Source: http://normanmarks.wordpress.com

I am still in the process of my detailed review of the update. However, I have already formed two opinions:

• The assertion that “an effective system of internal control reduces, to an acceptable level, the risk of not achieving an entity objective and may relate to one, two, or all three categories of objectives” is excellent and I am pleased that it comes before any discussion of principles
• The assertion that follows, that this (reducing risk to an acceptable level) requires that “each of the five components and relevant principles is present and functioning” creates a serious problem

Let’s examine the problem created by COSO saying that effective internal control requires that all relevant principles are present and functioning. I say ‘principles’ because the Framework asserts that no component can be assessed as present and functioning if there are major issues with any of the related principles.

Rather than taking an approach that requires that risks to the achievement of objectives be identified, and then an assessment made as to whether the combination of controls across all components of the Internal Control Framework reduces the level of risk to acceptable levels (i.e., a top-down, risk-based approach like those recommended in PCAOB, SEC, and IIA guidance), the assessor is directed to assess the principles. This creates a high risk, highlighted by many commentators on the drafts submitted earlier for review, that the assessment will be based on a checklist: a checklist formed by the principles.

Now an argument can be made, requiring some contortions of logic, that the same result as a top-down and risk-based approach is achieved because the principles include the required steps of a risk-based approach (principle 7 refers to the identification of risks, principle 10 identifies control activities that “contribute to the mitigation of risks to the achievement of objectives to acceptable levels”, and principle 11 talks about IT general controls – though they should be included in principle 10). Then, so the logic goes, the assessment is made as to whether there are any major deficiencies (i.e., one that “severely reduces the likelihood that the entity can achieve its objectives”). Does this, in fact, result in the same assessment?

Possible, but unlikely.

1. As we know from PCAOB and SEC guidance and our experience on SOX assessments, indirect entity-level controls do not necessarily result in a higher risk of failure to achieve objectives (in the case of SOX, the objective is a set of financial statements free from material misstatement). Indirect entity-level controls only create a higher risk that direct controls will fail. Then it is up to the assessor to determine whether, especially considering the quality of monitoring controls,  the risk to objectives is greater than acceptable levels
2. The determination of a major deficiency (see above) is not whether the risk to achievement of objectives is greater than acceptable levels. That assessment, requiring judgment, still has to be made but is not referred to as far as I can tell in the updated Framework
3. I believe it is likely that an assessment based on the principles rather than risks to the achievement of objectives will result in (a) assessment of principles that are not relevant to the assessment of risk to achievement of objectives, and (b) a failure to consider all the key controls (using SOX language) relied upon to reduce the level of risk to objectives to acceptable levels

Why do I believe this? Just look at the COSO (or PwC) suggested templates for assessing internal control. Do they take a top-down, risk-based approach, or do they instead ask for an assessment of the principles, with yes or no answers and no reference to acceptable levels of risk?

I suspect that over time we will learn how to use the updated Framework while remaining true to the top-down and risk-based approach. But, in the meantime I fear that many will lose their way.

Until now, the choice has been rules-based or principles-based. I always thought that in the case of internal control, principles-based referred to the principle that internal control is not perfect and only provides reasonable assurance that risks to the achievement of objectives are at acceptable levels. PwC and COSO have blurred, in my opinion, the distinction between rules-based and principles-based. I just wished they had gone for “risk-based”.

I welcome your comments.