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Evaluating the external auditors

June 14, 2015 7 comments

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.

Lessons Learned from the Transition to COSO 2013

May 3, 2015 5 comments

Protiviti has shared with us a useful Top 10 Lessons Learned from Implementing COSO 2013.

I especially like this section:

It is presumed that everyone understands that a top-down, risk-based approach remains applicable to Section 404 compliance, and the transition to the 2013 updated Framework does not affect this. While we don’t list this as a lesson, we could have, because some companies either forgot or neglected to apply this approach when setting the scope and objectives for using the Framework. As a result, they went overboard with their controls documentation and testing. We can’t stress enough that the COSO 2013 Framework did not change the essence of, and the need for, a top-down, risk-based approach in complying with SOX Section 404.

The report has a number of excellent pieces of advice. However, I wouldn’t be me if I didn’t have points of disagreement.

The first is on mapping. It is NOT necessary to map all your controls to the principles. If we take principle 10, for example, it states “The organization selects and develops control activities that contribute to the mitigation of risks to the achievement of objectives to acceptable levels”. Rather than map all your control activities to this principle (or to principle 11, which is the same – just for IT general controls), the organization needs to identify the control(s) it relies on for its assessment that the principles are present and functioning[1]. For principles 10 and 11, that will be the SOX scoping exercise. For the principle on fraud, the control that should be identified is the fraud risk assessment, not every control relied on to detect or prevent fraud.

Then there is the assertion that indirect controls are the same as entity-level controls. COSO (both 1992 and 2013) tell us, correctly, that activities in each of its components may operate at any level within the organization. For example, let’s say that an account analysis is prepared by Corporate Finance as part of the period-end close. This entity-level control may operate with sufficient precision to be relied upon to detect a material error or omission in that account. But the entity-level control is a direct control, not an indirect control. (A direct control can be relied upon to prevent or detect an error. An indirect control is one that serves to increase or decrease the likelihood that other, direct, controls will function effectively. Hiring, integrity, oversight by the board – these are indirect controls where a defect would increase the likelihood that affected direct controls would fail.)

Another example that helps us understand the difference is the hiring process (related to principle 4, in the Control Environment). The hiring process most often is at a lower level than the entity-level, often as deep as the activity level as that is where most hiring managers reside. Controls in the hiring process in this situation are activity level (or what I call ‘intermediate level’ controls, operating at a location or business unit rather than either the top or the bottom of the organization) and are indirect controls.

I could quibble with one or two more points, but I don’t want to detract from the report. I want, instead, to encourage you to read and discuss it.

What do you think?

What additional lessons have you learned?

[1] Full credit for this wording goes to the E&Y national office, who used it in a conversation I had with them about the firm’s training of its audit staff.

The most important sentence in COSO

April 25, 2015 13 comments

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?

Going crazy with COSO 2013 for SOX

February 18, 2015 20 comments

For some reason, I only just saw a new PwC publication, Present and functioning: Fine-tuning your ICFR using the COSO update, dated November 2014.

PwC provided the project team for the COSO 2013 update of the Internal Controls – Integrated Framework, so their advice and insight should merit our attention.

The trouble is that it very easy to go overboard and do much more work than is necessary to update your SOX program for COSO 2013.

I fear that PwC may help people go crazy, rather than perform the few additional procedures necessary. I respect those who have said, rightly in my view, that if you were able to comply with the requirements of COSO 1992 (the original version) and either the SEC guidance (in their Interpretive Guidance) or PCAOB Standard Number 5, you should already be in compliance with COSO 2013.

The key is to be able to demonstrate that.

We need to remember these facts:

  1. Neither the SEC nor the PCAOB has updated regulatory guidance for management or the external auditor since the release of COSO 2013. That guidance, reinforced by the PCAOB October 2013 Staff Practice Report) mandates a top-down and risk-based approach. It requires a focus on the potential for a material error or omission in the financial statements filed with the SEC.
  2. COSO 2013 says that internal control is effective when it reduces the risk to the achievement of objectives to acceptable levels. For SOX, that means that there are no material weaknesses.
  3. COSO 2013 also says that a principle can be deemed present and functioning if there are no “major deficiencies” that represent a significant level of risk to the achievement of the objective – in other words, there are no material weaknesses due to a failure of elements relating to a principle.

Now let’s have a look at what PwC has to say.

“With the COSO’s 1992 Control Framework being superseded by the 2013 updated edition on December 15, 2014, now is the time for companies to use the updated framework to evaluate the effectiveness of their systems of internal control over financial reporting.”

I agree with this statement. This is a great opportunity to ensure an effective and efficient program is in place.

“The updated framework formalizes 17 principles that stipulate more granular evaluative criteria to help a company’s management assess the design and operating effectiveness of its ICFR.”

They forget to say that COSO informs us that internal control is effective if it reduces risk to the achievement of objectives to acceptable levels. They also forget to remind us that the SOX assessment must be top-down, risk-based, and focused on the potential for a material error or omission.

“We don’t believe that implementation of the 2013 framework affects management’s existing control activities…. assuming that a company’s control activities have been assessed as effective, reevaluating them according to the 2013 framework is not necessary.”

While there is an element of truth to this, organizations should not be assessing control activities in isolation – they should be assessing whether the combination of controls provides reasonable assurance that there are no material errors or omissions. Focusing on one component by itself is insufficient and, I believe, incorrect.

In addition, the selection of controls for reliance should always be re-evaluated as the business is likely to have changed, including materiality, significant accounts and locations, and so on.

“We believe the most immediate value of applying the 2013 framework lies in the opportunity it provides for taking a fresh look at indirect entity-level controls.”

Again, the SOX scoping should be focused on the combination of controls that provides reasonable assurance. In addition, some principles (such as the hiring and training of employees, or the provision of training and obtaining certification of employees in the code of conduct) are performed at the activity level. COSO tells us that activities in each of the COSO components may exist at any level of the organization. So, we need to recognize that indirect controls may operate at the entity (corporate) level, activity level, or any level in between (such as at the business unit or regional level).

