This article was published in Thomson Reuters’ Internal Auditing in May/June, 2013 …
Charles D. Schrock, CPA, CIA CRMA
Senior Vice President
Inland Bank and Trust, Oak Brook, IL
Daniel J. Gaffney, CPA, CFF, CIA, CISA
Daniel Gaffney & Associates LLC, Chicago, IL
Auditors understand the fundamental value of risk management. Although ‘formal’ risk management may not be our day-to-day job, it’s always a part of what we do. That’s probably true for your executive management team also. We know that Audit Committees are vitally interested in risk management, even if they don’t know precisely what it is.
http://www.pwc.com/en_US/us/corporate-governance/assets/annual-corporate-director-survey-2011.pdf (reference for the following)
According to the 2011 Annual Corporate Director Survey issued by PricewaterhouseCoopers, LLP, risk management remains at the top of the list of stakeholder concerns. Only 19% of directors measured their board as very effective at monitoring a risk management plan that mitigates corporate exposure. In an effort to enhance this performance, 57% of respondents reported they would like to increase their focus on risk.
http://www.kpmginstitutes.com/aci/insights/2012/pdf/beyond-risk-management-directorship-sept-oct-2012.pdf?utm_source=page&utm_medium=/aci/insights/2012/audit-committee-roundup-beyond-risk-management-sept-2012.aspx&utm_campaign=download (reference for the following)
Survey findings from our latest KPMG Roundtable Series in more than 25 cities are telling: Only 39 percent of the 1,200-plus directors and senior management polled during the series said they are satisfied that their company’s governance activities are appropriately focused on the greatest risks to the company’s reputation and brand. Less than a quarter said they are satisfied that key governance activities are aligned with the company’s risk hot spots, and that the company’s governance activities are integrated into the strategy and add “real value” beyond simple compliance.
http://www.kpmginstitutes.com/aci/insights/2013/pdf/2013-audit-committee-issues-conference-report.pdf (reference for the following)
As highlighted by the conference dialogue, internal audit can be most effective when focused on the critical risks to the business, including operational risks and related controls. Among the keys to fully leveraging internal audit:
- Challenging internal audit to take the lead in coordinating with other governance, risk, and compliance functions within the organization to limit duplication in coverage and, more importantly, to prevent gaps
- Maintaining a direct, open line of communication between internal audit and the audit committee
- Ensuring that internal audit has the resources, skills, and stature within the organization to succeed
Organizations want to manage risks. They want internal audit to be a part of the risk management process. The most common sources of guidance for risk management come from COSO and ISO. While both of these sources are strong on theory, they tend to fall short on practical guidance for implementing risk management. They provide even less guidance to us, as auditors, as we try to use risk management as a tool for our own purposes.
Performance Risk Management (PRM) is a new approach to risk management. It was developed in order to bridge the gap between theory and implementation. PRM is based on the sound fundamental ideas within the COSO and ISO models. PRM brings ERM into the real world. It aligns ERM with the way that organizations truly function.
Performance Risk Management is a process for addressing risk in a straight-forward and practical way that works for both management and auditors. As auditors, we can use Performance Risk Management to develop the audit plan, the audit program, and the audit steps. By using risk management as a foundation for our own activities, we can help our organizations start to develop a risk management emphasis that our boards of directors want. Additionally, we can serve as a force for change within our organizations as the expert advisors to help implement practical risk management more broadly.
Performance Risk Management was developed as a tool for management. However, it also helps auditors in three ways:
- It helps auditors discuss objectives and risks in ways that are relevant to auditees, executives, and Audit Committee members;
- It helps auditors set high level audit plans and budgets by identifying what’s important to the organization and, accordingly, what areas most need assurance from internal audit; and
- It helps auditors design better low-level tests because it requires auditors to focus on specific risks within a particular process.
Before going further, it’s important to identify the three foundational ideas that make Performance Risk Management unique. It will then be easier to discuss in greater detail how it helps us as auditors.
- Objectives, not risks, are the most fundamental component of PRM.
- Each person in the organization ‘owns’ one or more of these objectives.
- Risks exist within the context of people trying to accomplish their objectives.
These foundational ideas help us, as auditors, in the following ways:
First, PRM provides a very straight-forward entry point for incorporating risk management into your audit activities. Without PRM, simply getting started with risk management can require a large top-down project to brainstorm and identify risks. PRM, on the other hand, does not require a global organizational initiative. It can be used in a focused way to understand the risks within a specific area. Because PRM focuses on objectives that are owned by a specific individual, you can choose which individual (and his/her objectives) you want to address. If, for example, you want to perform an audit of your Regional Accounts Payable function, you can begin by using PRM to focus on the objectives of the Regional Accounts Payable Manager.
