Accrual Method

The accrual accounting method is defined as the method of keeping accounts which shows expenses incurred and income earned for a given period, although such expenses and income may not have been actually paid or received in cash.  Hence, the financial statements show revenues and expenses, even before any such revenues or expenses are paid.

The accrual method is the more acceptable and the more widely used because it correctly matches the earning process to the activity.  In other words, revenue is recorded when services or goods are rendered or shipped, regardless of when paid.

Cash Method

The cash method of accounting is familiar to most individuals since personal income tax returns are filed on the cash basis.  As the name implies, revenues and expenses are only recorded when the consideration paid actually changes hands.  This could be months after the actual event occurred.

Many small business owners prefer the cash basis due to its simplicity and ease of understanding.  At the end of any given period, the recorded net income will agree more closely to the change in the business’s cash balance.  However, when requesting financing from any bank or agency, business owners are generally asked to furnish financial statements, prepared on the accrual basis.  Clearly any “stakeholders” want to see the true effect on the financial statements of activities, as they occur, as opposed to when they are paid.

Many small businesses (under $1,000,000 in sales) may use the cash basis method for filing business tax returns, even if the business keeps its books on the accrual basis.  In a growing business, income taxes can be deferred for a year for revenues recorded from increases in accounts receivables.

Percentage of Completion Method

The percentage of completion method is a variant of the accrual method, used for businesses with long term contracts, primarily construction contractors.  Instead of valuing revenues based on services invoiced, contractors will adjust the revenue billed to agree with the estimated percentage of the total contract that has been completed to date.

Reporting Standards

Many transactions are entered routinely through the accounting system without much concern about reporting standards.  However, other transactions can be handled in different ways depending on a person’s judgment over the facts and circumstances.  For example, if a business decides to lease an expensive piece of machinery, how should it record lease payments?  Perhaps they should be simply charged to lease expense.   Do you have a lease policy procedure? Your accounting policies should clearly state how to record leases.

However, maybe the terms of the lease imply an obligation and the payments represent a pay-off of that obligation.  In that case, a portion of the payment should be applied to the debt and the other portion charged to interest expense.

The resulting financial statements would look different in those two cases.  The usefulness of financial statements would be severely limited if their presentation was based solely upon the preparer’s judgment.  Consequently, certain standards must be agreed upon and followed.

GAAP – Generally Accepted Accounting Principles

There was no commonly agreed upon standardization over accounting practices for within past accounting systems until after the great depression of 1933.  In response to the vast sums lost by investors in the stock market crash, the Securities and Exchange Commission (SEC) was established and given authority to set accounting standards for publicly held corporations.

In an effort to stave off further government regulation, the accounting profession, organized under the American Institute of Certified Public Accountants (AICPA), issued its first auditing standards in 1939.  This began its attempt at self-regulation, though the AICPA continues to work with the SEC and defers to the SEC on regulatory reporting requirements for publicly held companies.

Between then and 1959 the AICPA issued 51 authoritative pronouncements known as Accounting Research Bulletins (ARB) that formed the basis of what became known as generally accepted accounting principles (GAAP).  From 1959 to 1973 the Accounting Principles Board (APB) issued 31 additional standards.

In 1973 a new full-time independent body, separate from the AICPA was created, called the Financial Accounting Standards Board (FASB).  This board has issued over 147 Statements of Standards by the end of 2002.  These standards, along with official interpretations, Accounting Research Bulletins (ARB), previously issued pronouncements, SEC rulings, industry guides, and other exposure drafts make up the current basket of generally accepted accounting principles.

The Matching Principle

Woven through all of the GAAP pronouncements are several universal principles.  One is the concept of matching.  Accrual and percentage of completion methods represent attempts to more properly match the financial statement presentation to the actual transactions that have occurred.  Revenues are matched to services performed and product sold, and expenses are matched to activities that have incurred expenses.  This is why accrual based reporting conforms to GAAP and cash based reporting does not.  The matching principle is a keystone of generally accepted accounting practice.

Conformity

Conformity is another widely used concept in accounting.  The method of implementing percentage of completion, for example, should be the same for all companies.  Only by practicing conformity will there be comparability.  Investors, lenders and business owners, could not properly evaluate the success of a particular business as compared to the rest of its industry, if all businesses used different methods for recording transactions.  Conformity is another fundamental principle in GAAP.

