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Thursday, March 03, 2005

Accounting rule exposes problems, stirs debate

More than 500 public companies have reported deficiencies with their internal accounting controls under a controversial new federal rule -- a figure sure to feed the continuing debate about the cost and usefulness of recent efforts to strengthen corporate governance.

To backers, the volume of disclosures demonstrates that the new rule, part of the 2002 Sarbanes-Oxley corporate-accountability law, is pushing a lot of U.S. companies into line. But business groups complain that it's costing them a lot of money and effort to turn up deficiencies that in most cases are inconsequential.

The rule, section 404 of Sarbanes-Oxley, requires companies to assess the internal controls they have in place to ensure their financial reporting is accurate and reliable -- and requires accounting firms to vouch for those controls.

A Wall Street Journal review of about 50 of the public filings shows that the reported weaknesses range from minor issues that are easily correctable to larger problems that may require restating past financial results. Among problems turning up are a lack of specialized accounting expertise, unfettered employee access to some financial systems, problems identifying when certain assets need to be written off and difficulty in tracking and reporting costs.

Many of the problems have been reported by small- and medium-sized companies, but among the biggest to report some deficiency in internal controls are McAfee Inc., SunTrust Banks Inc., Eastman Kodak Co. and Toys "R" Us Inc. Securities and Exchange Commission officials say more disclosures are expected. Some companies have seen their stocks drop after disclosing deficiencies, but some have seen no reaction at all.

While the rule only requires companies to disclose material weaknesses in their annual reports, many companies have begun alerting investors about deficiencies and potential problems. The rule is intended as a disclosure mechanism to alert investors about problems, but companies could face SEC action if they report serious deficiencies or if they fail to disclose serious shortcomings.

"The internal-control disclosure requirement has the potential to provide the greatest long-term benefit in financial reporting," said Alan Beller, SEC's director of corporation finance.

Defenders say the disclosures stem from tougher auditing standards set by accounting firms embarrassed after recent financial frauds at Enron Corp., WorldCom Inc. and other companies.

"Auditors are no longer going to provide any type of flexibility to management," said Chris Mears, a partner with Rothstein Kass, an accounting and consulting firm.

But many executives call the rule onerous and say it is fattening the bottom lines of accounting firms while costing other companies billions of dollars.

Financial Executives International, a membership and advocacy group for financial executives, claims companies will spend an average of $3 million apiece to comply with the rule. Companies with more than $5 billion in revenue are expected to spend about $8 million on average, while companies with less than $100 million in revenue are expected to spend about $550,000 on average. Annual costs are expected to drop after the first year or two of the rule's implementation.

"I believe the external auditors are exceeding the intent of 404," said Alex Davern, finance chief for National Instruments Corp. and chairman of American Electronics Association's SOX 404 committee.

Mr. Davern says external auditors are requiring companies to pay for things that won't prevent fraud. "We had to pay an auditor to come to a meeting to prove the meeting took place," he said. He is lobbying regulators to tailor the rules for different-sized companies, thus softening the requirements for smaller firms.

Under the rule, management must conduct its own look at everything from who can access sensitive financial data to how many accountants a company has on staff, all to ensure that the data on its financial reports is accurate. After a company's managers review internal controls, its externanducted. They say companies' costs stem not from aggressive auditing, but from the rule's requirement that companies pay for two reviews.

"There's somewhat of a dual track of work that's going on, which leads to some perception of a lot of cost being incurred, but we are as auditors bound" by the accounting board's standard, said Bob Dohrer, an accountant with McGladrey & Pullen LLP and a member of the American Institute of Certified Public Accountants' SOX 404 task force.

Because the rule is so new, he said, auditors have no choice but to strictly adhere to the accounting board's standard, he said. "We struggle internally with the fact that, not having gone through this before, how much room do you have to interpret certain provisions?" he said. "And at the end of the day it comes back to the words" established by the accounting board.

Still, SEC Chairman William Donaldson recently said that while he supports the regulation, it may need some fine-tuning and announced a public roundtable on the rule for April 13. SEC Commissioner Cynthia Glassman, a Republican who has at times clashed with Mr. Donaldson, said she's concerned that the rule may have resulted in auditors -- rather than management -- dictating how companies think about internal controls.

Some firms have said they plan to go private to avoid compliance with section 404 and other Sarbanes-Oxley rules. Among them are Paul Mueller Co., a manufacturing firm; Ohio Art Co., which makes Etch-A-Sketch; and ShoLodge Inc., which owns and operates Shoney's Inns. All have announced plans to deregister their securities, saying the costs of operating as a public company -- including complying with Sarbanes-Oxley -- have gotten too high.

For some companies, the problems uncovered have constituted a "material weakness," which means there are one or more significant deficiencies that result in "more than a remote likelihood that a material misstatement in the company's annual or interim financial statements will not be prevented or detected."

Last month, Eastman Kodak disclosed errors in its income-tax accounting and said it expected its auditor, PricewaterhouseCoopers, to issue an "adverse opinion" on its internal controls. The company was only able to report preliminary results for the fourth quarter and said "adjustments may result" after an analysis of its income tax accounting is completed. Despite the disclosure, Kodak's stock rose after the announcement, which analysts attributed to positive comments the company made simultaneously about its operations.

Some companies have said they plan to restate based on errors identified during reviews of their internal controls. Terex Corp., which manufactures construction-related and other equipment, said last month it would restate full-year earnings for 2001 to 2003 after discovering "imbalances" in certain company accounts. The company said the need to restate "arose primarily from the company's failure to properly record certain inter-company transactions." The change isn't expected to be material, and Terex's stock dropped 39 cents, or less than 1 percent, after the disclosure.

Tom Gelston, director of investor relations at Terex, said Terex had replaced an "antiquated" financial-reporting system in order to comply with Sarbanes-Oxley and that the new system revealed the problems. "Getting ready for the internal controls review helped discover this," Mr. Gelston said.

Navistar International Corp., a holding company that makes trucks and engines and has a finance arm that provides financing for trucks in the U.S. and Mexico, said an evaluation of its internal controls found "weaknesses in the disclosure controls and procedures within the company's finance subsidiary." In particular, Navistar said it had used improper accounting for the securitization of some loans. The company also identified a "lack of sufficient specialized" accounting personnel. Navistar has said it plans to restate financial results for fiscal 2002 and 2003 and the first three quarters of fiscal 2004 because of the accounting error. Some results will be adjusted upward, some downward.

To be sure, accounting firms are expected to see a big jump in revenue from the rule. Mr. Mears said audit costs are expected to increase 30 percent to 40 percent this year for companies with between $50 million to $500 million in revenue.

But Raymond Beier, a partner with PricewaterhouseCoopers, said auditors are doing what's required under Sarbanes-Oxley and that companies can benefit by systematically reviewing their internal controls.

"Auditors are trying to do the best job they can," he said. "Sarbanes-Oxley and 404 are first and foremost aimed at restoring investor confidence and improving the reliability of financial reporting. To that end, compelling companies to look more deeply at their financial reporting can certainly create the right environment for reducing the risk of fraud."

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