April 2005 Weakness Disclosures Heavy With Lease Issues

According to a review of internal control disclosures made during the month April 2005, 58 companies disclosed material weaknesses in their internal control over financial reporting. As usual, we're making the complete list—including excerpts and the original filings—available to subscribers in the box at right.

The number of weakness disclosures was down significantly from the 116 that were made in March 2005; however, the decease was largely due to the high volume of companies filing their annual reports in March.

For year-over-year comparison, only 39 companies made similar disclosures in April 2004, which was of course prior to the effective date of Section 404 of The Sarbanes-Oxley Act of 2002.

Leases Leases Leases

The largest number of disclosures were related to leasing issues. In April, 22.6 percent of all disclosures cited lease accounting. In March, leases and loans accounted for less than 10 percent of all disclosures.

Many of the companies making lease-related disclosures claimed they were being made in the wake of a letter written by the Securities and Exchange Commission’s chief accountant to a professional accounting group. The letter, written itself after a wave of restatements to correct lease-related accounting errors, reiterated the rules.

According to an article published by Compliance Week at the time, the SEC’s Donald Nicolaisen focused his letter on three issues related to lease accounting: depreciation of the costs to improve leased property, how to recognize periods of free or reduced rent, and how to account for landlord incentives to make improvements. Nicolaisen addressed the letter to Robert Keuppers, chairman of the Center for Public Company Audit Firms, which is an arm of the American Institute of Certified Public Accountants.

Ciesielski

“Now that it’s known that there’s been low-grade accounting for leases making some headlines, firms and their auditors will check to see if their own policies make sense,” predicted Jack Ciesielski, a CPA and owner of research firm R.G. Associates on his industry Web site. “Expect more lease-driven restatements, and not just in one industry or in clients of one audit firm.”

And that certainly seems to be the case.

$1.2 billion retailer Stage Stores, for example, disclosed that—after management reviewed the company's lease accounting practices in light of the views expressed by the SEC—"management concluded that the Company's controls over the selection and monitoring of appropriate assumptions and factors affecting lease accounting practices were insufficient." The company ultimately determined that its rent, depreciation, and interest expense, property and equipment, finance lease obligations, deferred rent credits and deferred income taxes in prior periods had been misstated, and in March the company's audit committee decided to restate financial results "to reflect the correction of these errors in the Company's lease accounting."

The same was the case at Gymboree, which noted that—again, after reviewing its lease accounting practices in light of the views expressed by the Office of the Chief Accountant of the SEC—the company determined that "the period over which it recognized rent expense and amortized lease incentives was incorrect due to deficient controls over the application of generally accepted accounting principles related to lease accounting."

Restoration Hardware also noted that the company reviewed its lease accounting in light of the views expressed by Nicolaisen. Less than a month after the letter became public, the company decided to restate results to correct certain lease accounting errors. "We evaluated the impact of this restatement in our assessment of internal control over financial reporting and concluded that the control deficiencies that resulted in incorrect lease accounting represented a material weakness as of January 29, 2005."

Other companies affected by the letter from the Office of the Chief Accountant were Jos. A Bank Clothiers, AnnTaylor Stores, Big 5 Sporting Goods, Red Robin Gourmet Burgers, and others.

MOST COMMON

Type

Percentage

Lease Accounting

22.58%

Accounting Policies, Practices

18.28%

Staff (Inexperienced, Lack of)

10.75%

Taxes

8.60%

GAAP Calculations, Policies

7.53%

Revenue Recognition

5.38%

Account Reconciliation

4.30%

Segregation of Duties

3.23%

IT Environment

3.23%

Financial Close Process

2.15%

Inventory Issues

2.15%

Control Environment

2.15%

Documentation

2.15%

Monitoring

2.15%

Anti-Fraud Controls

1.08%

SAS 70 Issues

1.08%

Timing (Not Enough Time)

1.08%

Uncategorized

1.08%

Based on 93 material weaknesses made in April 2005; some companies disclosed more than one weakness.

Taxes And GAAP

18 percent of the weakness disclosures were related to accounting policies and procedures. Solagen, for example, in a fairly typical disclosures, wrote that it had a weakness in accounting systems and control procedures, noting that certain control procedures "were inadequate to insure that certain indirect costs associated with the production process were properly classified in the Company's financial statements." CSK Auto Corp. noted that "controls over the estimation and accounting for vendor allowances did not operate effectively," and Ceridian disclosed "Inadequate financial statement preparation and review procedures."

