The Illusion of Security: Why Your Internal Control Might Be a House of Cards

 

Once, during a consulting project, a manager told me something that sounded reassuring: "We have control for outgoing goods; it’s done every single day." However, as I dove into the process, I discovered the harsh reality behind those words. That "control" was merely an employee jotting down what left the warehouse in a notebook, no verification, no signature, and no oversight. In the manager's mind, the risk was covered; in practice, he had a hollow procedure, but not an effective control.

Many people confuse control with bureaucracy, and I often hear that "bureaucracy kills business." But that isn't true. 

Bureaucracy, in its essence, is not a bad thing. If we look at Max Weber’s theory, we understand that it was conceived as a form of human organization based on rationality, ensuring impersonality, a clear hierarchy, and meritocracy. It ensures that the process depends on the rule, rather than the mood of whoever is executing it. 

I always say that bureaucracy is simply the formalization of what is already working.

The real problem isn't bureaucracy itself, but "bureaucratic excess", when the ritual becomes more important than the result. 

An internal control system based on best practices, right sized to keep risk factors within acceptable levels, is essential for operational efficiency. It creates order and prevents the "rigidity" that often blinds an operation.

We know that internal control is an action designed to mitigate the cause of a risk before it materializes. It manifests in the "doing": in the review, the verification, the recalculation, and the careful approval. If there is no confrontation between "what should be" and "what is," the risk continues to walk freely through your company’s hallways.

For a control action to be more than just figurative, it requires four non-negotiable attributes:

• First, the Objective, which is the very reason for its existence and must target the risk factor. For example, if the risk is the use of incorrect labor hours, the objective is to ensure that the hours in the payroll system are consistent with the time-tracking system.

• Second, Practical Action, such as a data verification. It is vital to formalize how this action is performed so that a "prudent person" could re-perform it.

• Third, the Evidence, because a control without a trail is invisible. It could be a sign-off, a system log, or an email. To an auditor or an internal controls specialist, a lack of evidence implies the control does not exist. Finally, the Frequency, which must match the speed of the risk, whether it be daily, monthly, or per event.

 

When we talk about Control Modeling, the starting point is knowing the risk factor and the magnitude of what we are mitigating, allowing us to define the necessary attributes to keep the operation within the organization's risk appetite. 

These same attributes allow us to evaluate Design Efficiency, concluding whether the control has the theoretical capacity to mitigate the risk.

 Once we move to Effectiveness Evaluation—the actual control testing—the focus shifts to two crucial points: discipline, observing if the evidence exists within the defined frequency; and quality, re-performing the action to ensure it wasn't just a formality. 

This is why these attributes must be formalized, at the very least, in an Internal Control Matrix.

 It is also fundamental to understand that control is neither absolute nor infallible, as it is designed and executed by people. And where there are humans, there is vulnerability—whether through errors in judgment or, in grave cases, omission, fraud, and collusion. Therefore, the effectiveness of a control does not reside solely on paper, but in the discipline and ethical stance of its execution.

Recently, the market witnessed a testimony that serves as a stark warning. A former bank director admitted to signing documents without reading them. More than a momentary lapse, his confession revealed a void: despite heading the department, he did not perform monitoring or prevention duties.
Here we have the perfect "Window Dressing Control"—the evidence and frequency exist, but the execution of the action is null.

Unfortunately, this is not an isolated case; it is present in many corporations where management still mistakenly views control as mere bureaucracy.

To conclude, I leave you with a thought for reflection:

"The effectiveness of a control depends on action, evidence, and frequency, but it only stops being a house of cards when the integrity of the person executing it is greater than the convenience of simply signing."

Be happy!

Let's make enterprise risk management simple!

 

Today I want to bring to our reflection a fundamental theme for the consolidation of corporate governance.

Let's talk about enterprise risk management.

I was preparing the course, and I came across a slide that I use to explain, the structure applied to risk management, and I felt motivated to bring this topic to our discussion.

Anyone who follows me on social media knows that I always try to bring a simple view to important topics related to management and governance, facilitating understanding and their application in corporate activities.

Simplicity is currently a competitive advantage for the organization, but understand that being simple does not mean being superficial.

Well, let's get back to our topic, which is risk management.

In a simple way, I can say that:

“Managing risks is a proactive activity, looking to the future, understanding the events, external and/or internal, that may materialize and adversely impact the company's or process's ability to achieve its objectives; evaluates them for their magnitude, and treats them based on the acceptable levels of risk defined by the corporation.”

