SOX risk assessment: best practices, steps, and importance

The Sarbanes-Oxley Act (SOX) regulates how companies collect, store, report, and audit financial data. SOX compliance is a critical concern for all publicly listed companies and businesses that report to the Securities and Exchange Commission (SEC). Building compliant systems begins with an understanding of SOX compliance risks.

This article will explain how to execute a SOX risk assessment. Explore risk assessment components and follow our step-by-step route to compliance.

What is SOX risk assessment?

SOX risk assessment identifies risks related to financial reporting and ensures that companies have SOX-compliant data handling systems. SOX compliance involves delivering accurate statements and protecting financial information from internal and external tampering. Achieving Internal Control over Financial Reporting (ICFR) starts with a robust understanding of compliance risks.

SOX is a core element of the regulatory system. Sarbanes Oxley was passed in 2002 to prevent corporate fraud and ensure accurate information for stakeholders. Today, the act enforces a strict separation between auditors and clients. It also requires companies to implement internal controls to prevent falsification of financial data.

Understanding SOX risk assessment: a deep dive

SOX risk assessment is the first step to avoiding compliance penalties.

Under section 404 of the Sarbanes Oxley Act, companies in the United States must execute an internal audit of their internal controls every year. This audit requires a full risk assessment to establish the audit scope, define control testing, and guide auditors.

Assessments generally run throughout the financial year. Companies create internal audit teams that carry out initial assessments. The audit team tests controls regularly before an external auditor executes a final control test. Audit findings are approved by executive stakeholders and integrated into the company's annual financial statement.

The crucial role of SOX risk assessment in financial reporting

Risk assessment is critical in regulatory compliance—particularly in the world of SOX.

SOX risk assessments look at risks affecting how companies use financial data. They assess security vulnerabilities that could allow external agents access to confidential data. They ensure financial data is segregated from other information and protected by robust defenses. And they check that only authorized users can access financial information.

Companies that execute SOX risk assessments gain a thorough understanding of SOX compliance requirements. Risk assessments generate documents that guide control implementation and policy development. They make sure companies focus on SOX-related risks and meet every core requirement.

A step-by-step guide to performing a SOX risk assessment

The key to SOX compliance is implementing a systematic plan. Following the steps below will ensure you are ready for your next SOX audit.

1. Defining materiality
2. Scoping: Company and location
3. Mapping transactions and business processes
4. Quantitative & qualitative risk analysis
5. IT integration: Application scoping
6. Identifying and documenting key controls

Now let's review each step in detail.

1. Defining materiality

The first risk assessment step involves understanding materiality. Materiality refers to metrics on financial statements that affect the decisions of users. If the omission or falsification of a piece of information could influence investor decisions, it counts as "material". Assessing risks related to material data classes is essential.

Assessors can calculate materiality as a percentage of assets, net income, or revenues. 3-5 percent of operating income is a good benchmark. However, qualitative factors may apply. For instance, a metric may be material if it relates to corporate fraud or has particular brand importance.

Audit teams should consult executive stakeholders to confirm materiality, as considerations vary between organizations.

2. Scoping: company and location

The next SOX risk assessment step involves scoping the exercise. Assessors must determine what locations and departments fall under the SOX assessment.

Calculate whether locations meet the materiality benchmarks agreed upon earlier. For example, assessing SOX risks is vital for a regional office handling 12 percent of corporate revenues. However, testing controls at a minor office dealing with 1-2 percent of revenues is not within scope.

3. Mapping transactions and business processes

Assessors must understand factors that cause balance sheets to expand or contract. Assess transaction flows and business processes to map how money moves within the corporate organization.

The underlying purpose of this section is to ensure that a company's published financial statement accurately represents business processes. Assessors must consult process owners to establish whether the metrics match.

4. Quantitative & qualitative risk analysis

When executing a company-wide SOX risk assessment, assessors must take a broad perspective on data risks. This entails quantitative and qualitative risks affecting how the organization records and presents financial information.

Quantitative analysis assesses measurable risk factors. Factors could include fraud, financial reporting errors, or broken internal controls. Assessors gather quantitative data relating to each risk and use that data to calculate risk impact and likelihood.

Data from this process enables audit teams to create a risk hierarchy. Each risk receives a score based on severity. Assessors log each score on a risk management plan that prioritizes mitigation actions and makes it easier to manage risk assessment workflows.

Qualitative risks cannot be modeled statistically but may pose a SOX compliance risk. Examples include regulatory developments, poor leadership, natural disasters, or strategic changes. Assessors must consider each risk according to probability and impact—and create mitigation plans.

When making qualitative assessments, it helps to consult critical stakeholders such as executives and department heads.

Both types of evaluation contribute to risk mitigation strategies. Assessors must take account of any factors that adversely affect the organization's SOX compliance position.

5. IT integration: application scoping

SOX risk assessment must also consider integrated IT assets that impact financial reporting. IT application scoping applies to applications, databases, and IT infrastructure that handle data that appears on financial statements.

In practice, this covers a broad range of assets. For example, companies may use in-house financial recording software and third-party accountancy tools. They may also store financial data on cloud containers and local data centers.

SOX controls apply to all IT assets connected to financial reporting. Office terminals, firewalls, remote work devices, and network servers may all be within scope if they process material data.

