Determinants and consequences of auditor‐provided tax services: A systematic review of the international literature

• Published date: 01 November 2021
• Author: Xuan Sean Sun,Ahsan Habib
• Date: 01 November 2021
• DOI: http://doi.org/10.1111/ijau.12244

ORIGINAL ARTICLE

Determinants and consequences of auditor-provided tax

services: A systematic review of the international literature

Xuan Sean Sun

1

| Ahsan Habib

2

1

Bryant University - BITZH program, Beijing

Institute of Technology Zhuhai, Zhuhai,

Guangdong Province, China

2

School of Accountancy, Massey University,

Auckland, New Zealand

Correspondence

Ahsan Habib, School of Accountancy, Massey

University, Private bag 102904 Auckland,

New Zealand.

Email: a.habib@massey.ac.nz

We review the empirical literature on the determinants and consequences of

auditor-provided tax services (APTS) and provide some directions for future research.

We first summarise two theoretical but competing perspectives on APTS provision,

namely, the knowledge spillover effect and the impaired independence effect. We

then review the evolution of APTS-related disclosures and regulations in selected

jurisdictions. Our review of the determinants of APTS suggests that such decisions

are related to the cost–benefit trade-off. We then review the literature on the

consequences of APTS. This strand of the literature in the United States supports the

knowledge spillover effect, but the findings in non-US settings are mixed. The market

perceptions of APTS in both the US and non-US settings suggest that market

participants react to APTS negatively during uncertain periods, whereas nonarchival

studies suggest that the perceptions of APTS vary between stakeholder groups and

with the types of APTS provided.

KEYWORDS

audit regulation, auditor-provided tax service, impairment of independence, knowledge

spillover, nonaudit services

JEL CLASSIFICATION

K33; M42; M48

1|INTRODUCTION

We provide a systematic literature review on the determinants and

consequences of auditor-provided tax services (hereafter APTS) in an

international setting, critique the findings and offer suggestions for

potential futureresearch in this area.

1

The well-known agencyproblem

between shareholders and managers demands auditing services to

provide independent assurance to corporatestakeholders that financial

statements prepared by managers comply with generally accepted

accounting principles (Agrawal & Chadha, 2005; Watts &

Zimmerman,1986). Therefore, auditor independenceis the cornerstone

of both audit quality and the auditing profession, as acknowledged by

international regulators and practitioners. For instance, the Interna-

tional Ethics Standards Board for Accountants (IESBA, 2018) requires

‘…professional accountants in public practice be independent when

performingaudit or review engagements’(Sec 400.1,p. 118).

IESBA (2018) explains two types of auditor independence: inde-

pendence of mind and independence in appearance. Independence of

mind is defined as ‘the state of mind that permits the expression of a

conclusion without being affected by influences that compromise

professional judgement, thereby allowing an individual to act with

integrity, and exercise objectivity and professional skepticism.’

(Sec. 400.5a). Independence in appearance is defined as ‘the

avoidance of facts and circumstances that are so significant that a

reasonable and informed third party would be likely to conclude that

a firm's or an audit or assurance team member's integrity, objectivity

or professional skepticism has been compromised’(Sec. 400.5b). The

former is also known as independence in fact, and the latter as

the stakeholders' perceptions of auditor independence. Academic

research struggles to provide direct evidence on the former and,

instead, uses various earnings quality proxies, for example, discretion-

ary accruals, accounting restatements and earnings conservatism, to

Received: 20 July 2020 Revised: 10 July 2021 Accepted: 14 July 2021

DOI: 10.1111/ijau.12244

Int J Audit. 2021;25:675–715. wileyonlinelibrary.com/journal/ijau ©2021 John Wiley & Sons Ltd 675

assess the presence or absence of such independence (e.g., Chung &

Kallapur, 2003; Frankel et al., 2002). With respect to independence in

appearance, archival research uses capital market-based measures to

capture perceived audit independence such as the market valuation of

accounting earnings (Francis & Ke, 2006; Ghosh et al., 2009; Krishnan

et al., 2005). Since being independent is necessary to ensure high

audit quality, we use ‘impaired independence’and ‘low audit quality’

as interchangeable terms for the remainder of the paper.

In the past two decades, the increased proportion of revenues

derived from providing nonaudit services (hereafter NAS) to audit

clients has raised significant concerns since high NAS might increase

economic bonding with clients and, hence, compromise auditor

independence (e.g., Agrawal & Chadha, 2005; DeAngelo, 1981;

Hermanson, 2009). This is also echoed by the US Securities and

Exchange Commission (SEC, 2003), which points out that the joint

provision of audit and NAS may reduce investors' confidence in

auditor independence and in the public capital markets. On the other

hand, the joint provision of audits and NAS may increase audit

efficiency, as the client-specific knowledge acquired from providing

NAS can be transferred to statutory audits, thereby enhancing

auditors' effectiveness and efficiency in performing audits. (e.g., Joe &

Vandervelde, 2007; Simunic, 1984).

