Does Your Internal Audit Scope Meet Regulatory Standards? 

A Two Part Series-Part TWO-Setting the Scope    

 

As we  noted in the first part of this series, the scope of the internal audit function at financial institutions has been an area of focus for  regulators.  In particular, regulators have focused on whether or not the scope of internal audits meets both regulatory standards and is appropriate in light of the overall risk profile of a financial institution.  It is the second of these two considerations that has most recently  caused findings and created concerns.    It is therefore, critical that the scope of audits reflect an understanding of the risks inherent at your financial institution.  

 

Using Risk Assessments Effectively  

The Federal Financial Institutions Examination Council (FFIEC”) issued a comprehensive policy statement on the audit process in 2003.  This statement is still the definitive regulatory guidance on the proper development and maintenance of the internal audit function for financial institutions.   The guidance states that risk assessments are a key component of internal audits.  A risk assessment is defined as follows:  

A control risk assessment (or risk assessment methodology) documents the internal auditor's understanding of the institution's significant business activities and their associated risks. These assessments typically analyze the risks inherent in a given business line, the mitigating control processes, and the resulting residual risk exposure of the institution. They should be updated regularly to reflect changes to the system of internal control or work processes, and to incorporate new lines of business.[1]

At smaller institutions, there generally is not a full time internal auditor on staff.  This does not obviate the need for comprehensive and timely risk assessments.  Unfortunately, the risk assessment process is often overlooked.   The risk assessment should consider the following:  

Past Examination and Audit Results-

It goes without saying that the past can be a  prelude to the future.   Prior findings are an immediate indication of lack of effectiveness of internal controls.  It is important that the root cause of the finding or recommendations from regulators is identified and addressed.  Internal audits should coordinate with the risk assessment to test the effectiveness of the remediation.   

Changes in Staff and Management

Change is inevitable and along with changes comes the possibility that additional training should be implemented or that the resources available to staff should also change.  For example, suppose the head of Note Operations is brand new.  This new manager will want to process loans using her/his own system.  Loan staff who may be used to past procedures may become confused.  Change generally increases the possibility of findings or mistakes.   Your risk assessment should take into account the risks associated with changes and how best to address them.  In addition, this is an area that should be covered by internal audit as it presents a risk.   

Changes in Products, Customers or Branches

It is also important that your risk assessment consider all  of the different aspects of changes that have occurred or will occur during the year.  Any new products or services, new vendors, and/or marketing campaigns that are designed to entice new types of customers are all changes that impact the overall risk profile of the institution.    The resources necessary to address these changes should also be a consideration for the internal audit.      

Changes in Regulations

Over the past few years, there have been a huge number of changes to regulations, guidance and directives from Federal and State agencies.  Many of these changes do not impact smaller institutions directly, but many do.  Moreover, there are often regulations that are finalized in one year that don’t become effective until the following year.   Part of your risk assessment process has to consider changes that will affect your institution.  The internal audit scope should also consider whether the institution is prepared to meet changing regulatory requirements.  

Monitoring systems in place

The information systems being employed to monitor the effectiveness of internal controls should be considered.  For many institutions, this system is comprised of word of mouth and the results of audits and examinations.  Information used by senior management and reported to the Board should be sufficient to allow credible challenges by the Board.[2]

Using the Risk assessment to Set Audit Scopes

Once a risk assessment is completed, the results should be directly tied to the internal audit schedule.   The FIIEC guidance points out the relationship between the internal audit plan and the risk assessment: 

 An internal audit plan is based on the control risk assessment and typically includes a summary of key internal controls within each significant business activity, the timing and frequency of planned internal audit work, and a resource budget.[3]

 

The risk assessment should prioritize the potential for findings, while the audit scope should be developed to test mitigation steps made to reduce findings.

The criticism that is often raised about outsourced audit is that the scope is incomplete.  This is often the case because outsourced vendors have developed their scope based upon best practices, and their experiences at various institutions.  While this is obviously a best practice for the audit vendor, the problem is that it doesn’t always fit the individual institution.   Information from a comprehensive risk assessment should be incorporated into the scope of an internal audit. 

In this manner, the auditor can best consider the areas of risk that are the highest priority at a particular institutions.  For example, when developing the scope for an independent audit of a BSA/AML program, the scope should include the most recent risk assessment.  Changes in the customer base, an increase in the overall risk profile of the bank or a change in personnel are all factors that should be included in the audit scope.  In addition, the auditor should consider whether current monitoring systems have the capability to properly monitor the additional level of risk.  Finally, the professional abilities of the BSA staff should be considered as they relate to additional risk.  

Ultimately, it is the responsibility of the Board to ensure that the internal audit is effectively testing the strength of internal controls.  

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[1] Interagency Policy Statement on the Internal Audit Function and its Outsourcing

[2] See for example, OCC Guidelines Establishing Heightened Standards for Certain Large Insured National Banks, Insured Federal Savings Associations

^[3] Interagency Policy Statement on the Internal Audit Function and its Outsourcing