Capital Markets

Where Material Weaknesses Really Matter

Some experts believe that during the 2005 annual-report season, many companies may be required to report material weaknesses in their internal cont...
Marie LeoneNovember 18, 2004

There’s no shortage of research detailing the struggles of CFOs with Section 404 of Sarbanes-Oxley, which became effective November 15 for companies’ first fiscal year ending after that date. Section 404 guides how auditors report on companies’ assessments of their internal controls.

In a July report, for example, the Center for Continuous Auditing concluded that half of $1 billion-plus U.S. companies had completed less than 60 percent of their preparations for meeting Section 404 requirements. And just last week, PricewaterhouseCoopers Dennis Nally said that a recent assessment by more than 700 PwC audit teams found that just 20 percent of clients are on schedule to complete their internal control reviews; at least 10 percent are at “extreme risk” of not finishing in time to get an auditor review.

For senior finance executives, however, those are not the most alarming statistics. Some experts believe that during the 2005 annual-report season, many companies may be required to report material weaknesses in their internal controls — and that those disclosures will hurt those companies’ credit ratings and share prices.

A “material weakness” — considered more severe than a “control deficiency” or a “significant deficiency” by the Public Company Accounting Oversight Board — creates “a more than remote” chance that “a material misstatement will not be prevented or detected” in a company’s financial statements. Disclosure of a material weakness often leads to short-term price volatility, attracts scrutiny from regulators, and even invites shareholder lawsuits.

Although companies have long been required to disclose control weaknesses, the annual testing demanded by Section 404 now leaves executives with little opportunity to plead ignorance — and thus makes disclosures more likely. (See CFO magazine’s September article “Raising Red Flags.”)

Since last November, more than 500 companies have disclosed a control weakness in a Securities and Exchange Commission filing; 54 percent (as of September) were material weaknesses, according to research by Lehigh University accounting professor Parveen Gupta. And the numbers seem to be rising; in a separate analysis, Compliance Week concluded that during October, 63 companies reported a material weakness in an SEC filing, compared with just 20 such disclosures in February.

What’s more, analysts from Moody’s Investors Service expect that “many” companies will report material weaknesses during the upcoming annual report season. Moody’s adds that some of those disclosures could lead to credit-rating reviews — perhaps even downgrades, which would raise the cost of capital for the affected companies.

Moody’s officials, however, are quick to quiet panicky speculation. “We’ve heard stories about investors and credit agencies overreacting to material-weakness charges,” says vice president and senior analyst Michael Doss. Although the ratings firm anticipates problems during the first year of compliance with Section 404, Doss says that Moody’s itself divides material weaknesses into two degrees of severity, and only the more severe cases will be in deep trouble.

“Category A” material weaknesses, according to Moody’s, concern control problems with specific transaction-level processes such as tax accrual, bad-debt reserves, and impairment charges. These require attention, but Doss maintains that external auditors can effectively “audit around” them and still deliver an unqualified opinion of the financial statements.

The less-common “Category B” material weaknesses, however, cannot be circumvented by auditors. These offenses can derail an organization, stresses Doss, because they represent “company level” control problems such as ineffective control environments, audit committees, and financial reporting processes, encompassing everything from a lax code of conduct, to feeble fraud-prevention guidelines, to poor attempts at assigning executive responsibility.

A company that reports a material weakness may also feel the effects on its share price, says Paisley Consulting executive Tim Leech, a former head of forensic accounting for Coopers & Lybrand Consulting. Leech, who is working with Gupta on an upcoming study of material-weakness disclosures, reckons that the professor’s final numbers will reveal a percentage decrease in the share price averaging in the low single digits.

Leech warns, however, of additional negative effects if investors assume that the disclosure is proof that management was concealing material information rather than fumbling through an accounting mistake. In such a case, he adds, a disclosure could also affect directors’ and officers’ insurance, making coverage more restrictive and more costly.

What about the timing of a material-weakness disclosure? Finance executives must strike a “delicate balance,” says Mary Ann Jorgenson, an attorney with law firm Squire Sanders. Balanced against the disclosure imperative, says Jorgenson, are many “shifting factors”; for instance, releasing premature findings that will require further adjustments could expose a company to fresh charges from shareholder plaintiffs with each correction.

On the brighter side, none of the experts we spoke to believes that the effects of Section 404 pose a long-term issue — except, of course, in the case of material weaknesses that are themselves severe enough to bring down a company.

Marie Leone’s “Capital Ideas” column appears every other Thursday. Contact her at [email protected].