How do we make decisions? Where does ERM fit?

How do you make decisions in your personal life?

How do you decide where to live, which car to buy, and where to go for lunch?

For many of us, the last is the most difficult decision to make in a day!

So let’s think about it.

 

It’s lunch time. Even if your watch didn’t tell you, your stomach is loud.

The first decision is whether you are going to eat at all.

Can you afford the time? Can you afford not to eat, given what lies ahead in your day?

What can you get done if you skip lunch? What will suffer if you don’t?

Did you bring your lunch to work? That would provide a compromise solution: eat while you work. Do you really want to do that and risk getting stains on your papers? Is it accepted behavior or will you be forced to leave your workspace for a lunch room or similar – in which case, time might be saved but the idea of eating and working may not be achieved.

If you have to get some lunch, where do you go?

Do you go where you love the food, or where you can get a quick bite of so-so flavor and be back at work promptly, or do you go somewhere where the food is just OK but at least is relatively quick?

Or, do you gather up some colleagues and have a lunch together? This may help with team spirit and other objectives but would take longer. Maybe your colleagues ‘expect’ you to go with them and failing to do so will affect your relationship with them.

Can you afford the time, given how much work you have and the deadlines given you by your boss?

 

There’s more to the lunch issue (such as how will you get to the restaurant and when you should leave), but let’s leave it there.

 

What we did was consider our current situation and determine whether it was acceptable or not. We decided that it was not, because we needed (and wanted) to eat. The value of eating outweighed the loss of time (sorry, boss).

We then considered all the options, the benefits and downsides of each.

We made a decision.

 

Where was the risk manager with his list of potential harms?

Did we have a separate analysis of the risks from any analysis of the benefits (getting more work done, satisfying the boss, enjoying our food, and being ready for the rest of the day)?

What would you say if one of your colleagues responded to every suggestion about a restaurant by pointing out what could go wrong (bad food, food poisoning, delays getting back, unpleasant service, and so on)?

Would you say he or she was doing their job well and look for a separate colleague to identify and assess all the good things that might happen by going to this or that restaurant?

 

Can risk practitioners continue to be the voice of gloom and expect to be asked to join the CEO for lunch at his or her club?

 

I welcome your thoughts.

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Risk appetite in practice

From time to time, I am asked about the best risk management activity I have seen. Perhaps the best overall ERM was at SAP. I wouldn’t say it was perfect but it did include not only periodic reviews but the careful consideration of risk in every revenue transaction (including contracting) and development activity.

The best risk management activity was when I was with Maxtor, a $4b hard drive manufacturing company. It was based in the US but had major operations in Singapore, which is where I saw this.

The head of procurement for the region, a vice president, and his director were evaluating bids to supply the two Singapore plants with critical materials.

Margins in that business were not high, so the effective management of cost was very important indeed.

[David Griffiths has pointed out that my post, as originally written, did not specify the objectives to which we have risks. I am adding them here:

• Procure critical materials at the lowest possible cost to optimize margins
• Ensure timely delivery of critical materials to support manufacturing and timely delivery of finished products to customers with a positive effect on customer satisfaction
• Minimize supply chain disruption risk
• Ensure quality materials so that scrap and rework are minimized, manufacturing is not delayed, costs are contained, and customers are satisfied]

But, there were additional issues or ‘risks’ to consider:

• The choice of a single vendor would increase the likelihood and extent of supply chain disruption if that vendor was hit by floods or other situations that could disrupt its ability to manufacture and deliver.
• If we were dependent on a single vendor, that vendor could demand price increases.
• If we were dependent on a single vendor, we could not switch with agility to another should the single vendor have quality manufacturing problems.
• If the decision was made to select two vendors, the total cost would be likely to increase.
• If two vendors were selected and the supply split between them, there would be less desire for them to make us a priority customer.
• If only two vendors were selected, there would still be significant supply-chain disruption risk.
• If more than two vendors were selected, additional agility would be obtained, but at a cost.
• If more than two vendors were selected, they might be less reliable because they would be less dependent on us as a major customer.

Cost was not the only consideration. Quality, timely delivery, and our agility to respond to any form of disruption were also very important.

The procurement VP gathered together all the potentially affected parties to participate in the decision, including the vice presidents for finance, sales, manufacturing, and quality.

They considered all the options, the consequences of each decision (both positive and negative), and decided to select three vendors and split the allocation between them. They also decided to negotiate backup supply contracts with a couple of other companies.

The decision involved taking a higher level of some risks and lower levels of others.

Basing the decision on whether one risk was too high would not have led to the optimal overall result.

Now, how would a risk appetite statement have helped the VP of procurement?

I believe the answer is “not at all”.

What do you think?

I welcome your comments.

The state of the internal audit profession

My friend Richard Chambers has written a couple of posts that merit our careful attention.

Frankly, all of his posts merit our attention, but these are important.

I ask that you review:

• The State of Internal Audit: Facts vs. Conjecture, and
• For Internal Audit, the Best Defense Is a Strong Offense

I have not spoken to Richard about either of his posts nor about his motivation for writing them. (See Note at conclusion.)

However, I suspect that they were sparked by articles such as this, Internal Audit Losing Prestige, Survey Finds. To quote that piece:

In the eyes of CFOs and many other senior executives and board members, the internal audit function is fast losing prestige, a new study suggests.

The reason? Most internal auditors are slow to help their employers prepare for and respond to major corporate “disruptions” like big regulatory changes and cyber attacks, according to PwC’s 2017 State of the Internal Audit Profession Study.

The portion of “stakeholders” — internal auditors, senior executives, and board members — reporting that “internal audit adds significant value” plummeted from 54% in 2016 to 44% in 2017, reaching the study’s lowest level in the five years PwC has been tracking the metric.

Tim Leech of Risk Oversight was more gloomy about the current state of internal audit when he wrote a piece with the highly provocative title of Is Internal Audit the next Blackberry.

Full disclosure requires that I tell you that I have known both Richard and Tim for a very long time.

• Richard and I come from different backgrounds but tend to see things in similar ways (while he served as CAE in the US public sector, I served as CAE for global public companies; he worked with PwC in the consulting and audit services area before becoming CEO and President of the IIA, while I started my career with PwC in public accounting). His position requires him to be diplomatic while I tend to be more provocative. I served many years on IIA committees and task forces and Richard and I have collaborated on a number of AuditChannel broadcasts.
• Tim and I also have different backgrounds. While he also started with PwC (in Canada) before moving into internal audit, he has been a consultant for the last 30 years. Tim and I often disagree but have a mutual respect. Recently he has shared drafts of his work with me for comment before they are published.

Richard is far more provocative than usual in his March 27 post when he says:

It is a truism that negative news tends to generate more attention, and of late there has been too much of it directed at internal audit. I wouldn’t go so far as to characterize it all as “fake news,” but much of it is “hyped news” at best. Whether it’s a media headline trumpeting a purported decline in stakeholder confidence in internal audit or pundits characterizing the profession in such stark terms as the next Blackberry, a few sensational “sound bites” can easily become fodder for those who are quick to relegate the profession to irrelevancy.

Naturally, Tim sees this as labeling his writing as “fake news”.

Richard is 100% correct when he states:

No one has been more open and transparent about challenges and opportunities facing our profession than I have been. Along with other leaders of The IIA, we have continuously challenged internal auditors to acknowledge and address any shortcomings that surface. Internal audit should never shy away from fair critique of its work. However, superficial interpretation of data about the profession can quickly morph from valid encouragement for continuous improvement to destructive criticism.

Equating survey results indicating that less than half the respondents believe “internal audit adds significant value” with a loss of prestige is fallacious. The fact that internal audit functions are able to add staff may indicate that they are being given more resources so they can do more and add greater value.

I don’t believe internal audit is “losing prestige”. My belief is that internal audit can and should do more to deliver the value that our stakeholders need.

Unfortunately, internal audit at many if not most organizations does not have a lot of prestige and the argument should be about increasing rather than losing it.

Let’s look at some more information.

