'Internal control' disclosures can both warn, give comfort


SOME CONSUMERS religiously balance their checkbooks, adding and subtracting deposits and withdrawals, and then comparing their figures to the penny with what the bank statement says.

Even those less conscientious will at least scan statements, perhaps doing some mental math to see if the numbers appear to add up.

Companies have their own system to assure the accuracy of their financial reporting, which includes earnings statements. These checks and balances are called "internal controls."

Investors soon are going to hear a lot about internal controls thanks to the Sarbanes-Oxley Act, passed in 2002 in response to corporate scandals involving accounting fabrications.

Section 404 of the act essentially requires public companies to disclose whether their internal controls are effective. It also requires independent auditors to disclose whether they agree with management and to conduct their own check into whether a company's internal controls are up to par.

As early as next month, investors will begin seeing the disclosures in the 10-K, an annual document filed with the Securities and Exchange Commission. The 10-K is available from the company or online at www.sec.gov. The SEC is urging companies to also put the disclosures in the glossy annual report to shareholders, which small investors are more inclined to peruse.

But as with so many company disclosures intended to make us better investors, will individuals actually use the information or will it be just more paper for the recycle bin?

If investors take the time to read the materials and know what to look for, they will benefit from the new disclosures, accountants say.

"If you will spend $25,000 to buy a car, do you buy the first car on the lot or study the product and what it delivers to you?" said Raymond J. Beier, a partner with PricewaterhouseCoopers in New York. "If someone is going to invest hard-earned money, wouldn't they want to invest in something they have some confidence in and some understanding of?"

Investors and the markets overall benefit in other ways, too, from these disclosures, Beier added. Section 404 will reduce fraud, increase the reliability of financial reports and, ultimately, boost investor confidence, he said.

Many companies, though, are howling about the immense amount of time and the expense - sometimes millions of dollars - required to comply with Section 404. Some small businesses say the burden is so great that they are considering taking their company private to avoid the measure.

Companies say they agree strong internal controls are necessary, but Section 404 is overkill and they want it amended.

Investor advocates say companies are missing the point.

"If your internal controls are not adequate, isn't it a good thing to find it out? And if they are, isn't it good to find that out, too?" said Nell Minow, editor of the Corporate Library, a corporate governance resource.

Some companies have been giving investors a heads-up about control weaknesses through quarterly reports and other releases.

Section 404 already is having an impact as companies are forced to review their internal controls.

Last year, 582 companies acknowledged material weaknesses or significant deficiencies in their internal controls, according to Compliance Week, a newsletter on corporate governance. And last month, two companies said they strengthened their controls after discovering that employees had embezzled money.

Also, Section 404 is largely responsible for the increase last year in the number of public companies revising their financial statements, said Huron Consulting Group in Chicago. Last year, the number of filings to amend statements reached 414, a 28 percent increase over the year before, Huron said.

Over the long term, Section 404 should reduce the need to revise financial statements as companies correct weaknesses in controls, said Bob Lipstein, a KPMG partner in charge of Section 404 services in Philadelphia.

Of course, some investors won't want to read the statements. These investors can watch securities analysts to see if they downgrade a stock because of problems with a company's internal controls, said Patrick McGurn, special counsel with Institutional Shareholder Services Inc. in Rockville.

But if you're one of those who diligently balance a checkbook, you might also be the type of investor who likes to do a little digging.

So, what do you look for?

First, did management report any material weaknesses, which are basically the likelihood that an error on financial statements will occur or go undetected?

An admitted weakness isn't necessarily a reason for shareholders to panic, accountants said. For example, a company might have discovered a problem with tracking its inventory and have taken steps to correct it, Beier said.

Some weaknesses are serious, though, and investors should be on the lookout for these:

A company that acknowledges that it is revising its financial statements because of fraud. Internal control problems that go on for years without being corrected. And a "tone at the top" problem, which refers to management that might put profits above everything else, including ethics.

Investors should look at the language of the disclosures, whether it's boilerplate or it appears that companies put care into reviewing controls, Minow said.

"Look for specific steps to address and re-evaluate the inadequacies. 'We are working on it' is not good enough," Minow said.

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose @baltsun.com.

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