yellow book

Nice Infographic, Now What?

Yes, the cube is cute, and the stack is pretty – but so what? What does all this new language mean to performance auditors, practically? What the cube and the stack are illustrating is the most up-to-date structure for approaching internal controls. This means that performance auditors are going to have to change the way they document internal controls! The GAO is working on a tool right now to help you with this task, but it won’t be published until the spring of 2019.

So, if you want to implement these changes in your internal control documentation right now, you will need to create a tool on your own. HUD has developed a tool that might get your creative juices flowing. Google “HUD IC Questionnaire 17 principles” to find it.

How are COSO and the Green Book Related?

But before we get too far along, let’s look at how the Green Book is related to the COSO (Committee of Sponsoring Organizations of the Treadway Commission) model and what our profession is trying to accomplish with both. As we will see, the Government Accountability Office (GAO) bases the Green Book on the COSO model.

The GAO Pushed for Better Controls in 1983.

In addition to auditing federal agencies and reporting the results back to Congress, the GAO also advises executive agencies on how to make government more efficient and effective. The Federal Managers Financial Integrity Act of 1982 requires the GAO to establish standards for internal controls. The GAO made its first efforts toward creating a standard for internal controls in 1983.

In the opening letter to this first version of the Green Book, the Comptroller General of the GAO said:

In the past decade, numerous situations came to light that dramatically demonstrated the need for controls as the Government experienced a rash of illegal, unauthorized, and questionable acts which were characterized as fraud, waste, and abuse. It is generally recognized that good internal controls would have made the commission of such wrongful acts more difficult. Consequently, increased attention is being directed toward strengthening internal controls to help restore confidence in Government and to improve its operations.

I wonder what the Comptroller General would think of the hijinks in the government realm in since that initial Green Book was issued 30 years ago!

Congress Pushed for Better Controls in 1977, and the Treadway Commission Was Formed

Six years before the Financial Managers Financial Integrity Act, corporate fraud was getting the attention of Congress. In 1977, Congress enacted the Foreign Corrupt Practices Act (FCPA) as a result of 400 US corporations admitting that they had made questionable or illegal payments to foreign officials as part of conducting business in other countries. In response, the Treadway Commission, a private-sector initiative, was formed in 1985 to inspect, analyze, and make recommendations on fraudulent corporate financial reporting.

The COSO Report Was Issued in 1992

As a result of the Treadway Commission’s initial report, the Committee of Sponsoring Organizations (COSO) was formed. COSO retained Coopers & Lybrand, a major CPA firm, to study the issues and create a report on controls. This report was titled Internal Control – Integrated Framework and was issued in 1992.

And for the first time, we were introduced to the COSO cube that many of us use in our work today.

Over time, the COSO model, as it came to be called, was integrated into various auditing standards including the American Institute of CPAs auditing standards, the GAO’s Generally Accepted Government Auditing Standards (the aforementioned Yellow Book), and the Institute of Internal Auditor’s professional literature.

SOX Renewed Interest in the COSO Model in 2002.

After a spate of corporate financial scandals (Enron, WorldCom, etc.) at the turn of the century, Congress passed the Sarbanes-Oxley Act (SOX) in 2002. The Sarbanes-Oxley Act requires that publicly traded companies in the United States certify that their internal controls over financial reporting are effective. Most corporations used the COSO model as the framework to guide this assessment.

The COSO Model and Report Were Revised in 2013

The COSO model was revised in 2013, more than 20 years after its initial creation. The 2013 revision didn’t alter the cube very much; the side of the cube now uses the term “division” instead of “unit,” and a few titles were changed on the face of the cube: “financial reporting” on the top of the original cube was changed to the more broad “reporting,” and “monitoring” was changed to “monitoring activities.”

The Five Components of Internal Control

The five components of internal control listed on the face of the cube are:

1. control environment
2. risk assessment
3. control activities
4. information and communication
5. monitoring

I need to admit, right up front, that I have never ‘clicked’ with face of the cube. You know how some business models just make you say to yourself, “Yes, of course, that is how it is!” For instance, the “Plan, do, check, act!” model. Those four steps – plan, do, check, act – are intuitive and sensible. The five components of internal control? Not so much.

Here is how I make sense of the five components (Warning: this appears nowhere in COSO literature!):

First, the organization needs to ask what risks it is facing. Once they have done this risk assessment, they can apply control activities to keep those risks from occurring. Then valid reports need to be generated that provide information and communicate with the stakeholders of the organization who need to know how well the controls are working. The organization should not just assume, but monitor to ensure, that the control activities and reports they put in place to tamp down risk are working. And all of this effort needs to take place within an encouraging, nurturing environment that appreciates and supports controls.