6. Identifying and documenting key controls

The final component in SOX risk assessment is key control identification. Relevant controls are tools, processes, or policies that ensure the accurate recording of material financial information.

Examples of controls include:

• Policies to segregate duties so more than one person approves transactions
• Encryption or firewalls to protect data from external agents
• Access controls that limit access to authorized users
• Account reconciliation tools to check users enter data correctly
• Physical controls guarding material assets
• Communication channels to report issues and protect whistle-blowers
• SOX monitoring activities and review policies to check control effectiveness
  
  

Determine which controls affect the integrity of material assets. Generally, material accounts require multiple controls. For example, access controls, encryption, reconciliation processes, monitoring, and physical controls should protect departmental accounts.

Auditors test controls for each critical risk. The company is SOX compliant when controls are functional. If not, mitigation action is needed. Audit teams must document mitigation actions in control assessment reports.

SOX compliance audit

SOX risk assessment procedures always require an internal control report. Companies create this report by executing an SOX compliance audit. This audit checks four main compliance themes:

• Data backups. How well the company backs up data to ensure integrity and prevent data loss. Security of storage facilities, detailed backup policies, and process testing are all critical.
• Control access. Whether material assets are accessible by unauthorized individuals or restricted to users with a business justification.
• Security. Companies must maintain data security systems to block cybersecurity threats that impact the accuracy of financial records.
• Management change. How well the company protects financial data during change processes.

What does a SOX audit involve?

SOX internal controls audits are mandatory compliance tasks. A control report features in every annual statement. Independent external experts carry out audits on a rotating basis (companies cannot use the same auditor every year).

During the audit, experts assess reporting risks and determine necessary controls under SOX section 404. Auditors test each key control to check it is present and operational. This task may involve technical testing, but audits also employ walkthroughs and in-person interviews.

Control auditors evaluate weaknesses and whether they impact financial reporting. They document findings in a SOX effectiveness evaluation, including recommended corrective actions. Managers then agree to take remedial action and attest to the audit findings. When mitigation is complete, the auditor provides their attestation, and the process concludes.

What types of organizations need SOX auditing?

Not all companies need to carry out SOX audits. Audits apply to:

• Publicly traded companies on US exchanges and wholly-owned subsidiaries
• Foreign publicly traded companies active in the USA
• Private companies before making an Initial Public Offering (IPO).
• Audit firms that supply SOX-related services
• Third-party service providers (if they handle financial data)

SOX report

A successful SOX report demonstrates that an organization meets SOX compliance requirements. Based on Section 404 of SOX legislation, the report includes a management assessment of the company's compliance position. As part of the annual financial statement, the CEO and CFO confirm that internal controls meet SOX requirements.

SOX reports include full details of internal controls, including testing outcomes and required remedial actions. They generally include feedback from the external auditor, including an assessment of the management attestation. The report may also detail upcoming actions to improve the organization's SOX compliance position.

Common pitfalls and challenges in SOX risk assessment

• Communication within SOX compliance teams. SOX risk assessment involves many moving parts. Individual team members may work on technical fixes, administrative policies, or site visits in distant offices. Establishing clear communication lines is essential. Regular progress reports, centralized task management, and clear project milestones help to keep everyone on track.
• Going too fast, too soon. It's important to assess SOX risks thoroughly without rushing. Managers must prioritize critical risks and devote enough time to implement mitigation actions. It also makes sense to take an iterative approach, assessing progress as you progress.
• Inadequate project scoping. Scoping relevant SOX risks is vital. Devote resources to identifying material assets and processes within the risk assessment scope. If necessary, enlist external expertise to understand SOX requirements, as poor scoping will ruin SOX risk assessments from the start.
• Inefficient technical processes. Manually gathering risk assessment data may be familiar. However, failure to leverage automated tools forces compliance teams to work harder than necessary. Use automation where possible to eliminate errors and enable efficient working.
• Resource issues. SOX risk assessors should have confidence in the resources available to them. Teams working within tight budgets may omit critical compliance risks to save costs. Provide executive support and supply assessors with the resources needed to ensure SOX compliance.

Conclusion

SOX risk assessment is a vital part of ensuring financial integrity. Risk assessors identify risks that could contaminate, conceal, or delete financial information. Compliance teams use this information to implement controls and—ultimately—avoid costly SOX violations.

FAQs

What is a SOX audit?

A SOX audit assesses whether a company complies with SOX regulations. Audits check that the tools and processes used to generate financial statements are reliable, independent, and accurate.

SOX audits must take place annually. Companies rely on internal audit teams to execute ongoing risk assessment and mitigation work. External auditors verify that controls are SOX compliant, and their judgment forms part of the company's annual statement.

What are SOX testing requirements?

SOX testing is a core component of SOX compliance audits. Testing covers four control areas specified in SOX Section 404. Control pillars include data security, access controls, data backups, and change management. Auditors test controls in every area to verify that they meet SOX requirements.

Testing follows a three-stage process. Initial assessments identify controls and assess SOX-related risks. Interim assessments check that controls operate as designed. Year-end testing validates the control environment and independently attests that the organization operates "adequate" financial data controls.

Disclaimer: This article is for informational purposes only and not legal advice. Use it at your own risk and consider consulting a licensed professional for legal matters. Content may not be up-to-date or applicable to your jurisdiction and is subject to change without notice.