The System and Organization Controls (SOC) 1 Type 2 report (or an ISAE 3402 Type 2 report) is an indispensable tool for a SOX practitioner when evaluating a user entity's internal control over financial reporting (ICFR) that relies on a third-party service organization. In this article, we provide an assessment framework focusing on critical areas a practitioner must evaluate to determine the reliance justified by the service organization's control environment.
A Type 2 report specifically provides assurance on the service organization's description of its system, the suitability of the design of controls, and the operating effectiveness of those controls throughout a specified period.
Phase 1: Establishing Context and Usability
The initial assessment confirms the report meets the necessary foundational criteria to support the user entity’s ICFR compliance review.
Verification of Scope and Type
The practitioner must confirm the report is explicitly a Type 2 report, meaning it covers the operation of controls over a designated period (e.g., July 1, 2024, to June 30, 2025). This contrasts with a Type 1 report, which only speaks to the design and implementation as at a specific date. The report's scope must cover controls that are likely to be relevant to user entities’ internal control over financial reporting.
Description Integrity
The practitioner reviews the service organization's "Description of the System" to confirm it fairly presents the system as designed and implemented. This comprehensive description should include the types of services and transactions processed, the relevant records (including accounting records), and the specific components of internal control implemented (Control Environment, Risk Assessment, Monitoring, etc.). The service organization confirms that the description does not omit or distort relevant information, though it is acknowledged that the report is prepared to meet the common needs of a broad range of user entities, and may not detail every aspect relevant to a specific user.
Subservice Organization Management
If the service organization uses subservice organizations (SSOs) to perform functions relevant to the user entity's ICFR, the practitioner must determine how those SSOs are addressed. If the Carve-out method is used (as frequently seen), the SSO's specific control objectives are excluded from the report's scope. The service organization must, however, have controls for monitoring the effectiveness of the SSO’s system. The user entity’s auditor must assess the adequacy of these monitoring controls, which might involve reviewing the SSO's own attestation reports.
Phase 2: Evaluating the Auditor’s Conclusion and Dependencies
The core of the assessment lies in the service auditor's opinion and the explicit limitations placed on reliance.
Auditor’s Opinion and Assurance
The practitioner looks for the auditor’s reasonable assurance conclusion (or opinion). This opinion confirms, in all material respects, that the description is fair, the controls were suitably designed, and the controls operated effectively throughout the period.
Interpreting Qualified Opinions
Any modification to the auditor’s opinion warrants immediate attention. A qualified opinion indicates material deficiencies. This could mean:
The system description does not fairly present the system.
The controls were not suitably designed (i.e., the risks that threatened the control objectives were not adequately mitigated). For instance, if change procedures lack appropriate review and approval by independent individuals, the design may be faulted.
The controls did not operate effectively throughout the period.
The practitioner must then assess whether the failure identified in the qualification materially affects the specific risks relevant to their user entity.
Dependencies on Complementary Controls
Crucially, the auditor’s opinion on operating effectiveness is often conditional. The auditor explicitly states that they have not evaluated the suitability of design or operating effectiveness of Complementary User Entity Controls (CUECs). The auditor’s conclusion is predicated on the assumption that CUECs (and Complementary Subservice Organization Controls, if applicable) operated effectively.
Phase 3: Reviewing Test Results and Practitioner Obligations
The final stage is tactical, translating the report’s findings into actionable items for the user entity.
Reviewing Detailed Testing and Deviations
The practitioner carefully examines the Testing Matrices. The auditor documents the controls tested, the nature of the tests (Inquiry, Observation, Inspection, Reperformance), and the results. While most tests may result in "No exceptions noted," any deviations identified must be critically analyzed. For instance, an observed weakness might be related to insufficient security testing or poor logging practices.
Implementing Complementary User Entity Controls (CUECs)
The most critical step for the SOX practitioner is to fully understand and implement the required Complementary User Entity Controls (CUECs). The service organization explicitly designs its controls with the assumption that the user entity is implementing these controls.
Key CUECs frequently required include:
Review of Reports: The user entity must perform timely review of reports provided by the service organization (e.g., SLA reports, financial reports, income distribution postings) for discrepancies or anomalies.
Transaction Authorization: The user entity must ensure that transactions initiated by the user (e.g., disbursements, budget requests) are appropriately authorized, complete, and accurate.
Access Review: The user entity must routinely review and approve access lists provided by the service organization for application-level access and confirm the ongoing appropriateness of access rights.
Change Notification: The user entity must provide timely written notification to the service organization regarding significant changes, such as employee separations or changes in authorized contacts/authority.
Failure to implement or operate these CUECs effectively invalidates the reliance placed on the service organization's controls, even if the SOC 1 Type 2 report received an unqualified opinion. It must also be acknowledged that the evaluation of control effectiveness is subject to the inherent risk that controls may become inadequate or fail in future periods. This means an annual audit report with a bridging letter to address uncovered reporting period, if any (as required in case of SOX-scope entities) is a mandatory practice.
We hope you find this framework useful in your review of SOC reports.
For more laser-focused advice tailored to your circumstances, feel free to contact us for a no-obligation consultation.