Having said which, the principles do offer us a new opportunity to determine which of these indirect controls need to be included in scope because a failure would represent an unacceptable level of risk – because they raise to an unacceptable level the likelihood that one or more key direct control relied on to prevent or detect a material error or omission might fail.

But, it all has to be within the context that we are focusing the scope, and the SOX program as a whole, on the risk of a material error or omission!

“…fine-tune the design and related documentation of indirect ELCs [entity-level controls] through mapping them to principles.”

Many have misguided organizations, telling them to “map their controls to the principles”. The proper guidance is to “identify the controls you are relying on to provide reasonable assurance that the principles are present and functioning”. Again, we need to remember that the principles can be deemed present and functioning if a failure would not represent a material weakness.

It is correct to say that if you have indirect controls (at entity or another level) that are not required to provide that reasonable assurance, they do not need to be included in scope for SOX.

“…we have noted the following areas in which management’s assessment has indicated room for optimization or improvement in control documentation.”

I suspect that the issue is not limited to control documentation! There is always room for improvement and it is useful to see what PwC has identified.

“Leading companies are formalizing or clarifying and incorporating into their evaluations of ICFR certain indirect ELCs that support existing human resources policies. Such controls usually consist of approvals of new hires and employee transfers (including background checks and assessments of requisite skills and experience when appropriate), requirements for professional certifications and training (e.g., in new and complex accounting standards), succession planning and retention of competent employees, and periodic reviews of employee performance to assess requisite skill levels and conduct. Compensation programs aligned with expected performance, competencies, and behaviors are also important to support ICFR objectives.”

If you believe that any organization’s HR policies and practices provide the assurance you need that every single key control is performed by individuals with the appropriate experience, knowledge, training, and so on, I have a bridge to sell you!

While it is very important to have excellence in hiring, training, supervision, career development, promotion and so on, I do not believe that for SOX it is productive to spend much time on controls in this area.

I very much prefer to assess the capabilities and competence of each control owner as part of the evaluation of the design and operation of each individual key control.

“In many organizations, the evaluation of fraud risks related to financial reporting is integrated into the overall assessment of financial-reporting risks……… In identifying and evaluating those risks, management investigates incentives, pressures, opportunities, attitudes, and rationalizations that might exist throughout the company in different departments and among various personnel.”

The first statement is (I hope) true, although I personally perform a separate assessment of fraud risk (focused on the risk of a material error or omission due to fraud) and generally find that they are addressed by the controls already identified for mistakes.

PwC talks about ‘scenarios’, while I talk about ‘fraud schemes’. In each case, we are talking about ‘how’ the fraud would be committed – an essential step in understanding the true nature of the risk and the controls that would prevent or detect it, if material.

However, going crazy about the fraud triangle is not recommended. We should focus on how we can provide reasonable assurance that a material error or omission due to fraud might be prevented or detected, and remember that the number of people with the ability to commit such a fraud is limited. More than 80% of reported material frauds have been perpetrated by the CEO and CFO acting together, not individuals “throughout the company in different departments and among various personnel.” Rationalization, for example, is an intensely personal action and not something that can be detected by looking broadly at even a segment of the workforce.

“Companies taking a thoughtful approach in transitioning to the 2013 framework—rather than viewing it as a mere compliance exercise—are finding value in the identification of opportunities to strengthen their ICFR.”

We are back on solid ground.

The focus has to remain solidly grounded on identifying and then testing the design and operation of the controls relied upon to prevent or detect a material error or omission. A top-down and risk-based approach is mandated.

Going beyond this may have value in improving operations and the achievement of other (than SOX) business objectives.

But let’s not go crazy!

I welcome your comments and, especially, your experiences with COSO 2013 and your external auditors.

By the way, I think it is well past time for COSO to issue a statement or other guidance to set people straight on the COSO 2013 principles when it comes to SOX. They need to explain that the primary evaluation criterion for effective internal control is whether there is reasonable assurance that risk to the achievement of principles is at an acceptable level. Then they need to explain that the principles offer more granulated guidance that can be used in assessing that risk and whether it is acceptable, but assessing the principles without the context of risk is misunderstanding COSO 2013.

Do you agree?

 

The effective audit committee

November 22, 2014 7 comments

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

November 15, 2014 4 comments

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.

New E-Book on Segregation of Duties: A Review

November 12, 2014 1 comment

I congratulate Larry Carter for his new e-book, published by Compliance Week, on the topic “Segregation of Duties and Sensitive Access: Leveraging System-Enforced Controls”.

This is a timely discussion and explanation of a difficult topic and it includes useful information on the differences between manual and automated controls, preventive and detective controls, and more.

I believe it will be a useful read for internal auditors and application developers who are relatively new to the area, and a reminder to more experienced individuals of some of the key points to consider when designing automated controls to prevent individuals from having more access than they need – which can lead not only to fraud, but disruption, errors, and accidents.

For example, when I was leading the internal audit and SOX programs at Maxtor Corporation, the external auditor asked for access so he could examine some of the SAP configurations as part of his control testing. IT inadvertently provided him not only with the access he requested, read-access to the tables involved, but the ability to change the accounting period. Without realizing what he was doing, the auditor closed the accounting period while our financial team was still posting quarter-end journal entries!

Larry makes the excellent point that we need to consider not only inappropriate combinations of access privileges (i.e., Segregation of Duties, or “SOD”) but inappropriate access to a single capability. He calls this latter Sensitive Access, although the more common term is Restricted Access (“RA”).

As he points out, it is good business practice to limit everybody to the access they need to perform their job. Although it may be easier to establish the same access ‘profile’ (a set of access privileges) for several people, care has to be taken to ensure that nobody has more access than they need. If they do, that creates a risk that they may deliberately or inadvertently use that access and create a problem.

Some years ago, my internal auditors found that an individual in Procurement had the ability to create a vendor in the system and approve payment, as well as approve a purchase order. This creates a risk of fraud. The IT manager said there was a control: “We don’t tell people what access they have”. As you might imagine, we didn’t accept that argument.

This brings me to the critical topic of risk.

