Which of the following is an allowable service that an auditor may provide to a public client?

EXECUTIVE SUMMARY

THE PASSAGE OF SARBANES-OXLEY LEFT MANY TAX practitioners wondering where they fit in under these new rules. The act did not list most tax services as one of the prohibited nonaudit services but said firms could perform such functions for audit clients with audit committee approval. THE ACT INCLUDES A LIST OF PROHIBITED NONAUDIT services auditors cannot perform at the same time as the audit under any circumstances. These include bookkeeping, internal audit outsourcing, temporary or permanent work as an employee, officer or director, legal services and others. There are some circumstances where certain tax work is a prohibited nonaudit service but it isn’t clear when other tax services are prohibited. THE SEC RULES DO NOT GIVE DEFINITIVE GUIDANCE on how audit committees should determine whether a tax service is an allowable activity requiring preapproval or a prohibited nonaudit service that even preapproval could not save. The rules say only that tax compliance, planning and advice are acceptable once they are preapproved. UNDER THE SEC RULES, CPAs WILL BE ALLOWED TO provide tax-minimization services to audit clients, except for transactions that have no business purpose other than tax avoidance. This essentially prohibits the sale or promotion of so-called tax shelters. It still isn’t clear who will determine whether a transaction has no business purpose. AS SPECIALTY PARTNERS, TAX PRACTITIONERS GENERALLY are exempt from the new mandatory partner rotation and time-out rules under Sarbanes-Oxley. They also are excluded from the rules that say compensating partners for procuring nonaudit services for the firm impairs their independence.

THOMAS J. PURCELL III, CPA, PhD, is associate professor of accounting and professor of law at Creighton University in Omaha, Nebraska. He is vice-chairman of the AICPA tax executive committee. His e-mail address is . DAVID LIFSON, CPA, is a partner with Hays & Co. LLP in New York City. He is a member of the AICPA board of directors and past chairman of the tax executive committee. His e-mail address is .

n response to the public outcry for enhanced investor protection, Congress enacted the Sarbanes-Oxley Act of 2002. Among other things it created new penalty and enforcement powers for the SEC—which subsequently issued audit rules—expanded the accountability of CEOs and CFOs for financial statements and enhanced audit committee responsibilities. The act’s primary focus, however, was on regulating auditors and audit firms serving public companies. It created the Public Company Accounting Oversight Board (PCAOB) and gave it responsibility to regulate accounting firms and set auditing standards. The act also mandated stricter audit engagement personnel rotation and changes to professional ethics standards to avoid actual and perceived conflicts of interest. In perhaps its most controversial section, the act included new independence rules that prohibit firms from providing audit clients with certain nonaudit services and required audit committee preapproval of all other such services.

The new SEC rules leave some tax practitioners wondering where they fit in. On its list of prohibited nonaudit services, the act did not include tax services but said firms could perform such services for audit clients with audit committee approval. This article discusses the impact on tax practice of the SEC rules to implement Sarbanes-Oxley. It covers the guidelines for nonaudit services, including some questions that remain unanswered. It also addresses nonservice issues (such as partner rotation) and concludes with some observations about the next steps CPA tax practitioners should consider taking.

BACKGROUND While Sarbanes-Oxley and subsequent guidance apply only to CPAs auditing the financial statements of “issuers,” many practitioners have very real concerns about the reaction of state legislative and regulatory bodies to the SEC rules implementing Sarbanes-Oxley. These rules have significantly affected the ability of CPAs to provide nonaudit services to audit and attest clients in public companies. The so-called cascade effect, in which state legislatures apply independence provisions similar to Sarbanes-Oxley to audits, reviews, compilations and related attest services for privately held companies, is a very real concern for the private sector and their CPAs. The AICPA endorsed many of the corporate governance changes Sarbanes-Oxley mandated for public issuers. However, a number of these changes would be inappropriate and even counterproductive if imposed at the state level on all corporate entities—both public and private. Several state legislatures are considering bills that would extend provisions similar to Sarbanes-Oxley to CPAs auditing private companies. For the most recent status of this activity and how they might be part of the dialogue in their home states, CPAs should go to www.aicpa.org/statelegis/index.asp .