Second, as auditors we want to assure that we are spending our time (and our audit budget) in the best possible ways. PRM supports this. As the Regional Accounts Payable Manager’s objectives are identified, PRM incorporates the idea of assigning an impact level (i.e., a rating) to each objective. In our example, after a little prompting, the Regional Accounts Payable Manager might tell you that her objectives are: i) paying the right vendors, ii) paying the right amount, iii) posting expenses to the right general ledger account, iv) paying within the right time frames, v) preparing management summary reports of accounts payable operations, and ,because she recently received a memo from HR as a reminder to all managers, vi) assuring that all human resource policies are fairly applied to her employees.
Each of these objectives may not be equally critical to the Regional Accounts Payable Manager, or the organization overall. The assignment of an impact level can help. PRM suggests assigning a factor (1 to 10, with 10 as most critical) to each objective. Together, the auditor and the AP manager might assign the following tentative values:
i) paying the right vendors – 6 (if you pay the wrong vendor, the money may be gone forever; however, the amounts involved won’t break the company)
ii) paying the right amount – 5 (not so critical – the company can typically make adjustments with a vendor later)
iii) posting to the right general ledger account – 4 (again, not so critical; the AP clerk can only post to a certain subset of general ledger accounts)
iv) paying in the right time frames – 6 (if not done in the right time frames, there may be a minor impact on either cash flow or discounts taken)
v) preparing management summary reports – ?? (as auditors, we may not be sure – how is this report used by senior management?)
vi) application of human resource policies – ?? (we know it’s important, but how important is it among this manager’s responsibilities?)
Understanding this relative ranking of the auditee’s objectives can help the auditor focus the audit on the more critical activities. What’s interesting is that this specific exercise yields two initial uncertainties that may need to be discussed with more senior people. Let’s consider the management summary reports. Unless we go through an exercise like this, the management summary reports may seem like an insignificant component of this person’s day-to-day activities. And that may be true. But, after discussing this with more senior executives, the auditor may learn that these reports are forming the basis for a major strategic vendor pricing initiative. Incorrect data could cost the organization $millions. If the auditor fails to specifically consider each task or objective owned by this Regional Accounts Payable Manager, he might miss the single most important activity that he needs to review. And, perhaps even more important, the Regional Accounts Payable Manager will now have a better understanding of the importance of this task.
Third, as auditors we need to design and execute audit tests. PRM helps with this as well. From the prior step, we can determine what general areas should be the focus of our audit testing. Now, we can formulate specific tests. Part of the PRM process is to identify specific real-world risks that may be associated with these objectives. We can do this through several techniques.
First, we should simply ask the manager “what can go wrong when you are determining who to pay?” We typically get very solid answers like “The approved invoice copy that I receive is sometimes unclear on the ultimate payee.” Of course, as auditors, we follow up with the question “if you’re uncertain, or if there is an error in the named payee, how would you catch that?” and “how often does that occur?” The goal is to understand what the risks might be and how likely they are to occur.
The second way that we can identify risks is to use standard frameworks, if such frameworks exist for the area under review. Examples of a framework might be the COBIT or ITIL frameworks within the information technology realm. Another helpful source of information might be existing internal control questionnaires. As auditors, we should not use these documents to simply take someone else’s list of risks. Instead, we use these frameworks and questionnaires to help assure that we remember to discuss major areas where risks might lurk.
Finally, the third way to identify risks is to simply consider the typical high-level categories. We should ask our auditees “are there any risks that might impact financial reporting? compliance? the company’s reputation? what about internal or external fraud? etc.” Again, the goal is to assure that we haven’t inadvertently skipped over entire categories of risk.
Once we have a reasonable list of real-world risks and identified their likelihood of impacting the success of the associated objective, we can determine how best to test. As auditors, we have training, experience and professional guidance to help us design tests. What PRM provides is a clearly documented rationale behind which risks are worthy of our testing.
This article begins to touch on the value that Performance Risk Management can bring to an organization and, more specifically, to internal auditors. The main benefits to us, as internal auditors, are:
- We are speaking with the auditees in ways that are relevant to their day-to-day activities. We build rapport when we can step away from “auditor-speak” and talk about what is really happening in their department.
- We have a systematic process (and associated documentation) to support our audit program and specific audit tests.
- Audit recommendations are linked to specific risks which, in turn, are tied to specific (and agree upon) objectives that exist within the audited area.
But there is one more benefit that demonstrates the value that internal audit can provide. You can become a model for organizational improvement. Through your use of PRM you are demonstrating the value that a straight-forward implementation of risk management can bring. Through your experience, you can help articulate the benefits of risk management as part of the organization’s overall risk management environment.
This article has described only some of the benefits of PRM. Additional benefits accrue when you add other well-integrated concepts such as Key Performance Indicators (KPI), Key Risk Indicators (KRI), risk assessments, and clear linking of individual objectives to higher level strategies. You can read more about Performance Risk Management at rskldr.com.
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