Larry makes the excellent and key point that you need to design your controls to address risk. You don’t design and operate controls for any other reason. With SOD, the primary reason for limiting inappropriate combinations of access is to prevent fraud. As he says, it is important to perform a fraud risk analysis and use that to identify the SOD controls you need.

When it comes to controls relating to sensitive or restricted access, the controls you need should also be determined by risk. For example, you will probably want to ensure that only a limited number of people have the ability to approve a journal entry, not only because of the risk of fraud but because you want an appropriate review and approval process to occur before they are posted. Similarly, you will want expenditures over a certain value to be approved by a more senior manager, and that is enforced through a restricted access control.

While Larry makes it clear that risk should drive the determination of what controls you need, I wish that had been how he designed his process for identifying necessary SOD and RA controls. Instead he identifies the total population of potential controls and only then considers (although it is less clear than it should be) whether the risk justifies having a control.

In fact, sometimes there are other controls (other than automated SOD or RA controls) that mitigate or even eliminate the risk. When the design of internal controls is based on a risk assessment that considers all the available controls, you are more likely to be able to design a more efficient combination of controls to address important risks. For example, let’s say you have a risk that individuals with inappropriate access to the spare parts inventory might use that to steal materials critical to manufacturing. At first blush, a control to ensure only authorized people have access might seem mandatory – and it would certainly be good practice. But, if the manager of the warehouse had an inventory taken of that area of the warehouse twice each day, the personnel working there could be relied upon to challenge anybody entering the space, and cameras detected any access, the value of an automated RA control is significantly diminished.

A related issue that Larry unfortunately doesn’t mention is the need to limit the access capabilities of the IT staff – not only to functions within applications, but to functions within IT business processes. For example, you need to limit who can change application code or bypass all your controls using “superuser” capabilities.

Another area that is often overlooked is the need to limit ‘read-only’ access to confidential information. Access privileges that allow unauthorized individuals to view customer or employee’s personal information, or confidential corporate information, may be required to comply with laws and regulations as well as to address the risk of theft or misuse of that information.

Overall, this is an e-book with a lot of useful information and it is an easy read.

Norman Marks is a semi-retired internal audit executive, author of World-Class Internal Audit and How Good is your GRC? (both are available on Amazon), and a frequent blogger on the topics of governance, risk management, internal audit, and the effective use of technology in running the business. He can be reached at nmarks2@yahoo.com.

Leading the 21st century organization

October 6, 2014 1 comment

I have been a fan of Tom Peters (author of “In Search of Excellence” and many more books) for more than 20 years.

While CAE at Tosco Corporation, I attended a presentation by him on something he called Wow! The concept, which I not only wrote about for the Internal Auditor magazine in 2001 but tried to incorporate into my internal audit practice, is to turn every project into something that you would tell your grandchildren about (Wow! indeed).

Tom is now 71 but hasn’t slowed down. He is amazingly actively presenting all over the world, writing books, and on Twitter (where we interact from time to time).

Recently, he was interviewed by McKinsey and I recommend reading the full piece. Here are some excerpts.

“My real bottom-line hypothesis is that nobody has a sweet clue what they’re doing. Therefore you better be trying stuff at an insanely rapid pace. You want to be screwing around with nearly everything. Relentless experimentation was probably important in the 1970s—now it’s do or die.”

“…the secret to success is daydreaming.”

“If you take a leadership job, you do people. Period. It’s what you do. It’s what you’re paid to do. People, period. Should you have a great strategy? Yes, you should. How do you get a great strategy? By finding the world’s greatest strategist, not by being the world’s greatest strategist. You do people.”

“We’re in the big-change business, aren’t we? Isn’t that the whole point? I mean, any idiot with a high IQ can invent a great strategy. What’s really hard is fighting against the unwashed masses and pulling it off—although there’s nothing stupider than saying change is about overcoming resistance. Change is about recruiting allies and working each other up to have the nerve to try the next experiment. You find allies. You encircle the buggers.”

“I’m more than willing to say that today’s two year old is going to deal with his or her fellow human beings differently than you or I do. But the reality is it’s 2014, not 2034, and I would argue that for the next 20 years, we’re still safe believing in the importance of face-to-face contact. I’m not arguing against virtual meetings, but I’m telling you that if I’m running IBM, I want to be on the road 200 days a year as much in 2014 as in 2004 or in 1974. It has nothing to do with the value of the tools, but I’ve got to see you face to face now and then; I don’t think I can do it all screen to screen.”

“At some deep level, people are people, and so I believe passionately that there is no difference between leading now and leading then. What I certainly believe is that anybody who is leading a sizable institution who doesn’t do what I did and take a year off and read or what have you, and who doesn’t embrace the new technology with youthful joy and glee, is out of business.”

This last is 100% consistent with the quote from another McKinsey Quarterly issue I used in Management for the Next 50 Years:

“Those who understand the depth, breadth, and radical nature of the change and opportunity that’s on the way will be best able to reset their intuitions accordingly, shape this new world, and thrive.”

Do you agree?

Leaders of internal audit should never be satisfied

September 12, 2014 7 comments

If you think you are world-class, it is time for you to consider change.

Our organizations and the risks they face are changing constantly and the pace of change is increasing.

Jack Welch once said: “If the rate of change on the outside exceeds the rate of change on the inside, the end is in sight.”

We should never be satisfied with where we are today, as this represents a risk that we will not be sufficiently agile to deal with risks tomorrow.

Here are a couple of excerpts from my book, World-Class-Internal Audit: Tales from my Journey. The first is on the need for change:

OK, you and your team have been recognized as adding huge value and being world-class.

Do you stop there, confident and happy in your success?

No. What is world-class for your organization today may be insufficient for tomorrow.

The CAE should have a thirst for change and growth. Learn not only from other internal audit leaders and what they do well. Learn from leaders of other organizations entirely, like Marketing and Sales.

I like to read magazines like Fast Company because they profile innovative and creative thinkers in all walks of life. Maybe what works for them could, with some tailoring, work for me. At least it might stimulate me to think about something I had never thought about before. It might stimulate me to challenge what had worked for me in the past.

Innovative leaders think outside the box. They create something that excels and they love it. They love it so much it becomes a box for them and limits their ability to discard it in favor of something new.

