of Section 404 of the Sarbanes-Oxley Act
Heng Hsieu Lin and Frederick H. Wu
MARCH 2006 - Section
404 of the Sarbanes-Oxley Act of 2002 (SOX) requires management
and independent auditors to report on the effectiveness of
internal control over financial reporting. The concept of
internal control is not new; what section 404 introduces is
mandatory reports on internal control by management and independent
auditors. The belief behind the requirement is that such audited
reports could prevent corporate scandals such as Enron and
aim is misguided for a number of reasons. First, internal
control was not conceptually designed to be a panacea for
corporate ills. Traditionally, in the audit literature,
the concept of internal control is narrow in scope and procedural
in application. It is narrow because the scope of internal
control is largely confined to accounting systems to support
the accounting process. It is procedural because auditors
tend to follow a set of prescribed mechanical procedures
to determine whether internal controls surrounding and embedded
in accounting systems are reliable. In general, auditors
will not concern themselves with controls beyond the accounting
process. This is where the problem of the traditional internal
control concept lies.
the Foreign Corrupt Practices Act of 1976 (FCPA) defines
the responsibilities of corporate management regarding the
establishment of an effective system of internal control.
Accordingly, the mechanism of corporate governance through
internal control has been mandatory since then. Section
404, in essence, renews the enforcement of the Foreign Corrupt
Practices Act. However, the failure of the FCPA should have
conveyed the potential difficulties in the implementation
of SOX section 404.
requiring independent auditors to attest to and render an
opinion on the effectiveness of internal control is nothing
new. The evaluation of internal control is an integral part
of a financial audit. The scope of the audit is based on
the assessment of the strengths and weaknesses of internal
control over a company’s accounting systems. At the
end of an audit engagement, independent auditors generally
provide a management report that includes recommendations
to strengthen internal control if it is found to be significantly
weak. If management uses the auditor’s report to improve
internal control, with the auditor required by section 404
to attest to management’s assertions about the effectiveness
of internal control, conflict-of-interest issues would be
Scandals, Not Accounting Scandals
did not cause the recent corporate scandals such as Enron
and WorldCom. Unreliable financial statements were the results
of management decisions, fraudulent or otherwise. To blame
management’s misdeeds on fraudulent financial statements
casts accountants as the scapegoats and misses the real
issue. Reliable financial reports rely to a certain extent
on effective internal controls, but effective internal controls
rely to a large extent on a reliable management system coupled
with strong corporate governance. (A management system is
a process of planning, executing, and control for all business
processes in an organization.) Management systems dictate
all business processes. When management deliberately or
even unlawfully manipulates business processes in order
to achieve desirable financial goals and present untruthful
financial reports to the public, accounting systems are
abused and victims rather than perpetrators. Internal control,
no matter how effective, is rendered impotent when management
decides to circumvent it. Therefore, internal control must
be extended to cover all major risks outside of the accounting
process. In other words, internal control rests on adequate
and comprehensive analysis of enterprise-wide risks.
and Purposes of Internal Control
to the Internal Control–Integrated Framework,
issued by the Committee of Sponsoring Organizations (COSO)
in 1992, internal controls encompass a set of policies,
rules, and procedures enacted by management to provide reasonable
assurance that 1) financial reporting is reliable, 2) its
operations are effective and efficient, and 3) its activities
comply with applicable laws and regulations. This definition
clearly indicates that internal control has purposes other
than reliable financial reporting. In fact, it implies that
internal control deals with potential risks existing in
three areas of business: information processes (capturing
data, maintaining databases, and providing information to
achieve reliable financial reporting); operation processes
(activities in the value chain to achieve operational efficiency
and effectiveness); and compliance processes (the objective
of conformity with laws and regulations).
most crucial is the management process, referred to above
as the management system, that dictates and controls all
other business processes. (“Business processes”
as used in this article refers to the combination of the
management, operation, information, and compliance processes.)
Lack of attention to internal controls in the management
process is another major weak spot of the traditional internal
control concept; it has not been explored and stressed in
the internal control literature. Risks in the management
processes, discussed below, are much more critical. Significant
potential risky events in every business process, if they
do occur, can contribute to failures of internal control
over financial reporting. Risks in the information process
are not the only source of failure of internal control over
financial reporting. Thus, a better way to state the requirement
of section 404 is:
and independent auditors are required to report on the
effectiveness of internal control over enterprise risks
affecting financial reporting.
effective system of internal control must be built on the
basis of the analysis of enterprise-wide risks.
independent auditors focus on risks directly related to
business transactions defined by generally accepted accounting
principles (GAAP), and therefore, risks in the information
process are the focal points in the evaluation of the strengths
and weaknesses of internal control. Risks, however, exist
in every business process, and some risks, if and when their
related events materialize, will significantly affect financial
reporting. In fact, major enterprise risks rarely occur
within the accounting process. Recent corporate malfeasances
such as Enron and WorldCom were the results of risks realized
in the management process and other major business processes,
and are examples of businesses that have been toppled by
the failures of information systems.
is not surprising that COSO proposed risk analysis as one
of the five components of internal control in its 1992 pronouncement.
