Enron Reopens Pandora's Box of Tax-Audit Conflicts

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."

Related links
Could Enron Collapse Lead to Big Five Losing Tax Work?

-Rosemary Schlank

You may like these other stories...

Did you ever feel as if you're preparing taxes in the Twilight Zone? You may be more right than you think. Each year, professional preparers all over the country have to work in a shadowy reflection of the normal tax...
The split over convergenceDavid M. Katz of CFO wrote an interesting article on Thursday about the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) backing away from their...
World Health Organization backs higher tobacco taxes to cut smokingThe World Health Organization (WHO) approved guidelines on Wednesday urging countries to increase cigarette taxes to help discourage smoking, wrote Martinne...

Already a member? log in here.

Upcoming CPE Webinars

Oct 21Kristen Rampe will share how to speak and write more effectively by understanding your own and your audience’s communication style.
Oct 22This webinar will include discussions of important issues in AU-C 800, Audits of Financial Statements Prepared in Accordance with Special Purpose Frameworks.
Oct 23Amber Setter will show the value of leadership assessments as tools for individual and organizational leadership development initiatives.
Oct 30Many Excel users have a love-hate relationship with workbook links.