The turnover of accounting firms at public companies slowed a bit in 2006, with 1,322 U.S. public companies disclosing they'd parted ways with their audit firms, including 66 companies that changed auditors more than once in the same year, according to a recent study.

Since 2002, with the fall of Arthur Andersen from the ranks of major audit firms, more than 6,500 companies have changed auditors, said Glass, Lewis & Co. in its research report. In 2005, 1,515 companies changed audit firms, indicating a slight slowdown in the rate at which companies switch firms.

Early changes in auditor have been attributed in large part to the demise of Arthur Andersen following collapses at Enron, WorldCom, and others. More recent changes, however, typically are tied to a shift toward mid-tier and smaller audit firms or changes to comply with independence rules that require more separation of tax and audit services. Investor advocates welcome more disclosure about auditor departures because they worry about whether a severed relationship might signal more veiled and nefarious motives, like disputes over accounting, fees, or potential fraud.

Glass Lewis says the majority of reasons are never disclosed, however. “Investors were left to guess the reasons for about three-fourths, or more than 1,000,” of the changes in 2006, the firm wrote in its report.

Mark Grothe, an analyst at Glass Lewis and author of the recent report, says the Securities and Exchange Commission slowly has been requiring more disclosure about changes in company-audit relationships over more than a decade, most recently with changes in Form 8-K that took effect in 2004.

For now, however, companies and auditors aren‘t required to say a great deal about why they’re parting, Grothe says. Grant Thornton is the lone accounting firm that has openly called on the Securities and Exchange Commission to take a more principled approach and simply require open disclosure about why a given company and its audit firm have split.

“I think there might be a perception that auditor changes aren‘t as big of a deal,” notes Grothe. “They aren’t necessarily on the front burner as far as regulators are concerned.”

Fornelli

Cynthia Fornelli, executive director of the Center for Audit Quality, says audit departure disclosure is not officially on the Center’s agenda, but it’s on the radar screen and may soon become more of a focus for the group, which is an extension of the American Institute of Certified Public Accountants.

“There are a number of reasons people could change auditor that have nothing to do with fraud,” sasy Fornelli. “When you know the reasons for changing auditors could be disclosed, that could be a deterrent in itself.”

Fornelli says she sees the potential for companies and auditors alike, not to mention shareholders, to benefit from increased disclosure. “Both sides are concerned about having their motivations misinterpreted,” she adds. “There can be terminations on both sides.”

While Fornelli says the overarching concept of increased disclosure is positive, she sees a number of potential problems in requiring it. She draws a parallel to the law surrounding human resources practices, which generally restrict what companies can say about departing employees because of concerns about libel, slander, and privacy.

“I’m not sure if the issues are directly parallel to a change in audit firm,” she says. “It’s different because it’s not an employer-employee relationship, but a service agreement. It’s certainly an item that should be explored.”

FIN 48: Modest Change For Large Companies

Early analysis of tax reserves suggests large public companies may only be mildly affected by new rules requiring more candid disclosure about tax uncertainties, but smaller companies may ultimately take a bigger hit.

FSA PRINCIPLES

Below is the conclusion to the not-yet-released study, “What can we learn about uncertain tax benefits from FIN 48?”

Financial Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, standardizes accounting for uncertain tax benefits and requires that companies disclose their tax reserves for unrecognized tax benefits. FIN 48 is effective for fiscal years beginning after December 15, 2006. FIN 48 provides incentives for asymmetric pre-adoption reporting, and we investigate whether firms report 2006 tax expense in ways unintended by the FASB. We consider whether firms release or build tax reserves during 2006 prior to FIN 48’s 2007 effective date. In small-sample analysis of 200 firms, reserve releases appear no more frequent or larger in 2006 than in 2005. Thus, we have no initial descriptive evidence that reserve changes appear generally different from prior years leading up to FIN48 adoption. We plan additional tests as we extend this research.

We also document the effects of FIN 48 adoption for 97 of the largest 100 calendar year, non-financial, non-regulated industry firms. The aggregate reserve of $82 billion is approximately two percent of assets. Of this amount, $57 billion would increase earnings if ever released. The aggregate change to reserves on adoption is only a $2 billion increase to stockholders’ equity, which is a relatively small adjustment compared to the total reserve. However, some companies had adoption effects in excess of 20 percent of the final reserve, and some reserves exceed five percent of assets.

Source: Jennifer Blouin, Cristi Gleason, Lillian Mills, and Stephanie Sikes, National Tax Journal.

A study under way for the National Tax Association suggests the top 100 public companies that are not regulated beyond the Securities and Exchange Commission are showing an aggregate reduction of $2 billion in tax reserves as a result of implementing the controversial Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes. FIN 48 requires companies to provide greater, more conservative detail where they may have uncertainty about benefits they are claiming in their tax returns with the Internal Revenue Service.

Mills

Lillian Mills, associate professor at the University of Texas at Austin and a co-author of the study, says tax reserves for the companies in the study totaled $82 billion, or 2 percent of assets. That’s the figure companies show for accounting purposes as an amount that might still be accessible to the IRS if agents were to successfully challenge all uncertain tax positions taken on tax returns.

The aggregate change in reserves of $2 billion represents an increase to stockholder equity, but Mills says overall it doesn't reflect a significant change. “I would have to characterize it as a modest aggregate change,” she tells Compliance Week. “In the aggregate, what companies were doing previously is pretty close to what the new standard required. In the economy as a whole, they were getting it pretty close to right.”

Mills says the study is still in draft form and is scheduled to be finalized and presented to the NTA in June; data is still outstanding for a few companies in the study group, she says. Mills expects the final results to show that while most companies fell along the average, a few standouts are reporting much bigger swings in tax reserves for both increases and decreases.

A decrease in tax reserves would suggest the company previously was taking a more conservative view of its uncertain positions than even FIN 48 requires, notes Mills. An increase, on the other hand, would suggest the company was taking a more aggressive view or simply faces a good deal more legitimate uncertainty as a result of changes in tax rules.

Mills cites changes in tax law that are just beginning to hit corporate books in 2006 where companies have some uncertainty about how rules and guidance ultimately will play out related to a deduction for domestic production activities. “To be fair, there can be uncertainty that’s not related to being aggressive in the sense that the IRS would view it as noncompliant,” she says. “The domestic activity deduction is a good example of that. It’s such a new law, and the guidance about exactly what the law requires is still very young.”

Bill Smith, director of the national tax office at CBIZ Accounting, says he’s hearing reports that proportionately the impact on tax reserves flowing through to shareholder equity may be greater for smaller companies than the NTA study is likely to show. Larger companies are more likely to be audited annually and perhaps even have an IRS agent on site.

“You‘re going to be a little less likely to take aggressive positions, and when you do, they’re probably [going to be] a little more carefully thought out and maybe even discussed with the agent,” Smith says. “If you don‘t have an agent on site and you’re not under constant audit (as with smaller companies), management has greater freedom to take positions that are not improper but more aggressive. It would make sense that a higher proportion of those positions are at smaller companies that are not under continual audit.”

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