Updated from 4:14 p.m. ESTHundreds of public companies soon may get a failing grade on a key Sarbanes-Oxley-related report. As disturbing as that may sound, some observers are more worried about how investors will react to such news. Many observers consider the reports, which were intended to prevent the next Enron-type debacle, to be the key provision of the Sarbanes-Oxley Act. But some accounting experts and regulators are warning investors that just because a company turns in an imperfect report doesn't mean it's a corporate scandal in the making. "It's important that investors have an understanding of what the material weakness is," added Erica Sulkowski, special adviser to the chief accountant of the Securities and Exchange Commission. But Grace Hinchman, senior vice president of Financial Executives International, warned, "The public at large may not understand that. That's a real concern." However, some corporate watchdogs think companies have little excuse for the poor reports, which concern a company's so-called internal controls. That so many companies may get a failing grade on their internal controls reports is "really fascinating," said Nell Minow, founder of the Corporate Library, a watchdog and research group. "They were supposed to have these controls in place for 30 years, and only now are figuring out that there's a problem." Internal controls are essentially a system of checks and balances designed to prevent corporate fraud. An example of such a control might be a provision that the person in charge of approving expense reports not be the same person who is in charge of cutting checks. While federal law has long required public companies to have such systems, Sarbanes-Oxley mandated companies for the first time to assess annually the state of their controls, and required auditors to scrutinize them as well.
The requirement began to take effect last week. Public companies with market capitalizations greater than $75 million are now required to include an assessment of their internal controls in their next annual report. Concerns about the rule have been rising for months. A number of companies have already
warned investors that they won't be able to comply with the provision or will only do so after incurring substantial costs. But some observers think that compliance with the new rule could be much lower than public companies have revealed to date: Many companies seem to be pushing up against their deadlines for complying with the rule. Some 46% of companies now expect to complete their evaluation and testing of their controls just one to two months before the end of their fiscal years, according to a report released Tuesday by Ernst & Young. In a previous report, published in May, Ernst & Young found that just 13% of companies expected to finish evaluating and testing their controls one to two months before their fiscal year ends, with most expecting to finish long before then. Some 70% of PricewaterhouseCoopers' clients are in danger of not completing their reports on time and some 10% are at "severe risk" of being unable to report that they have effective controls in place, the firm's U.S. Chairman Dennis Nally said earlier this month, according to published reports. The SEC has heard from others that 20% or more of companies that are supposed to produce reports either won't meet the deadline to complete them or will have to report "material weaknesses" in their internal controls, according to Sulkowski. But some accounting experts are warning that things won't be as bad as these statistics might suggest. Not all internal control problems are the same, they say. For instance, a company might have to report a "material weakness" even if it has already taken steps to correct the problem, but hasn't had enough time to test the fix.
And some companies may not be able to include an auditor's sign-off on their controls simply because the auditors haven't completed their jobs yet -- or because the Big Four auditing firms are focusing on their biggest clients. "There's not enough accountants to go around -- although they're hard-pressed to make that admission," said Hinchman of FEI, a professional organization representing corporate CFOs, treasurers and controllers. Representatives of Grant Thornton, Ernst & Young and KPMG were not immediately available for comment. Representatives of PricewaterhouseCoopers and Deloitte Touche Tohmatsu did not return calls seeking comment. The bigger problem is the standards that auditors are holding corporations to for complying with the internal controls provisions, say some observers. To give their approval for a company's internal controls, auditors are essentially putting in place a system of zero tolerance for so-called material weaknesses in controls, said Jeff Brotman, a professor of accounting at the University of Pennsylvania's law school and the managing partner of Philadelphia-based Ledgewood Law Firm. The chances that a corporate employee will commit fraud are probably no more likely at a General Electric than they are a much smaller company, Brotman said. But because of their differences in sizes, the bar is much lower at a smaller company for what constitutes a "material weakness" in controls, he said. What's needed in the future is for auditors to be more thoughtful about assessing internal controls and what constitutes a problem, particularly at smaller companies, Brotman said. "This is much more burdensome on some of the smaller companies than the larger companies," Brotman said. "In most cases, a material weakness won't lead to material exploitation." Corporate critics have taken issue with such arguments, noting that the bulk of restatements in recent years have come from small- to mid-cap companies, not the GE's of the world.
Making it easier for companies to comply with the internal controls provision "would be completely the wrong response," said Minow. What may be a more likely response in the near term is that the SEC gives companies and auditors more time to complete their internal-controls reports. The agency is mulling the possibility of granting a limited and temporary extension, said Sulkowski. "We haven't made any decisions yet. We're still considering it," she said. Extending the deadline might well be the best way to handle the situation, said Minow. "We don't want in any way to encourage
companies to say that they are in better shape than really are," she said. "You're better off giving them extensions to get it right."