E&Y, Their Audit Client Wal-Mart, and Value Pricing

This was originally posted October 29, 2007.  It’s worth everyone – I’m talking to you SEC and PCAOB – taking another look at this given Wal-Mart’s Mexican bribery problems and the SEC investigation of Ernst & Young for tax lobbying to audit clients.  (Ernst & Young has been silent and left out of most media discussion about Wal-Mart’s FCPA problems in Mexico and elsewhere.)

There’s been a lot of press about E&Y’s support for Wal-Mart’s tax-minimization tactics. If anyone had any doubt that this is what the firms do and this is what companies want from them, this little engagement should have settled the question.

The WSJ is very blunt when it describes the approach Wal-Mart and E&Y took. The information is only available because of a lawsuit by the State of North Carolina to challenge the strategy with regard to their use of REITs to dodge some tax.

In May 2001, Wal-Mart Stores Inc. issued an appeal to big accounting firms: Find us creative new ways to cut our state tax bills. Ernst & Young LLP swung into action. Senior tax experts at the big accounting firm swapped ideas via email and in a series of meetings. At least one gathering, according to an internal Ernst & Young calendar, took place in Wal-Mart’s headquarters in the “Tax Shelter Room.”

Wal-Mart decided to hire Ernst & Young to help devise complex tax strategies to use in at least four big states. The accounting firm, for example, helped Wal-Mart take tax deductions in California for dividends it never actually paid. And in Texas, Ernst & Young advised, the giant retailer could exploit a wrinkle in the tax law involving limited partners from out-of-state — a maneuver subsequently shut down by the state’s legislature.

Big companies hardly ever discuss how outside accountants, lawyers and investment bankers help them cut their tax bills. But Ernst & Young’s contributions to Wal-Mart’s state-tax minimization project are outlined in a raft of documents filed in recent months in North Carolina state court, where the state’s attorney general is challenging a Wal-Mart tax-cutting structure involving real-estate investment trusts. The material, which includes company emails and memos, provides a rare window into accountants’ role in generating tax-reduction ideas at one major company.

…documents from the North Carolina case indicate that Wal-Mart, from the outset, had one primary purpose: cutting its state income taxes. Ernst & Young worked to fulfill that goal. In 2002, for example, the accounting firm delivered a 37-page proposal laying out a smorgasbord of 27 potential tax strategies, most tailored to a particular state’s tax code. It described one of them as “a very aggressive strategy with considerable risk.”

What was interesting to me was another blog, WakeupWalMart, which actually links to an invoice from E&Y to Wal-Mart (also available via the WSJ.) This invoice shows that pricing for these services was not hourly, but value-based. Firms and their clients put a value on the services and the firms charge a percentage or a flat rate, sometimes taking a contingency fee (only, according to the rules, if they are not also the external auditor of the company.)

Ernst and Young have been Wal-Mart’s independent auditors for a long time, including the fiscal year 2001 when this work started. Was the tax work structured on a flat fee or a contingency/reward for results basis?

PCAOB and SEC, you should want to know, especially given the large percentage these fees represent as compared to the regular audit fees.

It’s not like E&Y is immune from tax shelter shenanigans or independence violations.

From Wal-Mart’s 2001 Proxy:

Fees for the annual audit for the fiscal year ended January 31, 2001 were $2,754,200. All other fees were $2,025,100, including audit-related services of $465,900 and non-audit services of $1,559,200. Audit-related services include fees for SEC registration statements, benefit plan audits, and consultation on accounting standards or transactions. Non-audit services were primarily tax services.

I recently commented on a WSJ law Blog post on a similar subject with regard to premium pricing by lawyers.

When is premium pricing or “value added billing” appropriate in professional services? My experience is primarily in technology consulting and internal audit/Sarbanes-Oxley type engagements, but there are three criteria that I think are relevant:

1)Does the work require specialized expertise? (i.e. not commodity-type transactional work)

2)Are the type of specialists needed to do the work in short supply?

3)Is there a non-negotiable time limit to complete the work?

Sounds like M&A fits the bill and I think they should charge what the market will bear. Hurrah for capitalism.

I should have added, “Be careful when it’s your audit client you are “value pricing.”