SOX 404 Explained: Demystifying Sarbanes-Oxley Act Section 404
Enron, WorldCom, Tyco… even two decades after their respective scandals, these names are still synonymous with corporate fraud. Congress passed the Sarbanes-Oxley Act of 2002, commonly referred to as SOX 404, in response to these egregious examples of corporate greed and misconduct. The law holds U.S. companies responsible for their financial record-keeping and reporting practices, and it stipulates criminal penalties for misconduct related to the manipulation, destruction, or alteration of financial records.
As a U.S. company, especially a publicly traded one, it’s vital to know what parts of SOX apply to your business and how to ensure compliance. Section 404 of the act (SOX 404) deals specifically with the internal controls and procedures that companies must implement in their financial reporting process. Keep reading to learn more.
What Is SOX 404? A Summary
SOX Section 404 (“Management Assessment of Internal Controls”) is commonly considered one of the most resource-intensive sections of the act to which companies must adhere. There are two subsections:
SOX 404(a) requires that companies implement and maintain effective internal controls. Companies document compliance with an “internal control report” with each of their annual reports mandated by the Securities Exchange Act of 1934, such as Form 10-K. This report, provided by company management, should describe and assess the effectiveness of the company’s internal control over financial reporting (ICFR).
SOX 404(b) requires that an independent auditor attest to and report on the assessment of internal controls provided by company management.
The Importance of SOX 404
While complying with SOX 404 can be a headache for executives, it serves an important purpose. Beyond shielding investors from risk, SOX 404 also safeguards a company’s reputation and longevity by annually assessing the design of their control environment and ensuring the controls are operating effectively with no gaps that would lead to a risk of incorrect financial statements.
Who Must Comply with SOX 404?
The Sarbanes-Oxley Act applies to all publicly traded companies in the U.S. (including wholly owned subsidiaries and publicly traded foreign companies that do business in the U.S.) with some important distinctions between SOX 404(a) and SOX 404(b). The Dodd-Frank Wall Street Reform and Consumer Protection Act codified an exemption to SOX 404(b) for non-accelerated filers, as defined by the Securities and Exchange Commission (SEC). In other words, companies that do not rise to the level of accelerated or large accelerated filers according to the SEC are not required to enlist an independent auditor for SOX testing and will only fall under the requirements of SOX 404(a).
The SEC updated its definitions of accelerated filer and large accelerated filer in March 2020, which led to a greater number of companies becoming exempt from SOX 404(b). Combined with previous SEC updates to its definition of smaller reporting companies (SRCs) in June 2018, companies meeting any of the following criteria are exempt from SOX 404(b):
SRCs (i.e., companies with less than $250 million in public float or less than $100 million in annual revenues with less than $700 million in public float) that reported less than $100 million in annual revenues in the most recent fiscal year
Emerging growth companies (EGCs) for the first five years following their initial public offerings, as long as they do not exceed annual gross revenues of $1.235 billion, have not issued more than $1 billion in non-convertible debt in the past three years, and do not become large accelerated filers
Newly acquired businesses in the first year following acquisition
Do Private Companies Need SOX 404 Testing?
While private companies and nonprofits are not required by law to perform SOX 404 audits, there are situations in which third parties may encourage them to perform various internal control audits (SOC/ISO) to ensure all systems and processes used in financial reporting are reviewed.
How SOX 404 Compliance Testing Works
The complete SOX testing process involves several rounds of internal testing throughout the year followed by an annual independent audit as required by SOX 404(b). If you are preparing for your first official SOX audit, consider working with compliance experts who can help you set processes up the right way and avoid headaches down the road.
That said, no matter how mature your company is or how robust your internal controls are, some deficiencies might be uncovered during SOX 404 testing. Often, auditors point to incomplete design or documentation of controls as the cause of weaknesses. Luckily, hiring an experienced compliance auditor gives you access to expert advice that helps you decide what parts of your processes require additional steps, signoffs, or documentation to ensure the effectiveness of internal control design and operations.
Combining SOX 404 Testing with Other Compliance Requirements
When it comes time for your yearly SOX audit, an external third party can provide subject matter expertise ensuring robust coverage of the control environment. As you research auditors, take into account any other compliance testing your company requires. Look for a SOX auditing firm that can help you with other compliance and cybersecurity certifications like SOC 1 or SOC 2.
Considering the strain that compliance testing can put on internal resources in terms of manpower and finances, it’s in your business’s best interest to avoid going through multiple rounds of auditing with different testing providers. Using an auditor who can identify the overlap of internal controls, processes, and evidence requests to satisfy multiple compliance efforts reduces the burden on your employees. Simply put, your team can get back to doing their jobs instead of tracking down documentation and information for auditors.
SOX 404 Compliance: Simplified
In summary, the Sarbanes-Oxley Act of 2002 was passed in response to major corporate scandals of the early 2000s. SOX 404 applies to most U.S. publicly traded companies and requires a yearly audit of internal controls and processes related to financial reporting. With A-LIGN, you get comprehensive control framework coverage and testing that will provide management and investors comfort that internal controls over financial reporting are designed and operating effectively. With the right controls in place, you don’t have to dread your annual SOX audit.
Reach out to A-LIGN’s SOX 404 experts today to learn how our decades of experience, comprehensive offerings, and flexible scheduling can help you avoid the fiscal year-end time crunch.
