SOX Compliance: Easy or Difficult?
It’s not easy but does not have to be difficult if you approach it the right way. Generally, a SOX project involves operational elements (i.e. getting things done) and technical compliance. As compared to financial statements compliance with US GAAP, a SOX project is more operational and less technical. The bulk of SOX work boils down to coordinating the work of accounting, payroll, sales and other departments to ensure all proper control activities are documented, executed, and tested on time.
SOX Concepts and Literature
There are a few sources of information that will help you comply. Theoretical foundations of SOX compliance are formulated in COSO framework. You can find it at coso.org, option Guidance, section Guidance on Internal Controls. There are a number of downloadable files that will explain how to establish and maintain a compliant system of internal controls.
At a very high level, COSO internal control framework is based on the following five components:
- Control Environment
- Risk Assessment
- Control Activities
- Information and Communication
- Monitoring of Controls
Another important source of information to consider is Audit Standard No. 5 (AS 5) published by Public Company Accounting Oversight Board (PCAOB). The standard is called “An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements”. Strictly speaking, the standard applies to external audits of internal controls. However, it still provides a good source of knowledge of the effective system of internal controls for everyone, not just auditors.
High level, the design and operation of internal controls should ensure that a) Company’s assets are properly safeguarded; b) Company’s financial statements comply with US GAAP.
Although some controls are executed and tested in a mechanical manner, it’s important to ensure that the way controls are designed and operate addresses the risk of potential misstatement. This serves as a high level goal for folks involved with designing and testing of internal controls.
SOX Implementation Plan
SOX implementation takes an extra effort. First off, try not to turn the whole project in a compliance exercise only. Instead, try to make it helpful to your company. Internal control requirements were implemented for a reason and, in theory, it’s a good one: making sure that Company’s assets are safeguarded and financial information is free of material errors.
Here is the 4 step process to implement SOX:
Step 1: Risk assessment, identify key financial reporting cycles, document key flow of information and activities taking place in each cycle.
Management should start with understanding of the risk of material misstatement in company’s financial statements. As part of the process, management analyzes the risk by significant transaction and account balances and their respective assertions. Financial statement assertions are: Existence or occurrence, Completeness, Valuation or allocation, Rights and obligations, Presentation and disclosure.
The above risk assessment is a foundation for developing appropriate control documentation including identification of key controls described below.
Examples of the financial reporting cycles are: Revenue and AR, Purchases and AP, Treasury, Income Taxes, Financial Close, etc. Sometimes, especially for a larger or even mid-sized organization it makes sense to also identify sub-cycles or sub-processes. For example, a revenue cycle can include the following sub-cycles: Contract signing, PO processing, Shipping, Revenue Recognition, etc.
You’ll need to document the flow of key activities taking place at noted processes and sub-processes. The documentation should include clear indication activities performed as well as folks involved with the activities, their roles and responsibilities.
Step 1 serves as a foundation for other steps of the implementation program. It’s important to get it right.
Step 2: Identify and document key controls within each financial reporting cycle.
Key controls are defined as those activities that mitigate the risk of material misstatement.
A control itself can be defined as a specific check or activity performed to ensure the control objective is met. As a refresher control objective is twofold: a) safeguarding of Company’s assets and b) ensuring that the financial information compliance with US GAAP. Examples of controls include account reconciliation, ensuring access to the accounting system is protected, etc.
There are multiple classifications of internal controls. Controls can be divided between Entity-Level, Divisional or Transactional. Controls can be Detective or Preventive, Manual or Automated. A separate class of controls is referred to as Information Technology General Controls or ITGC. ITGC controls cover such areas as password policy, system operation including segregation of duties and system changes.
Key controls should be documented. The documentation is often time taking place in the same document where managed documented Company’s processes and sub-processes as part of Step 1. Documented processes along with relevant controls are often referred to as Control Narratives.