My friend Joe McCafferty of MISTI recently wrote about comments by a panel that included other friends, Larry Harrington and Angela Wizany, along with Brian Christensen of Protiviti. Joe’s piece is titled Stakeholders are sending a clear message to internal audit to step up its game.

I strongly recommend reading the piece and noting the eight action items.

One quote by Brian caught my eye:

Stakeholders are challenging us to get out of our swim lanes. We as auditors are so accustomed to doing our behaviors. We have our audit plans, we have our pencils. But [stakeholders] talked to us about the fact that things change. Be adaptable, be flexible, and be receptive to embracing new challenges and taking them on.

I have worked with IIA Malaysia in the past, including talking on their behalf to the Malaysia Securities Commission and presenting to board members. The profession appears to be strong there, but a recent survey indicates that more is needed.

An article in the local business newspaper reported that:

Public listed companies (PLCs) in the country still have much room to strengthen their internal audit functions, according to a year-long survey commissioned by the Institute of Internal Audit Malaysia (IIAM).

In a statement, IIAM said 54% of the PLCs on the Main Market preferred to outsource their internal audit function and almost all (90%) of these PLCs that outsourced paid RM100,000 or less in a year.

“The amounts incurred indicate that very junior staff or very few staff were in the audit team and a limited scope was covered. The low amounts are also a sign that the staff are not professional staff and may not have the experience and skillset to effectively carry out the work, thus less is spent,” the institute said.

“PLCs should consider the professional qualifications, certification and experience of their OSPs (outsourced service providers) in relation to the scope of the work required to ensure adequate coverage of risk areas and reliable reports are issued.”

Tim has every right to challenge the current state of internal auditing and I know Richard respects that.

I don’t agree with Tim’s reference to a “direct report internal audit paradigm”. While he has explained what he means to me in private conversation, I strongly doubt that many know what he is referring to. However, I do agree that internal audit should provide assurance on the effectiveness of risk management and its ability to help the organization make intelligent decisions and achieve objectives.

There is some merit to Tim’s thinking, but I always struggle with the way he says it. (Sorry, Tim).

Nevertheless, we need people like Tim to challenge us.

Now is the time to step back and think about why the surveys are saying what they are saying, and then talk about what needs to be done about it.

Richard and I have both shared our views with new books.

• Auditing that matters takes on the issue of auditing the risks that really matter to the success of the organization and then sharing with executive management and the board what they need to know.
• Trusted Advisors: Key Attributes of Outstanding Internal Auditors discusses the “top attributes needed to excel as an internal audit professional and be viewed as the go-to person within the entity”.

I would like to think that between us we have charted a way forward.

Internal auditors need to be “proactive” and “forward-looking” according to our Principles for Effective Internal Auditing.

Let’s adopt that mindset for our own practices and profession.

Forward ho! The future is bright. Internal auditing in 2020 and beyond may well be quite different than it has been in the past.

I welcome your comments.

 

 

NOTE: I shared a draft of this post with both Richard and Tim. Neither has a concern, although Tim and I remain at odds over his terminology and perhaps more.

Why do so many practitioners misunderstand risk?

My apologies in advance to all those who talk about third-party risk, IT risk, cyber risk, and so on.

We don’t, or shouldn’t, address risk for its own sake. That’s what we are doing when we talk about these risk silos.

We should address risk because of its potential effect on the achievement of enterprise objectives.

Think about a tree.

In root cause analysis, we are taught that in order to understand the true cause of a problem, we need to do more than look at the symptoms (such as discoloration of the leaves or flaking of the bark on the trunk of the tree). We need to ask the question “why” multiple times to get to the true root cause.

Unless the root cause is addressed, the malaise will continue.

In a similar fashion, most risk practitioners and auditors (both internal and external) talk about risk at the individual root level.

Talking about cyber, or third party risk, is talking about a problem at an individual root level.

What we need to do is sit back and think about the potential effect of a root level issue on the overall health of the tree.

If we find issues at the root level, such as the potential for a breach that results in a prolonged systems outage or a failure by a third party service provider, what does that mean for the health of the tree?

Now let’s extend the metaphor one more step.

This is a fruit tree in an orchard owned and operated by a fruit farmer.

If a problem is found with one tree, is there a problem with multiple trees?

How will this problem, even if limited to a single tree or branch of a single tree, affect the overall health of the business?

Will the owner of the orchard be able to achieve his or her business objectives?

Multiple issues at the root level (i.e., sources of risk) need to be considered when the orchard owner is making strategic decisions such as when to feed the trees and when to harvest the fruit.

Considering, reporting, and “managing” risk at the root level is disconnected from running the business and achieving enterprise objectives.

I remind you of the concepts in A revolution in risk management.

Use the information about root level risk to help management understand how likely and to what extent it is that each enterprise business objective will be achieved.

Is the anticipated level of achievement acceptable?

I welcome your thoughts.

 

When to audit business locations

One of the readers of my work sent me this message.

I was reading your article about modern risk based audit [link added] published in the IIA journal. I find the approach very interesting.

In developing my plan I used to do the traditional risk assessment by identifying the audit universe then prioritizing entities based on risk. In your suggested approach, an auditor should start from the company strategy and objectives, identify the risks that jeopardize these objectives (this could be done through risk management) then audit controls related to those risks.

I had a discussion about that approach 4 months back and I got a lot of opposition from CAEs who audit banks. Their opinion is that they have to audit the big branches every year. I would really appreciate your opinion on that as, for some industries, it seems that covering the audit universe is as important as starting from the risks to objectives (such as expansion in a certain country).

I have seen a lot of CAEs surrender to the old approach simply because they are not politically strong to raise big strategic alarms to their board audit committees and senior management.

Apologies for reaching out to you this way, but I’m very passionate about what I do and I would like to learn and implement new good ideas such as the one suggested by you in the IIA journal.

I will start working on my annual plan now changing the lens to start from the risks on objectives and not from the audit universe. I appreciate the opportunity to be able to reach out for you if I had a difficulty in implementing this?

I enjoy the opportunity to mentor others and to evangelize internal auditing, so I replied straight away.

I used to be in internal audit at a bank, in ancient history, and understand the perspective. The idea is that the larger branches are a significant source of risk. I don’t quarrel with that, but how much work do you need to do there – that’s the key question! Do you look at every risk that is significant to the branch, or only those that are significant (in aggregate) to the bank as a whole?

The risk (pun intended) is that by focusing on details at the branch level you miss the big picture. I write about this in my internal audit book. At Solectron, we had about 120 factories (sites) and margins were so small that a serious issue at any one site could be significant to the business as a whole. My predecessor had an audit plan that spent 90% of the time auditing the sites.

Soon after I took over as CAE, I went over to my IT auditor who, like the rest of the team, was preparing for the next site audit. I asked what he was working on – perhaps looking at some analytics to improve his understanding of the business before he arrived. No. He was starting to draft the audit report! He told me that he found the same issues at every site, so he knew in advance what he would find at the next one!

I asked what corrective actions came from his findings and he explained that local management would upgrade the security, etc.

But, when I asked whether he or the former CAE had thought about whether this pervasive problem should be escalated to corporate and the office of the CIO, he said “no”. No audit had been performed of corporate IT, even the corporate IT security function.

Down in the weeds, missing the big picture.

I changed the approach to the one I discuss in my writing. We looked at the business risks to the enterprise should IT fail in some fashion. That led us to audit the way in which the company approached IT security, the leadership and capabilities of the corporate IT function, and so on.

Recently, Paul Sobel and I were on an OCEG webinar and talked about the topic of my book, world-class internal auditing. One of the survey questions asked whether those listening based their audit plans on risks at the location level or at the enterprise level. Unfortunately, the great majority used the ‘old’ approach, but we were heartened to hear that they intended to move to the ‘newer’ enterprise-risk based approach.

Where are you now and are you changing?

What should be audited at each location or within each business process? The risk to the process or the risk to the enterprise?

By the way, look at a related post on the IIA blog (it will appear this week) where a board member says that most internal audit ‘findings’ are mundane. I believe that is due, in part, to auditors being focused on risks in the weeds rather than to the enterprise.

