Editor’s Note: This is part two of a six-part series on the Internal Audit Value Chain, which can act as a blue print for building a successful internal audit function. Click here for the other articles in the series.
Whenever it comes to talking about internal audit’s role in risk management, things always gets a little dicey.
Everyone agrees that internal audit has an important part to play in risk management, but just where to draw the line is always a controversial topic. Some think internal audit should play a lead role in risk management, setting the risk management agenda and advising management on risk issues. Others take a more purist position, stating that internal audit should only be there to audit the risk management function.
It’s not surprising. There are widely divergent views on the job of internal audit in general. As an internal auditor, I often ask clients and stakeholders what they believe to be my role. The answers tend to vary widely depending on the maturity level of the client’s internal controls environment. Some see internal audit mainly as the function in charge of Sarbanes-Oxley (SOX) compliance, while others say that it is to uncover fraud or malfeasance. The one common reply, however, that internal auditors are the “controls experts,” rarely changes. That makes me wonder. Where did I fail in educating clients and stakeholders about internal audit’s roles and objectives?
If stakeholders have a narrow and incorrect idea of the problems we solve as internal auditors, what are we doing collectively to change that perception? This well-known quote by psychologist Abraham Maslow illustrates how easy it can be to incorrectly define a problem: “If the only tool you have is a hammer, then every problem looks like a nail.” If stakeholders view internal auditors as only “control experts,” then I can correctly rephrase Maslow’s quote to say: “If our only tools as internal auditors are controls, then every problem looks like a potential risk.”
If we want to think more broadly and completely about the role of internal audit in risk management, we need to think beyond controls. So then, what tools are required for the internal audit function to navigate the volatile and complex risk environment to create value? The internal audit risk management toolbox should include the following:
- The identification of risks
- The prioritization of risks
- The evaluation of the underlying processes, systems, and management’s capabilities to manage risks
- The design and implementation of internal controls to mitigate risks
- The continuous monitoring and evaluation of controls to determine their effectiveness in mitigating risks
These are important ways we can create value as internal auditors and how clients and stakeholders should define our roles as “control experts.”
The Internal Audit Value Chain
In the first article in this series, “Many Internal Audit Failures Stem from Misalignment with the Company Strategy,” I defined the Internal Audit Value Chain (IAVC) and its key components. The IAVC is “Enterprise-wide initiatives impacting functional areas across every organization, involving a combination of people, processes, technology, and ‘tone at the top’ to drive accomplishment of goals and profitability.” Internal audit’s role in the value chain requires understanding the organization’s: (1) strategic direction, (2) risk management and monitoring, (3) operational efficiencies, (4) quality and compliance, (5) financial reporting, and (6) responsiveness to customer and regulatory needs to create value. It’s important to keep in mind that these priorities are not static and vary as enterprise-wide objectives and needs evolve. In this article, part two, we are looking, as you have now guessed, at risk management and monitoring.
In the Institute of Internal Auditors’ Internal Auditor publication, “Optimizing Internal Audit,” I defined risk assessments as they relate to ongoing organizational activities to include: an understanding of internal audit priorities that drive annual audit plans and information obtained and evaluated by internal auditors from continuously interacting with stakeholders. Internal auditors simply must have a strong understanding of the macro and micro risks impacting their respective organizations.
Eight Steps to Navigate Volatile Risk Environments
There are eight primary steps internal audit teams can take in collaboration with stakeholders to identify and mitigate evolving risks that could have significant impact on their organizations if ignored. They include:
1) Ensure collaboration among the three lines of defense: There are many adaptations of the three-lines-of-defense approach to involve business lines, risk management, and compliance and audit team collaboration in identifying and managing risks. KPMG provided a good example in a white-paper by Doron Telem titled “The Three Lines of Defense: Making the Transition to a Mature Risk Management Model.” In the paper, Telem asserts that such collaboration, “could entail workshops with management, as well as some external expertise and interviews (including with non-management individuals) to ensure as many issues as possible have been considered.”
I also prefer consulting the IIA position paper: “Three Lines of Defense in Effective Risks Management and Control” as the base-line example. The IIA paper acknowledges the unique factors impacting every organization that must be considered in coordinating the three-lines-of-defense duties and the underlying role of each group in the risk management process.
For a recap of the three lines of defense:
- The first line of defense consists of lines of business (LOB) / department managers who are the owners of risks.
- The second line of defense consists of risk management, control management, and compliance professionals with limited independence identifying and mitigating risks.
- The third line of defense consists of risks assurance professionals with greater independence such as internal audit reporting to the audit committee or other governing body.
Prior to assigning any LOB lead as a “risk owner,” steps must be taken to validate that risk owners have the technical skills to understand the dynamic nature of the risks assigned to them. If a manager began as a bank teller say 30 years ago, for example, and excelled through promotions into leadership positions, assigning key risks to such a manager, without evaluating his or her skills in the context of current operating environment would be significantly risky. The threats to banking have evolved a great deal during the past 30 years.
The IIA paper concludes that all three-lines should exist in some form at every organization, regardless of size or complexity. A modified version of this framework is needed for any organization, including government agencies, to effectively identify and mitigate risks.
2) Adopt a risk management methodology or framework: According to the IIA’s 2018 North American Pulse of Internal Audit report, chief audit executives (CAEs) need to position internal audit to be an internal disruptor, relentlessly challenging the status quo and identifying and focusing on emerging risks.
