The Cost of Independence: Evidence from Companies’ Decisions to Dismiss Audit Firms as Tax-Service Providers

Abstract

This study examines whether companies’ decisions to dismiss or substantially reduce reliance on their audit firms as tax-service providers in the wake of the Sarbanes-Oxley Act affect tax avoidance. We hypothesize that decoupling audit and tax-service provision and subsequently obtaining tax services from a new provider can result in decreased tax avoidance because the new provider lacks familiarity with client’s existing tax planning or does not have the expertise to generate new tax-avoidance opportunities. Consistent with our hypotheses, our results reveal that sample companies’ book (cash) effective tax rates increased by an economically significant 1.36 (1.63) percentage points in the year after terminating or substantially decreasing purchases of tax services from their audit firms, and discretionary permanent book-tax differences declined significantly. We find that decreases in tax avoidance were larger for companies whose outgoing tax-service providers were tax-specific industry experts. When (1) we examine companies that appointed or substantially increased reliance on their audit firm as tax-service providers and (2) we re-estimate our models in a subsequent period when dismissal decisions were unlikely to stem from regulatory reforms, we do not find an effect on tax avoidance.

Keywords: Auditor Independence, Auditor-Provided Tax Services, Tax Fees, Tax Avoidance