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Study: Disclosing Control Weaknesses Does You Few Favors

Tammy Whitehouse | April 28, 2015

Companies that disclose control problems ahead of restatements get no pat on the back or other indicators of gratitude from investors. On the contrary, they are more likely to face harsher consequences for their transparency than companies that provide no advance warning.

David WeberThat’s the conclusion of a recent academic study, “Does SOX Have Teeth?,” published in The Accounting Review. The paper explores the consequences of the failure to report existing internal control weaknesses. It says companies are more likely to face penalties if they foretell weakness in controls than companies that restate with no prior warning of control weakness. “Companies which evidently take SOX 404 to heart are penalized,” said co-author David Weber of the University of Connecticut in a statement.

The study is based on an analysis of 659 companies that filed financial restatements from after Sarbanes-Oxley took effect in 2004 through 2010. The analysis revealed 134 companies reported material weaknesses in internal controls before restating, and 525 did not. Of those that did not disclose control weaknesses before restating, 314 specifically acknowledged weaknesses in controls in hindsight with the restatement.

The analysis continued by looking at and controlling for the effect of event subsequent to the restatement such as enforcement actions by the Securities and Exchange Commission, class-action lawsuits, replacements of the CEO or CFO within a year of the restatement, and changes in external audit firm. Under all four scenarios, companies that reported weaknesses before the restatement fared no better, and more often fared worse, on all those fronts than companies that did not precede a restatement with a control weakness disclosure. 

The study finds, for example, that companies providing advance notice of control weakness are 6 percent more likely to face an action by the SEC and 5 percent to 10 percent more likely to face a class-action lawsuit. Turnover among top management is 15 percent to 26 percent more likely, and auditor turnover is 6 percent to 9 percent more likely, the study says.

Croteau-brian-1214Brian Croteau, a deputy chief accountant at the SEC, has spoken openly of his concerns regarding the reporting of internal control weaknesses and the SEC’s efforts to study and address the issue, even with enforcements. “Based upon our cumulative efforts this year, I continue to question whether material weaknesses are being properly identified, evaluated, and disclosed,” he said at a national conference in December. “Our efforts throughout the SEC pertaining to the internal control over financial reporting requirements are ongoing, coordinated, and increasingly integrated into our routine consultation, disclosure review, and enforcement efforts.”

At a recent regional conference of the Institute of Management Accountants, Croteau said that focus continues. SEC reviews of company disclosures sometimes causes companies to go back and reconsider whether they have control problems to disclose, he said. “We’re making sure the evaluation of ICFR continues to be robust and the evaluation of deficiencies continues to be appropriate,” he said. “Otherwise, investors are not getting the information they need.” 

Weber sees that regulators have been exploring a decline in the reporting of internal control weaknesses. “Was the decline a result of improved internal controls or just that weaknesses were not being reported?” he said. “Our paper goes a fair way, I believe, toward answering that question."