Material-Weakness Reports Skyrocket

''We think it's fair to say that most of the weaknesses disclosed in 2005 did not develop overnight,'' says a newly released report.

A total of 586 companies reported material weaknesses through early May of this year, compared with 313 for all of 2004, according to shareholder-advisory firm Glass, Lewis & Co.

The new analysis by the independent research firm is another confirmation that audit firms have increased their scrutiny of clients to ensure compliance with Section 404 of the Sarbanes-Oxley Act. Section 404, which requires an independent auditor to attest to a company’s internal controls, became effective for many public companies beginning with their first fiscal year ending after November 15, 2004.

Glass, Lewis also found that clients of Big Four firms PricewaterhouseCoopers, Ernst & Young, KPMG, and Deloitte & Touche, as well as Grant Thornton and BDO Seidman, all have disclosed material weaknesses more frequently this year than last. Deloitte & Touche had the largest yearly difference; last year, only 2 percent of its clients made such a disclosure, compared with 6.5 percent through early May of this year.

Those results prompted Glass, Lewis to question how vigorously accounting firms required clients to disclose weaknesses in the past. “We think it’s fair to say that most of the weaknesses disclosed in 2005 did not develop overnight, especially those related to a company’s overall control environment,” the report noted. Before Section 404 became effective, companies were required to disclose deficiencies only in the case of an auditor’s termination, Glass, Lewis added.

The report also examined the number of qualified opinions (including adverse and disclaimed opinions), which Glass, Lewis maintains is an indication of the rigor of audits. PricewaterhouseCoopers and Ernst & Young issued qualified opinions for 3 percent of their clients; KPMG and Deloitte and Touche, for 4 percent, and Grant Thornton and BDO Seidman, about 5 percent. Glass, Lewis found, however, that in analyzing the 366 qualified opinions received by companies with poor internal controls, “no firm stands out as issuing significantly more qualified opinions relative to the number of companies it audits.”

Looking at the data by market capitalization, the report found that almost 11 percent of publicly traded companies with a market cap over $75 million reported internal control deficiencies between January 1, 2004, and May 2, 2005. Those companies reported a total of 672 disclosures during that period — 61 percent of the 1,104 disclosures overall. Companies with a market cap under $75 million — the “non-accelerated filers” that are not required to comply with Section 404 until their first fiscal year ending after July 15, 2006 — reported 39 percent of the material weaknesses disclosed during that period.

Although the Glass, Lewis report corroborates industry anecdotes of more-stringent audits in the wake of Sarbanes-Oxley, it does not attempt to assign other motives for increased diligence — let alone the reasons for the high cost of 404 compliance.

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