Does it still sound like Greek? Let’s dig a tiny bit deeper. Let’s begin with an overview of the five components starting where the cube starts, with the control environment.

Do You Care about the Environment?

The control environment component directly addresses the attitudes of the leaders of an organization toward controls. You will also hear this component described as ‘tone at the top.’ If the leaders of an organization are uninterested in excellence in operations, strict compliance with laws and regulations, and accurate and transparent reporting, efforts toward those objectives by the employees will fail.

I have seen a wide variety of control environments, as I am sure you have. Some control environments are strong and reassuring. Others vary from strong to weak depending on who is in the leadership position, and others are crazy disasters that eventually implode. And no matter the size of your entity, the leadership’s attitude permeates the whole organization. One of my jumbo clients sells groceries in 28 countries. Since I am also a customer of this grocery retailer, I was very pleased to hear an executive in charge of food safety initiatives talk openly and emotionally about his responsibilities to keep customers safe.

He began his presentation by sharing the pictures of children in his briefcase that he looks at every day. These were not picture of his children, but children who had died of food borne illness from all food sellers – groceries and restaurants – in the United States. Then he began to share statistics about how vulnerable children are to food borne illnesses. It was clear from talking to his grocery managers, that his serious attitude toward a serious risk had also affected their attitudes and, therefore, controls.

If his powerful message permeated such a large organization, imagine how much more the viewpoint of a leader in a small organization affects controls. Smaller organizations are particularly vulnerable to the attitudes of the leadership.

Regrettably, I agreed to be the treasurer for a small organization, the local chapter of the National Speaker’s Association and served for three years. We had about thirty members and six of them were on the board. The tone at the top dramatically altered the control environment every time we elected a new president.

Most of the members of the local chapter were motivational speakers, and some of them thought that if you just believed something with all your heart and mind, you could wish anything into existence. So, when I informed them at our first board meeting that I had carefully looked over the books and that we were close to bankruptcy, the response from the president was, “Well, if we just think positive thoughts, everything will work out.” A few meetings later, my less-than-positive prognosis came true. We were broke and couldn’t pay the hotel after our monthly Saturday meeting.

The chapter’s president conveniently disappeared after I informed her of this fact. Luckily, one of our successful and moneyed members named Jim stepped in and paid the bill.

Our new savior, Jim, was immediately appointed president. Jim was a six-and-a-half-foot tall ex-Marine who knew how to lead. At our first board meeting, he told the group that we were going to set a strict budget, and that we were going to talk about it at every meeting. All expenditures had to be approved by me before they were incurred. I silently clapped and cheered in my little accounting heart!

Everyone on the board was paying attention to my financial presentation at meetings (or at least they looked like they were paying attention), and I felt great about my role as treasurer. By the end of Jim’s term, we had built our bank account balance up to a healthy $14,000.

But, when Jim’s term was up, the group elected sweet John to be our leader. John preferred to spend the board meeting hugging and vision casting rather than worrying about tacky old money. At our first meeting under John’s leadership, we all discussed relaxation techniques – which just happened to be the focus of John’s signature speech. The group again began to ignore the budget, and by the end of John’s term, we were again near bankruptcy.

I realized that I would only be successful as a treasurer with the chapter if I had the strong support of the president. It didn’t matter how wonderful and clear and compelling my budget presentations were (and I tried everything I could to wake them up to the reality of the situation – emoticons, colors, graphics, dancing, singing). I was ignored. Only when Jim created an environment of compliance and fiscal restraint did the controls over our finances work.

My situation as a powerless treasurer plays out on larger, more important scales all the time. Do you remember the financial executive at Enron, Sherron Watkins, who wrote a memo to the chief executive about Enron’s fraudulent financial statements? The leadership didn’t want to hear it and published the erroneous financial results for public consumption. No matter how well she did her job, without the support of the organization’s leadership, her efforts were thwarted.

Controls Mitigate Risks

The second component – risk assessment – is all about making sure we put our resources toward things that matter. We don’t need controls over things we aren’t worried about. Controls are created to mitigate or reduce risk.

Here is a personal example: My family has two cars. One represents more risk to us than the other because it is worth more money. Let me begin by saying that my husband and I only buy used cars and pay cash for them. I was raised in new or nearly new cars. My father bought a new car every few years and still does. But now that I am paying the bills, I appreciate my husband’s view that new cars waste money.

My husband has been driving the same Toyota Sienna minivan (that we, of course, bought used) for the past 10 years or so. It has over 200,000 miles on it and doesn’t show any sign of stopping. It looks like a hideous, rolling pile of retro junk. It is worth about $1000 per the Kelly Blue Book.

