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Coso 2013 Internal Control Over External Financial Reporting - Integrate 1 PDF
Coso 2013 Internal Control Over External Financial Reporting - Integrate 1 PDF
C o m m i t t e e o f S p o n s o r i n g O r g a n i z a t i o n s o f t h e T r e a d w a y C o m m i s s i o n
May 2013
This project was commissioned by COSO, which is dedicated to providing thought lead-
ership through the development of comprehensive frameworks and guidance on internal
control, enterprise risk management, and fraud deterrence designed to improve organi-
zational performance and oversight and to reduce the extent of fraud in organizations.
COSO is a private sector initiative, jointly sponsored and funded by:
978-1-93735-241-7
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Co m m it te e o f S p o n s o r in g O rgani z ati o ns o f the Tre adway Co mmi ssi o n
C o m m i t t e e o f S p o n s o r i n g O r g a n i z a t i o n s o f t h e T r e a d w a y C o m m i s s i o n
May 2013
Committee of Sponsoring Organizations of
the Treadway Commission
Board Members
David L. Landsittel Mark S. Beasley Richard F. Chambers
COSO Chair Douglas F. Prawitt The Institute of Internal Auditors
American Accounting Association
PwC—Author
Principal Contributors
Miles E.A. Everson Stephen E. Soske J. Aaron Garcia
Engagement Leader Project Lead Partner Project Lead Director
New York, USA Boston, USA San Diego, USA
Sallie Jo Perraglia
Manager
New York, USA
Advisory Council
Members at Large
Jennifer Burns James DeLoach Trent Gazzaway
Deloitte Protiviti Grant Thornton
Partner Managing Director Partner
1. Introduction............................................................................................................1
2. Control Environment............................................................................................. 13
3. Risk Assessment..................................................................................................49
4. Control Activities..................................................................................................79
Appendices
In the twenty years since the release of the original framework, business and operating
environments have changed dramatically, becoming increasingly complex, technologi-
cally driven, and global. At the same time, stakeholders have become more engaged,
seeking greater transparency and accountability for the integrity of systems of inter-
nal control that support business decisions and governance of the organization. The
Framework and the Compendium incorporate many of these changes including:
The Compendium provides practical approaches and examples that illustrate how the
components and principles set forth in the Framework can be applied in preparing
external financial statements. It neither replaces nor modifies the Framework; rather,
it is a supplemental document that can be used in concert with the Framework when
considering internal control over external financial reporting.
Finally, the COSO Board would like to thank PwC and the Advisory Council for their
contributions in developing the Compendium. Their full consideration of input provided
by many stakeholders and their attention to detail were instrumental in ensuring that the
Compendium will be helpful to a variety of organizations in applying the Framework to
internal control over external financial reporting.
David L. Landsittel
COSO Chair
•• Other external financial reporting derived from an entity’s financial and accounting
books and records
Intended Audience
The Compendium has been developed to assist those users of the Framework who are
responsible for designing, implementing, and conducting a system of internal control
over external financial reporting (ICEFR) that supports the preparation of financial state-
ments and other external financial reporting. It is also relevant to entities that report on
the effectiveness of a system of internal control over external financial reporting relating
to the preparation of financial statements. The preparation of financial statements for
external purposes and other external financial reporting applies to the following types of
entities:
•• Approaches describe how organizations may apply these principles within their
system of internal control over external financial reporting. Approaches are
designed to give users of the Compendium a summary-level description of activi-
ties that management may consider as they apply the Framework in an ICEFR
context.
Finally, the Compendium includes an index to all the examples, by topic, in Appendix
A, organized by topics relating to the changes in business and operating environments
noted in the Foreword to the Framework.
Limitations of Illustrations
The approaches and examples do not attempt to illustrate all aspects of the compo-
nents and relevant principles necessary for effective internal control relating to external
financial reporting objectives. Further, they are not sufficient to enable an organization
to determine that each of the five components and relevant principles is present and
functioning. Instead, the approaches and examples are intended to illustrate how prin-
ciples may be present and functioning.
The approaches and examples are samples of activities for management to consider,
rather than a complete or authoritative list. The components, principles, and definitions
illustrated in the Compendium are consistent with those found in the Framework, and
readers should refer to the Framework for a comprehensive discussion of how entities
design, implement, and conduct a system of internal control, and for the requirements
of effective internal control.
1 The Framework uses the terms “present and functioning” with respect to principles and components, and
“selects, develops, and deploys” with respect to controls to effect principles.
Another form of financial statements prepared for external purposes may be finan-
cial reports prepared in accordance with a special purpose framework, such as those
established by taxing authorities or regulatory agencies, or those required through
contracts and agreements. These financial reports are typically distributed to specified
external users (e.g., reporting to a bank on financial covenants established in a loan
agreement, reporting to a taxing authority in connection with filing tax returns, reporting
on financial information to an energy regulatory commission).
2 Applicable accounting standards, rules, and regulations may include accounting principles generally ac-
cepted in the US (US GAAP), International Financial Reporting Standards (IFRS), Securities and Exchange
Commission rules for disclosure, and others.
For example, a company that must comply with the classification criteria established by
the United States Securities Exchange Commission (SEC) would use only the defini-
tions and guidance set out for classifying internal control deficiencies as a material
weakness, significant deficiency, or control deficiency.3 If an internal control deficiency
is determined to rise to the level of a material weakness, the organization would not
be able to conclude that the entity’s system of internal control over financial reporting
has met the requirements for effective internal control as set out in the Framework. If
an internal control deficiency does not rise to the level of material weakness the entity
could achieve effective internal control over financial reporting.
Within the boundaries established by laws, rules, regulations, and standards, manage-
ment exercises judgment to assess the severity of an internal control deficiency, or
combination of deficiencies, in determining whether components are present, function-
ing, and operating together, and ultimately in concluding that the entity’s system of
internal control is effective.
3 For the purposes of the Compendium, approaches and examples use the term “material weakness” as
defined by the Securities Exchange Commission in the United States in the Securities Exchange Act of
1934 Rule 12b-2 [17 CFR 240.12b-2]. “Material weakness” means a deficiency, or a combination of defi-
ciencies, in internal control over financial reporting such that there is a reasonable possibility that a material
misstatement of the registrant’s annual or interim financial statements will not be prevented or detected on
a timely basis.
Further, management assesses and affirms the suitability of the accounting principles to
apply to transactions and events of the entity. For example, management specifies that
FASB Accounting Standard Codification Topic 605 Revenue Recognition and SAB 101A
Revenue Recognition in Financial Statements (US GAAP) or IAS 18 Revenue Recogni-
tion (IFRS) applies to all sales transactions as applicable to achieve the entity or sub-
units’ respective external financial reporting objective.
Considers Materiality
Financial statement materiality sets the threshold for determining whether a financial
amount is relevant. Entities must consider suitable laws, rules, regulations, and stan-
dards promulgated by regulators and standard setters.5
4 The United States Securities and Exchange Commission (SEC) “Commission Guidance Regarding
Management’s Report on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the
Securities Exchange Act of 1934” states that “Management is responsible for maintaining a system of
internal control over financial reporting (‘ICFR’) that provides reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external purposes in accordance with
generally accepted accounting principles.”
5 For example, the SEC issued Topic 1M of the Staff Accounting Bulletins to provide guidance on assess-
ing materiality and immaterial misstatements that are intentional. The International Accounting Standards
Board provides a definition of materiality in paragraph QC11 of the “Conceptual framework for financial
reporting 2010.”
•• Rights and Obligations—Assets are the rights and liabilities are the obligations of
the entity at a given date.
For example, management specifies sub-objectives for sales transactions that address
relevant financial statement assertions such as:
•• Presentation and disclosures relating to sales are properly described, sorted, and
classified.
6 These financial statement assertions are substantially consistent with those described in the standards of
the American Institute of Certified Public Accountants, the Public Company Accounting Oversight Board,
and the International Auditing and Assurance Standards Board.
Management’s assessment of such risks involves a dynamic and iterative process. The
initial assessment undertaken by management likely requires a comprehensive effort to
identify and analyze the risk of not preventing or detecting, in a timely manner, a mate-
rial omission within or misstatement of the entity’s financial statements. The nature and
frequency of performing ongoing and periodic risk assessments vary among entities,
based on individual facts and circumstances.
Even though every entity requires a process to identify and assess the external and
internal factors that contribute to the risk of achieving its objectives, specific changes
and rates of changes in these factors (including those that could significantly impact
internal control over external financial reporting) vary from entity to entity. For example,
different entities and subunits may:
Additionally, the size and complexity of the entity play a part in determining the nature
and frequency of the risk assessment process. Large, complex organizations may
require dedicated cross-functional and cross-territorial management and other person-
nel with necessary expertise to perform comprehensive risk assessments. Management
of smaller entities may be able to perform its risk assessment through direct supervision
and day-to-day involvement in operations.
As part of the risk assessment process, the organization identifies the various ways that
fraudulent financial reporting can occur, considering:
•• Degree of estimates and judgments underlying the accounting for and disclosure
of transactions and events
•• Fraud schemes and scenarios common to the industry sectors and markets in
which the entity operates
Also, as part of the risk assessment process, the organization identifies risks pertaining
to the completeness and accuracy of recording any material misappropriation of assets.
Misstatements may arise from failing to record the material loss of assets or manipulat-
ing the financial statements to conceal such a loss.
Management Override
“Management override” refers to actions taken by management in an attempt to over-
ride the entity’s controls for an illegitimate purpose such as personal gain or to enhance
the presentation or disclosure of the entity’s financial condition or results of operation.
As part of its assessment of fraud risk, management considers the risk of management
override of internal control. The board of directors or subset of the board (e.g., audit
committee) oversees this assessment and challenges management when warranted.
The entity’s control environment can significantly influence the risk of management
override. The risk of management override is especially relevant for smaller entities
where senior management is typically selecting, developing, and deploying controls to
effect principles.
•• Sales commissions or agents’ fees that appear excessive in relation to those nor-
mally paid or the services actually received
Management also considers possible corruption occurring within the entity. Corruption
is generally relevant to the compliance category of objectives but could influence the
control environment that affects achievement of the entity’s external financial reporting
objectives. This includes considering the incentives and pressures across the organiza-
tion to achieve the entity’s external financial reporting objectives while demonstrating
adherence to the expected standards of conduct and the effect of the control environ-
ment, specifically actions linked to Principle 4 (Demonstrates Commitment to Compe-
tence) and Principle 5 (Enforces Accountability). Aspects of corruption typically relate
to illegal acts that are considered in government statutes relevant to external financial
reporting.
In assessing possible corruption, the entity is not expected to directly manage the
actions of personnel within external parties, including those relating to outsourced
service providers and other parties interacting with the entity. However, depending on
the level of risk assessed, management may stipulate the expected level of performance
and standards of conduct through contractual relations, and develop controls that
maintain oversight of third-party actions. Where necessary, management responds to
detected unusual actions of others.
