ISC CPA Exam: Understanding the Carve-Out vs the Inclusive Method of Reporting on CSOCs in a SOC Engagement

Introduction

Overview of SOC Engagements and Their Importance in Reporting on Service Organizations

In this article, we’ll cover understanding the carve-out vs the inclusive method of reporting on CSOCs in a SOC engagement. Service Organization Control (SOC) engagements play a crucial role in assessing the internal controls of service organizations that handle or process critical data for clients. These reports are used by external auditors and stakeholders to gain assurance over the effectiveness of controls that relate to the services provided. SOC engagements help organizations demonstrate their compliance with industry regulations and internal standards, thus increasing trust with clients, particularly when dealing with sensitive data.

There are three main types of SOC reports—SOC 1, SOC 2, and SOC 3. SOC 1 reports focus on internal controls over financial reporting, SOC 2 reports assess controls related to security, availability, processing integrity, confidentiality, and privacy, and SOC 3 is a more general-purpose report often used for marketing purposes. The accuracy and completeness of SOC reports are critical for organizations looking to maintain and improve relationships with their clients and to meet regulatory requirements.

The Significance of Control System Outsourcing Components (CSOCs) in SOC Engagements

Control System Outsourcing Components (CSOCs) refer to portions of an organization’s control environment that have been outsourced to third-party service providers. In today’s complex business environment, many organizations rely on external vendors or partners to perform essential services, from IT management to data storage. These third-party providers are often integral to the organization’s overall control framework.

The need to account for outsourced components has led to the development of specific methodologies for reporting on CSOCs in SOC engagements. Since these outsourced services often impact key controls, failing to properly report on them can undermine the integrity of the SOC report. Auditors need to understand how CSOCs fit into the broader system of controls, which has led to the creation of different reporting methods for addressing these components in SOC reports.

Introduction to the Two Primary Methods of Reporting on CSOCs: Carve-Out and Inclusive

When reporting on the controls of a service organization that has outsourced key functions, auditors have two main reporting methodologies to choose from: the Carve-Out method and the Inclusive method.

• The Carve-Out Method excludes outsourced components from the scope of the SOC report. Under this method, the service organization acknowledges the existence of outsourced controls but does not include them in the audit. Instead, it is disclosed that these components are managed by another entity, and any reliance on the third-party’s controls is noted separately. This method often requires the user organization to obtain assurance from the third-party provider through their own SOC report.
• The Inclusive Method includes the outsourced controls in the scope of the SOC report, treating the CSOCs as part of the service organization’s overall control environment. This method extends the auditor’s responsibility to assess and report on the effectiveness of controls operated by the third-party service provider as if they were part of the service organization itself.

Each method has its advantages and challenges, and the choice between Carve-Out and Inclusive reporting depends on the service organization’s structure, the extent of outsourcing, and client requirements. Understanding these methods is essential for preparing an accurate SOC report that appropriately reflects the service organization’s control environment.

Understanding SOC Engagements and CSOCs

Overview of SOC 1, SOC 2, and SOC 3 Reports

SOC reports are essential tools for service organizations to demonstrate the effectiveness of their internal controls. These reports are often requested by clients or stakeholders to gain assurance over the controls that impact the services provided, particularly when sensitive data or processes are involved. There are three main types of SOC reports, each tailored to different needs and purposes:

• SOC 1 Report: A SOC 1 report focuses on internal controls related to financial reporting. It is particularly relevant for service organizations that affect their clients’ financial statements, such as payroll processors or data centers hosting financial systems. The report helps user auditors assess the impact of the service organization’s controls on their clients’ financial reporting.
• SOC 2 Report: SOC 2 reports are broader in scope and examine controls related to five trust service categories: security, availability, processing integrity, confidentiality, and privacy. SOC 2 is particularly valuable for service organizations managing sensitive client data or operating IT systems. Unlike SOC 1, SOC 2 is not restricted to financial reporting but focuses on the overall risk management of data handling and system processes.
• SOC 3 Report: SOC 3 reports are essentially a public-facing version of a SOC 2 report. They include a summary of the SOC 2 findings without disclosing sensitive details. SOC 3 reports are often used by service organizations to promote their compliance with industry standards and their commitment to secure and effective operations. While they are less detailed, SOC 3 reports offer public assurance of control effectiveness.

