Thursday, January 23, 2020

Discovery Energy ($DENR) filed its latest quarterly report this week, and we noticed that the company disclosed a material weakness in its financial reporting.

That unto itself is never welcome news. A material weakness warns investors that a firm’s corporate accounting is shaky, and might not be able to prevent serious errors in financial reporting.

What caught our eye with Discovery, however, was the nature of its material weakness. Discovery doesn’t have enough accountants to prevent people from cooking the books.

Sure, the company draped that fact in more bureaucratic language; it described the problem as “the lack of segregation of accounting duties as a result of limited personnel resources.” But let’s have no illusions here. Discovery has a shortage of suitable accounting talent.

That got us wondering — what other firms have material weaknesses due to personnel issues? What other causes of material weaknesses are out there these days? So we fired up our Interactive Disclosure database to investigate.

First, the mechanics of the process. Looking up material weaknesses is a straightforward exercise in Calcbench. Choose whatever group of companies you want to examine; then set the disclosure type menu (left side of screen) to “Controls & Procedures;” then enter “material weakness” in the text search box on the right, with the “restrict to specified disclosure type” box checked underneath. See Figure 1, below.

We found 31 firms disclosing material weaknesses for Q4 2019 so far — with many more filers yet to come, so that number will likely increase substantially. Some of the more interesting examples include…

AZZ Inc. ($AZZ), an electrical equipment manufacturer based in Fort Worth, Texas. The company first discovered material weaknesses in its controls for revenue recognition. Then as part of a larger review, AZZ also found more weaknesses in its controls for tax compliance. So those are problems of improperly designed accounting procedures rather than lack of accountants — but a material weakness in financial reporting, they are nevertheless.

AZZ says in a filing from Jan. 9 that those problems are now fixed and its latest numbers are reliable.

The material weakness from ShiftPixy ($PIXY) makes for even more painful reading. In a filing from Jan. 21, the company admits right away: “current accounting staff is small… we did not have the required infrastructure or accounting staff expertise to adequately prepare financial statements in accordance with U.S. GAAP as well as meeting the higher demands of being a U.S. public company.”

That lack of experienced staff led to the discovery of a material misstatement in Q3 2019 regarding derivative financial instruments ShiftPixy was carrying on the books. So the company hired a new CFO with experience in financial instruments accounting, and is stepping up spending on accounting staff and resources generally. Welcome to NFL football, ShiftPixy.

And Laredo Oil ($LRDC) had this to say in a filing from Jan. 14 that nicely captures the problem for a lot of firms:

Our size has prevented us from being able to employ sufficient resources to enable us to have an adequate level of supervision and segregation of duties. Therefore, it is difficult to effectively segregate accounting duties which comprises a material weakness in internal controls. This lack of segregation of duties leads management to conclude that the Company’s disclosure controls and procedures are not effective to give reasonable assurance that the information required to be disclosed in reports that the Company files under the Exchange Act is recorded, processed, summarized and reported as and when required.

Translation: Laredo can’t hire enough accountants to assure that all transactions will be free from potential tampering (that’s what the “segregation of duties” part means), so the company is simply going to live with the risk. It is taking no new steps to resolve the weakness.

That’s not an ideal answer, but in many cases it’s the best one a company can give. Accountants cost money, and good ones cost a lot of money. For some firms, hiring enough of them to eliminate a material weakness just won’t be economically feasible. So they disclose the weakness to investors and move on with life.

Anyway, those are just a few examples. You can find many more with little difficulty, and then proceed accordingly. We just put the data in your hands to help you make the best decision.

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