Swimming Against the Tide: The Hidden Costs of Offshoring

By Jo Ann M. Pinto

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An Offshoring Primer

To its proponents, offshoring offers tangible benefits: Routine, labor-intensive tasks can be performed at a much lower cost in developing countries. U.S. manufacturers began relocating production facilities to low-wage countries decades ago, but until recently, white-collar workers were relatively insulated from the quest to reduce labor costs. The Internet has paved the way for the export of professional services to lower-cost environments. India is an especially appealing location because of its relatively well educated and English-speaking workforce, favorable cost structure, and a time difference that allows workflows to continue around the clock. Advocates of offshoring claim that the overall demand for U.S. goods and services will increase with the rising incomes of consumers in developing countries. Proponents also contend that highly skilled tasks, such as analyzing reports and rendering consulting services, will continue to be performed by domestic workers.

While the largest accounting firms have always maintained overseas offices to service multinational clients, recent reports in the financial press suggest that firms of all sizes now offshore tax-preparation services to processing centers in India. In many cases this fact is not shared with the client; nor does it necessarily translate into a lower fee for tax services rendered. Firms engaged in this practice have a U.S. partner review the return and provide the tax-planning advice.

According to the New York Times, an estimated 100,000 returns were prepared overseas during the 2004 filing season. While this is a tiny slice of the overall market for tax-preparation services, the number was virtually nonexistent just three years ago.

Are Clients’ Best Interests Served?

As someone who has engaged in tax-preparation services, I know that there is simply no substitute for face-to-face contact with the client. Important, tax-saving information can be transmitted between the client and tax preparer during a live interview. I recall the following incident from a tax season years ago: While completing the return of an elderly widow, I asked her in passing what she did in her spare time. She laughed and said she had little spare time because, in addition to holding down a part-time job, she kept house for her son, daughter-in-law, and three grandchildren (who lived in her home). The new information she disclosed changed her filing status from single to head-of-household. Aside from meeting the other requirements, her unmarried granddaughter was a “qualifying person” for purposes of determining head-of-household status. Not only was I able to use this information for the current year, I filed amended returns for the prior three years, reaping her several thousand dollars in tax refunds.

That anecdote, only one of dozens I could recount, highlights how live tax interviews can provide real added value to the taxpayer.

Is There a Substitute for Experience?

To exercise appropriate due diligence, tax preparers must be able to extract from their clients relevant information solicited in plain language. For example, it is imperative for tax preparers to understand what constitutes ordinary and necessary expenses for a wide range of businesses; someone unfamiliar with American culture may be unable to make the distinction. A well-seasoned tax professional combines extensive knowledge of the tax code, well-honed interpersonal skills, and good business sense.

One acquires such skills from years of professional experience. An accountant cannot review a return or provide tax-planning advice without the experience of having personally prepared hundreds if not thousands of returns. In the academic literature, practical experience translates into procedural knowledge, which stands in contrast to declarative or book knowledge. Numerous studies, supplemented by common sense, indicate that even the brightest accounting students leave college with little or no procedural knowledge.

Exporting the base of the professional pyramid deprives future generations of the opportunity to acquire the knowledge and skills that will allow them to advance. Furthermore, information flows work best when preparers, reviewers, partners, and clients all have live contact with one another.

Data Security Issues

Many clients may be disturbed to find out that their return is outsourced to an overseas processing center. The prospect of fomenting client ill will is why firms engaged in this activity may be reluctant to disclose it. Although Internet usage has grown exponentially, a March 2004 report by the Conference Board suggests that many individuals do not feel comfortable transmitting confidential personal and financial information over the World Wide Web. Fully 57% of households surveyed with online access choose not to file their tax return electronically, citing concerns with data security.

Outsourcing intermediaries, including Datamatix, SurePrep, and Outsource Partners International, contend that their Indian-based operations adhere to strict security measures in order to protect the integrity and privacy of client data. For example, Sureprep’s Indian employees are required to sign nondisclosure/confidentiality agreements. Data are encrypted during transfers to ensure their integrity. Additionally, access to data-processing centers is restricted by biometric palm scanners that verify employee identification. Other security measures include scanning source documents in the United States before they are transmitted, and printing the returns stateside in order to maintain a paperless environment in India.

