Better than one in every eight U.S. corporations that have undergone the more rigorous audits mandated by the Sarbanes-Oxley Act during the past year have been flagged for ineffective internal controls over their financial reporting, officials at the Public Company Accounting Oversight Board disclosed during a recent meeting with the organization's Standing Advisory Group.
The high rate of "material weaknesses" cited by auditors is likely to climb even higher during the coming year, as thousands of smaller corporations with less sophisticated internal control systems become subject to the new SOX financial reporting rules.
Much of the teeth-gnashing has involved SOX Section 404, which requires top managers of publicly traded companies to report on the effectiveness of the corporation's internal financial controls, and obliges auditors to attest to the accuracy of management's assessment.
If the auditor identifies one or more material weaknesses in the company's reporting, Securities and Exchange Commission rules prohibit management from concluding that their internal controls are effective.
Larger corporations in the first wave of companies subject to the new rules "have found the first year challenging," and "many companies found Section 404's requirements costly and burdensome," the oversight body acknowledged. The fact that some 12 percent of these companies were flagged for material weaknesses during the first year of SOX compliance adds insult to injury.
According to figures released by the board during the SAG meeting, 2,984 corporations had undergone audits under the new Section 404 rules by June 1, 2005, and 364 of these companies (12 percent) were cited for material weaknesses in their internal controls.
Significantly, the PCAOB noted that financial services companies were substantially less likely to be flagged for weaknesses, while smaller companies and firms in the retail and service industry showed higher rates of reports of these same deficiencies. Problems associated with revenue recognition, tax accounting and proper accounting for leases were among the key issues that led to weakness reports, the PCAOB noted.
Ineffective audit committees were rarely blamed for the weaknesses identified by auditors during the past year. Rather, the board said that the top reason was "personnel issues" - especially a lack of internal accounting staff "at the necessary level of expertise."
The high rate of weaknesses found during the latest round of audits raised eyebrows among some members of advisory panel, including former SEC chief accountant Lynn Turner.
Turner, managing director at proxy researcher Glass Lewis & Co., expressed concerns that the rate of material weaknesses uncovered by accountants may rise significantly later this year, as smaller corporations are brought under the new SOX audit requirements.
Adding to the likelihood of problems when these companies begin compliance with Section 404 later this year is suspected foot-dragging among the management of small firms that will soon be required to attest to their internal controls.
Turner said that many accountants have told him that their smaller audit clients are "procrastinating" about SOX compliance - a development that could lead to a "crunch" at the end of the year.
Concern over the rate of material weaknesses uncovered during SOX audits was also voiced by board member Kayla Gillan, who described the first year of implementation as "incredibly stressful" for public companies and their auditors.
During the meeting, a panel of auditors, including representatives from Grant Thornton and Ernst & Young, among other major firms, cited the following factors as likely to increase the prospects of a material weakness for companies:
* A decentralized operating structure;
* A growth pattern that relies on acquisitions;
* A vulnerability to the effects of regulatory or technological changes;
* A history of audit adjustments; and,
* A heavy dependence on automation without sufficient in-house information technology personnel.
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