The primary objective of risk management is to allow the corporation, in the pursuit of fulfilling its mission, to conduct, direct and maintain its activities, actions and decisions, within its acceptable level of risk, defined by risk appetite.

The starting point for risk management is the correct understanding of objectives, whether strategic, corporate and/or operational. If we do not know the objectives clearly, it is difficult to know the risks in a comprehensive way.

Not using objectives as a basis for identifying risks is the most common mistake I find in corporations, causing time and resources to be spent in a wrong and ineffective way.

Remember that the risk event directly impacts the ability to achieve the objectives.

Regarding the operational objectives, those that relate to the various existing processes for the operationalization of the organization's activities, I recommend the definition of the objectives inherent to each of the processes, as well as the objectives related to legal compliance, objectives related to moral values of the organization, and objectives related to the consistency, integrity, confidentiality and recoverability of the processed data.

The better the definition of objectives, the more effective the identification of risks tends to be.

Well, since we have already determined the objectives, we now begin the process of identifying the events, external and/or internal, that may impact the corporation.

Then, in a simple way, we begin to identify the risks that, if materialized, will adversely impact the organization's ability to achieve its objectives. We can see risk as the negative view of the objective, for example: If one of the inherent objectives of a purchase process is to buy only products and/or services necessary for the operation of the corporation, the risk may be the purchase of products and/or or services not necessary for the operation.

Based on the understanding of the objectives, try to identify all risk events that relate to it. This is a brainstorming activity. There is no Cartesian way of doing this.

Once all the perceived risks are related, the next step is to know their causes, that is, the events that could materialize the risk.

It is the risk factors (causes) that we assess the magnitude of and that we treat, so it is important to be judicious in identifying them.

To illustrate, let's go back to the example of the purchasing process, why can the corporation buy products and/or services not necessary for the operation? The answers to this question will allow us to identify the risk factors. Example: a. A wrong purchase requisition, b. Lack of inventory planning, c. A fraud.

This procedure must be performed for all identified risks, without exception.

Very well, at this point, our risk matrix already has three basic columns: Column of objectives, column of risks related to each of the objectives and column of risk factors related to each of the identified risks.

The next step is the analysis and assessment of risk factors through the matrix reading of probability (frequency) and impact (in several dimensions, such as financial, image, market-share and others).

At this point, it is important that the corporation has metrics, approved by senior management, to assess the magnitude (probability and impact) of risk factors.

It is also important that the company already has a risk appetite defined by top management. As a suggestion, to facilitate the risk management process, guide senior management to define the risk appetite based on the heat map resulting from the metrics, indicating the quadrant that should be considered as the accepted level risk.

I like to use metrics with five levels of probability and five levels of impact, so that the heat map has quadrants from 01 to 25. In this case, risk appetite can be defined as being one of the existing quadrants, for example the high management can direct your risk appetite to quadrant six, so anything above will need to be addressed.

One of the problems that I come across, in this evaluation stage, is in relation to the use of complex metrics, with the inclusion of weights, weighted average and other calculations that only bring complexity and delay to the process.

Note that, more important than the accuracy of the risk factor measurement, is the action that management takes to address it. It doesn't matter if the risk is 15,234 or 15, what really matters is the action that management takes to mitigate the risk factor.

The calculation is simple: probability x impact = gross risk

Another important point at this stage of the evaluation is the definition of impact, that is, if the event materializes, what impact will it bring to the organization. Some corporations seek to assess impact through a weighted average across the various dimensions. The suggestion is to work with the dimension that receives the primary impact, and not with a weighted average of the impact in the different dimensions, because, note that this is not how it happens in reality. Example: if the event materializes and impacts the image, it will not necessarily impact, simultaneously, the other dimensions measured, so it is best to focus on treating the effect on the image, ensuring that it does not affect secondarily the other dimensions.

Okay, now that we know the magnitude (gross risk) for all risk factors, whether inherent, compliance, fraud, or IT, the next step is to compare the magnitude obtained with the risk appetite, and based on in this, determine the best treatment to align the raw risk with the risk appetite determined by the organization.

Keep in mind that the primary objective of risk management is to enable the corporation to act within its acceptable level of risk, formalized through the definition of risk appetite.

Risk factor treatment can be: Accept, Share, Avoid and Mitigate.

We can accept the risk, when the gross risk is already aligned or below the risk appetite, however accepting the risk does not mean doing nothing, but monitoring the risk factors, because today it is low, tomorrow it may change and with this change our treatment.

Another important point is in relation to who can accept the risk, and my suggestion is that it need to be accepted by the statutory managers, since legally they are the ones who take the risk for the company, including their private assets.