Are you ready for the new technology that will change our world, again?

It’s not that long since we were dismissing the Internet of Things as something very much ‘next generation’. But, as you will see from Deloitte’s collection of articles (Deloitte Review Issue 17), many organizations are already starting to deploy related technologies. I also like Wired magazine’s older piece.

Have a look at this article in the New York Times that provided some consumer-related examples. Texas Instruments has a web page with a broader view, mentioning building and home automation; smart cities; smart manufacturing; wearables; healthcare; and automotive. Talking of the latter, AT&T is connecting a host of new cars to the Internet through in-auto WiFi.

At the same time, technology referred to as Machine Learning (see this from the founder of Sun Microsystems) will be putting many jobs at risk, including analysis and decision-making (also see this article in The Atlantic). If that is not enough, the IMF has weighed in on the topic with a piece called Toil and Technology.

Is your organization open to the possibilities – the new universe of potential products and services, efficiencies in operations, and insights into the market? Or do you wait and follow the market leader, running the risk of being left in their dust?

Do you have the capabilities to understand and assess the risks as well as the opportunities?

Do your strategic planning and risk management processes allow you to identify, assess and evaluate all the effects of what might be around the corner? Or do you have one group of people assessing potential opportunity and another, totally separate, assessing downside risk?

How can isolated opportunity and downside risk processes get you where you need to go, making intelligent decisions and optimizing outcomes?

When you are looking forward, whether at the horizon or just a few feet in front of you, several situations and events are possible and each has a combination of positive and negative effects.

Intelligent decision-making means understanding all these possibilities and considering them together before making an informed decision. It is not sufficient to simply net off the positive and negative, as (a) they may occur at different times, and (b) their effects may be felt in different ways, such as a potentially positive effect on profits, but a negative potential effect on cash flow and liquidity; the negative effect may be outside acceptable ranges.

With these new technologies disrupting our world, every organization needs to question whether it has the capability to evaluate them and determine how and when to start deploying them.

COSO ERM and ISO 31000 are under review and updates are expected in the next year or so. I hope that they both move towards providing guidance on risk-intelligent and informed decision-making where all the potential effects of uncertainty are considered, rather than guiding us on the silo of risk management.

Are you ready?

I welcome your comments.

 

For more on this and related topics, please consider World-Class Risk Management.

Assessing the organization’s culture

It’s difficult to argue that an organization’s culture does not have a huge effect on the actions of its board, management, and staff.

Fingers have been pointed at the culture at GM, Toshiba, a number of US banks, RBS, and more – asserting that problems with the culture of the organization led to financial reporting issues, compliance failures, and excessive risk-taking.

Now, a new report by the Institute of Business Ethics, Checking Culture:  new role for internal audit, “shines a spotlight on the role of internal audit in advising boards on whether a company is living up to its ethical values”.

The authors quote the CEO of the UK’s Chartered Institute of Internal Auditors (UKIIA):

“Through a properly positioned, resourced and independent internal audit function a board can satisfy itself not only that the tone at the top represents the right values and ethics, but more importantly, that this is being reflected in actions and decisions taken throughout the organisation.”

In 2014, the UKIIA published Culture and the role of internal audit.

I strongly recommend reference to both papers.

As usual, I have some concerns.

• While internal audit clearly has a role, why is the assessment of culture not performed by management – specifically by the Human Resources function? Wouldn’t internal audit add more value if it worked with that function and helped them not only assess culture periodically but build detective controls to identify potential problems on a continuing basis?
• There is no single culture within an organization. The UKIIA report includes this great quote: “The problem is; complex organisations, like the NHS [the National Health Service], mean there is no ‘one NHS’. There is a tangled undergrowth of subcultures that, even if they wanted to march in step, probably couldn’t hear the drum beat”.
• Culture has many forms: ethics; risk; performance; teamwork and collaboration; innovative; entrepreneurial; and so on. All of these are critical to success, but they can be in conflict with one another, such as risk-taking and entrepreneurial. Any audit engagement would need to focus on specific areas and know where management and the board draw the line between acceptable and non-acceptable. Taking too little risk can be as damaging as taking too much!
• Culture is very personal! It changes as managers and other leaders change, as business conditions change, and so on. Any audit engagement has to take note that the behavior of decision-makers can change in an instant and any assessment can quickly be out-of-date and misleading. In fact, poor behavior by a tiny fraction of the organization can have massive impact – and this may not be detected by any survey.

Does this mean that internal audit should not have a role? No. They should.

This is my preference:

1. All internal auditors should be aware and alert to any indicators of inappropriate behavior of any kind: from ethical lapses, to excessive risk-taking, to disregard for compliance, to poor teamwork, to ineffective supervision and management, to bias or discrimination, to – you name it.
2. Internal auditors should not be afraid of bringing these issues to the attention, not only of senior internal audit management (so that the need can be assessed for a broader review to determine whether this is an individual, team, or broader problem) but to more senior management and Human Resources so they can take action.
3. The CAE should talk to the CEO and the head of Human Resources and help them establish the proper guidance, communication and training in desired behaviors, as well as periodic assessments and detective controls to assure compliance.
4. The CAE and the CEO should discuss the organization’s culture and its condition with the board (or committee of the board) on a regular basis. My preference is for the CEO to take the lead, with additional information provided by the CAE on internal audit’s related activities and opinion.

For a different spin, check these out:

• What are the most common organizational culture problems?
• 3 Cultural Problems That Cause Good Employees to Go Bad
• 7 signs your organization has a toxic corporate culture
• Risk Culture (Institute of Risk Management)

What do you think the role of audit should be, especially vs. the role of management, when it comes to culture?

Core Principles for Effective Internal Audit

The IIA released an update to its standards (specifically, the International Professional Practices Framework, or IPPF) at its recent International Conference, in Vancouver. They now include new Core Principles for the Professional Practice of Internal Auditing, as well as a Mission of Internal Audit statement.

This is how the principles are described:

The Core Principles, taken as a whole, articulate internal audit effectiveness. For an internal audit function to be considered effective, all Principles should be present and operating effectively. How an internal auditor, as well as an internal audit activity, demonstrates achievement of the Core Principles may be quite different from organization to organization, but failure to achieve any of the Principles would imply that an internal audit activity was not as effective as it could be in achieving internal audit’s mission (see Mission of Internal Audit[1]).

• Demonstrates integrity.
• Demonstrates competence and due professional care.
• Is objective and free from undue influence (independent).
• Aligns with the strategies, objectives, and risks of the organization.
• Is appropriately positioned and adequately resourced.
• Demonstrates quality and continuous improvement.
• Communicates effectively.
• Provides risk-based assurance.
• Is insightful, proactive, and future-focused.
• Promotes organizational improvement.

I was privileged to be a member of the task force (RTF), composed of leading internal audit practitioners from across the globe, which recommended that the IIA leave the definition of internal audit unchanged but add core principles and a mission statement. Taking the last item first, we recognize that each IA department will probably have its own mission statement, customized to its organization and charter. However, including a generalized mission statement in IIA guidance would be useful.

The RTF debated whether the IIA standards are rules-based or principles-based. We all felt that they are principles-based, so somebody asked what those principles are. After a lot of discussion, we developed ten that after minor word changes are the Core Principles listed above.

In August, I am joining with Paul Sobel in a free OCEG webinar to discuss World-Class Internal Auditing (based, in part, on my book of the same name). One of the questions we will each answer is which of the principles is our favorite. My choice will probably be “is insightful, proactive, and future focused”. I explained why in a post last year, Auditing Forward.

But, I might also choose “communicates effectively”. Here are a few excerpts from the book:

It is revealing that the IIA Standards do not require an audit report! Standard 2400, Communicating Results, simply says “Internal auditors must communicate the results of engagements.”

The audit report, I learned, is not a document that summarizes what we did and shares what we would like to tell management and the board.

Instead, it is a communication vehicle. It is the traditional way internal audit communicates what management and the board need to know about the results of our work.

