Thursday, April 10, 2008

Weak Internal Controls at Verifone Prompt Large Financial Restatement.

In December 2007, weak internal controls on Inventory processes, forced the management of Verifone Holdings Inc.,(the maker of electronic payment equipment) to restate their financial statements for the Quarters ended January 2007, April 30, 2007 and July 31, 2007. Verifone's fiscal year ends October of each year.

At the time of the initial December 2007 announcement, management estimated reductions to previously reported inventories of approximately $7 million, $16 million and $30 million as of January 31, 2007, April 30, 2007 and July 31, 2007, respectively, and reductions to previously reported pre tax income of approximately $8 million, $7 million and $13 million for the three month periods ended January 31, 2007, April 30, 2007 and July 31, 2007, respectively.

Almost three months later and with the help of 70 staffers from an independent general counsel as well as a forensic accounting firm, Verifone's management is ready with their 'final' estimate.

A few days back, Verifone managment reported that the audit committee had completed their investigation. Their final tally on reduction in the value of inventories was pegged at approximately $13 million, $23 million and $40 million at January 31, 2007, April 30, 2007, and July 31, 2007 These are considerably higher as compared to the originally reported estimates of reductions. These are also unaudited and subject to the review of their public accounting firm.

The cause of such a large restatement has been attributed to weak internal controls surrounding the inventory financial reporting and accounting process.

Specific remedial measures have been recommended in the audit committee's final report:
-- Implementation of a more stringent voucher approval process for manual journal entries;
-- Implementation of enhanced information technology/enterprise resource planning systems commensurate with the increased size and complexity of VeriFone's businesses;
-- Adding appropriate accounting and finance resources through additional centralized staffing with individuals having sufficient knowledge and experience in cost accounting and other GAAP principles;
-- Enhanced segregation of duties between the financial planning and the accounting and control functions;
-- Improvements in governance and compliance functions to improve control consciousness and appropriate adherence to generally accepted accounting principles, as well as improved tone, communication, documentation, education and training for employees involved in the financial reporting process, including the appointment of a chief legal and compliance officer; and
-- Personnel actions, including the termination of the Company's supply chain controller, enhanced supervision and other actions.

Besides the obvious accounting gaps, the recommendations also indicate a weak Human Resource function. Inadequately trained and incompetent personnel combined with weak oversight will almost certainly lead to disastrous results.
Manual Journal entries are one of the few items that receive maximum scrutiny from auditors.

Inadequate seggregation of duties is an issue that receives a high severity rating in an audit report. How could such issues have escaped audit attention?

The company's external auditors, Messrs Ernst & Young LLP issued an unqualified, clean audit report for the year ended October 2006. The Management assertion that is required under the Sarbanes Oxley Act, 2002 also held no indication of any weak internal controls. The managment stated "our management (including our chief executive officer and chief financial officer) concluded that our internal control over financial reporting was effective as of October 31, 2006.Management’s assessment of the effectiveness of our internal control over financial reporting as of October 31, 2006 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report included at Item 8 in this Annual Report on Form 10-K." There has been nothing in any statement from Verifone's management that can assure investors and authorities that the same inventory issues from 2007 were not creep into the prior years financial statments.

The SEC has sent an informal letter to Verifone managment asking to interview a few present and previous employees. Does the SEC or the PCAOB plan to involve the public accounting firm as well? I have written to the PCAOB to comment on this issue. Their response is awaited and once received will be posted on this blog.

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