UK: Lessons Best Learnt Early - Securities and Banking Update May 2005

Last Updated: 11 May 2005
Article by Alan Chaudhuri

Most Read Contributor in UK, August 2017

The first attestations in the US under Sarbanes-Oxley Section 404 (SOX 404) have taken place and whilst the attestation requirement for foreign companies was recently deferred, many have chosen to press ahead with plans for the current year. Alan Chaudhuri, reviews the experiences to date and sets out some lessons learnt from the US.

Whilst the recent announcement by the SEC to delay attestation requirements for foreign registrants has been welcomed, most organisations have taken the decision to press ahead with documentation and testing plans in the current year. Decisions have been driven by a need to ensure that momentum is not lost as well as a desire to use the extended period to enhance documentation and identify and rectify potential weaknesses. Set out below are some areas where lessons learnt from organisations in the US may prove helpful.

Testing and identification of potential Deficiencies
The choice of which department performs the testing is a key decision within any project. For initial periods, organisations have found it beneficial to use departments, such as internal audit, with experience of evaluating internal controls.

The use of qualified individuals helps ensure consistency and quality in the testing performed and the benefits that should be obtained in future years should not be underestimated – as testing is transitioned into "business as usual", it will be beneficial to have a high quality standard which can be replicated by individuals with less experience of internal controls testing. The delay allows such decisions in respect of testing to be reassessed and appropriate resourcing models to be put in place. Cost implications of using departments such as internal audit should be viewed in light of the fact that the auditing standards allow the independent auditor to rely on the work of others (e.g. tests performed by internal auditors) in completing their own evaluation.

Most organisations have recognised the importance of allowing sufficient time for rectification of potential deficiencies and most test plans were originally designed with an aim of completing the majority of the testing at least one quarter prior to the year end. The delay allows a "dry run" to occur at foreign registrants in the current year. Although the identification of potential deficiencies will vary by organisation, set out below are some areas where management focus may be required:

Manual processes
Manual processes increase the risk of errors. Attestation is required on all financial information reported within the financial statements, and disclosures are where manual processes most often exist. In particular many foreign registrants maintain their financial records in accordance with local accounting standards and the US GAAP reconciliation is often seen as a "oneoff" year end activity for preparing the Form 20-F. Although this may not necessarily indicate a control weakness, management should ensure that the US GAAP reconciliation process is effectively integrated into the company’s primary financial reporting process at both the group and divisional/subsidiary level. Also it is important to realise that should the independent auditor identify an adjustment (as has often occurred in the past in respect of US GAAP and other disclosures), this would ordinarily be required to be assessed as a control deficiency.

More importantly, for many foreign registrants, the implementation of International Financial Reporting Standards (IFRS) currently involves numerous manual processes. Management should focus on ensuring that controls surrounding these processes, especially those procedures which are fundamentally different to historic processes, are robust. With the increase in detailed accounting rules under IFRS, the importance of documented accounting policies is increased. For completeness purposes, management should ensure that controls have been identified, documented and tested for all such accounting treatments.

Financial closing and reporting processes
In certain instances, companies may not have historically designed appropriate controls to address risks associated with the financial reporting process. Where this is the case, it is worthwhile performing more regular "hard closes" in relation to significant adjustment types, such as those related to accruals, provisions, impairments, and the provision of income taxes. This will enable the organisation more opportunities to test and rectify deficiencies in the processes.

Information technology
Within the financial services industry, adequate controls over information technology are critical and hence historically, organisations have dedicated more resources to this area than in other non-regulated industries. However, despite this, experience has shown that enhancements to existing processes are often required, especially in relation to information security and change management. Where weaknesses are identified, the magnitude of their importance needs to be addressed. In large organisations there are likely to be a number of weaknesses identified and hence, as with documentation and testing, it is important that there is consistency in classification. The classification of weaknesses determines the urgency of the remedial action required to be taken and hence it is critical that the classification is correct, especially in an environment with constrained resources. The classification of identified weaknesses is highly judgemental and it is beneficial to create detailed guidance to be followed throughout the organisation.

Management’s plans for full attestation during 2006 will no doubt be modified to take into account lesson learnt from procedures performed during 2005. In the longer term, it is critical that SOX 404 attestation is not seen as a 2005 or 2006 exercise. Ensuring the SOX 404 exercise is viewed as being as efficient and beneficial as possible will help ensure this occurs. Key areas of focus in this respect include:

Performance of testing
As the SOX process becomes increasingly embedded into the normal course of business, management should ensure that adequate training is given to all involved. First year testing experiences will show areas where testing could be reduced (for example by amalgamating the testing of certain controls) and areas where testing should be increased. A review of the lessons learnt following the first year of testing is highly recommended.

Consistency of control
The documentation and testing of controls is likely to identify differences in the control activities within an organisation. Management should take the opportunity to use the documentation produced to facilitate a review of consistency of controls in different parts of an organisation. This review will help identify where control activities could be made more efficient and where control activities in one area are performed to a higher level of detail than in other areas. Whilst some differences will always remain, a consistency review would be beneficial in management’s efforts to standardise and benchmark controls to the most applicable internal standard.

Testing for internal assurance
In the initial years, it is inevitable that documentation and testing procedures will be viewed as an exercise in achieving regulatory compliance. In future years, management should build on the work performed for SOX 404 purposes in order to enhance routine procedures, improving the overall control environment. In this respect, management should consider the application of SOX 404 type procedures in areas which are currently deemed out of scope of for compliance purposes. Whilst a requirement to produce comprehensive documentation and testing of controls may be too onerous in these areas, it may be beneficial to obtain sign-off from relevant individuals that key controls (as defined) within their areas exist and are operating effectively. Additionally as the process becomes more embedded, it would be beneficial to test controls and obtain sign-offs (for all controls) on a more regular basis (perhaps quarterly) rather than just on an annual basis. 

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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