We should not only think out of the box, but stay out of the box, and kick it as soon as somebody builds one.

This is what I had to say about the future of internal audit:

Internal audit has made great strides since I first became a CAE in 1990.

We have moved the edge of the practice from controls auditing to assurance over governance, risk, and control processes.

The majority of CAEs now report directly to the audit committee with functional reporting to at least the CFO if not the CEO.

But that leading edge is a thin one.

Far too few internal audit departments assess and provide assurance on the effectiveness of risk management.

Even fewer consider the risks of failures in governance programs and processes and include related engagements in their audit plan.

As I travel around the world, talking to internal auditors from Malaysia to Ottawa, I find a consistent pattern of growth. But, there remain pockets where the internal auditor is only there so that management can “check the box”. This seems especially true in government (from local to national), where internal audit departments are upgraded or disbanded based on politics – a concept I find abhorrent in what should be an independent and objective function.

Part of the problem is that audit committees don’t understand the potential of internal audit – and too many CAEs are not educating them. So, they don’t demand more and too many CAEs are satisfied doing what is expected without trying to change and upgrade those expectations.

Still, I expect that internal auditing practices will continue to improve. Organizations need them, as PwC says, to move to the “next platform” and provide assurance that is not just about what used to be the risks, but what they are now and will be in the near future.

Our business environment is becoming more complex, more dynamic, and changing at an accelerating speed. I expect that internal audit leaders will risk to the challenge.

Those that do will create a competitive advantage for their organizations.

Does your internal audit department need to change? Is it able to deliver world-class products and services that represent a competitive advantage for the organization? Do you help them increase the likelihood and scale of success?

Are you ready to adapt to tomorrow’s challenges?

I welcome your comments.

Dynamic, iterative, and responsive to change

August 23, 2014 4 comments

One of the principles for effective risk management in the ISO 31000:2009 global risk management standard is that risk management should be “dynamic, iterative, and responsive to change”.

I really like that. It captures a number of key ingredients for the effective management of uncertainty and risk.

Dynamic” implies that risk management operates at the speed of the business. It is far more than the occasional, even if regular, assessment of a list of so-called top risks. “Dynamic” is when the consideration and management of risk is part of the fabric of the organization, and an element in daily decision-making and operations of the organization. It is active and essential.

Iterative” is about a reliable set of processes and systems for identifying, assessing, evaluating, and treating risk. It means that when management makes decisions, based in part on risk information, there are proven processes and the information is reliable.

Finally, “responsive to change” is essential when risk changes at speed. Every day there is a potential surprise, a new or changed situation to which the organization should at least consider responding. It could be a shift in exchange rates, a change in the government of a nation where you do business, a flood that affects the supply of a critical component, the decision in a court case that affects you directly (because you are a party) or indirectly (because it creates a new interpretation of a regulation with which you must comply), the loss of a key customer, a new product from a competitor, the loss of a key employee, or so on.

Stuff happens and it changes or creates risk.

The organization must be responsive to change, nimble and agile in modifying strategy and execution.

All of this applies not only to risk management but also to internal audit (and to finance and the rest of the organization, in truth).

Is your internal audit function “dynamic, iterative, and responsive to change“?

For that matter, do IT, Finance, Operations, and so on meet the principle behind that phrase?

Or are they slow, scattered, and stubbornly reluctant to change?

Is that a risk to which we must respond?

I welcome your comments.

Where is internal audit world-class?

August 17, 2014 20 comments

A conversation I just had with Michael Corcoran left me wondering which companies have now or in the past had what one might consider “world-class” internal audit departments?

My personal view is that the CAE is the last person to say his or her internal audit department should be considered world-class.

Instead, that should only be awarded by members of the audit committee or top executives (although I am not sure I would give as much credence to the opinion of a CFO who wants IA to focus on financial and compliance risks).

I would allow members of the audit team to make the award based on what they hear from senior operational executives.

As a former CAE, I am going to hold to my word and not name any of my prior teams. If they want, they can speak for themselves.

So, please use the comments to identify the IA departments you think are world-class and why.

SEC and SOX plus COSO 2013 News

August 16, 2014 4 comments

I want to share two situations/reports. The first relates to SOX, the second to COSO 2013.

 

SEC Charges SOX 302 Violation

On July 30th, the SEC published a press release “SEC Charges Company CEO and Former CFO With Hiding Internal Controls Deficiencies and Violating Sarbanes-Oxley Requirements”.

Here are the key points in the SEC’s remarks:

The Sarbanes-Oxley Act of 2002 requires a management’s report on internal controls over financial reporting to be included in a company’s annual report.  The CEO and CFO must sign certifications confirming they’ve disclosed all significant deficiencies to the outside auditors, reviewed the annual report, and attest to its accuracy.

The SEC’s Enforcement Division alleges that CEO Marc Sherman and former CFO Edward L. Cummings represented in a management’s report accompanying the fiscal year 2008 annual report for QSGI Inc. that Sherman participated in management’s assessment of the internal controls.  However, Sherman did not actually participate.  The Enforcement Division further alleges that Sherman and Cummings each certified that they had disclosed all significant deficiencies in internal controls to the outside auditors.  On the contrary, Sherman and Cummings misled the auditors – chiefly by withholding that inadequate inventory controls existed within the company’s Minnesota operations.  They also withheld from auditors and investors that Sherman was directing and Cummings participating in a series of maneuvers to accelerate the recognition of certain inventory and accounts receivables in QSGI’s books and records by up to a week at a time.  The improper accounting maneuvers, which rendered QSGI’s books and records inaccurate, were performed in order to maximize the amount of money that QSGI could borrow from its chief creditor.

According to the SEC’s orders, Sherman and Cummings signed a Form 10-K and Sherman signed a Form 10-K/A each containing the false management’s report on internal controls over financial reporting.  And each signed certifications required under Section 302 of the Sarbanes-Oxley Act in which they falsely represented that they had evaluated the report and disclosed all significant deficiencies to the auditors.

What is new is that the executives were found to have violated not only the annual Section 404 requirement that the SOX compliance program is generally focused on, but the quarterly Section 302 certification process.