Valuation

A common consensus in GAAP reporting is the agreement that financial statements are valued on an historical basis.  This is an important concept that provides for consistent conformity.  As an example, real estate is valued at its original cost, not what it might be worth on an appraised value.

Accounting board pronouncements have continued to modify this principle to make financial reports even more conservative than historical basis, by requiring a downward adjustment, if the potential selling value has fallen below the original cost.

An example is inventory, when obsolescence reduces its value below its original cost. Another example is the yearly devaluing of fixed assets through depreciation.  Each year the original cost of a building or equipment is lowered by writing off a portion of its expected life and expensing it to depreciation.  Other assets like accounts receivable are reviewed and written down to their expected realizable value by charging off any amount deemed uncollectible to bad debt expense.

The overall attempt is to present financial statements on the most conservative basis possible.  The objective is to ensure that the net worth recorded on a company’s financial statements is never more than the true value of a company, based upon the lower of historical cost or the expected realized selling price of its assets minus its liabilities.

Events in the early years of the 2000′s have shown how important this objective is.  In spite of all the GAAP pronouncements in place, “creative accounting” techniques that push the gray areas of accounting valuation issues have resulted in significant, previously undisclosed impairments to the financial statements of companies like Tyco, Enron, and WorldCom.

Inventory Valuation

Inventory valuation is a specially treated area that deserves specific mention.  Inventory is always valued at the lower or cost or market (realizable value, net of selling costs).  However, cost can be determined in three different ways.

First In – First Out (FIFO) values the cost of inventory based on the principle that the first item purchased is the first item to be sold.  Visually, this method mimics a store owner’s method of stocking shelves by putting its most recent purchases at the back of the shelf, so that the older product is sold first.  Hence, the value of the amount of inventory on hand, always represents the cost of the very latest purchases.  In a true FIFO valuation, each purchase is tracked as a separate layer with its own cost.  Sales are also tracked and taken from one or more specific layers.

A variant on the FIFO method is the Average Cost FIFO method, which eliminates the need to keep track of separate purchasing layers.  The cost of each new purchase is added to the “pool” which changes the overall cost of the “pool”.  Sales are then taken from this single “pool”, leaving a value of the inventory on hand that closely resembles, but not necessarily equals, the value of inventory on a true FIFO method.

A final method of valuation is based on Last In – First Out (LIFO).  This is the opposite of FIFO: the last items purchased are deemed to be the first items sold.  This means that the ending inventory value is comprised of the very first items purchased.  This value could be lower than the FIFO value, particularly in inflationary times.

One might ask how two opposing methods of valuation could both be allowed under GAAP, particularly, when this would seem to violate the important principle of conformity.  This is one of many good examples of the challenge to create a consensus of opinion when there are several options, which have equal justification and support.  Accounting principles are not static laws handed down from the mountaintop, hence the term, “generally accepted”.

In this case, there is current justification and support for either method.  In deference to conformity, GAAP provides that financial statements valuing inventory on LIFO are to include a footnote reference, which discloses the valuation difference between LIFO and FIFO.  This is one of many compromises that provide conformity over different methods of valuation.

Materiality

A final important concept in all of GAAP is materiality.  Surprisingly, coming from a group of professionals known for their penchant for chasing down pennies, every pronouncement contains a materiality clause that allows for non-compliance in any area, if the effect on the financial statement presentation is clearly immaterial.  In other words, if the effect is minimal or does not represent a significant change in the financial position of the account then it might be considered immaterial.

Balance sheet

Contains accounts whose value is determined at a specific point in time.

Assets – accounts with value that you own

• Cash – the amount on hand or in the bank at a specific point in time
• Accounts Receivable – how much people owe you
• Inventory – the value of business merchandise for sale
• Fixed Assets – the value of property and equipment

Liabilities – accounts with value that you owe to others

• Accounts Payable – how much you owe others for unpaid purchases
• Debt – how much you owe others for money borrowed
• Other Liabilities – services or money owed to others

Equity – accounts with paid in capital or earned from profits.

