New PCAOB Rules Affect Personal Tax Services for Key Management

By A. Michael Hirsh

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The PCAOB adopted this and other rules it first proposed in December 2004, and circulated them for public comment. As written, the rules are somewhat broad in scope. For example, one rule states the general principle that persons associated with registered public accounting firms should not cause the firm to violate applicable laws, rules, and standards. A second rule requires a registered public accounting firm and its associated officials to be independent of the firm’s audit clients. The rules clearly target the use of outside auditors for personal tax services.

According to the new rules, an accounting firm is not independent of an audit client if it provides any tax services to an individual in a financial reporting oversight role at the audit client, or to an immediate family member of any such person. The definition of “financial reporting oversight role’’ follows the existing SEC definition and includes the client’s CEO, president, CFO, chief operating officer, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting, and treasurer. Related provisions deal with subsidiaries and affiliates. Although the rule does not cover other nonaudit services and tax services provided to directors, to company officials without financial oversight, or to audit committee members, the PCAOB urges audit committees to scrutinize any services provided by auditors to any individuals in the company.

Before adopting its new rules, the PCAOB received comments from groups, including the AICPA’s Center for Public Company Audit Firms (CPCAF). In an early alert to members, CPCAF director Lillian Ceynowa wrote that “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.” Moreover, Ceynowa said, “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.”

Then–PCAOB Chairman William McDonough, however, argued that such services can impugn the objectivity and independence of auditing firms—and are the reason for the PCAOB’s new rules:

Some have argued that auditors should be permitted to perform tax services for senior executives of audit clients in order to assure investors that those executives are not evading tax laws or otherwise involved in questionable conduct. The argument has the same flaw as the argument that auditors should be permitted to keep the books of their audit clients, on the theory that the auditors will at least make the book right.Undoubtedly expert accountants can prepare impeccable books, but in doing so they lose the impartiality that is critical to their role.

On the subject of contingent fees, the new rule states that an audit firm’s independence is impaired if it receives a contingent fee or commission for any service to an audit client. Although the SEC’s existing rule has an exception for certain contingent fees in tax matters, the PCAOB rule prohibits all such contingent fees.

Regarding tax-motivated transactions, the new rules state that an audit firm is not independent if it provides services to an audit client on specified classes of tax-motivated transactions. The suspect categories are transactions with tax adviser–imposed conditions of confidentiality, and any transaction initially recommended by an auditor or tax adviser “and a significant purpose of which is tax avoidance, unless the proposed tax treatment is at least more likely than not to be allowable under applicable tax laws.” These standards are also used in federal tax legislation in applying penalties and ethical standards for written advice.

Another key element in the new rules is preapproval of tax services. The rules suggest that tax services, like other services provided by the auditor, must be preapproved by the audit committee. The rules also specify steps the audit firm must take in seeking preapproval for tax services, including documentation of the auditor’s discussion of the proposed services with the audit committee. The PCAOB did, however, eliminate a proposed requirement that audit committees review engagement letters for the auditor’s proposed tax services. Opponents argued successfully that such reviews would create a burden for audit committees because engagement letters are both numerous and lengthy.

Although the SEC may modify some provisions in these rules, changes will probably be minor. The PCAOB and the SEC have made it clear that their intention is to erect a higher wall between outside audit services and other services that may compromise independence.

The new rules are online at www.pcaob.org/rules/docket_017/index.aspx. Information may also be obtained by contacting the PCAOB’s Washington, D.C., office at 202-207-9100.