Corporate America’s finance staff now has some hard evidence for their bosses, regulators and investors to support recurring claims of an overwhelming workload. The internal controls over financial reporting aren’t what they should be, and a shortage of skilled personnel is the most common cause.
According to a Compliance Week analysis of the disclosures at 400 public companies that reported material weaknesses within the last year, "personnel" topped the list of problem areas. Of the 400 randomly sampled companies, 41.5 percent said their weaknesses were related to insufficient staffing, poor training, related issues, including segregation of duties.
Tholey
“It’s training, it’s skills, it’s tight staffing, it’s segregation of duties,” says James Tholey, managing director with Accume Partners. “And you can’t bounce things off your auditor like you used to, although that’s softening now somewhat. It’s not any one of those things; it’s all those things.”
When internal control reports first became the law of the land with Sarbanes-Oxley, tension between preparers and auditors hit an all-time high because auditors’ conservative take on the rules said companies demonstrated a weakness or a deficiency in internal controls if they had to rely on the auditors to help prepare financial reports.
Auditors are moderating on that point, Tholey says, but the wall between auditors and preparers remains somewhat in place, cutting companies off from a traditional source of accounting expertise. That has affected all areas of reporting to some extent, he and others say.
Rittenberg
“The biggest theme here is the personnel issue, and that sort of permeates everything else,” says Larry Rittenberg, an accounting professor at the University of Wisconsin and chairman of the Committee of Sponsoring Organizations, noting that companies citing a personnel problem usually cited other problems as well.
Of the 166 companies that reported a personnel problem as cause for their disclosed material weakness, 88 percent reported additional trouble spots, like violations of financial procedures, tax problems, lack of proper documentation, or problems with IT systems.
Joseph Carcello, director of research at the University of Tennessee’s Corporate Governance Center, says that’s because the causes for material weaknesses or other deficiencies in internal controls are bound to overlap. “These things interact. Some of the tax problems, for example, might be disguised as people problems,” he says.
The evidence of the interplay is greatest in disclosures like one from Design Within Reach, a $158 million consumer products company in San Francisco that described practically every reporting problem in the book: period-end financial reporting process, segregation of duties, access to IT systems, account summaries and reconciliations, policies and procedures, inventory management, accounts payable, taxes, invoicing and accounts receivable. Design’s most recent chief financial officer, Ken La Honta, resigned on Aug. 16; spokesmen for the company were not available for comment.
Carcello
“Why don’t you just say you did not maintain effective control over two-thirds of what’s in your balance sheet?” Carcello quips.
Such extensive problems are indicative of a larger tone-at-the-top problem, he says, which 5 percent of companies in the Compliance Week analysis reported as cause for concern. In each of those cases, companies reported tone not as an isolated problem, but as one of several problems with reporting.
“Tone at the top is pervasive,” Tholey says. “It’s not isolated. If there’s a problem with tone, it will show up in three, four, five, six different places.”
Other Problems
Behind personnel, taxes emerged as the No. 2 problem area—but to little surprise, says Jack Ciesielski, owner of research and advisory firm R.G. Associates. “Tax problems are going to be more plentiful no matter what industry or what size the company because everyone gets touched,” he says. “No one is immune to taxes.”
MOST COMMON WEAKNESSES
Below is a summary of the most frequently cited material weaknesses, as tracked in Compliance Week's analysis:
Weakness
Companies Reporting
Percent Of Cos.
Personnel
166
41.5%
Taxes
132
33.0%
Financial Procedures *
106
26.5%
Documentation
67
16.8%
Revenue Recognition
58
14.5%
IT, Financial Systems
52
13.0%
Hedge Accounting
28
7.0%
Cash Flows
27
6.8%
Tone at Top
20
5.0%
Lease Accounting
18
4.5%
Vendor Contracts
14
3.5%
Notes:
"Percent Of Cos." column does not total 100 percent, as many companies disclosed more than one "type" of weakness. Also, the categorization of weaknesses is subjective, and is not a science, so some weaknesses could have been listed in more than one category; we have done our best to remain consistent, depending on the company's particular disclosure. "Other Accounting" issues—including disparate problems like M&A accounting or litigation valuation errors—also yielded a large number of weaknesses. Please see spreadsheet (below) for details.
* The "Financial Procedures" category typically included problems related to the financial close process, account reconciliation, or inventory processes.
Source:
Compliance Week Analysis Of Internal Control Weakness Disclosures (Sept. 6, 2006)
Complexity is another factor in tax weaknesses, says Tholey of Accume Partners. “There are lots of common tripping points. Taxes are replete with opportunities for error.”
The divide between accounting firms and clients has an effect here too, Tholey adds. Recent audit rules have created a greater separation of auditing and tax work, resulting in a significant personnel shift that has occurred throughout the market.
“Companies used to rely on their external auditors to help with tax issues to some extent, but that’s been slowed down too,” he says. Tholey points to the example of Cambrex Corp., a $450 million pharmaceuticals company in East Rutherford, N.J., that disclosed personnel and tax problems.
“The company did not have a sufficient level of experienced personnel to enable the company to properly consider and apply generally accepted accounting principles to the accounting for income taxes,” Cambrex said in its 10-K filing.
Ciesielski
Ciesielski says even new rules requiring companies to expense stock options play a part in tax reporting problems. Companies have always been required to keep tax records related to stock options, but recordkeeping was lax when options were reported simply as a footnote to the financial statements. Now that companies must report options as an expense on the balance sheet, they are scrambling with inadequate historical records, even after the Financial Accounting Standards Board created a shortcut method to address the problem, he says.
“In general, taxes are a nexus where a lot of things can go wrong,” he says.
Other reporting trouble spots for companies included documentation (16.8 percent), revenue recognition (14.5 percent), information systems (13 percent), and cash flow (6.8 percent).
Only a handful of companies reported problems with leases (4.5 percent) and derivatives (7 percent), however—both of which led to record numbers of restatements in 2005. Carcello believes the restatement wave may have adequately addressed the problem.
Tholey, however, suspects more problems in those areas will become evident in future reporting periods. “The story’s not completely over there yet,” he insists.
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