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Why Small-Cap Firms Need 404 Reviews
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Posted by: Jack Ciesielski 9/9/2005 7:06 AM
Fountain Powerboat, a $23 million market cap firm trading on the Amex (ticker: FPB), filed a non-reliance 8-K with the SEC yesterday. It'll be restating financials for the fiscal year ended June 30, 2004 and the quarterly periods ended September 30, 2004, December 31, 2004 and March 31, 2005.

How come? For "... adjustments that will affect revenue, assets and liabilities. As a result of these adjustments, the Company estimates that net income in the fiscal year ended June 30, 2004 will be decreased by approximately $700,000 to $800,000 (or $0.15 to $0.17 per share) and that retained earnings will be decreased by approximately $700,000 to $800,000." For perspective, consider that Fountain Powerboat's common equity at June 30, 2004 totaled $6.34 million; the correction of the retained earnings will decrease common equity by 11% to 13%. Ouch.

The filing goes on to outline the ups and downs that will occur in the subsequent quarterly filings:
"The amendment to the Company's Quarterly Report on Form 10-Q for quarterly period ended September 30, 2004 will contain adjustments that will affect revenue, cost of goods sold and selling expense in that period and we estimate that net income and stockholders equity will be decreased by approximately $575,000 to $625,000 (or $0.11 to $0.12 per share). The amendment to the Company's Quarterly Report on Form 10-Q for the quarterly period ended December 31, 2004 will contain adjustments that will affect revenue, cost of goods sold and selling expense for that period and we estimate that net income and stockholders equity will be increased by approximately $150,000 to $200,000 (or $0.03 to $0.04 per share). The amendment to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2005 will contain adjustments that will affect revenue, cost of goods sold and selling expense for that period and we estimate that net income and stockholders equity will be increased by approximately $100,000 to $150,000 (or $0.02 to $0.03 per share)."

Apparently, there were some mistakes in recognizing the timing of transactions, lowering earnings and equity in some periods, only to be reversed in later periods. In the long run, maybe they tend to cancel each other out (though not completely, in this case). In the multiple short runs, though, investors are basing their decisions on flawed information.

What led to FPB's problems? " ... [T]here were omissions and errors in the entry and reconciliation of certain items to the general ledger during these periods...These errors occurred as a result of human error, coupled with certain weaknesses in internal controls over financial reporting. The Company's controller at the time, who was solely responsible for such entries, is no longer with the Company and has not cooperated with us during this process. The Company has taken steps to implement improvements in its system of internal controls over financial reporting to reduce the likelihood that omissions or errors in the general ledger entries will occur in the future. Such steps include, but are not limited to, an increase in the number of accounting and financial reporting personnel at the Company and the implementation of controls to verify and reconcile the entry of items to the general ledger."

In a phrase, weak internal controls led to FPB's problems - and as the paragraph above indicates, it will be costly to fix them. Increasing the financial reporting and accounting personnel has a price tag - which has been bitterly complained about by the small business lobby in trying to roll back the Sarbox provisions that will require reporting on their internal control systems.

On the part of the complainers, that's penny-pinching short-termism at its worst. Sure, there will be explicit costs for FPB and its ilk if they have to hire more - and more competent - personnel than in the past. Sure, it'll show up in the earnings statement. But what about the costs that don't show up in the P&L? I sure don't wish any ill winds to Fountain Powerboat, but once there's a restatement like this, the plaintiffs bar usually swoops in like buzzards on a fresh carcass - in which case, there will be explicit costs (legal counsel, settlements) and implicit ones (distractions for management). Shareholders who acted on the improper information suffer a pervasive cost too - the cost of making decisions they might not have otherwise made.

Good internal controls are designed to prevent and detect errors. They have an upfront cost. They are efficient managerial tools. Lawsuits are designed to punish wrongs through reallocation of capital. They have an after-the-fact cost. They are an inefficient way to allocate capital. Do small company managers really want to be gamblers - hoping that they don't have problems that good internal controls would prevent and detect, just so they avoid their explicit costs? It seems like a bad bet; if they're wrong, they'll be tagged with explicit costs and lose their own credibility. Maybe it only matters if you can experience shame.
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