As if investors and public companies didn't have enough to worry about, a recent "trend alert" from Glass Lewis & Co., an investment research and proxy advisory firm in San Francisco, reported that control deficiencies reported by large companies are at an all-time high, with an increase of 87 percent between 2003 and late 2004 and early 2005.

The report referred mostly to "accelerated filers" - those who have issued an annual report under Sections 302 and 404 of the Sarbanes-Oxley Act, and most of whom have market capitalizations over $75 million. This was the first time these companies have had to report under SOX. A few smaller companies have voluntarily complied as well, and were therefore represented in the report.

Glass Lewis research analyst Leah Townsend, CPA, said that it may have been the increased scrutiny that led to the apparent increase in disclosed deficiencies. "It's kind of unusual that as soon as these companies are audited, the problems fall out," Townsend said. "It looks like, if management had been left on their own, they wouldn't have disclosed anything or wouldn't even have known, because they weren't testing."

The report said that only 43 percent of the companies that received a qualified opinion had previously cautioned investors that deficiencies existed, and 94 percent had certified their internal controls as effective in the quarterly filing before their annual report was issued with a qualified opinion.

In all, the report said, nearly 11 percent of public companies with market capitalizations over $75 million disclosed control deficiencies between Jan. 1, 2004, and May 2, 2005.

The implications are staggering, and the causes are not al-together clear. Apparently, scrutiny has something to do with the increase.

"There is definitely more scrutiny placed on auditors now," Townsend said, without claiming to link scrutiny with the disclosures. "They have to answer to the Public Company Accounting Oversight Board, so they're probably a little more thorough with their audit plan, making sure they're following everything. So you have the PCAOB and Section 404 combining, and suddenly companies are disclosing a lot more."

The most common type of material weaknesses that were reported involved financial systems and procedures, and personnel issues. Together, they accounted for 60 percent of the disclosures.

The report also found an interesting difference in 404-related audit results among Big Four and second-tier CPA firms. Deloitte & Touche and KPMG found material weaknesses at 8 percent of their large clients and issued qualified opinions on 4 percent. PricewaterhouseCoopers and Ernst & Young found material weaknesses at 6 percent, and 3 percent received qualified opinions.

BDO Seidman and Grant Thornton, on the other hand, found almost twice as many problems. Fifteen percent of their public company clients reported material deficiencies, and 5 percent received qualified opinions.

Jay Howell, assistant director of assurance of BDO's northwest region and overseer of SOX 404 policy, said that the size of the clients may explain the higher rate of disclosed deficiencies.

"The higher rate of material weaknesses that we're observing is a reflection of our client base, which tends to be companies smaller than those of the Big Four clients," Howell said. "These smaller companies have unique challenges when it comes to implementing SOX Section 404, and that's coming through in the higher material weakness rate. And when we look at our client base and break it down, the ones that have the material weaknesses are the smaller clients. The larger clients that we serve did not have as many problems."

Howell said that the larger clients tend to be more mature and better organized operationally, while smaller clients lacked a depth of technical accounting resources. He also noted that most companies were able to correct deficiencies before an annual audit if they had time to do so.

The most common source of material weakness at BDO, Howell said, related to the difficulty of following complex generally accepted accounting principles. In some cases, he said, companies lacked sufficient accounting staff capable of dealing with the arcane transactions of a financially aggressive business. In other cases, companies could not attract qualified staff due to a general shortage of accountants with sophisticated skills. While these problems might appear to be personnel issues, he said, ultimately they go back to difficulties with GAAP.

Some companies, Howell said, can't even find a CPA firm to help them prepare for audits under SOX requirements - or even to perform an audit.

"Because there's a limited number of firms [that can audit public companies], companies are having difficulty because of independence rules, and conflicts of interest will see their choices severely limited," Howell said. "As the non-accelerated filers start coming online for 404, that problem is going to accelerate, and it's quite likely we'll see companies that can't find a qualified audit firm."

Given that most companies are not among the accelerated filers in the report, the findings may be the tip of an iceberg that could have broader implications for financial markets.

The Glass Lewis report found that the stock price of companies reporting material weaknesses declined 0.9 percent more than the market for the week after the deficiencies were announced. Companies filing late Section 404 reports dropped 2.9 percent after announcing deficiencies.

Non-accelerated filers do not have to comply with Sarbanes-Oxley until they issue their 2006 annual reports, so the full extent of deficiencies may not be known until early 2007. Until then, markets may be nervous with uncertainty.

Howell said that new internal control guidelines expected in draft form soon from the Commission of Sponsoring Organizations should help smaller companies deal with the challenges of complying with the requirements of Sarbanes-Oxley.

The Glass Lewis report said that the findings should be considered as industry tries to balance the burden and benefits of accounting standards and Sarbanes-Oxley.

"Contaminated financial information has inflicted monetary damage and diminished investor confidence in the capital markets," the report states. "Compliance with SOX 404 appears to have brought to light internal control deficiencies at more than 1,100 public companies. Given that nearly 10 percent of public companies disclosed control deficiencies, financial statements were not as clean as we thought, and consequently may need to be filtered by careful analysis."

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