In the meantime, the regulators noted that the beneficial versus

the detrimental effects of NAS on audit quality depend on the types

of NAS (SEC, 2003, 2014). In particular, the SEC (2002, 2003)

describes APTS as services that ‘…traditionally have been viewed as

closely related to audit services and as not being in conflict with an

auditor's independence’, thereby financial statements users would

view APTS more favourably than other types of NAS. As a result, in

the aftermath of some regulatory reforms, the regulators in several

jurisdictions, for example, the United States and the European Union

(hereafter EU), decided to prohibit certain types of NAS but continued

to allow auditors to provide APTS to their audit clients

(EU Directive, 2006; EU Regulation, 2014; SEC, 2003, 2006). Conse-

quently, APTS became the largest source of nonaudit revenues under

the current environment in several jurisdictions (e.g., Alsadoun

et al., 2018; Beasley et al., 2009; Chen et al., 2019; DeFond &

Francis, 2005; Dobler, 2014; Francis, 2006). APTS could be further

categorised into tax compliance and tax planning services. The former

generally refers to preparing, signing and filing a tax return for the tax

authorities, whereas the latter refers to a diverse range of services

that could help clients manage tax affairs efficiently and find

legitimate tax-saving opportunities. Therefore, firms' investment in

tax planning services could generate substantial benefits (Mills

et al., 1998) that tax compliance services cannot provide (Chyz

et al., 2021). In some extreme cases, firms adopt tax positions,

courtesy of APTS-induced tax planning, reducing their tax liabilities to

zero. Naturally, tax planning services are more damaging than tax

compliance services from the tax authority's point of view.

The empirical evidence, however, appears to be far less conclu-

sive. The extant literature generally suggests that the simultaneous

provision of audit and APTS by the same audit firm can result in either

a‘knowledge spillover benefit’or a potential ‘impaired independence

effect’(e.g., Alsadoun et al., 2018; De Simone et al., 2015; Gleason &

Mills, 2011; Kinney et al., 2004; Lisic, 2014; McGuire et al., 2012).

The proponents argue that APTS facilitate the verification of

tax-related accounts in financial statements by statutory auditors

(e.g., Francis, 2006; McGuire et al., 2012; Seetharaman et al., 2011).

Auditors evaluate the validity of accrued taxes payable and tax

contingent liabilities on the balance sheet, income tax expenses on

the income statement and the related note disclosures, in order to

provide adequate assurance to the investing public about the

appropriateness of these items and disclosures (Barrett, 2004).

Managers can use valuation allowances (Frank & Rego, 2006), tax

contingency reserves (Gupta et al., 2016), estimates of accrued taxes

(Dhaliwal et al., 2004) and the designation of permanently reinvested

earnings (Krull, 2004) to manage earnings. Material information about

risky tax transactions tends to be hidden in these accounts and

disclosures, thereby making proper auditing of tax accounts very

difficult for external auditors.

Since client-specific knowledge is more likely to be shared within

the same audit firm between the audit and tax departments

(Gleason & Mills, 2011), the provision of APTS helps statutory

auditors better understand clients' revenue-generating activities,

revenue-recognition policies, accounting implications of (uncertain)

tax positions and other tax-related activities, which could assist the

auditors in planning strategies: especially the tax-related ones. Such

knowledge sharing also benefits audit clients. For example, because of

their better understanding of clients' operations and structures and

their knowledge about the cutting-edge tax technologies, incumbent

auditors have competitive positions over other external tax consul-

tants as well as over clients' internal tax personnel, in reducing both

taxes paid and tax expenses for financial statements (e.g., Maydew &

Shackelford, 2007).

2

Despite the potential benefits from knowledge spillover, the

opponents of providing APTS argue that auditors may acquiesce or be

perceived as having acquiesced to clients' aggressive accounting prac-

tices in order to retain lucrative tax services (e.g., Mishra et al., 2005).

For instance, auditors might help clients manage earnings aggressively

to avoid taxes (Alsadoun et al., 2018; Armstrong et al., 2012; Klassen

et al., 2016). The regulators, too, have expressed concerns about

APTS threatening auditor independence and have banned certain

types of tax services that are more likely to impair auditor indepen-

dence (SEC, 2006).

3

Nevertheless, some audit firms continued to

provide some APTS that have been banned by the SEC. For example,

KPMG was charged by the SEC (2014) for the practice of loaning tax

professionals to audit clients, which violated the rule prohibiting

auditors from acting as an employee of clients. The SEC (2014)

affirmed that auditors must assess the independence threats of

providing certain types of NAS carefully, rather than just consider

whether the proposed services fall within one of the permissible

categories. These mixed results make our synthesis important not only

to regulators but also to academic researchers.