The AICPA tax section includes 23,000 AICPA members who practice in the area of tax. According to a national survey by the Texas Society of CPAs, tax services were the source of between 48% and 52% of all fees for the different categories of accounting firms participating in the survey. Source: AICPA, www.aicpa.org ; Texas Society of CPAs, www.tscpa.org .

In implementing the rules, public companies will incur substantial costs of separate corporate governance/monitoring systems (audit committees with independent members) as well as higher fees for acquiring nonaudit services from accounting firms other than their auditors. Many private clients say the cost of segregating advisers far outweighs any benefit from apparent enhanced corporate governance. These clients do not want to lose the valuable nonaudit services their independent CPAs regularly deliver using knowledge gained in the annual attestation engagement. Although many CPA firms are already adjusting to the need to segregate services to avoid violating GAO and SEC independence standards, it’s clear all firms will be forced to change if states extend these rules to attest engagements for private companies.

PERMITTED NONAUDIT SERVICES With only a few exceptions, the rules do not specifically mention tax services in the list of prohibited nonaudit services (see “ Prohibited Nonaudit Services ” ). CPAs can do transfer pricing, cost segregation studies and tax-only valuations, as long as the results are not subject to audit procedures as part of the financial statement audit. Apparently CPAs can offer comments on the qualifications of candidates for senior executive positions when asked by the company to do so without specifying a preference and provide tax advice on compensation packages. But there still are many open issues related to tax services the rules might consider prohibited nonaudit services.

The new SEC rules do not give CPAs definitive guidance on how audit committees should determine whether a tax service is an allowable activity requiring preapproval or is a prohibited service even preapproval cannot save. The only guidance is in a footnote, where the SEC says merely labeling a service as tax does not preclude it from being a prohibited nonaudit service.

In the discussion accompanying the rules, the section on tax services says CPAs can continue to provide them for audit clients. Examples of allowable services include compliance, planning and advisory engagements. The rules do not limit allowable services to federal or state income tax issues. However, representing the client in a tax, district or federal claims court is specifically designated an impairment of independence. In addition, the discussion cautions audit committees to carefully analyze transactions that may resemble so-called tax shelters.

TAX SERVICES
An area of uncertainty is how to resolve the potential nonaudit/tax services overlap. Some tax-related nonaudit services that are compliance, planning or advisory in nature might arguably be included in one of the prohibited nonaudit services; even audit committee preapproval would not prevent providing them from being an impairment of independence.

The rules do not give CPAs definitive guidance on how audit committees should determine whether a tax service is an allowable activity requiring preapproval or is a prohibited service even preapproval cannot save. The rules the SEC initially proposed put the burden on the accountant and the audit committee by referring to whether the auditor would be auditing its own work, acting as management or as an advocate. The rules the SEC issued as final keep this language but provide no new standards to help the audit committee, other than reiterating that tax compliance, planning and advice are acceptable once preapproved. The rules say the audit committee must preapprove all “permissible” (nonprohibited) nonaudit services. Recent SEC guidance says the committee’s preapproval procedures must be detailed as to the services it is approving and not result in the audit committee’s delegating its responsibilities to management.

The only guidance is in footnote 111 to the rules, where the SEC says merely labeling a service as tax does not preclude it from being a prohibited nonaudit service. This addresses obvious sham situations but not legitimate overlaps. There is evidence some audit committees are resolving such overlaps by treating all nonaudit services as prohibited. By not providing clearer standards, the SEC opened up the possibility companies will apply the rules to tax-based nonaudit services inconsistently.

Here are some nonaudit services CPAs customarily provide in their tax practices that should be acceptable under the rules:

Payroll, sales, property, state income, federal income and other tax-compliance services, even though the audit firm reviews the client’s work that becomes part of the financial records through the recording of a liability.

Traditional tax planning services, such as where the CPA prepares an analysis of a transaction (lease vs. buy) and the client uses the CPA’s work product to develop the appropriate financial accounting entries.