Risk Response
When preparing financial statements for external purposes management exercises judg-
ment in complying with external financial reporting requirements. Management consid-
ers how risks of material omission and misstatement should be managed across the
entity. Management selects, develops, and deploys controls to effect principles within
•• Competency of the personnel responsible for internal control over external finan-
cial reporting
Further, management may enhance the efficiency in the design, implementation, and
conduct of a system of internal control over external financial reporting by, for instance,
acknowledging the following;
•• Focusing on those areas of risk that exceed acceptance levels and need to be
managed across the entity may reduce efforts spent mitigating risks in areas of
lesser significance.
•• Coordinating efforts for managing risks across multiple objectives may reduce the
number of discrete, layered-on controls.
Smaller Entities
The principles underlying the components of internal control apply to entities of all
types and sizes. However, smaller entities may apply these principles using different
approaches. For example, all public companies have boards of directors or other similar
governing bodies with oversight responsibilities relating to the entity’s external financial
reporting. A smaller entity may have a less complex business model, organizational
and legal structure, and operations, and more frequent communication with directors,
enabling greater reliance on board oversight for achieving effective internal control.
Documentation
Two levels of documentation should be considered in relation to financial statements for
external purposes:
For each approach, one or more examples are provided to illustrate how an important
aspect has been put in place by entities that prepare financial statements for external
purposes. The examples are based on actual experiences of entities, although some
details have been modified for the purposes of this publication (e.g., entity and personal
names are fictional and should not be attributed to any specific entity). The examples
are not intended to be construed as “best practices” or suggested solutions for users of
the Framework. Further, the examples are not necessarily sufficient to demonstrate that
a particular principle is present and functioning as defined in the Framework.
These approaches and examples are likely to be relevant to many types of entities
(whether public, private, not-for-profit, or governmental) that aim to prepare financial
statements for external purposes and other forms of external financial reporting. Where
an example does not apply to all types of entities, this is noted. Finally, even though the
approaches and examples primarily relate to preparing financial statements for external
purposes, any entity seeking to design, implement, and conduct a system of internal
control to achieve other external financial reporting objectives may find them beneficial.
2. Control Environment
Chapter Summary
Principles Approaches
Principles Approaches
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
•• Sets the Tone at the Top—The board of directors and management at all levels of
the organization demonstrate through their directives, actions, and behavior the
importance of integrity and ethical values to support the functioning of the system
of internal control.
7 The term “organization” is used to collectively capture the board of directors, management, and other
entity personnel as reflected in the definition of internal control.
•• Setting the expectation that personnel raise issues or questions relating to the
application of the defined standards
•• Making explicit the consequences for deviations from standards of conduct at any
level in the organization
•• Ensuring that new and existing employees are trained on the entity’s standards
of conduct and continuing education, and providing appropriate briefings to third
parties engaging in business with the company
•• Providing staff with ethics training opportunities to ensure that all employees have
the knowledge to identify and deal with dilemmas
Furthermore, Zanzibar Co. provides a supplier code of conduct to its vendors as part
of its service-level agreements, which provide a basis for evaluation alongside product/
service delivery evaluation.
Senior management and the board of directors annually review and discuss any
changes needed to the code or how it is administered, considering external and internal
factors, including the coverage of the company’s key risk areas, any known compliance
issues, and results of monitoring activities. For instance, over time, Zanzibar Co. has
added provisions to address new, applicable laws and has provided more guidance on
what constitutes an appropriate gift or entertainment.
•• Day-to-day actions and decision making at all levels of the organization that are
consistent with the expected standards of conduct
•• Interactions with suppliers, customers, and other external parties that reflect fair
and honest dealings
•• Timely inquiries and investigations into any alleged conduct that is inconsistent
with the entity’s standards of conduct
While this approach can be synonymous with that of establishing standards of conduct
when both operate effectively, history has shown instances where organizations define
and communicate honorable standards of conduct, yet management does not internal-
ize or exhibit these standards in its conduct, and therefore sets a different tone than
what is expected.
consequences of violations of the code. The newsletter draws attention to the multitude
of resources available to discuss and resolve ethical issues; it also reports what actions
are taken by senior management when the code is violated at any level of the organiza-
tion. The newsletter illustrates the open dialogue and resolution of issues that is actively
promoted by senior management.
Examples of ethical dilemmas are provided, along with suggested resolutions. The
newsletter points out that reports of violations originate from a variety of sources,
including employees, managers, the company’s anonymous hotline, and external
parties. Responses range from no action (in cases where the violation is shown not to
have occurred) to various levels of discipline, including dismissal.
Finally, the newsletter reminds all Aerospacial S.A. employees—from senior manage-
ment to entry-level—that as part of their annual performance review they must certify
that they have read the company’s mission statement and code of conduct and that
they comply with policies at all times.
•• Considering the results from ongoing and separate evaluations of internal control,
which include evaluations of internal control at outsourced service providers and
business partners who provide information necessary to produce external finan-
cial reporting
•• Analyzing issues and trends from hotlines and help lines made available within
the organization that could indicate potential fraud occurrences and other
ethical concerns
•• Requesting feedback from meetings held with outsourced service providers and
business partners when obtaining financial information or information that impacts
the entity’s internal control over external financial reporting
IT service provider. The standards consist of three documents: the code of ethics and
standards of personal conduct, the compliance policy statement, and the expected
standards of conduct.
•• When applicable, assessing the financial statement impact and determining what
internal controls over external financial reporting may have failed to detect the
matter
•• Identifying and communicating with anyone under investigation (or after thorough
investigation in instances of alleged fraud), and following up on any corrective
actions taken to remedy the matter in a consistent and timely basis and according
to prescribed company guidelines
•• Informing the board of deviations in the application of the standards and any
waivers that may have been granted or that are being considered
•• Determining how and when the violation will be communicated and if it will be
made public
•• Depending on the nature and pervasiveness of the deviation that has occurred,
establishing remediation activities as needed to make retrospective corrections
and forward-looking improvements
Best Fit’s policy clearly states that if such an illegal act or impropriety is confirmed,
the company will terminate the employee, revoke all access privileges, and file formal
charges with appropriate authorities. The policy also requires the human resources
manager to document the situation and its resolution, analyze the root cause of the
breach, and implement any additional remedial steps to avoid similar occurrences in the
future. Progress reports are regularly provided to the audit committee.
During one instance, facilitation payments were made to obtain certain contracts, the
policy was immediately applied, and an investigation was launched. The audit com-
mittee was notified and regularly presented with progress updates and the proposed
corrective actions for approval.
Points of Focus
The following points of focus highlight important characteristics relating to this principle.
•• Understand the key risks facing the organization and the processes management
uses to identify, assess, and manage risks, considering internal audit findings,
litigation, compensation schemes, regulation, and compliance
8 In practice, many of the activities of the board of directors included here would be carried out by one of its
committees, such as the audit committee.
•• Confirm or reject the basis for management estimates and proposed accounting
policy changes before approving
The results of the evaluation are used to determine whether the roles and responsibili-
ties of the committee have been met and could result in committee member changes or
impact remuneration. In addition to the annual review, every three years the company
conducts a benchmark review against leading practices and refines its charter,
as appropriate.
•• An audit committee, whose chairman is responsible for ensuring that the commit-
tee acts as an independent and objective advisor to the deputy head and provides
guidance on the adequacy of the agency’s system of internal control, financial
reporting and disclosures.
performance of internal control across the business in regular meetings between man- Applies Relevant Expertise
agement and the board. The processes and structures particularly relevant to the audit Operates Independently
committee of the board are those that provide: • Provides Oversight for the System of
•• Appropriate forums to enable board members to ask probing questions Internal Control
of management
•• Criteria and procedures for calling special and/or urgent meetings as necessary
•• Allocation of time in board meetings for discussions with external advisors, inter-
nal and external auditors, and legal counsel without management being present
The policies and practices are updated as needed to reflect changes in internal and
external expectations, including rules and regulations.
Financial Management
Before each committee meeting, she circulates the draft agenda both to the commit-
tee members and the external auditors to solicit their input on any additional technical
accounting agenda items they would like to discuss. Ms. White is committed to keeping
open channels of communication with the external audit engagement partner and the
company’s chief audit executive to ensure she receives timely updates on any discus-
sions occurring with management as technical matters emerge. Internal audit, litigation,
and corporate social responsibility are a few of the areas that are regularly solicited for
input by the board or audit committee.
The board reviews the results of due diligence performed on potential board candi-
dates and confirms their competence and ability to remain unbiased. The procedures to
ensure that potential board members meet the defined criteria may include:
•• Evaluating the key risks facing the organization and accordingly defining board
member profile requirements
•• Considering skills and expertise, ranging from financial to regulatory and various
technical knowledge needed to understand the issues that could affect the com-
pany’s external financial reporting
•• Reviewing information about financial and other relationships with the company,
its external auditors, or management
•• Evaluating periodically the due diligence procedures used for identifying potential
directors, including checking that an individual director’s certifications are com-
plete, up-to-date, and comply with the entity’s ethics guidelines and indepen-
dence rules
9 Standard setters, regulators, or listing agencies may have specific requirements for director independ-
ence, qualifications, and the makeup of the audit committee, which will vary by jurisdiction/country.
Giante Ore recognized that it needed to strengthen its control environment and board
effectiveness. To that end, it revisited its board structure. The three relatives and one
personal friend of the CEO left the board and have been replaced by four independent
directors, all of whom are financially literate. One of the four has specific financial exper-
tise. These directors have now been appointed to a newly formed audit committee with
its responsibilities set forth in a charter.
The same team conducts an annual review to ensure that board members continue
to have the requisite competence and independence given the entity’s stakeholder
needs. The senior management of Greene Inc. provides the results of the review in its
public filings.
•• Evaluating other risks facing the organization, with the potential impact on finan-
cial reporting
This practice is carried out for all assumptions related to key financial statement
accounts, disclosures, and relevant assertions most subject to management judgment
and bias. For example, for Custom Engineering’s annual goodwill evaluation, manage-
ment provides relevant information on any specialists engaged to assist the company,
key judgments and assumptions included in the company’s discounted cash flow
model, plausible sensitivity scenarios that were considered, and confirmation of the
appropriate technical accounting standard applied.
effectively positions her to monitor the external auditor’s performance and make an
informed judgment on any need to modify or terminate the relationship.
The audit committee also regularly meets with Seaworthy’s chief audit executive to
ensure that the same oversight objectives of the internal audit function are attained.
The chief audit executive reports directly to the audit committee to enable an objective
mindset within the internal audit organization and to facilitate the escalation of issues
independent of management, if so required.
10 This example is continued in Chapter 6, Monitoring Activities, to illustrate how monitoring activities may
assess whether controls to effect principles in the control environment are deployed as intended (see
page 147).