Definition of Control System Outsourcing Components (CSOCs) and Their Role in Service Organizations

Control System Outsourcing Components (CSOCs) are parts of an organization’s control environment that are managed by third-party service providers. In the modern business landscape, many organizations rely on external vendors to perform essential functions, such as IT infrastructure management, data processing, cloud hosting, or even security monitoring. These third-party vendors often control key processes or systems that directly impact the organization’s overall operational and control environment.

CSOCs represent any outsourced services or operations that play a role in ensuring compliance with a service organization’s internal controls. For example, a service organization providing cloud-based financial software might outsource data storage and management to a third-party data center. The effectiveness of that third-party’s controls is crucial to the integrity of the service organization’s overall system, as any failures in the outsourced component could affect data security, availability, or financial reporting.

The Relevance of Reporting on CSOCs in a SOC Engagement

Including CSOCs in a SOC engagement is critical to providing a complete picture of a service organization’s control environment. Since many key functions may be outsourced, ignoring these components could result in an incomplete or inaccurate understanding of the risks and controls in place. SOC reports that address outsourced components help user organizations and their auditors assess the full risk landscape, ensuring that all critical processes are evaluated.

Auditors must decide whether to use the Carve-Out or Inclusive method to report on these CSOCs. The Carve-Out method acknowledges that third-party services are relied upon but excludes them from the scope of the SOC audit. The Inclusive method, on the other hand, integrates these third-party services into the scope of the audit, assessing their effectiveness alongside the primary service organization’s internal controls.

By appropriately reporting on CSOCs, service organizations can provide transparency, ensuring that their clients and other stakeholders have a clear understanding of the control environment, including any outsourced functions. This transparency helps maintain trust and confidence in the organization’s ability to manage risk and maintain control over critical services.

The Carve-Out Method of Reporting

Explanation of the Carve-Out Method

The Carve-Out method of reporting is an approach used in SOC engagements when the service organization outsources certain key controls to a third-party provider. In this method, the outsourced components, known as Control System Outsourcing Components (CSOCs), are explicitly excluded from the scope of the SOC audit. Instead, the SOC report acknowledges the existence of the outsourced controls but does not include an evaluation of their effectiveness.

In practical terms, this means that the auditor will focus solely on the controls maintained and operated by the primary service organization while disclosing that certain controls are managed by another service provider. The responsibility of assessing the effectiveness of these outsourced controls is left to the user organization, which may request a separate SOC report from the third-party provider.

When and Why the Carve-Out Method Is Used in Reporting

The Carve-Out method is typically used when the service organization does not have full oversight or control over the outsourced components. It is often the preferred option in situations where the third-party provider operates independently and has its own set of internal controls, audited under a separate SOC report. The service organization using the Carve-Out method acknowledges reliance on these external controls but shifts the responsibility of evaluating them to the user organization.

This method is commonly employed in the following scenarios:

• Complex Outsourcing Arrangements: When an organization outsources a significant portion of its IT infrastructure, data management, or other critical functions to a third party.
• Separate SOC Reports for Third Parties: If the third-party provider already issues its own SOC report, the service organization may opt to “carve out” these components from its own report, directing users to rely on the third-party’s SOC report.
• Limited Control Over Third Parties: When the primary service organization does not have adequate oversight of the outsourced controls, it may choose the Carve-Out method to limit the scope of its responsibility in the SOC engagement.

Steps Involved in Preparing a SOC Report Using the Carve-Out Method

1. Identify Outsourced Components: The first step in preparing a SOC report using the Carve-Out method is to identify which key controls or components have been outsourced to third-party providers.
2. Disclose the Use of Third Parties: The SOC report must include a clear disclosure stating which components have been outsourced and are not covered by the scope of the SOC audit. This disclosure is typically placed in the description of the service organization’s system of controls.
3. Reference Third-Party SOC Reports (If Applicable): If the third-party provider issues its own SOC report, the service organization should reference this report and advise the user organization to obtain it for a full understanding of the outsourced controls.
4. Perform the SOC Audit on Internal Controls: The SOC auditor focuses on the internal controls maintained by the service organization and performs the necessary procedures to assess their design and operational effectiveness.
5. Report on Internal Controls and the Carve-Out Components: The final SOC report will include the results of the audit of the internal controls while noting the exclusion of the outsourced components. It will often state that the service organization’s controls, excluding the carved-out portions, are appropriately designed and operating effectively.