• Contributed Capital – money invested in business by ownership
• Distributions – dividends and other types of money paid out to ownership
• Capital Stock -            money invested in exchange for company ownership
• Retained Earnings – earnings retained in business from net profits

Income Statement

This statement contains accounts whose value is determined over a period of time (e.g., day, week).

Income: total sales and income recorded over a period time

Expenses: total purchases and other expenses recorded over a period of time

Basic Accounting Formula

All transactions are posted to one or more of these accounts.  As discussed earlier, every posted transaction must balance.  That is, debits must equal credits.  Furthermore, the result of every posting, if done correctly, will never put the Basic Accounting Formula out of balance.  Asset accounts will always equal the total of all liability and owner equity accounts.  If this formula is ever out of balance, the cause will always be an incorrect transaction posting where debits did not equal credits.

Assets include those accounts, which give value to the company: cash, accounts receivable, inventory, property, etc.  Liabilities are those accounts which reduce the company’s value:  accounts payable, debt, and other liabilities.  If total assets are greater than liabilities, then this net value (that is, the total of all assets minus liabilities) represents the true value of the business, otherwise known as its Equity. Hence, the Basic Accounting Formula can be expressed and equally understood in these two ways:

Assets = Liabilities + Equity

or

Equity = Assets – Liabilities

If the company’s assets are less than its liabilities, then it will necessarily show a negative equity.  This makes intuitive sense to anyone following the demise of a business in bankruptcy.  When a business owes more than it has in value, the resulting negative equity is an obvious warning sign.

The equity accounts include owner’s contributions, distributions, and retained earnings.  Retained earnings operate in a manner unique to all other accounts.  It contains the net effect of postings to all income and expense accounts.  It is truly the one account, which links the balance sheet accounts (assets, liabilities and owner’s equity) with the income and expense accounts.

Understanding the importance of retained earnings, the Basic Accounting Equation could be expanded thus:

ASSETS  =  LIABILITIES  + (Investor and owner contributions, and distributions + Retained Earnings)

OR

ASSETS  =  LIABILITIES  +  (OWNER’S EQUITY ACCOUNTS +  INCOME – EXPENSE)

———————EQUITY ———————————

When a transaction, like writing a check or paying a bill, is executed in an accounting program, the software is designed to take this transaction event and create the proper and necessary debit and credit entries to record the effects of the transaction in the appropriate journals and general ledger accounts.  Your accounting policies and procedures should help you acheive accounting control.

If you qualify as a non-accelerated filer (i.e., your company’s public float is under $75 million), you’ll have to start complying with Section 404(b) of SOX, which requires company management and independent auditors to sign off on, or attest to, the effectiveness of your risk control framework or accounting policies and procedures for internal control.  Are your processes protecting you from the risk of material misstatements (RMM)?

Sarbanes Oxley Compliance Costs Too High?

When it was first enacted, the Sarbanes-Oxley Act (SOX) did not apply to non-accelerated filers because it was believed SOX compliance costs would be too high.  Several delays and extensions have been given to non-accelerated filers because the Office of Economic Analysis (OEA), which advises the SEC, needed to complete a study on SOX compliance costs. The study was completed in September, 2009, and was quickly followed by the announcement (on October 2) of the June 15th compliance deadline.

It didn’t surprise anyone when the OEA study showed that SOX compliance costs increase with company size; the study also confirmed that annual compliance costs decrease over time and that, overall, compliance costs have decreased since 2007.  In other words, while larger companies achieving SOX compliance had higher costs overall, there are fixed SOX compliance costs that impact all organizations, regardless of size, and companies have gotten smarter on how to implement Sarbanes-Oxley.

How Do You Control Sarbanes-Oxley Compliance Costs?

There are three major factors that drive up the cost of complying with SOX: cost of scale; cost of review; and cost of improvement.  The more control you have over all three of these, the lower your costs to implement Sarbanes-Oxley compliance will be.

Sarbanes-Oxley Cost of Scale

Why do larger companies incur higher overall compliance costs?  Because of the sheer size — scale – of their operations!  More operating locations, more employees, and more processes means more time and people needed to review accounting policies, procedures, and internal controls.  There is no easy answer to the question of scale: larger size translates into more risk management, internal controls, and accounting processes.

