Until now, Section 404 has been a headache for corporate secretaries and financial controllers, with many IROs sitting on the sidelines of the process. Under the rule, companies must certify internal controls and report any deficiencies or material weaknesses within 75 days of their year-end.
Many US-listed companies have had to report in line with Section 404 in their 10Ks for the first time this reporting period. And there is much speculation about how the market will react to the reporting of material weaknesses, with some saying certain types of errors could prompt investors to sell. This is obviously where 404 hits home for IR. Even if shareholders don’t sell the stock, they’re closely scrutinizing compliance – so IR must be ready to field questions from the buy side.
A material weakness is anything likely to affect the financial results of a company, and it must be recorded in the financial statements. ‘Investors will pay attention to material weaknesses and there will be different levels of reaction, depending on the type of mistake,’ notes Alex Braverman, VP and corporate controller at Massachusetts-based NMS Communications, a telecom network hardware manufacturer. ‘If you can’t get the revenue right, for example, that would have a significant impact on performance,’ notes William Walker, CFO and secretary at semiconductor developer Hifn, based in Silicon Valley.
While investors will look at compliance with 404 on a case-by-case basis, there are a few types of material weaknesses that will raise red flags across the board. ‘Revenue recognition is one, as is risk control – the latter particularly concerns the buy side,’ says Stephen Galbraith, principal of Maverick Capital, a New York-based hedge fund.
‘Tone at the top or insufficient sophistication of the accounting leaders in the company will also be cause for concern,’ adds Brian Lane, formerly head of the SEC’s corporate finance division and now a lawyer with Gibson Dunn & Crutcher.
The lowdown
Questions about the oversight of manual journal entries will also be of concern, notes Ann Marie Hunker, corporate controller with M/I Homes, a homebuilder based in Ohio. ‘Things that happen not as part of routine transactions, that are not system processes – such as a company making a $5 mn or $10 mn entry without anybody checking,’ she says. M/I will file its 10K this month and so far hasn’t recorded any material weaknesses.
Companies could also face downgrades from ratings agencies in reporting certain types of material weaknesses. Fitch, for instance, outlines several criteria for a potential credit downgrade including the nature and extent of the weakness (see below). ‘For the most part, we will be concerned about surprises,’ says William Mann, associate director at Fitch. ‘To some degree it depends on the rating of the company,’ adds Roger Merritt, Fitch’s managing director and senior credit officer. ‘As you move up the rating scale, you increasingly hold companies to a higher standard in terms of earnings quality, management and financial controls. It would be surprising for a highly rated company with a history of good earnings quality to suddenly announce it has a problem with controls around revenue recognition.’
A company could, however, have pristine numbers and still be forced to record a material weakness in its 10K. Because this portion of Sox is designed to test whether a corporation is following its own reporting rules, any deviation from those guidelines is viewed negatively, even if it’s not a sign of poor financials or fraud. For example, if a company sells an item for less than the price it lists, it is not following its own procedures and the accounting records will not match its internal controls, hence a potential material weakness.
‘If I review someone for creditworthiness and my accounts receivable puts the report in one folder and the credit in another, and the rules say they should go in one, internal disclosure procedures have been violated,’ points out Walker. ‘It gets as goofy as that.’
This is reinforced by outside auditors who are paranoid about having a regulatory body overseeing their work in this area. ‘I can see the work the Public Company Accounting Oversight Board (PCAOB) is prescribing [auditors] do and it adds a level of conservatism,’ says Hunker.
‘Auditors are treating minor deficiencies seriously because if you don’t correct them, in year two they get worse and, if you don’t correct them in year three, they might become a material weakness,’ explains Edmund Becmer, finance and accounting practice leader at Hudson Global Resources, a California-based consulting firm.
Shoot first
Still, some think the slowness of the process for complying with 404 and the fact that many firms have already reported material weaknesses has tamed the market’s potential reaction. ‘A de-sensitivity has occurred; sophisticated investors will look at each weakness to determine whether it is one they should be concerned about,’ says Lane.
It’s believed that between 10 percent and 40 percent of companies complying with 404 will be defined as deficient – and the lower the percentage, the stronger the buy side’s response. ‘If it’s 40 percent, it will be a ‘ho hum’ because everyone will be in the same boat,’ says Walker. ‘But if it’s 10 percent, it will indicate there are certain problems with specific companies.’
Galbraith says when firms report certain errors, investors will shoot first and ask questions later – but he also believes the effect on performance will be short term. ‘Companies that subsequently respond thoughtfully to the questions about these internal controls will recoup their lost value quickly,’ he concludes.
