Struggling to incorporate the COSO
recommendations into your audit process?
By Dennis Applegate
and Ted Wills
In 1992, the committee of sponsoring organizations of the Treadway Commission (COSO) issued a landmark report on internal control. Internal ControlIntegrated Framework, which is often referred to as "COSO" provides a sound basis for establishing internal control systems and determining their effectiveness.
Following the reports publication, The Boeing Company adopted the COSO principles partly as the basis for its internal control policies and procedures. As a result, our internal audit department began to rate the quality of internal controls covered in each audit. We soon discovered that incorporating these standards into actual practice proved challenging. While informative, our ratings were mostly subjective, lacking the systematic analysis and documented support normally reflected in our reports. To achieve a higher quality result, we reengineered our existing audit methodologyfrom inception, through fieldwork, to final reportingto fit the COSO framework.
Our effort was a success. No longer incidental to our processes, COSO now provides the foundation for all our audit work.
According to COSO, the three primary objectives of an internal control system are to ensure (1) efficient and effective operations, (2) accurate financial reporting, and (3) compliance with laws and regulations. The report also outlines five essential components of an effective internal control system:
° THE CONTROL ENVIRONMENT, which establishes the foundation for the internal control system by providing fundamental discipline and structure.
° RISK ASSESSMENT, which involves the identification and analysis by managementnot the internal auditorof relevant risks to achieving predetermined objectives.
° CONTROL ACTIVITIES, or the policies, procedures, and practices that ensure management objectives are achieved and risk mitigation strategies are carried out.
° INFORMATION AND COMMUNICATION, which support all other control components by communicating control responsibilities to employees and by providing information in a form and time frame that allows people to carry out their duties.
° MONITORING, which covers the external oversight of internal controls by management or other parties outside the process; or the application of independent methodologies, like customized procedures or standard checklists, by employees within a process.
We use these elements to define the control objective to be audited, assess the components of Boeings control system, and report the results to management. Integrating COSO in this manner adds structure to our audit process, ensures that appropriate criteria are considered in key phases of each audit, and provides a trail to support the conclusions reached.
If, after conducting audit research or fieldwork, a deviation from the predefined objective becomes necessary, the proposed change must be reviewed and approved by audit management. The working papers also must be amended to describe the rationale for changing the objective. As a practical matter, audit projects are normally completed without varying from the initial COSO objective.
Most audit projects will have a readily apparent objective based on the function or process to be reviewed. For example, a "program shop scheduling" audit clearly falls into the operations category. The objective of other audits, however, may not be so obvious. A "receiving inspection" audit may have either an operations focus or a compliance focus, depending on the type of management controls to be examined. Similarly, an audit such as "cost collection on the shop floor" may focus on operations or financial reporting, again depending on the controls to be assessed. For those few projects where the COSO objective is not clearly ascertainable, it is the auditors responsibility to identify the controls on which the majority of the audit work will concentrate and to select the appropriate audit objective based on the following guidance.
BENEFITS OF COSO-BASED AUDITS
Operations An operations objective focuses on controls governing efficiency and effectiveness. Effectiveness concerns the quality of controls over the achievement of specific management objectives, while efficiency addresses the quality of controls yielding an optimum measure of resource inputs to productive outputs. An operations audit should determine whether the organization can be reasonably assured that no material inefficiencies or lack of effectiveness exist in the audited organization or process.
Because Boeing is in a highly regulated industry, it is tempting to regard every operations audit as a compliance audit. However, an overall evaluation cannot be provided unless the audit evaluates the entire system of controls for ensuring compliance with laws and regulations. Such a system includes the relationship with the regulatory agency, Boeing internal policies and procedures, the people specifically assigned to promote compliance, and the methods for monitoring compliance effectiveness. Only audits that address each aspect of the compliance program can render an overall opinion on how well the system of internal controls assures compliance with the laws and regulations in question.
At the same time, operations audits that incidentally identify noncompliance with internal procedures provide useful information that must be communicated to management. Auditors are expected to note such potentially illegal violations as incidental findings on the control evaluation form.
RATING CRITERIA FOR COSO-BASED AUDITS
Financial Reporting In audits where the objective is financial reporting, emphasis is placed on the adequacy and effectiveness of management controls governing the reliability of financial data used for external reporting purposes. An audit based on such controls should provide reasonable assurance that no material misstatements exist in the examined data. Tracing audit controls and financial data back to the financial statements is indicative of an audit with a financial reporting objective.