Recently, I bought a beautiful, jumbo Lexus sedan with 100,000 miles on it. The sedan cost us around $18,000. We park my Lexus in the garage and repair every little ding. The mini-van is always exposed to the weather, and if it gets a ding, my husband reasons that it only adds to its character. Because more of our money is at risk in the Lexus, (and more of my ego is on the line with the Lexus!), we treat it better and we endeavor to control what happens to it. When a hailstorm hits – as they do at least once a year here in Austin – my husband’s first question is, “Is the Lexus in the garage?”

What do you care about in your organization? Is it that your assets are safeguarded? Is it that your customers and employees are safe? Maybe you care the most about making a difference to the disadvantaged? While it would be nice to have the time and the resources to worry and control everything, no individual or organization in the history of the world has been able to pull that off.

What a risk assessment does is lay out all of the possible things you might care about on the table (or in an Excel table!). It gives you a way of ranking them and deciding where you will to focus your efforts. Controls cost time and money, and you want to be intentional about applying them.

I have seen a wide variety of risk assessment models and risk assessment documentation. You can really go nuts refining the risk assessment and contemplating every eventuality, but at a very basic level, all you have to do is decide if you care. Simply ask yourself what could go wrong. And if you don’t care about the resulting answer, you don’t need any controls over it. So, if I ask myself if I will care if my Lexus suffers hail damage, I would say that I care – the mini-van, not so much.

What Most People Think of When They Think of Controls

The third component – control activities – is what most auditors think of when they think of applying controls. Control activities include such things as segregation of critical duties, transaction approvals, timely reviews of transactions, and documentation.

Figure 6 of the Green Book contains a fabulous list of control activities:

Figure 6: Examples of Common Categories of Control Activities

1. Top level reviews of actual performance
2. Reviews by management at the functional or activity level
3. Management of human capital
4. Controls over information processing
5. Physical control over vulnerable assets
6. Establishment and review of performance measures and indicators
7. Segregation of duties
8. Proper execution of transactions
9. Accurate and timely recording of transactions
10. Access restrictions to and accountability for resources and records
11. Appropriate documentation of transactions and internal controls

You Aren’t in This Alone!

Information and communication, the fourth component, acknowledges that you aren’t in this all by yourself. Various stakeholders need to keep informed about what is going on.

Any endeavor will generate critical information and this information will allow stakeholders to evaluate the success of the organization’s efforts. The information and communication component asks the manager who they need to communicate with, what they need to share, and whether the data the manager is sharing is valid.

Hopefully, You Are Being Carefully Watched, But Not in a Creepy Way

Just performing a risk assessment, applying control activities, and communicating with stakeholders is not enough. Unfortunately, we aren’t done. We need the final component – monitoring.

We can’t just set things up and hope that they run on their own forever and ever. Over time, controls slip away and atrophy. Somehow, we need to monitor to make sure that controls are working as intended and make corrections when they aren’t working as intended. And, let’s be honest here, things never work exactly as we intend.

What this means is, that if you are following the COSO model, someone will be watching! It is best if this someone can be honest about what they see without suffering any consequences, and they might watch continually or just occasionally.

We auditors apply the monitoring component and the information and communication component to our audit quality control system by creating an annual monitoring report each year.

Summarizing Five Components of Control

Let’s recap. First you have to decide what you care about and what risks you are unwilling to tolerate. You then apply controls activities to the risks you aren’t interested in experiencing. You need to share the data your activities generate (information and communication) with stakeholders and set up a monitoring function to make sure that everything you have put in place to mitigate the risks is operating as intended. All of this needs to take place within an environment that values and supports controls.

The Top and Side of the Cube: A Little Whine with That Cheese?

In order to make the top and the side of the cube come alive here, I am going to talk about my tiny little operation. And I am probably going to come off as a little whiney in places.

You see, I suffered an embarrassing failure in my business that I am still smarting over. Have you ever seen that poster on Despair, Inc.’s website of a shipwreck? Underneath it is says, “It could be that the purpose of your life is only to serve as a warning to others.” Sometimes I feel like that. See? Whiney.

My Little Idea That Became a Big Set of Processes

Since I like to write, I decided that I should start writing self-study books and selling them through other continuing professional education providers and on my own website. If anyone had told me how involved this idea was going to be before I started, I would have probably stopped right there. But luckily, I was innocent, unaware, and hopeful.

I knew before I started that writing a book is pretty involved. Writing the text is just the beginning; the text has to be edited, revised, and formatted. Lots of processes for that.

