Early Riser: Brassica Internal Control Weaknesses

 

(A disclosure first: I own shares of EK, and so do my asset management clients. End of disclosure.)

Eastman Kodak released its fourth quarter earnings yesterday, and released something else as well: news that it has internal control issues and will receive an adverse opinion from auditors PricewaterhouseCoopers on said controls. (Maybe this is what Sam Brassica had on his mind in Davos yesterday.)

This is the first forecast I’ve seen from a major firm about the content and tone of their forthcoming internal control review report. Investors are naturally curious about what dark secrets, if any, these reports may reveal and how the stock market will react. Let’s see what we can parse out of the news of this “early discloser.” (Don’t get your hopes up.)

From this first glimpse, it’s hard to tell much: Kodak shares closed 11 cents higher on the day of the announcement -leading one to perhaps believe the market has a “so what?” attitude on internal control weaknesses. But the company also released fairly upbeat news about its foray into digital photography; that bit of news might have had more of an effect on stock prices than the internal controls announcement.

What about the nature of the internal control weakness? Read the 8-K excerpt below, quoting Robert Brust, Kodak’s CFO:

“Remember that Kodak has been devoting significant resources for more than a year to assessing, and strengthening as appropriate, its controls in the context of its Sarbanes-Oxley Section 404 review,” Brust said. “This situation arises from tax accounting errors, not misconduct. It involves complex tax rules, in many cases relating to our restructuring actions overseas, that vary by country.

“Kodak’s management, in conjunction with external consultants, is currently analyzing its income tax accounts, and adjustments may result from this review,” Brust said. “We are moving as quickly as we can to take appropriate corrective action, and we are keeping the Audit Committee of the company’s Board of Directors fully informed. We expect to complete the work during the next six weeks, at which time we will issue final results for the fourth quarter and for the year.”

As a result of the income tax accounting errors, the company has determined that it has an internal control deficiency that constitutes a “material weakness,” as defined by the Public Company Accounting Oversight Board’s Auditing Standard No. 2. Consequently, management will be unable to conclude that the company’s internal controls over financial reporting are effective as of Dec. 31, 2004. Therefore, PricewaterhouseCoopers will issue an adverse opinion with respect to the company’s internal controls over financial reporting. An assessment of the company’s internal controls will be included in its Annual Report on Form 10-K, which will be filed in March.

From the sound of it, there isn’t malfeasance, theft or cash involved – and maybe if there had been, there would have been a more negative stock price reaction, one that overpowered the digital photography “good news. “

My guess on the reactions to these disclosures: the nature of the weaknesses and flaws giving rise to an adverse opinion will be what matters most – and the earnestness with which a firm will attack its described problems. Internal control weaknesses over cash or those relating to profound earnings impacts, will likely be viewed most fearfully by the market. And companies that beat around the bush, giving only vague reasons about the nature of the audit opinion, will probably see their stock prices suffer the most.

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