Tax Non-Audit Services and Client Income Tax Estimation Error

Abstract

Theory suggests that accounting firms providing both audit and non-audit services to a single client can generate knowledge spillover or impair auditor independence through self-review or self-interest threats. Knowledge spillover (independence impairment) should manifest as better (worse) financial reporting quality within clients’ tax accounts. Prior research on tax non-audit services finds mixed evidence, and largely examines clients’ actual and potential tax-related material GAAP violations. We posit that auditors are likely to avoid these more extreme financial reporting outcomes due to reputation and litigation concerns, and re-examine this question using a more subtle measure of tax-specific financial reporting quality. We find that greater amounts of tax non-audit services are associated with greater estimation error in the tax account. This finding is consistent with the self-review threat impairing auditor independence, and is inconsistent with knowledge spillover. Inferences are robust to considering various potential sources of endogeneity. Additional analyses reveal that this relation is partially offset by auditor expertise, and concentrated in client-years where auditors face both self-review and financial self-interest threats. Our findings inform a recent public policy debate that questions whether one accounting firm should be permitted to provide tax services to its audit clients.

Keywords: audit quality; income tax estimation error; auditor-provided tax services; tax non-audit services

JEL Classification: M41; M44; M49