Financial analysts are supposed to be able to trust the disclosures that firms report in their financial statements. Usually that’s the case — but not always.
This week we have an interesting example of that phenomenon from agriculture giant CHS Inc. ($CHSCP), which filed its latest quarterly report on Tuesday. Tucked away in the Controls & Procedures part of the report, CHS confessed that it had ineffective disclosure controls and procedures, thanks to a material weakness in its financial reporting.
Translation: CHS has enough weaknesses in the systems it uses to govern its financial transactions that the company can’t guarantee the reliability of what it’s reporting. So analysts and investors should proceed with caution.
That’s the headline message, at least. When you delve into precisely what CHS said, you get a fascinating glimpse into how material weaknesses arise, what a company does to resolve them, and how long that remedial effort can take.
Let’s start with what CHS had to say. First was this:
Our disclosure controls and procedures were not effective because of the material weaknesses in our internal control over financial reporting disclosed within Management’s Annual Report on Internal Control Over Financial Reporting in Item 9A of our Annual Report on Form 10-K for the year ended August 31, 2019.
OK, so the material weaknesses in question were first reported last summer. That’s easy enough to investigate; just crack open our Interactive Disclosure tool to call up the annual report CHS filed at the time, and see what the company had to say about its controls and procedures then.
That’s what we did, and CHS’ disclosures tell quite a tale. Turns out that CHS has been grappling with weak financial reporting for years. It first discovered material weaknesses in 2018, that led to a restatement of financial results for all of 2016 and 2017, plus parts of 2018.
Three material weaknesses discovered in 2018 were resolved by mid-2019, when CHS filed its 10-K. They involved ineffective controls for intercompany transactions, freight contracts, and the review of journal entries and reconciliations in grain marketing operations.
Alas, CHS still had two more weaknesses unresolved when its fiscal year ended last August. First, it didn’t have effective processes to assure that accounting policies are being followed properly; and it had weak IT controls, which could let miscreants feed bogus data into the accounting systems and inflate financial results.
Those two lingering issues are what CHS is talking about in its Controls & Procedures disclosure filed this week. As you can see, sometimes resolving material weaknesses in financial reporting takes a looooong time.
What, exactly, is CHS management doing to solve the problem? CHS said this in its quarterly report:
The following remediation efforts were taken during the quarter ended May 31, 2020:
We continue to enhance our overall financial control environment through the following:
- Held bi-weekly steering committee meetings consisting of senior finance, legal, information technology (“IT”), operational and human resources leaders to oversee the design and implementation of remediation plans.
- Continued developing, executing and monitoring detailed remediation plans in response to each of the remaining previously identified material weaknesses.
- Continued execution of our plans designed to remediate the two remaining previously identified material weaknesses, including (1) implementing and reinforcing an adequate process for monitoring proper functioning of internal controls… and training and (2) designing and maintaining effective controls over certain IT general controls for information systems that are relevant to the preparation of our financial statements and testing the effectiveness of remediated controls.
- Continued hiring for our teams in functional areas as necessary to ensure the size and skill set of those teams is adequate given the size, scale and complexity of our organization, industry and required internal controls over financial reporting.
So CHS is on a painstaking journey to strengthen its financial reporting. We wish them well.
Audit firms and corporate audit committees would pay the most attention to disclosures like this, so they could, for example, benchmark their own disclosures about material weaknesses against a peer.
Financial analysts should always give controls & procedures the once-over as well, since the disclosures here can offer hints about potential future trouble or just help you understand the risk you’re accepting as you evaluate a firm’s numbers.
As always, the devil is in the details — which are in the footnotes, and Calcbench has captured it all.
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