Raising Red Flags

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

More often, it’s hard to separate the effect of the disclosure from the rest of the news that accompanies it. Nortel Networks, Bristol-Myers Squibb, and Goodyear Tire & Rubber Co., for example, ended up restating earnings in part due to errors created by their lack of internal controls, which clearly had an impact on investors. At other companies, such as Mirant and WorldCom, the discovery came during well-publicized cleanup efforts after financial disasters, and had little effect on the stock.

The market does seem to have some sympathy for what companies are enduring, however. When Alloy Inc. revealed that KPMG had deemed its accounting staff’s inability to properly account for goodwill as a material weakness in its May 27 10-K, its stock actually went up. Says Poss: “Everyone knows a lot of companies are struggling with the 404 issues.” In fact, he predicts that in the first year, “so many companies will get a negative opinion [on their internal controls] that it will be little more than background noise.”

While William J. McDonough, chairman of the PCAOB, won’t speculate on the number of negative opinions, he recently told CFO (see “The Enforcer,” August) that he believes “markets will distinguish [between] cases in which a company just isn’t very well managed [and cases in which] a company has work to do, but will probably get a clean opinion next year.”

All in the Details

The level of detail many firms are providing about their remediation may be helping to assuage investors’ fears. “Companies want to illustrate the minutiae of the improvements they’re trying to make,” says Compliance Week editor Scott Cohen. Sola International Inc.’s June 10-K, for example, described the plan that new CFO Ron Dutt had presented to the board last October to correct deficiencies related to staffing, as well as a list of steps taken, including a reorganization of the international finance staff and the addition of three CPAs to its corporate accounting staff.

Some companies, such as Roanoke Electric Steel, are disclosing their hiring plans even when the underlying problem was not deemed to be material. “We wanted our shareholders to know that we were addressing it,” says CFO Meikle, “so we went ahead and said we had the problem but we were going to solve it.”

How well such efforts will insure companies against failing Section 404 is unclear, since passing depends largely on which problems still exist and their effects on financial statements. However, Wagner says that identifying finance-staff turnover as a risk and establishing plans to mitigate it, like “making sure they’re adequately compensated, sufficiently trained, and given enough time to allow them to get on top of increasingly complex issues,” is key to making auditors comfortable.

To that end, experts say that even damaging revelations about internal controls may be better than staying silent. Levi Strauss & Co. and Sonus Networks Inc., for example, have already been cited for allegedly failing to disclose control weaknesses as part of broader class action lawsuits. “You can pretty much count on the fact that any cases concerning GAAP violations brought after the 404 deadline are going to point to SEC reports that discuss internal controls,” says Bruce Carton, executive director of Institutional Shareholder Services’s Securities and Class Action Services.

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