A Carnaby Street for Taxes

New auditor conflict-of-interest rules send corporate clients scattering from the Big Four in search of smaller tax specialists.
Marie LeoneFebruary 16, 2006

It wasn’t by choice. Nevertheless, tax director Laurie Beaudet erased her auditor, PricewaterhouseCoopers, from a list of possible vendors for a tax project she planned to outsource. “It’s not the end of the world, but we did have to change our thinking about who to put out bids to,” recalls Beaudet, director of tax for metals processor and distributor Ryerson Inc.

Last year, Beaudet decided to outsource a FAS 109 (Accounting for Income Taxes) project to an outside firm, mainly because of a staffing-related issue. Although her six-person staff (including three tax managers) had the expertise, they didn’t have the time to focus on the matter; it would take a senior tax manager two to three months to complete, she estimated.

Usually, Beaudet would have included PwC on her request-for-proposal list because of the firm’s expertise and insider-like knowledge of Ryerson and the metals industry. But final auditor-independence rules issued by the Public Company Accounting Oversight Board (PCAOB) and awaiting approval by the Securities and Exchange Commission, will likely ban auditors from performing certain tax work for their clients. Beaudet thus wants to fill her list for such projects with other firms.

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Because PwC’s scope of work for Ryerson was limited by the new rules, Beaudet “was forced to build a new network” of specialists that could take on tax tasks that were either too time-consuming for the in-house staff or that required specialized knowledge that the staff didn’t have.

The limits put on PwC and other audit firms stem from Section 103 of the Sarbanes-Oxley Act, which directs the PCAOB to forge auditor-independence rules for registered public accounting firms. Those rules, which have been newly issued by the board, essentially fortify independence strictures for auditors and expand existing SEC rules, notes George Victor, the partner in charge of quality control at the Holtz Rubenstein Reminick LLP accounting firm.

He explains that four of the PCAOB’s auditor-independence rules relate specifically to tax services:

• Rule 3524, which mandates audit committee pre-approval before an auditor works on certain non-audit jobs. Those jobs include tax services that aren’t prohibited outright under Sarbox’s scope-of-service provision, Section 201.

• Rule 3521, which bans auditors from providing tax-planning services — including the development of tax shelters — on a contingent-fee or commission basis. The thinking is that a conflict of interest can arise if auditors’ fees are based on a percentage of tax savings.

• Rule 3522, which bars auditors from providing services related to “aggressive tax transactions.” Those are defined as schemes that are “more likely than not” to be disallowed by the Internal Revenue Service because their only purpose is tax avoidance.

• Rule 3523, which forbids audit firms from providing tax services to CFOs, CEOs, or other client-company officers who have roles in financial-reporting oversight.

Further, Sarbox 201 speaks directly to audit firms, banning them from engaging in, among other non-audit services, bookkeeping for audit clients. Generally, the section bars a company’s auditors from performing any tax accounting work done under FAS 109 (the standard covering income tax accounting).

Boon Town

In practice, the PCAOB’s new rules have moved some companies to switch from their Big Four auditors to other accountancies for non-audit work; the rules have also spawned a cottage industry comprised of boutique tax firms. For instance, Beaudet outsourced her FAS 109 project to Capital J Advisors, a specialized tax firm based in Chicago. According to Beaudet, the firm was “a very cost-effective way to get expertise.”

She notes that Capital J’s hourly rate exceeded those of public accounting firms, which would have likely dispatched lower-level accountants to the task. But Beaudet was looking for a higher-level tax expert for her project, and the Capital J rate was lower than what a full partner at a Big Four would have charged. “These aren’t the guys you hire to sit around and do tax returns,” says Beaudet. (Under the new rules, auditors can still prepare corporate tax returns for clients.)

The rise of new boutiques has also prompted the migration of Big Four partners to these smaller firms. Beaudet, a former KPMG tax accountant, explains that the corporate tax community is relatively small and close-knit. Increasingly, the corporate-tax-accounting community has been abuzz with tales of tax partners from public accountancies that have left to start their own specialty firms. Some of the accountant-entrepreneurs have felt constrained by rules that wouldn’t allow them to focus on challenging tax work, she says.

Indeed, Capital J is one example. Co-founder John Walsh is a former Ernst & Young tax consultant, while his brother and co-founder James Walsh was a consultant with Arthur Andersen’s audit and investment banking divisions.

A side effect of the PCAOB rules is that increasing numbers of high-net-worth individuals have been seeking tax help from midsized public accounting firms like Holtz Rubenstein. That’s because CEOs, CFOs, and other wealthy corporate officers that previously hired their company’s auditor for personal income tax work are barred from employing those auditors under the new regulations.

As tax deadlines approach, the companies most likely to outsource projects are those with relatively small tax departments that have complex tax issues to sort out. That includes companies like Ryerson that do business across state and international borders or have thorny FAS 109 issues.

Other tax issues that may require expert intervention include those involving purchase-accounting (stemming from acquisitions) and LIFO accounting, which focuses on inventory valuation for tax purposes. (The LIFO, or “last in first out,” methodology uses the most recent items purchased to establish a benchmark cost of the same items over a particular period of time.)

One challenge for a company switching to a new tax specialist is that the firm lacks an auditor’s experience with that specific client, Beaudet says. Hiring new outsourcers thus requires more staff time to get the newcomer up to speed. In a perfect world, she says she’d prefer simply to use the bidding process to “get the best person for the best price,” and eliminate the worry about whether the person is an auditor for her company.

In the larger scheme, however, she thinks that the process of finding new tax advisors has been “very positive.” While eliminated the possibility of conflicts of interest, it enabled her to build a network of specialists.

Indeed, the tax director says she had no troubles in finding vendors during her search. “We’re big enough that we are on [tax firms’] target lists. In other words, tax specialists empowered by the new PCAOB rules are courting companies like Ryerson, as well as the other way around.