Excavations in Accounting
To Monitor Internal Controls, Firms Dig Ever Deeper Into Their Books

By Terence O'Hara
Washington Post Staff Writer
Monday, January 30, 2006

The problem, at first, seemed manageable. When auditors at the Mills Corp. found in late 2004 that the company had mistakes in its joint venture accounting, it was the type of issue that in another era might have led the company to adjust a few numbers and tweak a few procedures, with investors none the wiser.

Even when Mills disclosed the error in early 2005, investors yawned, and Mills' stock price marched to an all-time high of $66.44 by early August.

Fast forward six months: Mills has had to restate its results a second time, write off a $4 million loan it could not collect, cancel 10 projects and fire 14 executives; suffered a 40 percent drop in its stock price; and caused a brief run on the business of its lead investor. An informal Securities and Exchange Commission inquiry is underway.

The 2002 Sarbanes-Oxley Act was meant to improve corporate accounting with its threat of criminal penalties for executives. But by upping the consequences for mistakes, it also has created an environment of near-constant internal review, a setting in which companies such as Mills might start pulling on the thread of a problem only to prompt a larger unraveling as other issues are unearthed.

In recent weeks, more than a half-dozen local publicly traded companies along with Mills have been forced to announce their numbers could not be trusted, admitting mistakes both major and minor:

· An Arlington power company checks its tax accounting -- and winds up erasing hundreds of millions of dollars in earnings.

· A Reston government contractor finds it must redo three years of accounting -- and starts encountering takeover pressure from an equity firm.

· A local biotech concludes that the accounting strategy it has used for the past four years isn't the right one after all.

· Mortgage companies Fannie Mae and Freddie Mac struggle still to correct billions of dollars of wrong accounting in a process that is taking years and requiring literally thousands of accountants, auditors and consultants.

Though Mills' most recent restatement will shave only 5 percent from its profit from 2002 to 2004, it has been taken as a sign of larger management issues and has led to calls for the company's sale.

Disclosing the first round of problems in February, Mills chief executive Laurence C. Siegel said the situation, which led auditors to chip ever deeper into the company's books, was "a by-product of the Sarbanes-Oxley environment where everybody is looking at things really closely, wanting to make sure they got it right."

The experience at Mills and elsewhere shows how substantially running a public company has changed since the enactment of Sarbanes-Oxley, a corporate accountability law that is prompting hundreds of accounting restatements and revealing internal problems that might never have been found or acknowledged otherwise, according to accounting and management experts.

"In the financial reporting world and auditing world, up until now, when someone came across an error in the numbers, the only thing that auditors had to do was get the numbers right, and that was the end of the story," said Mike Ramos, a Denver accountant and consultant who wrote one of the first books on Sarbanes-Oxley compliance. "Now, under Sarbanes-Oxley, they have to probe a little deeper and find out how the mistake occurred in the first place. Which can lead to the conclusion that they never had proper controls in the first place. Not so long ago, internal-control problems would never have seen the light of day."

By contrast, Sarbanes-Oxley's focus on internal controls -- the systems put in place to make sure factual financial and other important information actually reaches top management -- has led to an environment of second-guessing by auditors, where even a minor accounting error can mushroom into a wholesale investigation of a company's accounting procedures. The law put the onus on chief executives to certify they have taken all reasonable efforts to make sure that the numbers are correct and that their companies are fraud-free. The result, experts say, is a rush to get every possible error, no matter how small, identified and disclosed.

"I think what [Sarbanes-Oxley] did, it created an environment where companies aren't allowed to make honest mistakes," said Colleen Sayther Cunningham, president of Financial Executives International, a trade group of 15,000 chief financial officers and other financial executives. "You're seeing companies wounded by errors that in the past wouldn't have required a restatement but would have been fixed going forward."

Institutional investor advisory firm Glass, Lewis & Co. estimates that by the time the books are closed for 2005, more than 1,200 of the country's approximately 15,000 public companies will have announced accounting restatements -- a record. There were 619 restatements in 2004. In 2001, the year before Sarbanes Oxley passed, there were 270.

