If medicine sometimes has to taste bad to be good, then the bitter tonic companies are swallowing as they clean up their financial reporting ought to work wonders. Rigorous new examinations prescribed by the Sarbanes-Oxley Act are making it hard for executives to close their books and report their financial results to the Securities & Exchange Commission on time. In just one week in early November, 61 companies with a market cap of $100 million or more announced they would be late with their filings, including info-tech giant Electronic Data Systems (EDS), General Motors (GM), and Suntrust Banks (STI). That was up 25% from the same period a year ago, according to Glass, Lewis & Co., an independent researcher.
There has been no letup in the trend. Since then, mortgage giant Fannie Mae (FNM) filed notice that it would be late as well. The problem isn't confined to big companies, either. Smaller outfits, such as restaurant chain Benihana Inc., have found themselves in the same boat.
More problems are likely to surface in the weeks leading up to Mar. 15. That's the first deadline for executives of large companies with calendar fiscal years to certify that they've checked and found their internal financial controls are working. Outside auditors also will have to issue their own certification. Before the next year is out, says Dennis M. Nally, chairman and senior partner of PricewaterhouseCoopers, 10% to 20% of all U.S. companies may uncover weaknesses in their controls. Some of them will have to delay their reports while they work out whether the weaknesses have created big errors in their numbers.
That's bad news, because the effect of delayed filings can be devastating. Companies (and their investors) often find themselves in a state of limbo in which their financials become suspect, shares plummet, and they can become targets of aggressive value investors. Those listed on the NASDAQ even have a scarlet letter -- an extra "E" -- tacked onto their stocks' tickers to show that their financial reports are incomplete. Twenty-five stocks, including Analogic Corp., carry this mark of shame.
Even worse consequences can arise. Filing late could trigger default clauses in bank loans -- forcing companies to pay higher interest rates, put up more security, or repay early. The SEC also can ban late filers from issuing or trading certain types of securities, crimping their financing possibilities. In the worst case, companies could be pushed out of the stock market. Nortel Networks (NT) has said that technically it could be delisted from the New York Stock Exchange if it doesn't complete its 2003 annual report -- now eight months overdue.
Why are so many businesses struggling? Apart from having to fix lax internal bookkeeping, they face stricter applications of accounting standards than before. Both result from laws Congress passed in 2002 after the Enron and WorldCom scandals. The new rules are forcing executives, directors, and auditors to turn over more rocks and root out bad accounting. "The incentive for all parties to get this right is much greater today than it was pre-Sarbanes-Oxley," says Nally.
Accountants are under even greater pressure: Their audits are subject to potentially career-wrecking review by the new Public Company Accounting Oversight Board. But they're also feeling more powerful in their dealings with executives because they're getting more attention from the audit committees of boards, especially as annual audits approach.
Auditors and companies are also reviewing -- and sometimes changing -- how they interpret and apply accounting principles. For example, a GM spokesman said the company was a day late filing its quarterly report on Nov. 10 because it wanted a current interpretation from the SEC of a rule on how to account for asset-backed securities. GM brought $6.8 billion of assets and related liabilities onto its balance sheet. And after Fannie Mae was blasted by its primary regulator in September for its accounting for derivatives and the costs of acquiring mortgages, at least five companies said they would file late because they were reviewing similar issues. Fannie says its accounting is by the book.
A GREATER UNDERSTANDING
The quarterly reports due by mid-November seem to have given executives fits enough. For example, as EDS approached its scheduled Oct. 26 third-quarter-results announcement, CEO Michael Jordan found himself arguing with KPMG auditors over whether EDS should take a charge for the cost of extra computer equipment and software it acquired for a big Navy contract that was cut back. The dispute forced Jordan to postpone his announcement twice, reveal that KPMG was asserting the company had deficient internal controls, and miss EDS' deadline for filing its report. When EDS finally announced results nearly a week later, on Nov. 15, it took a $375 million charge on the computers plus some small expenses on other items. "These did not turn out to be of any great significance," Jordan insisted in a conference call with investors the next day. "It doesn't matter, really."
The stock market seemed to agree: EDS shares rose 2.7% the next day. But the episode was more significant than one day's trading results. Investors now understand more about the risks EDS takes on big contracts and the accounting judgments it makes. "I've got to give the auditors kudos," says Lynn E. Turner, research director at Glass, Lewis, who often fought with big auditing firms when he was SEC chief accountant. "We are seeing more cases where they are willing to stick to their guns and, in this pro- cess, get more information to investors."
Jordan's fight with KPMG was a mere tussle compared with the war between auditors from Deloitte & Touche and Molex, a Lisle (Ill.) manufacturer of electrical components with $2.2 billion in sales. On Nov. 11 the company said it was late filing its quarterly report and had demoted its chief financial officer. Deloitte auditors had complained after discovering that executives had not told them about an earlier mistake in valuing inventory. Two days later, on a Saturday, Deloitte demanded that the CEO be replaced, too. The Molex board unanimously rejected the demand. On Nov. 15 Molex announced Deloitte had quit and it had filed with the SEC. "We strongly disagree with their approach," Molex co-Chairman Frederick A. Krehbiel said in a written statement at the time. The company did not return calls asking for comment. In a letter to the SEC, Deloitte stood by its actions.
Such problems can send company shares on roller-coaster rides. On Oct. 21, Investors Financial Services Corp. (IFIN) decided to delay filing to correct the way it accounted for purchases of mortgage-backed securities. Its stock plunged 16%. Three weeks later, after IFS had amended three years of results, its stock had recovered. CFO John N. Spinney Jr. says the company found the problem during a review of internal controls.
Likewise, shares of Flowserve Corp., a $2.4 billion maker of oil and chemical pumps, plunged 11% on Oct. 27 after the company said it would be late with a report and had to correct previously announced earnings. Flowserve said it had discovered material weaknesses in its internal controls and that some expenses had not been recorded in the right periods. Earlier, similar problems had triggered a formal SEC investigation. Flowserve has replaced its CFO and pledged to spend $15 million to fix its bookkeeping; its shares have recovered. A company spokesman says that cooperating with the SEC is slowing work on current reports.
Between wild stock swings and fights with auditors, the next several months will be all too memorable for investors and executives. But if the new scrutiny delivers more trustworthy numbers, the nasty medicine will have worked.
By David Henry in New York, with Andrew Park