The audit report is not for our benefit as internal auditors. It is not a way to document our work and demonstrate how thorough we were. It is for the benefit of the readers of the report, management, and (when I was CAE) the audit committee. It tells them what they need to know, which is typically whether there is anything they need to worry about.

………………….

I talked to my key stakeholders in management and on the audit committee and listened carefully so I could understand what they needed to hear after an audit was completed.

I heard them say that they wanted to know the answers to two questions:

1. Is there anything they need to worry about?
2. Are there any issues of such significance that somebody in senior management should be monitoring how and when they are addressed?

In other words, they wanted to manage by exception. They were going to trust internal audit and operating management to address routine issues; they didn’t want to waste their time (my expression; they didn’t actually use those words) on matters that didn’t merit their attention.

………………….

The traditional way to express an opinion in an audit report is through a rating scale, such as one that uses a three point scale of Satisfactory, Needs Improvement, and Unsatisfactory.

I don’t believe that a rating scale conveys to the executive reader what they need to know.

If we are tasked with assessing controls over risks, we should not only be telling management whether the risks are being managed effectively but explain, in business language, the effect on corporate objectives.

………………….

My focus is always on providing each stakeholder with the information they need to run the business, when they need it, in a clear and easy-to-consume fashion.

………………….

Which are your favorite principles?

Do you agree with my thoughts on auditing forward and effective communications?

How does your internal audit department measure up to these principles?

[1] To enhance and protect organizational value by providing risk-based and objective assurance, advice, and insight.

Compliance and risk appetite

Recently, a compliance thought leader and practitioner asked my opinion about the relevance of risk management and specifically risk appetite to compliance and ethics programs.

The gentleman also asked for my thoughts on GRC and compliance; I think I have made that clear in other posts – the only useful way of thinking about GRC is the OCEG view, which focuses on the capability to achieve success while acting ethically and in compliance with applicable laws and regulations. Compliance issues must be considered within the context of driving to organizational success.

In this post, I want to focus on compliance and risk management/appetite.

Let me start by saying that I am a firm believer in taking a risk management approach to the business objective of operating in compliance with both (a) laws and regulations and (b) society’s expectations, even when they are not reflected in laws and regulations. This is reinforced by regulatory guidance, such as in the US Federal Sentencing Guidelines, which explain that when a reasonable process is followed to identify, assess, evaluate, and treat compliance-related risks, the organization has a defense against (at least criminal) prosecution. The UK’s Bribery Act (2010) similarly requires that the organization assess and then treat bribery-related risks.

I think the question comes down to whether you can – or should – establish a risk appetite for (a) the risk of failing to comply with rules or regulations, or (b) the risk that you will experience fraud.

I have a general problem with the practical application of the concept of risk appetite. While it sounds good, and establishes what the board and top management consider acceptable levels of risk, I believe it has significant issues when it comes to influencing the day-to-day taking of risk.

Here is an edited excerpt from my new book, World-Class Risk Management, in which I dedicate quite a few pages to the discussion of risk appetite and criteria.

Evaluating a risk to determine whether it is acceptable or not requires what ISO refers to as ‘risk criteria’ and COSO refers to as a combination of ‘risk appetite’ and ‘risk tolerance’.

I am not a big fan of ‘risk appetite’, not because it is necessarily wrong in theory, but because the practice seems massively flawed.

This is how the COSO Enterprise Risk Management – Integrated Framework defines risk appetite.

Risk appetite is the amount of risk, on a broad level, an organization is willing to accept in pursuit of value. Each organization pursues various objectives to add value and should broadly understand the risk it is willing to undertake in doing so.

One of the immediate problems is that it talks about an “amount of risk”. As we have seen, there are more often than not multiple potential impacts from a possible situation, event, or decision and each of those potential impacts has a different likelihood. When people look at the COSO definition, they see risk appetite as a single number or value. They may say that their risk appetite is $100 million. Others prefer to use descriptive language, such as “The organization has a higher risk appetite related to strategic objectives and is willing to accept higher losses in the pursuit of higher returns.”

Whether in life or business, people make decisions to take a risk because of the likelihood of potential impacts – not the size of the impact alone. Rather than the risk appetite being $100 million, it is the 5% (say) likelihood of a $100 million impact.

Setting that critical objection aside for the moment, it is downright silly (and I make no apology for saying this) to put a single value on the level of risk that an organization is willing to accept in the pursuit of value. COSO may talk about “the amount of risk, on a broad level”, implying that there is a single number, but I don’t believe that the authors of the COSO Framework meant that you can aggregate all your different risks into a single number.

Every organization has multiple types of risk, from compliance (the risk of not complying with laws and regulations) to employee safety, financial loss, reputation damage, loss of customers, inability to protect intellectual property, and so on. How can you add each of these up and arrive at a total that is meaningful – even if you could put a number on each of the risks individually?

If a company sets its risk appetite at $10 million, then that might be the total of these different forms of risk:

Non-compliance with applicable laws and regulations	$1,000,000
Loss in value of foreign currency due to exchange rate changes	$1,500,000
Quality in manufacturing leading to customer issues	$2,000,000
Employee safety	$1,500,000
Loss of intellectual property	$1,000,000
Competitor-driven price pressure affecting revenue	$2,000,000
Other	$1,000,000

I have problems with one risk appetite when the organization has multiple sources of risk.

• “I want to manage each of these in isolation. For example, I want to make sure that I am not taking an unacceptable level of risk of non-compliance with applicable laws and regulations irrespective of what is happening to other risks.”
• “When you start aggregating risks into a single number and base decisions on acceptable levels of risk on that total, it implies (using the example above) that if the level of quality risk drops from $2m to $1.5m but my risk appetite remains at $10m, I can accept an increase in the risk of non-compliance from $1m to $1.5m. That is absurd.”

The first line is “non-compliance with applicable laws and regulations”. I have a problem setting a “risk appetite” for non-compliance. It may be perceived as indicating that the organization is willing to fail to comply with laws and regulations in order to make a profit; if this becomes public, there is likely to be a strong reaction from regulators and the organization’s reputation would (and deserves to) take a huge hit.

Setting a risk appetite for employee safety is also a problem. As I say:

…. no company should, for many reasons including legal ones, consider putting a number on the level of acceptable employee safety issues; the closest I might consider is the number of lost days, but that is not a good measure of the impact of an employee safety event and might also be considered as indicating a lack of appropriate concern for the safety of employees (and others). Putting zero as the level of risk is also absurd, because the only way to eliminate the potential for a safety incident is to shut down.

That last sentence is a key one.

While risk appetites such as $1m for non-compliance or $1.5m for employee safety are problematic, it is unrealistic to set the level of either at zero. The only way to ensure that there are no compliance or safety issues is to close the business.

COSO advocates would say that risk appetite can be expressed in qualitative instead of quantitative terms. This is what I said about that.

The other form of expression of risk appetite is the descriptive form. The example I gave earlier was “The organization has a higher risk appetite related to strategic objectives and is willing to accept higher losses in the pursuit of higher returns.” Does this mean anything? Will it guide a decision-maker when he considering how much risk is acceptable? No.

Saying that “The organization has a higher risk appetite related to strategic objectives and is willing to accept higher losses in the pursuit of higher returns”, or “The organization has a low risk appetite related to risky ventures and, therefore, is willing to invest in new business but with a low appetite for potential losses” may make the executive team feel good, believe they have ‘ticked the risk appetite box’, but it accomplishes absolutely nothing at all.

Why do I say that it accomplishes absolutely nothing? Because (a) how can you measure whether the level of risk is acceptable based on these descriptions, and (b) how do managers know they are taking the right level of the right risk as they make decisions and run the business?

If risk appetite doesn’t work for compliance, then what does?

I believe that the concept of risk criteria (found in ISO 31000:2009) is better suited.

Management and the board have to determine how much to invest in compliance and at what point they are satisfied that they have reasonable processes of acceptable quality .

The regulators recognize that an organization can only establish and maintain reasonable processes, systems, and organizational structures when it comes to compliance. Failures will happen, because organizations have human employees and partners. What is crucial is whether the organization is taking what a reasonable person would believe are appropriate measures to ensure compliance.