In September 2004, COSO extended and refined the original
concept of risk analysis by proposing an integrated framework
for enterprise risk management, which is designed to manage
risk by providing reasonable assurance regarding the achievement
of the following entity objectives:
Strategic: high-level goals, aligned with and supporting
Operations: effective and efficient use of its resources;
Reporting: reliability of financial reporting; and
Compliance: compliance with applicable laws and regulations.
in the process of creating value for its customers and other
stakeholders, an entity must be able to systematically assess
and analyze all material risks that affect the aforementioned
and Decision Risks in the Management Process
entity, whether for-profit or not-for-profit, exists to
create value for its stakeholders. In the course of creating
value, the entity’s management has to follow a process
to make important decisions regarding goals, strategies,
and resource acquisition and allocation for all of its operations.
This is the planning stage of the so-called management system
or process. After the entity formulates a strategic plan,
the process moves to the stages of execution (of the plan)
and control (of operations). The process ends with an assessment
of the results of operations as compared to the strategic
plan by means of the entity’s information systems,
mainly accounting systems. This information serves management
in making further decisions regarding goals, strategies,
and resource allocation, and the strategic planning cycle
decisions made in the management process entail uncertainties—unattainable
goals due to fatal strategies, and operational failures
due to inefficient allocation and ineffective application
of resources. The chosen strategy presents risks associated
with competition in the marketplace as well as with hard-to-predict
economic, political, and social events. Allocating and applying
resources presents risks associated with the quality and
marketability of products or services. Decisions about strategic
and resource choices are the most critical issues to every
business entity, because most business failures are due
to strategic errors or inefficient and ineffective operations
that lead to uncompetitive products or services.
controls must function effectively in the management process.
Policies and procedures must be established to govern the
strategic planning process. In particular, accounting systems
must have the mechanism of measuring strategic variables
to highlight strategic success or failure. Information about
strategic success or failure must be provided to the board
of directors for effective monitoring. The difficult part
of assessing strategic results is unraveling legally questionable
management decisions that are hidden in the quarterly and
annual financial reports. Currently, internal controls for
the management process in many business entities are either
lacking or working poorly. Enron’s strategy to create
special purpose entities was a strategic risk as well as
a decision risk. Arthur Andersen’s shredding of documents
related to Enron’s audit was a strategic risk as well
as a decision risk.
Process and Risks
process refers to the sequential events of capturing business
transaction data, maintaining databases or master files,
and providing information from databases to internal users
for managerial planning and control and to external users
for making financing and investment decisions. This process,
if supported by accounting systems, is also called the accounting
capturing is the most crucial event in the accounting process
because most cases of unreliable financial reporting are
the results of data manipulation, and also because internal
controls are generally designed to capture more unintentional
data errors than intentional ones. As the saying goes, Garbage
in, garbage out. No matter how good the accounting systems
are, erroneous data lead to unreliable financial reports.
If errors are significant or material, erroneous data, intentional
or unintentional, pose information risks in financial reporting.
To prevent data errors and minimize input risks, control
devices (policies, rules, procedures, and methods), generally
referred to as “input controls,” are established.
Input controls are particularly necessary in order to prevent
accounting managers, in cooperation with the CEO, from initiating
matter how many input controls an entity has designed and
established, internal control may not be able to handle
uncertainties related to the performance estimates of certain
financial variables that must be made for financial reporting.
Examples include banks’ bad-debt reserves; property
and casualty insurers’ loss reserves; and corporations’
assumed earnings rate on pension assets. The risks with
these estimates of reserves are high and real. Real-world
examples include Clear Channel’s $4.9 billion write-off,
restatements by restaurant companies for lease accounting,
and GE’s restatement for derivatives.
key point is that not all accounting data are factual and
empirically verifiable. Some of the aforementioned financial
estimates are probabilistic (e.g., bad debts and casualty
loss reserves); some are logical (e.g., depreciation and
amortization); and some are subjective (e.g., bank cash
reserves or goodwill). An auditor cannot simply say that
financial statements are reliable when probabilistic data
represent the probable results of a future event, that logical
data may be illogical when circumstances have changed, or
that subjective data are simply subjective. That is why
internal control is not a panacea.
can lead to information risks during the processing of data.