I have been warning, in both my SOX book for the IIA and in my training classes that ‘one of these days’ somebody would be charged with a Section 302 certification violation. In my conversations with the SEC when I was writing my SOX book for the IIA, they indicated that Section 302 violation was a future rather than a current focus.

But here they are now.

In the Section 302 certification, the CEO and CFO personally sign, and therefore are liable, that the following statements are true:

“The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and ICFR (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

  • Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
  • Designed such internal control over financial reporting, or caused such ICFR to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
  • Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
  • Disclosed in this report any change in the registrant’s ICFR that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

“The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

  • All significant deficiencies and material weaknesses in the design or operation of ICFR which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
  • Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.”

In the book, I say:

“…. prudence suggests that management:

  • Has a reasonably formal, documented process for making the quarterly assessment that is included in the 10-Q and supports the Section 302 certifications.
    • This can be included in the activities of the company’s disclosure committee, which most of the larger companies have established.
    • The process should include the assessment of all internal control deficiencies known to management, including those identified not only during management’s assessment process but also by either the external auditors in their Sarbanes-Oxley work or by internal audit in its various audit activities.
    • The system of ICFR must provide reasonable assurance with respect to the quarterly financial statements and the annual statements. The quarterly assessment is against a lower — typically one quarter the size — determination of what constitutes “material”.
    • The process and results should be reviewed and discussed with the CEO and CFO to support their Section 302 certifications.
  • Confirms that the external auditors do not disagree with management’s quarterly assessment.
  • Understands ― which requires an appropriate process to gather the necessary information ― whether there have been any major changes in the system of internal control during the quarter. A major change can include improvements and degradations in the system of internal control. While Section 302 only requires the disclosure in the 10-Q of a material weakness and the communication to the audit committee of a material or significant deficiency, the correction of a significant deficiency may be considered a major change and, if so, should be disclosed.”

Question: Have you discussed with and obtained guidance from your legal team whether a potential material weakness identified by your periodic SOX testing means that the CEO and CFO should not say, in their current quarter Section 302 certification, that the disclosure controls are effective?

 

Mapping of Controls to COSO 2013 Principles is Wrong

I am still trying to get information on what the major auditing firms are telling clients about COSO 2013.

I was able to get on a call with a Deloitte practice partner and one of the SOX/COSO leaders in the Deloitte head office.

It was refreshing to hear that they understand that the top-down and risk-based approach mandated by PCAOB Auditing Standard Number 5 remains at the heart of the firm’s approach.

The head office leader made a comment that I like very much.

She said that many registrants are trying to map all their (key) controls from 2013 to one or more of the COSO principles.

This is wrong.

There is no such requirement, nor is it useful.

What is needed is to demonstrate which controls are being relied upon to support management’s determination whether the principles are achieved.

I cover this in detail in the SOX book and in my SOX Master Class training. Basically, my approach is to determine how a failure to achieve a principle might raise the level of risk of a material error or omission above acceptable levels; we then identify the key controls that will be relied upon to address such risks. Where the risk is assessed as low, management’s self-assessment of the controls may be sufficient.

Unfortunately, I know of at least one Deloitte senior manager who doesn’t understand.

I wonder how many other external audit teams are ‘requiring’ that companies do more than is necessary.

Please share through comments or private email to me at nmarks2@yahoo.com.

 

I welcome your insights and observations.

World-Class Internal Audit

August 13, 2014 4 comments

Over the years, I have had the privilege of leading world-class internal auditors – world-class people who deliver world-class internal audit services to our customers on the board and in management.

I hesitate to call the teams I have led world-class. There has always been room for improvement.

But our customers and peers have called us world-class. For example, executives and audit committee members have said:

  • “Internal audit provides us with a competitive advantage”
  • “You have yet to perform an audit I wouldn’t gladly pay for”
  • “You help the audit committee sleep through the night”
  • “You are not a typical internal auditor”

When Arthur Andersen (and then Protiviti with KnowledgeLeader) built their on-line repository of best practices, ours was the first internal audit function profiled.

Now that I am retired (even if still busy), I have found the time to collect stories from my professional life in a new book: World-Class Internal Audit: Tales from my Journey (see below for links to the book). These are stories about experiences that have shaped me as a leader as well as how I approach internal audit.

World-Class Internal Audit

My hope is that the book will not only be an easy and entertaining read, but my successes and failures, together with my reflections, will help you as you consider your own career.

Some stories are, I hope, amusing. Some are about learning experiences (i.e., mistakes and embarrassments) from which I grew.

I have also included comments and observations from members of my teams, some of whom followed me as I moved to other companies. For example, a current chief audit executive who worked with me at two different companies had this to say:

“Norman had a unique leadership philosophy where he adapted to the demands of the situation, the abilities of the staff and the needs of the organization. He was able to move between leadership styles utilizing the one needed for the challenges that the company was facing. He was at times visionary along with a coaching emphasis while not micromanaging. Norman set high standards, was democratic but occasionally would utilize a classic authoritarian style when needed with certain employees and situations. Norman moved easily between leadership styles which resulted in developing World Class departments. As the Chief Audit Executive for a semiconductor company I still consult Norman on various audit topics and practice leadership techniques I learned under his tutelage.”

The book is available in paperback (or on Amazon) or as an e-book (Kindle).

Here’s one of the stories in Chapter 5 on the topic of “the value of writing and teaching”. The ‘David’ referred to was my boss at Coopers, David Clark.

My next adventure took me into a new and smaller world: the world of microprocessors.

People I knew were buying do-it-yourself microcomputer ‘kits’ from mail order stores, and the technical computing journals were starting to hint that these devices had the potential to move from a hobby to a business tool. In 1974, a company called Zilog was founded and in 1976 they introduced the Z80, an 8-bit microprocessor that was a significant advance from the early Intel 8080 model. The Z80 allowed more powerful devices and the military, in particular, used it extensively. The Z80 powered early business computers, such as the Osborne, Kaypro, Xerox 820, Radio Shack TRS 80, and Amstrad. I purchased a Radio Shack TRS 80 Model II a little later – but that’s another story.

