Raising Red Flags

As they identify control weaknesses, companies find a common one: inadequate finance staffs.

Experts say many of the issues being revealed might once have stayed behind closed doors until fixed. But an arguably broader definition of what constitutes a “reportable condition” is making that strategy harder to pull off. Auditing Standard 2, recently issued by the Public Company Accounting Oversight Board (PCAOB), parses the historically used phrase into three categories — control deficiencies, significant deficiencies, and material weaknesses — in order of severity. The old standard allowed for a “low” probability of error before the dreaded material-weakness label was applied. But now a material weakness is one that creates “a more than remote” chance that “a material misstatement will not be prevented or detected” in a company’s financial statements. And to further complicate matters, now multiple significant deficiencies can combine to equal a material weakness.

While auditors and companies (which must conduct their own independent assessments) must vet all types of deficiencies, only material weaknesses must be disclosed. But delineating between what does and does not have to be disclosed “requires a lot of judgment,” says Wagner, who expects there to be “a fair amount of discussion and dialogue” between companies and auditors.

Such semantic issues are already leading to serious arguments between CFOs and auditors, as filings show. A number of companies, such as PhotoMedex Inc., Sports Club Co., and Alloy Inc., dismissed their auditors shortly after they identified the problems. At other firms, such as Western United Holding Co., auditors resigned because they were unwilling to rely on the data provided by management. AirGate PCS Inc., meanwhile, simply disagreed with KPMG in its second-quarter 10-Q. “The company believed that no reportable condition existed by the end of fiscal year September 30, 2003″ related to a previously disclosed problem with the accounts-receivable information provided by Sprint Corp., “but our independent auditors have not made that finding.”

When auditors and management disagree, however, auditors usually prevail. For example, a dismissal triggers a requirement to disclose any differences the two have had, including those regarding controls. And companies that maintain their relationships with the audit firm are usually bound to make the suggested changes. AirGate, for instance, has promised to disclose “all changes in internal controls with respect to financial information provided by Sprint that involves an item in excess of $1 million, and on a select basis, those changes with respect to financial information below this threshold.” Roanoke Electric Steel Corp. CFO Mark G. Meikle had to hire a new staff member to placate his auditors. “We have always run a lean shop, and so we had some middle managers who were multitasking,” he says, a situation that Deloitte & Touche considered a significant deficiency. Compensatory measures, such as having higher-ups approve the managers’ decisions, did not solve the problem, he says, so “we realigned and readjusted so we wouldn’t have that problem again.”

Background Noise?

The fear, of course, is that disclosing a control weakness will cause investors to doubt the financials. That’s what happened to New York Stock Exchange-traded Adecco SA, which announced in January that Ernst & Young was refusing to sign off on its financial statements based on weak internal controls. The company’s stock price dropped about 35 percent from the previous day and was still trading at more than 20 percent below preannouncement levels at press time — even after Adecco had spent more than $121 million to confirm the accuracy of the financial statements and replaced its CFO.

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