part II report findings pertain to firm-wide quality control deficiencies (versus particular engagements), we expect the audit firm response to a publicly disclosed Part II report to be significant in contrast to a Part I report. To date the PCAOB has publicly released Part II reports for three of the four Big 4 accounting firms: Deloitte (PCAOB 2008, PCAOB 2009A), Ernst & Young (PCAOB 2010A) and PricewaterhouseCoopers (PCAOB 2009B, PCAOB 2010B). Each of the reports covers similar topics and generally pertains to internal control testing, tone at the top, and other various topics. 12 However, the 2008 Deloitte report contains one sufficiently different item in comparison to the other four reports. In this report, the PCAOB identified sufficient cause for concern about the effectiveness of Deloitte s quality controls with respect to the audit procedures performed on income tax accounts (PCAOB 2008). The PCAOB cites two specific engagements with deficiencies in audits of income tax balances and identifies that the issues are prevalent throughout the audit firm as a whole. Given the significance of the public disclosure of a Part II inspection report and the uniqueness of Deloitte s 2008 report as it pertains to the auditing of tax accounts, we believe this provides an ideal setting to examine how financial reporting changes in response to increased auditor scrutiny over income taxes. We are able to examine the significance of the content of the inspection reports by comparing changes in income tax accounts between Deloitte clients and other Part II reports that are not tax specific. 12 See Table 1 Panel B for a summary of deficiencies noted in PCAOB Part II reports. 11

13 We define auditor scrutiny in our setting as an increased level of effort, more diligent attention to the tax accounts, and additional professional skepticism. Deloitte s 2008 Part II report specifically identifies general concerns regarding: The design, adequacy, clarity, communication, and implementation of the Firm s audit methodology and other audit policies, including a possible need to require more thorough auditing of material transactions and management s estimates; The sufficiency of the Firm s emphasis on the critical need to exercise due care and professional skepticism when performing audits; The Firm s supervision and review activities to ensure that the audit is performed thoroughly and with due care; The enforcement, through appropriate monitoring and disciplinary activities, of compliance with the Firm s policies and procedures; and The quality, delivery, relevance, and timeliness of the Firm s training programs for audit personnel. (PCAOB 2008, p.16) While these changes to auditor scrutiny are not generally observable, we anticipate changes to financial reporting for income taxes and use changes in these accounts as a proxy for the observable outcome resulting from changes in auditor scrutiny. PCAOB Inspection and Financial Reporting Prior literature examining the content and quality of the PCAOB inspection process focuses on general changes in the inspection process and responses to Part I reports. Further, these studies focus on how the inspection reports impact financial reporting decisions. Carcello et al. (2011) provide evidence that the inception of the PCAOB inspection process as a whole yields an increase in audit quality (proxied by a decrease in the absolute value of discretionary accruals) and an increase in financial reporting quality. For annually inspected auditors (such as those in our study), Gunny and Zhang (2013) find that deficiencies identified in PCAOB inspection reports do not distinguish audit quality. In fact, in some settings, high-deficiency auditors are associated with higher audit quality. 12

14 We seek to contribute to the mixed results regarding the effectiveness of the PCAOB inspection process by examining financial reporting changes in response to the Part II inspection reports. In these reports, the PCAOB identifies concerns regarding review of a firm s stated quality control policies and procedures and on inferences that can be drawn from respects in which a firm s system has failed to assure quality in the actual performance of engagements (PCAOB 2008, p. 11). In addition, since the reports we study are publicly disclosed, the deficiencies identified were not adequately remedied within the remediation period. 13 Therefore, we expect auditors to increase attention and scrutiny over the accounts identified in the Part II report in the year following the remediation period. Since Deloitte s PCAOB Part II provides a setting in which we expect a change in auditor scrutiny over tax accounts, we expect a change in the financial reporting of tax accounts of these Deloitte clients. Tax Reporting Companies have incentives to engage in tax strategies in order to meet financial reporting goals as well as generate incremental cash flows for the firm by decreasing cash tax payments in a particular year. For example, Dhaliwal et al. (2004) find that the tax accounts are used as a last ditch effort to meet earnings targets. In addition, Phillips et al. (2002) suggest that deferred tax expense is useful in identifying earnings management to avoid an earnings decline as managers can use the discretion under GAAP to manage financial statement income upwards while not affecting taxable income. Additionally, while tax planning comes at a cost, Mills et al. (1998) associate a one-dollar increase in tax planning costs with four dollars in tax savings, indicating that on average companies realize a positive return on investments from tax planning. 13 Only unremediated issues are included in the publicly disclosed Part II report. We note gaps in the numbering of the items publicly disclosed, suggesting the presence of items that were adequately addressed in the remediation period and are therefore not publicly disclosed. 13