I believe that the organization should be able to establish measures, risk criteria, to ensure that its processes are at that reasonable level and operating as desired. But the concept of risk appetite for compliance is flawed.

A risk appetite statement tends to focus on the level of incidents and losses, which is after the fact. Management needs guidance to help them make investments and other decisions as they run the business. I don’t see risk appetite helping them do that.

By the way, there is another problem with compliance and risk appetite when organizations set a single level for all compliance requirements.

I want to make sure I am not taking an unacceptable level of risk of non-compliance with each law and regulation that is applicable. Does it make sense to aggregate the risk of non-compliance with environmental regulations, safety standards, financial reporting rules, corruption and bribery provisions, and so on? No. Each of these should be managed individually.

Ethics and fraud are different.

Again, we have to be realistic and recognize that it is impossible to reduce the risk of ethical violations and fraud to zero.

However, there is not (in my experience) the same reputation risk when it comes to establishing acceptable levels – the levels below which the cost of fighting fraud starts to exceed the reduction in fraud risk.

When I was CAE at Tosco, we owned thousands of Circle K stores. Just like every store operator, we experienced what is called “shrink” – the theft of inventory by employees, customers, and vendors. Industry experience was that, though undesirable, shrink of 1.25% was acceptable because spending more on increased store audits, supervision, cameras, etc. would cost more than any reduction in shrink.

Managing the risks of compliance or ethical failures is important. But, for the most part I find risk appetite leaves me hungry.

What do you think?

BTW, both my World-Class Risk Management and World-Class Internal Auditing books are available on Amazon.

The value of heat maps in risk reporting

Here is another excerpt from the World-Class Risk Management book. Your comments are welcome.

As you can see, I spend a fair amount of time in the book challenging ‘traditional’ precepts, such as (in this case) the value of heat maps in providing useful information about risks across the enterprise.

 

Heat Maps

Some prefer a heat map to illustrate the comparative levels (typically using a combination of potential impact and likelihood) of each risk.

A heat map is very effective in communicating which risks rate highest when you consider their potential impact and the likelihood of that impact. The reader is naturally drawn to the top right quadrant (high significance and high likelihood), while items in other quadrants receive less attention.

But there are a number of problems with a report like this, whether it is in the form of a heat map or a table.

1. It is a point-in-time report.

When management and the board rely on the review of a report that purports to show the top risks to the organization and their condition, unless they are reviewing a dynamically changing report (such as a dashboard on a tablet) they are reviewing information that is out-of-date. Its value will depend on the extent that risks have emerged or changed.

In some cases, that information is still useful. It provides management with a sense of the top risks and their condition, but they need to recognize that it may be out of date by the time they receive it.

 

2. It is not a complete picture.

This is a list of a select number of risks. It cannot ever be a list of all the risks, because as discussed earlier risks are created or modified with every decision. At best, it is a list of those risks that are determined to be of a continuing nature and merit continuing attention. At worst, it is a list of the few risks that management has decided to review on a periodic basis without any systematic process behind it to ensure new risks are added promptly and those that no longer merit attention are removed. In other words, the worst case is enterprise list management.

There is a serious risk (pun intended) that management and the board will be lulled into believing that because they are paying regular attention to a list of top risks that they are managing risk and uncertainty across the organization – while nothing could be further from the truth.

 

3. It doesn’t always identify the risks that need attention.

Whether you prefer the COSO or ISO guidance, risks require special attention when they are outside acceptable levels (risk appetite for COSO and risk criteria for ISO). Just because a risk rates ‘high’ because the likelihood of a significant impact is assessed as high doesn’t mean that action is required by senior management or that significant attention should be paid by the board. They may just be risks that are ‘inherent’ in the organization and its business model, or risks that the organization has chosen to take to satisfy its objectives and to create value for its stakeholders and shareholders.

This report does not distinguish risks that the organization has previously decided to accept from those that exceed acceptable levels. Chapter 13 on risk evaluation discusses how I would assess whether a risk is within acceptable levels or not.

 

4. The assessment of impact and likelihood may not be reliable.

I discuss this further in chapter 12 on risk analysis.

 

5. It only shows impact and likelihood

As I will explain in chapter 13 on risk evaluation, sometimes there are other attributes of a risk that need to considered when determining whether a risk at acceptable levels. Some have upgraded the simple heat map I show above to include trends (whether the level of risk is increasing or decreasing) and other information. But it is next to impossible to include every relevant attribute in a heat map.

 

6. It doesn’t show whether objectives are in jeopardy.

As I mentioned above, management and the board need to know not only which specific risks merit attention, but whether they are on track to achieve their objectives.

On the other hand, some risk sources[1] (such as the penetration of our computer network, referred to as cyber risk) can have multiple effects (such as business disruption, legal liability, and the loss of intellectual property) and affect multiple objectives (such as those concerned with compliance with privacy regulations, maintaining or enhancing reputation with customers, and revenue growth). It is very important to produce and review a report that highlights when the total effect of a risk source, considering all affected objectives, is beyond acceptable levels. While it may not significantly affect a single objective, the aggregated effect on the organization may merit the attention of the executive leadership and the board.

[1] As noted in the Language of Risk section, many refer to these as “risks” when, from an ISO perspective, they should be called “risk sources” (element which alone or in combination has the intrinsic potential to give rise to risk). For example, the World Economic Forum publishes annual reports on top global risks, which it defines as “an uncertain event or condition that, if it occurs, can cause significant negative impact for several countries or industries within the next 10 years.”

Evaluating the external auditors

The Audit Committee Collaboration (six associations or firms, including the National Association of Corporate Directors and NYSE Governance Services) recently published External Auditor Assessment Tool: A Reference for Audit Committees Worldwide.

It’s a good product, useful for audit committees and those who advise them (especially CAEs, CFOs, and general counsel).

The tool includes an overview of the topic, a discussion of important areas to assess (with sample questions for each), and a sample questionnaire to ask management to complete.

However, the document does not talk about the critical need for the audit committee to exercise professional skepticism and ask penetrating questions to test the external audit team’s quality.

Given the publicized failures of the audit firms to detect serious issues (fortunately few, but still too many) – the latest being FIFA (see this in CFO.com) – and the deficiencies continually found by the PCAOB Examiners, audit committees must take this matter seriously.

Let me Illustrate with a story. Some years ago, I joined a global manufacturing company as the head of the internal audit function, with responsibility for the SOX program. I was the first to hold that position; previously, the internal audit function had been outsourced. Within a couple of months, I attended my first audit committee meeting. I informed them that there was an internal control issue that, if not addressed by year-end, might be considered a material weakness in the system of internal control over financial reporting. None of the corporate financial reporting team was a CPA! That included the CFO, the Corporate Controller, and the entire financial reporting team. I told that that, apart from the Asia-Pacific team in Singapore, the only CPAs on staff were me, the Treasurer, and a business unit controller. The deficiency was that, as a result, the financial reporting team relied heavily on the external auditors for technical accounting advice – and this was no longer permitted.

The chairman of the audit committee turned to the CFO, asked him if that was correct, and received an (unapologetic) affirmative. The chairman then turned to the audit partner, seated directly to his right, and asked if he knew about this. The partner also gave an unapologetic “yes” in reply.

The chairman then asked the CEO (incidentally, the former CFO whose policy it had been not to hire CPAs) to address the issue promptly, which it was.

However, the audit committee totally let the audit partner off the hook. The audit firm had never reported this as an issue to the audit committee, even though it had been in place for several years. The chairman did not ask the audit partner why, whether he agreed with my assessment of the issue, why the firm had not identified this as a material weakness or significant deficiency in prior years, or any other related question.

If you talk to those in management who work with the external audit team, the most frequent complaint is that the auditors don’t use judgment and common sense. They worry about the trivial rather than what is important and potentially material to the financial statements. In addition, they often are unreasonable and unwilling to work with management – going overboard to preserve the appearance of independence.

