Remediation, Updates Dominate May 2005 Disclosures

A review of internal control disclosures made during the month of May 2005 shows that companies are successfully remediating internal control weaknesses disclosed in prior months, while others are amending opinions from "effective" to "ineffective."

Some of the disclosures—including excerpts and the original filings—are available to subscribers in the box at right.

As was the case with disclosures made during prior months, the majority of the weaknesses reported by public companies involved accounting issues, or problems with financial systems and procedures. That included problems with account reconciliation, the financial close process, lease accounting, revenue recognition, and other issues (see chart below, left, for breakdown of disclosures).

In total, those accounting and financial problems accounted for nearly 65 percent of all weakness disclosures.

Weaknesses related to a company's personnel—including problems like inexperienced accounting staffs, or poor segregation of duties—accounted for approximately 14 percent of the disclosures.

8.5 percent of the disclosures were related to information technology issues. That's higher than average; of the nearly 750 weakness disclosures in 2004 reviewed by Compliance Week, only 3.5 percent involved IT issues. However, the relatively small number does sync with a recent study co-authored by Lehigh University accounting professor Parveen Gupta, which indicated companies may be understating deficiencies in information technology controls. According to a Compliance Week article in May 2004 that reviewed the study's findings, Gupta believes the low rate of disclosed IT weaknesses doesn’t square with the prevalence of information technology in most companies today.

More than 5 percent of the disclosures made in May 2005 could be categorized as weaknesses with the company's control environment.

$149.2 million supercomputer maker Cray, for example, noted that its control environment "did not sufficiently promote effective internal control over financial reporting throughout our management structure."

To many experts, those problems with the control environment are considered the most grave of weaknesses. That's because the control environment sets the entire tone of an organization, influencing the ethical values and integrity of employees. "It is the foundation for all other components of internal control, providing discipline and structure," notes the widely utilized Internal Control—Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission.

MOST COMMON

Type

Pct.

Accounting Policies, Practices

23.9%

Taxes

9.9%

Staff (Inexperienced, Lack of)

8.5%

Revenue Recognition

8.5%

IT Environment

8.5%

Financial Close Process

7.0%

Control Environment

5.6%

Lease Accounting

5.6%

Segregation of Duties

5.6%

Documentation

4.2%

Inventory Issues

4.2%

Stock Option, Comp. Accounting

2.8%

Valuation Issues

1.4%

SAS 70, Partner

1.4%

Account Reconciliation

1.4%

Uncategorized

1.4%

Based on 71 material weaknesses made in May 2005; some companies disclosed more than one weakness.

As has been the case during prior months, approximately 75 percent of the weakness disclosures came from companies with less than $1 billion in revenue. Only four companies making such disclosures had revenue of more than $10 billion: General Electric, Toys R Us, AIG, and The Great Atlantic & Pacific Tea Company.

Remediation Disclosures

During the month of May, several companies disclosed that they had successfully remediated weaknesses announced in prior periods.

$173.3 million air conditioning and heating equipment manufacturer AAON, for example, noted it had remediated a weakness "with respect to the preparation of certain adjustments recorded by management related to the valuation of inventory and the capitalization of certain purchase price variances and absorption of manufacturing overhead." As Compliance Week reported in April, the industrial manufacturer had disclosed two weaknesses on March 16.

Similarly, The Meridian Resource Corporation, a $202.3 million independent oil and natural gas company, stated that it had identified and remediated certain material weaknesses in the fourth quarter of 2004. According to an amended annual report filed May 2, the material weaknesses that were remediated at Meridian related to "a lack of effective controls over the coding of certain workover invoices, ... controls over the revenue accrual process ... [and] a lack of proper segregation of duties associated with the initiation and

execution of wire transfers..."

Among the most detailed remediation announcements was from $12.1 billion Masco, one of the world’s largest manufacturers of consumer home products—the company operates dozens of household brands like Delta Faucet and cabinet-maker KraftMaid. In a quarterly report filed May 10, the company published a detailed list of steps it had taken to remediate a weakness disclosed in its last annual report. Steps taken included the

training of staffers,

the hiring of financial management positions,

the streamlining and standardization of the accounts payable process,

and the expansion and reinforcement of the need for "timeliness

and transparency of communication around significant financial and

business matters between the [affected] business unit and group oversight

management."

Of course, not every company's remediation efforts was successful. A few companies, for example, filed quarterly reports in which they were required to disclose that they still had a material weakness, because a problem disclosed in their annual report had not been fully remediated. That was the case at $1.9 billion household appliance components maker Tecumseh Products. In a 10-Q filed May 6, the company disclosed that certain material weaknesses that caused the company's internal controls to be deemed ineffective as of its 2004 year-end had "not yet been fully corrected and are, therefore, not effective as of March 31, 2005."

Stun gun maker Taser International also filed a quarterly report in May which stated that, because a material weakness reported in an amended annual report "had not yet been remediated at March 31, 2005, our disclosure controls and procedures were ineffective as of March 31, 2005..."

Other companies actually discovered new problems during the remediation process. $3.8 billion disk-drive maker Maxtor Corp., for example, announced on May 4 that the financials in the company's annual report should not be relied upon because of certain financial statement errors. The problem, related to lease accounting, was discovered by the company's accounting and finance staff while they were preparing Maxtor's latest quarterly report. While "reviewing certain complex, non-routine transactions in remediation of the material weakness in internal controls over financial reporting as of December 25, 2004," the staff "determined that certain lease accounting entries originally recorded in April 2001 were in error."

