Editor’s note: Glenn Conway is a partner with Visage Solutions, LLC.Every time you see a headline concerning an accounting scandal, financial restatement, executive termination or suspension, SEC action, or otherwise, you may think to yourself, “When is this going to end?”
Our best guess is that by 2006, it will begin to slow down. That’s right, 2006. Here’s why.
Reason One: The most significant driver for financial restatements and auditor issues over the next two years will be Section 404 of the Sarbanes Oxley Act. This section deals with management assessment of internal controls and auditor certification of those controls. While many public corporations have spent the last few months (or last 1.5 years) documenting and solidifying their internal control systems, the rubber meets the road beginning 11/15/04. That is, everything until then is essentially practice and dry-runs for the very first, on-the-record, internal control audits.
Reason Two: VisageSolutions believes that a significant number of corporations will receive negative attests on their internal control audits and/or their auditors will disclaim an opinion. Since the first “of record” internal control over financial reporting audits (ICOFR Audits) will be completed in November and December of this year, it will be sometime around February, 2005, before the initial audit results from these initial ICOFR audits for affected companies are publicly released concurrent with corporate 10Ks and Annual Reports. That means that sometime around next February, it will start to become clear which companies (officially) have internal control problems.
Reason Three: Once the first internal control audits are completed and the results announced, many companies will return to the drawing board on their own internal control programs. This should happen around March-June, 2005. These companies will attempt to make up for lost time, revise their internal control documentation and implementation initiatives, re-evaluate their I/T systems affected by internal control issues, hire more or different consultants to help them re-work their earlier compliance documentation, and re-visit with their outside counsel the findings from the earliest internal control audit reports. They will look for parallels and exposures in their own companies. There will be a number of very concerned executives.
Reason Four: Companies whose internal control systems are branded “ineffective” by their auditors will probably see their stock values slip. Likewise, companies whose management assessments of internal control beget negative auditor attests will see their stock values hit, and a number of managements may well be sued for failing to implement an effective controls system. It will be especially embarrassing for CEOs and CFOs who assert that their ICOFR systems are effective, only to have their auditors disagree.
Reason Five: There will probably be another round of announced re-statements and/or investigations after the first ICOFR audits are released. That is because weaknesses in ICOFR presumably suggest financial statement errors and financial statement errors suggest ICOFR weaknesses. If the auditors find problems on the one hand it suggests problems on the other. This means that companies with recognized weaknesses in ICOFR may be candidates for financial restatements for prior periods.
Reason Six: Assuming this logic holds, there will probably be additional financial re-statements announced later this year and into 2005 in connection with ICOFR evaluations and newfound auditor conservatism and independence.
Reason Seven: As 2005 unfolds, companies will swallow the results of their first, of-record, ICOFR audits, and will announce re-statements and/or ICOFR fixes with some regularity. Since the auditors must also judge the performance of audit committees, it is inevitable that selected audit committees will be judged ineffective, and there will be changes at the boards-of-directors level.
Reason Eight: Executives and audit committee members affected by the negative auditor attests, who face potential or likely shareholder suits, or SEC investigations in conjunction with ICOFR deficiencies, restatements, etc., will continue to fall or resign from their companies. In this sense 2005 may be a watershed year.
Reason Nine: In 2005 the first civil and/or criminal trials should occur for executives and board members charged under the Sarbanes-Oxley Act. To date, the well-publicized cases involving executives and boards of Enron, WorldCom/MCI, Adelphia, Healthsouth, and the like, have been brought on the basis of pre-2002 law. In 2004 we are seeing the first (executive) charges being brought under the 7/02 Sarbanes-Oxley Law. In 2005 we should see the first court cases and judicial precedents connected with Sarbanes.
Reason Ten: By the end of 2005, virtually every public company in the U.S. will have completed its first ICOFR audit cycle. Certain foreign-owned companies, etc. will not see their first ICOFR audits until early 2006. Nonetheless, as a practical matter, 2005 will be the watershed year for ICOFR. It is likely that the most egregious and/or significant problems will come to light before EOY 2005.
This means that matters should start to settle by early 2006.
Reason 11: By mid year 2005, we predict that many investors will become jaded and/or bored with ICOFR failures. Executives who preside over weak ICOFR systems will rightfully fall or come under intense scrutiny and investor wrath. But it may be that there will be enough (too many?) companies with weaknesses that lawsuits abate simply because there are too many companies to sue.
Reason 12: Insurance carriers who provide Director and Officer (D&O) insurance will have a challenging year. Many D&O policies being written today exclude or limit insurance coverage when financial re-statements occur. The presumption for the exclusion is that a re-statement is/was due to fraud or negligence on the part of the management team and auditor. Insurers don’t want to pay for negligent and/or fraudulent managements. It is reasonable to believe that these same insurers will caveat D&O policies going forward to limit coverage in cases of ineffective ICOFR systems.
And all of this hits in 2005. A fun year, huh?
Look for improved stability in 2006. Of course, VisageSolutions hopes that executives and boards take these matters seriously now to solidify their ICOFR systems, I/T integration, etc., to limit the likelihood of negative attests in late 2004 and through 2005. Companies that solidify their information and financial transparency in 2004 may not be casualties in 2005.
VisageSolutions is a group of experienced operational executives focused on providing cost-effective, technology-based Sarbanes-Oxley solutions. By working carefully with their clients VisageSolutions provides customized solutions that focus on reducing the “operational cost” of sustained compliance through an optimum combination of existing and new technologies and tools, and business process integration. See www.visagesolutions.com for more information and related links.