I addressed this in a prior post, when I said the audit committee should consider:

• Whether the external auditor has adopted an appropriate attitude for working with the company, including management and the internal auditor
• Whether the auditor has taken a top-down and risk-based approach that focuses on what matters and not on trivia, minimizing both cost and disruption, and
• Whether issues are addressed with common sense rather than a desire to prove themselves

Does your audit committee perform an appropriate review and assessment of the external audit firm and their performance?

I welcome your comments.

Cyber risk and the boardroom

The National Association of Corporate Directors (NACD) has published a discussion between the leader of PwC’s Center for Board Governance, Mary Ann Cloyd, and an expert on cyber who formally served as a leader of the US Air Force’s cyber operations, Suzanne Vautrinot.

It’s an interesting read on a number of levels; I recommend it for board members, executives, information security professionals and auditors.

Here are some of the points in the discussion worth emphasizing:

“An R&D organization, a manufacturer, a retail company, a financial institution, and a critical utility would likely have different considerations regarding cyber risk. Certainly, some of the solutions and security technology can be the same, but it’s not a cookie-cutter approach. An informed risk assessment and management strategy must be part of the dialogue.”

“When we as board members are dealing with something that requires true core competency expertise—whether it’s mergers and acquisitions or banking and investments or cybersecurity—there are advisors and experts to turn to because it is their core competency. They can facilitate the discussion and provide background information, and enable the board to have a very robust, fulsome conversation about risks and actions.”

“The board needs to be comfortable having the conversation with management and the internal experts. They need to understand how cybersecurity risk affects business decisions and strategy. The board can then have a conversation with management saying, ‘OK, given this kind of risk, what are we willing to accept or do to try to mitigate it? Let’s have a conversation about how we do this currently in our corporation and why.’”

“Cloyd: What you just described doesn’t sound unique to cybersecurity. It’s like other business risks that you’re assessing, evaluating, and dealing with. It’s another part of the risk appetite discussion. Vautrinot: Correct. The only thing that’s different is the expertise you bring in, and the conversation you have may involve slightly different technology.”

“Cloyd: Cybersecurity is like other risks, so don’t be intimidated by it. Just put on your director hat and oversee this as you do other major risks. Vautrinot: And demand that the answers be provided in a way that you understand. Continue to ask questions until you understand, because sometimes the words or the jargon get in the way.”

“Cybersecurity is a business issue, it’s not just a technology issue.”

This was a fairly long conversation as these things go, but time and other limitations probably affected the discussion – and limited the ability to probe the topic in greater depth.

For example, there are some more points that I would emphasize to boards:

• It is impossible to eliminate cyber-related risk. The goal should be to understand what the risk is at any point and obtain assurance that management (a) knows what the risk is, (b) considers it as part of decision-making, including its potential effect on new initiatives, (c) has established at what point the risk becomes acceptable, because investing more has diminishing returns, (d) has reason to believe its ability to prevent/detect cyber breaches is at the right level, considering the risk and the cost of additional measures (and is taking corrective actions when it is not at the desired level), (e) has a process to respond promptly and appropriately in the event of a breach, (f) has tested that capability, and (g) has a process in place to communicate to the board the information the board needs, when it needs it, to provide effective oversight.
• Cyber risk should not be managed separately from enterprise or business risk. Cyber may be only one of several sources of risk to a new initiative, and the total risk to that initiative needs to be understood.
• Cyber-related risk should be assessed and evaluated based on its effect on the business, not based on some calculated value for the information asset.
• The board can never have, or maintain, the level of sophisticated knowledge required to assess cyber risk itself. It needs to ask questions and probe management’s responses until it has confidence that management has the ability to address cyber risk.

I welcome your comments and observations on the article and my points, above.

How much cyber risk should you take?

I have been spending a fair amount of time over the last few months, talking and listening to board members and advisors, including industry experts, about cyber risk.

A number of things are clear:

• Boards, not just those members who are on the audit and/or risk committee, are concerned about cyber and the risk it represents to their organization. They are concerned because they don’t understand it – and the actions they should take as directors. The level of concern is sufficient for them to attend conferences dedicated to the topic rather than relying on their organization.
• They are not comfortable with the information they are receiving on cyber risk from management – management’s assessment of the risk that it represents to their organization; the measures management has taken to (a) prevent intrusions, (b) detect intrusions that got past defenses, and (c) respond to such intrusions; how cyber risk is or may be affected by changes in the business, including new business initiatives; and, the current level and trend of intrusion attacks (some form of metrics).
• The risk should be assessed, evaluated, and addressed, not in isolation as a separate IT or cyber risk, but in terms of its potential effect on the business. Cyber risk should be integrated into enterprise risk management. Not only does it need to be assessed in terms of its potential effect on organizational business objectives, but it is only one of several risks that may affect each business objective.
• It is impossible to eliminate cyber risk. In fact, it is broadly recognized that it is impossible to have impenetrable defenses (although every reasonable effort should be made to harden them). That mandates increased attention to the timely detection of those who have breached the defenses, as well as the capability to respond at speed.
• Because it is impossible to eliminate risk, a decision has to be made (by the board and management, with advice and counsel from IT, information security, the risk officer, and internal audit) as to the level of risk that is acceptable. How much will the organization invest in cyber compared to the level of risk and the need for those same resources to be invested in other initiatives? The board members did not like to hear talk of accepting a level of risk, but that is an uncomfortable fact of life – they need to get over and deal with it!

The National Association of Corporate Directors has published a handbook on cyber for directors (free after registration).

Here is a list of questions I believe directors should consider. They should be asked of executive management (not just the CIO or CISO) in a session dedicated to cyber.

1. How do you identify and assess cyber-related risks?
2. Is your assessment of cyber-related risks integrated with your enterprise-wide risk management program so you can include all the potential effects on the business (including business disruption, reputation risk, inability to bill customers, loss of IP, compliance risk, and so on) and not just “IT-risk”?
3. How do you evaluate the risk to know whether it is too high?
4. How do you decide what actions to take and how much resource to allocate?
5. How often do you update your cyber risk assessment? Do you have sufficient insight into changes in cyber-related risks?
6. How do you assess the potential new risks introduced by new technology? How do you determine when to take the risk because of the business value?
7. Are you satisfied that you have an appropriate level of protection in place to minimize the risk of a successful attack?
8. How will you know when your defenses have been breached? Will you know fast enough to minimize any loss or damage?
9. Can you respond appropriately at speed?
10. What procedures are in place to notify you, and then the board, in the event of a breach?
11. Who has responsibility for cybersecurity and do they have the access they need to senior management?
12. Is there an appropriate risk-aware culture within the organization, especially given the potential for any manager to introduce new risks by signing up for new cloud services?

I welcome your thoughts, perspectives, and comments.

A huge problem with risk appetite and risk levels

COSO’s ERM Framework defines risk appetite in a way that many have adopted:

“Risk appetite is the amount of risk, on a broad level, an organization is willing to accept in pursuit of value. Each organization pursues various objectives to add value and should broadly understand the risk it is willing to undertake in doing so.”

The problem I want to discuss is whether there is such a thing as an “amount of risk”.

The traditional way of assessing a risk is to establish values for its potential impact (or consequences) and their likelihood. The assessment might also include qualitative attributes of the risk, such as the speed of impact and so on.

But, for many risks there is more than one possible impact, with varying levels of likelihood.

Take the example of an organization that wants to expand and sell its products in a new country. It has set a sales target of 10,000 units in the first year, but recognizes not only that the target may not be reached but that, if things work well, it might be exceeded.

If the sales target is not reached, the initiative will result in a loss of as much as 500 units of currency. The likelihood of that loss is estimated at 5% and is considered unacceptable. There is also a 10% likelihood of a 250 loss, also unacceptable.

Management decides to treat the risk through a number of actions, including advertising and the use of in-country agents, which should reduce the likelihood and extent of losses. However, the cost of these actions will reduce the profits achieved when sales reach or exceed target.

The chart below shows the distribution of possible P&L results, both before and after treating the risk.

So there is no single “amount of risk”. There are many possible outcomes.