15 Anecdotal evidence and accounting research suggests that executives seem to particularly focus on GAAP ETR as a measure of tax performance. In a survey of tax executives, Graham et al. (2014) find that public firms focus more on GAAP ETR relative to cash taxes paid. In addition they find that the impact of tax strategies on earnings per share is an important metric in evaluating whether to implement a particular tax strategy or not. Accordingly, Armstrong et al. (2012) document that tax director incentive compensation is negatively associated with the firm s GAAP ETR, but not with cash ETR, or the book-tax gap, providing additional support for importance of GAAP ETR as a performance metric in public companies. FIN No. 48, Accounting for Uncertainty in Income Taxes (FIN 48) requires firms to estimate, record, and disclose a liability for uncertain tax benefits (UTBs) in its financial statements. When a tax position is determined to fall below the more-likely-than-not threshold the firm cannot recognize the tax benefit as a reduction in current year tax expense. Therefore, we suggest that to the extent that firms engage in tax strategies to manage GAAP ETR, they will also seek to use the discretion available to them under FIN 48 to be able to recognize the benefits of the tax strategies (Cazier et al. 2011). Recent literature documents divergent reporting under FIN 48 (De Simone et al. 2013), suggesting that managerial discretion exists in how a particular transaction is evaluated under the more-likely-than-not threshold, even within the same auditor. Furthermore, the PCAOB notes that taxes are a difficult area to audit, given management s estimates and the complexities of tax systems. (PCAOB 2010) Ceteris paribus, a change in auditor scrutiny over the tax accounts should lead to a diminished ability for executives to manage these accounts to meet financial reporting goals and thus we expect higher GAAP ETRs and higher UTBs for Deloitte clients in the year after Deloitte s Part II remediation. The nature of the two measures leads to a nice contrast. While the 14

16 UTB is management s estimate of uncertain tax liability, GAAP ETR is less subject to estimation. However, the audit committees and executives of Deloitte clients are aware of the contents of the Part II report and the remediation process. Therefore, the clients may change their tax strategies in anticipation of increased scrutiny over the tax accounts in the coming periods, which would result in changes to reported GAAP ETR and UTBs, including a potential decrease in actual uncertain tax positions. Thus, while making a directional prediction is difficult, we expect the audit firm s clients to change reporting of GAAP ETR and UTBs in response to a change in auditor scrutiny over tax accounts. Thus we broadly hypothesize: Hypothesis: An increase in auditor scrutiny over tax accounts is associated with a change in client financial reporting of tax accounts. III. RESEARCH DESIGN Inspection Reports The purpose of our study is to examine the association between an increase in audit scrutiny in response to a significant shock, specifically a Part II PCAOB inspection report, and a change in financial reporting of income tax accounts. We focus on the Deloitte 2008 Part II report which identifies deficiencies in audits of tax accounts and tax estimates. This requires us first to identify publicly disclosed Part II reports for major accounting firms. 14 In Table 1 we present a summary of the five PCOAB Part II inspection reports for major firms that have been publicly disclosed as of the end of 2013 as well as the dates of the reports, the inspection period, 14 Non-major audit firms or triennially inspected audit firms have had numerous PCOAB Part II inspection reports publicly disclosed (Nagy 2014 identifies 161 Part II reports publicly issued between 2007 and 2012). Due to the stark differences that exist between both major auditors versus non-major auditors as well as the differences in their clienteles, we subjectively focus on the PCAOB Part II inspection reports of major audit firms. 15