You can reduce the scope of SOX compliance by addressing the greatest risks first (note that PCAOB Auditing Standard #5 was developed for this purpose).  Don’t try to address all risks at once — this is what drives up compliance costs.  But, which risks do you address first?  Determine a threshold, or cutoff, for risk materiality, then decide which risks are most material to your company.

Remember — this is an ongoing process of improving your SOX compliance, not a one-time SOX compliance event.  Next year, you can (and probably should) lower the threshold and address your “second-tier” risks, and continue to annually adjust your threshold until you are comfortable.  Management decides on the internal controls needed to cover the identified risks.

Also, if you decide wrong and set your risk threshold too low or too high, you’ve identified a material weakness in your risk control framework.  You think you’ve exposed a flaw in your system, but consider that your system is also about continual improvement.  The only flaw is failing to improve: work on improving your internal controls – adjust your risk threshold – and you can demonstrate that you have a SOX-compliant system.

Sarbanes-Oxley Cost of Review

The cost of review represents the Check and Act phases of the Plan-Do-Check-Act (PDCA) process approach.  All companies needing to comply with SOX have to have some form of review process that tests accounting’s internal controls and gives management the confidence to attest to the validity of the company’s financial statements.

Internal audits, management reviews, management and auditor attestation, and board oversight are fixed costs of Sarbanes-Oxley compliance.  Every company has to operationally demonstrate to top management that internal controls are in place and are working.  Larger companies have to spend more, of course, but every company must spend a minimum amount for basic compliance.

As with the cost of scale, you can reduce the scope of SOX compliance by addressing the largest risks first in your audit plan.  You don’t have to audit every accounting process every year.  Start with the accounting processes that have the greatest impact — those that pose the greatest risk of material misstatement if they don’t work.  Review past audit opinions, your compliance plan, and your definition of materiality and adjust your audit plan to deal with the greatest risks.

Management decides on the internal controls and testing needed to ensure that the identified risks are controlled.  If you find that your audit plan hasn’t addressed the right risks, you adjust the plan.  Again, lessons learned — and implemented — show that your system is driving improvement and is, therefore, Sarbanes-Oxley-compliant.

Sarbanes-Oxley Cost of Improvement

The cost of improvement comes under the “Plan” and “Do” phases of the PDCA process.  Sarbanes-Oxley compliance starts with a compliance plan, one that identifies the risks you need to control.  Your compliance plan is the foundation of your risk control framework.  With a sound compliance plan in place, management can make better decisions regarding internal controls, such as implementing accounting policies and procedures that reduce or eliminate the risk of material financial misstatement.

Developing accounting policies and procedures is the “Do” in “Plan-Do-Check-Act”.  Your risk control framework identifies individual risks (e.g., the chance a receivable is not collected on time). Your accounting policies (e.g., collect accounts receivable within 30 days) and procedures (daily A/R aging reports, phone calls, collection letters, etc.) are forms of internal control that demonstrate your compliance with Section 404 of SOX.

Are your accounting policies and procedures for compliance, or control?  Well, control comes before compliance, but many companies have confused the two and wasted a lot of time and money.  You can reduce the scope of SOX compliance by controlling your greatest risks first with your accounting policies and procedures.

You don’t have to write a policy or procedure for every accounting process at once.  Once again, start with the accounting processes that, if they don’t work, pose the greatest risk of material financial misstatement.  Review audit opinions, your compliance plan, and your definition of materiality, then develop and implement the accounting policies and procedures that address your greatest risks first.

Management makes the final determination of which accounting policies and procedures are needed.  If you develop cash policies and procedures that do not (adequately) control the identified risks, you have a material weakness.  Improve your accounting procedures for internal control and you demonstrate Sarbanes-Oxley compliance.

Bizmanualz Accounting Policies and Procedures Reduce Sarbanes-Oxley Compliance Costs

Sample accounting policies and procedures serve as a model, or framework, for your own accounting policies and procedures.  The CFO Accounting Policies and Procedures Manuals set contains 239 procedures you can use to address the ten accounting cycles.