I believed in the potential and wanted to share that vision with the rest of CAG. After obtaining materials directly from Zilog and accumulating a number of pieces from journals, I started to write. I was smart enough to include diagrams, but not smart enough to please David with the initial drafts of my paper.

After I had exhausted my patience and wanted to give up, and David had nearly exhausted his patience with me, he gave me two pieces of sage advice:

  1. Tell him (in person) why this is important. Say it and then write what you said. As you are saying it, learn from the listener (David) how to express your thoughts in a way that will be understood – and learn what not to say because it will not be understood.
  2. Avoid technical language and use ordinary English where possible. If you have to be technical, explain the terms clearly so that the non-technical person will understand.

I ended up writing a much longer piece, but it worked. While not everybody would share my opinion of the potential, everybody understood what I was talking about.

Later that year, I was asked to be one of the teachers at the off-site training session for people joining CAG. This was a wonderful learning experience for me. The task of teaching meant that I had to master the fundamentals of what I needed to teach. It was also essential that I avoided technical language when plain English could be used – and that I explain the technical in easy-to-absorb-and retain terms.

This set of experiences led me to require all of my staff to:

  • Write and speak for the people who are listening, the people you are trying to influence, inform, or persuade
  • Write and say what they need to hear, rather than what you want to say
  • Use language they understand. If they don’t start with a decent understanding of the topic, explain any technical terms in ways they can understand
  • Give examples and use diagrams; they are of great value in expressing ideas, especially to those who are visually oriented (i.e., absorb concepts from seeing better than they do by reading). I became used to getting up and using a chalkboard to diagram and explain what I was trying to communicate
  • Master the fundamentals: you won’t get far explaining anything unless you have deep understanding of the topic yourself

I hope you enjoy this story and consider the book.

Advancing the Practice of Internal Audit

August 9, 2014 17 comments

As I mentioned earlier, I was honored to be a member of the Re-Look Task Force that has proposed changes to the IIA’s standards framework (IPPF).

One of the changes is to introduce Core Principles for the Professional Practice of Internal Auditing.

The first nine are “motherhood and apple pie” restatements of what I hope we all know are necessary attributes of internal auditing, such as our integrity, resources, and ability to communicate. They are important to restate because although they may be obviously necessary, they are not all always present in practice.

For example, I continue to meet CAEs who don’t have sufficient resources to address more than a handful of critical risks. The last has been charged with all the SOX work without being given the resources necessary to provide both his core internal audit assurance work and the consulting services necessary to manage the SOX program.

The three that I think will help advance the professional practice of internal auditing are the last three on the list (which should be the first three).

10. Provides reliable assurance to those charged with governance.

11. Is insightful, proactive, and future-focused.

12. Promotes positive change.

What is “assurance”? Our stakeholders need to know if the processes for governance, management of risk, and the related controls can be relied upon to manage critical risks at acceptable levels: whether they will enable the organization to take the right risks with confidence and achieve or surpass objectives.

They need our professional opinion.

I hope this principle will advance the practice of providing such an opinion, a formal one, to the board and top management.

A list of deficiencies is not assurance.

#11 is very interesting. Surveys continue to tell us that our stakeholders on the board and in executive management want more from us. In addition to focusing on the right risks (a deficiency in our practice according to recent PwC and KPMG surveys), they value our insight – what we can tell them about management processes and practices beyond what we might put in the audit report.

Our traditional role is to report on what has happened (and gone wrong) in the past – hindsight. We should instead help our organizations, their executive team and board, manage into the future.

This means moving from hindsight to foresight with insight into current and foreseeable conditions.

We should be proactive in looking at changes in business systems and processes, organizational structures and staffing, and more – providing consulting services to help ensure our future is one with adequate management of risk, including security and controls.

The great Canadian ice hockey player, Wayne Gretzky, was asked “what is the secret of your success?” His answer:

“I skate to where the puck is going to be

We need to audit where the risk is going to be.

The last talks about the need to do more than make a recommendation and let management respond. We need to promote positive change. I ask that you read and comment on my article in the August issue of the Internal Auditor magazine on “The Internal Audit Evangelist”.

In another article in the same issue, the author talks about his department achieving an acceptance rate of 84% on its recommendations. Management accepted and implemented 84% of internal audit ratings.

My comment?

That is a 16% failure rate!

Where is the value when management only occasionally listens to us?

How will management see us if we frequently are unable to see business risks and needs in the same light as they see them?

There is zero value in recommendations.

There is only value in positive change.

We should work with management to ensure we agree on the facts, agree on the risk to objectives (specifying which are at risk), agree on whether that risk should be accepted or treated, and then agree and help them determine the best path forward.

If the great majority of internal audit departments are able to say that:

  1. We provide our stakeholders with the assurance they need to manage and direct the organization with confidence
  2. We provide insight into current conditions and our work is focused on the risks that will face the organization as it moves forward, and
  3. We work with management to effect positive change

the professional practice of internal audit will be one worthy of pride.

I welcome your thoughts and comments.

Updating the IIA Standards

August 7, 2014 3 comments

The IIA is asking for its members’ opinion on a set of proposed changes to the framework for its Standards (the IPPF). The detailed Standards are not changing, but the proposed changes are significant and merit every audit professional’s attention.

The proposal was crafted by a select group of practitioners called the “Re-Look Task Force”, and I was privileged to be a member.

The proposal explains the recommended changes and asks a number of questions to elicit members’ opinions and suggestions for improvement.

I encourage all IIA members across the world to read the proposal carefully and provide your input.

You should receive a copy of the proposal from your institute. You can also download it from either the IIA Global or IIA North America web site. In addition, Hal Garyn, a Vice President with The IIA, has recorded a video (http://auditchannel.tv/video/1321/The-IPPF-Is-Evolving-How-You-Can-Help).

I want to share my perspective on the changes, hoping that might be useful to you.

The proposal represents the consensus view. While there were, in a few cases, disagreements among the task force members, those disagreements were minor. The questions we included are designed to address those issues.