Sharing risk is a process where another corporation, be it a financial institution or an insurance company, accepts to take part of the risk for the company. Example: Insurance policies, or foreign exchange hedge. Note that this is an answer on impact and not probability.

Another form of treatment for risk factors is risk avoidance. It is one of the most difficult answers to work with, because in order to avoid risks, the organization can no longer be exposed to risk, which means, in most cases, strategic decision-making, such as the company's exit from a market, or closing a unit, or not carrying out an operation, etc.

Finally, we have the possibility of mitigating the risk factor, which operationally speaking, requires the implementation of an internal control to mitigate the probability of the risk event materializing.

Just remembering that internal controls are:

“Actions, formalized in policies and procedures, aimed at mitigating the probability of materialization of the risk event. These are actions of review, checking, certification, validation, authorization, approval, etc.”

Depending on the materiality and nature of the risk, in addition to the probability response, it will be necessary to prepare a contingency plan, which aims to minimize the effect of the impact, when the risk event materializes.

Once the responses have been determined and implemented, the next step is to calculate the residual risk, which is the effect remaining after the treatment action, and make sure it aligns with the risk appetite defined by the corporation.

Remember that simplicity is currently a competitive advantage! Bring simplicity to operation, not superficiality!

Be happy!

Por que os programas de compliance falham?

 

Como acontece com outras práticas de governança, o programa de compliance, para ser efetivo, requer que os pilares que irão sustentá-lo, no tempo e espaço, estejam presentes.

Vejamos alguns pontos com os quais normalmente me deparo nas corporações:

• Encontro programas de compliance que se restringem apenas na existência de políticas de integridade, que é importante, mas não o suficiente.
• Também, me confronto com programas muito bem elaborados e formalizados em políticas e procedimentos, entretanto, infelizmente, este programa fica somente no papel.
• Me deparo com áreas de compliance que sua atividade se resume na execução de controle, por meio do preenchimento de checklist, passando a ser, neste caso, parte da primeira linha de gestão, perdendo sua identidade de área especialista de segunda linha de gestão.

Não quero dizer com isto, que contar com um bom programa de integridade, ou ter um processo adequadamente formalizado, ou realizar um monitoramento independente não seja importante. Sim é importante, mas é preciso é que tudo isto faça parte de um processo mais amplo, estruturado e integrado.

Gosto sempre de lembrar que compliance é na realidade “atitude”.

É a atitude que todos, que façam parte ou se relacionam com a corporação, executem suas atividades, ações e decisões dentro dos valores morais e éticos da organização, amparado pelos requisitos legais, sejam eles oriundos de legislação externa, do país, estado, munícipio ou do órgão regulador, sem exceção.

Outro ponto importante que devemos considerar é que se o objetivo é ter uma corporação onde suas atividades sejam amparadas pelos seus valores morais e éticos, dentro dos requisitos legais, temos o “risco” de isto não acontecer.  

Se compreendemos que não estar em compliance é um risco, precisamos gerenciá-lo por meio de um processo estruturado para a identificação dos riscos e seus fatores, avaliando sua magnitude e no final, tratando-o de forma a manter o fator de risco alinhado ao apetite a risco da organização, que neste caso deve ser zero, por motivos óbvios.

Agora, considerando que se não todos, uma boa parte dos fatores de riscos tem sua origem em fatores internos, podemos dizer que o seu tratamento será por meio da implementação de um sistema de controle interno, o qual é formado por ações, formalizadas em políticas e procedimentos, para a mitigação da probabilidade do evento de riscos se materializar.

Então, até aqui, podemos compreender que um programa de compliance para ser efetivo necessita estar amparado por um processo integrado para o gerenciamento dos fatores de riscos, o qual por sua vez, necessita de um eficaz sistema de controles internos.

Mas tudo isto, ainda não é suficiente para que o programa de compliance realmente funcione apropriadamente. É importante que os três pilares basilares estejam presentes. Os pilares são:

1.   Cultura – A organização precisa ter um conjunto de valores e crenças apropriados para influenciar e alinhar a atitude e o comportamento de todos colaboradores, prestadores, terceiros aos requisitos de compliance.

