It's getting much harder for public companies to keep skeletons in their closets. As they ready internal controls for the harsh light of Section 404-compliance testing, the pressure to disclose problems uncovered in the process has become palpable.
"Problems" can mean poor procedures or IT weaknesses, but in many cases they are more basic: unqualified or inadequate finance staffs. "A company needs to have a certain amount of [in-house] knowledge to determine the appropriate accounting issues, now that it cannot rely so heavily on its auditor," says Richard Steinberg, who led Pricewaterhouse-Coopers's governance practice before starting his eponymous consulting firm.
In the first six months of the year, more than 100 companies raised red flags about the current state of their internal controls in their Securities and Exchange Commission filings, largely at the behest of their auditors, according to a CFO magazine analysis of a database compiled by Compliance Week newsletter.
The deficiencies that BDO Seidman noted at $14.5 million Advanced Materials Group Inc., which included operating without a full-time CFO and a lack of staff expertise, were typical of what one-third of companies making disclosures heard. And while smaller companies are most susceptible to such criticisms, large companies are not immune. PwC told international insurance giant AXA that the company had "insufficient personnel in the corporate accounting department with sufficient knowledge...of U.S. GAAP," the company reported in June.
With the threat of Section 404 failures looming, many firms are scrambling to fix their problems by hiring additional personnel and reorganizing. Thanks to quarterly Section 302 certification requirements, though, many are finding that agreeing to remedy weaknesses also entails reporting them. That means even the companies that end up passing Section 404 may be exposed to unwelcome investor scrutiny. The big question, says Wayne Avellanet, director of internal control at SST Truck Co., is: "Will I suffer the consequences of having a material weakness because I have a problem I can't fix fast enough?"
Roanoke Electric Steel Corp. CFO Mark G. Meikle had to hire a new staff member to placate his auditors. "We have always run a lean shop, and so we had some middle managers who were multitasking," he says, a situation that Deloitte & Touche considered a significant deficiency. Compensatory measures, such as having higher-ups approve the managers' decisions, did not solve the problem, he says, so "we realigned and readjusted so we wouldn't have that problem again." (For more on identifying control weaknesses, read CFO magazine's September article "Raising Red Flags.")