Public Company Accounting Oversight Board
Published on May 10th, 2003 by J.T in MoneyIn a day or two, I will be posting my comments on Mike Brewster’s article, which follows below, about what the Public Accounting Oversight Board should do.
Tax ’services’ must be challenged
Commentary: Accounting board should confront Big Four
By Mike Brewster
Last Update: 12:06 AM ET May 6, 2003EDITOR’S NOTE: Mike Brewster is author of the recently released “Unaccountable: How the Accounting Profession Forfeited A Public Trust.”
NEW YORK (CBS.MW) — For the first time in 70 years, auditors won’t be writing the rules that govern public company audits.
Late last month the SEC officially recognized the Public Company Accounting Oversight Board (PCAOB), the new accounting watchdog formed under the Sarbanes-Oxley Act.
The PCAOB now has the right to set auditing guidelines, mandate that auditors aggressively search for corporate fraud, and sanction wayward auditors and accounting firms.
But, ironically, the real barometer of how aggressive the PCAOB and its incoming chairman, William McDonough, will be in their quest to repair the state of the accounting has more to do with tax shelters than auditing.
Tax work makes up roughly one-third of the revenues at the Big Four accounting firms.
These tax services fall under two general rubrics: tax compliance — basically filing tax returns for companies and individual corporate executives — and the far more lucrative tax planning services.
It turns out that accounting firms make a perfect foil for companies looking to push the regulatory envelope in terms of corporate tax savings. Management can say that their tax strategies were hatched not by its internal tax team, but rather by its high-priced, expert accountant, which at once deflects responsibility and gives the shining veneer of outside legitimacy.
The Big Four firms employ attorneys and accountants who couldn’t audit a lemonade stand, but instead have developed specialties in state, federal, and international taxation. This below-the-radar screen army of tax experts has been working for the past 20 years to dramatically lower the rate of corporate taxation in this country.
The mechanics
It works like this: Company A, tired of seeing its competitors post much higher earnings due to their low tax exposure, hires a Big Four firm to devise tax strategies to get its worldwide tax rate down from, say, 39 percent to 35 percent. The accounting firm then offers a menu of tax mitigation strategies ranging from ideas as straightforward as contributing more to local charities to as complex as pulling entire corporate operations out of high-tax countries. The client’s corporate tax department then picks and chooses which strategies it wishes to incorporate, often based on which ones will — when implemented — make the fewest headlines.
Depending on the company, this could save tens of millions or even hundreds of millions of dollars in taxes each year. And soon — voila! Significantly lower tax liability translates into a better bottom line and a higher stock price.
Until recently, companies employing aggressive tax planning didn’t have to worry much about unwanted attention. For one thing, companies don’t need to discuss their tax philosophy or particular tax strategies in annual reports; simple disclosure of the overall effective tax rate is all that is required.
In addition, because the impact of many complicated international tax shelters spreads the pain around the various countries in which a company operates, it’s been hard to get any one government or locality that upset about their falling tax revenues. Third, the drive to implement overtly aggressive corporate tax mitigation strategies has ramped up only since the late 1990s, when pressures to increase revenue and hit the stock price goal became all consuming. In fact, for many years, many of America’s biggest industrial companies — organizations like IBM, General Electric, and General Motors — wore their enthusiasm for ponying up big tax dollars as a badge of honor, evidence of patriotism on par with a “Made in America” bumper sticker.
From 1960 through 1989, for example, the effective state corporate tax rate rapidly increased in the United States, almost doubling. Now, the contribution of corporate tax revenues to state coffers is currently about the same level as it was in the 1970s.
But the biggest story is at the federal level. In 1991, the relationship between corporate book income and corporate taxable income was approximately equal. By 1996, corporate book income was 40 percent higher than corporate taxable income. In real dollars, that equates into a decrease of 10 percent in the federal corporate tax base. That’s a lot of expensed client dinners. And a lot of corporate profit taken off the table.
Lost effects
The effects of the loss of tax revenue are evident everywhere today.
Particularly at the state level, where capitols from Albany to Austin are running huge deficits, government officials have been highlighting their deteriorating tax bases. Much of that ire has been directed toward the global accounting firms, who have obviously made themselves an easy target because of the deterioration of their core product, the audit.
Now that it is apparent just how egregiously the big accounting firms let lucrative consulting services dominate the resources and attention of their best partners in the 1990s, the gaze of regulators and Congress has turned to tax services.
Right now it’s an open question as to whether the PCAOB will see these services for what they truly are: consulting services that, if performed for an audit client, can cause an enormous conflict of interest.
After all, how is the lead partner on an audit engagement supposed to call a management team to task on its lax financial statements if what she’s really concerned about is her firm’s multi-million dollar tax project that dramatically reduces the reported revenues on those very same financial statements?
The PCAOB must consider two questions as it grapples with the tax service issue: do the most aggressive of these cutting-edge tax shelters, even if deemed legal by Congress, really produce a fair result in terms of the public good? In the event PCAOB answers this question with a “Yes,” it then must consider classifying these tax services in the same family of consulting services that were barred by Sarbanes-Oxley.
Back in 2000, the global accounting firms successfully convinced Arthur Levitt that tax work was integral to doing a good audit. But in the wake of Enron, WorldCom, Global Crossing, Tyco, Ahold and HealthSouth, this line of reasoning has been completely fallen into disrepute.
The keys to performing a rigorous audit are integrity, professional skepticism, and good auditing standards applied intelligently — not extraneous information gathered from consulting or tax projects.
It’s instructive to remember that Enron had not paid any federal corporate income tax for several years before its bankruptcy.
If an accounting firm has provided tax services so aggressively that its client reports no taxable income, that circumstance might be a good indication that other shenanigans are going on at the company as well.
