Accounting regulators have drawn an historic line in the sand between audit and tax services, giving accounting firms another reason to act cautiously when providing tax services to audit clients.

THE RULES

Independence, Taxes

PCAOB Rule On Independence, Tax Services, Contingent Fees

Related Briefing Paper On Independence Rules

Questions? Contact PCAOB Assistant Chief Auditor Bella Rivshin, (202) 207-9180

Remediation

PCAOB Rule On Remediation Of Material Weaknesses

Related Briefing Paper On Remediation

Contact PCAOB Associate Chief Auditor Laura Phillips, (202) 207-9111

PCAOB Statements

Statement By PCAOB Chairman William McDonough

Statement By PCAOB Member Kayla Gillan

Statement By PCAOB Member Daniel Goelzer

Related Coverage

Should Boards Be Told Of PCAOB Auditor Probes? (July 2005)

PCAOB Posts Additional Audit Firm Inspection Reports (July 2005)

June 2005 Internal Control Report: All About Remediation (July 2005)

As expected, the Public Company Accounting Oversight Board last week finalized ethics and independence rules that spell out specific guidelines for where tax services may and may not be offered to audit clients to assure auditor independence is not compromised.

Separately, the PCAOB adopted a new standard that allows audit firms, if they choose, to issue opinions on management assertions that reported material weaknesses have been corrected. Previously, audit firms had no standard to follow on issuing opinions outside the context of the annual audit.

The new ethics and independence rules bar audit firms from three situations:

Setting contingent fees for tax services;

Providing tax services based on confidential transactions or aggressive interpretation of tax rules; and

Providing tax services to management members (or their immediate family) who have a role in financial reporting.

In addition, the new rules define the approval process an audit firm must pursue with a client’s audit committee when proposing allowed tax services; the rules also define the personal responsibility of representatives of the audit firm to assure the firm’s independence.

A Higher Standard

The PCAOB sifted through more than 800 comment letters before finalizing the proposal, and bent to comments on two specific issues, according to observers. Carl Duyck, a tax partner at PricewaterhouseCoopers, said the Board changed the bar on what it considered inappropriate behavior on the part of an individual who might cause a violation.

As proposed, the rules viewed even an inadvertent violation as cause for action, but the Board modified the final rule to indicate a more reckless or deliberate violation would be necessary to trigger disciplinary action, he said. “The board initially proposed a low standard, but moved it to a higher level in the final rule,” Duyck said.

The Board also modified its pre-approval process to eliminate the requirement that a company’s audit committee review engagement letters for the auditor’s proposed tax services. Comment letters protested that it would result in excessive administrative burden on the audit committee because engagement letters would be numerous and lengthy.

“With a global company, there could be 50 to 100 different tax projects, and that means 50 to 100 engagement letters,” Duyck said. The Board recognized that “the audit committee’s time is valuable and they did not intend to bury the audit committee in paper.”

Under the new rule, the audit firm must provide a description of the service to the audit committee, discuss how the service could or could not hamper independence, and document the discussion. “The idea is that they want the dialogue between the auditor and the audit committee on those things that are relevant to the audit,” Duyck said.

The Center for Public Company Audit Firms, which is an arm of the American Institute of Certified Public Accountants, and other commenters lobbied the PCAOB unsuccessfully to allow more tax services to management members.

In an alert to members, CPCAF Director Lillian Ceynowa wrote: “Some Center members … believed that the performance of tax services for the audit client’s individuals in a financial reporting oversight role would not result in a threat to the auditor’s independence. Tax services to individuals in a financial reporting oversight role have been a mainstay of the tax practices of a majority of the Center’s members without creating independence problems for many years.”

Ceynowa reminded accountants that there is still a good bit of tax service that can be provided under the new rules. Permitted services, she said, include routine tax return preparation and tax compliance, general tax planning and advice, international assignment tax services, and employee personal tax services except as specified with regard to management members.

Tax Planning vs. Avoidance

At least one tax expert, however, worries that the language of the new rules will put a significant damper on tax planning services. Mike Metz, executive vice president of tax for RSM McGladrey, said the rule language casts a pall an what has otherwise been regarded as conventional tax planning strategy—that of accelerating deductions and deferring income to defer tax obligations into a future tax payment period.

In defining the term “tax avoidance” as it relates to prohibited aggressive tax services, the PCAOB rule says “The term ‘tax avoidance’ should be understood to include acceleration of deductions into earlier taxable years and deferral of income into later taxable years.”

Metz said that definition seems at odds with the tenets of traditional tax planning services, which the new PCAOB rules specifically permit. “This is not tax avoidance,” Metz said of the acceleration and deferral tactics. “This is purely a timing issue.”

He questions whether audit firms now will feel confident providing traditional tax planning services to audit clients when the PCAOB rules take such a position on the acceleration-deferral strategy. “I think more companies will look outside their audit firm to do their tax planning work,” he said, a trend he described as already well developed as a result of Sarbanes-Oxley.

Anne Marchetti with Parson Consulting said the shift is well under way and that the new rules represent what has already become standard practice for most audit firms and public companies. “These rules really formalize processes that companies have already informally adopted,” she said.

Remediation

On material weakness reporting, the PCAOB adopted Audit Standard No. 4, establishing requirements and providing direction for auditors who are asked to report on whether a previously material weakness in internal controls continues to exist. It allows auditors to weigh in their judgment when management wants to report somewhere mid-year that they’ve corrected a material weakness they disclosed during annual reporting process.

The Board adopted the rule essentially as proposed in December, Marchetti said. She described the new standard as simply the penning of a logical provision. “Anything they can give us in black and white adds clarity and drives us toward overall compliance,” she said.

The new rules, briefing papers, statements, and related articles are all available from the box above, right.

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