Workpapers and Work Product Privilege
Textron and the Auditor-Attorney Relationship
Alexander L. Gabbin and Jean T. Wells
APRIL 2008 -
The recent decision in United States v. Textron Inc. and Subsidiaries
[507 F. Supp. 2d 138 (D.R.I. Aug. 28, 2007)] will have far-reaching
implications for the treatment and discoverability of tax accrual
workpapers prepared in reliance on advice provided by attorneys.
While the court held that disclosure of risk of liability by a client’s
attorneys to an independent auditor for the purpose of developing
tax accruals waived the attorney-client privilege, it did not waive
the “work product privilege,” which exists to serve
a different public policy than the attorney-client privilege. In
January 2008, the IRS appealed the district court’s decision
to the First Circuit Court of Appeals.
involved the government’s attempt to enforce an IRS summons
for all of Textron’s tax accrual workpapers. The ultimate
outcome of Textron will have implications for the delicate
30-year balance forged between independent auditors and external
attorneys, two parties who work together to maintain confidence
in financial statements without intruding upon the confidentiality
of the attorney-client and the work product privileges.
the court affirmed the principle that tax workpapers fall within
the protection of work product privilege. Generally, the work
product privilege serves as a barrier to prevent a potential adversary
from gaining an unfair advantage over a party by obtaining documents
prepared by the party or its counsel in anticipation of litigation.
Such documents could benefit the adversary by revealing the party’s
strategy or the party’s own assessment of the strengths
and weaknesses of its case. In Textron, the court ruled
that only disclosures by Textron that were inconsistent with keeping
the information from an adversary would constitute a waiver of
work product privilege. Textron had disclosed the tax workpapers
only to its independent auditors, who gave Textron a pledge of
began when the IRS sought to enforce a 2005 IRS summons issued
to Textron to produce all of its tax accrual workpapers for the
tax year ending December 29, 2001, and the workpapers in connection
with the IRS’s examination of tax liabilities for 1998–2001.
The IRS was particularly concerned about nine sale-in, lease-out
(SILO) transactions that a Textron subsidiary had engaged in.
SILO transactions were classified as “listed transactions”
by the IRS in February 2005 (Notice 2005-13).
highlights the IRS’s increased focus on seeking tax accrual
workpapers. The IRS has had the right to obtain tax accrual workpapers
for more than 30 years, but it seldom exercised this authority
prior to 2002. Before Enron’s collapse and the plethora
of concurrent corporate scandals, the IRS had requested tax accrual
workpapers only five times in 30 years. After 2002, the IRS’s
policy of voluntary restraint dramatically changed. In 2005 alone,
the IRS requested tax accrual workpapers a total of 50 times (“Reed
Smith Bulletin 06-26,” September 2006), including Textron’s.
This surge suggests that such behavior may be the start of increased
vigilance from other governmental agencies and regulators.
to produce its tax accrual workpapers on the basis that they were
protected by attorney-client privilege, tax practitioner–client
privilege, and work product privilege. Textron claimed that its
ultimate purpose in preparing the tax accrual workpapers was to
ensure that it was adequately reserved for any future litigation.
Textron also asserted that the summons was issued so that the
IRS could use the documents related to the SILO transactions as
a bargaining lever in settlement negotiations.
The IRS argued
that Textron’s tax accrual workpapers should not receive
work product privilege protection, because they were prepared
in the ordinary course of business. The IRS maintained that Textron
would have created the workpapers in essentially similar form
irrespective of litigation. The IRS further asserted that Textron’s
primary purpose for preparing the workpapers was to demonstrate
that its contingent liability reserves were in accordance with
GAAP and thereby deserved a clean audit opinion from the independent
was not persuaded by the IRS’s “ordinary course of
business” argument. Focusing instead on the contingent liability
reserves reported in Textron’s audited financial statements,
the court reasoned there would have been no need to create a reserve
in the first place if Textron had not anticipated a dispute with
the IRS that was likely to result in litigation or another adversarial
found that Textron had waived the attorney-client privilege and
the tax practitioner–client privilege when it provided the
workpapers to its independent auditors. Nevertheless, the court
found that Textron did not waive the work product privilege, because
the independent auditors had confidentially agreed not to disclose
the information in the workpapers. Furthermore, the court relied
on AICPA Code of Professional Conduct Rule 301, which expressly
states that the independent auditor has a professional obligation
to not “disclose any confidential client information without
the specific consent of the client.” The court concluded
that the IRS failed to demonstrate a “substantial need”
for the workpapers, because the determination of any tax owed
by Textron must be based on factual information readily available
by other means.
