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Senior management's tone, competence, and reliability are essential to reliable financial reporting. The new internal control audit reports required by Section 404 of the Sarbanes-Oxley Act (SOX) provide interesting new insights into internal control weaknesses related to senior management.
As far back as the Treadway Commission's Report of the National Commission on Fraudulent Financial Reporting in the late 1980s, many have recognized the importance of "tone at the top" as a fundamental ingredient of reliable financial reporting. If senior management's ethical tone is deficient, then almost no amount of detailed control procedures will be effective in preventing fraud and abuse. Similarly, Fraudulent Financial Reporting: 1987-1997-An Analysis of U.S. Public Companies, sponsored by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), found that top management was implicated in the vast majority of accounting frauds. The authors called for a renewed focus on tone at the top.
Since these two reports were published, we have seen unprecedented levels of senior-management-driven accounting fraud in large public companies: Enron, WorldCom, Adelphia, Tyco, and others. In response to these massive frauds, the Sarbanes-Oxley Act requires, among other things, the auditor to express an opinion on the client's internal control over financial reporting. The logic behind this edict (found in SOX Section 404) is that financial reporting will be more reliable and management override less likely if the company's internal control system, including the control environment, is sound.
Auditors issuing opinions on internal control effectiveness must consider a variety of issues, including senior management's competence and ethical tone, in assessing the effectiveness of controls. Given these evaluations, the Section 404 audit reports provide an opportunity to examine the following questions:
1. Do auditors' Section 404 reports provide evidence of material weaknesses in internal control due to problems with senior management's tone, competence, or reliability?
2. If so, what specific senior-management-related weaknesses are cited, and what remedies are companies using to address these problems?
We believe that the answers to these two questions will provide important insights into corporate vulnerability to senior-management-related weaknesses and the methods used to remediate such weaknesses. The results should contribute to the efforts of auditors, directors, and management accountants.
SECTION 404
Under SOX Section 404, if the auditor identifies any material weaknesses in internal...