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
Each unit or department within the entity that is relevant to external financial report-
ing aligns its roles and responsibilities to processes supporting the financial reporting
objectives. Senior management and the board of directors verify that accountability
and information flow within each of the various organizational structures (by business
segment, geographical location, legal entity, or other) continually support the achieve-
ment of the entity’s existing financial reporting objectives. Existing structures are peri-
odically assessed for relevance considering changes in the entity or the environment in
which it operates to ensure such alignment.
The clear statement of roles helps to ensure responsibilities are carried out in support
of the organization’s objectives. It also provides the basis for risk assessment, control
activities, information and communication, and monitoring activities along different
dimensions simultaneously.
For key financial reporting positions, the board of directors reviews management’s
descriptions of the related authorities and responsibilities and considers how those
positions affect the strength of internal control over external financial reporting.
When applicable, the responsibilities of externally sourced support personnel are out-
lined through service-level agreements, specifically targeting timeliness and the quality
of financial reports generated.
SureSafe identified a small reputable company, J.K. Green and Associates, as one
that would meet its processing, reporting, and internal control needs. The service-
level agreement signed by both parties specifies each party’s expectations and
responsibilities for the services provided and internal control over the outsourced
business processes.
The audit committee reviews and approves the plan, recognizing that it may need to
be revisited periodically to respond to significant changes in the company, such as
new product lines, acquisitions, unexpected regulatory issues, etc. The audit commit-
tee regularly assesses the independence of the chief audit executive and evaluates the
activities of the internal audit function.
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
The finance department regularly reviews the entity’s accounting and reporting policies
and practices, and updates these as necessary to keep pace with internal expecta-
tions and external factors, including changes in technical standards and regulatory
requirements.
The human resources department periodically updates materials outlining the compa-
ny’s policies and procedures on attracting, training, coaching, evaluating, and retaining
personnel.
•• Conducting exit interviews to uncover any concerns related to the entity’s internal
control over external financial reporting
When hired, the successful candidate will be expected to participate in several relevant
conferences throughout the year to maintain a current level of knowledge of industry
and financial reporting matters and recognize that he or she is valued as an important
asset to the company.
Credit Safe periodically evaluates every employee’s performance and tracks it against
established objectives. Management provides feedback and guidance to help employ-
ees achieve the objectives. At the end of each year, an employee’s performance is rated
as one of several categories: superior, exceeds expectations, meets expectations,
needs improvement, or unsatisfactory.
This intensive training has provided senior management of Orex with the confidence
that their CFO and controller now have sufficient knowledge to make informed decisions
on the proper application of the standard. Documentation of the training attended has
been tracked and included in Ms. Shreve’s and Mr. Tellemann’s employee files.
For successful selection and use of the vendor’s services, management was careful to
verify that the vendor met the suitability standards set forth in Compu Services’ poli-
cies. Being directly affected by the quality of the control procedures carried out by the
vendor, the CFO spends time with the vendor to understand any assumptions used in
models or calculations, particularly as they may impact financial reporting. Indeed, while
Compu Services’ management chooses to outsource certain tax activities, it remains
responsible for the effectiveness of relevant controls regardless of where they are oper-
ated. The company therefore requests annual independent certifications of the vendor’s
internal control effectiveness.
•• Ensuring individual and team goals in support of the achievement of the enti-
ty’s objectives are defined, use observable metrics, and are communicated to
each employee
Using the same criteria, the board of directors evaluates the competencies of individu-
als serving in key financial reporting roles, such as the chief executive officer, chief
financial officer, and chief audit executive.
with the company’s human resources director, chief audit executive, and legal counsel
to review the roles, responsibilities, and performance of the various company manag-
ers. The review focuses on aligning respective managerial responsibilities with Lead
Products’ organization chart, and the managers’ expertise and experience in carrying
out the responsibilities. The audit committee also evaluates the independence of the
relationship between management and the chief audit executive, considering input from
the chief financial officer and other primary customers of internal audit services.
Consequently, the CEO, CFO, and vice-president of human resources together annually
review employee job descriptions, workload, and performance assessments. During a
recent review, they determined that the company’s controller, hired initially to perform
basic accounting and bookkeeping functions, no longer had the expertise needed for
the associated financial reporting responsibilities. The company has now assigned the
controller to a position better suited to his skills, and hired an individual with the requi-
site competencies as controller.
The talent management strategy has allowed North-to-South to confidently plan for
the future.
Enforces Accountability
Principle 5. The organization holds individuals
accountable for their internal control responsibilities in the
pursuit of objectives.
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
Representing its products adequately to its customers, saying no to bribes and other
illicit practices, and delivering timely products or services in accordance with quality
standards are the explicit expectations of the company and of each one of its repre-
sentatives. Management communicates and reinforces these messages continually
and holds its people accountable to these measures in their day-to-day decisions and
overall risk and performance results, which it tracks proactively through client satis-
faction dashboard reports and reactively through incident reporting. The company
requires its employees to sign off on the goals mutually agreed to with management
at the beginning of the year, recognizing that these may be revisited during the year as
necessary to respond to changes in the business, and on their achieved performance at
year-end.
Goals are defined, performance is evaluated, and employees are held accountable
within the local organizational structure and within their functional reporting structure.
The chief financial officer further requires each of his finance managers to certify to
him the absence of any instances of fraud, the effectiveness of the internal control over
external financial reporting, and the reliability of the financial results produced.
Senior management subsequently reports to the board what factors were considered
in developing the performance measures, incentives, and rewards and how they are
expected to drive the desired behavior.
The credit does not preclude the internal audit department from reporting specific defi-
ciencies to management or the board when warranted, but it does positively affect the
grading system, which can affect departmental compensation and benefits. The result
is that Modern Financial Services is more likely to identify control deficiencies before
they can become material to the organization.
•• Monitoring the changing sources of threats that cause pressure to bypass estab-
lished controls or take shortcuts
•• Considering whether the selection of accounting policies has been unduly influ-
enced by the established performance measures
The board of director’s oversees the periodic assessment to ensure it has been com-
pleted, and may subsequently approve compensation plans. The board also pro-
vides oversight to ensure that the performance measures and compensation plans
established for senior management are appropriately aligned with the entity’s strategic
objectives and balanced to promote the desired accountability without causing exces-
sive pressure that could lead to fraudulent financial reporting.
The compensation committee routinely reviews the performance goals and awards for
ongoing relevance and to determine whether they create unnecessary pressures or
unintended consequences. It continually focuses on identifying those short-term sales
objectives that may cause management to take undue risk, cut corners, or commit fraud
that could harm the company’s sustainable growth objectives.
Based on these reviews, goals and awards are modified as necessary, and changes are
approved by the board of directors annually. The performance goals and awards consist
of the following and are subject to audit:
•• Audit scores
•• Customer care
•• Efficiency ratio
Any incentive compensation that is approved and ratified by the board is distributed to
individuals annually.
values. Information items that Timber Co. values are specific comments on how man-
agement does or does not reflect values are captured through employee feedback.
During the employee performance review and appraisal process, management provides
feedback about the extent to which each employee has performed in accordance with
the company’s core values of sound integrity and ethics.
3. Risk Assessment
Chapter Summary
Every entity faces a variety of risks from both external and internal
sources. Risk is defined as the possibility that an event will occur
and adversely affect the achievement of objectives. Risk assessment
involves a dynamic and iterative process for identifying and assessing
risks to the achievement of objectives. Risks to the achievement of these
objectives from across the entity are considered relative to established
risk tolerances. Thus, risk assessment forms the basis for determining
how risks will be managed. A precondition to risk assessment is the
establishment of objectives, linked at different levels of the entity.
Management specifies objectives within categories relating to operations,
reporting, and compliance with sufficient clarity to be able to identify
and analyze risks to those objectives. Management also considers the
suitability of the objectives for the entity. Risk assessment also requires
management to consider the impact of possible changes in the external
environment and within its own business model that may render internal
control ineffective.
Principles Approaches
•• Assessing Materiality
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
•• Existence
•• Completeness
•• Valuation or allocation
A-Middle’s management considers the level of materiality when reviewing the com-
pany’s activities and interim reports and determining whether all significant risks and
accounts have been captured. This information is used as a guideline in focusing on
detailed risks within each financial statement line item and disclosure. Further, manage-
ment also considers non-financial disclosures reported in the company’s 10-K. This
approach is illustrated on the following page.
relating to its accounts and activities. For instance, management has specified objec-
tives relating to:
•• Sales existence and completeness financial statement assertions for all sales
transactions recorded during the period11
•• Treasury valuation and allocation financial statement assertions for all investments
held and recorded as of period end
Annually, finance management reviews these objectives and sub-objectives for ongoing
relevance and suitability with respect to the company’s accounts and activities. Where
changes are expected to occur—for instance, the adoption of a newly published
accounting standard or guidance or new commercial event or trend—appropriate man-
agement communicates the need to reconsider these objectives to those responsible
for the objective-setting process.
Within the sales process, management accepts deposits from one frequent customer,
Hall Electronics, which relate to the purchase of several home theater systems. Valley
Services sets aside the theater systems in its inventory until Hall Electonics requests
delivery, usually within thirty days. Valley Service must either refund to Hall Electonics
the cash or provide a relacement home theater system if a system is damaged or lost
prior to delivery.
Management had previously established a policy where revenue was recognized upon
payment for goods, regardless of whether the goods were delivered. In assessing the
suitability of the objectives specified for financial reporting, the controller, Alex Robert-
son, determined that this policy may not be in accordance with IFRS. Consequently, he
requested senior management to review this policy in conjunction with the objective-
setting process. In addition, he advised the internal audit group, which then monitored
the resolution of this matter.
11 For purposes of this example, not all relevant financial statement assertions have been included.
•• Size of financial statement elements (i.e., current assets, current liabilities, total
assets, total revenues, net income) and financial statement measures (i.e., finan-
cial position, financial performance, and cash flows)
Looking at this new source of potential revenue relative to the income statement, Bot-
tomer Holdings considered the effect on its total revenues and net income and has now
concluded that the laundry revenue is expected to generate $150,000 to $200,000 of
revenue per year.
Management has considered the overall materiality of this account using the quantita-
tive measure of $500,000. Management also considered other qualitative factors and
determined that this new source of income would:
•• Not change a loss into income—the company has been profitable over the past
five years.
•• Not impact compliance with loan covenants and other contractual agreements—
none of the mortgages on the buildings would require changes in loan repayment
rates based on higher income levels.
Based on the assessment, management has concluded that the new source of
income is not material to the overall financial statement presentation. Accordingly,
in specifying its external reporting objectives, management has incorporated this
new source of revenue into its overall revenue objectives as determined by Gener-
ally Accepted Accounting Principles but has not set out new, unique objectives for
laundry-related revenue.
policies of similar entities. For entities that have multiple reporting obligations, such as
statutory reporting in international locations, management assesses the requirements
relative to the respective divisions or operating units.
