How Markets Punish Material Weaknesses

A new report examines shortcomings that lead to losses in share price; Sarbanes-Oxley requirements are understood poorly by investors, say some observers.

Neri Bukspan suggests thinking of material-weakness disclosures as computer-virus warnings. Bukspan, the chief accountant at Standard & Poor’s, observes that the discovery of a virus is always worrisome, but how to proceed is even more important. Does the “virus” — that is, the material weakness — warrant a “complete system overhaul,” or has the problem been identified, quarantined, and fixed?

Of all the S&P-rated companies that disclosed a material weakness, notes Bukspan, fewer than 10 percent were downgraded, added to RatingsWatch, or given a negative outlook. He says that’s because many control deficiencies are not systemic or indicative of broader accounting or reporting problems, and they don’t hinder a company’s ability to issue accurate, timely reports that can be relied on to assess financial health.

The S&P chief accountant does acknowledge that disclosures of material weaknesses can be a “circular exercise”; it’s common for the discovery of one problem to lead to others. Such disclosures also bring to mind the “chicken and the egg puzzle,” he adds. That is, it’s often difficult to tell whether the material weakness is the cause or the effect of more-serious problems, including restatements, accounting scandals, and ineffective management.

The bond and stock markets seem to be reacting judiciously to news of material weaknesses, observes Bukspan. He points to a March study by S&P that assessed the bond market’s reaction to material-weakness disclosures by financial-service companies; the study found no discernable change in rates.

Even when the market does not react to material weaknesses, says Bukspan, the disclosures “allow investors to sort out the consequences.” But Section 404 requirements are even less familiar to investors than they are to companies, he adds. It may be two or three years until the markets have sufficient experience with Sarbanes-Oxley disclosures — and until analysts can make a definitive statement about the effects of material weaknesses on share price.

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