Companies are describing extensive details about the measures undertaken to remediate internal control weaknesses disclosed as per Section 404 of The Sarbanes-Oxley Act of 2002. That's according to Compliance Week's latest analysis of internal control disclosures made during the month of June 2005. Some of the disclosures—including excerpts and the original filings—are available to subscribers in the box below, right.

The weakness disclosures made during June 2005 were typical of prior months' disclosures. A majority of the weaknesses were related to problems with companies' financial systems and procedures. Among the several problems cited by $28 billion auto parts maker Delphi Corp., for example, were "neffective or inadequate accounting policies to ensure the proper and consistent application of GAAP throughout the organization." Pacific Capital Bancorp noted that it "did not maintain effective controls over approval of general ledger journal entries."

Problems with lease accounting and inventory tracking were also common (see chart below, left, for breakdown of disclosures).

Personnel issues accounted for 13 percent of the weakness disclosures in June 2005. Most of those problems were related to lack of experienced accounting department staffers, which is typical of small companies with less than $1 billion in revenue. $56.9 million Sonic Solutions, for example, acknowledged that it "did not maintain sufficient personnel with an appropriate level of accounting knowledge, experience and training in the application of generally accepted accounting principles (GAAP) commensurate with our financial reporting requirements." However, the problem was also apparent at larger companies as well; Delphi stated that it had "insufficient numbers of personnel having appropriate knowledge, experience and training in the application of GAAP at the divisional level, and insufficient personnel at the Company’s headquarters to provide effective oversight and review of financial transactions."

67 percent of the weakness disclosures came from companies with less than $1 billion in revenue.

Among the more interesting disclosures was one from $173.2 million Silicon Image, which noted a weakness resulting from the resignation of four of the company's five independent directors. The resignations left the audit committee with one member. In addition, said the company in an 8-K filed June 7, "the sole remaining member of the Audit Committee was not a 'financial expert,' as that term is defined by the rules of the Securities and Exchange Commission."

Also of note was a weakness cited by Delphi related to "Ineffective 'tone' within the organization related to the discouragement, prevention or detection of management override, as well as inadequate emphasis on thorough and proper analysis of accounts and financial transactions." According to the widely adopted internal control framework published by the Committee of Sponsoring Organizations of the Treadway Commission, the tone of an organization—including the integrity and ethical values of employees—is part of its "control environment." As Compliance Week has covered extensively over the past two years, many experts believe that problems with tone and the control environment are the most grave of weaknesses; according to the COSO framework, the control environment is "the foundation for all other components of internal control, providing discipline and structure."

MOST COMMON

Type

Pct.

Financial Systems & Procedures

Accounting Policies, Practices

33.3%

Lease Accounting

10.0%

Inventory Issues

6.7%

Stock Option, Comp. Accounting

6.7%

Taxes

6.7%

Account Reconciliation

3.3%

Financial Close Process

3.3%

Revenue Recognition

3.3%

Valuation Issues

3.3%

Subtotal

76.7%

Personnel Issues

Staff (Inexperienced, Lack of)

10.0%

Segregation of Duties

3.3%

Subtotal

13.3%

Other Problems

Control Environment

3.3%

M&A Issues

3.3%

Board Independence

3.3%

Subtotal

10.0%

Based on 29 material weaknesses made in June 2005; some companies disclosed more than one weakness.

Remediation Disclosures

Companies continue to provide significant detail on the steps they are taking to remediate problems disclosed in prior months.

Earlier this year, for example, $1.5 billion candle maker Blyth disclosed that it had a weakness related to income tax accounting and reconciliation processes. Two months later, the company explained in its 10-Q the steps it had taken to improve those controls, including the formalization of processes, procedures and documentation standards relating to income tax provisions. The company also noted that it had sped up and enhanced the review of its preparation of income tax provisions, and had actually restructured its tax department "to ensure appropriate segregation of duties regarding preparation and review of the quarterly and annual income tax provision." Blyth also engaged Ernst & Young to assist in its accounting for income taxes; the company's auditor is PricewaterhouseCoopers.

$1.5 billion bar code maker Symbol Technologies, which last year reached an agreement with the SEC and the U.S. Attorney's Office over allegations that it violated federal securities laws, also provided a detailed remediation report in its latest 10-Q. One year prior, Symbol had disclosed a material weakness related to revenue recognition, but in June 2005 the company said, "We believe we have finalized several actions undertaken that have improved the effectiveness of our internal controls.

Among the most significant organizational changes at the company was centralization of the responsibility of revenue under a revenue controller's department, which reports to the chief accounting officer. The company then identified "responsible associates" for account reconciliations and approvals, and formalized related procedures under a "worldwide policies and procedures group." To eliminate duplicate and manual processes, the company also developed what it calls a "comprehensive business transformation strategy" that would consolidate its legacy systems into one ERP platform. For those transactions that still require manual intervention, Symbol implemented a more formal review process. "As a result of these and other measures we have taken to date," said the company in its quarterly report, "we believe this material weakness and other deficiencies described above have been remediated."

Not every company was successful in remediating its weaknesses, though. $1.9 billion Amkor Technology, for example, disclosed that it had a problem related to the way that certain capital expenditures were reflected in accordance with SFAS 95, an accounting standard related to the statement of cash flows. In its 10-Q for the first three months of 2005, Amkor indicated "that management believed the material weakness had been remediated." However, in the process of finalizing the company's 2004 restatement, it determined that efforts it had undertaken "did not remediate the material weakness and the process required enhancement to ensure that all amounts of unpaid capital expenditures were identified." As a result,

the company implemented "an enhanced process to identify all unpaid capital expenditures at the end of the reporting period to ensure capital expenditures are properly reflected in the consolidated statement of cash flows in accordance with SFAS 95." According to an 8-K filed June 6,

the company's management "believes this enhanced process will remediate the material weakness discussed above."

Voice over IP provider Net2Phone also disclosed that its deficiencies have yet to be fully remediated. Though the company announced that new systems have been designed the implemented to repair the weakness—which was related to fixed assets and depreciation expense—Net2Phone acknowledged in an 8-K filed June 6 that the problems "remain significant enough to continue to be reported as a 'material weakness' in the Company’s financial controls as defined in AS No. 2."

The List, And Our Standard Disclosure

As usual, we’re making available to subscribers a sample list of public companies that disclosed weaknesses in their internal control over financial reporting during the month of June 2005. Sample remediation disclosures are also available (see box above, right). The list 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. Asyst Technologies, for example, discussed a material weakness in an 8-K filed June 15; however, the company had already disclosed that weakness Dec. 30, 2004.

In an 8-K filed June 20, Deloitte and Touche consented to the "incorporation by reference" of certain documents related to the acquisition of Pulitzer by Lee Enterprises; however, the internal control weakness mentioned in the filing had already been disclosed on March 17.

Wireless Facilities also mentioned a weakness in an 8-K filed June 10 that had already been disclosed. The same was the case at Pathmark Stores, Usec, and others.

Inclusions

We did, however, include disclosures that provided material updates to previous announcements.

Vesta Insurance, for example, disclosed a weakness back on March 14 related to the firm's consolidation process. But on June 3, Vesta noted that it had identified another material weaknesses "in ceded reinsurance and financial management and may identify additional material weaknesses as the internal control assessments are completed."

The same was the case at Flowserve and other companies.

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. On June 15, for example, Macromedia disclosed a weakness related to the fact that the company's policies and procedures "did not include adequate management oversight and review of the Company’s accounting for income taxes." We've categorized that disclosure as one related to taxes; however, the disclosure could have been categorized as a personnel problem, as management oversight was cited.

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 top, right.

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