17 and public release dates. Panel A presents relevant dates and Panel B presents detail of the content of the PCAOB publicly issued Part II reports to date. In Panel A we note the PCAOB has publicly disclosed Part II inspection reports for three of the four Big 4 accounting firms, but none of the second tier audit firms. The date of the report is the actual date that the inspection report was issued to the audit firm, the end of the remediation period occurs one year later and is the date by which the audit firm may submit a Rule 4009 submission documenting how the audit firm has addressed the PCAOB s concerns (PCAOB 2006). The date of public disclosure is the date in which the report was publicly released through a press release and publication on the PCAOB website, indicating the PCAOB determined some portion of the concerns were not adequately remedied. Upon notification that the audit firm did not adequately address the PCAOB s concerns and that the report will be publicly disclosed, the audit firm has the opportunity to appeal to the SEC for reconsideration. As a result, we note a time lag between the end of remediation and public disclosure. 15 Lastly, of interest to this study, Deloitte s 2008 report is the only report with tax related issues. From this, we infer that the tax issues identified that year were adequately remediated in the subsequent year as evidenced by a lack of tax issues noted in the subsequent Part II report issued for Deloitte. This provides an expectation that Deloitte changed quality controls over audits of tax accounts and tax strategies subsequent to the end of the 2008 report s remediation period but prior to the end of the 2009 report s remediation period. Panel B summarizes the deficiencies related to audit performance and other general observations in each of the publicly disclosed Part II reports. Note that the Deloitte 2008 report is 15 Given the existence of a time lag between remediation and appeal, it is possible other Part II inspection reports will be publicly disclosed pending SEC review. The process is highly confidential and therefore we are unable to identify any other undisclosed Part II reports at this time. However, the existence of other undisclosed Part II reports would bias against our findings. 16

18 the only Part II report that identifies specific accounts (income taxes). Deloitte 2008 and all other publicly disclosed Part II reports identify non-account specific areas of concern (i.e., auditing estimates, auditing fair value measures, due care and professional skepticism). This provides the setting for our study to examine the impact of a change in auditor scrutiny on client reporting. [INSERT TABLE 1] Determination of Periods PCAOB Part II inspection reports are only publicly disclosed if the quality control concerns are not remediated during the 12-month period after its initial issuance to the audit firm and only for quality control items the PCAOB determines are not adequately remediated (PCAOB 2006). We expect that the year subsequent to the notification that this report will be publicly disclosed, the auditor significantly changes the audit methodology as well as the overall level of scrutiny for areas the PCAOB identifies as inadequately remediated. While we expect the auditor made changes in response to the PCAOB findings during the remediation period, the public disclosure of the Part II report indicates any actions were not sufficient to satisfy the PCAOB concerns. However, once the PCAOB determines the report will be publicly disclosed, we expect the audit firm will make additional improvements to their audit processes in order to avoid the public disclosure of a Part II report in the next year. Additionally, we expect audit firms will communicate anticipated changes in audit focus to clients and audit committees. Likewise, audit committees may inquire about PCAOB reports and the nature of any changes impacting the firm. PCAOB guidance to audit committees specifically suggests they inquire of their auditor about not only publicly disclosed (Part I) deficiencies, but any undisclosed quality control deficiencies from Part II of the PCAOB inspection report (PCAOB 2012). As a result, our period of interest for each Part II inspection report is the year in which the remediation 17

19 period ended. For example, Deloitte s 2008 (issued May 19, 2008) report has a remediation period that ends on or about May 18, Before the 12-month period ends, the audit firm may make a Rule 4009 submission concerning the ways in which the firm has addressed the PCAOB criticisms of the quality control processes (PCAOB 2006). The PCAOB then notifies the audit firm if it has appropriately addressed the concerns. The subsequent public disclosure of Deloitte s Part II report indicates the PCAOB determined its concerns were not appropriately addressed and the audit firm was then left with the task to address these comments prior to the end of the next remediation period or be subject to another publicly disclosed Part II inspection report. Since Deloitte likely did not want to have multiple Part II inspection reports publicly disclosed, we anticipate that the auditors substantially changed their practice and audit methodology prior to the next year. 16 The PCAOB suggests that, while an auditor is not required to remediate quality control issues, the public issuance of any continuing issues is an incentive for auditors to make changes to their internal processes (PCAOB 2006). As a result, we examine changes from the year-end prior to the end of the remediation to the year-end subsequent to the end of the remediation period in order to measure the impacts of the Part II inspection reports. Thus, we anticipate changes to financial reporting of tax accounts for Deloitte 2009 year-end clients. See further illustration in Figure 1. [INSERT FIGURE 1] 16 Concurrent literature investigates whether Part II inspection reports generate a negative market reaction to the audit firm s clients and whether clients dismiss their auditor as a result of these reports (Muriel 2013). As a result, numerous Part II inspection reports may lead to client dissatisfaction and provide the audit firms with an incentive to rectify the issues. Similarly, Nagy (2014) finds auditors suffer a decrease in market share after the public issuance of PCAOB Part II reports and Buslepp and Victoravich (2014) find that Part II reports of triennially inspected auditors are associated with a greater likelihood of undetected material errors and auditor resignations. 18