Benefits and Limitations of the Carve-Out Method

Benefits:

• Simplified Audit Scope: The Carve-Out method narrows the focus of the SOC audit to only those controls that the service organization directly manages, reducing the complexity and time involved in the audit process.
• Reduced Liability: By carving out outsourced components, the service organization limits its responsibility for the effectiveness of third-party controls, passing that responsibility to the user organization or the third-party provider.
• Availability of Separate SOC Reports: In cases where the third-party provider has its own SOC report, the Carve-Out method allows the user organization to obtain detailed assurance directly from the provider, ensuring comprehensive coverage.

Limitations:

• Lack of Complete Transparency: Since the Carve-Out method excludes key controls, the SOC report may not provide a complete picture of the service organization’s control environment. User organizations may need to rely on multiple SOC reports to gain a full understanding.
• Increased Responsibility for User Organizations: The user organization must obtain and evaluate the third-party’s SOC report, adding an additional layer of complexity and responsibility for ensuring control effectiveness across the entire system.
• Potential for Gaps in Assurance: If the third-party provider does not issue a SOC report or if there is poor communication between the service organization and the third party, there may be gaps in assurance over the outsourced components.

The Carve-Out method is a practical approach for service organizations that rely on third-party providers, but it requires careful coordination and communication to ensure that all relevant controls are appropriately assessed and reported.

The Inclusive Method of Reporting

Explanation of the Inclusive Method

The Inclusive method of reporting is an approach used in SOC engagements where the service organization includes outsourced components, known as Control System Outsourcing Components (CSOCs), within the scope of its SOC report. This means that any controls managed by third-party service providers are treated as part of the service organization’s overall control environment and are subject to the same evaluation and scrutiny as the internal controls operated by the primary organization.

In the Inclusive method, the auditor assesses not only the service organization’s internal controls but also the controls in place at the third-party provider that directly impact the services or systems provided to the organization’s clients. This method integrates all critical outsourced functions into a single SOC report, offering a more comprehensive view of the control environment.

When and Why the Inclusive Method Is Used in Reporting

The Inclusive method is typically chosen when the service organization wants to provide a complete picture of its control environment, including any outsourced services that are critical to its operations. It is often used in cases where the service organization has substantial oversight or influence over the outsourced components or where the outsourced service is integral to the organization’s ability to meet its control objectives.

Common scenarios for using the Inclusive method include:

• Critical Dependence on Outsourced Services: If the service organization relies heavily on a third party for essential operations (e.g., cloud hosting, IT security), the Inclusive method ensures that these outsourced controls are fully assessed.
• Desire for a Single, Comprehensive SOC Report: Organizations may prefer to issue one SOC report that includes all relevant controls, both internal and outsourced, to avoid the need for clients or stakeholders to obtain multiple SOC reports.
• Oversight and Influence Over Third-Party Providers: If the service organization has significant control over or insight into the third-party provider’s operations, the Inclusive method may be used to reflect the integrated nature of the control environment.

Steps Involved in Preparing a SOC Report Using the Inclusive Method

1. Identify Outsourced Components to Be Included: The first step in using the Inclusive method is to identify the key controls or components managed by third-party providers that will be included in the SOC report.
2. Evaluate the Third-Party Provider’s Controls: The auditor must assess the controls in place at the third-party provider, either through direct testing or through reliance on the provider’s own control testing and documentation. This evaluation must cover all aspects of the outsourced controls that are relevant to the service organization’s overall control objectives.
3. Integrate Third-Party Controls into the SOC Engagement: The outsourced controls are treated as part of the primary service organization’s control environment. This means that the SOC auditor must integrate the results of the third-party control evaluation into the overall audit plan and documentation.
4. Prepare a Comprehensive SOC Report: The final SOC report will include the third-party controls alongside the internal controls of the service organization. The report will describe how these controls work together to meet the control objectives and provide assurance over both internal and outsourced operations.
5. Communicate the Scope of the Report: The SOC report should clearly communicate that it includes both the internal controls of the service organization and the relevant controls of the third-party provider. This ensures transparency and helps users understand the breadth of the report’s coverage.

