t the request of subscribers, Compliance Week offers a Remediation Center, in which readers can submit questions—anonymously—to securities and accounting experts. Compliance Week's editors will review all questions and then submit them—confidentially, of course—to specialists who can address the issues. The questions and responses will then be reprinted in a future edition of Compliance Week. Below is one of the Q&As; ask your own questions by clicking here.

ABOUT THE EXPERT

Jim Mack is the partner-in-charge of the EisnerAmper Consulting Services Group. Among the primary services offered by EisnerAmper Consulting Services are: enterprise risk management; internal audit and controls; Sarbanes-Oxley compliance; pre-IPO readiness; finance function transformation and technology risk, including privacy and data security. As Mack observes, “Many of these services have existed for years but in the current environment of reputational and regulatory risk, coupled with a rocky recovery from a severe recession, the need for these services by regulated companies is now enhanced and very real.”

Mack has broad experience providing audit and consulting services to companies in the financial services, life sciences, and energy sectors. With 25 years of experience, Mack is a seasoned client service professional with extensive expertise advising senior executives and boards of directors on how to navigate emerging accounting and regulatory rulemaking. He has led audit engagements for companies in various stages of evolution, from start-ups to Fortune 50 entities and with private, public, and alternative ownership structures. He has served as the outsourced internal audit leader for several NYSE-listed entities and directed dozens of Sarbanes-Oxley 404 implementations.

Jim Prior to joining EisnerAmper, Mack was the president of West Valley Group which specialized in assisting senior executives in making their operations more successful through the use of enterprise risk assessment, CFO support, and merger integration solutions. The group focused on serving companies in the insurance, energy, manufacturing, and healthcare industries. As a senior partner at SMART Business Advisory and Consulting, Mack was the partner-in-charge of the advisory and assurance business services practice, practice leader – enterprise risk services and partner – insurance services. He was a key member of the team that built the organization into a top 25 firm. In addition, he spent 12 years with Ernst & Young where he served some of the Philadelphia office's largest clients.

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QUESTION

I'm the head of internal audit and compliance for my company, and the primary executive in charge of SOX 404 compliance. For the past three years my company has reported a material weakness in our internal control over financial reporting—specifically, we can't ensure that financial risks arising from complex, non-routine transactions are caught in a timely manner and properly accounted for when we find them. Basically, our weakness is inadequate accounting resources and skill sets, and we've reported that for three years running.

Every quarter, I'm pressured to substantiate why this weakness should remain in our SEC filing. The company hasn't implemented any new controls or system changes to seal up this weakness; instead, other people here contend that if we have two clean quarters (no material adjustments noted by our external auditors), then we'll be ready to claim that our weakness has been remedied.

Since this weakness is fundamentally about skill sets, can we argue that over time our staff have become smarter, and the clean quarters are evidence of that?  

ANSWER

Material weaknesses in competency controls are often difficult to come to terms with. They require solutions that are not as simple as the implementation of a basic control process such as a reconciliation or management approval. In the initial years of Sarbanes-Oxley 404 certifications, material weaknesses in competency controls were very common. Studies of public filings in this period concluded that the majority of material weaknesses involved the lack of qualified accounting personnel at companies with highly complex accounting issues. Accounting for income taxes and revenue recognition were commonly noted as accounting areas for which companies did not have internal resources qualified to prepare reliable accounting conclusions.

Remember, the definition of a material weakness relates to a deficiency or combination of deficiencies that “results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.” Alternatively, a significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting “that is less severe than a material weakness yet important enough to merit attention by those responsible for oversight of a company's financial reporting.” The occurrence of a material misstatement is not required to arrive at these conclusions, but significant audit adjustments are typically viewed as evidence of significant deficiencies or material weaknesses. This can become frustrating for companies in situations where audit adjustments arise as a matter of interpretation or matters that fall into the proverbial “grey area” of accounting rulemaking. Many companies have had to report material weaknesses due to audit adjustments in areas that are not cut and dry. A material weakness is a hard pill to swallow when it arises from a difference of opinion.

Essentially the material weakness you describe results from the conclusion that the barn door is open. The company is not judged to have adequate resources to deal with emerging or complex accounting issues. The fact that the horses have not left the barn is not adequate to alleviate the material weakness. The lack of audit adjustments alone, particularly in interim periods, may not be enough to change the conclusion.

An obvious fix is to upgrade the team. For some companies, however, the complexity of current or potential accounting matters exceeds the talent of the accounting personnel. Smaller companies, entities in specialized industries or companies outside of major cities may find it difficult to attract and retain all the expertise they require. But the upgrading of talent does not always require adding an FTE or other staff changes. There are a number of firms that provide accounting consulting services that could supplement the talent of the internal team. Another option is to engage part time or recently retired executive that have experience broad enough to provide reliable accounting conclusions. Your outside auditors should view this favorably. If you believe that your teams' skills have advanced sufficiently to overcome the weakness, you should attempt to document and substantiate this to your auditors and possibly consider changing the reporting of this issue to a significant deficiency. That may be a difficult case to make. It is likely that something more substantial will need to change.

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Specialists are solicited by the editor to answer Remediation Center questions based on their knowledge of the subject matter and their ability to provide commentary in their particular area of expertise.