Fewer Firms Report Material Weaknesses

Among Moody's-rated companies, those disclosing material weaknesses fell sharply last year. Moody's wants more emphasis on such reports being leading indicators of problems.

Sharply fewer companies rated by Moody’s Investors Services reported material weaknesses in their internal controls during 2006, the third year of reporting under Section 404 of the Sarbanes-Oxley Act, the rating service said.

Moody’s said that 55 companies among those that it rates reported material weaknesses last year, down from 75 in 2005 and 97 in 2004, the first year of reporting under 404.

Moody’s noted the 55 reports of material weakness may understate the actual number of problems, given that hundreds of public companies restated their financial statements for errors during 2006. “However, a steady drop in the number of restatements among companies
reporting under Section 404 strongly suggests that underneath the radar screen of public reporting, controls are genuinely improving,” said Moody’s managing director Gregory Jonas.

“We continue to believe that reporting on internal control helps restore investor confidence in financial reporting,” he added. “We perceive that companies continue to strengthen accounting controls and invest in the infrastructure needed to support quality reporting, in a large part because of required reporting on controls.”

According to Moody’s, statements of material weakness under Section 404 would be more useful to investors if they served “as leading indicators rather than lagging ones for internal control problems, and, second, there were more reports of material weaknesses related to fraud controls.” During the latest year, only three Moody’s rated companies referred to weaknesses in fraud-related controls in their Section 404 statements, it said. And in each case the companies had already disclosed fraudulent reporting prior to the statement under Sec 404.

“The data suggest that management and auditors require evidence of a financial reporting problem before they are willing to conclude that a control concern is a material weakness,” Jonas said. “Should there be any changes to Section 404, ideally one focus would be on these weaknesses in Section 404 reporting — the lack of focus on fraud and leading indicators of financial reporting problems.”

Of the 55 companies reporting weaknesses in the latest year, Moody’s reported, 16 were delinquent filers, 24 had what Moody’s calls a Category B weakness (generally serious enough to warrant convening a rating committee), and 15 had Category A weaknesses, “probably readily fixable and not requiring review by a rating committee.” Moody’s said it treats delinquent filing as a Category B weakness.

In the year in which there were 75 companies reporting material weaknesses, 21 were delinquent filers, 34 had Category B weaknesses, and 20 had Category A weaknesses. In the first year of Section 404 reporting, 17 companies were delinquent filers, 30 had Category B weaknesses, and 50 had Category A weaknesses.

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