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Current Issues With COSO’s Draft Framework Update
Failure in the COSO Framework Community
In 1992, COSO issued its original COSO Internal Control – Integrated Framework. This framework was in response to the requirements of the 1977 US Foreign Corrupt Practices Act. Framework stakeholders raised the following points in their comments on the draft COSO 2012 update:
1. The vast majority of companies at the center of the global financial crisis were in compliance with SEC regulations that included effective internal controls over financial reporting (ICFR). Companies’ SEC filings claim effective ICFRs under COSO. Their ICFR assessment fails.
2. COSO has not defined and declared problems with existing COSO Framework content. An updated solution to a set of unknown problems has begun to be formulated.
3. The COSO 2012 update of the framework was developed primarily from a frame of reference.
4. This iterative development approach did not follow a “good decision workflow” process. The timing of the process does not provide for sufficient review, discussion and consensus development among different stakeholders with different frames of reference.
COSO has created a summary definition for an internal control framework that includes three control objective categories: operations, financial reporting, and compliance. Also the principles related to control are divided into five summary elements:
1. Risk assessment
2. Control environment – tone at the top
3. Control activities
4. Information and Communications
COSO followed up its original framework documentation with additional documentation on the principles and their properties. In 2004, COSO created guidance on how to design and implement an enterprise-wide risk management framework. In 2006, COSO issued guidance on the principles and attributes of the ICFR framework for small public companies. This document was used extensively by the SEC and PCAOB in their 2007 guidance and audit regulations. A set of principles-based documents for evaluation and assessment of the ICFR have been developed. COSO should be congratulated for avoiding the use of a rules-based approach.
Various commenters are calling on COSO to accomplish the following:
1. Public companies regulated by the SEC must have reliable guidance on how to apply principles to address business opportunities and risks with an effective and unique set of internal controls. The guidance should provide a comprehensive methodology for the assessment of ICFR.
2. COSO must clearly articulate the issues in existing framework materials and their application when formulating controls. There are broader issues in the creation, maintenance and evaluation of the COSO framework by management. A review of management’s assessments has identified significant deficiencies in corporate governance. Regulators do not yet appear to provide clear guidance on how external auditors should perform their assurance role. SEC’s focus on ICFR.
3. COSO must directly address quality control improvements for corporate governance and risk assessment. Better corporate governance and risk assessment are essential to prevent and reduce executive management excesses. The initial SOX regulations and the reactions to those SOX regulations did not address the corporate governance and risk management issues that Congress was trying to address with Sarbanes-Oxley. Auditing Standard 2 and the predominance of management’s internal control framework lead to the detailed processing of transactions, ignoring entity-level risk assessments. This opened the door for corporate governance and risk management failures: ie AIG, Fannie/Freddie, Lehman Brothers, Country Wide, Merrill Lynch, MF Global, Lehman Brothers, etc.
4. COSO must implement a “Good Judgment Workflow” process for approval of revisions to its content. COSO must recognize that developers are dominated by a single frame of reference: the Big Auditing Firm experience. Those of us who are external auditors, internal auditors, CFOs, CEOs, consultants to SEC registered firms, and educators of the framework understand how limited this frame of reference is in presenting an effective comprehensive framework.
5. COSO is required to establish a strategic plan and a tactical plan for its activities related to “quality control” over corporate governance and the issuance of audited financial statements. The Foreign Corrupt Practices Act of 1977 was the first federal mandate to use an internal control framework. COSO’s current framework was designed to meet this requirement. Most shareholders did not take this requirement seriously until the Sarbanes-Oxley Act was passed. During this 25-year period little work was done by COSO to advance the art of ICFR.
Confidence in COSO 2.0
Stakeholders believe that COSO can move forward to create a better set of guidance on establishing, maintaining and evaluating internal control frameworks. Historically, COSO has produced several guidance documents that have contributed to improving the internal control framework. Countless professionals have reached a foundational level of competency in elements of the framework using COSO content as part of their mentoring. Auditing firms have greatly increased their auditing of ICFRs and documentation of this test in their workpapers. Audit quality control systems are improving in most companies. Current members of COSO are motivated to increase the guidance being provided.
1. Develop a strategic and technical plan to update the original COSO framework as a quality control methodology covering corporate governance, financial reporting and compliance.
2. In the short term strategic period:
a Extend the current development team with additional frames of reference.
b Define a clear “good decision workflow” for comments, discussion, and approval that produce new base documents.
c Issue a clear problem statement that supports improvement efforts.
3. Recognize that if private stakeholders do not create a comprehensive set of guidelines, we will continue to have Congress and regulators set the guidelines.
4. Risk management, corporate governance, legal, information technology, quality control practices, operations, regulators, etc. Add membership and governance to COSO stakeholders who bring co-reference frames.
COSO will find that if all stakeholders participate in the process, we can advance the state of the art in the framework. If we can do this, we will create value for society as a whole.
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