SOX 404: Management's guide to internal controls assessment

Section 404 of the Sarbanes-Oxley Act (SOX) is a critical component of the U.S. legislation aimed at improving the accuracy and reliability of corporate financial reporting. It specifically requires publicly traded companies to establish and maintain an adequate internal control structure and procedures for financial reporting.

Compliance with Section 404 is not just a legal obligation but a strategic initiative that helps organizations safeguard against financial inaccuracies and fraud. By rigorously documenting, testing, and improving internal controls, companies can enhance operational efficiency, reduce the risk of financial misstatements, and build greater trust with investors and stakeholders.

Subsections under Section 404 of the SOX Act

1. Section 404(a) of the SOX Act mandates that the Securities and Exchange Commission (SEC) establish rules requiring each annual report filed under sections 13(a) or 15(d) of the Securities Exchange Act of 1934 to include an internal control report. This report must:
   • State that management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting.
   • Provide an assessment, at the end of the most recent fiscal year, of the effectiveness of the issuer's internal control structure and procedures for financial reporting.
2. Section 404(b) of the SOX Act mandates that each registered public accounting firm responsible for preparing or issuing an audit report for an issuer must attest to and report on the internal control assessment made by the issuer's management. This attestation must comply with standards for attestation engagements established by the appropriate regulatory board and cannot be treated as a separate engagement.

Key requirements of SOX Section 404

1. SOX Section 404 requires management to,
   • Implement a robust internal control system over financial reporting.
   • Conduct annual assessments to evaluate the effectiveness of these controls.
   • Include an internal control report in the annual filing, affirming the responsibility for internal controls and providing an assessment of their effectiveness.
2. External auditors must,
   • Perform an independent audit of the internal control system.
   • Issue an attestation report on the management's assessment of internal controls.

Exemptions under SOX Section 404

Exemptions under SOX Section 404 provide relief to smaller and emerging companies from rigorous external audits, helping them comply with financial reporting standards without incurring prohibitive costs.

Non-accelerated filers

This exemption applies to companies with a public float (the value of outstanding shares held by public investors) of less than $75 million. These companies are not required to obtain an independent auditor's attestation on their internal controls assessment. However, they are still subject to SOX Section 404(a), which requires management to conduct an internal controls assessment and maintain related documentation.

Emerging growth companies (EGCs)

This exemption applies to companies that have completed an IPO within the past five years and meet certain revenue thresholds (less than $1 billion in annual gross revenue for the most recent fiscal year). Similar to non-accelerated filers, EGCs are not required to obtain an independent auditor's attestation. They are still obligated to conduct an internal controls assessment under SOX 404(a) but have a grace period to comply with the full requirements.

Internal controls in SOX Section 404

Internal controls in SOX Section 404 are mechanisms and procedures implemented by companies to ensure the accuracy and integrity of financial reporting, promote accountability, and prevent fraud. Key aspects include identifying and addressing internal control deficiencies and material weaknesses, which are significant issues that could lead to errors or misstatements in financial reports.

Management is required to conduct a thorough assessment of these controls, often using frameworks like COSO, and annually report on their effectiveness. This process involves certifying the accuracy of financial statements and disclosing any deficiencies or weaknesses, thereby ensuring transparency, accountability, and investor confidence in the company's financial practices.

To learn more about the COSO framework and how it is used, click here.

Begin your journey to SOX Section 404 compliance with ManageEngine

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Start your compliance journey with ManageEngine and ensure your organization meets the stringent standards of the SOX Act.