Auditor-Provided Tax Nonaudit Services and the Implied Cost of Equity Capital

Abstract

SUMMARY Although the Sarbanes-Oxley Act of 2002 (SOX) banned most nonaudit services (NAS), it did not restrict auditors from providing tax NAS to their audit clients. In the post-SOX period, regulators and investors are highly concerned about the increase in tax NAS and consequently calling for restrictions. The profession contends that tax NAS are beneficial to the audit and opposes limitations. We contribute to this ongoing debate and fill a void in the literature by examining investors' perception of auditor-provided tax NAS, as reflected in the implied cost of equity capital. Our results suggest that investors require higher cost of equity capital for clients that generate more tax NAS revenue for their auditor's office. Further tests reveal that our main finding is driven by audit clients that report more uncertain tax reserves (higher tax risk), rather than clients that exhibit poor financial reporting quality. The effects we document are economically significant and robust to a large battery of sensitivity tests. Our findings suggest that investors seem to negatively perceive tax NAS because of punitive and cash flow risks associated with tax NAS. Data Availability: All data are publicly available from sources identified in the text.