Benefits and Limitations of the Inclusive Method

Benefits:

• Comprehensive View of the Control Environment: The Inclusive method provides a complete picture of the service organization’s control environment, including all critical outsourced components. This approach eliminates the need for separate SOC reports from third-party providers, offering stakeholders a single source of assurance.
• Enhanced Assurance for Clients and Stakeholders: By including third-party controls in the scope of the SOC report, the Inclusive method gives clients and stakeholders greater confidence that all key controls have been thoroughly assessed, reducing the risk of gaps in assurance.
• Simplified Reporting for User Organizations: Clients of the service organization benefit from receiving a single SOC report that covers all relevant controls, rather than having to obtain and evaluate separate SOC reports from third-party providers.

Limitations:

• Increased Audit Complexity: Including third-party controls in the scope of the SOC report increases the complexity of the audit. Auditors must assess not only the service organization’s internal controls but also the controls of third-party providers, which can require additional time, coordination, and expertise.
• Limited Control Over Third-Party Operations: Even though the third-party controls are included in the SOC report, the service organization may not have full oversight or control over these outsourced operations. This can make it challenging for the auditor to obtain sufficient evidence of control effectiveness.
• Potential for Audit Scope Creep: Including third-party controls in the audit scope can lead to broader evaluations than initially planned, increasing costs and time for both the service organization and the auditor.

The Inclusive method of reporting offers a more holistic view of a service organization’s control environment, providing greater transparency and assurance to clients. However, it also introduces additional complexity to the audit process, requiring careful coordination between the service organization, third-party providers, and auditors.

Key Differences Between the Carve-Out and Inclusive Methods

Comparison of Reporting Obligations Between the Two Methods

The primary difference between the Carve-Out and Inclusive methods lies in the extent of the auditor’s responsibility and the service organization’s reporting obligations regarding outsourced controls, also known as Control System Outsourcing Components (CSOCs).

• Carve-Out Method: In the Carve-Out method, the service organization discloses that certain key controls are outsourced to a third-party provider, but those controls are excluded from the scope of the SOC audit. The auditor’s responsibility is limited to assessing the internal controls maintained by the service organization. The responsibility for evaluating the effectiveness of the third-party’s controls falls to the user organization or requires a separate SOC report from the third-party provider.
• Inclusive Method: In contrast, the Inclusive method integrates the outsourced controls into the SOC report, meaning that the auditor evaluates both the service organization’s internal controls and the outsourced controls. This method places greater reporting obligations on the service organization and its auditor, as they must assess the third-party’s controls as if they were part of the service organization’s system of controls.

How Each Method Impacts the Scope and Depth of a SOC Report

The choice between the Carve-Out and Inclusive methods significantly affects the scope and depth of the SOC report.

• Carve-Out Method: The scope of the SOC report is narrower in the Carve-Out method since it excludes the outsourced controls. The report focuses only on the service organization’s internal control environment and acknowledges that certain key controls are managed externally. This approach reduces the depth of assurance provided in relation to the third-party provider’s controls, as the auditor does not directly assess these outsourced controls.
• Inclusive Method: The scope of the SOC report is broader in the Inclusive method, as it includes both internal and outsourced controls within the audit’s scope. This results in a more comprehensive evaluation of the entire control environment, including third-party components. The depth of the report is enhanced since it provides assurance not only over the service organization’s internal processes but also over critical outsourced functions. However, this increased scope adds complexity to the audit process, as auditors must assess both internal and third-party controls.

Practical Considerations for Auditors and Organizations When Choosing a Method

When deciding between the Carve-Out and Inclusive methods, service organizations and auditors must consider several practical factors:

1. Extent of Outsourcing: If the service organization has outsourced a significant portion of its key controls, the Inclusive method may provide a more accurate and complete representation of its control environment. On the other hand, if only a small portion of controls are outsourced, the Carve-Out method may be sufficient.
2. Third-Party SOC Reports: If the third-party provider already issues its own SOC report, the Carve-Out method may be preferred, as the user organization can obtain assurance directly from the third-party provider. This can reduce the need for the service organization to include the third-party controls in its own SOC report.
3. Level of Oversight and Influence: Service organizations with significant oversight or influence over the outsourced operations may find the Inclusive method more appropriate, as they can better assess the third-party’s controls. Conversely, if the service organization has little to no control over the outsourced provider, the Carve-Out method might be a more practical choice.
4. Client and Stakeholder Preferences: Some clients or stakeholders may require a more comprehensive SOC report that includes third-party controls, making the Inclusive method a better fit. Others may be satisfied with a Carve-Out report if the third-party provider has its own SOC audit.
5. Audit Complexity and Cost: The Inclusive method typically increases the complexity and cost of the SOC audit due to the need for auditors to assess both internal and outsourced controls. Organizations with limited resources or audit budgets may prefer the Carve-Out method to keep the audit scope more manageable.
6. Regulatory Requirements: Certain industries or jurisdictions may have specific requirements regarding the reporting of outsourced controls in SOC engagements. Organizations should ensure that the chosen method complies with any relevant regulations or standards.

