What is the COSO Framework?
The COSO Framework is a system used to establish internal controls to be integrated into business processes. Collectively, these controls provide reasonable assurance that the organization is operating ethically, transparently and in accordance with established industry standards.
COSO is an acronym for the Committee of Sponsoring Organizations. The committee created the framework in 1992, led by Executive Vice President and General Counsel, James Treadway, Jr. along with several private sector organizations, including the following:
- American Accounting Association
- Financial Executives International
- The Institute of Internal Auditors
- American Institute of Certified Public Accountants
- The Institute of Management Accountants (formerly the National Association of Cost Accountants)
The COSO framework was updated in 2013 to include the COSO cube, a 3-D diagram that demonstrates how all elements of an internal control system are related. In 2017, the committee introduced their COSO Enterprise Risk Management Framework. The COSO ERM Framework aims to help organizations understand and prioritize risks and create a strong link between risk, strategy and how a business performs.
What are the five components of the COSO Framework?
Here are the five components of the COSO framework:
- Control environment. The control environment seeks to make sure that all business processes are based on the use of industry-standard practices. This can help ensure that the business is run in a responsible way. It may also reduce an organization's legal exposure if the organization is able to prove that its business processes are all based around industry standard practices. Additionally, the control environment can help with making sure that an organization is adhering to regulatory compliance requirements.
- Risk assessment and management. Risk assessment and management -- which is sometimes referred to as enterprise risk management -- is based on the idea that risk is an inherent part of doing business. However, those same risks can sometimes cause a business to suffer adverse consequences. As such, organizations commonly adopt risk management plans that help them to identify risks and either reduce or eliminate risks deemed to pose a threat to the organization's well-being.
- Control activities. Control activities are also tied to the concept of risk management. They are essentially internal controls that are put into place to make sure that business processes are performed in a way that helps an organization to meet its business objectives without introducing unnecessary risks into the process.
- Information and communications. Communications rules are put in place to make sure that both internal and external communications adhere to legal requirements, ethical values and standard industry practices. For example, private sector organizations commonly adopt privacy policies establishing how customer data can be used.
- Monitoring. At a minimum, monitoring is performed by an internal auditor who makes sure that employees are adhering to established internal controls. However, in the case of public companies, it is relatively common for an outside auditor to evaluate the organization's regulatory compliance. In either case, the audit results are usually reported to the board of directors.
How is the COSO Framework used?
The COSO Framework is heavily used by publicly traded companies and accounting and financial firms. The framework seeks to put internal controls in place that formalize the way in which key business processes are performed. This helps organizations to adhere to legal and ethical requirements, while also focusing on risk assessment and management. In addition to integrating such controls into key business processes, the framework places a heavy emphasis on monitoring and reporting, especially as it relates to using internal auditors to monitor adherence to established controls.
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What are the benefits and limitations of the COSO Framework?
One of the primary benefits to implementing the COSO Framework is that it helps business processes to be performed in a uniform manner according to a set of internal controls. Depending on how these controls are designed, they can improve efficiency while also reducing risks.
Another benefit is that an organization that fully employs the COSO Framework is often in a better position to detect fraudulent activity, whether that activity is perpetrated by cyber criminals, customers or trusted employees. Because the framework focuses on risk mitigation and adherence to established best practices, vulnerabilities can be significantly reduced.
Finally, some organizations find that when they implement carefully crafted internal controls, it helps them to make existing business processes more efficient. This can help reduce costs and make the organization more profitable.
Despite the benefits associated with implementing the COSO Framework, it is not without its limitations. The most significant of these limitations is that the framework can be difficult to implement for two main reasons. First, the framework is relatively broad in scope, which means that it can be applied to a wide variety of organizations and processes. But this broad scope also means that the framework lacks a significant amount of prescriptive guidance.
The second limitation that can make the framework difficult to apply is its organizational structure. The COSO Framework is broken into a series of rigid categories. Organizations often find that there are certain processes that could conceivably fall into multiple categories, or that do not align well with any of the categories. As such, organizations will often have to make some tough decisions when implementing the framework.