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July 15, 2002
Auditors: Stick to Your Auditing Reform
By Bernard Wolfman

ARLINGTON, VA, JULY 15, 2002: The United States Senate is about to pass a bill called the Public Company Accounting Reform and Investor Protection Act of 2002. If it becomes law, that will be good, but for two reasons it will not be good enough. The bill is designed to eliminate auditor conflict-of-interest but it fails to achieve its goal in two major respects.

First, because an auditor of public companies should have only one focus, only one group to whom it dedicates its fidelity and service, to the public investors and not to the company it is auditing, the bill wisely prohibits an auditor from rendering nonaudit services to its audit clients. By way of example it lists a number of such nonaudit services, including "legal services and expert services unrelated to the audit," services that are commonly referred to as "consulting." It is regrettable, however, that the bill expressly permits an auditor to provide tax services if the corporation's audit committee gives its approval. Tax advice and tax planning are, of course, designed to save the company taxes, and often do, most of the time legitimately, sometimes questionably or illegitimately. The line between the legitimate and the questionable is sometimes clear and sometimes fuzzy.

Tax shelter plans are sold to companies for big dollars, and with justification the IRS will often disallow them when it can find them. Investors and their financial advisors should be able to know from looking at a company's financial statement whether the auditor believes that the tax shelters in which the company has invested are vulnerable. If the auditor thinks they are vulnerable, the auditor should make sure that the company's reserve for taxes is large enough to account for the additional taxes the company may have to pay if the IRS disallows the shelter. At the least, the possibility should be noted in a footnote to the financials. No auditor who has sold a company a tax shelter or other tax minimization plan should audit that company because clearly the auditor would be conflicted. The auditor would be in the position of having either to indicate the plan it sold the client was vulnerable or to hide something from public investors that they need to know. This conflict should not be subject to waiver by the company's audit committee, just as the prohibition of an auditor's rendering non-tax expert services may not be waived. Too much is at stake to allow otherwise, and the bill should be amended to correct this flaw.

Second, under the bill, auditors would be prohibited from delivering consulting services to their audit clients, but they would be allowed to perform these services for all others. On the surface, but only there, that sounds reasonable. A serious problem, however, lies in the fact that the Big 5 accounting-consulting firms are dominant when it comes to the audit of public companies. The Big 5 audit more than 90 percent of them. Moreover, all five sell essentially the same types of consulting services and products. And so, for example, if Deloitte and Touche audits Coat Co. and sells a tax shelter plan to Hat Co., audited by KPMG, there would be no violation of the proposed law. But to allow that result would be naive at best because Arthur Andersen or Ernst & Young or KPMG or PwC has sold Coat Co. a tax shelter similar in all major respects to the one that Deloitte sold to Hat Co. It would, therefore, be highly unlikely, indeed bizarre, for Deloitte to require Coat Co. to footnote the vulnerability of the plan it bought from, say, PwC, when Deloitte has been marketing the same kind of plan to Hat Co. as well as to every other company that it does not audit. The reality is that conflict-of-interest is present whenever a public company auditor renders nonaudit services to anyone, not just to its audit clients.

The bill about to pass the Senate should be fortified by an amendment that (1) would include tax services among the nonaudit expert services prohibited to auditors, and not allow the prohibition to be waived by an audit committee just as all other nonaudit expert service may not be waived, and (2) would prohibit an auditor from performing nonaudit services for anyone, not just to its audit clients, requiring auditors to stick to their auditing.

Bernard Wolfman is Fessenden Professor of Law at Harvard Law School, where he teaches and writes on federal income taxation and standards of tax practice. Wolfman 's article appears in the July 8 issue of TAX NOTES magazine, a weekly magazine covering federal, state, and international tax issues.

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Media Release 2002-5