Ethical Issues

CPAs that outsource tax-preparation engagements to a third party must be careful not to violate standards and regulations promulgated by both the AICPA and the IRS. Under the AICPA Code of Professional Conduct, Rule 301, Computer Processing of Client Returns, accountants “must take all necessary precautions to be sure the use of outside services does not result in the release of confidential information.” In the event that a breach of this duty occurs, the CPA, not the outsourcer, is ultimately liable to the client.

At its January 22, 2004, meeting, the AICPA’s Professional Ethics Committee established a task force to examine whether the AICPA needs to update its rules on outsourcing to incorporate contemporary developments in this area. The AICPA’s decision to revisit the ethical considerations of outsourcing was prompted in part because current regulations do not specifically address the issue of employing offshore entities.

In addition, the IRS has rules regarding safeguarding the integrity of client information. Specifically, IRC section 7216 “prohibits anyone who is involved in the preparation of tax returns from knowingly or recklessly disclosing or using the tax-related information provided other than in connection with the preparation of such returns.” IRC section 7216 allows the sharing of client data with an outside vendor as long as the information is used for the express purpose of preparing that individual’s tax return. Preparers that violate these rules could face fines or imprisonment.

From the perspective of both the AICPA and the IRS, the U.S. CPA or tax preparer will be sanctioned if client data leaks out to unauthorized parties. The outsourcing firms mentioned above contend that they employ Indian Chartered Accountants, who face licensing requirements similar to those of U.S. CPAs. Mediating international disputes about ethics violations may be difficult, however, because different governing bodies license and regulate the practice of accounting.

Liability questions. In addition to ethical issues, individuals and firms that use offshoring must evaluate whether their professional liability insurance will remain in force if they outsource tax preparation to a foreign operation. Val McDonald, an underwriter with Target Insurance Services in Avon, Connecticut, which provides errors-and-omissions coverage for tax preparation, said she would not feel comfortable with the practice and suspects that some firms are not disclosing this practice to insurers. In her words, she “would look at a firm very differently” if they were engaged in this practice. McDonald, an experienced underwriter whose product is endorsed by the National Society of Tax Professionals, stresses that when she writes a policy she is insuring a known entity—that is, a U.S.-based professional.

Potential Political Backlash

Many outsourcing decisions are motivated by the desire to decrease costs; however, these decisions may lead to declining customer satisfaction due to a perceived drop in quality, the fear of identity theft, lack of fee savings, and concerns about the exportation of U.S. jobs.

Predictably, the debate over the efficacy of offshoring has spilled over into the political arena. It is estimated that 250,000 to 500,000 U.S. positions have been eliminated during the past three years due to overseas outsourcing. Although these dislocations may be temporarily painful, supporters of free trade contend that offshoring is just the next, natural step in the evolution of global commerce. Opponents view the exportation of white-collar jobs as tantamount to economic treason.

Daniel W. Drezner, writing in Foreign Affairs, points out that the economic benefits of offshoring, which in his opinion are very real, are relatively diffuse, while the costs from job losses are relatively concentrated within a few sectors of the economy. A taxpayer’s sensitivity to this issue may be influenced by the extent that either clients or their friends or family members have been victimized by overseas outsourcing.

Are the Cost Savings Real?

According to a case study prepared by Outsource Partners International, it costs a typical regional U.S. CPA firm $255 to prepare an average individual tax return. Meanwhile, outsourcing intermediaries such as Xpitax charge between $75 and $110 to prepare a tax return in India. These numbers translate into a savings of 57% to 71% per return processed.

The promised cost savings may not materialize, however, due to several factors. First, the estimated labor savings may be predicated on unrealistic assumptions about the time required for U.S. employees to complete tax preparation work, employee productivity, and labor rates. Second, setting up and coordinating work that is done half a world away entails new costs. Third, monitoring quality control at a remote location may be difficult. Finally, while Indian accountants currently command wages that are a fraction of those paid to their U.S. counterparts, wages will eventually rise if the demand for competent professionals outstrips the supply.

The offshoring of tax preparation was not even envisioned a decade ago and remained a novelty just three years ago. How widespread this practice will eventually become remains to be seen. The accounting profession has always adapted to change, and in the past 20 years it has benefited enormously from advances in information technology. Will this latest innovation enhance the value of accounting services and perhaps increase their affordability? Or will offshoring produce deep structural changes within the profession, reducing employment opportunities for U.S. accountants? Only time will tell.