SEC Chief Mary Schapiro recently stated that “there will be no further Commission extensions.  It is important for all public companies – and their auditors – to act with deliberate speed to move toward full Section 404 compliance.”  Although legislation has recently been introduced to permanently exempt non-accelerated filers from Sarbanes-Oxley Section 404(b) compliance, there’s no guarantee that Congress will act or that the public won’t demand better information and you won’t need to comply with 404.  Besides, having an effective system of internal controls makes good business sense.

Using prewritten procedures will save you hundreds — possibly thousands — of hours in researching, writing, and implementing accounting policies, procedures, and internal control for Section 404 compliance.  Save even more time implementing additional internal controls for sales and marketing, security, disaster recovery, and ISO 9001 compliance using the CEO Company Policies and Procedures Manuals.  Download free samples of our procedures and judge for yourself.

Static versus Dynamic Systems

When I was studying engineering in college we had to take many different classes in control.  The simplest ones to talk about are the mechanical versions of static systems and dynamic systems.  Static systems are those that don’t change over time like a bridge or a flag pole.  You had to figure the forces on these systems and calculate the stress, tension, torque, etc.  I found statics pretty straightforward.

Next came dynamic systems, which are static systems that can (as a result of other forces) change over time like a suspension bridge that sways in the wind.  Things got tricky, fast.  We had to use fancy calculus like differential equations to solve the problem.  Why (you might ask)?

The thing about static systems is that you have no feedback.  So the static equation is drawn with the forces in balance and feedback set to zero.  With no feedback the problem is easy or relatively easy using basic calculus.  In contrast, dynamic systems have feedback.  The wind pushes on the bridge and the bridge pushes back (basic physics: a force is met with an equal but opposite force).  This “pushing back” starts the feedback, but feedback can also produce feedback loops, which means the bridge begins to oscillate as it rocks back and forth in the wind.

You see the wind is not a constant force, its velocity changes over time.  So this is a complex situation that becomes difficult to solve.  If we fail to produce the right answer, the bridge could fall apart in the wind (it has happened).  Positive feedback loops amplify the signal and can cause such destruction (i.e. a vicious cycle) whereas negative feedback loops reduce the signal and result in… control.

So when you design your procedures, are you designing in positive feedback loops that amplify your output and lead to the destruction of your process or are you designing in negative feedback loops that result in the control you are looking for?

Static versus Dynamic Control

Funny, we have to take into account the dynamic nature of a bridge before we built it but do you take into account the dynamics of a business process when you capture it in your knowledge management system?

Business policies and procedures are not static.  They involve people that provide feedback; they involve customers, suppliers, and management that all provide feedback. So how do you integrate this natural feedback into your procedure?  Start by planning for it.  Plan for both positive and negative feedback but most importantly harvest the negative feedback.

Planning for feedback means data, scoreboards, process reviews, process audits, management reviews, customer and supplier surveys, discussions, interviews, comments, and most of all collaboration.  We need to design collaboration into business procedures to allow for the natural feedback process to occur.  Just like building a bridge requires us to understand the forces at work BEFORE we build the bridge, so it is with building business policies and procedures.

Compliance and Control

Can you really have compliance without control?  You can check the box that a business procedures exists but a procedure requirement is not about existence it is about deployment and usage.  There is a reason for every requirement.  The standards we talk about (ISO 9000, Sarbanes Oxley, GMPs) are all about reducing risks or reducing risks using negative feedback right?  The next time you have to write business procedures think about how you can introduce negative feedback to obtain the control that the standards are really asking for.

Cash Security Is About Prevention

The same idea applies to your cash process; you want to use best cash practices and follow proper cash procedures.  In business you can reduce cash risk with good cash controls through removing opportunity and temptation.  While your employees may be honest, sloppy cash control is like leaving your car windows down at the mall… you are just begging for something bad to happen.

Proper cash security precautions in cash controls involve several basic tenets, but the most important is clear and accurate recording of all cash that is received and of all cash disbursements.  Make sure all cash transactions are documented and recorded immediately.  A delay in recording cash transactions not only introduces an opportunity for errors, but also creates the opportunity for temptation that could lead to cash fraud.  The recording element of the cash process doesn’t have to be difficult or complex.  In fact, simple basic cash records can improve the likelihood they will be done immediately and with less error, and thus reduce risks to cash.