An objective methodology should be used to evaluate and prioritize risks in the context of the organization’s strategic direction. The process should be ongoing and provide flexibility to make timely changes as new information becomes available. A comprehensive risk assessment methodology should include mitigation strategies in the context of the organization’s resources, such as: culture, processes, technology, and risk tolerance.
3) Establish operational risk management (ORM) and chief risk officer (CRO) roles and authority: How much authority does the ORM function and CRO have in influencing key decisions? ORM is a highly specialized function requiring complex data analysis and modeling skills with responsibility to identify and monitor risk exposures against risk appetites.
Executives, committees, and business unit managers making key decisions might not view risks through the same lens as ORM experts. Could there be instances when ORM predicted an incident, but lacked the authority to mitigate the risks? It happens all the time. Any disconnects between ORM conclusions and management decisions should be taken seriously by an independent function such as internal audit for further review.
4) Conduct continuous monitoring and assessments: I have always wondered why the concept of continuous auditing and monitoring is frequently discussed by internal audit practitioners but not often implemented. Plenty of literature exists on this topic. A Deloitte white-paper, “Continuous Monitoring and Continuous Auditing: From Idea to Implantation,” for example, covers this topic in great detail. The paper provides two key explanations as to why few organizations implement continuous monitoring and auditing. First, management have not seen a clear, strong business case for establishing either continuous monitoring or continuous auditing in their organizations. Second, management lacks a clear picture of how continuous monitoring and auditing would be implemented.
Given the increasing threats and dynamic nature of risks confronting many organizations, an inflexible or static “annual audit plan” approach might not provide the responsiveness needed for internal audit to quickly change course and address evolving risks. The use of Risk and Control Self-Assessments (RCSA’s) in theory seems a practical approach. However, the output from using RCSA’s and the skills of the risks’ owners might highlight inefficiencies in identifying and mitigating evolving risks.
5) Perform Test-of-Design (TOD) and Test-of-Operating Effectiveness (TOE) for high-risk controls, processes, and functions: If the cost of implementing a given control should not exceed the benefits of that control, then some element of prioritization is needed to determine which controls to test and when. Internal controls that mitigate key risks to the organization across various LOB functions are the logical places to start. Management and internal audit can use other subjective factors to include operational or compliance needs and determine other areas to perform TOD and TOE.
Using limited organizational resources to perform extensive TOD and TOE without a focused approach on risks or other factors is not ideal. With adequate planning and emphasis, performing TOD and TOE remain critical tools for management and internal audit to use in navigating volatile risks environments to create value. Findings from controls testing create value if recommendations are properly documented in a way LOB can understand disconnects and see the value of remediating issues to prevent re-occurrence.
6) Achieve line-of-business collaboration and consensus on findings and recommendations: For any collaboration to be expected from LOB leadership, internal audit should have obtained their blessing on which areas to review as part of annual or periodic audit planning. For the three-lines-of defense to function correctly, stakeholders—including ORM and CRO—must collaborate extensively during the audit planning, execution, reporting, and remediation phases. Without this level of participation, internal audit will run into several roadblocks along the way to navigating volatile risks environments. The interpersonal, problem solving, communication, and technical skills of the internal audit team are the foundations of any effort to obtain consensus on findings and recommendations. The desired output is LOB processes and controls to mitigate risks and prevent re-occurrence.
7) Help foster a positive corporate culture and tone-at-the-top: Quantifying and qualifying the impact of failures of culture and tone at the top, if not properly addressed, are near impossible in the long term. For example, the problems at Wells Fargo I covered in Part One, “Many Internal Audit Failures Stem from Misalignment with the Company Strategy,” that began in September 2016, could not be quantified as of May 2018.
Consistent failures stemming from poor tone-at-the-top, sub-culture clashes across different LOB’s within an organization, lack of skills to identify and mitigate key risks, and inability to implement continuous monitoring and oversight of key functions are a few examples that could expose an organization to significant risks. Internal audit will see these dynamics at varying levels in the course of executing our missions. Failures to accept the reality and risks associated with these problems can be directly linked with the inability of the internal audit function to navigate volatile risks environments to create value.
8) Consider external factors that could encourage excessive risk-taking: There are no easy solutions for regulators to effectively enforce regulations across industries to protect consumers and create desired outcomes. Regulators are often behind the times or allow loopholes—often temporary—in the enforcement of regulations. Management will often use these loopholes or the “everyone is doing it” rationale to justify excessive risk-taking. Internal audit must understand external factors and loopholes used by management to obscure the true risk landscape and implement adequate processes to identify and mitigate risks.
While these eight steps are not the totality of internal audit’s role in helping the organization identify and manage risk, they provide a solid roadmap for internal audit to navigate the volatile and complex risk environment and create value for the organization along the way. Executives and managers should empower risk management and internal audit teams to help quickly identify risks, prioritize risks, evaluate the underlying process and systems related to risk management, and assess the design and implementation of internal controls to mitigate risks. Significant risks must be identified and mitigation strategies and controls implemented in a timely manner to avoid long-term financial losses and reputational damage. 
Click here for the other articles in the series.
Jonathan Ngah, CISA, CIA, CFE, CGFM, is a Principal at Synergy Integration Advisors, a consulting firm providing audit and governance, risk, and compliance (GRC) solutions to federal government agencies, and private-sector and not-for-profit organizations.
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Thank you for this insightful and educating article.