Understanding the Sarbanes-Oxley Act of 2002

Author: Robert Rinninsland
Publication Date: February 13, 2002

Understanding the Sarbanes-Oxley Act of 2002

-The Tax Director’s Perspective
  by Robert Rinninsland, Attorney *

Where did Corporate America go so wrong? What didn’t we do that we should have done? What did we do that we should not have done?  These questions have permeated the U.S. financial landscape in the post-Enron, post- Arthur Andersen period.  One can argue that our current state of affairs is a result of both our accounting ignorance and immorality:

• Complicated off-balance sheet arrangements that may or may not have had legitimate business purposes obscured key aspects of a reporting company’s financial condition. 
• The proliferation of stock-based compensation arrangements put pressure on near-term earnings per share performances and encouraged “pushing the envelope” accounting and financial statement positions. 

 

In response, Congress enacted sweeping new Corporate Governance legislation, the Sarbanes-Oxley Act of 2002, Pub. L. 107-204, 116 Stat. 745 (2002), signed on July 30, 2002.  This article first examines the background and legislative history of the auditor independence rules in Sarbanes-Oxley.  Next, the article will review recent proposed regulations issued by the SEC, involving the new Corporate Governance rules.  Finally, the article will consider the role of the Chief Tax Officer and auditor independence issues addressed by Sarbanes-Oxley.  In the brave new world of financial reporting, the Chief Tax Officer’s, and thus the Corporate Tax Department’s, relationship with the company’s auditing firm is now at issue. 

 

Sarbanes-Oxley Background and Legislative History

In many respects, Sarbanes-Oxley represents the end of one era and the beginning of another.  The legislation’s intent is no less than to change American corporate culture by drawing a direct enforceable relationship between senior Corporate management and the integrity and quality of their companies’ financial statements.  It does this by implementing specific rules governing the reporting of financial results under U.S. GAAP on the part of SEC reporting companies.[i]  These rules, as stated in the relevant portion of the Senate report on Sarbanes-Oxley, are meant to:

 

“improve quality and transparency in financial reporting and independent audits and accounting services for public companies, to create a Public Company Accounting Oversight Board, to enhance the standard-setting process for accounting practices, to strengthen the independence of firms that audit public companies, to increase corporate responsibility and the usefulness of corporate financial disclosure, to protect the objectivity and independence of securities analysts, to improve Securities and Exchange Commission resources and oversight and for other purposes.”[ii] 

 

The Heart of the Matter for the Tax Function - Title II of Sarbanes-Oxley

 

A number of Sarbanes-Oxley provisions will have an effect on the tax department of SEC reporting companies.  They include:

• compliance with the Public Company Accounting Oversight Board directives,
• dealing with rotating auditing firm partners,
• enhanced disclosures of financial results, and
• new reporting analysts’ responsibilities. 

 

More significantly, management of the tax function will be affected by changes in its relationship with its auditing firm and the establishment of financial reporting policies and procedures by the company’s Audit Committee of its Board of Directors.  These issues have as a practical matter blended together in the discussion around the auditor independence provisions of Sarbanes-Oxley and the recent SEC regulations.  

The basic rules of auditor independence established by the SEC must control, that is, auditors cannot audit their own work, an auditor cannot function in the role of management, and an auditor cannot serve in an advocacy role.  The auditor independence provisions of Sarbanes-Oxley are found in Title II, Section 201.[iii]  These are services that by definition cannot be performed by auditing firms for their audit clients.  Furthermore, Section 201 goes on to state;

 

“A registered public accounting firm may engage in any non-audit service, including tax services, that is not described in any of the paragraphs (1) through (9) of subsection (g) for an audit client, only if the activity is approved in advance by the audit committee of the issuer in accordance with subsection (i).”[iv] 

 

Thus, from the auditing firm perspective, particularly as to tax services, is the glass half-empty or half-full?  The answer to this question depends on the a combination of factors, most notably the scope of an audit activity as one which affects the financial statements, the definition of tax services themselves as non-audit services, and the approach the audit committee takes in approval of non-audit services.  