Proper Cash Controls Need Proper Cash Records for Reconciliation

With the proper records created during all cash transactions, then regular reconciliation can take place.  Depending on your organization, there may be reconciliations that need to occur at several levels. These can include cash drawer reconciliations at the end of a shift or the business day, reconciliation prior to a bank deposit, and regular bank statement reconciliations.  As explained in the last week’s discussion on cash control procedures, management or owner involvement in reconciliation and regular internal audits sends a signal to all members of the organization who handle cash that internal cash control is a priority.

Separation of Duties Is a Key Facet of Internal Cash Control

Proper separation of duties is also an important tool that discourages unethical cash practices.  The idea behind separation of duties is that it is much less likely for two employees to collude to commit fraud than it is for one employee to act alone.  This obviously applies to the reconciliation duties discussed above.  The person who does the daily cash deposit reconciliation should not be the one conducting the monthly bank statement reconciliation.
Frequently, cash procedures call for two people being present any time a large amount of cash is being handled or transported.  This helps prevent internal fraud as well as discourages threats of external theft or robbery.  A restriction on the number of people who have access to cash is also an important method to prevent cash fraud and abuse.  It creates a high level of accountability, which in turn reduces temptation and your cash risks.  If 20 people work in a business, but only three have access to the cash drawer or petty cash, then theoretically you have reduced the risk of abuse by 85%.

Use Proper Physical Control for Cash Management

Physical control over cash means how the cash is literally stored and handled.  The obvious rule of thumb is that the less cash on the premises then the less chance for theft or embezzlement.   Make bank deposits as often as necessary and you can even engage an armored car service that will regularly transport your cash safely.  Keep the cash you have on hand in a safe if possible; or at least securely locked.  Without good physical control it is difficult to restrict access as mentioned above.

Along with good physical control of cash, it is a good cash practice to keep cash records in a separate location from the cash itself.  That way if fraud or theft does occur, they cannot easily take, destroy or modify the cash records.  Separation of cash records and cash can discourage theft, or at least allow the theft to be discovered and clearly documented.

Define Cash Processes and Keep Cash Procedures Current

Proper cash controls can be documented in cash procedures as part of your cash management process.  Be sure to understand the cash process and document it clearly in an accounting procedure.  Keeping your cash procedures correct and up to date also sends an important message to your staff about the due diligence of owners and managers.  If the cash process changes then changing the documented cash procedures should be a high priority.

Cash security practices are vital for internal cash controls, and the goal should be to prevent fraud and theft before it happens.  The proper control involves all the elements we have discussed; proper cash records, separating duties, regular oversight and audits, physical handling, and understanding the cash management process including correct cash procedures.  Proper control reduces temptation and opportunity – the keys to prevention.

To a degree, the confusion over SOX seems inordinate in relation to the complexity of the regulation. Actually, compared to the intricacy of other regulations enforced by the Securities and Exchange Commission (SEC), Sarbanes-Oxley compliance is relatively straightforward. It is somewhat hard to understand why there is so much misunderstanding about Sarbanes-Oxley, so let’s review the basics.

SOX Compliance Basics

As noted, for the most part the efforts required to comply with SOX should not be difficult. In fact, the most arcane sections of the law require no effort by publicly traded companies whatsoever. These Sarbanes-Oxley sections deal with topics such as:

• Authorization and establishment of the Public Company Accounting Oversight Board (PCAOB)
• Funding and reviewing studies on corporate accountability and fraud
• Increasing punishment for white collar crime

As a brief overview shows, most sections of the SOX regulation that do require action by publicly traded companies are not that demanding:

• Creating an Audit Committee from the Board of Directors to oversee independent financial auditing activities, directly receive audit reports, and develop a process for receiving and investigating anonymous complaints about unethical accounting practices. The committee must be chaired by someone with accounting or finance experience.

• Using auditors that are independent from other company relationships, are registered with the PCAOB and comply with its requirements, and lead auditors that are rotated at least every five years.

