Financial industry groups have asked the U.S. Supreme Court to
review a First Circuit Court of Appeals ruling that tax accrual work
papers are discoverable by the IRS since they are done for
SEC-mandated financial statements and not litigation. The groups
have filed amicus briefs with the Court generally arguing that
letting the decision stand will have a chilling effect on company
management’s communications with their outside auditors, which in
turn would adversely impact the accuracy of financial statements
filed with the SEC ( Textron Inc. v. U.S., Doc. No. 09-750).
The First Circuit said that the purpose of the tax
audit work papers was not to prepare for litigation, but to make
book entries, prepare financial statements and obtain a clean audit.
IRS expert and former PCAOB Chief Auditor Douglas Carmichael
testified that tax accrual work papers include all of the support
for the tax assets and liabilities shown in the financial
statements. The Supreme Court is expected to act upon the Textron
petition early this spring. The outcome of the case has broad
implications beyond the tax field and affects every public company
and audit firms with public issuer clients.
FASB Standard No. 5 sets the standards for financial
accounting and the reporting of all material loss contingencies
related to income taxes. FASB Interpretation No. 48 provides
guidance on GAAP accounting for income taxes. Taken together, FIN 48
and FAS 5 establish a GAAP requirement that public companies must
evaluate the possible impact of tax and non-tax contingencies on
their financial statements.
In auditing the financial statements, independent
auditors must follow generally accepted auditing standards in order
to render an opinion that a company’s financial statements fairly
present its financial position, results of operations, and cash
flows in conformity with GAAP. In order to prepare their financial
statements in accordance with GAAP, public companies share their
analysis in tax accrual work papers with their independent auditors.
The importance of Textron was borne out by
recent remarks by SEC Enforcement Division chief Robert Khuzami who
said that, in light of the First Circuit ruling, the Commission is
skeptical of an auditor’s assertion of privilege for tax accrual
work papers on behalf of an audit client. What Khuzami described as
the First Circuit’s common sense analysis is how the SEC staff
evaluates these types of assertions of privilege. The staff does not
see how the audit documentation prepared by or relied upon by an
auditor in connection with an audit report can be privileged, or how
any claimed privilege has not been waived. Audit documentation is
collected or prepared for the purpose of issuing an audit opinion,
Khuzami said, not for the purpose of litigation. Sharing the work
product with auditors, who are supposed to be public watchdogs,
strongly undermines any such claim.
In its brief, Financial Executives International said
that company management has a powerful incentive to provide an
independent auditor with all information the auditor deems necessary
to evaluate the adequacy of the corporate financial statements. The
interest of investors in having access to accurate financial
statements requires that the tax work papers be protected. The
integrity of the securities markets requires that published
financial statements filed with the SEC fairly reflect a public
company’s financial position.
It follows that, in providing assurance that a
company’s financial statements fairly reflect its financial
position, an independent auditor serves the public interest. The
First Circuit ruling that tax accrual work papers are not protected
creates a great tension with the public interest in candid
communications with an independent auditor. FEI urged the Supreme
Court to endorse a test permitting companies to share candid
assessments of potential litigation claims with their outside
auditors without fear that such information would be accessible by
competitors or adversaries.
In its brief, the Association of Corporate Counsel
argued that, if the Supreme Court does overturn the First Circuit’s
ruling, company executives stand to be less informed than they
should be about the legal risks of business and income tax
decisions. The inevitable result will be a reduction in effective
self-policing and a rise in mismanaged transactions.
The Association asserts that the First Circuit
decision is flawed on two grounds. First, the decision derails the
sensible development and practical application of the work-product
doctrine. Other courts have recognized that modern corporations
constantly rely on their attorneys for preventive evaluations of the
litigation and regulatory risks of tax-related business decisions
before they are undertaken. Second, the decision undermines the
important efforts by counsel to promote preventive compliance and
important financial accounting functions necessary to assure
corporate accountability.
In its brief, the Chamber of Commerce urged the Court
to recognize the principle espoused by some lower federal courts
that sharing privileged materials between a company and its outside
auditor is precisely the type of limited alliance that should be
encouraged because it furthers the company’s and the public’s
interest in detecting corporate malfeasance. The Chamber also noted
that, if allowed to stand, the First Circuit’s standard would
hamstring the ability of companies to work efficiently with outside
counsel on analyses of financial reporting. FASB expects companies
to seek the views of counsel and other advisers with regard to
contingent tax liabilities.