It is not sufficient to place a value on the distribution of all possible outcomes and compare that to some other value established as the acceptable level – because some of the points may individually be unacceptable and require treatment.

In this example, management has decided that the likelihood of the greatest levels of loss is unacceptable. If they had reduced the array of possibilities to a calculated number (perhaps based on the area under the curve), they probably would not have considered whether each possibility was acceptable and would not have taken the appropriate action.

Knowing whether the possibilities are acceptable or not, and making appropriate actions to treat them, is critical. A single “amount of risk” fails that test.

We could take this discussion a lot further, but I will stop here. What do you think?

The most important sentence in COSO

In my opinion, one sentence stands out, whether you are looking at the COSO Internal Control – Integrated Framework (2013 version) or the COSO Enterprise Risk Management – Integrated Framework.

That sentence is:

An effective system of internal control reduces, to an acceptable level, the risk of not achieving an objective relating to one, two, or all three categories.

The sentence is important because it emphasizes the fact that the purpose of controls is to address risk, and that you have ‘enough’ control when risk is at desired levels.

To me, this means that:

1. Before you assess the effectiveness of internal control, you need to know your objective(s), because we are talking about risk to objectives – not risk out of context
2. You need to know the risk to those objectives
3. You need to know what is an acceptable level of risk for each objective, and
4. You need to be able to assess whether the controls provide reasonable assurance that risk is at acceptable levels

You may ask “where is that sentence?”, because when consultants (and even COSO and IIA) make presentations on COSO 2013 and effective internal control, all you hear about are the principles and components.

In fact, anybody who reads COSO 2013 should have no difficulty finding this most important sentence. It’s in the section headed “Requirements for Effective Internal Control”.

This is how that section starts:

An effective system of internal control provides reasonable assurance regarding achievement of an entity’s objectives. Because internal control is relevant both to the entity and its subunits, an effective system of internal control may relate to a specific part of the organizational structure. An effective system of internal control reduces, to an acceptable level, the risk of not achieving an objective relating to one, two, or all three categories. It requires that:

• Each of the five components of internal control and relevant principles are present and functioning
• The five components are operating together in an integrated manner

There is no mention of satisfying the requirement that the “components and relevant principles are present and functioning” until after the reference to risk being at acceptable levels.

In fact, I believe – and I know of at least one prominent COSO leader agrees – that assessing the presence and functioning of the components and principles is secondary, provided to help with the assessment.

Let’s have a look at the very next paragraph in the section:

When a major deficiency exists with respect to the presence and functioning of a component or relevant principle or in terms of the components operating together, the organization cannot conclude that it has met the requirements for an effective system of internal control.

When you look at this with the (COSO) risk lens, this translates to the ability to assess internal control as effective, and the principles and components as present and functioning, as long as there is no deficiency in internal control that is rated as “major”.

How does COSO determine whether a deficiency is “major”? That can be found in the section, “Deficiencies in Internal Control”.

An internal control deficiency or combination of deficiencies that is severe enough to adversely affect the likelihood that the entity can achieve its objectives is referred to as a “major deficiency”.

Let’s translate this as well:

1. If the likelihood of achieving objective(s) is “severe”, then the risk is outside acceptable levels.
2. If the risk is outside acceptable levels, not only should the related component(s) or principle(s) not be assessed as present and functioning, but internal control is not considered effective.
3. When it comes to SOX compliance, a “major deficiency” translates to a “material weakness”. The objective for SOX is to file financial statements with the SEC that are free of material error or omission. The acceptable level of risk is where the likelihood of a material error or omission is less than reasonably possible.
4. That means that if the deficiency is less than “major” (or “material” for SOX purposes), then the related component(s) or principle(s) can be assessed as present and functioning – and internal control can be assessed as effective.

So, the only way to assess whether the principles and components are present and functioning is to determine whether the risk to objectives (after considering any related control deficiency) is at acceptable levels.

Do you see what I mean?

Risk is at the core. Assessing the presence and functioning of components or principles without first understanding what is an acceptable level of risk to objectives is misunderstanding COSO!

Why are so many blind to this most important sentence?

I have a theory: the presentations were all prepared based on the Exposure Draft. That document failed to reference the requirement that internal control be designed to bring risk within acceptable levels. (The defect was fixed after comments were received on the issue.)

Do you have a better theory?

Can you explain the blindness of so many to the most important sentence in the entire Framework?

KPMG and I talk about changes at the Audit Committee meeting

I am used to seeing some new thinking from our Canadian friends. That is hardly the case when you look at a recent publication from KPMG Canada, Audit Trends: The official word on what’s changing and how audit committees are responding.

That title not only sets the expectations high, but sets KPMG up for a fall.

This is how they start us off, with an astonishing headline section:

ACs TODAY DEAL WITH A BROAD RANGE OF ISSUES, AND ACCOMPANYING RISKS, THAT ARE BEYOND FINANCIAL STATEMENTS, REPORTING AND INTERNAL CONTROLS OVER FINANCIAL REPORTING – THEIR TRADITIONAL AREAS OF RESPONSIBILITY.

These include CFO succession management; forecasting & planning; liquidity; M&A; environmental, social and governance factors; fraud and more.

My first audit committee meeting, as the chief internal auditor, was about 25 years ago. If memory serves me well, the only audit committee meetings that focused only on “financial statements, reporting, and internal controls over financial reporting” over those 25 years were short calls to review earnings releases, and so on. Not a single in-person meeting was limited to these few topics.

KPMG continues:

THE DAYS WHEN THE AC AGENDA WAS SOLELY DOMINATED BY AUDIT MATTERS AND TECHNICAL ACCOUNTING DISCUSSIONS ARE GONE.

Sorry, KPMG, but the world does not spin around the axis of the CPA firm.

Here’s another silly profundity, a highlighted quote from the Vancouver practice leader:

“Organizations today rely heavily on technology to manage internal processes and external customer relationships, it is therefore essential for ACs to understand what management is doing to mitigate IT risks.”

In 1990, my company was totally reliant on technology. Not only was it relied upon for internal business processes, but our oil refineries were highly automated. So-called IT risks (so-called, because the only risks are risks to the business – which may come from failure in the use or management of technology) were so extensive that I dedicated a third of my budget to IT audit. Going back even further, the savings and loan companies I worked for in the mid to late-1980s relied “heavily on heavily on technology to manage internal processes and external customer relationships”.

So what are the changes that should be happening at the audit committee? Here are six ideas:

1. The audit committee should be asking management to provide assurance that it has effective processes for addressing risk (both threats and opportunities) as it sets strategies and plans, monitors performance, and runs the business every day. The audit committee should not be limited to a review of the “risk de jour”; it should require that management explain how it has embedded the consideration of risk into the organization’s processes and every decision.
2. The audit committee should insist that it obtain a formal report, at least annually, from the chief audit executive, with an assessment of the adequacy of management’s processes for managing risk, including the adequacy of the controls over the more significant risks.
3. With the enormous potential for both harm and strategic value of new, disruptive technology, the audit committee can help the full board by challenging management on its approach to new technology. Does the IT function have the agility, resources, and capability to partner with the business and take full advantage of new technologies, while managing downside risk?
4. Continuing with that theme, is the organization hamstrung by legacy infrastructure and systems that inhibit its agility, its potential for moving quickly as business conditions and opportunities change? Is it able to change systems and processes fast enough?
5. The COSO 2013 update of the Internal Controls – Integrated Framework is an opportunity to revisit a number of issues. One that should be high on the agenda is whether the company is providing decision-makers across the organization, from Strategy-setting to Marketing to Finance to Operations, with the information it needs to drive success? This is not just about the deployment of Big Data Analytics because that is just a tool. It is about (a) understanding what information is available and can be used to advantage, (b) obtaining it at speed, and then (c) delivering it everywhere it should be used in a form that enables prompt use and action.
6. With all the demands on the audit committee, there is a need to re-examine its composition and processes. Do its members have all the experiences and skills necessary to perform with high quality, addressing issues relating to the management of risk, the use of technology, the changing global world, and so on? Should it receive more periodic briefings from experts on these topics? Do its members even have the ability to dedicate the time they need? Are they receiving the information they need to be effective (studies say they do not)?