The task force discussed whether it was time to make a change to the Definition of Internal Auditing. Quite a few changes were suggested, but in my view they were only tinkering with the words and not changing the underlying message: that ours is an assurance activity (in my opinion this is our primary mission) that also helps our organizations succeed through consulting/advisory services that contribute to the improvement of governance, risk management, and related control processes.

We talked about changing “consulting” to “advisory”. We talked about ways to make the wording more succinct.

But in the end, it was tinkering and we recognized a change could lead to issues where the Definition has been incorporated into other standards, corporate governance codes, and so on.

I think the right decision was made, to leave the Definition unchanged.

We also talked about the Standards being “principle-based” rather than “rule-based”. If so, what are the principles?

Again, we spent a lot of time defining and then wordsmithing the principles.

I think the list included in the proposal is a good one. I will write separately about some of the principles and why I like them.

One of the questions is whether the principles are shown in the best order. This is one area where I was in the minority. While I see the logic of the proposed order, I would put the last three first as they represent what we are all about. The other nine are how we get there. You can share your opinion by answering a question on the order of the principles.

Although presented before the principles, the discussion of a mission came after.  I like it! It is short and sweet and captures the essence of the purpose and value of internal auditing.

I like the other suggestions for supplemental guidance, guidance on emerging issues, and local guidance. The last should be useful where local practices are in a different environment than in other countries. For example, I work with IIA chapters and institutes around the world and know that in some nations there are many family-owned corporations; in others there are a lot of government-owned for-profit companies. There will now be a place for local IIA organizations to craft guidance that addresses local issues in ways global guidance cannot.

If you haven’t already seen the proposal, please watch for it and if necessary check the IIA web site.

Feel free to share your thought here for discussion.

More Poor Guidance on COSO 2013

July 30, 2014 2 comments

I continue to be concerned that accounting firms are providing poor guidance to their clients and other organizations.

Let’s look at new guidance from PwC’s Canadian firm, “What does it mean to me? Frequently asked questions about the COSO Updated Framework”.

PwC asks and provides their answers to a few questions, including:

Q: What might happen if my company does not update to the 2013 Framework?

A: There are indications that the SEC will take a close look at any company that doesn’t make this transition. We’re encouraging our clients to transition before December 15, 2014.

Norman: PwC fails to point out that this only applies to the SOX assessment of internal control over financial reporting for organizations subject to that compliance requirement. There is no requirement to adopt COSO 2013 for any other business objective.

Q: Are there new/updated requirements for effectiveness?

A: While the fundamental requirements haven’t changed, there’s greater clarity around what management should assess in determining effectiveness. The requirements are that:

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

Norman: I find it unforgiveable that PwC omits the first and most significant requirement: internal control is effective when it provides reasonable assurance that risk to objectives is at acceptable levels. Unforgiveable because this is the primary and overriding way to assess internal control; it comes ahead of the requirements relating to components and relevant principles in the COSO section on Effectiveness; and PwC really should get this right as they wrote the COSO 2013 update! (By the way, I give PwC kudos for pointing out that the “fundamental requirements have not changed”.)

Q: Isn’t this just a mapping exercise? Can’t you just use the template?

A: The mapping of controls based on the 1992 Original Framework to the updated 2013 Updated Framework is a key part of the transition. Many companies seem to think it’s just a mapping exercise and that there’s little they need to do to apply the update. We’ve heard of other organizations who think that because they had a clean certification last year, there won’t be any challenges this year. However, once they start this mapping, many companies are finding that updates are needed to their system of internal control. The mapping templates help draw this out, and management should expect some level of added effort to the update.

Norman: There is no requirement to map your controls from last year to the Principles. This is a creation of consultants.

The requirement is to demonstrate that the Principles are present and functioning, which will serve to demonstrate that the components are present and functioning and working together in an integrated manner.

I give credit to Deloitte for including this distinction in their firm’s internal training (according to the lady who runs it for them). Companies don’t need to take all their existing controls and map them to the new Principles. Instead, they need to identify the controls that satisfy the Principles.

I again give credit to Deloitte for training their people that there is no need to identify controls for every Point of Focus. The latter are provided to assist in addressing the Principles.

The other major problem, and this applies to every guidance I have seen on COSO 2013, is the failure to note that the requirement to assess internal control over financial reporting using a top-down and risk-based approach has not changed. This is mandated in Auditing Standard Number 5 (which has not been changed), included in the SEC’s Interpretive Guidance (which has not been changed), and strongly reinforced in the PCAOB’s Staff Alert 11 of October, 2013 (published after the release of COSO 2013).

The assessment of the Principles should be based on whether any gap represents what COSO calls a major deficiency: one which represents a significant risk to the achievement of the objective of reliable financial reporting to the SEC. Absent such a major deficiency, which basically translates to a material weakness, the Principles can be assessed as present and functioning. I haev confirmed this with COSO and several audit firm partners.

Finally, the mapping templates can be and generally are misused. When consideration of risk is not included, these templates are just checklists. This is why many organizations are warning against the checklist approach to COSO 2013 adopted by firms and registrants alike.

I like how the PCAOB Board Member Jeanette Franzel advised organizations to avoid the checklist approach and use the 2013 Update as an opportunity to revisit the system of internal control’s design, effectiveness, and efficiency.

I have talked to a number of PwC partners about the COSO 2013 update and its effect on SOX. They “get it” so this failure to talk about providing reasonable assurance that risk to objectives is at acceptable levels is not pervasive across PwC. I hope it is limited to this guidance.

These partners know that the assessment of effective internal control over financial reporting is still based on whether there are no material weaknesses. Translating this into COSO language: the objective is to file financial statements that are free of defect; the acceptable level of risk is that they do not contain any material errors or omissions; if there are no material weaknesses, then it should be possible to show that the principles are free of major deficiency and thus present and functioning.

I welcome your comments.

By the way, this is addressed in more detail in the guidance to management on SOX published by the IIA (written by me).

Understanding Governance Risks

July 14, 2014 4 comments

How many boards, let alone risk officers, think about the risks to their organization if the governance by the board and top management is ineffective?

Certainly, people talk about the potential for the wrong tone at the top. Frankly, I doubt that members of the board will be able to detect those situations where top executives talk a good game but walk to a different tune; where they put the interests of their pockets ahead of the reputation and long-term success of the organization; where they are prepared to take risks with the organization’s resources without risk to their own..

