The last thing the Big Four needed was yet another scandal. But they've got one–this time over tax shelters.
On a snowy Friday in February, dozens of men and women shuffled through Arthur Andersen's spacious Midtown Manhattan office. The place hadn't seen this much activity in months. But it wasn't a sign that the once-proud accounting firm decimated by the Enron scandal was suddenly springing back to life. The visitors hadn't come for help in setting up off-balance-sheet partnerships. No, the firm was selling its furniture and artwork–and the people roaming the halls were hunting for bargains.
A year ago Andersen was still a thriving business, with 28,000 workers in the U.S. and $9 billion in annual revenues. Today it exists–barely–employing fewer than 500 people. Scores of them spend their time traveling from office to office, auctioning stuff off. Meanwhile, with the accounting industry leaping from one crisis to another–the latest one concerns the marketing of suspect tax shelters–investors wonder whether the same fate awaits the remaining Big Four firms.
Accounting firms lobbied successfully last year to block proposals that would have severely limited the type of work they can perform for public companies. There was no conflict of interest between auditing and tax advice, they argued. The latest debacle suggests otherwise. And with each new scandal, the profession hurtles closer to a future it wants desperately to avoid, one in which public accounting firms perform audits and nothing else. To escape that outcome, the Big Four will have to convince regulators that they are serious about changing the way they do business.
Nor is that their only problem. Shocked by Enron's abuse of corporate tax shelters, Congress is taking steps to outlaw such structures. In addition, all the firms face a wave of litigation from wealthy clients who bought into complex individual tax shelters marketed in the 1990s. The IRS is cracking down and pressing investors who used shelters to pay back taxes, interest, and penalties. The clients in turn are suing their accountants for fraud and malpractice. Some have filed civil racketeering claims, which will allow them to collect triple damages if they win. The issue burst on to front pages earlier this month when the board of Sprint ousted CEO William Esrey and president Ronald LeMay over tax shelters they had bought from the firm's auditor, Ernst & Young. (E&Y says it stands by the tax advice it provided the deposed executives.)
Although the extent of the industry's potential liability from failed tax schemes isn't yet known, it is likely to run into the billions. The Justice Department is also suing–on behalf of the IRS–KPMG and another firm, BDO Seidman, for withholding documents related to their promotion of tax shelters. PricewaterhouseCoopers has already paid $1 million to settle an IRS examination of its tax shelter business.
As if all that weren't enough, the Big Four are still fighting lawsuits from shareholders angry about earnings restatements at companies they audited. One firm, KPMG, is especially vulnerable. On Jan. 29 the SEC filed a civil fraud complaint against the firm for allowing Xerox to inflate its revenues by $3 billion between 1997 and 2000. (KPMG says it “did the right thing” at Xerox and calls the SEC complaint an “injustice.”)
As usual, the accountants have only themselves to blame. Their lax attitudes toward aggressive corporate accounting and their decision to market risky tax strategies have the same root cause: greed, coupled with a peculiar inferiority complex. Accountants have always wanted to be more than mere bean counters. In the 1990s they invested heavily in consulting, investment banking, and even legal services. The big firms seemed almost embarrassed by their “legacy role” as guardians of the public's trust in financial reporting. There was more sex appeal–and money–elsewhere.
To increase revenues, accounting firms began using their audits as loss leaders for selling more lucrative consulting work. They also discovered a gold mine in tax shelters. In 1991 the American Institute of Certified Public Accountants changed its code of professional conduct to allow accountants to charge performance-based contingency fees, as opposed to traditional hourly rates. The change set off a race to invent and market tax strategies, for which accountants would ask clients to pay 10% to 40% of the amount they saved in taxes. Tax experts say many of the schemes the accounting firms were selling crossed the line. “They were based on a literal interpretation of the law, but what was being accomplished was clearly violating the spirit of the law,” says Robert Willens, a Lehman Brothers accounting expert who has reviewed dozens of tax shelters.
Throughout much of the 1990s the IRS lacked the resources to combat proliferating tax-shelter sales. The schemes were too complex for the IRS to understand–unless someone tipped it off–and the accounting firms made prospective clients sign nondisclosure agreements. By the end of the Clinton administration, however, the Treasury started cracking down. The IRS forced accounting firms to turn over information about how they marketed shelters–including client lists. The agency offered amnesty programs to encourage individuals using suspect structures to come forward. And when it uncovered an abusive tax strategy, it issued notices banning it and recommended penalties. “At one point they were issuing notices almost weekly,” Willens says.
Now accounting firms are in hot water with both the IRS and their former clients. “It's not like they screwed people who can't come after them,” says Blair Fensterstock, a lawyer who is suing E&Y for $1 billion on behalf of four executives who bought a shelter idea now being challenged by the IRS. Several suits have been filed against the other firms as well.
The industry also faces the prospect of further regulation. New moves are afoot to shutter the shelter business. For example, in regulations issued in late January the SEC told corporate audit committees to “strictly scrutinize” tax services their auditors were providing. Several Congressional Democrats have written the SEC asking it to go even further and ban the auditors from performing tax work.
A host of corporate-governance experts criticize accounting firms for using their position as auditors to sell tax advice to individual executives. Sometimes firms have made more money selling such advice than they did auditing an entire company. That was true at Sprint, where in 2000 Esrey and LeMay paid E&Y $5.8 million–3% of their investment in tax shelters the accounting firm recommended–while Sprint paid E&Y just $2.5 million for the audit and another $2.6 million for services related to it. “Should the accounting firm advising the company also advise the executives? Probably not,” says shareholder activist Nell Minow. The new Public Company Accounting Oversight Board will probably examine the subject when it starts work in April.
Another issue is contingent fees. In 2000 the SEC prohibited accounting firms from taking a cut of clients' tax savings when selling advice to companies they audit. But many think the government should ban their use in all cases. To preempt the regulators, the AICPA may urge the IRS to bolster disclosure of any tax strategy sold under a confidentiality agreement or a contingency arrangement.
Some individual accounting firms are doing more–getting out of the shelter game altogether. Even before its legal settlement with the IRS, PwC had stopped mass-marketing tax shelters. Others may follow its lead. Ironically, the scandals during the past year present accountants with an opportunity. Corporations are now willing to pay for high-quality audits. That may enable the Big Four to shed their more dubious practices and regain public trust. Eliminating abusive tax shelters would be a good place to start. Otherwise, they too may one day find themselves selling off furniture.