Last month, as the post-Enron audit-reform talks escalated, Bernard Wolfman warned Harvey Pitt, chairman of the Securities and Exchange Commission (SEC), that a Pandora's box of potential conflicts of interest can arise when an accounting firm provides tax products or advice to an audit client.
Bernard Wolfman is the Fessenden Professor of Law at Harvard Law School and one of the nation’s foremost experts on legal ethics in tax practice. This is not the first time Professor Wolfman has spoken out on this controversial and multi-faceted subject. But this time, he received a cordial reply from Robert Burns, chief counsel to SEC's Office of the Chief Accountant. Mr. Burns said the SEC will carefully consider Professor Wolfman’s input as it turns Chairman Pitt’s audit reform plans into a comprehensive and detailed proposal.
Potential Tax-Audit Conflicts
"There are broad and pervasive issues that the SEC needs to deal with," explains Professor Wolfman. In the letter he sent to the SEC, he outlined three hypothetical cases for further study. All three involve a CPA firm (Audit LLP) whose professionals are all CPAs and none are also lawyers.
- Case 1. Audit LLP provides the attest function for corporate client A. It sells a tax product to A for a flat sum of $100,000, telling A the product should save it $1 million in federal income taxes over four years.
- Case 2. Audit LLP provides the attest function for corporate client B. It advises B to write off $2 million of expenditures, although it recognizes that if B is audited by the IRS, the write-off will be disallowed and the expenditures capitalized as a result of the Supreme Court’s holding in the INDOPCO case.
- Case 3. Audit LLP provides the attest function to corporate client C and also advises client C on tax matters. Without consulting Audit, C purchases a tax product from another tax product huckster. The product is similar but not identical to the one Audit sold to A.
Do any of these cases present a conflict of interest for Audit LLP? Professor Wolfman believes a case can be made for answering "yes" to all three, if the taxes involved are material. The reasoning: In order to issue an audit opinion, the auditors must use their judgment regarding the accuracy of their client's reserve for taxes, and the facts in all three cases are likely to raise suspicions that Audit's tax role has affected its judgment.
The Case for Complete Separation of Audit and Tax Services
One possible fix suggested by others is to bar auditors from providing tax planning services to their clients. In fact, the SEC considered that solution when it drafted its auditor independence rules two years ago. But Professor Wolfman points out that in Case C, even this seemingly draconian measure would not suffice to prevent all potential conflicts of interests. The only totally effective solution, explains Professor Wolfman, is to provide for a complete separation of duties in which audit firms would not be permitted to provide tax products or tax consultative services at all.
Taking this line of reasoning to its logical conclusion, Professor Wolfman says, "Auditors should offer only the vital auditing service, and tax services should be provided by tax consultants -- lawyers or CPAs (whether or not also lawyers) -- who are not engaged in providing the attest function to anyone."