If the audit committee is spending more than 20% of its precious time on “financial statements, reporting, and internal controls over financial reporting”, something is seriously wrong.

I welcome your comments – especially on these six suggestions.

Why Internal Audit Fails at Many Organizations

When recent studies by KPMG and PwC indicate that about half of internal audit’s key stakeholders (board members and top executives) do not believe that internal audit is neither delivering the value it should nor addressing the risks that matter, we have to recognize that internal auditing is failing at many organizations.

With that in mind, a recent PwC publication in its Audit Committee Excellence series, Achieving Excellence: Overseeing internal audit, merits our attention.

My opinion is that while the audit committee members may be assessing internal audit performance as ‘needs improvement’, they should be looking in the mirror. Internal audit reports to them; if it is not performing to their satisfaction, they are either failing to communicate expectations clearly, not demanding the necessary improvements, not providing the critical support they need when management is pulling them in a different direction, not taking actions (such as replacing the CAE) to effect change, or all of the above.

Audit committee members need guidance and while the IIA does provide some excellent insights from time to time, the audit firms’ publications are often one of the first that are read.

The PwC publication makes some very good points but unfortunately demonstrates a limited understanding of internal audit best practices. This could be because it was written by their governance team rather than by their internal audit services leaders. (PwC’s internal audit services arm has produced not only good guidance from time to time (including their State of the Internal Audit Profession series), but some excellent thoughts leaders (including the IIA CEO, Richard Chambers).)

Let’s look at what they did well:

“A priority for the audit committee should be empowering the internal audit organization by providing visible support.”

This is an excellent point and PwC describes it well. The audit committee should actively engage internal audit and by showing its respect for the CAE and his team promote respect by management.

“Sometimes internal audit crafts an annual plan that leverages its group’s capabilities rather than addressing the company’s key risks. Audit committees will want to be on the lookout for this.”

Another fine point. The audit committee should take responsibility for ensuring that internal audit addresses the risks that matter to the organization.

“Understand whether resource constraints (e.g., restrictions on travel budgets or the ability to source technical skills) have an impact on the scope of what internal audit plans to do. If the impact of any restrictions concerns the audit committee, take steps to help internal audit get the resources it needs.”

The audit committee should ensure that internal audit has an appropriate level of resources, sufficient to provide quality insight and foresight on the risks that matter now and will matter in the near future.

“Audit committees should determine if they are accepting a sub-excellent level of performance and competence in a CAE (and internal audit function) that it wouldn’t be willing to accept for a CFO (or other key role).”

If the CAE is not considered as critical to the success of the audit committee, something is wrong and the audit committee should take action – even if, perhaps especially if, management holds the CAE in high regard while he delivers little of value to the audit committee.

Periodically discuss whether the amount and type of information internal audit reports to the committee is appropriate.

While this is an essential activity, PwC doesn’t get the issue right. The audit committee should ensure it receives the information it needs to perform its responsibilities for governance and oversight of management. That is not a simple matter, as PwC implies, of being succinct in how the CAE presents audit findings.

What did they miss?

1. The audit committee should ensure that all the risks that matter now and will matter in the near future are getting the appropriate level of attention from internal audit.
2. The audit committee should challenge any audit activity that is not designed to address a risk that matters.
3. The audit committee should take a very strong stance that internal audit reports to them and serves their needs first, not those of management. The PwC paper identifies two reporting lines but is wish-washy on the subject, only saying that “Directors and management should reach consensus on which areas should be internal audit priorities.”
4. The audit committee should challenge internal audit on how they work with the risk management activity. Where it exists, are they assessing its effectiveness? Are they working effectively with risk management? Do they leverage management’s assessment of risk appropriately?
5. The audit committee should be concerned about the CAE’s objectivity and independence from undue management influence. Does he have one eye on internal audit and the other eye on his next position within the company?
6. The audit committee should also ensure that it has an appropriate role in the hiring, performance assessment, compensation, and (where necessary) firing of the CAE.
7. Finally, but in many ways most importantly, the audit committee should require that the CAE provide them with a formal assessment of the company’s management of risks and the effectiveness of related internal controls.

The publication makes some technical mistakes because the authors are not internal audit practitioners. Can you spot them?

That’s my challenge to you – in addition to welcoming your comments.

The effective audit committee

A short article in CGMA Magazine, Ingredients of an effective audit committee, caught my eye. I recommend reading it.

I think there are some key ingredients to an effective audit committee that are often overlooked. They include:

1. The members have to read all the material for the audit committee meeting before the meeting. It’s amazing how often they don’t, which reduces the meeting to absorbing the material rather than a constructive discussion of its implications.
2. The members have to be ready, willing, and able to constructively challenge all the other participants, including the external and internal auditors as well as financial, operating, and executive management. Too often, they are deferent to the external auditor (for reasons that escape me) and too anxious to be collegial to challenge senior management.
3. They need a sufficient understanding of the business, its external context (including competitors and the regulatory environment), its strategies and objectives, risks to the achievement of its objectives, and the fundamentals of risk management and financial reporting, to ask the right questions. They don’t need to have a deep understanding if they are willing to use their common sense.
4. They need to be willing to ask a silly question.
5. They need to persevere until they get a common sense response.
6. No board or committee of the board can be effective if they don’t receive the information they need when they need it. I am frustrated when I read surveys that say they don’t receive the information they need – they should be demanding it and accepting no excuses when management is slow to respond.
7. Audit committee members will not be effective if they are only present and functioning at quarterly meetings. They need to be monitoring and asking questions far more often, as they see or suspect changes that might affect the organization and their oversight responsibilities.

What do you think?

I welcome your comments.

Leveraging the COSO Internal Control Update for Advantage

PwC, who led the project for COSO that updated the Internal Control – Integrated Framework, have shared 10 Minutes on why the COSO Update deserves your attention.

PwC has taken credit for writing the update – and I happy to give them the credit, but if they want that then they also have to recognize the limitations.

Personally, I think they have exaggerated the value of the update. For example, they say that the updated version is “applicable to more business objectives”. Frankly, that is nonsense. The 1992 framework could be and was being applied by practitioners (including me) to any and all objectives, including internal financial reporting and all forms of non-financial reporting (contrary to PwC’s views in this latest document).

Nevertheless, I agree with PwC that the update provides an excellent opportunity to revisit both the effectiveness and efficiency of your internal controls.

PwC shares their approach, which I don’t think is correct as it is not risk-based.

Here is mine:

1. Do you understand the risks to your mission-critical objectives?
2. Do you have the controls in place to give you reasonable assurance that those risks are being managed at acceptable levels? (If you are concerned about satisfying the new COSO Principles, remember that they can be assessed as present and functioning as long as there are no major weaknesses that indicate that risks are not managed at acceptable levels).
3. Do you have the right controls? Are they the most effective and efficient combination of controls? Do you have too many (COSO doesn’t ask this question, nor whether you have the best combination of controls)?
4. As you look at your strategies and plans for the next year or so, do you have to make changes to your internal controls so they can support changes in your business and its operations?

I welcome your views.

Information Security and Risk

Should information security (or cyber, if we follow the latest fad) be based on risk? What is that risk, is it risk to the information or other IT resources, or is it risk to the business?

I congratulate John Pironti and Dark Reading for the intelligent perspective in a short video interview.

Two points stand out for me:

1. The investment in information security/cyber should be based on the risk to the business and the achievement of business objectives.
2. Information security professionals need to talk to the business in the language of the business – which is risk and performance. That means that the CISO and team need to understand the business objectives and how a failure in cyber might impair the ability to achieve them.

Information security professionals will be able to get and retain the attention of executives when they are able to explain how investments in information security help managers and the business as a whole succeed.

While information security professionals should continue to advance their understanding of technical issues, most need to upgrade their understanding of the business and business risks. Risk management guidance, such as the ISO 31000:2009 global risk management standard, should be required reading in addition to business and technical journals.

I welcome your comments.