• Avoiding improper relationships and creating transparency through implementing policies such as restricting employee movement between auditors and the organization; disclosing financial transactions (i.e. loans) with executives and officers; disclosing major stockholders; restricting officer and executive trading of company stocks when other employees are restricted from doing so; and prohibiting retaliation on whistleblowers.

• Management establishing an internal control system that ensures proper accounting practices and safeguards, produces accurate financial statements, as well as annually verifying the control system’s effectiveness.

Sarbanes-Oxley Section 404 Internal Control Compliance

It is that last item listed, management establishing and verifying an effective internal control system listed in SOX Section 404, that causes the most problems for publicly traded companies. Between Sarbanes-Oxley passage and its implementation, the SEC was inundated with questions and inquiries about how to comply with this internal control requirement.

In response to these concerns the SEC pointed to a 1992 report from The Committee of Sponsoring Organizations of the Treadway Commission (known as COSO) called “Internal Control – Integrated Framework.” The SEC cited this COSO report as one example of internal control, but also indicated that this was by no means the only method of effective internal controls.

The Role of Procedures in SOX Section 404 Compliance

It is somewhat unclear how well the SEC’s reference to the COSO report helped in clearing up confusion over internal controls. In response to the requirement, some companies began to “procedure-ize” all of their activities in finance and accounting, mistaking mounds and mounds of procedures for an internal control system.

While procedures are an important component of internal control, creating stacks of paper really only exacerbates the problem. By writing everything down in great detail and putting it in procedures you are setting your internal control system up for failure. Now anytime you do something somewhat differently than what is minutely documented in your procedures – you are not in compliance because you are not following your control system procedures.

In the next article in this series we will further consider the more (or only?) complicated aspect of Sarbanes-Oxley compliance: creating an internal control system and the role of accounting procedures, and the important role of using internal controls to address risk. In the meantime, feel free to browse sample procedures from our CFO-Controller Series and review the selection of accounting procedures for an accounting or finance control system. Our pre-written, editable accounting procedures in MS Word format are based on established best practices, and can provide an important head-start for developing key procedures as part of internal control.

To learn more about Bizmanualz Accounting Procedures go to http://www.bizmanualz.com/accounting/ and check out the Accounting Policies and Procedures Manual or sign up for the Bizmanualz Newsletter and download a free sample accounting procedure right now.

Transparency and Due Diligence

The root cause of this, one could argue, is the lack of transparency and due diligence. Financial institutions did not collect the proper information from people they were lending money to. Those buying packaged securities containing bad loans apparently didn’t really know what they were buying. Those engaged in credit default swaps didn’t really know the viability of the institutions they were insuring and didn’t have the capital to pay the defaults should an institution fail. Without the necessary transparency and due diligence then lies and deception go unchallenged, particularly when people are being dishonest with themselves.

But wait a minute! Wasn’t Sarbanes-Oxley (SOX) supposed to put an end to all that? Aren’t public companies, financial or otherwise, supposed to have an accounting internal control system in place as well as checks and balances to prevent unrealistic, overly optimistic projections and reporting? Obviously, though well-intentioned, SOX has not been as effective as it should be in preventing fraud, abuse, and intentional ignorance. It apparently also has not been successful at encouraging organizations to implement effective financial internal control systems and improve corporate governance.

Proper Internal Controls

Transparency and due diligence are two positive results of a proper internal control system, which is required by SOX. While most SOX requirements are simple and straightforward (i.e., an independent auditor), the internal system mentioned in sections 302 and 404 seems to be little understood, and the cause of most of the confusion surrounding SOX. Yet, it is this provision of Sarbanes-Oxley which could have done the most to prevent our current crises.

A proper internal control system would have required that information provided by loan applicants be verified as accurate, and established that applicants had the means to repay the loan. An internal control system would have ensured the due diligence and transparency by investment banks and institutions buying these mortgages bundled into investment securities, which obviously didn’t happen. It would have required that those selling default swaps understand what they were insuring and that they have the means to back them up.

Not only are meaningful financial control systems apparently being ignored or misunderstood by those running many publicly traded companies, they are apparently ignored or misunderstood by auditors as well. Many of these companies, especially banks, had to have undergone several audits since Sarbanes-Oxley took effect. Can regulations like SOX be effective if auditing systems to ensure compliance aren’t effective?

