The COSO framework is a means of designing, implementing, and evaluating control within an organization. The COSO framework’s five components are control environment, risk assessment, control activities, information and communication, and monitoring activities. As a fraud risk management tool, businesses can design, implement, and evaluate internal control procedures.
Understanding the COSO framework
According to the Association of Certified Fraud Examiners, weak internal control is the cause of almost 50% of all company fraud.
To develop a strong and effective internal control system, the COSO framework was created by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The committee is comprised of representatives from various industries, including accounting, finance, and auditing.
Collectively, the committee develops procedural guidance that assists businesses with risk assessment. In so doing, internal controls are strengthened to reduce the likelihood of fraud.
What constitutes internal control? How is it defined?
The COSO framework states that internal control is a “process effected by an entity’s board of directors, management and other personnel designed to provide reasonable assurance of the achievement of objectives” under the following categories:
- Operational effectiveness and efficiency. This includes performance goals and securing assets against potential fraud.
- Financial reporting liability – whether that be internally or externally. Transparency, punctuality, and reliability are vital.
- Legal and regulatory compliance.
The five components of the COSO framework
Five components work together to deliver an effective internal control system while supporting the vision, goals, or objectives of the business concerned.
Let’s take a look at each in more detail.
1 – Control Environment
This encompasses the standards or processes that dictate internal control across an organization. Typically, upper management will set the tone regarding the importance of establishing and then maintaining internal control. This creates an environment that attracts, develops, and then retains talented individuals. There is also accountability in performance and rewards and incentives are routinely given where appropriate. To some extent, the control environment also extends to ethical values and organizational structure.
2 – Risk assessment
Every business deals with risk, but not all deal with risk effectively. Those with robust internal control will assess each risk according to the level of the threat to company objectives and established risk tolerances.
Importantly, businesses must consider internal and external risks that can weaken internal control.
3 – Control activities
Once risks have been identified, policies and procedures must be devised to mitigate against them. These so-called “control activities” must be implemented across the organization to help it achieve stated goals without taking unnecessary risks.
Here, internal control is maintained by authorizations, approvals, verifications, and performance reviews. If possible, employee duties should also be segregated commensurate with experience or skill level.
4 – Information and communication
COSO framework principles help ensure that all internal and external communications adhere to company procedures and further company objectives. Information must also be disseminated only when appropriate. For example, a new policy should be communicated to every employee in the organization. However, share price sensitive information should be confined to upper management until released to the market.
5 – Monitoring activities
Monitoring controls is just as important – if not more important – than establishing them. Periodic evaluation should be incorporated into all business practices to ensure that controls are being maintained.
Externally, financial reporting is a particularly important in deterring fraud.
- The COSO framework is a fraud risk management tool that businesses use to design, implement, and evaluate internal control procedures.
- The COSO framework guides the best practices for operational effectiveness, financial reporting, and legal or regulatory compliance.
- The COSO framework has five core components. In combination, each allows a business to maintain internal control without sacrificing the ability to meet goals or uphold company values.