Auditor professional skepticism and deferred tax asset valuation allowance

Abstract

In response to calls for more research on whether auditors exercise sufficient professional skepticism when evaluating subjective evidence, we examine whether auditors are professionally skeptical toward their clients' estimates of deferred tax asset valuation allowance (VA). Our findings indicate that, on average, auditors are not sufficiently skeptical of VA estimates when assessing a client's going-concern status. Specifically, auditors tend to exhibit over-reliance on clients' VA estimates, relative to the VA's association with subsequent bankruptcy. However, auditors with industry or tax expertise, and those from Big 4 auditors exhibit greater professional skepticism toward the VA. In addition, using the collapse of Arthur Andersen as a plausibly exogenous shock, we find that successor auditors who took over former clients of Arthur Andersen demonstrate more professional skepticism toward the VA than Arthur Andersen did. Overall, our study suggests that auditors are overly reliant on management-provided estimates in going-concern decisions and offers potential channels for improvement.