Of Newton, Heisenberg, and Sarbanes-Oxley--corporate accountability and the provision of tax services. (Foreword).

Isaac Newton Meets Arthur Andersen, Enron, and WorldCom

An immutable law of physics--Newton's third law of motion--is that for each action there is an equal and opposite reaction. Technically speaking, Newton's third law means that in every interaction, there is a pair of forces acting on the two interacting objects. The size of the forces en the first object equals the size of the force on the second object. And the direction of the force on the first object is opposite to the direction of the force on the second object.

Newton's third law of motion has an analog in the realm of public policy, law, and politics. For proof, you need look no further than Congress's enactment earlier this year to the Sarbanes-Oxley Act of 2002, which was intended to enhance corporate responsibility (through new corporate governance and disclosure obligations), to increase auditor independence and establish greater oversight of the audit process for public companies, and to toughen the penalties for securities law fraud and other violations. Sarbanes-Oxley was the "equal and opposite reaction" to an alphabet soup of corporate and accounting scandals, from Adelphia to Xerox, with Arthur Andersen, Enron, and most particularly WorldCom providing the main impetus. The titillating nature of some of the scandals--whether involving allegations of insider trading by Martha Stewart or $6,000 shower curtains for Tyco International CEO Dennis Kozlowski--fanned the flames and provided a nexus between the arcana of generally accepted accounting principles, the white-hot rhetoric of Washington, and the public at large. And in the end, Congress rushed to overwhelmingly pass and President Bush signed legislation whose precise effects remain unknown but whose purpose was, the public was told, to fundamentally change the nature of corporate governance.

Overview of Sarbanes-Oxley

The Sarbanes-Oxley Act represents the most important legislation affecting corporate governance and the accounting profession in 70 years. The Act prohibits personal loans to executive officers and directors. It requires CEOs and CFOs to certify each annual and quarterly report filed with the Securities and Exchange Commission and imposes criminal penalties for false certifications. It accelerates the reporting requirements in respect of changes in equity ownership, and generally increases the level and timeliness of financial disclosures. And it significantly increases the penalties for security law violations.

Of direct relevance to tax executives is the Act's auditor independence provisions. Sarbanes-Oxley expands the role of corporate audit committees and expressly prohibits audit firms from providing specified types of non-audit services to their audit clients. Non-audit services that are not expressly prohibited may continue to be provided, so long as they are approved in advance by the audit committee. Significantly, in setting forth the pre-approval rule, Congress used the phrase "including tax services." In addition, the law requires significant disclosures in respect of the non-audit services provided by the audit firm. Finally, the law contains a provision stating that it is the sense of the Senate that the CEO should sign a company's federal tax return.

Under the legislation, the SEC is to issue final auditor independence rules by January 26, 2003. As a general matter, some of the law's provisions became effective upon enactment whereas others will not become operative for up to 15 months.

What Does Sarbanes-Oxley Mean for Tax Executives?

Even though regulatory guidance is months away, tax executives need to begin to understand how Sarbanes-Oxley may affect their companies and their relationships with their auditors. The questions are provocative. Do prohibited non-audit services encompass services (such as a section 482 valuation study or representation of a client in an tax examination) that accounting firms have rendered for years? Alternatively, do such services fall within the scope of permissible services (subject to pre-approval) by virtue of the phrase "including tax services" in the listing of non-audit services? Stated differently, if a service is arguably a valuation, legal, or expert service but also a tax service, which provision of Sarbanes-Oxley trumps--the prohibition or the pre-approval provision?

The language of the statute is ambiguous in many respects, perhaps because it was drafted on an expedited basis, perhaps because ambiguity was a tool to achieve consensus. Behind differences over the meaning of words lies concern about the effect of the law on the marketplace for tax services. Some commentators argue that Sarbanes-Oxley was an "equal and opposite" to corporate governance and accounting scandals and suggest that attempts to minimize or mute the changes represent "whistling past the graveyard" by the accounting firms or, worse, evidence that proponents "just don't get it." Others argue that, even read most expansively, Sarbanes-Oxley does not go far enough, and further legislation is needed to expressly ban audit firms from providing any non-audit services. Thus, they argue, Congress intended to work a monumental change in the relationship between accounting firms and their audit clients--a change that would foreclose a significant part of the market to audit firms. The American College of Tax Counsel, for example, has submitted comments to the SEC, essentially arguing that audit firms should be prohibited from performing tax services other than the preparation and filing of the tax return.