By carefully considering these practical factors, service organizations and auditors can make informed decisions about whether to use the Carve-Out or Inclusive method, ensuring that the SOC report appropriately reflects the organization’s control environment and meets stakeholder expectations.

Choosing Between the Carve-Out and Inclusive Methods

Factors Influencing the Decision Between Carve-Out and Inclusive Methods

When selecting between the Carve-Out and Inclusive methods for SOC reporting, several factors come into play, impacting the decision of both the service organization and its auditors. These factors include:

1. Level of Control Over Outsourced Components: If the service organization has significant control over the third-party provider or exercises substantial oversight of the outsourced components, the Inclusive method may be preferred. Conversely, when the third-party provider operates independently with minimal oversight from the service organization, the Carve-Out method is typically more appropriate.
2. Availability of Third-Party SOC Reports: If the outsourced service provider has its own SOC report, the Carve-Out method is often a more practical choice. This allows the service organization to refer clients to the third-party’s SOC report for assurance over outsourced controls. If no SOC report is available from the third-party provider, the Inclusive method might be necessary to ensure comprehensive reporting.
3. Complexity of Outsourced Services: The complexity and criticality of the outsourced services also influence the decision. If the outsourced components play a critical role in the service organization’s overall operations (e.g., data security or cloud infrastructure), the Inclusive method may provide greater transparency and assurance to stakeholders. For less critical or ancillary services, the Carve-Out method may be sufficient.
4. Audit Cost and Complexity: The Inclusive method often increases the complexity and cost of the audit, as the auditor must assess both internal and third-party controls. Organizations with limited resources may opt for the Carve-Out method to reduce audit scope and costs, while still ensuring that key outsourced components are disclosed.

Client Preferences and Regulatory Considerations

The preferences of clients and stakeholders can significantly influence the decision between the Carve-Out and Inclusive methods:

1. Client Assurance Needs: Some clients, particularly those in regulated industries or with high security concerns, may require a SOC report that includes all relevant controls, including outsourced ones. In such cases, the Inclusive method may be necessary to meet client demands for comprehensive assurance. On the other hand, if clients are satisfied with obtaining a separate SOC report from the third-party provider, the Carve-Out method may suffice.
2. Regulatory Requirements: Regulatory frameworks and industry standards may dictate the level of detail required in SOC reports, especially when dealing with sensitive industries like finance, healthcare, or government contracting. For example, certain regulatory bodies may require a full evaluation of all controls, including those outsourced to third-party providers, favoring the Inclusive method. Organizations must ensure their SOC reporting complies with any regulatory mandates to avoid potential compliance risks.
3. User Auditor Expectations: In some cases, user auditors may have specific expectations regarding the scope of a SOC report. For instance, auditors may need comprehensive details on all controls impacting financial reporting or security, pushing the service organization to use the Inclusive method to meet those requirements.

Industry-Specific Norms or Requirements

Different industries have developed their own norms and best practices for SOC reporting, which can influence the decision between the Carve-Out and Inclusive methods:

1. Technology and Cloud Services: In industries where cloud computing and outsourced IT services are prevalent, the Inclusive method may be more common. Clients often expect a comprehensive SOC report that includes outsourced IT controls, as they need assurance over the security and reliability of third-party providers. The complexity of managing IT security and data protection in cloud environments makes full transparency critical, especially in highly regulated sectors like finance or healthcare.
2. Financial Services: In the financial services industry, where third-party providers often handle critical functions like payment processing or data storage, there may be a preference for the Inclusive method to ensure that all components affecting financial reporting are thoroughly assessed. Regulatory requirements in this sector, such as those imposed by the Federal Reserve or the Securities and Exchange Commission (SEC), may also favor more comprehensive reporting.
3. Healthcare: The healthcare industry, governed by stringent data protection laws like the Health Insurance Portability and Accountability Act (HIPAA), may require a more detailed evaluation of all controls, including outsourced functions that handle sensitive patient information. The Inclusive method can provide the depth of assurance needed to meet these strict requirements and safeguard against data breaches.
4. Retail and E-Commerce: In industries like retail and e-commerce, where customer data security is critical but operations may be spread across numerous third-party providers (e.g., payment gateways, cloud providers), a mix of Carve-Out and Inclusive methods might be used. Organizations may choose the Carve-Out method for less critical third-party providers while opting for the Inclusive method when key services, such as payment processing or customer data management, are outsourced.

