SOX 404 Compliance

INTRODUCTION

Last year’s passage of Auditing Standard No. 5 (AS-5) seems to have been the Public Company Accounting Oversight Board’s (PCAOB) attempt to swing the Sarbanes Oxley regulatory pendulum back from the process oriented, control-centric, “kitchen sink” approach to one that allowed companies to make intelligent choices around properly mitigating their financial reporting risks via a top-down risk assessment. This in theory should have significantly lowered the amount of work to be done and the costs to be incurred. Furthermore, Auditing Standard 5 also encouraged auditors to rely on the work of others (i.e. documenting and testing key controls) when evaluating the system of internal control, which should have reduced the overall costs of SOX compliance even further.  Unfortunately, in practice, these savings have not been fully realized

In point of fact, external auditors often duplicate their clients’ internally-generated work or perform testing of controls deemed non-key because of management’s inability to clearly and succinctly demonstrate how their own efforts addressed the organization’s financial reporting risks for the relevant assertions of significant accounts and disclosures.  If management is unable do so, then external auditors have no other choice than to exercise their own judgment in determining what work must be done to arrive at an opinion regarding the adequacy of internal control.  Their judgment would include selecting the controls required to achieve financial assertion coverage as well as the nature (inquiry/observation, examination, or re-performance), timing (reporting periods from which samples will be selected), and extent (sample sizes) of the tests to be performed on those controls.  In the current business environment, meeting professional obligations to third-party users of financial statements may impact an auditor’s testing decisions - better safe than sorry.

If an organization truly wants to benefit from AS 5, then it must adopt a systematic, objective approach to evaluating financial reporting and internal control risks and demonstrate management’s testing approach adequately addresses those risks.

CHALLENGES IMPACTING MANAGEMENT’S ABILITY TO EVAULUATE INTERNAL CONTROL OVER FINANCIAL REPORTING

Financial Statement Assertion Coverage

Financial statement assertions are nothing new - Sarbanes Oxley has merely changed them from implicit to overt declarations regarding the balances and disclosures reported by management.  Management must now be able to articulate which assertions should be made about a particular account and what assertions each control provides coverage for.  Inexperience with performing this task or unfamiliarity with the details or nuances of each control by the person performing the “Assertion Sourcing” task can result in four common problems:

1.Failure to document and evaluate all relevant assertions for each significant account.  As a result, it becomes difficult if not impossible to ascertain whether all controls necessary to adequately report on an account are in place.
2.Redundant controls resulting in unnecessary testing due to the difficulty in evaluating the “many to many” relationships of risks, controls, and accounts. 
3.Associating to an assertion the wrong controls, i.e. ones that won’t help meet the assertion.  This situation can result from misunderstanding either the control or the assertion definition.

Claiming a control meets an assertion when it actually covers only a portion.  For instance, the Completeness assertion is really composed of both Completeness and Cutoff; that is, all transactions are recorded in the proper period.  A control like bank reconciliations allows management to assert proper cut-off, but not the completeness of the transactions, which should have been recorded in the General Ledger.
A SUGGESTED METHODOLOGY TO OVERCOME THESE ISSUES

Control Sourcing - Ensuring Assertion Coverage While Optimizing Controls

To overcome these issues, a control-optimization effort can be designed to identify duplicative, overlapping, or non-financial key controls for elimination from testing, as well as any areas where additional controls are needed or testing needs to be enhanced.  However, while critical, the effort is not always simple.  Effective control-optimization requires the ability to evaluate the “many to many” relationships of risks, controls, and accounts and evaluate which control would best enable management to make assertions about significant accounts.  Control optimization also requires understanding which major classes of transactions in each cycle impact those accounts.  Since many organizations utilize spreadsheets to capture the risk and control data attributes/elements, they often find it difficult to evaluate the assertion coverage obtained, because there are too many unique dimensions for Excel to deal with.  Management should consider a true database structure to facilitate “Control Sourcing” to accounts and assertions in order to identify both duplication and control gaps via exposure by analysis.
Risk-Based Testing

Many organizations currently utilize a “one size fits all” approach to control testing.  Control frequency determines sample sizes and the nature of the tests tends to skew towards examination and re-performance.  Internal audit or independent management testers obtain evidence of the control and

Management should consider utilizing an approach which considers the combined effect of Financial Reporting risk (FR) (think Materiality and Impact) and Internal Control risk (IC) (think Likelihood), enabling them to assess the relative significance of controls and potential impact of control failures on Internal Control over Financial Reporting (ICFR) by calculating a numeric score based on objective risk criteria relevant to account balances, assertions, process and controls in a highly defined manner.  No longer would all controls be equal.  Instead, those whose failure could result in a more significant misstatement of the results of operations and required disclosures would receive more robust, objective and timely scrutiny. 

The firm of AC Lordi Consulting has developed such a testing methodology and then taken it one step further. It leverages the information gained during the risk assessment, by                                                                                                                                                                                             recommending the nature (inquiry/observation, examination, re-performance), extent (sample sizes) and timing (period from which samples are drawn) for a test based  on the ICFR  score obtained for the related control. 

For instance, an automated application control, in a well-controlled ERP environment, ensuring the summary of data compiled in the Accounts Receivable sub-ledger is completely and accurately recorded in the General Ledger is much less risky than the activities of an individual summarizing a list of invoices and then data-entering them to the General Ledger via a manual journal entry.  Failure of either control would result in relatively the same financial reporting risk, but the process and control risk of the latter would be significantly higher, So the second control would receive a higher ICFR score based on the Process and controls IC risk contribution This higher score would portend a more severe approach to testing, likely resulting in a larger sample size, performed more often and much closer to the end of the reporting period.

Additionally, this methodology permits an organization to both spread the work more evenly over the year by testing the controls with lower (less risky) ICFR scores earlier in earlier quarters while ensuring management tests controls with higher ICFR scores closer to end of the reporting year and the testing is assigned to the more objective and independent Internal Audit function.

Instead of the usual two-phased approach to testing where the bulk of the testing is performed perhaps nine months into the year, with the remainder done shortly after year-end, and all controls have samples drawn from each of the two periods, management can schedule the tests to occur during less demanding timeframes and Internal Audit can integrate its testing with existing audit responsibilities.

CONCLUSION

Management should take a proactive position in helping frame the conversation regarding testing with the external auditors by providing sufficient documentation of a “top-down, risk-based” evaluation of the risks to providing timely and adequate financial results and disclosures to third-parties.  Their approach should clearly show how the evaluation focused efforts on riskier activities and should aid management in achieving their desired goal of reducing compliance costs by clearly demonstrating to the external auditors familiarity with what could go wrong.  Such an approach should also provide senior management and the Board of Directors with greater assurance that their duties have been properly discharged.
Management’s ability to evaluate its control environment is highly dependent on its ability to properly structure its risk assessment in a way that allows deep visibility into the nature of the framework. Knowing what controls can be omitted and what tests can be simplified amounts to understanding the importance associated to a control and the gaps that exist in meeting the assertions. But with the right methodology, data structures and reporting toolsets, this exercise becomes straightforward and highly cost-effective.

Copyright April 2008 Christopher D Coigne and John Dorsam