•• Situations where multiple acceptable alternatives are available and the rationale
for selecting one policy over another
•• Where differences are required, the alternatives that are available and the rationale
for selecting one policy over another
•• Where differences are required, identifying the policies selected by other compa-
nies within an identified peer group
Once he has completed his review, Mr. DeQuincy communicates the differences and the
rationale for selection to the corporate controller.
•• To analyze its various business units for new and discontinued product develop-
ments and changes in the company’s markets, ensuring that they are conveyed
appropriately in the financial statements
In addition, the audit committee discusses with management how any significant activi-
ties that it is aware of will be included in the financial statements.
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
For example, the risk of material omission and misstatement due to revenue recognition
was rated as 4 (medium-high). Contributing to this assessment was consideration of the
likelihood and impact of the organization failing to:
•• Account for complex sales promotions and discounts completely and accurately
•• Update IT systems to account for complex revenue transactions that could lead to
inappropriate recognition of revenue
•• Impact on Financial Statement Accounts—The potential impact on financial • Estimates Significance of Risks Identified
reporting objectives is measured quantitatively. Each account is assessed in Determines How to Respond to Risks
relation to its respective category, such as total assets or revenues. Management
also qualitatively assesses the potential for certain accounts to be understated.
Considering the quantitative and qualitative characteristics, management catego-
rizes accounts as high, medium, and low, based on their impact on the financial
statements. Where risks vary by sub-account, management considers risk at that
level.
The resulting risk assessment is illustrated below. (Note: Additional detail underlying the
risk assessment would typically be present supporting this analysis. For purposes of
this example the summary of the assessment is provided.)
12 As noted in Principle 8, identifying and analyzing fraud risks are integral parts of the risk
assessment process.
Financial Statement Account/ As % of Impact on Account Business Fraud Entity- Overall Relevant Assertions1414
Disclosure Total F/S1313 Charac Process Risk wide Rating
teristics Charac Factors
E C V/A R&O P&D
teristics
BALANCE SHEET
ASSETS
Prepaid Expenses 4% L M L L L L P P P P P
Inventory 35% H M M M L M P P P P P
61
62
Financial Statement Account/ As % of Impact on Account Business Fraud Entity- Overall Relevant Assertions14
Disclosure Total F/S13 Charac Process Risk wide Rating
teristics Charac Factors
E C V/A R&O P&D
teristics
LIABILITIES
Warranty 15% H M M M L M P P P P P
SHAREHOLDERS’ EQUITY
Common Stock 5% M M M L L L P P P P P
INCOME STATEMENT
REVENUES
OPERATING EXPENSES
G&A Expense 3% L M L L L L P P P
OTHER EXPENSES
Risk Assessment | Identifies and Analyzes Risks
63
64
Financial Statement Account/ As % of Impact on Account Business Fraud Entity- Overall Significant Assertions7
Disclosure Total F/S Charac Process Risk wide Rating
teristics Charac Factors
E C V/A R&O P&D
teristics
The information technology managers of Sure Health Care meet with finance personnel
every month to discuss process, changes, and projects in each functional area relat-
ing to financial reporting. The meetings are used to update team members and discuss
issues or changes to the processes. Additionally, management meets with outside legal
counsel every quarter to discuss the effects of any external regulatory changes that may
impact financial reporting.
•• Relevant IT staff, along with business process owners, map the related applica-
tions to the operating systems, databases, and supporting IT processes, and
consider inherent risks and what improvements are needed.
•• Nature of transactions
The risk assessment is prepared by the CFO, Gerald Timewell, and the COO, Inga Karran,
with input from many others within the organization. The resulting assessment, for finan-
cial reporting purposes, considers the above risk factors in determining the significance of
risks of material omission and misstatement related to the financial reporting assertions.
For instance, management increased the assessed risk relating to existence of federal
funding revenue from moderate to high after considering that there is:
Based on this risk assessment, Mr. Timewell and Ms. Karran develop preliminary
positions on the risk response. These determinations are key inputs into determining
required control activities.
The company is currently examining ways to enhance its risk response decisions to
reduce the significance of the risk by altering either likelihood or impact. Given the com-
pany’s current level of losses (1.6%), accepting the risk would not be acceptable, and
management elects to implement control activities that reduce the likelihood of losses
and can detect losses sooner.
Best Bits management also notes the level of losses other companies incur due to
shrinkage. The figure below shows the shrinkage for several other similar companies
within a benchmark group. Best Bits’ losses are noted underneath for comparison.
3.5
3.0
Quartile 4 1.80%–3.50%
2.5
Quartile 3 1.30%–1.80%
2.0 Quartile 2 0.88%–1.30%
1.5 1.6 Quartile 1 0.33%–0.88%
1.0
Best Bits Other Companies
0.5
Average Low Median High
0.0
1.60% 0.33% 1.30% 3.50%
Using the data provided in this analysis, management believes that a loss rate target of
1.3% is suitable for the company (e.g., top of quartile 2) and additional control activities
are developed within the receiving and shipping process (as part of the Control Activi-
ties component). Further, management accelerates the frequency of physical inventory
counts to quarterly to improve the accuracy of financial reporting.
•• Technological developments
Management considers internal factors that may impact the entity’s ability to achieve its
financial reporting objectives, such as:
Where these factors are noted, management also considers—in conjunction with the
Information and Communication principles—whether some form of internal and/or exter-
nal communications are needed.
Based on the insights gathered from those discussions, Mr. Burtnyk provides feed-
back to the various department leaders of World Find. In turn, the department heads
use this information to identify additional information requirements and potential
technology changes.
In one instance, World Find determined that the accounting requirements for a new
value-added tax in one jurisdiction could impact operations in that jurisdiction as well
as two other jurisdictions that interact with it. Based on this assessment, manage-
ment commenced a project to further refine the assessment of the risks related to the
accounting of the new commodity tax, which then served as a basis for how to respond
to those specific risks.
Ms. Campbell has noted instances in the past year where shipping documentation was
not provided to the finance department in a timely manner, sometimes as late as two
weeks after the shipment was completed. These delays have resulted in misstatement
of revenue. Ms. Campbell has determined that the risk related to revenue completeness
needs to be further reduced, and so she has decided to implement a bar-code scanner
shipping system to track and capture shipments and revenue.
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
ways that fraud and misconduct can occur, considering: Assesses Incentive and Pressures
• Assesses Opportunities
•• The degree of estimates and judgments in external financial reporting
• Assesses Attitudes and Rationalizations
•• Methodology for recording and calculating certain accounts (e.g., inventory)
•• Fraud schemes and scenarios that are common to the industry sectors and
markets in which the entity operates
•• Nature of automation
•• Last-minute transactions
•• Historical fraud activities, including theft of inventory and the processes in place
to identify and record such theft
•• The methodology used for recording and calculating inventory and shrinkage
•• Whistle-blower reports
With this information, Mr. Kates forms a preliminary view of the potential fraud activities,
which he discusses with management of each jurisdiction in order to consider implica-
tions and what control activities can reduce the risk of fraud. He also has discussions
with human resources personnel and reviews information in the staff files. He uses his
historical knowledge and staff information to assess the attitude of the local manage-
ment toward the tolerance of fraud and to determine whether local management may
rationalize fraudulent activities, including corruption.
After completing his fraud risk assessment, Mr. Kates submits a report
to the audit committee for its consideration in management oversight.
In addition, the audit committee asks the chief audit executive about:
•• What fraud risks are being monitored by the internal audit team on a periodic or
regular basis
•• Whether anything has occurred that would lead internal audit to change its
assessment of the risk of management override of internal controls
With this information in hand, the audit committee discusses with the full board and
senior management any concerns that need added management focus.
After these discussions for Schmidt Auto’s last fiscal year, the board determined that
the CFO’s incentive compensation, 80% of which was based on the current year’s net
revenue, was too high and focused too much on the short term. The compensation
committee subsequently reduced the incentive compensation, with 40% derived from
current year’s net revenue.
15 This example is continued in Chapter 6, Monitoring Activities, to illustrate how monitoring activities
may assess whether controls to effect principles in the risk assessment are deployed as intended (see
page 149).
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
may include reviewing the following: Assesses Changes to the Business Model
Assesses Changes in Leadership
•• Websites and social media
•• Search engines
•• Conferences
•• Professional organizations
During this process, the accounting and finance departments of Clear Blue Auto
determined how plant shutdowns would affect the financial statements. This included
potential penalties contained within various sales contracts, possible obsolescence of
parts required for a particular model year being phased out, and greater impacts from
extended delays in supply of parts. They also evaluated what insurance coverage was
available to mitigate potential losses. These teams were also responsible for identifying
incremental risks from required system and process changes when working with the
company’s suppliers.
The potential impact of this hurricane was updated and communicated to the compa-
ny’s board of directors later that day.
Over the next 100 days, Mr. McPherson will be holding individual meetings with each
functional team to discuss their current objectives, how those objectives might be
changed, and how those changes would impact the assessment of risks to reliable
financial reporting. He expects that some at Garner’s Heating will be surprised with his
proposed changes to policies, which have been largely unchanged for several years.
This includes the company’s CFO, Ruth Koziak, who is responsible for analyzing the
change in strategy and the implications to financial reporting.
At the end of the 100 days, Mr. McPherson intends to reconvene the larger group to
discuss how the company should change, and the incremental risks (including financial
reporting) that may come with the change. It will then be up to Ms. Koziak and the chief
audit executive to consider the implications of the company’s new vision and the effects
it will have on the external financial reporting objectives.
•• Different laws and regulations, including those that would affect the company’s
ability to defend its patents
Each of these factors presents incremental risks to financial reporting and processes
that need to be managed. Therefore, Consecutive’s corporate controller is performing
a risk assessment with the finance teams in the international locations to ensure these
new risks are identified and to help management determine how best to respond.
•• New markets that will be encountered by the combined company (including differ-
ing financial reporting standards)
•• The ability to achieve the anticipated synergies from the acquisition and whether
these synergies will create incremental risks to financial reporting
A project team has been formed for the transition to ensure that all risks are appropri-
ately identified across all business units and functional areas. Any identified risks are
passed on for assessment to senior management, including the company’s chief oper-
ating officer and chief financial officer.
If the transition for a particular position is expected to occur within the next two years,
representatives of the audit committee interview the candidates to ensure that their
views on internal control are consistent with those expected by the audit committee.
The board considers that feedback attained when making any decisions within the
scope of its responsibility. The audit committee communicates its findings to the CEO
and other members of senior management, who ultimately will make a decision on
successors.
The successful candidate, Jenny Acosta, has a strong background and focus on cost
management and streamlining operations. However she agrees with the audit commit-
tee that this streamlining could result in fewer processes and controls, especially those
viewed to be labor intensive, and that such changes could erode the quality of reporting
and increase certain financial reporting risks.
