This is Part2 of an article on developing quantitative indicators of risk to support the annual risk-based audit planning process.
Part1 presented the concept that risk (Probability and Impact) can be measured quantitatively by looking at Complexity and Change (which increase the probability) and Materiality or Volume (which increases the impact). It also encouraged you to look at more than financial risk. Part 2 presents examples of indicators of risk and an approach that you can use to develop your own quantitative indicators.
The following are examples of data-driven risk indicators for various risk categories:
- Financial – an entity that has multiple responsibility centers, a large degree of discretionary spending, and a high number of journal entries and suspense account transactions has a higher level of financial risk than one that has a single responsibility center and primarily non-discretionary spending (e.g. regular salary).
- Operational – a production plant that has multiple production lines that produce both standard and customized products, requiring changes in the product line, has a higher operational risk than one with a single production line producing a standard product.
- Legal – an entity that is highly regulated and subject to national, international regulations and has a higher level of ongoing litigation has a higher legal risk that one that is not regulated.
- Technological – an entity dependent on rapidly changing technology has a higher technological risk that one that has a stable technological environment.
- Environmental – entity that is highly regulated in an area that is subject to changing environmental regulations, has a lower level of organizational maturity and experience levels of staff, and high costs of non-compliance has a higher environmental risk than one that is not regulated or has minimal non-compliance costs.
- HR – an entity that spans multiple locations and has full-time, part-time and casual employees – many with very little experience – has a higher level of HR risk than one that operates from a single location and only has full-time employees with many years of experience.
The data-driven indicators are relative – comparing the risk level of an audit entity to other entities (e.g. one activity or region to another). The result is a data-driven relative risk ranking of each entity on each risk indicator and risk category. The overall risk for each entity/activity can be assessed by combining the rating for all risk categories. Thus, audit can identify entities with the highest financial or operational, etc. risk and the entities with the highest overall risk; or assess the effectiveness of risk mitigation efforts on corporate risks.
Data-driven indicators make the risk identification and assessment process easier to update, more responsive to changing levels of risk; and they support an analysis of the source of the risk. Transactional quantitative indicators of risk can be viewed at any level or slice of the organization. Auditors can drill down into a corporate risk or risk category to assess and compare every region, plant, division, project, etc. The risk categories can also determine, for example, what is causing a higher level of legal or strategic risk. In addition, during the development of the annual risk-based plan or the corporate risk profile, the analysis supports the conduct of more productive interviews with management. It provides insights that allow auditors to ask questions that focus on the areas of highest risk to the specific audit entity (e.g. “Why do you have twice the number of journal entries and reversals as other financial managers?” or “What are your plans to address both the high existing HR vacancy rate and the large number of employees who are eligible for retirement within two years?”). This can direct management’s attention to risks that might not have been known previously – making the risk discussion more valuable to both parties.
During the planning phase of an audit, drilling down into the data-driven indicators can focus the audit on specific risk issues (e.g. operational inefficiencies, emerging regulatory changes) or identify best practices. For example, it is easy to examine the risk indicators for an audit entity to determine the factors causing, for example, HR risk to be high. This can help shape the audit scope and objectives making the audit more effective and efficient.
Data-driven risk indicators can also be used on an ongoing basis to assess the risk associated with specific corporate initiatives (e.g. a proposed merger or acquisition) on all categories of risk not just financial. For example, a quick assessment of the HR risk factors could identify emerging HR issues (high turnover and eligibility for retirement rates) in a company where a merger is being proposed. Data-driven risk indicators can also highlight financial risks related to the proposed merger company’s current financial management control framework including highlighting a different financial management framework which may negatively impact the merger. In addition, a potential merger’s risk indicators can be compared to previous mergers (successful and unsuccessful) to determine the relative risk and areas of highest concern. This would better inform management decisions and risk management activities.
To support the risk-based plan, the identification of potential data-driven risk indicators should be considered for each corporate risk and for all risk categories. Auditors should work with the Chief Risk Officer and subject matter experts to examine the risks; identify drivers that affect the risk; and develop data-driven indicators for each risk driver. Table 1 is illustrative of the process to identify data-driven risk indicators for HR. The same process can be used for each risk category (finance, legal and regulatory, etc.). The first step is to define the sub-categories of risk (e.g. recruitment); then the associated risk drivers (e.g. lack of resources); and finally the data-driven risk indicator (e.g. increasing number of vacant positions).
Table 1 – Development of HR Risk Category Indicators
||Data-Driven Risk Indicator
|Recruiting – failure to attract people with the right competencies.
||· Lack of resources
· Lack of skilled employees
• Acting appointments
|Resource Allocation – failure to allocate resources in an effective manner to support the achievement of goals and objectives.
||• Inappropriate resources for tasks
|• Employee type (full-time, part time, seasonal, contractor, etc)
• Employee classification
• Employee status
|Retention – failure to retain people with the right competencies and match them to the right jobs.