Thus, internal controls are also designed to prevent and
detect errors and to minimize risks at this stage of the
information process. This area is generally referred to
in the internal control literature as “processing
controls.” Various systems-documentation manuals in
business entities prescribe how systems should be operated
in order to process transactions accurately. These manuals
include established policies, rules, and procedures that
personnel must follow in order to maintain reliable databases
or master files from which financial information is produced.
These manuals also give rise to tools that can provide reasonable
assurance that data are correctly processed. Such tools
include test data, edit programs, and run-to-run reconciliation.
errors can occur and risks can become real due to lack of
controls over the access to financial information. A particular
concern of any business entity is the protection of sensitive
information. Internal controls, generally referred to as
output controls, are designed to handle the potential risks
of losing or abusing sensitive financial data. Again, policies,
rules, and procedures should be established to control errors
and to minimize risks in handling the accounting system’s
input-processing-output controls, generally referred to
as application controls, are not sufficient to ensure reliable
financial reporting if there is a poor control environment
surrounding the applications of information technologies
(IT). For example, if a firm does not build a culture of
ethical behavior for its employees over time, controls in
the information process could be circumvented or tempered.
controls to handle risks outside of accounting systems are
generally referred to as general controls, encompassing
proper separation of duties in the accounting department
and between users’ departments and the IT department,
physical assess and security, logical access controls, systems
development standards, and contingency or recovery plans.
COSO treats this area as the control environment of the
entity, but subsequently renames it as the internal environment,
one component of enterprise risk management.
Processes and Risks
and application controls cannot be adequate unless risks
in the operation processes are also effectively monitored.
Operational processes are the primary and supportive activities
in the value chain. Primary activities—namely, acquisition
of resources, conversion of resources to products or services,
and distribution, marketing, and sales of products and services—create
products or services that customers are willing to pay for.
Business entities create value through these primary activities.
Supportive activities, such as research and development,
management, IT, and organizational structure, are designed
to enhance the operational efficiency and effectiveness
of primary activities.
risks of producing unreliable financial reports could exist
in any operation process. For example, improper handling
of sales and purchase procedures could lead to overstatement
of sales and understatement of costs in the financial statements—an
operational risk, if not detected and prevented. Or, if
the sales management of a telecommunication company treats
intra- or intercompany transactions as sales, the intentional
misrepresentation of the bogus sales in the financial reports
is the result of the covert operation in the sales process,
having nothing to do with internal controls in the accounting
systems. So, information risks pose threats simply due to
control deficiencies in the operation processes.
stated previously, efficiency and effectiveness of the operation
processes is one of three control objectives of internal
control as defined by COSO. Failure in this objective could
lead to failure in financial reporting. Recent sensational
corporate news stories that were the result of control failures
in operation processes include controversies over Tyco’s
handling of employee loans and AIG’s handling of risk-free
insurance. In these cases, accounting systems might have
captured data from ill-conceived transactions that occurred
in the business processes and were conveyed to the accounting
system as authorized and genuine transactions. When erroneous
transactions are treated as if they were authenticated in
the operation processes, controls break down, leading to
financial reporting failures.
business history illustrates that financial reporting failures
were due to control deficiencies in operation processes,
operation management must be made responsible for establishing
an effective system of internal control. To blame such failures
on the accounting system is to misplace the causes underlying
the failures. Internal control should permeate every segment
of an entity’s business and should be the concern
of all operation management, not only management in the
accounting process. This is the spirit of what COSO defines
as the control environment of the business entity.
financial reporting, every public company must comply with
applicable laws and regulations issued by the SEC and the
Public Company Accounting Oversight Board (PCAOB). Violations
of laws and regulations under their oversight may be deemed
criminal. For example, banks have specific laws and regulations
to follow. Similar situations exist in other industries.
At the state level, every business entity must also comply
with state laws and regulations applicable to the entity’s
of federal and state laws and regulations can jeopardize
an entity’s financial condition and its survival,
as exemplified by the demise of several public companies
in the past decade. Thus, control policies, rules, and procedures
must be established to reduce the risks of noncompliance.
