An overwhelming majority of large public companies now report strong internal controls over financial reporting—a further indicator that Sarbanes-Oxley may be producing its intended effect, and possibly portending a future of fewer financial restatements.
A Compliance Week study of the 10-K filings of nearly 300 Dec. 31 year-end filers found that only 2 percent rated their internal control over financial reporting as ineffective.
The companies all generated annual revenue of at least $1 billion, and were in "Year Two" of compliance with Sarbanes-Oxley.
Crow
“Companies in the U.S. today do try to be careful,” says Charles Crow, a partner at the law firm Crow & Associates in Princeton, N.J. “The Enron trial, the WorldCom problems, the Adelphia problems, these are still in the frontal lobe of people. They’re not going to want to invite this misery into their own lives.”
The companies’ large size may have given them an advantage over smaller ones because they could afford additional resources, such as the hiring of more controllers, to make sure they achieved regulatory compliance, says John Orrico, a portfolio manager at Water Island Capital in New York, who runs the firm’s $180 million Arbitrage Fund.
Orrico
“They can afford to pay outside auditors to accompany many of the policies and procedures to make themselves compliant,” Orrico says. “We look at a lot of smaller companies. A lot of little companies put up their statements saying they’re not compliant. It doesn’t help their stock prices; it makes members of their boards uneasy to sit on their boards. Everyone is focused on it. They’re concerned, and they do spend the money if they can.”
Eastman Kodak, American International Group and Dynegy were among the six companies in Compliance Week’s study whose managements and auditors confessed to ineffective controls. Other companies notable for recent restatements of prior years—Goodyear, Xerox, Qwest Communications and Tenet Healthcare among them—reported effective internal controls and clean audit opinions for 2005.
David Richards, president of the Institute of Internal Auditors, cautions that restatements are always going to exist, since accounting rules change and differences of opinion on some financial reporting decisions will emerge among auditor, regulator and corporation. Regardless, others say the financial reporting world has taken SOX to heart.
Martin
“The accounting world has been very shaken. It’s very defensive, very concerned about risk profile and liability,” says David Martin, head of the securities practice at law firm Covington & Burling, and a former director of corporation finance at the Securities and Exchange Commission. “The questions and concerns raised early on were whether outside audit firms were being too strict in the way 404 reviews were being done. I think that’s becoming more nuanced. The accounting firms are doing a better job at applying the standards and the companies are doing a better job at documenting, testing and showcasing to the audit firms.”
When Eastman Kodak released its annual report in March, the photography giant announced adjustments to its 2005 earnings from the results that were distributed through its earnings release in January. The adjustments stemmed from three material weaknesses disclosed in the annual report, spokesman David Lanzillo says.
They included weaknesses in the company’s internal controls to account for income taxes, as well as for pension and other postretirement benefit plans, as disclosed in Kodak’s 2004 annual report and in the 10-Q for each of the first three quarters of last year. Kodak also identified weakness in controls for the preparation and review of spreadsheets for the three- and nine-month periods ended Sept. 30. As of Dec. 31, the company had remediated the issues with the help of external advisers, Kodak said in its 2005 report.
AIG, the troubled insurance giant, restated financial data for the years 2002, 2003 and 2004, following an internal review of all accounting in the wake of federal and state investigations.
RELATED NEWS
PWC Finds 404 Compliance Prompts Improvement
A new report from PricewaterhouseCoopers says nearly 80 percent of companies that filed adverse opinions about their SOX compliance in 2004 had improved their internal control over financial reporting for 2005.
The study reviewed the assessments of internal controls in the 10-K documents of 2,573 companies that had to comply with Section 404 in year one and year two as of April 17, according to Raymond Beier, a senior partner at PWC. Of that number, only 82 companies filed adverse opinions this year, down from 371 last year.
“To me, this asserts very clearly that 404 is delivering value,” Beier says. “It put a spotlight on the system and caused companies to react. This data proves companies are reacting.”
Eighty-six companies in the PWC study faltered, moving from clean opinions in 2004 to adverse ones last year. The top three reasons companies reported adverse opinions included concerns about not having adequate documentation for policies adopted or entries made (34 percent); material or numerous auditor year-end adjustments (25 percent); and insufficient accounting personnel resources or competencies by the company (16 percent).
Beier says the data illustrate that Section 404 has triggered an intense effort by companies and auditors to identify, evaluate and report on internal control systems. It has also led management to “take ownership” of accounting and finance functions more directly, and upended the usual relationships between companies’ auditors, audit committees, executives and boards of directors, he says.
“The efforts have reduced the risk of an Enron situation significantly,” Beier said. “This was in fact the key of what 404 was looking to deliver.”
The data for the PWC study is preliminary and will be updated as companies file their 10-ks throughout the year, Beier says. The survey was not available to the public as of presstime.
By Christine Dunn
“Our acknowledgment of these weaknesses stemmed from receiving subpoenas from the New York state attorney general’s office and the SEC,” spokesman Christian Murray says. “These are things that if you look to the recent 10-K in 2005, we’ve addressed many of them but we’ve still got a few more to go. Toward the end of 2005, there were changes to our corporate governance guidelines, for example. Earlier this year we settled with the SEC, the Department of Justice and the New York state attorney general. We’ve put for the most part the issues behind us with regulators.”
Dynegy announced adjustments to income taxes for its continuing and discontinued operations on March 14, six days after the Houston-based company released earnings. The adjustments came out of compliance efforts with Section 404 of SOX, spokesman David Byford says. “During the course of our review, we identified a material weakness,” he says. “We disclosed this properly in our form 10-K.”
More Experience, Better Results
Beier
Echoing Compliance Week’s findings, PricewaterhouseCoopers published its own research this week suggesting a sharp decline in the number of adverse opinions issued for accelerated filers now two years into SOX compliance. That drop indicates improvement in internal controls “and the value delivered by 404,” says Raymond Beier, a senior partner at the firm.
Richards of the IIA suspects the adoption this year of risk-based approaches to the assessment of internal controls may have a big effect on companies’ compliance costs. This approach allows a company and its external auditor to focus only on those key controls that aim to mitigate the exposure that would occur if a material event affected the financial statements or disclosures. It enables a company to examine those transactions where error is most likely to occur, and in which a material misstatement might take place if the controls were ineffective, Richards explains.
Such an approach will result in fewer controls being tested and monitored compared with the first year that Sarbanes-Oxley’s requirements went into effect, he says.
Richards
“If the external auditors look at a smaller number of controls when they are issuing an opinion, then they’re more likely to be more efficient in their assessment,” Richards says. “Their reliance on the work of the internal auditors enables them to reduce the amount of testing they perform and helps them to achieve efficiency.”
An analysis of whether the percentage of companies that rate their controls as ineffective rises, declines or stays the same in future years should provide more insight into the efficacy of SOX requirements on companies’ operations, he and others add. (This is the first year in which Compliance Week conducted its study.)
“I think there still is an undercurrent of insecurity about the reliability of numbers in the market, because of the continuing efforts being made to really install and maintain effective internal controls,” Covington & Burling’s Martin said. “I think another cycle or two would make people comfortable that we’ve turned the corner. Then we’d hit stability. I don’t think we’re at the finish line yet.”
The Compliance Week report, available in Microsoft Excel format, and related coverage can be found in the box above, right.
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