on the Auditor-Attorney Relationship
immediate effect of the decision is specific to Textron, a larger
issue is at stake in this case. Textron is significant
because of its potential impact on interactions between auditors
and attorneys. More than 30 years ago, the AICPA and the American
Bar Association (ABA) approved a 1975/1976 treaty between the
ABA (Statement of Policy Regarding Lawyers’ Responses to
Auditors’ Requests) and the AICPA (“Standards of Fieldwork,”
Exhibit II of AU Section 337) to fulfill their respective professional
responsibilities to corporate clients, regulatory agencies, and
the public. Today, however, this treaty may be on the verge of
unraveling. If it is not replaced with some means of balancing
the legitimate responsibilities of a corporation’s external
attorneys and independent auditors, the consequences for U.S.
corporations competing in a global market could be catastrophic.
are placing the treaty in jeopardy, leading to the auditor/attorney
dilemma now confronting corporate management? First, a major change
in the landscape for public accountants occurred with the passage
of the Sarbanes-Oxley Act of 2002 (SOX) and the resulting power
of the Public Company Accounting Oversight Board (PCAOB) over
GAAP and generally accepted auditing standards (GAAS). With the
passage of SOX, the PCAOB rather than private sector organizations
establishes auditing, attestation, ethics, and internal control
standards for public companies. This significant development completely
changes the parties capable of negotiating and enforcing cooperative
arrangements such as the ABA-AICPA treaty.
force is the fact that the United States has the dubious distinction
of being the most litigious nation in the world. In the authors’
opinion, no corporate endeavor that is less than perfect is safe
from unwarranted class action suits, excessive damage awards,
and frivolous lawsuits. Aggressive plaintiffs’ lawyers search
for every opportunity to launch actions against deep-pocketed
corporate targets. These attorneys seek access to confidential
corporate documents in hopes of bullying corporations into out-of-court
settlements rather than face lengthy public court battles.
it was justified public outrage at the Enron era corporate scandals
and the failure of existing checks and balances to prevent corporate
abuses that primarily led to the passage of SOX. The consequences
of this legislation include an increased focus on financial reporting
transparency and a call for greater vigilance from independent
auditors. SOX attempts to convince a post-Enron era investing
public that corporate financial reporting can be trusted. Auditors
have responded by requiring increased levels of assurance and
documentation from audit clients before issuing clean opinions.
therefore, comes at a critical time. The outcome of this case
is an important barometer for gauging where the conflict in public
policy values between the client, legal counsel, and the independent
auditor is headed. On the one hand is preservation of the fundamental
provisions of attorney-client and work product privileges so that
there remains a zone of privacy for legal research, the development
of legal strategies, and the encouragement of full candor between
corporate management and its legal counsel. An equally important,
though competing, public policy value is the need for reliable
financial reporting and effective audits. The auditor-attorney
dilemma that corporate management currently faces is how to balance
these competing public policy values in today’s litigious
and demanding audit environment.
Had the court
not ruled in favor of Textron, efforts to avert a complete meltdown
between auditors and attorneys over attorney-client and work product
privilege issues would have been comparable to steering a small
fishing boat through a perfect storm. Corporate management would
have to face tough choices. It could choose to keep its legal
advice and other confidential materials private from its auditors
to protect itself from an adversary’s litigation discovery
demands. Alternatively, it could waive its attorney-client and
work product privileges and avoid the possibility of repercussions
from its independent auditors.
treaty has not received explicit endorsement from the PCAOB. Its
usefulness and future applicability in the current financial reporting
environment are in a state of flux. Presently, given a lose-lose
predicament with few options, corporate management has to look
to Congress or the courts to help forge an arrangement that balances
these important, but competing, public policies.
decision fills a need Congress may be unable or unwilling to address.
This decision is a model for an arrangement that satisfies the
legitimate needs of the auditors while balancing the needs of
corporate management. Furthermore, the court’s reasoning
in Textron may apply to non–tax-related workpapers,
supporting financial statement accruals where litigation is anticipated.
Without reasonable protection from regulatory agencies, plaintiffs’
lawyers, and similar adversaries seeking confidential information
that could force unwarranted settlements or successful litigation
against the company, shareholder value is likely to suffer, as
will the competitiveness of U.S. corporations in the global market.
L. Gabbin, PhD, CPA, is the KPMG LLP Professor of Accounting
at James Madison University, Harrisonburg, Va.
Jean T. Wells, JD, CPA, is an assistant professor
of accounting at Howard University, Washington, D.C.