Analysis of client records (with recommendations for redesign) to determine strategies for minimizing state and local income, sales, property and payroll taxes.

Appraisal services undertaken for tax-compliance reasons (such as assigning values to intangible assets under IRC section 197, calculating gains on distributions of assets to shareholders under section 311, valuing assets and liabilities for a section 338 election, implementing mark-to-market values under section 475 and allocating purchase prices under section 1060), even though the company uses the derived values in part for financial statement purposes.

Tax-consulting engagements that examine, for example, the efficiency of internal tax departments, procedures used to protest state and local property tax valuations or state income tax studies.

“Loaning” tax staff or supervisors to an audit client for special projects or short-term personnel emergencies.

Designing or commenting on the tax aspects of a compensation package for specific individuals or the general management staff of the audit client—for example, reviewing the applicability of antidiscrimination provisions of IRC section 132 and the reasonable compensation and incentive compensation provisions of section 162(m).

Meeting with prospective candidates for the tax director or CFO position to discuss the tax issues the company faces.

Recommending that controlling shareholders sell their stock to an ESOP to take advantage of IRC section 1042; advising a client to consider an ESOP as part of a benefits package (or, if an ESOP already exists, that a client sell additional shares to it); or recommending that an estate sell its stock in an audit client to use the provisions of IRC section 303 or to otherwise efficiently administer the estate.

Representing the audit client in IRS exams, sales tax proceedings, state income tax audits, payroll tax audits, local government property tax proceedings and the like.

Helping an audit client prepare requests for a ruling or changes in accounting periods or method or for determination letters on various issues from the IRS or other administrative agencies.

TAX SHELTERS
One of the most controversial aspects of the Enron collapse was the alleged involvement of the company’s independent auditor in marketing aggressive tax planning ideas the IRS and the courts subsequently found to be abusive. The Congressional Record , the SEC rules as originally proposed, public comments on those rules, the final rules and public comment since the SEC adopted them are replete with statements about the negative impact of all tax-shelter and tax-advisory activity, including abusive shelters, on auditor independence. Although we are unaware of empirical or other evidence that the combination of attest services and tax activity in fact impairs independence, the potential for and appearance of such impairment does exist, especially where the tax strategies have no legitimate business purpose.

The rules the SEC originally proposed had listed “formulation of tax strategies (tax shelters) designed to minimize a company’s tax obligations” as an impairment. In its comments on those rules the AICPA noted that tax-minimization strategies can lower the cost of capital, increase free cash flow, make more funds available for dividend distributions, raise aftertax earnings per share and generally result in greater value for a corporation’s stockholders. The AICPA suggested CPAs be allowed to provide tax-minimization services to audit clients, except for transactions with no business purpose other than tax avoidance (unless consistent with applicable tax laws). The rules the SEC issued as final substantially adopted the AICPA recommendation. By removing the tax-strategies language and reiterating the policy that CPAs can provide tax services (such as compliance, planning and advice) to audit clients without impairing independence the SEC has likely narrowed the circumstances where impairment can happen. What those circumstances might be and who will determine whether a transaction has no business purpose other than tax avoidance remain undecided.

NONSERVICE ISSUES
The SEC rules require mandatory rotation of the lead and other partners after five years on the engagement and then subject them to a five-year “time-out.” In smaller practices with a limited number of partners, tax partners may provide services—both tax and audit support—to a variety of audit clients. The rules as earlier proposed would have included these partners in the mandatory rotation in all cases. The AICPA addressed this concern in its comments, and the final SEC rules exclude firms with 10 or fewer partners and 5 or fewer clients who are issuers under the Securities and Exchange Act of 1934 as well as “specialty” partners (defined in footnote 137 to include tax partners) from the rotation/time-out requirement. Recent SEC guidance clarifies that tax partners can be “relationship partners” (those who have a high level of contact with management and the audit committee) and thus be subject to the rotation rules.

A s an alternative for small firms, the rules require the PCAOB to conduct a mandatory review of a firm’s covered engagements once every three years. For specialty partners and relationship partners who are not lead partners, the rules extend the rotation period to seven years and shorten the time-out to two years (the SEC created the term specialty partner to refer to partners providing tax services to their audit colleagues as part of the audit).