The decision to use the Carve-Out or Inclusive method is shaped by a combination of control over outsourced services, client needs, regulatory requirements, and industry norms. Service organizations must carefully evaluate these factors to ensure that their SOC reporting provides the appropriate level of assurance and transparency for their clients and stakeholders.

Example Scenarios

Example 1: Carve-Out Method for a Payroll Processing Company

Scenario: A payroll processing company provides outsourced payroll services to small businesses. The company uses a third-party cloud provider to host its payroll software and manage its IT infrastructure, but it does not have direct control over the cloud provider’s internal operations. The cloud provider issues its own SOC report covering security, availability, and data integrity controls.

Preferred Method: Carve-Out Method

Rationale: In this scenario, the payroll processing company has limited control over the third-party cloud provider’s operations and relies on the cloud provider’s own SOC report to evaluate its controls. Since the cloud provider already issues a SOC report, the payroll company can exclude the cloud provider’s controls from the scope of its own SOC report, opting for the Carve-Out method.

Outcome and Reporting Structure:

• Scope: The SOC report for the payroll processing company would focus on internal controls related to payroll processing, data accuracy, and compliance with tax reporting requirements. The third-party cloud provider’s controls would be explicitly carved out of the audit scope.
• Disclosure: The SOC report would include a clear disclosure noting that the cloud provider’s controls are excluded and that a separate SOC report is available from the cloud provider.
• Key Differences: The report would provide assurance over the payroll company’s controls but would leave the evaluation of the cloud provider’s controls to the user organization or the cloud provider’s SOC report. This results in a more focused and limited scope, reducing the burden on the payroll processing company but potentially requiring clients to seek additional assurance from the cloud provider.

Example 2: Inclusive Method for a Healthcare Data Management Provider

Scenario: A healthcare data management company stores and processes sensitive patient information for hospitals and clinics. The company outsources its data storage to a third-party data center, but the data management provider maintains strict oversight and conducts regular reviews of the data center’s security and privacy controls. Both the healthcare provider and the data center play critical roles in ensuring compliance with the Health Insurance Portability and Accountability Act (HIPAA).

Preferred Method: Inclusive Method

Rationale: Given the critical nature of the outsourced data storage and the healthcare provider’s close oversight of the data center’s operations, the Inclusive method is more appropriate. The healthcare provider wants to offer clients a comprehensive SOC report that includes both its internal controls and the data center’s controls, providing full assurance over the entire data management process.

Outcome and Reporting Structure:

• Scope: The SOC report would cover both the healthcare provider’s internal controls over patient data management and the third-party data center’s controls over data security, availability, and privacy.
• Evaluation of Third-Party Controls: The auditor would assess the effectiveness of the data center’s controls as part of the overall audit. This would involve obtaining documentation and testing evidence directly from the data center.
• Key Differences: The Inclusive method provides a broader, more comprehensive SOC report that includes assurance over both internal and outsourced controls. This approach gives clients a complete view of the control environment, reducing the need to obtain additional SOC reports. However, the complexity and cost of the audit increase due to the inclusion of third-party controls.

Example 3: Carve-Out Method for a Retail E-Commerce Platform

Scenario: A retail e-commerce platform uses a third-party payment gateway to process customer transactions and a separate vendor for logistics and shipping services. The platform has minimal oversight over the payment gateway’s internal controls, but the gateway provider issues a SOC report covering payment security and fraud prevention. The logistics provider does not issue a SOC report, but its operations are not considered material to the e-commerce platform’s financial reporting.

Preferred Method: Carve-Out Method

Rationale: In this case, the e-commerce platform has little control over the third-party payment gateway and relies on its SOC report to evaluate payment-related controls. The logistics provider’s controls are not critical enough to warrant inclusion in the SOC report. Therefore, the Carve-Out method is the better choice, excluding both the payment gateway and logistics provider from the SOC audit while referencing the payment gateway’s SOC report for assurance.