An audit that reviews the assumptions and methods used to estimate contract costs-at-completion typically has a financial reporting objective. Similarly, audits of accounting controls that govern the preparation of financial statements generally will have financial reporting as their audit objective. Though there are exceptions, many finance-function audits focus on financial reporting since their scope often reflects the audit objective.
It might be initially difficult to determine, for example, whether an audit objective for accounts payable belongs in the operations or the financial reporting arena. The answer would depend on the kind of management controls to be audited. Likewise, audits of "cost screening for government allowability" could potentially address all three objectives: process efficiency and effectivenessoperations; adherence to Federal Acquisition Regulations (FAR) requirementscompliance; and reliability of cost classification and transaction processingfinancial reporting. Selecting the objective is a matter of auditor judgment and depends on the nature and preponderance of management controls to be examined.
Compliance Audits based on compliance focus on the adequacy and effectiveness of management controls governing adherence to external laws and regulations. Such audits are primarily concerned with the correlation between laws and company procedure and actual practice. We usually consult our in-house legal counsel extensively during audits of this naturean excellent indication that the audit should have compliance as its objective.
An audit of company adherence to the provisions of the Foreign Corrupt Practices Act is illustrative of a typical compliance audit. Examples also include audits of controls governing compliance to FAR "cost disclosure," FAR "defective pricing" requirements, and the Federal Aviation Administrations "unapproved parts" inspection requirements.
ASSESSING CONTROL COMPONENTS
In defining each control component, COSO identifies several control factors. We use these factors, as criteria for rating the effectiveness of controls. Our auditors must consider each factor during audit program development, and they must design appropriate inquiries and tests when assessing control effectiveness. By requiring each control component and factor to be addressed, we are seeking to ensure greater consistency in audit performance and to maximize audit effectiveness.
To ease understanding and application of the criteria, control component ratings are restricted to satisfactory or unsatisfactory. We considered alternative rating structures, but concluded that this binary approach, along with supporting rationale, communicated the right information. In unusual cases where the auditor stumbles across a reportable condition outside the system of internal controls being audited, an "incidentalsatisfactory or unsatisfactory" observation may be recorded.
The assigned ratings must comport with the predefined criteria, be predicated on reliable audit evidence, and be documented in the working papers. If controls provide reasonable assurance that management objectives will be achieved, a satisfactory rating is assigned. An unsatisfactory rating is used if controls do not provide such assurance. While auditor judgment plays a significant role in assigning ratings, the existence of corrective recommendations suggests an unsatisfactory condition. To support auditors in rating controls, weve provided guidance that addresses each control component.
The Boeing Control Evaluation Form
Control Environment For ease of analysis, the control factors for this component have been divided into hard and soft controls. At Boeing, hard controls consist of organizational structure, assignment of authority and responsibility, and human resources policies and practices. All three are relatively traditional areas examined in most audits. Audit evidence for each should be readily available.
Soft controls include ethics, commitment to competence, and management operating style. Such controls have traditionally been overlooked in audits because documented evidence of the audit condition is difficult to obtain and test.
If any one of the hard controls isnt functioning effectively in the area being audited, an unsatisfactory rating is warranted. On the other hand, proper behavior is assumed for soft controls. An unfavorable audit conclusion is reached only if improper behavior is observed. A satisfactory rating wouldnt be ruled out if the auditor finds no direct evidence that the "soft controls" are in place. Only if instances of unethical, incompetent, or improper management behavior are discovered should the auditor consider an unsatisfactory rating. The level of assurance provided by the auditor for soft controls is, therefore, much less than normally rendered. As techniques for testing soft controls improve, rating criteria may be revised to render more positive assurance.
Risk Assessment According to COSO, effective risk assessment requires:
° Predefinition of objectives.
If any one of these factors is absent, an unsatisfactory rating is generally warranted. Furthermore, audit inquiries and tests should be designed to determine if there are key risks not contemplated by management. If such risks are identified and deemed critical, an unsatisfactory rating should be rendered on that basis alone, even if all the factors listed are present.
Control Activities Regardless of the type of audit or the nature of the control activities being examined, it is standard audit practice to document specific control activities and related control objectives in auditor working papers. Generic control activities by type of audit might include:
Financialwritten procedures, authorizations, record-keeping, management reviews, and asset safeguards segregated to prevent fraudulent financial data and asset misappropriation.
Information Systemgeneral, hardware, and application controls designed to ensure the reliability of the operating system, the accuracy of the data outputs, and the protection of equipment and files.
Operational directive, preventive, and detective controls focused on achieving efficient resource usage and effectiveness as measured by the extent to which specific control objectives are achieved.