The act says there is a conflict of interest if the audit client employs as its CEO, CFO, controller or chief accounting officer anyone who worked for the audit firm in any capacity on the company’s audit during the prior year. The SEC rules interpret this to mean a conflict exists if the client employs a former partner, principal or professional employee in a financial reporting oversight role—someone with direct responsibility over those who prepare the financial statements and related information (such as management’s discussion and analysis). It isn’t clear from the text whether “financial reporting oversight” includes an internal tax department. The discussion accompanying the rules further clarifies that the restriction covers the lead and concurring partners and other members of the audit engagement team who spend more than 10 hours on the audit. The team includes all partners and professional employees participating in the audit, plus firm personnel who “consult” with the engagement team on technical issues.

Although the SEC uses the term specialty partner , the audit engagement team discussion does not include this language. Thus, it isn’t clear whether a tax partner providing more than 10 hours of service to an audit engagement team is a team member (because he or she is consulting on technical issues) or should be excluded because he or she is a specialty partner.

Although the act does not address it, in its proposed rules the SEC had said partner compensation provisions that rewarded auditors for procuring nonaudit services would impair independence. The final rules keep this provision, but modify it to exclude specialty (tax) partners and also to provide an exception for small firms.

Fees . Proxy disclosure rules require companies to reveal the amount of audit and nonaudit fees they pay their CPA. The rules the SEC originally proposed would have modified this by requiring disclosure of audit fees, audit-related fees, tax fees and all other fees as separate categories. It was unclear how companies should have categorized tax-accrual activities and other audit-related tax services. The final rules say tax services related to compliance with GAAS are audit services. The tax-services category includes all of the typical tax functions of a CPA firm. The company must disclose the audit committee preapproval procedures it follows. The disclosure must contain a qualitative discussion of the types of services in each category other than audit. Thus, the tax-services section of the disclosure must indicate the types of tax compliance, planning and advisory services the firm provided, but doesn’t have to disclose the amount of fees for each subcategory.

PRACTICAL TIPS TO REMEMBER Tax practitioners should exercise caution in working with public companies because Sarbanes-Oxley and the final version of the SEC implementation rules aren’t completely clear about where some tax services fit on the list of prohibited nonaudit services. Given the lack of clear guidance, CPAs should be prepared for audit committees to apply the rules to tax-based nonaudit services cautiously and perhaps be inconsistent in determining whether an activity is an allowable one requiring committee preapproval or is a prohibited service even preapproval cannot sanction. When CPAs and audit committees are uncertain about how the SEC guidance applies to a particular tax service, they should consider seeking guidance from the commission through a no-action letter. This process can take up to 90 days.

THE NEXT STEPS
The IRS and Treasury Department usually clarify uncertainties in federal tax provisions via formal and informal guidance contained in temporary and proposed regulations, published revenue and letter rulings, announcements and other sources. The SEC provides some advance guidance through no-action letters and clarifies developing issues by publishing frequently asked questions (for example, see www.sec.gov/info/accountants/ocafaqaudind080703.htm ) and through staff accounting bulletins, staff legal bulletins and telephone interpretations and supplements. However, the SEC does not consistently disseminate this guidance for public access. Accordingly, uncertainty will continue about the inclusion of specific tax services on the list of prohibited nonaudit services as the SEC guidance process unfolds. CPAs and audit committees should consider seeking assurance from the SEC on questionable areas through a no-action letter, which may take up to 90 days.

N otwithstanding the statutory assurance that CPAs can provide nonprohibited tax services to audit clients on a preapproval basis, not all observers are pleased the SEC rules issued as final continue to allow accountants to perform tax services for audit clients. In addition, as noted above, the rules do not provide sufficient guidance on tax shelters. There is continuing political pressure for Congress to respond to these two issues, and both the Senate banking committee and the House financial services committee have held hearings on Sarbanes-Oxley implementation. Despite calls by some to revisit the rules, no one expects the SEC to reopen the process. The PCAOB, however, said it will consider the impact of auditors’ providing tax services to audit clients. Any proposed changes the board suggests would be effective only after the SEC exercised its rule-making authority.

