U.S. Congress passed the Sarbanes-Oxley Act of 2002 to shore up perceived weaknesses in accounting regulations. Part of the resulting changes was explicitly prohibiting a company from using its external auditor for internal control. The Act stressed the importance of account reconciliation as a form of preventative control and fraud protection.

Banning external auditors forces companies to replace auditor consultation with other internal controls. Since 2002, focus on account reconciliation is the chief tool for identifying and fixing accounting errors before SEC filings. This accelerated a standardization of reconciliation processes among publicly traded companies in the United States.

Sarbanes-Oxley Regulations

Internal control of publicly traded companies is addressed in sections 404 and 409 of the Sarbanes-Oxley Act. These regulations stress the importance of the balance sheet and, more specifically, the quality of information fed into the balance sheet.

The Act established the Public Company Accounting Oversight Board to register public accounting firms that audit traded companies. This board has the authority to impose rules regarding auditing techniques, corporate ethics and quality control.

These regulations do not only impact financial accounting; operational management is regulated even down to the way inventory is stored and monitored. The Act infamously forbids "material weakness" in internal control, a broad and vague term. Any instances of possible material weakness need to be publicly disclosed along with the financial accounts.

Material weakness is identified in three major areas: segregation of duties, technology issues and account reconciliation. Sarbanes-Oxley stresses that account reconciliation needs to include frequent inventory counts and reviews of inventory valuation methods. Regulators also expect companies to maintain technology capable of supporting a speedy reconciliation process.

Sarbanes Testing

Publicly traded companies perform tests to check their readiness for a Sarbanes-Oxley audit. This is sometimes referred to in accounting circles as "Sarbanes testing." An effective Sarbanes test includes reconciling source documents and providing documentation for all inflows and outflows, payables and receivables or other ledger items. This is more challenging and more necessary for firms with complex, interrelated ledger systems and company operations.

Those conducting account reconciliation should look for material misstatements in the financial statements. This is more difficult in practice than in theory, as the thresholds for material misstatements and material weakness, each contributing to "lack of internal controls," are ill-defined.

Enhanced Financial Disclosures

Under Sarbanes-Oxley, a public company has to disclose several types of transactions or errors not required under previous accounting laws. Companies with any off-balance sheet transactions, such as those involving special-purpose vehicles, need to be reported and publicly disclosed. Any pro-forma information must be made public as well. Companies need to establish procedures for assessing internal controls, primarily through account reconciliation, and then disclose the reporting on management's assessment of such controls. It is also particularly important to discover and disclose all auditing risks in the balance sheet. All balance sheet accounts should be classified as either high-risk, moderate-risk or low-risk.

  1. Why is reconciliation important in accounting?

    Learn about accounting reconciliation and its importance for individuals and businesses to help prevent fraudulent activity ... Read Answer >>
  2. How does bank reconciliation affect a cash control policy?

    Understand how the bank reconciliation process augments a company's cash controls and is an essential part of proper cash ... Read Answer >>
  3. What are some examples of inherent risk?

    Read about the nature of inherent risk in preparing and executing financial audits, including some common situations that ... Read Answer >>
  4. What Are the GAAP Standards for Digital Documents?

    Learn how Sarbanes-Oxley Act of 2002 affects document storage requirements under GAAP. Read Answer >>
  5. What are the advantages and disadvantages for a company going public?

    Companies often use an initial public offering (IPO) as a way to generate capital. There are both advantages and disadvantages ... Read Answer >>
  6. How important are contingent liabilities in an audit?

    Read about the importance of contingent liabilities during an audit, why audits are necessary and how contingent liabilities ... Read Answer >>
Related Articles
  1. Insights

    Examining A Career As An Auditor

    Stricter government regulations have put auditing professionals in demand.
  2. Personal Finance

    Compliance: The Price Companies Pay

    Increased compliance standards make investors feel safer, but they also increase the cost of doing business.
  3. Managing Wealth

    Controller: Job Description & Average Salary

    Learn about becoming a controller and what the job entails. Understand the education and skills required, and how much money you can expect to make.
  4. Personal Finance

    Financial auditor: Job details and average salary

    Discover what it means to hold a financial auditor position, including job duties, education and training, required skills and expected salary.
  5. Managing Wealth

    Internal Auditor: Job Description & Average Salary

    Learn about what the job of internal auditor entails, as well as the median salary, education and certifications required and future career path.
  6. Insights

    IT Security Auditing

    Find out about this promising career that can match IT with business studies.
  7. Personal Finance

    Controller: Career Path & Qualifications

    Find out what it takes to become a financial controller, starting with undergraduate educational requirements and moving into professional certification.
  8. Insights

    Financial Auditor: Career Path & Qualifications

    Learn more about what it takes to become an internal or external financial auditor, and determine whether the profession is right for you.
  9. Managing Wealth

    Accounting Research Manager: Job Description & Average Salary

    Learn about the average salary of an accounting research manager as well as the necessary skills, experience and education, and licenses to hold this position.
  10. Personal Finance

    Accountant: Career Path & Qualifications

    Learn the different career paths a new accountant can take, and understand the educational requirements for the career, which vary based on position.
  1. Reconciliation

    Reconciliation is the key process used to determine whether the ...
  2. Bank Reconciliation Statement

    A bank reconciliation statement is a form that allows individuals ...
  3. Material Weakness

    A material weakness occurs when a company's internal controls ...
  4. Independent Auditor

    A certified public accountant who examines the financial records ...
  5. Audit

    An unbiased examination and evaluation of the financial statements ...
  6. Detective Control

    Detective control is an accounting term that refers to a type ...
Hot Definitions
  1. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  2. Entrepreneur

    An Entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture. ...
  3. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  4. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  5. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  6. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
Trading Center