INTERNAL AUDIT SERVICES

Internal Controls as they Relate to OMB Circular A-123

December 2006

Audit Project No. 2509

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Management’s Responsibility for Internal Control

In December 2004, The United States Office of Management and Budget (OMB) released a revised Circular A-123, which stipulates that federal agencies must provide assurance about the adequacy of internal controls and the reliability of financial reporting.

The Circular was issued under the authority of the Federal Managers’ Financial Integrity Act of 1982 (FMFIA) and became effective fiscal year 2006.

DOE delegated responsibility for implementation of OMB Circular A-123 to its contractors.

OMB Circular A-123 Background

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OMB Guidance

Federal agencies must test, evaluate, and report on the effectiveness of their internal controls over financial reporting, which is similar to what is required of publicly traded companies under Sarbanes-Oxley section 404.

Key difference between Sarbanes-Oxley and OMB A-123 is that Federal agencies are not required to have an external audit opinion on their internal controls.

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Definition of Internal Control

Internal control is a process, put in place by management and other personnel, designed to provide reasonable assurance that we will achieve the following objectives:

Effectiveness and efficiency of operations Reliability of financial reporting Compliance with applicable laws and regulations

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FY07 OMB A-123 Team Members

Jeffrey Fernandez, OCFO – Attester Minh Huebner, OCFO – Implementer Grace Huang, OCFO – Project Lead Kim Martens, IAS – Testing Lead John Chernowski, OIA - Project Team Member Ira Nishibayashi, OIA - Project Team Member Michele Mock, OCFO – Project Team Member Rose Katsus, OCFO – Project Team Member Lauretta Corsair, OCFO – Project Team Member Rosalyn Height, OCFO – Project Team Member Rich Nosek, IT – Project Team Member

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OMB A-123 Steering Committee

Jeffrey Fernandez, Chief Financial Officer

David McGraw, Chief Operations Officer

James Krupnick, Institutional Assurance Director

Sandy Merola, Deputy Chief Operations Officer

James Siegrist, Associate Laboratory Director

Graham Fleming, Deputy Laboratory Director

Glenn Woods, Laboratory Counsel

Terrence Hamilton, Internal Audit Director

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COSO Framework of Internal Control

Control Environment – Sets the tone of the organization, influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure.

Risk Assessment - Internal control should provide for an assessment of the risks the Labfaces from both external and internal sources in order to determine how risks shouldbe managed.

Control Activities -Internal control activities help ensure that management's directives arecarried out. The control activities should be effective and efficient in accomplishingcontrol objectives. Includes policies and procedures.

Monitor Performance - Internal control monitoring should assess the quality ofperformance over time and ensure that the findings of audits and other reviews arepromptly resolved.

Information and Communication - Information should be recorded and communicatedto management and others within the entity who need it and in a form and within a timeframe that enables them to carry out their internal control and other responsibilities.

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Five Control Components

All 5 of the internal control components work together to establish a strong internal control structure.

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Control Environment

Control Environment

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Risk Assessment

ControlEnvironment

Perform

Risk Assessment

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Control Activities

ControlEnvironment

Implement Control Activities

PerformRisk Assessment

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Two Types of Control Activities

Control Activities

Preventive controls are designed to provide reasonable assurance that onlyvalid transactions are recognized, approved and submitted for processing.They are applied before the processing activity occurs. This type of control isgenerally more effective in a strong control environment than detectivecontrols.

Detective controls are designed to provide reasonable assurance that errorsand irregularities are discovered and corrected on a timely basis. DetectiveControls normally are performed after processing has been completed. Theyare particularly important in an environment that has relatively weak preventive techniques.

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Monitor Performance

ControlEnvironment

Implement Control Activities

Monitor Performance

PerformRisk Assessment

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Information and Communication

ControlEnvironment

Implement Control Activities

Monitor Performance

Information

Communication

andan

dPerform

Risk Assessment

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Limitations of an Internal Control Structure

Errors may arise from misunderstandings of instructions, mistakesmistakes of judgment, fatigue, etc.

Controls that depend on the segregation of duties may be circumvented by collusioncollusion.

ManagementManagement may overrideoverride the structure

Compliance may deteriorate over timedeteriorate over time

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Internal Control Myths and Facts

MYTHS:

Internal control starts with a strong set of policies and procedures.

Internal control: That’s why we have internal auditors!

Internal control is a finance thing.

Internal controls are essentially negative, like a list of “thou-shalt-nots.”

Internal controls take time away from our core activities of research, operations, and customer service.

FACTS:

Internal control starts with a strong control environment.

While internal auditors play a key role in the system of control, management is the primary owner of internal control.

Internal control is integral to every aspect of business.

Internal control makes the right things happen the first time.

Internal controls should be built “into,” not “onto” business processes.