We choose a systematic rather than a structured literature

review. The advantage of systematic reviews lies in a ‘replicable,

scientific and transparent process that enables the researcher to

676 SUN AND HABIB

provide an audit trail, justifying his/her conclusions’(Tranfield

et al., 2003, p. 218). We adapt the Haapamäki and Sihvonen (2019)

and Gepp et al. (2020) approaches to collecting papers for inclusion in

this literature review, which combine both electronic and manual

searches. First, we performed an extensive search via the Scopus

database to identify potential studies published in accounting journals.

Pany and Reckers (1983) report the first study that investigated the

stakeholder's perception of APTS. Therefore, we restrict the journal

library search to papers published between 1983 and April 2021, with

a keywords search that includes ‘tax* service*’,‘auditor-provided tax

service*’,‘APTS’,‘tax NAS’,‘NAS’,‘nonaudit service*’,‘nonaudit

service*’,‘nonaudit fee*’,‘nonaudit fee*’,‘NAS fee*’,‘tax fee*’,‘tax

specialisation’, and ‘tax expertise’. We include APTS studies published

in nonaccounting journals as well (e.g., Journal of Corporate Finance)

to make the review comprehensive. To maintain the quality of this

review, we include only those journals listed in the 2019 Australian

Business Deans Council (ABDC) rankings.

4

The search process generated 346 papers with proposed

keywords from accounting journals. We then screened them manually

to identify papers that examine either determinants or consequences

of APTS by reviewing abstracts, hypotheses and empirical results

sections, and by tracking down references in those papers. We per-

formed the same methods to search for papers from nonaccounting

journals. This screening process resulted in 101 papers published in

business journals. To include the most recent research related to

APTS, we also included some high-quality working papers. Similar

to Harvey et al. (2016), we selected working papers (1) that have been

presented at top conferences, (2) that have been cited one or more

times by other published papers or (3) having at least one author in

the author team who has published one or more papers on this topic,

to maintain the quality of this review. This process yielded a total of

11 working papers.

Our final sample consists of 112 papers with an overwhelming

majority of the papers examining the consequences of APTS and only

20 papers examining the determinants of APTS. Table 1 displays the

journals' details and publication trends. As shown in Table 1, five

journals, namely, The Accounting Review;Contemporary Accounting

Research;Journal of Accounting,Auditing,& Finance;Auditing: A Journal

of Practice & Theory and The Journal of the American Taxation

Association; published more than 40% of the APTS research. A total of

41, 45 and 15 papers have been published in A*, A and B-ranked

journals, respectively. We also observe that there has been a

TABLE 1 Trend of publication: APTS studies

Panel A: Details of journals that

published APTS studies Rank N%

The Accounting Review A* 11 9.82

Contemporary Accounting Research A* 10 8.93

Journal of Accounting,Auditing & Finance A 9 8.04

Auditing: A Journal of Practice & Theory A* 8 7.14

The Journal of the American Taxation

Association

A 8 7.14

International Journal of Auditing A 6 5.36

Advances in Accounting A 5 4.46

Managerial Auditing Journal A 5 4.46

Journal of Accounting and Public Policy A 3 2.68

Journal of Accounting Research A* 3 2.68

Accounting and Business Research A 2 1.79

European Accounting Review A* 2 1.79

Journal of Accounting and Economics A* 2 1.79

Journal of Contemporary Accounting &

Economics

A 2 1.79

Journal of International Accounting,

Auditing and Taxation

B 2 1.79

Journal of International Financial

Management & Accounting

B 2 1.79

Review of Accounting and Fnance B 2 1.79

Review of Accounting Studies A* 2 1.79

The International Journal of Accounting A 2 1.79

Accounting Horizons A 1 0.89

Accounting Perspectives B 1 0.89

Advances in Taxation B 1 0.89

Asia-Pacific Journal of Accounting &

Economics

B 1 0.89

British Accounting Review A* 1 0.89

International Journal of Accounting &

Information Management

B 1 0.89

Journal of Applied Accounting Research B 1 0.89

Journal of Business Finance & Accounting A* 1 0.89

Journal of Business Research A 1 0.89

Journal of Corporate Accounting & Finance B 1 0.89

Journal of Corporate Finance A* 1 0.89

Meditari Accountancy Research A 1 0.89

Pacific Accounting Review B 1 0.89

Research in Accounting Regulation B 1 0.89

Spanish Journal of Finance and Accounting B 1 0.89

Total number of published papers 101 90.17

Working papers 11 9.83

Total 112 100%

Panel B: Yearly distribution of APTS studies

N%

1986–2005 10 8.93

2006–2010 14 12.5

(Continues)

TABLE 1 (Continued)

Panel B: Yearly distribution of APTS studies

N%

2011–2015 37 33.04

2016–2020 36 32.14

To April 2021 and In press 15 13.39

Total 112 100.0%

Abbreviation: APTS, auditor-provided tax services.

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