With this in mind, the audit committee has begun to request quarterly updates of
controls that have been removed by management and the potential impact on financial
reporting. In addition, this information is incorporated by the internal audit group into its
internal audit planning process.
4. Control Activities
Chapter Summary
11. The organization selects and develops general control activities over
technology to support the achievement of objectives.
Principles Approaches
11. The organization selects and devel- •• Using Risk and Control Matrices to
ops general control activities over Document Technology Dependencies
technology to support the achieve-
•• Evaluating End-User Computing
ment of objectives.
•• Implementing or Monitoring Control
Activities when Outsourcing IT Func-
tions to a Third Party
Points of Focus
The following points of focus highlight important characteristics relating to this principle.
Management considers the segregation of duties and a mix of transaction control activi-
ties and business process reviews. Management considers using automated controls
whenever the systems in place make it possible. These are supplemented by manual
control activities where automated controls are not available.
After these workshops, Prescott International is able to select and develop poli-
cies and procedures appropriate to its business. The controller reviews the matrix
of control activities and risks in order to identify any potential risks not previously
noted, recommend additional control activities if necessary, and remove unnecessary
control activities.
•• Identified risks
•• Control activities
Ordering Invoicing
16 Note that this is an illustrative matrix and flowchart and does not represent a complete list of all financial
risks and control activities in a typical purchasing and payables process.
Control Financial F/S Control Frequency Control Description Manual/ Preventive/ Infor-
Risk(s) Asser- Level of Control Automated/ Detective mation
tions IT Depen- Processing
(note 1) dent Manual Objective
(note 2)
A Orders are not V Transaction Multiple During the purchase order (PO) creation Automated Preventive A, V
accurate Level times per the system performs edit checks (auto-
day populated fields, format checks and
use of drop-down lists) of the relevant
data fields and auto-populates vendor
and item details using the vendor
and item master file respectively. The
system populates price in the purchase
order from the approved master file
based on the product entered.
B Orders are E/O Transaction Multiple The system blocks POs not using an Automated Preventive A,V
from an unap- Level times per approved vendor and items from the
proved vendor day related master file. Blocked POs are
included in the PO exception report
that is reviewed daily by the purchasing
manager who works with the purchas-
ing agent to either correct or cancel
the PO.
C Order prices V Transaction Multiple Manually entered PO prices outside Manual Preventive A,V
are inaccurate Level times per those specified in the approved master
day file must be reviewed and approved in
the system by the purchasing manager
for processing to continue. Rejected
POs are canceled in the system.
D Orders are V, E/O Transaction Multiple Purchase orders (POs) must be Manual Preventive A,V
inaccurate or Level times per approved by the appropriate buyer
not valid day who is in charge of signing the PO. The
buyer reviews the PO for various items,
including any items out of policy, such
as excessive price discounts, inac-
curate calculations, and amounts over
the purchasing agents authorization
limits, etc.
E Invoice V, E/O, Transaction Multiple The system performs a three-way Automated Preventive A,V
processing is R&O Level times per match by comparing pertinent data
inaccurate or day (e.g., price, quantity) between the
not valid purchase order, invoice, and receiving
document. As part of the three-way
match the mathematical accuracy
of the incoming invoice is checked.
Invoice processing is blocked when
differences exceed a predetermined
threshold. Blocked invoices are
included in the matching exception
report that is reviewed daily by the
payables manager who investigates
and resolves the issue.
Management obtains an understanding of the service organization’s activities and Addresses Segregation of Duties
whether those activities impact significant classes of transactions, accounts, or disclo-
sures in the company’s reporting process. In determining the significance of the service
organization’s processes to the financial statements, the entity considers the following
factors:
•• The risk of material omission and misstatement associated with the assertions
affected by the processes of the service organization, including whether the
activities involve assets that are susceptible to loss or misappropriation
•• The nature and complexity of the services provided by the service organization
and whether they are highly standardized and used extensively by many organiza-
tions or unique and used only by a few
•• The extent to which the entity’s processes and control activities interact with
those of the service organization
•• The entity’s control activities that are applied to the transactions affected by the
service organization’s activities
•• The terms of the contract between the entity and the service organization, and the
degree to which authority is delegated to the service organization
•• Identifies the specific control activities performed by the service organization that
are relevant to financial statement assertions, and/or
•• Selects and develops control activities internally over the activities performed by
the service organization.
If an appropriate report does not exist, management can use the entity’s own resources,
such as internal audit, to review the control activities and ensure that any external finan-
cial reporting risks are mitigated by the combination of its own control activities and
those of the service organization.
Jennssen Inc. engages a service auditor to audit its control activities over transac-
tion initiation, processing, and recording, and to issue an SSAE 16 (SOC1)17 report on
controls. When Green Grow Now obtains the report, it assesses whether the described
control objectives and control activities performed by Jennssen impact internal control
over external financial reporting related to the existence, completeness, and valuation of
payroll expense.
Green Grow Now considers the test results in the report and whether any exceptions
have been identified. It also considers the period covered by the report and concludes
that it needs additional evidence of the operation of control activities for the period
not covered. The management communicates directly with Jennssen to inquire about
any changes to its processes; Jennssen confirms in writing that no changes have
been made.
Based on this information, Green Grow Now concludes that no further action is needed.
It also reviews the control activities that it is expected to have in place in its own organi-
zation (as specified by the user control activities in the SSAE 16 report) to verify they are
implemented and operating as intended.
17 An independent auditor’s report on the design and operating effectiveness of controls at a service
organization
The management of Funnell Medi-Quip evaluates the nature of the control activities
of Oxford Financial Experts and its own control activities over Oxford. The manage-
ment team determines that the risk of material omission and misstatement associated
with the financial statement assertions affected by the processes of the Oxford is high.
Funnell Medi-Quip concludes that additional information is needed to evaluate the
design and operating effectiveness of Oxford’s control activities. The management team
performs tests at Oxford, using the internal audit group to verify that the control activi-
ties are implemented and operating as intended. Funnell also tests its own user control
activities.
•• The type of control (i.e., manual or automated) and the frequency with which
it operates
•• The nature and materiality of misstatements that the control is intended to prevent
or detect
•• The degree to which the control relies on the effectiveness of other controls (e.g.,
general technology controls)
In balancing its control activities within the processing of journal entries in the financial
reporting cycle, EJ’s Corporation focuses on the following preventive control activities:
To begin the analysis, the CFO of each of the company’s five business units reviews
the balance sheet and income statement in detail to identify and explain any variances
from budget and prior year actual results over a predetermined threshold (which varies
by business unit). The threshold, which ranges from 5% to 10% of pre-tax income, has
been developed by senior management to help detect potentially material differences
considering the following factors:
•• The nature of assets and liabilities and transactions executed at the business
unit, including significant transactions or initiatives undertaken outside the normal
course of business
The analysis is then submitted to Zephyr’s corporate center for review. Senior manage-
ment hold monthly meetings with the representatives from each business unit (usually a
business unit CFO) to understand why there are significant differences that are exceed-
ing predefined thresholds and to determine whether corrective action is necessary.
•• Automated preventive controls are embedded within JMC’s ERP system support
generation of sub-ledger reporting, including historical aging, collection, and
write-off of receivables by customer, which provides a level of consistency for the
completeness and accuracy of reporting used in making estimates.
•• The controller assesses the reasonableness of the final estimate by reviewing the
rationale supporting the selection of the historical percentage used to calculate
the preliminary estimate and the rationale supporting any material adjustments,
and considering the consistency with her knowledge of industry, business, and
customer trends/events.
Gentry has identified the following benefits that would arise out of using an automated
account reconciliation tool:
Gentry Co. decides to implement a partial automated process. It uses both qualitative
and quantitative factors to determine which reconciliations will be automated and which
will continue to be manual. The factors considered favorable to automation include
low complexity of transactions, absence of significant judgments and estimates, low
number of manual journal entries and adjustments, low susceptibility of transactions to
fraud, and high-volume, low-dollar value of transactions, combined with low degree of
variation against the expected account balance.
•• An inventory clerk documents and tracks all inventory levels, reducing the risk
of obsolescence.
•• A controller reviews exception reports of all inventory purchases with a price more
than 10% above current average costing.
18 This example is likely to be most relevant for smaller entities or the smaller sub-units of larger entities.
Senior finance, operations, IT, internal audit, and compliance management have
reviewed and approved the task force’s recommendations. Commensurate with the
policy changes, IT has updated access rights across the various systems. Control
activities were selected and deployed to help ensure that the segregation of duties is
maintained, including policies and procedures for user management and IT’s review
and approval of access requests. The policies also include the segregation of duties as
criteria in the annual review of access rights performed by user management for each
financial reporting relevant system.
Furthermore, the application routinely scans security roles and end-user access, gener-
ates reports of access risks and conflicts, and routes the reports to the appropriate
people for review. If a user requires access to conflicting transactions, the applica-
tion recommends a mitigating control activity. Frencorp management’s review of the
access risks and conflicts reports and mitigating control activity decisions are logged in
the application.
Points of Focus
The following points of focus highlight important characteristics relating to the principle:
The walkthrough covered each major class of transactions. The internal audit team
asked the relevant personnel of the newspaper chain about all significant aspects of
the process.
Smythe & Smythe also classified the spreadsheets as high in complexity because they
included the use of macros and multiple supporting spreadsheets to which cells and
values were interlinked. The spreadsheets were used either as the basis for journal
entries into the general ledger (LIFO reserve) or as financial statement disclosures (fair
value of goodwill, intangible assets, and debt).
The company considered the security, maintenance, and update risks of the spread-
sheets and then selected and developed the following control activities:19
•• Calculation Testing—When changes to formulas are made they are tested against
a manual calculation for accuracy. All spreadsheet formulas are checked for accu-
racy at least once a year.
19 Note that not all these control activities are technology general controls only. The first and last bullets
could be considered business process–level controls; however the entire list is included to illustrate a more
complete consideration of spreadsheets.
If an appropriate report does not exist, management uses internal resources (e.g.,
internal audit) to review the controls at the third party, verifying that the combination of
the company’s controls and those at the service organization mitigate risks to external
financial reporting to an acceptable level.
To that end, the management of E-Book Frontier assessed the risks associated with the
business processes outsourced to the ERP cloud service provider and determined a
number of control activities and information requirements that needed to be addressed.
E-Book Frontier management obtained a Statement on Standards for Attestation
Engagements (SSAE) No. 16 (SOC 1) report on internal controls prepared by a third-
party service auditor. As part of developing and deploying internal controls across the
end-to-end business processes managed in part by the CSP, E-Book Frontier incorpo-
rated the review of the audit report as a control activity. In performing its review, man-
agement noted the following:
•• The scope of the report included certain application controls and technology
general controls that were evaluated for both design and operating effectiveness.
The controls relating to the customized configuration for the organization were not
addressed in the service auditor’s report. Management evaluated the impacted
business process and related financial reporting risks and selected and devel-
oped additional actions and control activities to address these risks.
