Four years after Congress passed the Sarbanes-Oxley Act to eradicate fraud at public companies, some firms are still reporting "material weaknesses" in their internal controls buzzwords that can send a stock plummeting and legal fees soaring.
In Los Angeles County, fax firm J2 Global Communications Inc., employment outsourcer First Consulting Group and auto parts supplier Superior Industries International Inc. have all reported material weaknesses and recently delayed filings with the Securities and Exchange Commission. They joined 115 other public companies with problems complying with the increasingly well-known Section 404 of the Sarbanes-Oxley Act. The provision requires that companies document and audit their internal financial controls essentially giving a stamp of approval to the reliability of financial statements.
Last year, a whopping 15 percent of public companies restated their financials double the number in 2004. So far this year, only 4.2 percent of public companies have had financial restatements, an indicator that the new regulations may be having the intended effect.
Mark Cheffers, chief executive of Audit Analytics.com, an independent research firm that specializes in audit issues, said public companies are getting hit by a new round of accounting issues related to taxes, environmental liabilities, hedging and executive compensation.
"As time goes by, the number of adverse (audit) opinions will almost by definition go up," Cheffers said. "There really is pressure on companies to make sure they get (their financials) right during the year, and that there aren't any surprises at year end."
Most problems that cause a company to report a material weakness stem from operational issues, such as revenue recognition, inventory valuation and liabilities. More complex issues have cropped up involving missteps in taxes, cash flow statements and warrants doled out to top executives.
Blase Dillingham, a partner at Manatt, Phelps & Phillips LLP, said the Public Company Accounting Oversight Board, created by the Sarbanes-Oxley Act, has been highly critical of a number of accounting firms, which may be causing more conservative opinions.
"To some degree it's really driven by the auditors," he said. "There's nothing a company can do about it except fix the problems and move on."
Material weaknesses can be difficult for individual investors to decipher. When J2 Global announced late last month that it would delay filing its annual report, the company attributed the delay to "an ongoing review of the pricing of services provided to J2 Global by one of its subsidiaries."
It did not say specifically that the issue involved is what is commonly referred to as "transfer pricing," a method used by companies to cut taxes by shifting revenues to a foreign subsidiary.
Jeff Adelman, J2 Global's vice president and legal counsel, said in an e-mail that certain taxes, like value added tax or VAT, are a "complex and evolving issue."
J2 Global reported that "the review" resulted in a higher tax burden of "$1.9 million or more" in 2005, which reduced the company's earnings by at least 7 cents a share to $2.08 share.
Even though J2 Global's stock plunged 13 percent to $41.66 a share a week after the disclosure, the company was able to rebound.
Within 10 days, J2 Global executives had managed to file the annual report, and even received two upgrades by analysts who downplayed the firm's audit troubles. Investors bid the stock price up to nearly $47 a share back to where it was trading before the material weakness was disclosed.
"There have been a number of companies that have disclosed material weaknesses and the market's reaction has been very tempered," said Julie Kaufer, a partner at Akin Gump Strauss Hauer Feld LLP.
A number of companies have dismissed their chief financial officers or auditors after finding a material weakness, or had to beef up their internal accounting departments.
First Consulting in Long Beach, had to delay its annual report because its auditor, Grant Thornton LLP is still reviewing its provision for income taxes. First Consulting said last week it will take a $1.3 million loss for 2005 related to tax accounting.
Andrew Demetriou, a partner at Fulbright & Jaworski in Los Angeles, said he wouldn't be surprised if public companies continued to delay filings and report material weakness issues for several years.
"Section 404 is a different animal than what's been asked of companies before," he said. "It requires that you ascertain the greatest potential for fraud, and document how the company has put controls in place to mitigate or keep the fraud from happening."
Demetriou said one of the main problems is that executives must come up with a plan to solve the internal deficiencies.
Superior Industries, in Van Nuys, a company that is already struggling with the downturn in the U.S. auto industry, recently reported three separate material weaknesses: tax accounting, inventory valuations and stock-based accounting.
In a filing last week, the company acknowledged that it did not have enough accounting and finance professionals with the "appropriate level of accounting knowledge," to assess its internal financial controls. It also stated that it did not maintain effective controls over the accounting of income taxes or the valuation of its aluminum inventory.
For all the problems complying with the new regulations have caused companies, Cheffers believes the overall effect has been positive.
"I don't think there's any question that the quality of financial reporting has gone up substantially in the post-Section 404 world," he said. "That's the good news. There has been a tremendous amount of clean up, and financial statements are more reliable now than they have been."
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