Implementing Final Regulations under Sarbanes-Oxley 

 

The SEC’s proposed regulations on auditor independence were issued on November 19, 2002 and sought comments from interested parties in time for final regulations to be promulgated by January 26, 2003.  There ensued an interesting and enlightening exchange between the accountants and the lawyers, which, as an in-house corporate Chief Tax Officer could imagine, took differing approaches to these factors.[v]In summary the discussion centered on two key issues:

1)       whether Sarbanes-Oxley meant to replace existing SEC auditor independence regulations with newer, stricter rules and

2)       under what circumstances does providing tax services violate one of the three SEC basic rules on auditor independence. 

The bar raised a threshold question as to what extent tax services other than the most basic (i.e. adding numbers, answering yes and no questions) were prohibited expert services on the part of the auditing firm.  They argued that any tax work that entailed any degree of judgement risked violating the rule on audit client advocacy.  They noted that tax judgment calls could affect tax reserves required on the balance sheet and link the audit firm too closely to the financials.  Finally, they argued against any “blanket pre-approvals” of audit firm tax services by the company’s audit committee.  

The auditing firms argued that their proprietary knowledge of their client’s business enhanced their ability to provide quality tax services that would in fact improve the quality of the overall audit work.  They distinguished tax compliance and tax planning services from services with more of an advocacy flavor, such as litigation.  They argued for a bright line test that would specify permitted and prohibited tax services.  Finally, they argued that not including tax services as a specifically prohibited audit firm activity strongly indicated Congress’ intent that most if not all tax services were permitted audit firm services.

The SEC did issue final regulations on auditor independence on January 28, 2003 to be effective May 6, 2003.  The initial impression of these regulations is that they allow some flexibility to the auditing firms to provide tax services to their audit clients but only if the client’s audit committee approves.   Rumblings have been heard that some SEC Commissioners have in fact expressed disappointment with what they perceive as too lenient an approach and intend to revisit some positions taken by the final regulations.  
 

The Tax Function’s Path Forward
 

Implementation of the Sarbanes-Oxley provisions will require no less than a total reengineering of the dynamics of an SEC-reporting company’s financial reporting process, from books of original entry right on through public filings, like the 10Q, 10K, press releases and analyst conferences.  Prior to Sarbanes-Oxley, senior corporate management’s chief concern was to manage the analyst expectations of the company’s financial performance.  To the extent this was successfully accomplished, the assumption was the stock price would appreciate at an acceptable rate.  The theory of stock based compensation packages, such as stock options, awards, etc., was to link senior management’s compensation to the company’s strategic financial goals.  However, this proved too often not to be the case.  Rather senior management in many cases abused the financial reporting process and imposed non-business pressure on the corporate organizations to take advantage of any flexibility the accounting rules offered.[vi] 

The Chief Tax Officer usually did not escape the non-business accounting pressure.  From a pure accounting/Earnings Per Share perspective, the effective tax rate represents one of the most significant P&L items say, between 25% and 40% of pretax income.  Reductions in the effective tax rate reflected a dollar for dollar increase in Earnings Per Share, the single key measurement of the company’s financial performance.[vii]

The question then for the Chief Tax Officer is what life will be like under the Sarbanes-Oxley regime.  The short answer to this should be that it will be no better or worse than for any other corporate financial department that contributes to the financial condition (and reporting thereof) of the company.  In order to be sure of this, however, we must develop a perspective on which aspects of Sarbanes-Oxley will have the greatest impact on the tax function.

How does a Chief Tax Officer and the tax department put this in perspective? By going back to basics.  The “basics” in this situation are similar to the old “it doesn’t say Hanes until I say it says Hanes” television commercials, where the elderly female quality control agent indicated that she had the final say so as to what articles carried the Hanes brand name. 