Responsibility for enforcing compliance policies, rules,
and procedures rests with the units whose operations are
affected by applicable laws and regulations. Therefore,
the risks of noncompliance exist in the operation processes
and, if related events actually occur, they can significantly
affect an entity’s operational results and financial
Framework for Enterprise Risk Management and Internal Control
the aforementioned types of risks, the PCAOB appears to
focus on information risks. In Auditing Standard 2 (2004),
the PCAOB defines internal control as follows:
process designed by, or under the supervision of, the
company’s principal executives … to provide
reasonable assurance regarding the reliability of financial
reporting and preparation of financial statements for
external purposes … [including] those policies and
pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions
and disposition of the assets of the company;
2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial
3) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use or disposition
of the company’s assets ….
definition indicates that the objective of internal control
is the reliability of financial reporting. The standard
does not address internal controls needed for countering
operational and compliance risks or controls over the crucial
risks in the operation, information, and compliance processes
generally will not create as much impact as risks in the
management process. The operation, information, and compliance
processes comprise repetitive and horizontally sequential
events that are easily automated. Enterprise resource planning
(ERP), electronic data interchange (EDI), supply-chain management
(SCM), and customer-relation management (CRM) software renders
these business processes efficient and effective. At the
same time, IT embedded into these processes also captures
and processes business data effectively and efficiently.
The same cannot be said for the management process.
important point is the pervasive application of IT in business.
Information processes are embedded into operation processes,
meaning that the two have to work together to achieve the
desired level of efficiency and effectiveness. This implies
that information risks are interlocked with operation risks.
This also means that internal controls for information processes
must be designed in conjunction with the design of internal
controls for operation risks.
if the operation, information, and compliance processes
are routine and repetitive, then monitoring (analyzing,
assessing, and documenting) risks and internal controls
in these processes should be the responsibility of the company’s
internal auditors, while monitoring risks and internal controls
in the management process should be the responsibility of
the external auditors. Independent external auditors can
evaluate management’s decisions more objectively.
This division of responsibilities should significantly reduce
the costs of implementing SOX section 404 in the long run.
stressed earlier, an effective system of internal control
must build on the foundation of effective management of
enterprise risks: strategic and decision risks, information
systems risks, operation risks, and compliance risks. This
is more than what the PCAOB requires, and it is consistent
with what COSO advocates in its new publication, Enterprise
Risk Management—Integrated Framework, wherein
COSO defines enterprise risk management as follows:
process, effected by an entity’s board of directors,
management and other personnel, applied in strategy setting
and across the enterprise, designed to identify potential
events that may affect the entity, and manage risk to
be within its risk appetite, to provide reasonable assurance
regarding the achievement of entity objectives.
objectives to be achieved by enterprise risk management
are: strategic goals, operational effectiveness and efficiency,
reliable financial reporting, and compliance with applicable
laws and regulations. Except for strategic goals, these
objectives are defined under the objectives of internal
control previously defined by COSO in its 1992 pronouncement.
Missing in COSO’s strategic risks analysis is accountability
of, and subsequently internal controls over, management’s
decision-making and action.
four objectives of enterprise risk management can be accomplished
by managing the four aforementioned types of risk. Strategic
and decision risk analysis will lead to establishing required
internal controls to achieve the strategic goals, that is,
creating value for stakeholders. Information risk analysis
will lead to developing internal controls to accomplish
the goal of reliable financial reporting. Operation risk
analysis will help establish internal control needed to
accomplish the goal of operational effectiveness and efficiency.
Finally, compliance risk analysis will help identify required
internal controls for achieving the compliance goal.
that may pose as risks in various business processes are
filtered through the respective systems of internal control
(see the Exhibit).
If these risks are high and not detected and prevented,
they will be filtered through controls in the accounting
information process. All transactions (events) in various
business processes may carry with them transaction risks
(errors) that are to enter the accounting information process.
At this critical stage, operation risks, management risks,
and compliance risks may all become a part of information
risks. To overcome these risks, general and application
controls are designed, tested, and implemented. The preventive
type of controls is particularly important to ensure that
only correct data are entered in accounting systems. The
established preventive input controls, however, no matter
how effective they are, cannot detect all material risks
from the operation and compliance processes. Furthermore,
managers may decide to circumvent the system of internal
control in the accounting process and thereby render internal
control futile. The decisions made in the management process
can overrule all controls in the accounting process.
risky events from operation and management processes as
well as risks within the information process become realized,
accounting systems will be contaminated with errors and
mistakes in data. In addition, risks within the information
process emerge when nonfactual data (estimates) are created.
These errors, if significant or material, and if not detected
and corrected, will lead to the creation of financial statements
that are not fairly presented.
here to see Sidebar.
Hsieu Lin, PhD, CPA`, is an adjunct professor in
the department of accounting at Washington State University
at Vancouver, Vancouver, Wash.
Frederick H. Wu, PhD, CMA, is a professor
in the department of accounting of the University of North
Texas, Denton, Texas.