By David Kocieniewski, BloombergBusinessweek
Facebook is having an argument with the Internal Revenue Service, which the social media giant says could cost it as much as $5 billion. The dispute involves a tax strategy designed by EY, formerly Ernst & Young, that helped Facebook slash billions from its U.S. tax bill since 2010. Part of Facebook’s defense is that the plan was fully reviewed by its outside auditors. The accounting firm that signed off on EY’s tax plan? EY.
Over the past four years, Facebook paid EY almost $23 million for auditing, plus $21 million for tax planning and other non-audit work. It’s not an uncommon arrangement: More than 100 U.S. companies have hired their auditors to also advise them on tax planning, including the tax implications of mergers, moving intellectual property to offshore subsidiaries, or corporate inversions (deals that move a company’s headquarters overseas). According to a Bloomberg analysis of data from U.S. Securities and Exchange Commission filings compiled by Audit Analytics, these services for audit clients generated more than $613 million in billings for the Big Four accounting firms from 2012 through 2015. About 10 percent of the fees that accounting firms make from audit clients are for non-audit work.
That’s a quarter as much as it was before the post-Enron scandal reforms enacted in 2002. The firms say they are so large that their consulting and auditing units are essentially separate. The Center for Audit Quality, an industry-funded group, says that by holding dual roles as consultant and auditor, firms gain a familiarity with the company’s finances, which helps them better serve the client and the public. Cindy Fornelli, executive director of the group, says academic studies show that consulting doesn’t weaken audit quality. “Investor confidence in capital markets, external auditors, and audited financial statements is strong,” she says.
But some business ethicists say those financial ties are bad for investors, who need auditors to give them an unvarnished look at a company’s finances. “The idea is simple: A company’s financial statements should be examined by an independent and skeptical third party,” says Matthew Barrett, a professor at Notre Dame Law School. “The auditors cannot have the same financial or personal interests as the client. Even the desire to keep the company as a client can blind an auditor or the auditing firm.”
The European Union enacted rules this year to restrict the amount of consulting work accounting firms can take from companies they audit. In the U.S., the SEC has taken some steps to enforce auditor independence, such as punishing firms that lobby for client companies. There is a regulation forbidding consulting work that places the accountant in the position of auditing his own work, but the agency hasn’t interpreted it to mean firms cannot provide any tax advice to audit clients.
Investor advocates and former regulators say that in complex transactions involving mergers or reorganizations, it’s important investors get as much independent assessment of a company as possible. “For today’s multinationals, investors have no reasonable way to determine a company’s value unless they know where the company is making its money and what its tax picture looks like,” says Tyler Gellasch, a former counsel to an SEC commissioner.
In the Facebook case, now being litigated in federal court in California, the company assigned some of its intellectual property to an Irish subsidiary in 2010. The IRS argues that EY used a “problematic” formula to drastically understate the value of this property, improperly lowering the company’s tax bill by hundreds of millions of dollars per year. Facebook didn’t respond to requests for comment. It said in court filings that the valuation it used was correct, and it’s said it should prevail. In a July SEC filing, Facebook told investors that if it loses it could owe additional taxes, penalties, and interest of $3 billion to $5 billion.
Other companies have also moved intellectual property overseas while using the same firm as tax strategist and auditor. They include GlaxoSmithKline, Microsoft, and Activision Blizzard. Spokespeople for those companies declined to discuss the role accounting companies played in their tax strategy.
Lynn Turner, a former chief accountant for the SEC, says the consulting work is a clear conflict, particularly when it involves tax planning. “When management requests an auditor create a tax scheme that the auditor must in turn audit as part of the financial statements, it destroys the auditor’s ability to be objective and free of conflict,” Turner says.
In a column called Point of View on the company website, EY weighed the arguments for and against allowing auditing companies to also conduct consulting work for clients. EY’s verdict: The potential for conflict can be managed. “We believe it improves audit quality for auditors to be able to provide these non-audit services,” EY said, “as long as they are preapproved by the audit committee and fully disclosed to shareholders.”
Some members of the Public Company Accounting Oversight Board, created after the Enron scandal to establish auditing standards for accountants, have cautioned about the growth of such consulting businesses. In June, board member Steven Harris appeared before an international corporate governance conference and warned: “I believe investors should be concerned.”
The bottom line: Investors rely on auditors to get a picture of a company’s financials and taxes. Critics worry consulting work could cloud that view.
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