What Lessons Can We Learn?

How well are internal control systems functioning in your business? We frequently point out that having an internal control system, whether for finance and accounting or for production, is not just about doing the minimum in order to comply with regulations like Sarbanes-Oxley or standards like ISO 9001. The goal of an internal control system is to improve an organization’s overall effectiveness and efficiency in order to achieve objectives across the organization; in finance, sales, design, manufacturing, and elsewhere in the organization.

When the only goal of an internal control system is compliance, then you are doing the absolute minimum. As we can see in this current example, basic compliance at the lowest level does not really protect your investors, your employees, your customers, and other stakeholders. Those banks and financial institutions, however, using an internal control system to continually improve and strengthen the organization, are much more to likely to be left standing when the financial world stops spinning. That is lesson we should all take to heart, no matter what kind of business we are in.

Is Sarbanes-Oxley working? Obviously not very well for many publicly traded companies who just did the minimum in order to comply. For organizations that took the initiative to put effective, meaningful internal control systems in place and created a culture of transparency and due diligence – it is probably working much better.

Our products will give you a head start by providing procedures based on industry best practices, and they come in an easy to edit Microsoft Word format.  To learn more about Bizmanualz Accounting Procedures go to http://www.bizmanualz.com/accounting/ and check out the Accounting Policies and Procedures Manual or sign up for the Bizmanualz Newsletter and download a free sample accounting procedure right now.

This month’s highlight was the release of the Finance Policies, Procedures & Forms manual. Our newest product is the result of a nearly year-long effort of intensive research, writing, editing, and reviewing. The Finance Manual was finally ready for production and shipping last week. We are very pleased with this new product, and the response from our customers, to date, has been tremendous.

The Finance Policies, Procedures & Forms Manual is primarily designed to assist companies of all sizes and types establish strong internal controls to simplify compliance with Sarbanes-Oxley and other financial regulations. Another important benefit of well-designed internal controls is the opportunity to measure and improve process effectiveness.

Improving Financial Performance through Clear Objectives

Almost every business pays attention to financial performance. Studies show, however, that small and medium-sized businesses frequently do not engage in thorough financial planning. What really drives financial performance is setting SMART objectives based on clear goals and then creating detailed action plans so that the objectives can be achieved.

Read more about setting clear objectives.

Using COSO Principles to Improve Performance

You may be familiar with the Committee of Sponsoring Organizations of the Treadway Commission, or COSO, framework for internal control. We have discussed it in past article, and it received significant attention when referenced by the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) as an example of an internal controls system meeting the requirements of the Sarbanes-Oxley Act (SOX), sections 302 and 404.

Read more about using COSO principles.

Read Chris Anderson’s article on Writing Policies and Procedures at work.com.

The New Finance Policies and Procedures Manual

If you are trying to build an internal control system to help you comply with Sarbanes-Oxley and other financial regulations, the new Finance Policies, Procedures and Forms manual can provide a big boost in your efforts. Why start from scratch when writing your financial policies and procedures to implement internal controls?

Read more about the new Finance Procedures Manual.

Besides helping comply with financial regulations, control systems can improve performance in all business segments. Through control activities, for example, policies and procedures can also incorporate the idea of setting process objectives along with regular measurement and review, as well as creating communication channels between key departments. In fact, all the procedures found in our policies and procedures manuals are based on the “Plan-Do-Check-Act” process model of continual improvement, including our newest release, the Finance Policies and Procedures Manual.

On That Note

Answer to this month’s question:

Sarbanes-Oxley (SOX) has generated a lot of discussion about internal controls: What are they? What do they do? Historically, for business finance and accounting processes, controls referred to preventing fraud and abuse. Increasing regulatory requirements have made compliance an important part of control system goals.

Policies and procedures are listed as key control activities in the COSO publication “Internal Control – Integrated Framework.” Both the SEC and PCAOB point to this COSO document as an example of internal controls that meets SOX requirements.

Please feel free to contact us with any questions or comments. Our policies, procedures and processes articles site has tons of useful information. Also, please let us know if you’d like any specific topic addressed in our future articles.

Regards,

Chris
Bizmanualz