•• The tests of controls covered a time period that correlated with ten months of
the company’s fiscal year, resulting in a gap of the last two months. Based on
management’s analysis on the relevance and risk of the related controls, E-Book
Frontier determined that corroborative inquiry with the CSP would be adequate for
the gap period. To evaluate the continued operation of the CSP controls, man-
agement interviewed key CSP personnel to assess whether any changes in the
controls or known failures had occurred since the date of the report.
Management reviewed the results of the tests of controls and the service auditor’s
opinion on the operating effectiveness of the controls to determine whether each control
objective was achieved. Two exceptions were noted in the report, and management
reviewed the additional information related to these that was provided by the CSP in the
unaudited portion of the report. They concluded that one exception was not relevant to
their organization. For the second exception, additional procedures were needed.
Based on these additional procedures, management concluded that the exceptions did
not result in a deficiency of their system of internal control.
•• Create a three-tier risk rating of the importance of an application and its data to
the reliability of the financial-reporting process.
•• Develop policies for the settings of key security parameters for all financially rel-
evant technology in use at the company for each risk rating level.
•• Assess the importance of each application and its associated infrastructure to the
reliability of financial reporting and assign it a risk rating.
•• Implement procedures to put in place and monitor compliance with the policies
for each application consistent with its associated rating.
For applications that process in real time, software is also used to automatically monitor
for errors, such as incomplete, inaccurate, or invalid record transfers between systems.
When a possible error is detected, the software attempts to resend the record without
error. If the error persists, an email alert is sent to an operator who corrects the error
following standard documented procedures. Financial management is notified of any
errors in a weekly report. The weekly report is reviewed to determine if any accounting
record adjustments are required due to the system problems. The controller reviews and
approves any changes. (Note: this could be considered a process-level control.)
•• Obtain a description of the change, the rationale for it, the impact on the com-
pany’s security environment, and implications for user interfaces.
•• Outline steps for a back-out plan should the upgrade not perform as expected.
•• Develop a plan to test that the edit and validation rules work properly, desired
system functions operate as expected and produce the desired results, undesired
processing results are prevented, and existing technical capabilities, including
control activities critical to external financial reporting, continue to work properly.
•• Obtain approval from financial and operational management and end users of the
test results prior to releasing the upgrade into production.
Because Summer Run does not have an automated code promotion utility to control
versions and migrations to the production environment, the IT manager, James Robb,
takes the following steps:
•• Assigns to the developer not working on a particular change the responsibility for
testing the change and migration to production
•• Locks versions following user acceptance testing to prohibit further change prior
to release
Mr. Robb also relies on these manual controls to manage the code version
and migration:
•• Creating a manual log listing the version of the code copied to the development
environment, along with date and time, and manually tracking the migration to test
and then to production.
•• Separating the review of all version control procedures prior to moving the
code to production from those performed by the individual responsible for the
IT functions.
The organization assigns the level of risk to one of four categories based on several
factors, including the length, level of effort, possible risks to financial processing and
control activities, and complexity of the change. Level 1 changes (the most risky) are
required to go through twenty quality gates, or control points, before implementation,
while Level 4 changes (the least risky) are required to go through only ten gates. All
changes that may affect financial processing and control activities are required to be
reviewed by someone in the finance department before being implemented.
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
•• Locations, units, and processes to which the policy and procedure applies • Takes Corrective Action
• Performs Using Competent Personnel
•• Roles and responsibilities for owning, creating, implementing, executing, and
maintaining the policy and procedure • Reassesses Policies and Procedures
•• Review date
revised estimates for each loss contingency, is reported to the corporate control-
ler. Information required for the disclosure of loss contingencies is provided to the
corporate office by location in quarterly financial/legal reporting in a prescribed
template. The template is updated, as necessary, through and including the date
of the related public filing.
The board of directors reviews and approves the annual budget, over and above the
required approval provided by the CEO. Authorization to incur liabilities on behalf of the
trade association is limited if they fall outside of the amounts approved in the budgeting
process for normal operations. The limits are:
•• CEO: Up to $50,000
•• Vice-presidents: Up to $10,000
•• Supervisors: Up to $500
Siobhan O’Reily, the association CEO, must review and approve in writing any capital-
ized purchases above $10,000. A purchase order must be prepared for all purchases,
and every disbursement of funds requires the receipt of an invoice. This policy does not
apply to the purchase of association investments, which are authorized by the board of
directors through its corporate investment policy.
Ms. O’Reily reviews all purchase orders for more than $10,000 for appropriateness. She
compares the amounts to budget, and if she uncovers a discrepancy, she sends the
purchase order back for investigation and follow-up.
Mr. Pender is responsible for reviewing initial draft financial statements (initial draft)
along with the corporate financial reporting package, which was prepared by Jayden
Roberts, director of financial reporting with input from Jack Jones, director of tax. Mr.
Pender’s responsibilities include:
•• Completing his review, updating initial draft, and submitting the final draft and
summary of any matters, which require resolution by senior management, to both
Ms. Champion and the disclosure compliance committee
Ms. Champion is responsible for reviewing the final draft and summary of matters that
require resolution. Her responsibilities are:
•• Asking Mr. Pender about the results of his review procedures and summary of
matters requiring resolution of senior management
•• Reading the final draft to identify any potential material misstatement (or omission)
in presentations and disclosures of business conditions, significant transactions,
and events
The disclosure compliance committee comprises the chief operating officer, chief finan-
cial officer, chief compliance officer, chief audit executive, vice-president of research
and development, vice-president of supply chain, controller, vice-president of tax, and
general counsel. The committee members review the final draft. Responsibilities of
committee members are:
•• Inquiring about the results of both Ms. Champion’s and Mr. Pender’s review
procedures
•• Informing the chief executive officer and chief financial officer of any changes,
deficiencies, or material weaknesses pointed out by the disclosure compliance
committee
The CEO and CFO approved modifications to the company’s revenue recognition
policy and related approval matrix that requires all significant software contracts be
reviewed by the CFO and other finance personnel before software revenue and sales
commissions are recognized. In addition, finance, legal, and sales personnel collabo-
rated in establishing standard contractual terms and conditions that would result in
proper recognition of revenue and commissions, and identifying variances from such
standards that would require review and approval by the CFO and/or other finance
personnel with appropriate technical competencies in applying the company’s revenue
recognition policy.
In addition, the CFO, sales executives, and legal staff meet annually with sales person-
nel to review the company’s policies, its standard and non-standard contractual terms
and conditions, its historical revenue recognition issues, and any specific commercial
arrangements to avoid. All subsidiary sales and finance personnel attend annual training
that focuses on how to comply with local laws and regulations and with the company’s
revenue recognition policies and procedures.
Mr. Whitfield periodically reviews actual costs incurred for a long-term project, ensur-
ing they are accurate, that indirect costs are appropriately allocated, and that change
orders and potential cost overruns do not exceed the authorized funding. If any vari-
ances from the cost baseline appear, he promptly investigates them and excludes incor-
rect or inappropriate changes from the reported cost or resource usage, which is used
as the basis for revenue recognition for the period. He also reviews the estimated costs
for reasonableness, taking into account the actual stage of construction at the end of
the reporting period.
•• The human resources department maintains a list of open change orders that is
reviewed daily for receipt of the confirmation from the IT department. If a receipt is
not received within twenty-four hours, a human resources representative follows
up with the IT group until the request is processed.
20 Investigation of the root cause of why the overstatement occurred is discussed in Chapter 6,
Monitoring Activities.
Budget formulation and execution processes and structures have been redesigned
centrally to identify and distinctly categorize funds for capital projects. These have been
distributed to individual departments by the financial planning and budgeting group.
The standard contract has also been modified to require purchased capital items to be
separately identified for each project (by budgetary funding code) and to not include
items for any other projects.
The agency has instituted new policies, mandatory annual training, weekly reviews of
pending contract actions, and monthly reviews of expenditures to ensure program com-
pliance. The efforts have dramatically reduced misclassifications and overcome audit
qualifications for plant, property, and equipment reporting.
Establishes Policies and Procedures to Approach: Conducting Regular and Ad Hoc Assessments of
Support Deployment of Management’s
Control Activities
Directives
E stablishes Responsibility and
On a regular basis, or when changes are made to financially significant processes and
Accountability for Executing Policies and systems, control activity owners in conjunction with financial reporting and control
Procedures experts review control activity documentation for continued relevance. Changes are
Performs in a Timely Manner made when redundant, obsolete, or ineffective control activities are found.21
Takes Corrective Action
Example: Regularly Assessing Policies and Procedures
Performs Using Competent Personnel
• Reassesses Policies and Procedures
Central Community Bank maintains a policy checklist on its intranet. The checklist
references all the pertinent company policies and management’s last review date, next
review date, and board of director review and approval as applicable. The policies
and procedures are reviewed annually or more frequently if necessary, in response to
changes in underlying business processes. The internal audit department assesses
compliance with company policy and procedures in conjunction with its internal
audit reviews.
21 This approach applies to changes that are not significant enough to go back through the risk
assessment process.
Chapter Summary
Principles Approaches
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
The following diagram illustrates key categories and types of information senior man-
agement may require in support of external financial reporting objectives:
•• Definition of roles and responsibilities for information gathering to allow the central
processing group to update patient records and process bills accurately and in a
more timely fashion
The data flow diagram below illustrates part of the company’s purchasing cycle. (Note:
The following data flow diagram does not depict a complete account of all the informa-
tion needs for the example. It does depict the flow of information at a high level, but
keep in mind that additional detailed specifics would be included in corresponding nar-
ratives, or additional flow diagrams or flowcharts would show a level deeper.)
Maintains Quality Throughout Processing •• Subscriptions to industry publications and regulatory updates
Considers Costs and Benefits •• Participation in industry conferences, trade shows, and other events
•• Subscription to third-party mailing lists and social media feeds (e.g., podcasts and
blogs) that pertain to the industry and company
Finance personnel evaluate the external information gathered and incorporate sig-
nificant events, trends, and changes into their day-to-day financial reporting or
related internal control responsibilities. In addition, finance personnel ensure that any
announcements about changes to current accounting standards or regulatory require-
ments are summarized, reviewed, and disseminated to the others within the external
financial reporting organization.
Accounting and finance personnel meet regularly with the internal audit department to
review and update internal accounting and control policies and procedures based on
the information gathered. In addition, they meet with the CFO to pass on any new infor-
mation and to discuss the impact on financial reporting and policies and procedures.
Accounting and finance managers update policies and procedures to reflect the impact
of the new information.
To reduce time, costs, and errors caused by human intervention, management has
implemented electronic data interchange (EDI) to replace the original process. Relevant
information about key business transactions is now automatically populated into the
company’s ERP system, and automated validation checks are in place to confirm that
information is transmitted completely and accurately. As well, the information gener-
ated through the EDI process is also available to production managers, order manage-
ment, and billing personnel, which allows them to perform control activities to support
proper end-to-end transaction processing, including creating the corresponding
accounting entries.