If key control activities have not been implemented or are not achieving their prescribed purpose, then an unsatisfactory rating for this control component normally would be warranted. Stated differently, there must be reasonable assurance that key control activities are operating as intended, based on their control objectives. If the risk mitigation strategy of management is absent or not adequately reflected in control activities, then this condition alone would call for an unsatisfactory rating.
INFORMATION AND COMMUNICATION COSO mentions several control factors for information and communication. We expect our auditors to assess at minimum:
If one or more of these factors are not operating effectively, an unsatisfactory rating should be considered.
Monitoring A process of control assessment established by management, monitoring determines the quality of the internal control system over time. Some form of independence from the daily process is necessary to ensure that monitoring serves as an effective control. Therefore, we do not consider routine management reviews of performance within a process as part of the monitoring component. Instead, such reviews are considered control activities.
Monitoring involves external oversight of internal controls by management or other parties outside the process. It may also include the application of independent methodologies, such as customized procedures or standard checklists, by employees within a process. If management fails to establish a monitoring process for its internal control system, either in the form of independent evaluations or ongoing monitoring, then a satisfactory rating for this control component normally would be inappropriate.
The control evaluation form is completed prior to the audit exit conference and reviewed with other auditors and audit management. These interim reviews determine whether sufficient basis exists for the ratings assigned. Auditors are encouraged to discuss the ratings with the audit customereither directly, using the control evaluation form, or indirectly during review and discussion of the audit findings. These discussions are most effective when we speak in terms of "our control framework" and avoid use of the "COSO" acronym.
The control evaluation form is finalized as the audit report is prepared, and a completed form is transmitted to the general auditor at the end of each project. Control ratings are summarized at group and company segment levels, forming a basis for reporting on the status of internal controls to senior management and the audit committee. Data is tracked to determine unsatisfactory control trends, as well as areas of audit risk to address in planning future audit projects. For example, if unsatisfactory ratings consistently appear in the monitoring control component, then additional audit emphasis and management visibility may be given to self-reviews, control self-assessment, and similar ongoing monitoring techniques. All control evaluations are summarized semi-annually and presented, with appropriate explanation, to the audit committee as part of the companys internal control systems assessment.
THE ROAD TO SUCCESS
In addition, there was limited understanding of the COSO framework among audit staff, and no criteria regarding control ratings were provided to ensure consistency. Compounding the problem, two significant mergers involving Boeing, Rockwell, and McDonnell Douglas consolidated three audit staffs with different perspectives on performing internal audits. Of even greater concern was the fact that many auditors failed to see any real benefit in rating internal controlsa perception not without merit given the lack of guidance and confusion over terminology.
These problems were overcome through a consensus-building process combining employee involvement, management direction, detailed written guidance, workshop training, and follow-up verification. Training workshops were held to educate audit staff in the nature, purpose, and use of COSO. Revisions to our audit methodology were presented at these workshops to ensure consistent application. COSO-based rating criteria also were provided to guide auditors in reporting internal control conditions. To ensure goal congruence, a new internal control policy and procedure were issued, standardizing COSO application throughout the company and emphasizing managements responsibility for implementation.
In addition, senior management support was crucial. Without this backing, many typical barriers to change would have blocked COSO implementation. Such support included:
One benefit of this effort has been improved reporting on the companys internal control status to our audit committee. Since weve reengineered our audit process to reflect the COSO principles, company directors and senior executive management receive a snapshot of internal control effectiveness based on assessments derived from our COSO rating system.
Adapting the COSO framework to our standard audit process has been beneficial in other ways, as well. Most notably, we believe that concentrating on a single COSO objective during each audit will ultimately improve the efficiency and effectiveness of our projects. Our policy, which requires that all five COSO components be covered in all audits, has already improved the effectiveness of our audit work in cases where these components were not addressed in prior audits.
Another key benefit has been the provision of a universal framework for internal auditing at the new Boeing. Focusing on COSO helped develop a perspective of internal control concepts common to the auditors of the three recently combined companies. The reliability and comparability of our audit work product, however, depends on continued adherence to the prescribed methodology, as inconsistent implementation poses an ongoing risk. Peer reviews and ongoing monitoring should help to mitigate this possibility.
The path to COSO-based auditing is not easily navigated. Yet those shops willing to make the journey will be rewarded by more thorough audit coverage and improved management reporting.
Dennis Applegate, CPA, CMA, CFM,
Ted Wills, CPA, is Senior Auditor for The Boeing Company. He can be reached via e-mail at email@example.com.
Published in the December 1999 issue of Internal Auditor, The Institute of Internal Auditor