20 Testing Models To examine the association between changes in financial reporting for income taxes and the changes in response to a PCAOB Part II inspection report, we use the change in GAAP ETR ( GAAP ETR) and the change in UTB ( UTB) as our dependent variables and an indicator for Deloitte s 2009 clients as our independent variable of interest. The GAAP effective tax rate is defined as the total tax expense per dollar of pre-tax book income and is commonly used to identify whether changes in tax strategies or positions are being used to impact accounting earnings (Hanlon and Heitzman 2010). All else equal, an increase in this metric from year t-1 to year t captures an increase in tax expense, which we interpret as potentially less aggressive accounting and a reduction in the use of ETR to manage reported earnings. 17 To examine the association between auditor changes in response to criticism by the PCAOB and the client s uncertain tax position reporting, we use the change in the liability for uncertain tax benefits ( UTB) as our dependent variable and an indicator for Deloitte s 2009 clients as our independent variable of interest. We follow prior literature and scale UTB by lagged total assets (Hutchens and Rego 2013). Our interest is in the change in UTB from year t-1 to year t to capture the change in either financial reporting of UTBs, actual changes in uncertain tax positions, or both. Thus our dependent variable for the UTB tests is the change in UTB from year t-1 to year t scaled by total assets in year t-1. Therefore our change measure is only influenced by changes in the UTB account as we use a fixed scalar (total assets in t-1) versus using the change in the ratio of UTB over total assets from t-1 to t, which is influenced by both 17 Our focus is on the financial reporting changes that result from a change in auditor scrutiny after the PCAOB issues a report of deficiencies, therefore we choose to focus on a firm s GAAP ETR, rather than cash ETR which is a common measure of tax avoidance in the tax literature. In untabulated results, we find similar results to our GAAP ETR results using a cash ETR measure. 19

21 changes in the UTB account and changes in total assets. 18 Ceteris paribus, a decrease in this measure from year t-1 to year t indicates reporting lower levels of uncertain tax positions. Similar to GAAP ETR, an increase in this balance suggests more conservative accounting and potentially less earnings management via UTBs. As a result, we examine whether Deloitte s 2009 clients substantially change their financial reporting of tax accounts from 2008 to 2009 using the following ordinary least squares linear regression model (throughout the paper subscripts are suppressed for ease of exposition): (1) GAAP ETR ( UTB) = α 0 + β 1 * PartIIDeloitte + Controls + ɛ. Controls are defined below and fully defined in the Appendix. The coefficient β 1 captures the change in GAAP ETR (UTB) for clients audited by Deloitte in 2009 relative to the change in GAAP ETR for other firms in our sample. We examine Deloitte clients in 2009, the year in which we anticipate Deloitte altered audit behavior to remediate the concerns of the PCAOB. 19 We expect a significant coefficient on PartIIDeloitte (β 1 0) if increased auditor scrutiny impacts the financial statement reporting for income taxes. A negative coefficient on the Deloitte indicator would suggest that in the year subsequent to the PCAOB inspection Deloitte clients report a lower GAAP ETR (UTB). A positive coefficient would indicate an increase in GAAP ETR (UTB), consistent with more conservative reporting with the increased auditor scrutiny. Alternatively, if β 1 is insignificant, we interpret it to mean that the increased auditor scrutiny over tax reporting is not associated with a change in financial statement reporting of tax accounts. 18 Our results are robust to calculating the change in UTB as the change in the ratio of UTB to lagged total assets from year t-1 to year t 19 Deloitte received an additional Part II report from the PCAOB unrelated to auditing of income tax accounts in Our Deloitte Part II variable only captures the Part II report of interest, the report publicly issued October 17,