Many companies identify and describe all relevant controls first and then identify those considered to be key.
Step 3: Perform and document walk-through of key internal controls to ensure their design is appropriate.
Generally, there are two parameters used in the assessment of internal controls: assessment of the design and assessment of operating effectiveness. Assessment of the design ensures that a control was developed or designed to address the risk of material misstatement. Operating effectiveness is concerned with the fact that the control is actually operated or executed as designed.
Step 3 is specifically concerned with controls’ design. Walk-throughs are performed by following one transaction from the beginning to the end. In practice, that boils down to testing one instance of a control. For example, let’s say the control in question has to do with matching PO with the vendor invoice and delivery note (a 3-way match). A tester can select one set of 3 documents and check how the match works. We address the documentation of the walk-through as part of Step 4 below.
Step 4: Test and document results of testing over key internal controls to ensure they operate effectively. Evaluate exceptions.
There are four main types of procedures performed as part of the control testing:
Inquiry involves asking appropriate questions and getting answers about operation of a control. Observation has to do with visually observing how the control is performed by the person responsible. Inspection is the review and examination of documentation supporting execution of the control in question. Reperformance involves tester’s re-performing of all activities of the key control.
The question is how many control instances should be tested. Many CPA firms developed testing tables indicating the amount of controls to test depending on the frequency of the control and risk involved. Control’s frequency can be annual, quarterly, monthly, weekly, daily, multiple times a day or ad-hoc. Generally, for automated controls testing one instance is sufficient provided ITGC controls operate effectively.
Many Companies also develop so called Control Testing Templates where actual testing work is documented. The template include control description, testing attributes, description of testing procedures performed, date of testing, roll-forward testing performed, among other details. Sometimes walk-throughs performed as part of Step 2 are documented in the same templates where the testing is documented. However, walk-throughs should be performed before the actual testing is.
It may be helpful to have one central depository of key controls referred to as Control Matrix. The Matrix will include the description of each control, financial cycle it belongs to, unique #, indication if it is manual or automated, estimated frequency for manual controls (e.g. monthly, quarterly, ad-hoc).
Other SOX Questions
Other typical questions relevant to SOX effort include the accuracy of the underlying information used in the execution of the control. For example, let’s assume that per the control description the Controller performs Balance Sheet variance analysis on a quarterly basis. Part of the control is to ensure there is a variance analysis with relevant explanations. Besides mere execution of the control description, we need to ensure that the balance sheet being analyzed is the most recent one and not one of the older versions without later adjustments. In other words, we need to ensure that the underlying information used in the execution of the control (i.e. the balance sheet) is accurate.
AS 5 requires auditors to use a Top-Down approach as part of their testing strategy. The approach establishes an order in which a control project is executed. Understanding of controls system and controls risk assessment come first. Testing of controls comes after. Entity level controls should be tested before transactional ones. Overall, the approach promotes healthy project management mindset and is relevant to external audits as well as SOX implementation.
Last topic we wanted to cover here is the difference between 404(a) and 404(b) compliance. 404(a) and (b) are two sub-sections or paragraphs of the Sarbanes Oxley Act introducing certain requirements relevant to internal controls over financial reporting. Paragraph 404(a) requires management of U.S. public companies to assess and report on the effectiveness of internal controls. Section 404(b) of the Act requires a registered public accounting firm to report on the assessment made by management as part of the 404(a) requirement.
Some companies are subject to 404(a) only. For examples, all non-accelerated filers have to comply with 404(a) but not 404(b). Non-accelerated filers include smaller reporting entities and debt filers. Smaller reporting entities include those that have public float at the end of the most recent second quarter of less than $ 250 million. So called Emerging Growth Companies are subject to 404(a) and not 404(b) for five years. First time filers can extent 404(a) and 404(b) compliance until filing their second annual report (10K). Last but not least, 404(a) and 404(b) compliance for newly acquired companies can be deferred by a year.
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