Inexperienced or understaffed accounting departments were cited in over 10 percent of the disclosures. Cray, for example, cited "insufficiently trained accounting personnel and management," while Crown Media Holdings cited a material weakness related to a lack of sufficient expertise.

8.6 percent of the disclosures cited tax issues, down dramatically from the 22 percent in March 2005. Hayes Lemmerz, for example, cited "ineffective reconciliation procedures associated with income tax accounting matters," and Kroger disclosed that it "did not maintain effective controls over the determination of deferred income tax balances related to a business combination."

GAAP calculations and policies were cited in over 7 percent of the disclosures, while revenue recognition was cited in about 5 percent.

See the chart above, left, for greater detail.

A Companies' Vendors Fall Short

For the second time, a company disclosed a weakness caused by an outside provider. Such scenarios become possible when public companies outsource critical functions—like payroll—to vendors who themselves have ineffective internal control over financial reporting; responsibility for financial controls stays in place.

To ensure that a company's controls aren't compromised by vendors, they can ask the vendors or suppliers to provide an audit known as a “SAS 70 Type II.” However, as is apparent from the April disclosures, that's not always easy.

In this case, the company affected—racetrack operator Magna Entertainment—attempted to get SAS 70 audits from three vendors who provide "totalisator" services. A totalizator, sometimes known as a tote board, is the technology behind pari-mutuel betting; the computerized system registers bets, calculates payoff odds, and divides the total amount bet among the winners.

Such systems play a critical role in racetrack betting, touching key financial allocation decisions; according to Magna, its financial statement balances, "including gross wagering revenues, purses, awards and others and settlements receivable and settlements payable," are impacted by tote information from the totalisator vendors.

Which is why a company like Magna would want its totalizator service providers to provide SAS 70 audits. Unfortunately, the company was unable to acquire such audits from two of its three vendors, thereby forcing Magna to state that it had a material weakness of its own.

Magna was not the first company to disclose such a problem. In March, $328.7 million Iomega had disclosed a weakness related to controls maintained by their "third-party distribution/logistics service provider."

The List, And Our Standard Disclosure

As usual, we’re making available to subscribers the list of public companies that disclosed weaknesses or deficiencies in their internal controls during the month of March 2005. The list only includes disclosures from

"Russell 3000® Index," which is comprised of the 3,000 largest and most liquid stocks, representing approximately 98 percent of the U.S. market.

Exclusions

We have attempted to eliminate duplicate disclosures. Main Street Banks, for example, listed on an earnings call slide presentation—attached as an exhibit to an April 20 8-K—a material weakness in internal controls due to staffing information. However, that information had already been disclosed in the company's 10-K, filed in March.

Others, like Advent Software, had also disclosed weaknesses in April that had already been made public. El Paso Electric noted that its recent restatement was related to a material weakness; however, that weakness had been disclosed in September of last year. In addition, the company noted that the restatement "does not constitute an additional material weakness and has not caused us to modify our previously issued Report on Internal Control Over Financial Reporting."

Inclusions

We did, however, include information on material updates to prior disclosures. Back in March, for example, CT Communications disclosed on Form 8-K a material weakness related to the overstatement of revenue for certain telephone systems. But in April, the company acknowledged in its 10-K that it actually had two other weaknesses, and that the company "did not maintain effective internal control over financial reporting as of December 31, 2004."

Similarly, $1.6 million Blythe identified an income tax related significant deficiency in an 8-K filed March 9, but on April 15 disclosed in its 10-K that a separate material weakness existed. Central Freight Lines had disclosed a weakness on March 17, but in April acknowledged that "one additional material weakness in internal control was identified, relating to the calculation of the valuation allowance for deferred tax assets."

Please note that Compliance Week does not publish this list to point an accusatory finger at companies with weaknesses; rather, our goal is to provide information to subscribers that might be helpful in understanding how their peers are making such disclosures and are approaching remediation.

In addition, we understand there is much gray area to our categorizations. For example, on April 19, $2.2 billion Hayes Lemmerz International disclosed a number of material weaknesses, including "ineffective reconciliation procedures associated with income tax accounting matters." We have categorized that disclosure as "Taxes"; however, the disclosure could have been categorized legitimately under "Account Reconciliation" or "Accounting Policies, Practices."

To those ends, readers should remember that the excerpts provided are just that: excerpts. The complete SEC filings are available for those who would like to review the disclosures in greater detail.

The lists are available from the box at right.