There has been, and continuous to be, much feverish activity up to, and will be even after, the cut off date of March 15, which is the time for the publication of the new Sarbanes/Oxley requirements.
Given the pressure they have been under and the criticism they have received, it is understandable that the auditing profession which has an important role and much discretion in their evaluations, is erring on the side of caution. Meaning that their evaluations and judgements will be as conservative as can be.
As this will the first certification under the new rules and as the auditors are being careful, we can expect many conditional opinions coming out.
This will play out as time goes on and a more normal situation will develop, which will provide the credible information required, on the one hand, but also allow for the flexibility and realism required to run a business.
Onésimo Alvarez-Moro
See Financial Times article:
Crunch time for Sarbanes-Oxley
By Andrew Parker in New York
Published: February 9 2005 01:00 Last updated: February 9 2005 01:00
Judgment day is fast approaching for US companies grappling with the most complex and expensive provisions in the Sarbanes-Oxley accounting and governance legislation.
Up to 5,000 large and medium-sized public companies must for the first time give detailed summaries about the state of their internal controls in forthcoming annual reports.
The reports must also include separate opinions by auditors on the effectiveness of the internal controls, which are supposed to ensure good accounting and guard against fraud.
Many of the companies that must comply with the requirements of Section 404 of the Sarbanes-Oxley legislation had fiscal year-ends on December 31 2004, and under separate rules have to file their annual reports with US regulators by March 15.
So over the next four weeks, given that the reports must be compiled and published, auditors are meeting companies to tell them whether they think their internal controls have made the grade.
Although no one knows for sure, the big four accounting firms Deloitte, Ernst & Young, KPMG and PwC suggest about 10 per cent of companies will reveal serious difficulties.
Either they will disclose “material weaknesses” in their controls that could cause inaccurate accounting, as required by Section 404, or say they have been unable to complete the assessment process on time.
The reports about internal controls will be the culmination of what has proved to be an exhausting and expensive process.
Companies have feared panic among investors and hostile reactions from credit rating agencies if they disclose material weaknesses, and so have poured resources into the onerous task of documenting and testing their controls, and fixing any problems.
For some, the task became a crisis management exercise, and many participants are feeling bruised and somewhat emotional.
Auditors face three common questions from clients in the crunch meetings. First, has the auditor concluded that the company has effective internal controls at its year-end? Second, how can the costs of the exercise be reduced? Third, how can the process be put on a sustainable footing so it can be repeated year-on-year, as required by Section 404?
Tim Flynn, head of audit at KPMG's US business, says: “In year two of 404, we must work with management to find ways to sustain ongoing compliance and monitoring, effectively and efficiently. The intense, project-oriented focus that prevailed in the initial year of implementation is not sustainable in terms of either cost or human resources.”
Some common problems are starting to emerge with internal controls at some companies. The first is multiple difficulties with information technology systems, including the basic need to ensure that only approved people have access to data.
The second is whether companies have adequate arrangements to detect fraud. The third is the quality of people and systems in the reporting process, notably on tax accounting.
Such problems could amount to significant deficiencies in internal controls. The key question is whether such deficiencies in turn add up to material weaknesses at a company's fiscal year-end.
For auditors, a material weakness is one resulting in a “more than remote likelihood” of inaccurate accounting. The likelihood test was set by regulators, and means auditors must exercise a high degree of judgment as to whether a company has a material weakness.
It is expected that some companies with significant deficiencies in their internal controls will say they have no material weaknesses, but their auditors will disagree and insist they have.
Stephen Wagner, co-chair of the Sarbanes-Oxley steering committee at Deloitte's US business, says: “The ‘reasonable man' rule plays in here in the sense that any time you are dealing with anything that could affect reputation or shareholder value, it is serious business particularly when it boils down to some level of judgment.”
Auditors have every reason to make conservative judgments. First, the Public Company Accounting Oversight Board, the profession's new and so far tough-minded regulator, will this year begin reviewing the work of auditors on internal controls. Second, auditors are in constant fear of litigation by aggrieved shareholders.
So can the pain of Section 404 be relieved? Many companies probably did too much documenting and testing of internal controls in 2004, and look set to reduce their efforts this year. Some also seem determined to put pressure on their audit committees to demand reductions in fees paid to auditors.
Regulators, led by the Securities and Exchange Commission, know they have to make life easier for companies to comply with Section 404.
While praising William Donaldson, SEC chairman, President George W. Bush last month called for “balance” in regulation so that the US does not become too onerous a place to do business.
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