CPAs who wish to provide tax services the act does not specifically prohibit to SEC audit clients must be aware they have to seek audit committee preapproval. They also should anticipate that audit committees will be cautious about resolving conflicting interpretations of the nature of a tax service in a manner favorable to the CPA firm. If appropriate, the parties can use SEC no-action letters to clarify this conflict. CPAs should recognize the nature of their responsibilities to the public and the boundaries of acceptable practice are evolving. The uncertainty is uncomfortable, but once resolved the profession will have a clearer sense of its public duty. This, in turn, should lead to a renewed sense of public trust in the profession and opportunities for appropriate rewards for practicing CPAs.

Prohibited Nonaudit Services The act and the SEC rules prohibit auditors from providing public audit clients with these services at the time of the audit:

Bookkeeping. The rules define this as maintaining or preparing a client’s accounting records, preparing the financial statements or the information that forms the basis of the statements or preparing or originating source data underlying the statements. An exception applies if the results will not be subject to audit procedures. Financial information systems design and implementation. These include any services related to the client’s information system unless the work product will not be subject to audit procedures. Recent SEC guidance indicates that if a CPA firm sells its proprietary tax-compliance software to the client this will not in itself be a financial information system issue. However, if the software also generates tax-accrual information the company will disclose in the financial statements, the rules will treat the service as financial information system design and implementation. Appraisal or valuation services, fairness opinions or contribution-in-kind reports. This covers any process of valuing assets (tangible or intangible) or liabilities, including financial instruments, assets and liabilities in mergers and real estate. Specifically excluded are services for nonfinancial reporting (such as transfer-pricing studies, cost segregation studies and other tax-only valuations). The audit firm can use its own experts to review the client’s work or the work of a third party employed by the client. An exception again applies if the results will not be subject to audit procedures. Actuarial services determining amounts recorded in financial statements. This excludes work designed to help the client understand the methods, models, assumptions and inputs a CPA uses to compute an amount. An exception applies for services not subject to audit procedures. Internal audit outsourcing. The prohibition extends to performing internal audit services related to internal accounting controls, financial systems or financial statements. The rules specifically exclude nonrecurring engagements in which the CPA evaluates “discrete items” or performs operational audits unrelated to internal controls.

Temporary or permanent work as an employee, officer or director. This includes fulfilling any decision-making, supervisory or monitoring functions for an audit client. Certain human resources functions. CPAs cannot help in the search for candidates for management or director positions, act as a negotiator for the client, undertake reference checks on prospective employees, engage in psychological testing of candidates or recommend a specific candidate for a position. The rules say acting as a negotiator includes determining compensation and fringe benefits. Broker-dealer, investment adviser or investment banker services. Under the rules CPAs who recommend to anyone that they buy or sell client securities will have provided a prohibited service. Legal services. Under the rules, CPAs cannot provide a service for an audit client that only someone licensed to practice law can perform. The concern this rule addresses is that the auditor would be acting as an advocate, which the SEC (partly in reliance on United States v. Arthur Young ) concludes would preclude the CPA from maintaining the “objectivity and impartiality that are necessary for an audit.” Expert services unrelated to the audit. A ccording to the rules, this covers engagements where the CPA firm’s specialized knowledge, experience and expertise support audit client positions in adversarial proceedings. The prohibition includes providing an opinion to the client or a client representative to advocate a client’s interests in litigation or in a regulatory or administrative investigation or proceeding. The rules do not define this term. The examples involve the SEC Division of Enforcement, forensic accounting engagements for the client itself and helping the audit committee investigate potential accounting impropriety. The rules appear to reject the proposal that the advocacy prohibition be confined to public settings and allow internal investigations and fact-finding engagements for the audit committee, as well as providing factual accounts, testimony or explanations of positions taken, conclusions reached or work performed.

Which of the following services may not be provided to audit clients?

What non

What other restrictions and requirements apply to auditors when providing nonaudit services to public companies?

For which of the following professional services must auditors be independent?