Question

Why is the Control Environment such a critical element of COSO? Identify three elements that create a strong control environment.

Answer 1

Control Environment is the set of standards, processes, and structures that provide the basis for carrying out internal control across the organization. The board of directors and senior management establish the tone at the top regarding the importance of inter­nal control including expected standards of conduct. Management reinforces expecta­tions at the various levels of the organization. The control environment comprises the integrity and ethical values of the organization; the parameters enabling the board of directors to carry out its governance oversight responsibilities; the organizational struc­ture and assignment of authority and responsibility; the process for attracting, develop­ing, and retaining competent individuals; and the rigor around performance measures, incentives, and rewards to drive accountability for performance. The resulting control environment has a pervasive impact on the overall system of internal control.

1 Communication and enforcement of integrity and ethical values
Many companies have high values and seek to promote honesty and integrity among their employees on a day-to-day basis. Clearly, if it is evident that such values do exist and are communicated effectively to employees and enforced, this will have the effect of increasing confidence in the design, administration and monitoring of controls – leading to a reduced risk of material misstatement in a company’s financial statements. For example, where a company adopts comprehensive anti-bribery and corruption policies and procedures with regard to contract tendering, and has formal employee notification and checking practices in this regard, it follows that there is reduced risk of material misstatement due to the omission of provisions for fines for the non-compliance with relevant laws and regulations.

2 Commitment to competence
Competence is the knowledge and skills necessary to accomplish tasks that define the individual’s job. It is self-evident that if individual employees are tasked with carrying out duties that are beyond their competence levels, then desired objectives are unlikely to be met. For example, there is an increased probability that the objective of avoiding material misstatement in a set of complex financial statements will not be met if prepared by an inexperienced company accountant. This is simply due to the inexperience (translating to a lower competence level) of the accountant.

3 Participation by those charged with governance
The directors of a limited liability/limited company are charged with the company’s governance. As such, they are responsible for overseeing the strategic direction of the company and its obligations related to its accountability – for example, to governments, shareholders and to society in general. In particular, in most jurisdictions the company’s directors are responsible for the preparation of its financial statements. Given the influence that the actions of directors have on a company’s internal control, the extent of their day-to-day active involvement in the company’s operations has a pervasive effect on the internal control of the company.