With the SEC meeting Tuesday to discuss the Public Company Accounting Oversight Board's proposed auditing standard for the hotly contested Section 404 of the Sarbanes-Oxley Act, I thought it might be the right time to highlight a few examples beyond Home Solutions (HSOA) on why Section 404 shouldn't be watered down - especially for small companies.
Yes, I know 404 is expensive to implement and much of what they come up with is boilerplate.
But part of the proposed changes would let auditors rely on third parties and the companies themselves to determine how effective internal controls are, rather than do their own assessment of the management's assessment. (I know that sounds time consuming, costly and downright wacky, but if auditors don't determine whether controls are effective - what's the point?)
And while some of what companies must disclose is boilerplate or relatively insignificant, as I showed with Home Solutions, some of it isn't, such as the company's inability to reconcile a general ledger accounts payable statement with a vendor's statement. That's the type of disclosure, by the way, that should be red flags galore for investors.
With the help of Glass Lewis, which provided the following examples, here are some others that one day may not be what I like to refer to as small cap traps:
Englobal (NASDAQ:ENG), which provides engineering and other services to the petroleum industry, disclosed in its 10-K that, among other things, the company didn't:
Have controls regarding the way it recognizes fixed price contracts, which account for 11% of revenues. Have proper controls over its internal audit process. Effectively and accurately close the general ledger in a timely manner.
Interstate Bakeries (OTC:IBCIQ), home of Twinkies, which has been relegated to the Pink Sheets after a series of financial mis-steps, gets dinged for, among other things:
It didn't maintain effective controls over the completeness, valuation and disclosure of its workers compensation accounts. It didn't have controls in place to make sure its pension plans were accounted for properly. It didn't have have proper controls to account for its property and equipment, which means some "may be improperly expensed or capitalized..."
Also from the Pink Sheets: Mini-cap BioSpecifics Technologies (NASDAQ:BSTC), a biopharma company, which conceded:
Bad controls over its cash disbursement systems, which means duplicate payments were made to certain vendors. It gave advanced cash to its chairman, which should have been considered a loan. It didn't maintain effective controls over its capital structure; without board approval, it gave 56,388 shares to consultants who provided personal services to its former chairman and CEO.
The list goes on, but you get my point. In each case, though, as a result of going through the process, the companies claim to have tightened their controls. While not guaranteeing that better controls will lead to better investments, they can't hurt!