My idea to sell to other vendors involved maintaining relationships with those vendors, creating and managing contracts, and lots and lots of communication. Process, process, process.

And since I wanted to sell the books on my website, I needed a website that would allow folks to buy things – so I needed an online store. Process. Since I wanted students to be able to buy and take an online quiz and get credit for the courses online, I had to work with programmers for years and years and years to create the quiz and automatic grading software. Process.

Do I need to go on? Because I can . . . I so can. But I’ll stop there and point out that everything I have described so far would be categorized as ‘operating’ on the top of the cube.

Let’s talk about the top of the cube for a minute…

The Top of the Cube

The top of the cube represents management’s objectives. In less fancy terms, it answers the question, “Why bother having controls?” Yes, as we said in an earlier chapter, controls are there to mitigate risk. But we wouldn’t even have a risk unless we decided to do something, to act in the world. I wouldn’t need controls and processes over my self-studies if I hadn’t decided to write and sell self-study books.

The management objectives at the top of the cube help us categorize why we do things. The top of the cube has three management objectives: operations, reporting, and compliance.

If management is concerned with operations, they are concerned that they deliver their goods and services while efficiently using their entity’s resources. If management is concerned about reporting, they are focused on making sure that reports generated for stakeholders are reliable. For instance, the entity needs to ensure that the financial statements it publishes and sends into regulators are accurate. And if the entity is concerned about compliance, they are making sure that they stay in line with laws and regulations.

I was mistaken that my business was mostly about writing (process or operations). It ended up being mostly about compliance.

Compliance Ate My Lunch

I recognized that no one would read my books for grins. I mean, who wants to read a 300-page book entitled, “The Yellow Book Interpreted” for fun and information only? I knew that I had to offer my books for continuing professional education credit or they wouldn’t sell at all. To qualify for continuing professional education credits for CPAs, I had to register with NASBA (the National Association of State Boards of Public Accountancy).

Years ago, the thought of working with NASBA was slightly intimidating but not prohibitively intimidating. But it seems that I chose a very bad moment to enter the market. As I was authoring my first books, NASBA was busy tightening up its requirements. This meant that I had to add all sorts of components to my books, including quiz questions that are hard to answer. By hard to answer, I mean I have to write the questions in such a way that the answer isn’t obvious – sort of like the obscure questions on the CPA exam. Oh joy! I never imagined myself as a question writer, but I embraced my new task and sent my first book into NASBA for testing. I passed and started selling my books.

All was well until my testing software started failing here and there, and I decided to create a new software program. The next time NASBA ran their test using my new software, they were able to find a flaw in the software that allowed students to jimmy the system and earn credit without taking the quiz. NASBA yanked my license. Huge, embarrassing ouch!

All the clients I had cultivated dropped me like a hot potato. I had to start the lengthy process of fixing the bugs in the software and applying for the license again. NASBA put the review of my courses on the back burner, and it took an entire year for them to review my courses and reinstate my license.

Compliance had eaten my lunch, and my dinner, and my midnight snack.

I won’t go into details about the remaining management objective, reporting, but as you can imagine, I must report to several regulatory bodies every year so that they can ensure I am staying in compliance. One regulatory body requires that I write out every course I offer on a teeny-tiny spreadsheet by hand! Electronic submissions are not allowed. Every course and every student must be tracked and maintained in reports that fit each regulator’s demands. Another process and another set of controls.

All organizations take on the same three areas – operations, compliance, and reporting when they decide to act.

Now for the Right-Hand Side of the Cube

If I told you that you needed to develop controls over the entire planet and keep everyone in line, you wouldn’t be too happy.

How about if I asked you to control the United States? Still too big a task? How about Texas? Yes, too big. How about Austin, Texas? No. How about the state capital complex in Austin, Texas? Getting closer.

What if I asked you to control the north door of the state capital to ensure that all people entering the state capitol building are screened by the Capitol Police? Now, I can work on controls for that! But anything larger, and I get overwhelmed.

And being overwhelmed probably means that I am going to approach the subject in a disorganized way. And being disorganized usually leads to leaving something important undone.

The whole point of the COSO cube is to help us organize our thoughts. The top organizes our purpose in creating controls, the front organizes the types of controls, and the right hand side simply helps us pick a subject — an area to work on. The side of the cube organizes the subject of our controls. This model lists the subject matter of controls as:

• Entity
• Division
• Operating Unit
• Function

• Entity: University of Universal Understanding (UUU)
• Division: Philosophy Department
• Operating Unit: Dean Supreme’s Office
• Function: Curriculum development and divination

Another Layer of Detail