[IMGCAP(1)]A recent report from the federal accounting industry watchdog agency, the Public Company Accounting Oversight Board, found that the incidence of deficient audits performed by the Big Four accounting firms doubled in 2010, reaching a somewhat horrifying 33 percent.

As a former partner at a Big Four accounting firm who has been practicing tax accounting for 35 years, I was not surprised.

In my opinion—and the opinions of my fellow tax directors at VPTax, Inc.—this is a familiar problem. And since it is systemic, it will not likely get much better.

The Sarbanes-Oxley Act of 2002 was intended to eliminate or at least reduce conflicts of interest by requiring audit committee-level pre-approval for non-audit services by auditors at the companies they audit and enforcing a code of ethics on senior client financial management. Unfortunately, these very visible steps only touch the surface.  Similar to the way audit standards are not guaranteed to discover fraud, SOX cannot be relied upon to shine the spotlight on independence violations.

The pressure on Big Four partners is to increase the firm’s revenue. Their challenge is that they are essentially an oligopoly, offering similar services with little or no incentive to compete aggressively against each other. Instead, they use their power and influence to cross-sell services and grow revenue streams within each client.

It is a fundamental truth that an accounting firm cannot and should not audit its own work. Ten years ago, SOX did make a difference. The Big Four gave up a lot of other advisory work at their audit clients. But bit by bit, they have crept back into many areas of activity.

Here are a couple of examples:

Recently, one of our public company clients hired a full-time tax director.  From the business’s inception through its initial public offering, we did all the tax work for this company.  In a stunningly visible contradiction of the principles of SOX, the new tax director engaged the company’s Big Four audit firm for expanded tax services.

We are still acting in a limited advisory role and doing a few other pieces of related work, so we have some visibility into what is going on. In at least one area, tax credits, the tax preparation is now not as thorough as it was before. The work that would justify the claimed credits is not being done, or not being done to the standard we consider appropriate and to which the company was accustomed. 

I know this pattern.  I can see what is coming: In two or three years, the audit firm will tell their client they are concerned about those tax credits. They will recommend a formal study to analyze and document the tax credits. The study will be disruptive to the company’s internal team, and the audit firm will bill a hefty fee for this study. When all is said and done, the credits will probably change by only a minor amount, but the audit firm will have a nice bump in revenue. 

Another example: We see Big Four firms recommending their own economic consultants to do transfer-pricing work when their audit clients set up or maintain an international structure. These structures are common among larger international companies. They are widely accepted as a valuable tool for companies to manage their worldwide tax liabilities. But to avoid running afoul of the IRS and foreign governments, it’s crucial that companies pay close attention to the details, including the transfer prices at which their subsidiaries buy and sell intellectual property and components or provide services to each other.

In one recent case, while planning an international structure based on our own experience and consultation with independent economists, we recommended a method and a value for certain transfer prices. In connection with their review of the proposed structure, the audit firm independently arrived at the same recommendation.  Surprisingly, as they later solicited additional transfer-pricing work in connection with the rollout of the structure, they significantly modified their transfer-pricing recommendation to enhance the benefit to the client.

Connecting the dots, client management sees the financial benefit of the audit firm’s transfer-pricing analysis and at the same time recognizes that the audit firm would obviously opine on the implications of the transfer pricing to the company’s financial statements.  It’s a no-lose proposition for the client.

Isn’t this wrong on two fronts? They’re using their audit influence to win work after which they audit their own work.  It’s easy to see where this process might lead.

Audit firms offer more and more attractive recommendations on certain valuations to make their bids more attractive to clients, along with the unspoken guarantee that their audit team will not question those valuations when it audits its own work. All it takes is a very aggressive management team to leverage that opportunity. Then we are back to new Enrons blowing up, at great cost to the public investing community.

James Doty, the chairman of the PCAOB—a role appointed by the SEC—focused on these dangers when he pointed out in a 2011 speech to public company directors that auditors are not sufficiently independent of the companies they are auditing. “These firms are highly competent,” he said. “And yet the failures continue to occur, in spite of firms' remediation efforts. I am left with the inescapable question whether the root of the problem is auditor skepticism, coming to ground in the bedrock of independence. The loss of independence destroys skepticism.”

Given the ethics requirements of SOX, you might wonder why clients put up with this.  In my opinion, it’s a matter of resources.

Corporate finance departments are being called upon to do more with less.  Accounting pronouncements and reporting requirements are increasingly complex, to the point that the Big Four firms have specialists for most technical issues to whom the rank and file auditors refer complex matters.  With the PCAOB bearing down on the auditors, the auditors bear down on the corporate finance groups.

Client management, faced with having to stay ahead of multiple auditors on multiple issues, ultimately throw up their hands in despair.  They take the path of least resistance and recommend the audit firm provide consulting services.  Management is aware that the audit committee likely trusts the audit firm.  Like the traditional axiom of purchasing agents goes, “Nobody ever got fired for buying IBM equipment.”

So it’s ultimately between the audit firm and the audit committee.  And SOX called for active involvement and a level of skepticism by said committee.  It anticipated that services would be awarded based on competition between service providers, based both on competence and cost.  It provides for an objective view as to whether the services provided by the accounting firm might jeopardize both the actual and appearance of independence by the audit firm.

Interestingly, the Big Four firms regularly court audit committee members, offering webinars and conferences.  They have a direct line with audit committee chairs, many of whom are former partners from the audit firm. 

The tragedy is that while the good parts of SOX are being eroded, the bad parts remain. The law has imposed an enormous burden of bureaucracy on finance departments. Literally thousands of questions now need to be answered as part of every year’s annual audit. Documents three inches thick have to be produced, packed with answers to questions about the accounts, policies and procedures. All this simply adds to the cost and the time involved, making it even harder for a diligent CFO to track and manage the accounting and reporting process.

Supreme Court Justice Louis Brandeis said sunshine is the best disinfectant. The solution to the problem is not more bureaucracy, but more transparency. These problems can be addressed. But they require a fresh look from people outside the charmed circle of the Big Four.

The people who got us into this mess are not the ones who will get us out.

Thomas M. Brehmer is the founder and a principal at VPTax, Inc., a specialist in corporate tax headquartered in Burlingame, Calif., with regional offices in San Francisco, Seattle and Las Vegas. He has been practicing tax accounting for 35 years. He was at KPMG for 14 years, and became a partner before leaving in 1991 to found VPTax. VPTax provides tax advisory and tax return preparation services to companies ranging from early stage startups to large multinational corporations. He can be reached at info@vptax.com. For more information, visit www.vptax.com or follow them on Twitter at @vptaxinc.

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