Accounting and finance personnel summarize the information gathered and meet
with the appropriate member of senior management to evaluate the impact on the
financial statements, internal control effectiveness, or changes needed to policies
and procedures.
Based on these meetings, Mr. Fernandez reviews inventory reserve policies, documents
key data points that impact prior estimates, and prepares an updated analysis support-
ing inventory reserve requirements. The CFO of Friesens then reviews and approves
the analysis as part of her review of the related journal entries during the month-end
closing cycle.
Arlene Gomez, the company controller, obtains monthly reports on operational and
compliance metrics from the chief operating officer. In addition, she reviews periodic
internal audit reports on the company’s adherence to policies and procedures related to
Management and employees in external financial reporting roles follow procedures • Maintains Quality Throughout Processing
for identifying and categorizing information. These procedures require that attributes Considers Costs and Benefits
about each piece of information be recorded before the information is accepted into the
repository. The attributes may include:
•• Information owner
•• Expected users
•• Criticality
•• Frequency
•• Process supported
•• Retention period
The information repositories are subject to control activities that help ensure the com-
pleteness, accuracy, security, validity, and lack of redundancy of the information.
•• The first phase of the project involved creating an inventory of the existing reports
identifying relevant sources and eliminating non-critical and redundant reports.
•• The second phase involved designing and implementing the functional and
technical capabilities needed to capture and store data used to generate relevant
information. This includes the consideration of automated control activities around
completeness, accuracy, restricted access, and validity of the data and informa-
tion generated.
•• The third phase involved training end users on techniques for effective input
and extraction of information and reports from the data warehouse using
reporting tools.
•• The final phase involved designing and implementing operating procedures and
control activities over the data warehouse and reporting tools to ensure the com-
pleteness, accuracy, restricted access, and validity of the data and information
input and reports generated.
The implementation project team was led by the controller, who was supported by
employees involved in the purchase to payables process. Workshops were held to
confirm the current end-to-end process and identify important information about
sources of transactions, key data requirements, risks to financial reporting, and informa-
tion required for accounting and reporting. The project team used the results from these
workshops to review the ERP module’s capabilities for automating tasks and controls
such as:
•• Checking that data input was valid, complete, and accurate to electronic sources
•• Passing data between the related transactions to minimize data entry and improve
data consistency
accurate, complete, and timely information to perform internal controls over the evalu-
ation of accounting entries and disclosures for accounts payable and accrued expense
balances, purchasing commitments, and expected cash balances.
The following flowchart was created as a result of the above procedures and assisted
management in identifying the relevant information.
B Checking that data input was valid, complete, and accurate to electronic
sources
The chief information officer and the credit and collections manager have designed
and implemented continuous transaction monitoring software to support their data and
information quality efforts. This software helps management to verify accounts receiv-
able balances each day and to avoid time-consuming month-end reconciliations by
quickly identifying data anomalies. Targeted data queries allow the software to identify
duplicate entries, unusual transactions, missing data, and incomplete data transfers.
Additionally, continuous monitoring software enables data analysis used to support
control activities to detect potential indicators of fraud.
Bio-Adaptive, Inc., a global life science and chemical manufacturer, has developed stan-
dard operating procedures to identify, classify, and secure financial data and informa-
tion across the entity and the stages of information life cycle (input, processing, output,
storage). As part of these procedures, personnel:
•• Identify financial data and information that requires restriction of access and
retention in order to meet reporting requirements
•• Assign appropriate data security categories to sensitive financial data and infor-
mation when input into the information system
•• Review automated application controls that support security, privacy, and storage
of financial data and information based on the data security category input
•• Review periodically that sensitive financial data and information have been prop-
erly categorized22
This process reduces the time required to format, organize, and report data. It also
enables the company to tag data through eXtensible Business Reporting Language
(XBRL). XBRL enables Freedom Corp. to meet certain external financial reporting
requirements and to perform comparative analyses to historical, competitor, and pro-
jected financial data.
22 This example is continued in Chapter 6, Monitoring Activities, to illustrate how monitoring activities may
assess whether controls to effect principles in information and communication are deployed as intended
(see page 147).
Communicates Internally
Principle 14. The organization internally communicates
information, including objectives and responsibilities for
internal control, necessary to support the functioning of
internal control.
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
company’s website
•• Senior finance and executive management visits to plants, sales offices, major
customers, and other locations
Mr. Tomlinson uses these mechanisms to reinforce company expectations for adher-
ence to internal control over external financial reporting, laws, and regulations; the
importance of the company’s internal audit function; and actions taken in response to
internal audit findings and internal control recommendations from its external auditors.
In turn, Ms. Wilcox finds the broadcast emails an effective means of sharing informa-
tion about the company’s business objectives and goals, including a periodic update
on progress toward those goals. She also visits the various corporate sites and meets
with employees and managers to ascertain how well they understand key business and
financial objectives relevant to their sites and to reinforce the messages about inter-
nal control from Mr. Tomlinson. Presentation material and supporting information and
intranet links are provided to the participants to support these communications.
•• Changes to accounting policy and regulatory rules that would impact how the
company processes its financial transactions and produces its financial reports
The internal audit department reviews the information in the repository as part of its
ongoing and separate evaluations. Updates to specific internal controls are commu-
nicated to both the control performer and reviewer through email alerts with links to
the repository.
•• Internal controls
The reporting tool also provides a personalized dashboard; workflow process (for
performance or review, as appropriate); reporting capabilities for more detailed status,
issues, and trends; and other information to understand and manage the individual’s
internal control responsibilities.
the method of communication. The charter specifies key guidelines, which may include: • C
ommunicates with The Board
of Directors
•• Frequency and number of board meetings, including committees of the board
Provides Separate Communication Lines
•• Objectives of each board or committee meeting (e.g., strategy reviews, annual • S elects Relevant Method of
budgets, and plan reviews) Communication
Mr. Cummins reviews the annual calendar of audit committee meetings and the general
agenda for each meeting. He develops specific topics for discussion for each meeting
relevant to the company’s external financial reporting requirements and confirms the
agenda details with the CFO, CAE, and audit committee chair. Based on the detailed
agenda, Mr. Cummins gathers relevant information to be included in the audit commit-
tee meeting materials that are sent to members one week prior to the meeting. From
time to time, he requests that members of management attend meetings to present
information in person and allow for active communication. For example, the CIO
presents on the company’s security and privacy programs and new events that may
impact risks.
Mr. Cummins also meets with the chair of the audit committee on a periodic basis to
communicate issues or risks related to significant, time-sensitive transactions, or to
update the audit committee chair on significant issues, such as investigations of poten-
tial fraud.
At each quarterly meeting, the CFO and the CAE present a summary of key changes
in internal control, results of evaluations, and actions in response to any deviations
identified. Matters of significance are reported in writing. The audit committee holds
separate private sessions with management and the external auditors. These sessions
provide the audit committee and either management or the auditors with an opportu-
nity to share sensitive information and ask probing questions that facilitate each party’s
responsibilities related to internal control.
The management team sends the package to the board in advance of the meeting to
allow board members to review and follow up with management in preparation of the
meeting, if necessary.
The hotline is administered by a third party. All matters received on the line are catego-
rized, summarized, and reported to a separate compliance department that reports to
internal audit. The director of compliance then reviews and prioritizes all reports.
Information about each reported matter, including evidence gathered, actions taken,
and conclusions reached, is documented in a separate, confidential section of the
hotline system.
•• Town hall meetings where employees are encouraged to ask questions and
discuss their concerns
As an added measure, all staff involved in the financial reporting process is assigned a
mentor with financial reporting and internal control experience. This provides an alterna-
tive to the employee’s line supervisor for discussing and reporting concerns on matters
such as compensation, operations, or internal controls.
The representatives on the council review all matters raised to consider how they
impact the various departments of Sea to Sky. Council members take turns recording
the meeting proceedings, which are reviewed by all council members and then shared
with the CFO.
Communicates Externally
Principle 15. The organization communicates with external
parties regarding matters affecting the functioning of
internal control.
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
•• Internal controls over transactions and balances that represent significant pay-
ables, receivables, or commitments to external stakeholders
•• Policies for protecting information received from external parties during normal
business transactions
•• Policies related to performing background checks and credit checks, or using col-
lection agencies
ConFab’s management team has specific policies and procedures for the purchasing,
manufacture, and preparation of shipments to mitigate its economic exposure and that
support its estimates for inventory reserves. Management communicates these policies
to the manufacturers, along with specific contract clauses that require adherence to the
policies and the right to audit by the company.
To ensure that policies and procedures are carried out as intended, ConFab has imple-
mented several methods of communicating with the contract manufacturers:
•• A website is built specifically for communications between the company and the
contract manufacturers.
•• A variety of periodic reports from the contract manufacturers are provided, which
are used in company control activities to ensure that inventory balances and
related estimates are properly reported.
ConFab also performs annual reviews of the contract manufacturers’ controls that
support the completeness and accuracy of reports provided throughout the year.
•• Meetings with outside advisors or subject matter specialists with the expertise to
assess complex accounting and disclosures for major transactions or events
After these discussions, Ms. Nachbar met with the senior management of Norgaard-
Kellogg responsible for trading activities to discuss the regulator’s findings and her
own evaluation of the issue and recommendations for enhancements. The informa-
tion was shared with the disclosure committee, a group responsible for assessing
the requirements for disclosures in external filings. After approval of the proposed
actions by the disclosure committee, Ms. Nachbar developed an action plan for updat-
ing internal control policies, procedures, and related documentation to address the
compliance requirements.
Clint Bell, the assistant treasurer, is responsible for obtaining and analyzing informa-
tion from an outside advisory firm related to the past, present, and future expectations
of currency fluctuations. One of his sources is a subscription service that provides
reporting on currency values, changes in values, and trends over periods of time. It also
provides alerts if currency fluctuations exceed certain thresholds.
Mr. Bell sets up the relevant currencies, time periods, and alerts appropriate for Nevio
Group. The treasurer reviews the settings and approves changes, if needed, each
quarter. On a monthly basis, or more frequently based on alerts received, Mr. Bell evalu-
ates the currency rates used for financial accounting associated with significant esti-
mates impacted by currency values.
Based on the information gathered and corroborated from various external sources, he
updates his analysis estimates. The analysis is given to the treasurer, director of finan-
cial reporting, and controller to help them ensure that the basis for their estimates and
communications in external reports is current and appropriate.