2.   Consciência – A cultura prepara o caminho, mas é importante contar com gestores, colaboradores, prestadores e terceiros que conscientemente acreditem, se comprometam, e que, apoiado pelos valores morais da organização e pelas melhores práticas de gestão, exemplifiquem e exerçam suas atividades dentro dos requisitos de compliance,

3.   Formalização – Para a manutenção da qualidade e entendimento das atividades, estrutura, processos e monitoramento é necessário a existência de um conjunto de documentos como: políticas, procedimentos, código de conduta, instruções de trabalho e outros. Esta documentação, uma vez atualizada e amplamente divulgadas, permite a equalização e alinhamento das atividades e operações, independentemente de qual ciclo de negócio ela pertencer.

Posso, sem medo de errar, dizer que o grande desafio para a implementação de um efetivo programa de compliance é com certeza trabalhar os dois primeiros pilares: cultura e consciência.

Os órgãos de governança, a alta e a média gestão têm papel importante nestes quesitos. Eles têm a responsabilidade de definir os valores, promover um ambiente propicio para a aplicação das melhores práticas de gestão, exemplificando estes valores em seu discurso, posicionamento, ações e em suas decisões.

Logicamente, tudo isto exige uma mudança mental e comportamental de todos os envolvidos, principalmente dos níveis de gestão e tomadores de decisão. Um programa estruturado de capacitação gerencial em governança, compliance e nas práticas de gestão tende a reduzir a resistência à mudança, mas o comprometimento incondicional aos requisitos de compliance, pelos membros dos órgãos de governança, será essencial para o amadurecimento da gestão em relação ao compliance e melhores práticas de gestão.

Cada linha de gestão deve conhecer claramente suas responsabilidades, de forma transparente, não podendo haver dúvidas, de forma que possam prestar conta, para quem os elegeu, sobre toda e qualquer materialização do risco de compliance e/ou violação aos valores morais da organização.

Temas estes que devem fazer parte da agenda do presidente, do conselho de administração e do comitê estatutário de auditoria.

Para finalizar, os programas de compliance que falham são aqueles, que por algum motivo, não contam, de forma equilibrada, com os três pilares: Cultura, Consciência e Formalização

Então: Reflita, inove, mude e no final

Seja feliz!

Internal controls, the responsibility of everyone!

Questioning who is responsible for internal controls is a common and recurring situation in the corporate world. When the company has an area of ​​internal controls, it is attempted to wrongly attribute this responsibility to it.

Why does this happen?

In my opinion, this behavior is a consequence of the lack of maturity in the management process in relation to good practices, in line with the fragility of a university that does not properly teach managers.

This weakness is evident when, managers and other professionals, relate internal controls to bureaucracy and / or “plastering” the business process. They fail to see and associate that internal control is a response to the action of mitigating a risk factor, which results in increasing the company's ability to achieve its strategic objectives.

The maturity of governance involves the improvement of the internal environment through the strengthening of the culture in the use of good management practices and the consolidation of awareness of risks and controls.

An essential point for this to happen is the correct addressing of the responsibility of each person within the organization in relation to the internal control system.

The model of the three management lines helps us to demonstrate these responsibilities, and was the basis for the construction of the diagram that I prepared to facilitate this understanding.

Let's see:

1. Governance Structure - I include here the Board and statutory committees, which are responsible for promoting the appropriate environment for the culture development and awareness of risks and controls. In addition, they must be committed to good management practices, supervising and monitoring the application of these concepts by the executive and operational management, following up on the implementation and improvement of internal controls.

2. Executive and Operational Management - In this case, executive management is the president and his directs, while operational management is the managers below the executive management line. The responsibility lies in exemplifying the commitment to internal controls, and in defining, implementing, executing and supervising the internal control system in order to keep operational risks within acceptable limits, as defined by the corporate risk appetite. This first line of management are the “owners” of risks and control, with no exception.

3. Specialists - Responsible for supporting the executive and operational management, first line, to apply the best management practices for the modeling, implementation, maintenance and improvement of the process and its internal control system integrated with the corporate risk management structure. This group includes specialists in internal controls, specialists in risk management, compliance and governance. They are the second line of management.

4. Internal audit - It is an independent and objective activity, usually reporting to the governance structure, with the objective of adding value, through the application and execution of an independent and objective evaluation on the internal control, risk management and corporate governance systems.

As you may see, every single person within an organization, without exception, has explicit responsibilities regarding internal controls, either in their design, implementation, execution or in their quality.

However, the greatest responsibility is left to the executive management (president and its directs) which must promote the properly environment, based in the ethics and best practices, in order to create the culture where all managers and employees recognize their responsibility for the existence of high quality internal control system.

I would like conclude this article with this quote:

“The great enemy of truth is often not the lie - deliberate, contrived and dishonest - but the myth - persistent, persuasive and unrealistic” J.F.Kennedy

 

Always, be happy!