For Arthur Andersen, the scandal was Enron, and before that, Sunbeam and Waste Management. For KPMG, it was Xerox (XRX). Now, PricewaterhouseCoopers has its own client implosion to worry about: Tyco International Ltd. (TYC) As the remarkable scale of misdoings at Tyco is revealed, the heat is rising for PwC, the firm that signed off on Tyco's financial statements for the past 8 years.
If Tyco's former chief executive, L. Dennis Kozlowski, and former chief financial officer, Mark Swartz, did loot $600 million from the company and its investors, as the Manhattan district attorney has charged, then where were the auditors? That's the question many investigators now reviewing PwC's work for Tyco are asking. Among them: the Internal Revenue Service, the Securities & Exchange Commission, plaintiffs' lawyers across the country, and Tyco itself, which has retained a forensic accounting firm to review its books.
As the Tyco scandal unfolds, the focus is increasingly turning toward PwC. The firm maintains it is cooperating fully with investigators and says it is not aware of being the target of any investigation. PwC also declined comment on Tyco, citing client confidentiality.
Still, critics abound. Especially outrageous to such critics as former SEC Chief Accountant Lynn E. Turner is PwC's failure to flag nearly $100 million in forgiven executive loans that Tyco booked against the gain from the partial initial public offering of a subsidiary in 2000. "Auditors must look at these large adjustments, because that is where we find the fraud has always been committed," says Turner.
But PwC's relationship with Tyco went far beyond auditing the company's books. Reducing its tax bill has long been a key Tyco strategy for boosting earnings, and PwC was deeply involved in that effort. According to its 2001 proxy statement, in addition to $13 million PwC earned in 2001 for auditing Tyco, the firm was paid even more--$18 million--for tax work. For that hefty fee, a Tyco spokesman says, PwC helped Tyco with its "U.S. tax planning, and the review and preparation of non-U.S. tax returns in more than 80 countries." In addition, Tyco says, "PwC reviews the Tyco tax department's analysis of our tax rate every quarter."
What tax work PwC was doing and how that affected its audits is of particular interest because Tyco has been based in the tax haven of Bermuda since 1997. It also has dozens of subsidiaries in other offshore tax havens. These moves saved the company hundreds of millions in U.S. taxes, providing it a major competitive advantage. Tyco says this structure saved the company $600 million in taxes in 2001 alone.
Although it is common practice among accounting firms to serve as both auditor and tax adviser, the dual role has given rise to a chorus of critics. And for PwC, wearing both hats at scandal-ridden Tyco risks at least an appearance of conflict of interest. That could further complicate life for PwC and its CEO, Samuel A. Di-Piazza Jr. Critics of the practice argue that tax work often involves helping companies take advantage of legal stratagems to cut their tax bills. A company must then estimate its tax bill and set up reserves to pay its taxes. A company that is sure its estimated tax savings would come through might reserve very little against the unlikely chance the savings would not occur. The accuracy of those estimated savings and reserves are then reviewed by the auditor, which in Tyco's case was the same firm, PwC. "You are auditing the validity of a product that you're selling," complains John L. Buckley, Democratic counsel to the House Ways & Means Committee. "It is a gross conflict of interest."
While it's not known whether PwC did anything wrong because of its dual role, it clearly raises questions about its work. After reading a recent SEC filing by Tyco outlining its internal probe of the former CEO, Lynn Turner says that $41 million of a $96 million loan-forgiveness scheme was charged to the balance sheet account for "accrued federal income tax." Says Turner: "I can't understand how they missed that one."
Now, as Tyco's new management attempts to untangle the company's myriad problems, that potential conflict may be coming into sharper focus. Tyco's new CEO, Edward D. Breen Jr., announced on Sept. 25 that the company would be raising its expected tax rate for 2002 to 22% from the extremely low 18.5% used by prior management. That will cut earnings of $160 million this year. "It would seem PwC gave Tyco overly aggressive advice," says Prudential Securities Inc. analyst Nicholas P. Heymann.
Tyco isn't the first audit client to cast a shadow on PwC's performance: Software maker MicroStrategy settled an SEC suit alleging it had violated accounting rules and overstated its results in December, 2000. Telecom giant Lucent Technologies continues to be under scrutiny for its accounting practices. The firm also had its own brush with regulators in June, when it agreed to provide the IRS with more information on shelters and their investors and to make a "substantial payment," according to the IRS.
In a case that strongly resembles that of Tyco, back in 1998 the U.S. tax court found that a Canadian company, Laidlaw Inc., an audit and tax client of what was then called Coopers & Lybrand, had violated U.S. tax law. The court determined that on Coopers' advice, Laidlaw had been too aggressive in deducting interest on loans from its offshore subsidiaries on its U.S. tax return. Laidlaw paid the government millions of dollars.
Now the danger is that Tyco could become, in the words of one former top tax official "Laidlaw 2." Like Laidlaw, Tyco finances much of its debt through a Luxembourg-based company, Tyco International Group. TIG then reloans the money to Tyco units in the U.S. and other high-tax jurisdictions. But to pass muster with the Internal Revenue Service, these intra-company loans must meet certain tests, including set debt-to-equity ratios. In his Sept. 25 call, Breen acknowledged that Tyco had reviewed its debt-to-equity ratios and concluded they were out of line. Ultimately, that forced Tyco to recapitalize "certain" of its offshore entities, which cut the amount of interest that could be written off for tax purposes. The end result: the higher tax rate this year.
Tyco declined to explain its moves in further detail; nor would PwC comment on the comparison with Laidlaw or its work for Tyco. But at the very least, PwC's extensive ties to Tyco are almost certain to end up costing the firm money. Although the audit firm has not yet been named in any of the 27 pending shareholder class actions stemming from the $90 billion decline in Tyco's market value this year, several law firms say they expect to soon add PwC as a defendant .
No one believes Tyco is likely to become as big a problem for PwC as Enron proved for document-shredding Andersen. But PwC clearly will face plenty of tough questions for months to come. By Nanette Byrnes in New York and William C. Symonds in Boston