Outcome and Reporting Structure:

• Scope: The SOC report would cover the e-commerce platform’s internal controls over website security, inventory management, and customer service. The payment gateway and logistics provider’s controls would be excluded from the scope.
• Disclosure: The SOC report would disclose that the payment processing is managed by a third-party provider and that a separate SOC report for the payment gateway is available. The logistics provider’s exclusion would also be noted, but without reference to an additional SOC report.
• Key Differences: The Carve-Out method results in a focused SOC report that addresses the e-commerce platform’s internal controls while directing clients to seek assurance over payment security from the third-party provider’s SOC report. This approach simplifies the audit process and keeps the focus on the e-commerce platform’s key internal controls, though it requires clients to obtain additional reports if they need assurance over payment processing.

Example 4: Inclusive Method for a Financial Services Firm

Scenario: A financial services firm provides asset management services and relies on a third-party IT provider to manage its client data and maintain its trading platform. The IT provider plays an integral role in ensuring the security, availability, and integrity of the trading platform, and the financial services firm has extensive oversight of the IT provider’s controls. The firm’s clients expect comprehensive assurance over both the firm’s internal controls and the IT provider’s operations.

Preferred Method: Inclusive Method

Rationale: Given the high level of dependence on the IT provider’s operations and the firm’s oversight of its controls, the Inclusive method is the best fit. The financial services firm can offer a SOC report that includes the IT provider’s controls, providing clients with full assurance over the security and performance of the trading platform.

Outcome and Reporting Structure:

• Scope: The SOC report would cover both the financial services firm’s internal controls over asset management and the IT provider’s controls over the trading platform’s security and integrity.
• Evaluation of Third-Party Controls: The auditor would evaluate the IT provider’s controls as part of the overall SOC audit, conducting tests to ensure that the third-party’s controls meet the required standards.
• Key Differences: The Inclusive method allows the financial services firm to provide a single, comprehensive SOC report that includes assurance over both internal and outsourced controls. This is particularly important for financial services clients, who demand high levels of assurance over the security and reliability of trading platforms. However, this method increases audit complexity and requires the financial services firm to coordinate closely with its IT provider to ensure a smooth audit process.

These scenarios illustrate how the choice between the Carve-Out and Inclusive methods can vary depending on the nature of the outsourced services, the level of oversight, and the needs of clients and stakeholders. Each method offers distinct advantages and challenges, and organizations must carefully consider which approach best meets their reporting and assurance requirements.

Best Practices for Reporting on CSOCs

Guidance for Practitioners on How to Document and Communicate the Choice of Reporting Method

When reporting on Control System Outsourcing Components (CSOCs) in SOC engagements, it is critical for practitioners to clearly document and communicate their choice of either the Carve-Out or Inclusive method. This ensures that stakeholders understand the scope of the SOC report and the extent of the auditor’s evaluation. Key steps include:

1. Clearly Define the Scope of Outsourced Controls: Practitioners should begin by identifying which components are outsourced to third-party providers and the extent to which these components impact the service organization’s control environment. This will guide the decision between the Carve-Out and Inclusive methods.
2. Explicitly State the Reporting Method: Whether the Carve-Out or Inclusive method is chosen, the SOC report must include a clear statement outlining the chosen method and its implications. For the Carve-Out method, practitioners should disclose that certain controls are excluded and direct users to any third-party SOC reports for further assurance. For the Inclusive method, the report should explicitly state that outsourced controls are integrated into the audit’s scope.
3. Provide a Detailed Description of Outsourced Components: The SOC report should include a description of the outsourced services and how they relate to the service organization’s overall system of controls. This description should clarify the role of third-party providers and whether their controls were assessed as part of the SOC engagement.
4. Reference Third-Party SOC Reports (If Applicable): When using the Carve-Out method, it is important to reference the existence of any separate SOC reports issued by the third-party provider. This ensures that users of the SOC report understand where to find additional information on the outsourced controls.

