Auditor-Small Issuer Controls Spats Seen

Will smaller companies get along with their auditors when their internal controls get reviewed for the first time?

Auditors and companies could soon clash on the issue of whether companies have the proper systems in place to avoid significant errors in their financial statements, Greg Wilson, deputy director of the Public Company Accounting Oversight Board’s inspections division, recently warned audit firms new to reviewing their clients’ internal controls.

Things may get touchy indeed. “There are going to be situations where issuers will have stated that in their view there are no material weaknesses and their auditors will finding something,” Wilson said during a recent Webcast sponsored by the Center for Audit Quality. “I don’t think it’s going to be terribly frequent,” he added, “but the nature of the beast is such that it will happen and there will be some interesting dialogue.”

While the largest of U.S. publicly traded companies are in their fifth year of complying with Section 404, the internal-controls provision of the Sarbanes-Oxley Act, smaller companies have yet to fully comply. It was only last year that nonaccelerated filers — defined by the Securities and Exchange Commission as those with a market capitalization of below $75 million — began filing management’s assessments of internal controls with their 10-Ks. For fiscal years ending after December 15, 2009, for the first time they’ll have to get their auditors’ signoff on their internal controls, also known as 404(b) reports.

It’s rare that disagreements between a company and its accounting firm as described by Wilson play out publicly, but it has happened at least once this year. First Place Financial, a bank with $3.4 billion in assets, fired its audit firm, Crowe Horwath, last month due to a disagreement about the effectiveness of one of its internal controls over financial reporting for its fiscal year ended June 30, 2009.

The issue: during its audit, Crowe found the bank’s fair-value calculation of loans held for sale was wrong — which would have resulted in First Place understating its net loss for the fourth quarter by 12.47%. The correction upped First Place’s net loss by $1.41 million; in the meantime, Crowe gave the bank an adverse opinion on its internal controls.

“Based upon…the potential magnitude of an error in determining the fair value of loans held for sale, the magnitude of the error we identified during our audit and the fact that the company’s internal control over financial reporting processes did not detect that error prior to our identification of it, we have determined it represents a material weakness in the company’s internal control over financial reporting at June 30, 2009,” Crowe wrote in a report dated September 14.

First Place doesn’t dispute its mistake, but doesn’t cotton to the notion that its internal controls will be branded ineffective until its next 10-K. The bank has since hired KPMG to take Crowe’s place.

Under the PCAOB’s Auditing Standard No. 5, a company that has one or more material weaknesses has ineffective internal controls. The error, according to First Place, wasn’t material and merely reflects a “significant deficiency,” which auditors consider “less severe” than a material weakness, meaning the deficiency doesn’t warrant public disclosure but management should be aware of it.

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