But governance risks extend well beyond that

Failures to have the time to question and obtain insight in how the organization actually works can leave the enterprise without effective risk management, information security, internal auditing, and more.

Failures to provide the board the information it needs when it needs leaves the directors blind, although they may think they can see.

The governance committee of the board should, in my opinion, consider risks related to governance processes every year. It should engage both the risk and internal audit teams to ensure a quality assessment is performed. Legal counsel should also be actively engaged as issues might have consequences if they are not handled well; for example, any assessment that the board has gaps in director knowledge, experience, or ability to challenge the executive team cannot be communicated outside the firm.

Do you agree? I welcome your comments.

How Good is your GRC? Twelve Questions to Guide Executives, Boards, and Practitioners

June 8, 2014 4 comments

Anyone who has been reading my posts should know that I have concerns about the way people are misusing the term GRC. In my April post, I closed with:

So here’s my recommendation to all: stop talking about GRC and start talking the language of the business. Let’s talk about how we can increase value to stakeholders, address potential obstacles and seize opportunities to excel, act with integrity and remain in compliance with current and anticipated regulations, and manage the organization to success.

So how do we move forward?

It is important to get each part of the business working well. But it is also important that they work together. We don’t want fragmented operations that operate in silos.

How can an organization’s board, executives, or internal auditors determine whether their different activities (such as strategy, performance, and risk management) are working together, in harmony, for the optimization of performance while acting with integrity?

I have a new e-book, How Good is your GRC? Twelve Questions to Guide Executives, Boards, and Practitioners. It consolidates my thinking about what GRC means and the business problem it represents (the failure to have the various pieces work together in harmony). I include twelve questions, with discussion, that you can use within your organization in a discussion or assessment process.

I welcome your thoughts and comments, and hope that you find the e-book useful.

By the way, if you don’t have a Kindle you can still read the e-book on your PC by downloading Amazon’s Kindle for PC.

The SOX State of the Nation

June 7, 2014 4 comments

Each of the last few years, Protiviti has conducted a survey to understand and then report on the state of SOX compliance programs. They recently published their 2014 Sarbanes-Oxley Compliance Report.

The Protiviti survey and analysis is interesting, useful, and valuable. If you contact them, they may be able to give you detail customized to your situation.

Not surprisingly, Protiviti has a major focus on how companies are adopting the 2013 update to the COSO Internal Controls – Integrated Framework.

I am surprised, as are the authors, that a large number of organizations “have yet to begin work on gaining an understanding of and implementing” COSO 2013. I join Protiviti in urging every organization subject to SOX to figure out their plan and discuss it with the external auditors a.s.a.p.

I am less surprised, even encouraged, that the majority of those who say they understand COSO 2013 are not anticipating a major increase in the level of work required for SOX compliance in 2014 and beyond. Here, I part ways with Protiviti who seem to believe that the external auditors will require organizations to do a lot more. That, in my opinion, would be a mistake.

Companies need to continue to take a top-down and risk-based approach to SOX, even in the face of COSO 2013, and this need not lead to an increase in the number of key controls included in scope (please see this post and the quotes from Jim DeLoach of Protiviti, Ray Purcell of Pfizer, and Marie Hollein of FEI).

For more on applying a top-down and risk-based approach (as required by PCAOB and SEC) to the COSO 2013 update, please see my May post on the topic. I cover it in detail in my SOX book for the IIA.

Protiviti reports that a large number of companies have, presumably with Audit Committee approval, asked the internal audit team to provide SOX project management and leadership. That is consistent with my reading of the market, from my SOX training classes and interactions on social media.

Protiviti did not address how many internal audit departments are performing SOX testing on behalf of management. My reading is that the majority of organizations is doing this, but in contrast with the early years of SOX now have sufficient resources to do both SOX testing and their normal internal audit work.

Protiviti also did not address the extent of external auditor reliance on management testing, especially where performed by internal audit. They pointed out that the PCAOB, in their October 2013 report, criticized the external audit firms for failing to document their reasons for assessing management testing to be sufficiently competent and objective for them to place reliance. Protiviti seems to assume that as the firms address this issue they will tend to reduce reliance on management testing. I fail to follow their logic.

I am pleased to report that I am now finding a number of companies where the external auditors are placing reliance on management testing for as much as 80% of the key controls work.

Another area where I tend to disagree with Protiviti is in the value of automating controls. Protiviti sees this as a significant opportunity, presumably because automated controls only need to be tested once instead of the multiple tests required of manual controls. But, this argument overlooks both the high cost of testing automated controls and the fact that they bring into scope more IT general controls risks.

However, overall Protiviti has continued to provide valuable insights into the state of SOX compliance and their report is a useful read.

I welcome your comments.

Reflections on the Third Line of Defense Model

May 23, 2014 14 comments

People are talking about the third line of defense model for internal audit.

–          The IIA has a Position Paper

–          KPMG wrote a paper

–          PwC has made its contribution

–          Protiviti extended the model to 5 lines of defense

–          Not to be left out, EY published a thoughtful piece

–          and Deloitte has a PowerPoint

I even did a webinar on the model (I don’t have link to the recording).

I think the model has some value in explaining how internal audit is not the primary player when it comes to risk or compliance – management is the primary player, assisted by organizations in the second line of defense such as the compliance function, physical security department, risk management, and so on – all part of management.

Internal audit can place some level of reliance on these “other assurance providers” in the second line of defense by assessing how well they monitor management performance of controls.

My problem with the model is that it is all about defense.

Organizations (and sports team) rarely succeed by only playing defense. (When the defense scores a touchdown, that is because they have become the offense after a turnover.)

Organizations (and sports teams) win through a combination of offense, defense, and (perhaps) special teams.

Internal audit can and should have a key role in all three elements of the business game: offense, defense, and special teams.

Internal audit exists not only to protect value, but to help organizations create value.

Too much focus on the Third Line of Defense model relegates us to the traditional policeman role, and sitting on the bench when the offense is on the field.

I welcome your comments.