January 20, 2005 by Canadian Underwriter
The implementation of section 404 of the Sarbanes-Oxley corporate governance requirements in the U.S. will likely lead to more frequent revelation of internal control problems on the part of corporations, says a new study by Fitch.
The rating agency says it expects “material weaknesses” will be reported during the next year to two by many companies as they comply with SOX 404. The legislation took effect for fiscal years ending after November 15, 2004.
SOX 404 requires corporate management and auditors to express “opinions” on controls over financial reporting, i.e. to report any perceived weaknesses or inadequate disclosure in financial reporting. In terms of corporate ratings, Fitch notes: “Should a weakness be disclosed or new weakness identified, negative rating actions may occur if the disclosure and/or further discussion with management reveals it to have a significant effect on a company’s future financial standing, or calls into question the data on which analysis has been based.”
This negative action on the part of the rater could mean a downgrade, but it could also mean a revision of the rating outlook or placing a company on a negative rating watch this is dependent on whether the perceived weakness is already accounted for in the rating or not, and what actions management plans to take to remedy the weakness. The rater says that while it does its own analysis of financial data reliability and reporting controls, it does rely on a corporation’s own internal controls, as well as that of auditors and regulators in determining the reliability of financial statements and disclosures.