Adjustments, Restatements Are Predictors Of Weaknesses

Most accelerated filers who received failing grades from their auditors in the Section 404 filings under Sarbanes-Oxley had material year-end adjustments or had restated their financials, according to an analysis of nearly 3,000 filings by AuditAnalytics.com of Manchaug, Mass.

Cheffers

Of 360 material weakness opinions reviews, 192—or 53.3 percent—had material year-end or auditor-initiated adjustments. 152 had restatements of financials, constituting 42.2 percent of the total. Although there was some overlap—some companies had both problems—about 80 percent of those reporting material weaknesses had one problem or the other, says Mark Cheffers, CEO of AuditAnalytics.com.

Cheffers told Compliance Week that the numbers didn’t completely surprise him because “if you’re clairvoyant” you’d assume that companies with year-end adjustments were good candidates for an adverse internal controls opinion. “But it surprised me that there was that many—more than 50 percent,” he says.

According to Cheffers, the data suggest that a standard has been set regarding the impact of those disclosures. “Going forward," he says, "if you have significant year-end adjustments—you’re not making adjustments you need to be making on a monthly basis and you have to correct a lot of things at year-end—the standard is going to be that you’re going to get an adverse opinion.”

Caine

Martin Caine, a CPA with Wolf & Co. in Springfield, Mass., agrees with Cheffers, noting it sense that a year-end adjustments or auditor-inspired adjustments would result in a material weakness. "If you give me a report when you’re happy with it and you’ve applied your controls—you’ve given me the green light—and [later] I find something and it’s material, that’s a strong indication of a material weakness,” says Caine.

But, while adjustments and restatements may be a good predictor of material weakness opinions, Cheffers says an auditor's adverse opinion is not inevitable. “Less than 50 percent [of companies] that indicated restatements [got] material weakness opinions," he says. "It’s by no means a guarantor of having a material weakness.”

Safe Levels

In total, just 12.75 percent of accelerated filers (as of May 15) had material weakness opinions, according to AuditAnalytics.com. That's slightly higher than the 9.8 percent tracked by Compliance Week [see box above, right].

But both numbers are lower than many had anticipated earlier on in the 404 process, notes Caine. As reported in Compliance Week last year, some experts had expected that 20 percent of issuers would get adverse opinions on their internal control over financial reporting. “There were some much higher estimates floating out there earlier," says Caine. "Some estimates were that 30-40 percent were expected to have some material weaknesses.”

Caine suggests that original estimates were a “worst case scenario” and that, once auditors “were able to do a measured weighting of all the controls that were in place and were able to determine that there were some off-setting controls that they could take advantage of,” the problems were “far less than what people had feared going in.”

Cheffers at AuditAnalytics.com told Compliance Week that the 12.75 percent number for accelerated filers “will go down and probably reach some steady safe level.”

However, when the percentages come out for non-accelerated filers, Cheffers said he expects they will be much higher. Non-accelerated filers “just fundamentally have some internal control problems,” he says. Small companies usually lack robust finance departments, and their controls are typically less mature than large organizations. “I don’t know how you’re going to get around that," adds Cheffers. "I would not be surprised if 50 percent of non-accelerated filers get material weakness opinions.”

Cheffers noted that BDO Seidman and Grant Thornton, auditors that have some of the smaller accelerated filers, had much higher percentages of material weakness opinions—BDO had 30.0 percent and Grant 28.2 percent [Compliance Week's analysis shows that the SOX 404 failing grades provided by those auditors is slightly lower, at 24.1 percent and 26.7 percent, respectively]. “That’s a predictor of what the non-accelerated filers will do,” says Cheffers.

Caine, whose firm handles a large number of non-accelerated filers, says he thinks some of the estimates of failing grades for those companies may be high. “I think we’ll come to find out that there are procedures in place—that management is managing the company somehow," he says. "I expect to see a good number [of material weakness opinions] but nothing outrageous.”

In addition to year-end adjustments and restatements of financials, a third major predictor of material weaknesses was personnel issues. “In more than 40 percent of the cases of material weaknesses, a deficiency in the number, competency or training of personnel was a major factor,” says Cheffers. Again, that number is slightly higher than Compliance Week's own analysis, but still accurate reflects the fact that "people problems" are a major cause of material weakness disclosures in companies of all size.

One area that was not much of a problem was deficiencies associated with internal audits. According to AuditAnalytics.com's analysis, only 1.1 percent of the companies with material weaknesses had a problem with internal audit and/or audit committees.

Related coverage, databases, and an auditor opinion "scorecard" are available in the box above, right.