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No Wiggle Room With Sarbanes-Oxley: Companies need a tight control system to fight financial fraud and miscues.

Article Excerpt
Enactment of the Sarbanes-Oxley law and issuance of related rules by the SEC have prompted these frequently asked questions on financial reporting and internal control from business executives: Does enhancing my internal control structure mean I have to significantly increase overhead? Do I have to disclose everything? If I must change the way I operate and report about the business, can someone provide some practical advice on how to deal with the new requirements?

Practical "how-to" guidance is the centerpiece of this article, a follow-on to our explanation of the far-reaching features of the new regulatory structure which appeared in the December 2002 issue of Mergers & Acquisitions. Besides explaining the operational guidelines, we present an Internal Control Matrix to highlight the main points of implementing the rules.

Internal Control

Although Sarbanes-Oxley addresses a plethora of corporate governance issues, its focus from a financial reporting perspective is a regulatory response aimed at preventing future financial reporting scandals. One of the principal ways to accomplish this objective is to strengthen a company's internal controls.

In the current business environment, errors in financial statements generally result from:

* Misappropriation of assets, by theft or by embezzling receipts, for example, or

* Direct manipulation, falsification, or general misrepresentation of results in financial statements.

While misappropriating assets can cost a company thousands, maybe millions, of dollars, fraudulent financial reporting may be in the billions and result in billion-dollar declines in market share and shareholder wealth.

Management can address the risk of misappropriated assets through strong policies, systems, and procedures, much of which can be delegated. But managers must get directly involved in preventing fraudulent financial reporting and in otherwise reviewing financial statements for transparency. In other words, a reader should be able to "look through" what is reflected in the financial statements and related notes and understand the underlying transactions they purport to represent.

The FASB's Statements of Financial Accounting Concepts elaborate on transparency by addressing such concepts as "reliability" and "representational faithfulness." Still another word describing representational faithfulness is "validity." A transaction must be valid before it can be recorded. In this regard, all transactions should be reviewed and approved by a person or persons at least one level higher than the initiator of the transaction. Management can override or circumvent almost any established control, particularly as it relates to the preparation of financial statements, and this is why oversight by the audit committee of the board of directors is critical.

If the daily recording of cash receipts and disbursements and revenues and expenses can be viewed as "routine" and subject to the appropriate level of internal control, material non-routine transactions need to be reviewed by senior management and again by the audit committee, especially if senior management initiated the transaction. It is no longer acceptable for the audit committee to allow senior management to clear the accounting for a material non-routine, new, or complex transaction with the outside auditor and receive a five-minute briefing on the process at the end of the year. That will no longer shield the audit committee from criticism, nor provide it with a defense if litigation ensues. The committee must thoroughly comprehend the economic substance of every material or otherwise significant transaction and understand what alternative accounting treatments may exist. In the end, the financial reporting of every transaction should follow the economic substance of the transaction, not just its form.

As for so-called "routine" issues, a common situation will help answer the question of when it is necessary to incur more overhead for internal control.

Anyone who goes to a movie theater gives his or her ticket to a ticket taker, perhaps unaware that the simple function of having someone other than the ticket issuer tear the ticket is a control procedure. Enlisting a second party forces a ticket issuer who may be leaning toward theft to include the ticket taker in any scheme. Even if we assume...

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