•• Sending to all customers periodic surveys with standard questions regarding the
company and its products or services
•• Confirmation of continued use of products or services that may impact the esti-
mated life of assets or term of contracts used for accounting judgments
•• Issues, concerns, or return activity of company products that may indicate that
recorded sales transactions were not valid
•• Feedback on company individuals that the customer interacts with during the
sales, delivery, support, customer service, or billing process
The information gathered through these conversations is shared with finance and other
relevant company personnel. Any issues that indicate a potential financial reporting
issue, such as incomplete delivery of products or services, or billing and payment, are
further investigated. Where changes in the accounting for transactions are needed,
additional reviews are performed to ensure that the issues are fully resolved. Also, an
evaluation of internal controls for deficiencies is conducted to prevent or detect issues
from recurring.
The director of internal audit, Naseema Bahair, evaluates each matter and develops an
action plan, which includes:
Internal control issues or recommendations for improvement that are identified by the
external audit firm are assigned to an employee in the impacted business process
area, and that person develops and presents a recommended response at the monthly
meeting, or more frequently if needed. The management team evaluates each response,
such as modifying internal control activities; reinforcing awareness; updating policy,
procedure, or control documentation; or performing additional evaluations, and assigns
responsibility for carrying out the response.
Results of the management meeting are communicated to the external audit firm. As
well, a summary of significant issues and observations are presented at the audit com-
mittee meeting at set intervals during the year or as necessary.
6. Monitoring Activities
Chapter Summary
Principles Approaches
17. The organization evaluates and com- •• Assessing and Reporting Deficiencies
municates internal control deficien-
•• Monitoring Corrective Action
cies in a timely manner to those
parties responsible for taking cor- •• Developing Guidelines for Reporting
rective action, including senior man- Deficiencies
agement and the board of directors,
as appropriate.
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
•• Integrates with Business Processes—Ongoing evaluations are built into the busi-
ness processes and adjust to changing conditions.
Uses Knowledgeable Personnel •• The entity’s regulatory requirements and financial reporting objectives
Integrates with Business Processes •• How quickly the entity’s industry and/or regulatory environment is changing or
• Adjusts Scope and Frequency anticipated to change
Objectively Evaluates
•• The results of historical evaluations of control effectiveness
•• Changes that have occurred in the current year that impact other components of
internal control
Senior management may also increase the frequency of separate evaluations from the
initial plan in processes where:
•• More active oversight of Viliam’s recently enhanced risk management and gover-
nance processes
•• An iterative risk assessment process that performs a risk review annually and
more often if the business changes
•• Reviews of financial and operational data to identify risks and adverse trends, and
to respond to them accordingly by conducting targeted audits
•• Identify necessary changes in design and conduct of internal controls that result Objectively Evaluates
from monitoring activities
•• Evaluate changes in people, processes, and technology that may impact the
design and implementation of controls
•• Establish a new baseline that incorporates any changes that impact the
previous baseline
Senior management may use the baseline information to establish which ongoing and
separate evaluations are most appropriate.
Some metrics have clearly defined allowable tolerances that have been calculated for
current performance data, which may be used to highlight anomalies. Other metrics
have less defined thresholds and are reviewed by knowledgeable employees for reason-
ableness and unusual items.
•• Current head count compared with expected and historical head count for the
month, quarter, and year
•• Current payroll compared with expected and historical payroll for the month,
quarter, and year
•• Current overtime in hours and dollars compared with expected and historical
overtime in hours and dollars for the month, quarter, and year
In his review, Mr. Saunders looks for any unusual fluctuations, such as increases and
decreases in the number of employees and excessive overtime. His review is done in
the context of current plant productivity and target thresholds based on historical data
and planned productivity, which varies by season. If Mr. Saunders identifies any fluctua-
tions, he investigates the underlying reasons and adjusts the process or control activi-
ties as needed.
23 Metrics, often operational in nature, may use information that indirectly signals a failure or anomaly, but
there may be other information available more directly linked to changes or failures. The value of metrics
should be considered when an entity evaluates what mix of ongoing and separate evaluations is appropri-
ate for that entity.
Mr. Rosco leverages his knowledge of changes in the business when developing
his expectations on how performance is likely to be consistent with, or vary from,
established targets. In the case of accounts payable KPIs, those variances from the
established targets could result from known factors, such as significant new vendors,
changes in payment terms, and cash flow goals. Where results do not meet expecta-
tions, Mr. Rosco evaluates them for potential underlying issues in established control
activities. Additionally he uses the KPIs to identify trends that could indicate some
fraudulent activity (e.g., he sees a concentration of payments to a vendor that is new or
for which he would not expect that volume).
He shares his findings with the management team, which uses the information in perfor-
mance appraisals and related development programs.
•• Detailed and/or summarized information about control performance • Uses Knowledgeable Personnel
• Integrates with Business Processes
•• Metrics being measured and/or information being highlighted for evaluation and
Adjusts Scope and Frequency
investigative follow-up
Objectively Evaluates
•• Visual depictions of the status of control operation
•• Key personnel and contact details for those responsible for processes and
sub-processes
24 A dashboard, a management tool or report that presents in a summarized manner data on the relevant
business performance areas, is often operational in nature and may use information that indirectly signals
a failure or anomaly, but there may be other information available more directly linked to changes or
failures. The value of metrics should be considered when an entity evaluates what mix of ongoing and
separate evaluations is appropriate for that entity.
Management then considers this information when reviewing tooling costs included in
inventory. In the monthly management meetings, these dashboards are reviewed. Each
of the managers responsible for specific tasks discusses recent progress and expected
changes over the coming month. To the extent that an increase in tool usage was noted,
management would expect that costs related to tooling would be up for the period.
25 Note that many automated activities used to prevent or detect unintended events or results would be
considered control activities.
monthly meetings to determine if any fraud is occurring or if journal entry control activi-
ties for authorization limits need to be changed.
26 This example is a continuation of the example in Chapter 2, Control Environment (see page 30).
27 This example is a continuation of the example in Chapter 5, Information and Communication (see page
123).
manufacturing facilities throughout the world. Every year, the company’s senior financial
officers for each division visit each subsidiary’s headquarters, manufacturing site, and/
or sales office to gain an understanding of significant business processes at those loca-
tions. During these visits, the senior financial officer discusses procedures and controls
for all relevant processes impacting financial reporting with those performing the control
activities and their supervisors. In addition, a mini-audit of select control activities is
conducted, the findings are documented, and the local team develops management
action plans for all pertinent recommendations. In addition, findings are shared broadly
throughout the organization to facilitate control enhancements at other locations,
and areas of concern impact the focus of future senior officer visits at this and other
locations.
The senior management of Jaron recognizes that self-assessment, while not completely
objective, is an effective first line of defense against internal control failure. Internal audit
helps compensate for the lack of objectivity in the control self-assessments by perform-
ing periodic audits and comparing the results to the self-assessments.
•• Areas where separate evaluations have identified control deficiencies that were
not reported through the self-assessments
Now Jaron and Associates is better able to focus its separate evaluation efforts on a
prioritized risk basis and modify ongoing evaluations where necessary.
•• Approval for the planned separate evaluation activities by the board of directors or
one of its committees
Once the review is complete, Ms. Geide submits a report on the process controls to
senior management and the board covering the scope of the work (including identifi-
cation of the controls evaluated), a description of the major risks and the appropriate-
ness of the controls, a list of identified deficiencies, and management’s response and
proposed remediation.
•• The outsourced service provider’s applicable control objectives Establishes Baseline Understanding
Uses Knowledgeable Personnel
Integrates with Business Processes
• Adjusts Scope and Frequency
28 This example is a continuation of the example in Chapter 3, Risk Assessment (see page 73).
• Objectively Evaluates
29 The review of controls at the outsourced service provider is covered in Chapter 4, Control Activities.
•• Details about which of the outsourced service provider’s internal control have
been examined and included in any report
•• The details and results from any independent audit testing performed
•• Special considerations for the outsourced service provider that impacts the report
To determine what impact any identified changes may have on the entity’s system of
internal control over external financial reporting, the following may also be assessed:
•• Whether exceptions were noted that may trigger further review by senior
management
Points of Focus
The following points of focus highlight important characteristics relating to this principle:
30 In many cases the board of directors will appoint a committee to oversee the system of internal control
depending on the objective. For example the board may appoint an audit committee to oversee system of
internal controls for financial reporting.
31 For example, in the United States, the SEC issued “Commission Guidance Regarding Management’s Re-
port on Internal Control Over Financial Reporting Under Section 13(a) or 15(d) of the Securities Exchange
Act of 1934.” Section B.1. covers the evaluation of control deficiencies that provides management with
guidance on the assessment and reporting of deficiencies.
variances of 10% for a particular vendor, Bosque & Sons Installers. An investiga-
tion confirmed that Mr. Chinstrap had an arrangement with Bosque & Sons for
a financial kickback and that Adelie Telecom was overpaying the contractor. To
address the deficiency in internal control, management implemented a supervi-
sory review for all payments within the 10% variance.
For each level of deficiency,32 the company’s internal reporting structure calls for certain
reporting procedures:
•• Deficiencies are reported in detail to the manager responsible for the control.
32 For purposes of this example the deficiency classifications used are those related to external financial
reporting in the US as promulgated by the SEC.
Specifically, the plan calls for one individual within the business unit to be assigned
responsibility for remediating specific control deficiencies. A time frame for remediation
is assigned to each control deficiency, based on its ranking. Working together, man-
agement and internal audit verify that deficiencies are remediated within the specified
time frame.
When sufficient action has not been able to be taken by the business on important
internal audit issues by the original reported implementation date, the process owner for
the area is invited to attend the audit committee and explain the issues associated with
implementation of appropriate actions.
Management has also developed with the audit committee a shared expectation, which
states that regardless of the previous categorization, management will report all defi-
ciencies resulting from:
The audit committee is briefed on the cause of the reported deficiencies and provides
oversight of management’s assessment of the deficiencies and the actions and status
of remediation plans.
Appendices
A: Examples by Topic
1. Expectations for Governance Oversight
Assessing and Disclosing Director Qualifications 28
Maintaining Oversight 72
4.
Demands and Complexities of Laws, Rules, Regulations, and
Standards
Analyzing Risks from External Factors 68
Obtaining Information from External Sources to Assist with Accounting Estimates 135
Data Capture and Processing for the Purchasing and Payables Cycle 120
Using Governance, Risk, and Compliance Technology to Manage Internal Controls 126
Identifying and Analyzing Risk of Material Omission and Misstatement Due to Fraud 73
Some respondents concurred with COSO that the Compendium provides useful illus-
trations of applying the Framework in an external financial reporting context. Some
respondents expressed a view that the Compendium would not set a higher thresh-
old for attaining effective internal control over external reporting or impose additional
burdens on entities that report on internal control over external financial reporting.
Some agreed that the Compendium applies to both larger and smaller entities; however
some requested additional examples specifically focused on smaller entities. PwC and
the COSO Board note that many examples were obtained and updated from the COSO
Guidance for Smaller Public Companies issued in 2006 and believe that most examples
included in the Compendium apply to both larger and smaller entities.
Additionally, the Introduction has been updated to include further discussions about:
•• Limitations of Illustrations
•• Risk Response