Tax reserves, auditor-provided tax services and FIN 48

Abstract

This study examines two types of consequences of FIN 48, the effect of FIN 48 on firm value and the effect of FIN 48 on audit fees, and shows that these consequences depend upon the size of the firm. Firm size and the role of the auditor are generally ignored in previous FIN 48-related studies. Because of different tax audit risks faced by firms of different sizes, I expect and find that FIN 48 affects firms or different sizes differently. After the adoption of FIN 48, the value relevance of tax reserves decreases for large firms but does not significantly change for medium and small firms. I also find that firms pay additional audit fees following FIN 48 and that the increase depends upon the size of the firm and the extent of tax services provided by the auditor. In addition, auditor-provided tax services mitigate the extra audit fees that firms with more tax reserves need to pay in the post-FIN 48 period. This study also investigates the effect of auditor-provided tax services on earnings management through tax reserves. I find that the auditor who provides more tax services facilitates large firms' earnings smoothing in the post-FIN 48 period, providing clear evidence of impairment of auditor independence due to tax services. This behavior does not exist within medium and small firms, arguably because the auditor does not compromise independence for less important clients.