• Low experience levels
· High turnover
|• Years of pensionable service
• Average age
• Average years in position
|Work environment – failure to treat people with value and respect.
||· Unhappy workforce
· High sick leave
|• Average sick leave/vacations
• Percentage departures
Once identified, the data-driven risk indicators should be categorized as indicators of volume, variability/change or complexity. The same process would be performed on the other risk categories.
Since each risk category (finance, HR, legal, etc.) will have several risk indicators related to each of volume, variability/change and complexity, determining the overall risk for each audit entity will be difficult to do manually. For example, you could have 7-8 risk categories (finance, HR, operations, legal, technological, etc.); with 5-10 risk indicators for each of volume, variability/change and complexity; and 20-50 audit entities for the annual risk-based audit plan totalling 700 – 4,000 risk measures. However, the details allow you to look at risk from an overall, a risk category or even a risk factor perspective. For example, you could easily determine that Entity A has the highest overall risk score, which is due to high risk scores in Finance, Operations and HR. The HR risk is being driven by high variability (employee turnover and percentage eligible for retirement) and the finance risk is due to the complexity of the financial framework. This will inform the planning phase of the audit of Entity A. A similar analysis can determine which audit entities are having the largest impact on corporate risks.
While the details provide information to support the planning and conduct of an audit, the risk-based plan needs a higher level view of risk. The solution is to develop a single composite data-driven risk score for each entity which includes all risk categories. This is a multi-step process, the first of which is to develop a single risk factor score for each of volume, variability/change and complexity for each risk category; second, consolidate the risk factor scores into a single risk category score for each risk category (finance, HR, operations, etc.); and third, consolidate the risk category scores into an overall risk rating for each entity.
The data-driven risk ratings can be used to rank entities based on based on their overall risk. In addition, qualitative and auditor judgment factors can now be included to arrive at a final risk rating. The final results can be sorted by risk ranking and audits assigned based on availability of resources.
The identification and assessment of data-driven key risk indicators can be accomplished easily and with minimal investment. A data-focused approach will allow internal audit to identify issues, target risks and allocate resources more effectively. It will support professional auditor judgment and make the annual risk-based audit plan more defensible, easier to update, and backed by quantitative and qualitative factors. The data-driven risk indicators are useful during the interview process, aid the planning phase of individual audits, and can be used to keep the annual risk-based audit plan current. The risk indicators can also be used to update corporate risk profiles, and assess the effectiveness of risk mitigation strategies and the risk associated with new strategic initiatives – providing valuable advice to senior management on all categories of risk. Audit functions that leverage a quantitative, data-driven approach to identifying and assessing risk, are more relevant to the business and can provide more efficient and improved risk coverage to senior management and the Board.
Examples of HR data-driven risk indicators
|Volume / Size
· Number of employees
· Total dollars of payroll
· Average age
· average age of senior managers
· Average years of pensionable service
· % of employee who can retire in least than 2 years
· Experience – years in dept / position / classification
· % fulltime employees
· % positions affected by org change in last year
· % employees in acting assignments
· % new hires (within last year)
· Total leave taken
· Average sick leave taken
· Average vacation leave take
· Average unpaid leave taken
· # types of employee
· # classifications of employee
· # geographic locations
· # unions
· % employee with non-standard hours
• % by Gender (M/F)
• % First Official Language (Eng/Fr/Sp/etc.)
Examples of financial data-driven risk indicators
· Total Expenses
· Total Revenue
· Total Assets
· Percentage of discretionary spending
· Percentage of expenditures in Period 12, 13+
· Total and number of JVs
· Total and number of suspense account transactions
· Total and number of Reversal documents
· Total and number of Losses
· Percentage of A/P transactions paid late (> 30 days)
· Percentage of A/R transactions more than 30 days overdue
· Number of Cost centres
· Number of General Ledger accounts
· Number of Foreign Currencies,
· Number of Document types
· Use of Internal Orders
· Use of Purchase orders
· Use of Fund reservations
· Use of Materiel and Asset numbers
· Use of Real estate blocks
· Use of Work Breakdown Structure
· Number of Employees
· Number of P-Cards
ACL Commands: TOTAL, STATISTICS, CLASSIFY, EXPRESSIONS, and RELATE. While the process used scripts to perform all the analysis, the commands were basic – such as Total Age 1 “Number_Emps” and then calculating the average age (Age / Number_Emps).
Lessons-learned: the analysis was extremely useful – particularly when discussing risks with managers. We have the risk measures for each audit entity and could ask pointed questions of managers of projects or activities or ask senior managers about emerging areas of risk based on a comparison of previous years’ data.
“Built it and they will come” – is sometimes true, but I found that I often had to educate the auditors on how to review the results and drill down into the details to better understand the source of the risk. To me it seems obvious – because I view a business process or activity from the data perspective – but this was not the case for all the auditors. They would have a financial, HR or environmental lens and couldn’t see how the data helped. Fortunately, with assistance, some were able to understand what the data was telling them about the entity/activity/process.
Using data-driven indicators of risk we were able to update the RBAP on a quarterly basis in hours. This allowed us to ensure that we were dealing with the highest areas of risk and to identify emerging areas of risk early.