CFO Blog: Commentary and Opinion

"The second panel is going to address generally the subject of disclosure and reporting to the public," explains Alan Beller of Corporate Finance.

If you're looking for some insight into the SEC's mindset, take note of his opening comments, which emphasize again the fact that companies have been required to maintain effective internal controls for nearly 30 years: "As we mentioned in the first panel, the requirement to have effective internal control dates from 1977. Section 404 does not change that. It is a disclosure and reporting provision. It requires management to disclose and assess for the first time in their annual report and requires auditors to audit management's assessment."

Beller began by asking Barbara Hackman Franklin, "As of the end of March, over 2500 companies had filed 10Ks and about 8% had indicated that their controls were not effective. Has that disclosure been effective?"

Hackman held up a pile of those very disclosures, and said she can look at this three ways, as a director, audit committee member, or investor. Without actually saying on behalf of which of those parties she thought she was speaking for, Hackman noted that she would like assurance that the 404 internal control compliance process was focused on the areas of greatest risk.

As an audit committee, she said, we were so focused on a significant deficiency, they were not focused on those things that were the greatest risk. As an investor (aha!) she said, she would like assurance that they were focused on the greatest risk.

In another shot at auditors, she noted that as an investor, she would be concerned about inconsistency between audit firm's findings. "How we fix that, I'm not sure. Myabe that's the PCAOB's Ball. But I see it as an issue and would like some assurance about it, no matter which chair I'm sitting in.

Calpers Mark Anson went back to the question of costs, and noted that "Calpers is willing to bear that cost." It's worth it, he says, if it helps avert one more Enron. "It's a cost that shareholders are willing to bear and helps us rely on the integrity of financial statements." With the advent of 404, he says, "we see the fiduciaries [the boards] paying much more attention to their fiduciary duties. The benefit of 404 is that it forces people to think critically about the integrity of the financial statements. So the benefits are hard to translate yet into dollar, but I think they will far outweigh the costs."

Turning to the preparer's side, Beller asked Interpublic Group controller Nick Cyprus if he needed more guidance from the SEC. Not particularly, responded Cyprus. "I'm confident that 404 will result in long run, in better and more transparent financial reporting. And I believe you will probably have less restatements as well, because incidental mistakes will be prevented. I'm a big fan of 404 and would not change it."

IPG, he noted, had material weaknesses and delayed its filing as a result. In 2Q04, the company disclosed publicly that it had material weaknesses in its disclosure controls. "I'm not sure if there wasn't a 404 whether you would have seen this in the past. But there is. And the benefits are significant. Management has a map to get its numbers better. Auditors have a map on how to [change their audit scope]. So I think 404 has done it's job.

Here's the input I've been waiting for from James Copeland. Copeland is audit committee chair of Equifax, Coca-Cola and, perhaps most significantly, the representative of the Chamber of Commerce.

"I believe it is very important that we do not oversell investors on 404. Even the best controls cannot prevent collusive fraud. You can write this down: We will see some collusive fraud in companies that have reported no material weaknesses."

Copeland noted that the PCAOB, despite its primary interface with auditors, has a substantial impact on issuers, and said issuers need to have some input into the PCAOB's standard setting process.

He also noted that 404 had caused companies to delay reorganizations, delay implementation of IT systems, and also delayed m&A. "I think it would be better to eliminate the pass fail and try to get a more nuanced system of reporting material weaknesses." He also called for "better definitions of materiality" (Good luck with that one, Jim).

I fell behind on my notetaking a bit, but Copeland did come out with some more specific recommendations than the Chamber has presented in the past few weeks, including input to the PCAOB standard setting process and the ability to eliminate a pass/fail 404 audit report.

Beller asked what is it about the SEC's rules that precludes auditors from making sensible distinctions between different types of material weaknesses, "because I'm not aware of anything that says that."

This question turned out to spark another round of beat-the-auditor.

Attorney John Huber of Latham & Watkins responded with a lengthy technical point that the rules do not differentiate, forcing the auditors to follow a particular process regardless of the type of weakness, and suggested that the SEC tinker with those rules.

Barbara Hackman Franklin related an anecdote about a company whose auditor found material weaknessss that sparked a major disagreement with management and resulted in the removal of the lead partner. "I think the auditors are afraid," she says. "I'm worried about these relationships [between auditors and companies] going forward."

Curtis Hage, CEO of Home Federal Bank, noted that the continual process of improvement within a company is not always properly evaluated by an auditor who comes in and sees a snapshot in time of that process. He complained that they have a lot of "freshman out of college" being sent to audit his firm. "I would caution against the idea that at the end of the day the auditor is always correct and management is always wrong."

The PCAOB's McDonough responded strongly that he was disturbed to hear Barbara Franklin Hackman's anecdote about a lead partner being removed because he didn't get along with the CEO and CFO. The firm, he said, should have resigned. "I don't think we should have lead partners thinking they can be bullied by CEOs and CFOs."

Continuing the discussion as to whether or not investors need better distinction between different types of material weaknesses:

Mark Anson of Calpers noted that before 404, there was widespread distrust in the equity markets. Now, he said, to general laughter, "we can focus our distrust on specific companies. This is a good thing."

Moody's Greg Jonas noted that 93 of Moody's rated companies have reported material weaknesses, and Moody's has so far reviewed 71. "Of those we have considered closely, we have had negative rating action in 12 of those cases," he noted. That's roughly 20%. "Would you conclude from that that we ought to have a dramatic reduction in number of weaknesses companies talked about? I suspect investors differ in their opinion about what is important. My vote would be to hold the course and let the market figure out what is important and what is not. That's what makes a market."