While Section 404 of Sarbanes-Oxley says management is responsible for establishing and reporting on a company's system of internal controls, more than half of 329 companies reporting control deficiency disclosures did so because their external auditors identified and reported those weaknesses, according to a report by the Financial Executives Research Foundation.

In a study of internal controls reporting by 329 companies, 54 percent made control deficiency disclosures because their external auditors identified the weaknesses and reported them to the audit committee. Only 28 percent of companies were proactive in bringing the reported control deficiencies to the attention of their external auditors and the audit committee, according to the report, "Control Deficiency Reporting," by Lehigh University accounting professor Parveen P. Gupta and Tim Leech, principal consultant and chief methodology officer of Paisley Consulting.

About 10 percent of the companies identified and reported control deficiencies to their audit committees jointly with their external auditors, while 6 percent disclosed control deficiencies through Form 8-K while disclosing an auditor change to the SEC. The remaining 2 percent reported control deficiencies either due to an internal investigation or a Securities and Exchange Commission probe.

The FERF analysis is based on 968 internal control deficiencies and 1,000 remediation actions disclosed by the companies in SEC filings between Nov. 1, 2003 and Oct. 31, 2004.

The report, which found that companies disclosed an average of three internal control deficiencies, noted that the larger a company's market cap, the more control deficiencies it reported. Small cap companies disclosed an average of 2.51 deficiencies; mid caps, 2.71; and large caps, 3.71. Disclosed remediation actions tracked similarly, with small caps averaging 2.5 disclosures; mid caps, 3.02; and large caps, 4.76.

Among the firms studied, 44 percent experienced an auditor change with a net shift occurring from Big Four firms to non Big Four firms. The Big Four had a net loss of 59 clients, while non Big Four firms had a net gain of 49 clients, according to the analysis.

More than half of the deficiencies in the sample were classified as material weaknesses. Sales revenue, accounts receivable, inventory and accounts payable were the most common areas experiencing control deficiencies, while less than 4 percent of the total reported control deficiencies were in information technology controls. None of the control deficiency disclosures claimed ineffective audit committee oversight, the authors noted.

The report is available at www.FEI.org/rfbookstore. The cost is $24.95 for FEI members and $49.95 for non-members.

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