The contrary argument is that these claims represent an overreaching, cynical attempt to "move the market" and thereby deny corporations a broad choice of tax service providers. Proponents of this view dismiss a broad interpretation of "legal," "expert," and "valuation" services as encompassing traditional tax services as a worse-case scenario and little more than self-serving "scare tactics" by attorneys designed to eliminate the competition. These commentators point to prior actions by the SEC and to the phrase "including tax services" in the legislation, arguing that it means that Congress intended to grandfather extant Lax services performed by audit firms. In other words, with respect to tax services (subject to the pre-approval process), it is "business as usual."

Werner Heisenberg Meets Harvey Pitt

Which interpretation is right? No one knows. And no one will know until the SEC issues regulations. The lack of clarity brings to mind another law of physics: the Heisenberg Uncertainty Principle. The principle, which recently re-emerged in public awareness by virtue of its role in the Pulitzer Prize-winning play Copenhagen, postulates that key physical quantities (for example, position and momentum) are paired up in quantum theory and, further, that the more precisely the position of a particle is determined, the less precisely its momentum can be assessed, and vice versa. Restated in layman's terms, this principle means that you cannot observe something without changing it. This is because to see a particle you either need to shine light on it or have it collide with a detector. The deleterious effects of the latter are obvious, but with the former, a photon of light hitting that particle will make it change velocity.

Applying Heisenberg's principle to corporate governance and accountability, it seems that the more one considers the implications of Sarbanes-Oxley--especially in the absence of implementing regulations--the less clear they become. It also seems clear, at least to some commentators, that the mere act of asking questions has the potential of changing the landscape.

From the Shadows to the Light

Whether or not Sarbanes-Oxley is clear, whether or not all its provisions are in force, whether or not the answers may be affected by asking the questions, tax professionals do not have the luxury of waiting. TEI members are all grappling with the questions of what the law means and what they must do with its provisions, and they are asking themselves, each other, their accounting firms, and their legal advisers. Unlike the laws passed by Congress, the laws of physics and nature cannot be repealed, modified, or subjectively interpreted.

Given the pressing need for guidance on the new legislation, Tax Executives Institute has undertaken a significant educational effort since enactment of the Sarbanes-Oxley Act. Believing that it is better for the law and its implications be openly debated "in the sunlight" rather than whispered about "in the shadows," the Institute and its chapters have already sponsored several educational sessions on the law. For example, on September 27, the Institute sponsored a telephone seminar on Sarbanes-Oxley that attracted nearly 1,000 participants.

With this issue of The Tax Executive, the debate moves to the printed page with two articles on Sarbanes-Oxley. In the first, Mark A. Oates and Daniel L. Goelzer, attorneys with the law firm of Baker & McKenzie, provide their views on the Act's provisions and potential effect on accounting firms' provision of non-audit tax services to their attest clients. Mr. Oates (who is a tax litigator) and Mr. Goelzer (who formerly served as General Counsel of the SEC) stake out the provocative ground that Sarbanes-Oxley may prevent companies from using their audit firms to provide what had previously been routine tax services. The second article, by Richard Y. Roberts of Thelen Reid & Priest, stands as a rebuttal to the Oates-Goelzer article. It builds the case that Sarbanes-Oxley prohibits few, if any, tax services. Mr. Roberts, who has represented accounting firms on a variety of issues, is a former SEC Commissioner.

What's Next?

Until further regulatory guidance is issued in the coming months, it is unknown whether Sarbanes-Oxley's prohibition on "legal services" and "expert services" will be construed to prohibit any of a wide variety of tax services traditionally provided by accounting firms to their attest clients. Moreover, determining whether and to what extent the rendition of tax services is permitted (subject to pre-approval) or proscribed is only the first question. Companies will have to weigh and decide whether, even if permitted, they want their audit firms to provide tax services and to what extent. In the first few months since the enactment of Sarbanes-Oxley, no clear trend has emerged, which is not surprising inasmuch as the Public Company Accounting Oversight Board has not been constituted, no regulations have been issued, and many of the provisions of Sarbanes-Oxley are not self-executing. Thus, there have been some reports of some companies engaging, subject to the pre-approval rules, in "business as usual" in respect of tax services. There have been contrasting reports of companies deciding to cut all tax ties with their audit firms. And there have been reports of companies adopting a middle ground or, perhaps even more prevalent, of choosing to wait and see until regulations are promulgated.

These corporate management issues, like the core legal issues, merit full exploration. TEI encourages a robust discussion of the meaning and significance of Sarbanes-Oxley. Please submit your comments, questions, ripostes, and rejoinders to: Editor, The Tax Executive, c/o Tax Executives Institute, 1200 G Street, N.W., Suite 300, Washington, D.C. 20005-3814, or emailed to [e-mail].

TIMOTHY J. McCORMALLY is Executive Director of Tax Executives Institute