Changing Opinions

At least two companies filed amended reports that altered management's prior opinion on the effectiveness of the company's internal control over financial reporting.

On May 10, for example, NL Industries announced that it would file an amended annual report that reflected a "noncash income tax benefit" in its year-end results.

Though the company's income from continuing operations for 2004—as well as its three previous quarterly reports—was unaffected by the adjustment, the company was forced to disclose that it had a material weakness. [The Public Company Accounting Oversight Board's internal control standard states that a restatement should be a "strong indicator" that a weakness exists]. The weakness precluded the company from concluding that its internal control over financial reporting was effective as of its year-end. "Therefore, the Company's previous conclusion, as reported in the Company's Management Report on Internal Control Over Financial Reporting contained in Item 9A of the Original Form 10-K, that it maintained effective internal control over financial reporting as of December 31, 2004, can no longer be relied upon and will be restated when it

files the Form 10-K/A."

The same was the case at $1.9 billion mobile phone maker Brightpoint. In the company's annual report filed in February, management provided a clean opinion of the company's internal control over financial reporting. That was despite the existence of "significant deficiencies that were deemed by the Company's management to not be

material weaknesses."

However, shortly after the annual report was filed, the company identified errors in its financial statements. "Management has concluded that these errors

resulted from material weaknesses in internal control in the Company's operations in France and Australia," reported the company in an amended 10-K filed May 9. As a result, the company's management "revised its assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2004..."

Setting The Stage

According to Compliance Week's database of previously disclosed material weaknesses (see searches in box above, right), companies appear to be doing a good job of informing the market of potential problems. The weakness at Tecumseh Products, for example, had been hinted at in November 2004, when the company stated it had identified "certain deficiencies" and might find other problems.

Cray, Inc., while disclosing a long list of weaknesses, had already set the stage for those disclosures in a series of announcements earlier this year. Back in March, the company disclosed that "we expect that we will identify one or more material weaknesses," and then in April, Cray said it had discovered weaknesses, but that testing and evaluation were not complete. In May, the company disclosed eight problems, including the fact that the company's control environment "did not sufficiently promote effective internal control over financial reporting throughout our management structure."

Sharper Image also disclosed a weakness that had been disclosed as a possibility in prior months. In an 8-K filed back in April, the company noted that had identified an error related to certain calculations and "missing product cost increases" relating to inventory that had been sold through. The result was an overstatement of net income. At the time, the company stated that it is "evaluating whether or not this restatement represents a material weakness"; on May 4, the company did indeed report a weakness.

The same was the case at Toys R Us. On April 14, the company delayed filing of its annual report, and noted that it expected to disclose a material weakness "due solely to the restatement related to the Company's accounting practices for leases and leasehold

improvements..." On May 2, the company disclosed the weakness.

Other companies not only set the stage for future disclosures, but updated the market on the escalation of the problem's criticality. Unizan Financial, for example, initially disclosed a deficiency back in November 2004. In February 2005, the company upgraded the problem, nothing that a weakness was now likely. On May 2, it disclosed the weaknesses, which were related to change controls and "security around user access rights to certain application systems."

Other problems weren't market surprises simply because the companies had already disclosed issues that would likely result in weakness disclosures. $36.9 million online education company eCollege, for example, disclosed back in August of 2004 that it would likely restate its 2003 and 2004 financial results to correct an accounting error in its company stock plan. On May 12, the company did indeed disclose a material error "in the accounting for the Company’s Employee Stock Purchase Plan under SFAS No. 123, Accounting for Stock-Based Compensation."

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 May 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. $1.0 billion Doral Financial, for example, provided information on a weakness related to the lack of effective controls over the valuation of certain floating interest rates; however, the company had already disclosed that weakness in an amended Form 8-K in April.

Churchill Downs also mentioned a weakness during a conference call with investors that was filed on Form 8-K; however, the company had already disclosed those problems in March.

The same was the case at Energy Conversion Devices, which filed an amended 10-K that repeated information disclosed back in October 2004. Compass Materials International also mentioned several tax-related weaknesses in an 8-K that announced the dismissal of PricewaterhouseCoopers as auditor; however, those weaknesses had already been disclosed in a 10-Q back in November 2004.

Other companies that disclosed weaknesses in May that had already been reported were Marshall Edwards, Viasat, Terex Corp., RAE Systems, DHB Industries, Actuate, and others.

Inclusions

We did, however, include disclosures that included material updates to previous announcements. $264.6 million IGate, for example, disclosed a material weakness in April related to "the application and monitoring of cash payments received from customers and the issuance of customer credit memos and discounts." But then in May, the company disclosed three new weaknesses related to accounts receivable accounting, deferred compensation calculations, and income tax calculations, including "the determination of income taxes payable, deferred income tax assets and liabilities and the related income tax provision."

RTI International Metals had disclosed weaknesses back in April, but noted that the company "has not yet completed the process of evaluating identified deficiencies against the Company's internal control framework." In May, the company provided additional details on the problem, which are included in May's list.

Similarly, CDI Corp. disclosed in March that it expected to report a material weakness, and in fact the company did report one on May 10.

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 May 2, for example, $494.5 million Carmike Cinemas disclosed that it did not maintain effective controls "over the accounting for and reporting of non-routine and non-systematic transactions because it did not have adequate personnel who possessed sufficient depth and experience to correctly account for such transactions in accordance with generally accepted accounting principles." We've categorized that disclosure as one related to Accounting Staff, as that was listed as the cause of the problem; however, the disclosure could have been categorized legitimately under "Accounting Policies And 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.