Companies Slow To Report Changes To Financial Systems

In filing a 10-Q last week, video giant Blockbuster became one of only a handful of companies to date to tell the Securities and Exchange Commission about a change to internal control over financial reporting regarding an upgrade to financial systems.

Blockbuster informed the Commission that it had recently “implemented PeopleSoft Financial Modules, a new enterprise resource planning … system which will serve as its general ledger of record going forward.” The company said that implementation of the PeopleSoft system “materially impacted the Company’s internal control over financial reporting by providing more timely and accurate financial and accounting information, reducing manual processes and providing a flexible architecture to easily interface with other systems to reduce data entry.”

According to the SEC rules implementing Section 404 of Sarbanes-Oxley, companies must evaluate any change in its internal control over financial reporting that occurred during a fiscal quarter “that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting.”

DeLoach

James DeLoach, managing director of the compliance and risk consulting firm Protiviti, says companies have been “asking for examples of disclosures of major upgrades of financial systems. To date, there hasn't been a robust record of disclosures of this kind.”

In fact, only a handful of companies have specifically cited upgraded financial systems. In addition to the Blockbuster disclosure, Disney recently made note of its implementation of new integrated finance and human resources applications software and related information technology systems. $649.7 million REIT AvalonBay reported that it had implemented a new purchasing and invoice system, and Southwest Airlines disclosed a new fuel inventory management application.

Herculean Efforts

DeLoach says one reason for the dearth of reports of systems upgrades is that the Commission didn’t require such disclosure in the first year of Section 404 compliance. “The SEC staff made it optional in Year One as companies got their internal controls ready for prime time,” he says. “But the staff has made it clear that disclosure of control improvements would be required in Year Two and thereafter if they materially affected internal control over financial reporting.”

A second reason for the small number of upgrade reports is that, since most companies were busy documenting and testing controls, not many companies actually made material improvements. “Few accelerated filers improved their financial applications during the first quarter this year because they were too busy completing the first year 404 compliance process,” says DeLoach.

Meier

Donald Meiers, a partner with the law firm Steptoe & Johnson in Washington, says that companies have been making “a Herculean-type” effort to comply with Section 404, and that the focus has been on etting ready for the initial management reports. “What’s largely been overlooked is that there would be a separate process associated with identifying changes,” says Meiers. “People are feeling exhausted by the process—I don’t think this has really gotten on their radar screen.”

Robert Kimball, a partner with Vinson & Elkins and Dallas, agrees that companies have been “so buried in the [404] process” that upgrades were put off due to concerns about costs and timing. “Some companies were delaying implementation of putting in new systems and doing upgrades because they were afraid they wouldn’t have sufficient time to adequately test them.”

Jones

There also may be a lack of understanding about what kinds of changes need to be disclosed, notes D. Michael Jones of McGuireWoods in Richmond, Virginia. “Most people think of it in terms of, ‘If you’ve got a problem, you disclose it,’” he says. “But it’s the good news as well as the bad news issues [that require disclosure]—most everyone has blinders on when they think of raising these issues.”

The challenge, of course, is that there is considerable gray area when it comes to control improvements, and little comparables or guidance. “If you went to a whole new enterprise management system it would be hard to believe that you could say that wouldn’t have a material affect on your controls,” he says. “But if you put a plug in here and a plug in there, maybe it wouldn’t have a material affect.”

Guidance Needed, Not Wanted

DeLoach at Protiviti expects to see more of these disclosures during the second and third quarters for this calendar year, as companies improve and upgrade their financial systems. He also says he wouldn’t be surprised if the SEC staff monitors these disclosures. “If they don't see many disclosures of improvements,” DeLoach predicts, “the [SEC] staff will likely publish additional guidance.”

To date, the Commission has said little about the subject, although it did briefly talk about it in a staff statement issued on May 16. In that statement, the Division of Corporation Finance addressed companies that might be delaying installations of new IT systems or upgrades due to time limitations; specifically, could executives exclude from the 404 assessment newly installed systems whose controls have not yet been fully tested or remediated?

“[W]ith respect to system changes, management can plan, design, and perform preliminary assessments of internal controls in advance of system implementations or upgrades,” the SEC staff said, noting that not all testing must occur at year end. “As a result, the staff does not believe it is appropriate to provide an exclusion by management of new IT systems and upgrades from the scope of its assessment of internal control over financial reporting.”

Meiers at Steptoe & Johnson says he doesn’t see much of an outcry for additional guidance. “I don’t think the SEC is going to do anything,” he predicts. “There may be additional guidance put out in the 404 area, but I don’t think it’s going to be [about] what’s constitutes a material change,” he adds, noting that the materiality-standard is very “facts-and-circumstances” specific.

In addition, Meiers says he isn’t even sure if executives want additional guidance on the topic. “They want the freedom to use their common sense,” he says.

Kimball at Vinson & Elkins says that, as time goes on, companies will likely adopt more transparent practices when it comes to reporting upgrades. In fact, he notes that companies can actually disclose too much information. “You can get so much detail as to changes as to be meaningless,” he says. “The challenge is to stick to the material stuff while giving enough transparency.”