Thursday, January 20, 2005

Fitch: How Sarbanes-Oxley 404 May Affect Companies' Ratings

Implementation of section 404 of Sarbanes-Oxley (SOX 404) will likely cause internal control problems to surface more frequently than in the past, according to a report issued by Fitch Ratings. Accordingly, Fitch expects that material weaknesses will be reported for a number of companies during the next year or two. The method and level of disclosure by a company reporting material weaknesses in their internal controls under SOX 404 may factor into credit actions by Fitch.

SOX 404, effective for fiscal years ended after Nov. 15, 2004, requires management and its auditors to express an opinion on the adequacy of controls over financial reporting and disclosure. 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. Though significant deficiencies are not required to be reported on a Form 10-K, such control weaknesses may have analytical implications.

Negative rating actions, if any, will be case-specific and may be in the form of a Rating Outlook revision, a Rating Watch Negative placement, or a downgrade, depending on the situation. Fitch's action will depend on whether the weaknesses in the company resulting in the statement have already been identified by Fitch, whether or not such weaknesses are already reflected in the ratings, and management's plans to remedy the situation.

Evaluating the reliability of financial data and assessing the internal controls over such data has always been an implicit part of Fitch's rating process. For example, serial restatements call into question financial reporting integrity. That said, Fitch places substantial reliance on a company's internal control framework and external auditors and regulators in determining that financial statements and disclosures accurately reflect a company's financial condition.

Fitch does not expect implementation of SOX 404 to be straightforward. The costs and time involved in establishing easily accessible evidence that controls over all elements of financial reporting that exist can be immense. To expect that all but a few companies will meet these challenges immediately is unrealistic, and as such, Fitch anticipates material weaknesses to be reported by management and its auditors for a number of the companies it rates during the next year or two.

'Sarbanes-Oxley Section 404: Fitch's Approach to Evaluating Management and Auditor Assessments of Internal Controls,' dated Jan. 19, 2005, is available on the Fitch Ratings web site.

Fitch: How Sarbanes-Oxley 404 May Affect Companies' Ratings

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