SOX Compliance

In 2002, the United States Congress passed the Sarbanes-Oxley (SOX) Act in response to the infamous Enron and WorldCom accounting frauds in which investors and shareholders collectively lost billions of dollars.

This act aims to bring transparency to all public companies’ financial matters and corporate governance and the firms representing them in the United States.

The SOX Act particularly impacts technology businesses in the US and how they manage data and has had a significant impact on how public tech companies manage their finances.

In this article, I’ll give you a brief introduction of the SOX Act and its compliance requirements from businesses in the U.S.

What Is SOX Compliance?

The SOX Act has 11 different titles that pertain to the finances, accounting practices, data management, investor relations, and corporate governance of publicly listed companies.

SOX Compliance refers to the minimum standards a public company in the U.S is required to maintain under the SOX Act.

Every publicly listed company in the US and management and accounting firms representing them must ensure SOX compliance.

SOX compliance is determined through annual company audits by independent audit firms, and the compliance report must be easily accessible to all company shareholders.

A company’s failure to comply with the SOX Act can result in various forms of penalties ranging from the public stock exchange delistings and invalidation of D&O insurance policies to fines of $5 million and up to 20 years in jail for its CEO and CFO.

The main goal of SOX compliance is to ensure that publicly listed organizations.

  • Are more transparent in their financial practices
  • Develop safeguards and controls to ensure accurate financial data reporting.
  • Publish audit reports of their management and accounting practices that are available to all shareholders.
  • Protect in-house whistleblowers who assist in identifying corporate and financial frauds.
  • Take measures to increase investor confidence and remove gray areas in financial reporting.

The overall impact of SOX compliance is positive since it brings more transparency to the financial matters of public companies and makes critical information accessible to the shareholders.

However, it also significantly increases the cost of managing, regulating, and securing data through various checks and performance standards of information systems where the data is stored.

A key outcome of the SOX Act was the formation of an independent auditing process through the Public Company Accounting Oversight Board (PCAOB). This practically ended self-regulation in organizations for auditing purposes and instead empowered the PCAOB to develop, establish, enforce, and audit industry standards.

The PCAOB also has the power to investigate any fraud allegations and regulate third-party audit firms. As a result, only PCAOB approved audit firms have permission to conduct SOX compliance audits.

How SOX Compliance Works

SOX Compliance is based on the 11 titles mentioned and described in the SOX Act. To ensure compliance, an organization needs to satisfy all the articles’ requirements in the SOX Act.

However, the following four sections of the SOX Act are generally considered the most important for SOX compliance.

Section 302 – Corporate Responsibility for Financial Reports

Companies must submit periodic (usually annual) financial reports reviewed and signed by their CEO and CFO. By signing the report, the officers certify that the report’s contents are 100% correct and validated through internal inspections and quality control within 90 days before publishing the report.

This means that the signing officers can be held responsible for inaccuracies or data manipulation in the reporting.

The report should also include a list of all the gaps in the organization’s internal controls and any fraud that involves employees responsible for the internal controls in any way.

Section 404 – Management Assessment of Internal Controls

The annual reports of all public companies should include an Internal Control Report that shares the list of all internal controls in place, their scope, procedural details, and reporting structure.

The report should also list any compliance issues with SOX standards in the existing internal controls.

The report’s independent auditor should also review and certify the company’s information in the same report.

Section 409 – Real-Time Issuer Disclosures

All public companies must update the public and their shareholders and investors in a timely manner about any material changes in their financial condition or operations.

Section 802 – Criminal Penalties for Altering Documents

This section of the SOX Act outlines the penalties (fines and imprisonment) for any who intentionally alters, destroys, mutilates, conceals, falsify records, documents, or tangible objects to influence a legal investigation.

The suggested penalties are fines of up to $5 million and imprisonment of up to 20 years.

This section also imposes penalties of fines and/or imprisonment up to 10 years on any accountant who knowingly and willfully violates the requirements of maintenance of all audit or review papers for five years.

The crux of all these sections is that public companies should develop internal systems and mechanisms to ensure that their financial reporting is accurate and does not mislead their investors and stakeholders in any way. Failure to do so will result in heavy penalties and legal proceedings.

How To Get Started With SOX Compliance

Developing procedures, controls, and standards to enforce SOX compliance within an organization is a long process.

Broadly speaking, we can break it down into the following six steps.