22 Control Variables In our change in GAAP ETR and change in UTB models, we include changes in determinants of GAAP ETR and UTB from prior literature, including size, profitability, foreign sales, discretionary accruals, leverage, research and development expense, market to book ratio, sales, selling general and administrative expenses, auditor expertise, property plant and equipment, equity income, net operating losses, and cash holdings (Cazier et al. 2009; McGuire et al. 2012; Hanlon et al. 2013; Christensen et al. 2013). All variables are measured as the change from year t-1 to year t and therefore a positive value represents an increase in the value while a negative value represents a decrease in the value. We also include a baseline lag level of GAAP ETR and UTB to control for the firm s initial level of ETR or UTB prior to any change. Lastly, we include year and industry fixed effects. 20 See the Appendix for a full list of variables and their construction. Sample Selection Our first sample (Part II sample) consists of all firms audited by an audit firm that receives a Part II inspection report, indicating the auditor did not appropriately remediate the concerns within a 12-month period. We expect the auditors change their audit approach to avoid the same issues in the following year. This limits our sample to firm s audited by Deloitte in 2009 and 2010, PWC in 2010 and 2011 and E&Y in This sample allows us to determine whether the observed effects are specific to changes made in response to Deloitte s 2008 Part II report or a general effect observed among all clients of auditors with publicly disclosed Part II reports. 20 In our Part II report sample, clients audited by Deloitte in 2009 are the only 2009 observations in the sample. Thus, for this sample, we include year indicators for the other years in our sample (2010 and 2011) to capture any specific year effects, but eliminate the 2009 indicator as it is perfectly collinear with our Deloitte Part II variable. 21

23 Our second sample (2009 sample) compares all firms audited by major audit firms in 2009 with those audited by Deloitte in This sample allows us to determine whether the changes in tax accounts for Deloitte s 2009 clients are in response to additional auditor scrutiny or if they result from an overall change in tax accounts for all firms in Our third sample (2010/2011 sample) includes all firms audited by major audit firms in 2010 and 2011, including those audited by audit firms that received a non-tax-related Part II report in those years. This allows us to examine whether the observed changes in tax reporting result from PCAOB Part II reports in general, or are instead influenced by the context of the report, in this case Deloitte s 2008 report identifying weaknesses in the auditing of tax accounts. 21 Within all samples, we eliminate all firms that do not have a calendar year-end. Anecdotal evidence suggest that most large-scale changes within an audit firm are mandatory for audit engagements with fiscal year-ends of December 15 th or later since this captures a substantial number of the engagements for that year. We acknowledge that auditors may implement changes prior to audits of calendar year end clients. Due to the inability to differentiate these engagements, we focus our sample on just those that are calendar year-end engagements. We believe that limiting our sample to calendar year-end firms provides us with a cleaner test of our hypothesis. Additionally, we eliminate all observations that do not have the necessary data to calculate the dependent and independent variables. We also eliminate any observations with a change in auditor between 2007 and 2012 to better isolate the auditor impact. This design choice allows us to specifically avoid a firm changing from a non-pcaob Part II auditor to a PCAOB Part II auditor in a later period, which allows us to more clearly isolate the auditor effect. Lastly, in our GAAP ETR sample, we eliminate all loss firms because losses 21 Recall that our study includes all annually inspected auditors ( Major audit firms ). Thus the 2009 and 2010/2011 samples include both Big 4 and other audit firms. Our results remain consistent if we restrict those samples to only Big 4 auditors. 22

24 impact the interpretation of ETR and loss firms have different financial reporting incentives. We retain loss firms in our UTB sample, but in untabulated results we confirm our results are consistent when loss firms are excluded. This results in a sample size of 2,248 observations for the Part II GAAP ETR sample and a size of 1,864 for the Part II UTB sample. 22 As noted above, we also construct 2009 (2,020 obs./1,730 obs.) and 2010/2011 (4,580 obs./3,828 obs.) samples to test our hypothesis. The sample selection is outlined in Table 2. [INSERT TABLE 2] IV. ANALYSIS OF RESULTS Descriptive Statistics and Correlations Table 3 reports descriptive statistics for the 2009 sample used for our GAAP ETR tests. Panel A provides the mean, standard deviations, and quartiles for the entire sample of firms in The mean for our primary variable of interest GAAP ETR is Thus, on average, firms in 2009 decreased their GAAP ETR by 0.69 percent. Since this value in itself is difficult to interpret across the entire sample, we partition the sample between Deloitte 2009 clients and clients of the other audit firms in 2009 to determine whether Deloitte clients, on average, had a statistically different change in GAAP ETR than clients of other audit firms in In Panel B, we note the Deloitte 2009 clients exhibit a increase in GAAP ETR while the remaining sample of 2009 firms has a mean decrease of Although this provides some evidence that clients subjected to additional auditor scrutiny on their tax accounts increase their tax expense in relation to earnings, the amounts are not significantly different from each other. Importantly, we do not note a significant difference in prior year GAAP ETR (lag GAAP ETR) between groups, 22 The UTB data is not well populated in COMPUSTAT, thus our UTB sample is smaller than our GAAP ETR sample. 23