 Under Sarbanes-Oxley, quality control responsibilities rest squarely on the shoulders of the company’s audit committee.  There are no permissible tax services performed by an audit firm until and unless the audit committee says so.  Under Title II, Secs. 202 and 204 and Title III,  the legislation contains guidelines for satisfying the pre-approval process for non-auditing services, issuing reports by the auditing firm to the audit committee and delegating audit committee control over the audit firms and the preparation of the financial statements. 

These provisions and the new SEC regulations place a great deal of discretion in the hands of the audit committee to handle a company’s, and, thus, the tax department’s relations with the audit firm.  The following initial steps should be on every tax department’s current list of objectives along with objectives particular to the specific company and corporate culture:

 

1.     Understand the mindset of the company’s audit committee on the audit firm’s independence.  As a practical matter, accounting firms with SEC reporting clients are visiting the audit committee’s of the clients individually to discuss their views on permissible versus prohibited services.  Indications are that the audit committees are erring on the side of conservatism.  If so, there may be key tax services that can no longer be performed by the audit firm.

2.     Understand and monitor developments in company accounting policy and internal controls.  The audit committee will be receiving input on the status of company internal controls and principal accounting policies that are reflected in the company’s financial statements.  They will also be receiving input on accounting policies considered but not adopted in the company’s financial statements. 

The internal controls and accounting policies would theoretically apply to any FAS #109 deferred tax accounting positions.  For example, the establishment of deferred tax assets and consideration of valuation allowances reducing such assets could be a material part of the financial statements and thus represent a significant accounting policy for audit committee review.  FAS #5 “cushion” accrual issues may also have to be discussed with the audit committee.  The tax department should be aware of the audit committee’s expectations regarding possible discussion or review of tax accounting positions that would drive the effective tax rate.

3.     Determine what tax projects have a significant effect on the effective tax rate.  The audit committee could take the position that the audit firm cannot perform any tax services that could be reflected in the financials and, thus, be in a position to audit its own work.  If so, tax projects with significant effective tax rate ramifications would have to remain outside the scope of discussions with the tax staff of the audit firm.  This point would also extend to a review of underpayment penalty positions under Sec. 6662, particularly if the cash tax savings from the tax return position were subject to an offsetting accrual for possible IRS challenge.

4.     Consider and plan for alternative sourcing of tax services.  The audit firm will have the right to review any tax services provided by another tax advisor in the course of its audit if those services could influence the effective tax rate.  The audit firm would contend that the effective tax rate is a significant component of the financial statements and any significant work product supporting it is subject to audit procedures.  This will most likely result in duplication of tax analysis that could result in increased SG&A expense. 

Obtaining experienced and reasonably priced tax counsel will be of increasing importance in the efficient management of the tax department.  Small “niche” firms or practitioners who specialize in various areas could become an attractive alternative assuming they can provide quality service at efficient rates.  This is particularly true in two areas, transfer pricing studies and cost segregation studies.  The SEC regulations specifically listed these activities as permissible tax services for the audit firm to perform for the audit client.  However, audit committees may be reluctant to allow this since these services may involve a high degree of business risk and tax judgement, as well as valuation (a prohibited service) expertise. The independent valuation firms, for example, will become important contributors of tax analysis in a situation where the audit firm refers the client to the valuation firm.  The audit firm then would then work with the valuation firm to insure a more efficient review of the valuation work in the context of its audit.

 

Conclusion

 

After due consideration of the above, one fact seems clear in the post-Enron, post-Arthur Andersen world of financial reporting.   The audit committees of the SEC reporting companies will have to perform the policy making and review functions that perhaps they were meant to perform all along.  The Chief Tax Officers and the company tax departments will find they have a new and interested audience to impress with their U.S. and worldwide tax abilities.  This is not an opportunity to be missed.

 

Robert Rinninsland is an attorney in Boca Raton, FL.  Mr. Rinninsland is a former Tax Director at Englehard Corp. in Iselin, NJ and is a frequent co-chair and lecturer at CITE’s Accounting for Income Tax (FAS #109)  and Managing the Corporate Effective Tax Rate courses.