Common Challenges and How to Overcome Them

Reporting on CSOCs can present several challenges for practitioners, but these can be effectively managed with the right strategies:

1. Challenge: Lack of Access to Third-Party Controls
   • Solution: One of the most common challenges in SOC engagements involving outsourced components is limited access to the third-party provider’s controls and documentation. This can make it difficult to perform a thorough evaluation, particularly when using the Inclusive method. To overcome this, practitioners should work closely with the third-party provider early in the engagement to ensure cooperation and access to necessary control documentation and evidence. Establishing clear communication channels and setting expectations upfront can help mitigate access issues.
2. Challenge: Determining the Appropriate Method
   • Solution: Deciding between the Carve-Out and Inclusive methods can be complex, especially when outsourced components are critical to the service organization’s operations. To make an informed decision, practitioners should assess factors such as the level of oversight over third-party controls, the availability of third-party SOC reports, and client expectations. Engaging with stakeholders early in the process can also help clarify preferences and ensure that the chosen method meets their needs.
3. Challenge: Managing Increased Audit Complexity with the Inclusive Method
   • Solution: The Inclusive method often results in a more complex audit, as it requires the auditor to assess both internal and outsourced controls. To manage this complexity, practitioners should develop a detailed audit plan that includes timelines and responsibilities for both the service organization and third-party providers. Coordinating efforts across all parties involved in the audit is key to ensuring a smooth process.

Tips for Maintaining Transparency and Completeness in SOC Reports Involving CSOCs

Transparency is essential when reporting on CSOCs, especially given the reliance on third-party providers. Practitioners should aim to provide stakeholders with a clear and complete picture of the control environment. Below are some tips to help maintain transparency and completeness in SOC reports:

1. Ensure Full Disclosure of Outsourced Components: Regardless of whether the Carve-Out or Inclusive method is used, it is essential to fully disclose all relevant outsourced components. Practitioners should provide detailed descriptions of what is outsourced, the scope of third-party controls, and how these outsourced services impact the overall control environment.
2. Use Clear and Concise Language: The SOC report should be written in a way that is easy to understand, especially when communicating complex topics such as the scope of third-party controls. Avoid overly technical language and instead focus on providing clear explanations of how outsourced components are handled in the audit.
3. Incorporate Visual Aids Where Appropriate: Visual aids, such as flowcharts or tables, can help clarify the role of outsourced components in the control environment and illustrate the scope of the audit. These can be particularly useful in demonstrating how different methods impact the assessment of third-party controls.
4. Reference Supporting Documentation: If using the Carve-Out method, reference any available SOC reports from third-party providers to ensure that users of the SOC report know where to find additional information. Similarly, for the Inclusive method, ensure that any assessments of third-party controls are well-documented and included in the SOC report.
5. Regularly Communicate with Stakeholders: Maintaining open communication with both the service organization and its clients is crucial for ensuring transparency. Regular updates on the audit’s progress, particularly when assessing third-party controls, can help address any concerns and ensure that the final report meets all parties’ expectations.

By following these best practices, practitioners can ensure that SOC reports involving CSOCs are clear, complete, and transparent, providing stakeholders with the information they need to assess the effectiveness of both internal and outsourced controls.

Conclusion

Recap of the Key Points Regarding the Carve-Out and Inclusive Methods

In SOC engagements, service organizations must choose between the Carve-Out and Inclusive methods for reporting on Control System Outsourcing Components (CSOCs). The Carve-Out method excludes outsourced controls from the SOC report, requiring user organizations to seek assurance from third-party SOC reports. This method reduces the audit scope and complexity but may necessitate additional effort from clients to obtain full assurance. In contrast, the Inclusive method integrates outsourced components into the SOC report, providing a more comprehensive view of the entire control environment, but at the cost of increased audit complexity and responsibility for both the service organization and the auditor.

Importance of Understanding Both Methods for Proper SOC Reporting

Understanding the nuances between the Carve-Out and Inclusive methods is crucial for proper SOC reporting. Service organizations, auditors, and stakeholders need to be aware of the benefits and limitations of each method to ensure that SOC reports accurately reflect the control environment and provide the appropriate level of assurance. Choosing the right method can have significant implications for audit scope, client trust, and compliance with industry regulations. By carefully evaluating outsourced components and client needs, organizations can make informed decisions that balance audit efficiency with the need for transparency.

Final Thoughts on Making Informed Decisions When Reporting on CSOCs in a SOC Engagement

Reporting on CSOCs in a SOC engagement requires careful planning and consideration of both the service organization’s operations and the expectations of stakeholders. The decision between the Carve-Out and Inclusive methods should be based on factors such as the level of control over third-party providers, the criticality of outsourced services, the availability of third-party SOC reports, and client assurance needs. By making informed decisions and clearly communicating the chosen reporting method, organizations can provide stakeholders with a SOC report that is both comprehensive and transparent, ensuring confidence in the control environment and the effectiveness of the services provided.