Source: Institute of Internal Auditors, 2003

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Your Role as Process Owner

Acknowledge your responsibility for the control structure within your

business processes

Identify, prioritize and review risks and controls

Remove obstacles for compliance; remedy control deficiencies

Perform self-assessments and document test work

Educate your personnel about OMB requirements

Reinforce internal focus on controls within your area

Surface any risks, concerns or issues promptly to allow adequate

attention for correction (don’t wait for an audit!)

Fix control gaps as soon as possible

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Entity + Process Controls = Assurance

Entity Controls Entity Controls relate to the organization as a whole and are not

specific to processes. Ensure the integrity and effectiveness of the organization and its

leadership. Entity Controls focus on 5 Standard Entity Areas (COSO).

Process Controls

Process Controls ensure the integrity and accuracy of the business transactions as they impact the financial statements.

In some cases, Process Controls supplement Entity Controls to mitigate risk.

Adapted from DOE A-123 All Hands Training

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OMB Entity Control Areas and Sub-Categories

Source: A-123 All Hands Training

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Process Cycles and Processes

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Example: Procure to Pay Process Cycle and Processes/Sub-Processes

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Inherent Risk

DOE’s approach to A-123 is based on evaluating controls to offset inherent risk.

Inherent Risk is the chance that a material misstatement will occur because there are no related internal controls in place.

Risks should be identified to cover the end to end process and should consider financial statement assertions (PERCV).

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PERCV – Financial Reporting Assertions

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Example of Process Risk Statement

Process: Payable Management Sub-Process: Disbursing

Risk Statement:Invalid or duplicate Payment may be made in excess of approved contractamount, resulting in loss to DOE (if not detected) and an increase in improper payments reported to DOE (if later detected).

Relation to PERCV:

• Existence and occurrence: Liabilities/Payables recorded do not exist.

• Rights and Obligations: Liabilities/Payables do not reflect valid obligations of the entity.

• Valuation or allocation: Expenses/Payments are inappropriately recorded/valued in financial statements.

Adapted from A-123 All Hands Training

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Example of Process Cycle Controls

Process: Payable Management Sub-Process: Disbursing

Risk Statement:Invalid or duplicate Payment may be made in excess of approved contractamount, resulting in loss to DOE (if not detected) and an increase in improper payments reported to DOE (if later detected).

Controls:1. System automatically closes contracts when receipts and invoices have

been posted and paid equal to the amount of the contract.2. Invoices in excess of contract are automatically rejected with the reason

code indicating that the contract is complete.3. Rejected invoices are sent back to appropriate departments for follow-up.

Adapted from A-123 All Hands Training

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Example of Entity Controls

Adapted from A-123 All Hands Training

Adapted from A-123 All Hands Training

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Inherent Risk Rating/Assessment

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Dual-Purpose Testing

A-123 employs a two step dual purpose testing approach.

1. Determining whether a control failure occurred (control operation); and

2. Determining whether the risk actually occurred (impact) as a result of the

control failure, where reasonable and appropriate.

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Types of Tests

Inquiry – ask a question– Interview staff to validate knowledge of a policy or requirement– Conduct a survey to obtain or validate information

Inspection – did it happen– Review sample of source documents for evidence of control execution– Review exception reports and related documentation to identify preventive control failures and validate follow-up for risk occurrence– Reconcile process/system documentation to actual operation

Observation – watch it happen– Monitor personnel to validate execution of manual controls– Observe occurrence of automated controls (e.g. popup warnings)

Re-performing – make it happenEnter a valid transaction to test control operation

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OMB Test Ratings

Test Ratings: Effective in FY 2007, test results will be scored on a scale of 3 to 7.

3 4 5 6 7

Significant Operational Deficiency

HIGH probability of risk occurring.

Operational

Deficiency

MORE than a REMOTE

possibility of the risk occurring.

Minor Operational

Deficiency

ONLY a REMOTE

possibility of the risk

occurring.

N/A Operating Effectively

LESS than a REMOTE

possibility of the risk

occurring.

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Communicating Internal Control Weaknesses

Reportable

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Sample Assurance Statement

Adapted from A-123 All Hands Training

Internal Control Certification:

Revised OMB A-123: Sample Assurance Statement

Fiscal Year 2XXX

Annual Assurance Statement on Internal Control over Financial Reporting

The [Agency’s] management is responsible for establishing and maintaining effective internal control over financial reporting, which includes safeguarding of assets and compliance with applicable laws and regulations. The [Agency] conducted its assessment of the effectiveness of the [Agency’s] internal control over financial reporting in accordance with OMB Circular A-123, Management’s Responsibility for Internal Control. Based on the results of this evaluation, the [Agency] can provide reasonable assurance that the internal control over financial reporting as of June 30, 2XXX was operating effectively and no material weaknesses were found in the design or operation of the internal controls over financial reporting.

_____________________________

Head of Agency