Surviving Three SOX Opinions: Small Businesses Need to Return to Accounting Fundamentals as They Undergo Scrutiny of Their Internal Controls

By Crawford, Wil; Klamm, Bonnie K. et al. | Strategic Finance, May 2007 | Go to article overview

Surviving Three SOX Opinions: Small Businesses Need to Return to Accounting Fundamentals as They Undergo Scrutiny of Their Internal Controls


Crawford, Wil, Klamm, Bonnie K., Watson, Marcia Weidenmier, Strategic Finance


Batter up! Small firms won't be able to dodge the triple threat much longer. On December 15, 2007, small firms (nonaccelerated filers with less than $75 million in public float) will have to comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (SOX). While accelerated filers (more than $700 million in public float) have been complying with SOX 404 since November 15, 2004, small firms have been exempt from these challenges. Smaller firms typically have weaker controls than larger firms do (most likely due to resource constraints), potentially making SOX 404 a huge challenge for their managers.

This article is designed to help small firms overcome the SOX challenge. To facilitate managers' understanding of the new requirements they face, we first provide an overview of the three required audit opinions. Then we analyze the deficiencies reported by a sample of accelerated filers. Understanding the deficiencies should help managers of small firms effectively and successfully plan their SOX compliance regimen.

THE THREE REQUIRED AUDIT OPINIONS

In the past, managers just had to sweat over achieving one unqualified audit opinion. Now the game has changed. Managers may be surprised to discover that SOX requires them to survive not one, not two, but three different audit opinions. To comply with SOX, a firm must endure the audit opinions shown in Figure 1:

[FIGURE 1 OMITTED]

New: Audit Opinion #1 -- Auditors express an opinion on management's assessment of the effectiveness of the company's internal controls over financial reporting.

New: Audit Opinion #2 -- Auditors express an opinion on the effectiveness of the internal controls over financial reporting.

Old: Audit Opinion #3 -- Auditors express an opinion on whether the financial statements are fairly stated.

Managers must realize a very important point: The three opinions apply only to financial reporting; operational reporting is not included. Yet managers who aren't already doing so should extend their analysis of internal controls to operational controls with the goal of improving the efficiency, effectiveness, and reliability of internal operational reporting and business processes. The current SOX analysis of financial controls should help provide a streamlined and cost-effective process of evaluating operational controls.

Along with managers, internal and external auditors also may be overwhelmed by the challenge of complying with SOX Section 404. Managers must understand their company's internal controls and report on the effectiveness of those controls, most likely with the help of internal auditors. External auditors then must attest to the accuracy of management's report as well as the effectiveness of the internal controls. If management identifies internal control weaknesses in its report, it will receive an unqualified opinion on the accuracy of the report (Audit Opinion #1) and an adverse opinion on the effectiveness of controls (Audit Opinion #2). Note, however, that the wording for Audit Opinions #1 and #2 isn't standard. Sometimes Audit Opinion #1 uses language such as management's report "is" or "is not fairly stated," while Audit Opinion #2 may attest that management "has" or "has not maintained effective controls." But regardless of the precise language used, the intent is clear. Furthermore, most managers believe that SOX 404 requires both Audit Opinions #1 and #2, but Audit Opinion #1 is required by SOX Section 404, and Audit Opinion #2 is really required by SOX Section 103.

Thus, a company now has the opportunity to receive an adverse opinion three times! In fact, it can receive any combination of opinions as shown in Figure 2. Obviously, managers want their company to be in the dark green area, and they want to avoid the orange, gray, and dark gray areas of the figure because those indicate that the firm's internal controls aren't effective and/or their financial reports aren't reliable. …

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