In addition, about 1,000 companies reported material weaknesses in their internal controls in their most recent quarterly filings.

Ramos and other experts predict that in a few years, the number of restatements will fall. But Harvey L. Pitt, former chairman of the SEC, said the increased scrutiny of internal controls could mean that high numbers of restatements will be a permanent fixture.

"I'm not sanguine that restatements will return to historic levels," Pitt said. "With companies much more focused and disciplined, there should be a lot fewer of these. But we're never going to see the elimination of restatements because that would mean we've eliminated mistakes, which of course is impossible."

While the benefits of cleaner accounting and better governance are real, so are the costs: Annapolis-based CompuDyne Corp. said recently that Sarbanes-Oxley reporting requirements had cost it $2.2 million in 2004.

Executives at the companies that recently announced restatements, including Mills, either didn't return phone calls seeking comment or would not speak on the record.

AES Corp., an Arlington owner of power plants and utilities around the world, has recently restated its results for the past three years downward by hundreds of millions of dollars, in large part because of pre-2002 errors in some of its deferred tax accounting at certain of its foreign subsidiaries. The problem came to light last year after the company identified a material weakness related to its accounting for deferred income taxes and embarked upon a global effort to perform more detailed reconciliations at its foreign subsidiaries. That effort, in turn, uncovered other unrelated accounting errors. AES said this month that its internal-control problems are being fixed and that its past results are now correct.

Allied Defense Group Inc., a Northern Virginia guns and ammunitions maker, has had problems with its foreign currency hedge accounting all year and has had to restate its results twice. Allied took the unusual move of replacing its auditor, Grant Thornton LLP, before the year closed, hiring BDO Seidman LLP in October.

Tier Technologies Inc., a Reston government contractor, also has been dealing with internal-control problems for more than a year. In December it said it would have to restate three years of results. Tier also hired a new auditor in early 2005.

Provident Bankshares Corp. of Baltimore in November found it had used improper hedge accounting on interest-rate swaps, which are derivatives used to guard against interest rate swings. In essence, an accounting method used and signed off on by auditors for years was retroactively judged to be worthless. The result: Provident shaved $947,000 off the earnings it reported in the 21 months ended Sept. 30.

In addition to these companies, Maryland real estate company American Community Properties Trust and McLean consulting firm BearingPoint Inc. have struggled with restatements in recent months. BearingPoint has more than 400 temporary accountants redoing its numbers for 2004 and 2005.

"The general consensus is [the restatements are] an indication of how well Sarbanes-Oxley is actually working," said Kurt Schacht, managing director of the Centre for Financial Market Integrity at the CFA Institute. "What you're seeing in essence is deferred maintenance, the fixing of internal controls that have been neglected, and in the first years after Sarbanes-Oxley, they will be weeded out. Over time, restatements will come down."

Mills, in the evolution of its accounting troubles over the past year, provides one of the most striking examples of the Sarbanes-Oxley environment. Mills in recent years expanded aggressively, buying malls and planning huge new developments, including the $1.3 billion Xanadu, a massive mall and entertainment center in the Meadowlands, N.J.

These massive bets, involving billions of dollars, heightened the risk for Mills if its internal controls couldn't keep up with the company's growth.

"As companies evolve through merger or growth, the needs of the business from an information-processing standpoint, those needs change," Ramos said. "And managers sometimes forget about that. For management of a growth company, accounting is not a glamorous thing; it's not sexy. Making the sale is sexy."

Seigel, Mills' chief executive, seemed to indicate that Mills had outgrown its internal controls.

"We have grown over the last few years from an entrepreneurial development company focused on essentially one product . . . to a diverse and complex business that operates and develops a range of retail venues on the international stage," he said in November. "Mills has clearly reached a stage where top management needs to increase its focus on forecasting and planning and enhancing our performance management, accounting, control, and reporting functions. This is underway. We need to ensure that our infrastructure can meet the demands of a business ripe with opportunity."