Step 1: Defining the Scope

The first step of SOX Compliance is to define the scope of the internal controls, the hierarchical positions responsible for ensuring the implementation of the controls, the signing off authority, and the approval chain.

In this step, you should also clearly identify the areas that need to comply with the SOX Act by mentioning the specific sections that apply to them.

Overall, this step should offer a bird’s-eye view of the SOX compliance procedure and everyone involved in it.

It should help the auditor identify any potential risks, how they might impact your business, and whether the controls in place are sufficient to prevent compliance issues.

Step 2: Determining Materiality and Risks

In this step, you need to develop a clear definition of what constitutes “material.” Financial statement items are considered “material” if they could influence the economic decisions of users.

Secondly, analyze the financials of all the locations where your business physically operates. Also, determine any transactions in your business locations that cause the financial statement account to increase or decrease.

And finally, identify the risks that could prevent the transactions from being correctly recorded.

Step 3: Applying SOX Controls

Once you’ve identified the risk areas that could prevent transactions from being correctly recorded, you need to apply internal controls that counter any such possibilities. This would include checks and balances in the financial reporting process to ensure that the transactions are correctly recorded and the accounts are accurately updated.

You must also determine whether to use manual or automated controls (or both) at different stages of the internal control process to ensure your records’ transparency and accuracy.

Step 4: Developing Fraud Prevention Mechanism

One of the primary objectives of applying internal controls and complying with SOX Acts is to prevent any form of fraudulent activities in analyzing, reporting, and managing data.

There are no fixed steps or guidelines in this regard, but generally, the following fraud prevention steps should be sufficient.

  • Segregation of duties: No single employee should have complete control over your data reporting and management. Instead, the different segments of the process should be assigned to various team members to prevent manipulation and over-dependency.
  • Employee expense reimbursements: Any reimbursements to employees for official tasks or approved benefits should be processed through a transparent mechanism to ensure no false claims are entertained.
  • Whistleblower Safety: Create processes to ensure whistleblower safety and anonymity to ensure employees can highlight procedural problems or fraudulent activities without fear.
  • Regular Reconciliation Of Bank Accounts: This would help highlight any differences in the actual bank figures and your internal financial records.

Step 5: Process and Control Documentation

The complete procedures of your internal controls, the responsible individuals, frequency and nature of tests, their associated risks, etc., should all be well-documented and controlled under a central repository.

Step 6: Periodic Testing Of Controls To Identify Deficiencies

Testing your internal controls helps you verify that you have the proper procedures in place that are being looked after by the right persons in your organization. You’re successfully able to prevent fraudulent reporting and ensure transparency n your financial structure.

The Benefits Of SOX Compliance

Organizations should not view SOX compliance as an additional cost or a legal binding with no value for their business.

Because when you apply adequate internal controls, ensure financial transparency, and comply with SOX regulations, your organization experiences several immediate and long-term benefits.

Here are some of them:

  • SOX compliance has dramatically improved corporate governance across publicly listed companies in the United States. As a result of the SOX Act, all publicly listed companies now have independent audit committees that ensure accurate financial reporting.
  • SOX recommends an organization-wide documentation standard for every financial process and reporting mechanism. This has long-term benefits for companies and helps in streamlining their processes and improve efficiency.
  • A direct result of documentation and SOX compliance is the standardization of processes. Process standardization is the first step of process optimization which ultimately leads to higher ROI for every process.
  • SOX compliance encourages process documentation, standardization, and automation, significantly reducing human errors, thus increasing an organization’s financial reporting accuracy.
  • SOX internal controls ensure that no single employee has the power or authority to manipulate company financials. This not only prevents fraud but also maintains the balance required for effective financial management.

Common Challenges In SOX Compliance

Organizations face various types of challenges in complying with the SOX act. Here are some of the most common challenges you may face.

  • SOX compliance requires additional infrastructure and resource costs for monitoring, reviewing, and analyzing financial transactions. This can become a significant challenge for organizations operating at lower margins.
  • SOX compliance focuses on fraud reduction through the distribution of responsibility and succession planning for every critical role in an organization. Experienced and influential employees often resist these changes.
  • For many companies, SOX compliance means a complete overhaul of their financial reporting structure which can be a significant challenge.
  • SOX compliance encourages automation of processes, reducing dependency on manual work, and creating a central repository of all organizational processes. For many organizations, these are fundamental changes to the way they work and can be challenging to execute.

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Bryan Wise
Bryan Wise,
Former VP of IT at GitLab

Incredible companies use Nira