ISC CPA Exam: Understanding the Considerations for Deciding Between and Use of, the Inclusive and Carve-Out Method for Subservice Organizations and CSOCs

Introduction

The Importance of Subservice Organizations in the Context of SOC (System and Organization Controls) Reports

In this article, we’ll cover understanding the considerations for deciding between and use of, the inclusive and carve-out method for subservice organizations and CSOCs. Subservice organizations play a critical role in the operational landscape of many businesses, especially those that rely on third-party services to handle significant aspects of their operations, such as IT infrastructure, cloud services, or payroll management. In SOC (System and Organization Controls) reporting, understanding the involvement of subservice organizations is essential because these organizations often manage key controls that impact financial reporting or other operational controls relevant to the user entity.

For auditors, subservice organizations can introduce complexity into the audit process. This is because the controls at the primary service organization may depend on the controls in place at a subservice organization. Auditors and users of SOC reports must consider how well the primary organization oversees these third-party controls, which directly impacts the reliability of the overall control environment. Therefore, evaluating how subservice organizations are included or excluded in SOC reports is crucial for ensuring that all risks and controls are adequately addressed.

Defining the Inclusive and Carve-Out Methods in SOC Reporting

When preparing a SOC report, service organizations must decide whether to include the subservice organization’s controls within their scope. This decision is managed using one of two approaches: the inclusive method or the carve-out method.

• Inclusive Method: Under the inclusive method, the controls of the subservice organization are integrated into the primary service organization’s SOC report. This means the report will cover both the service organization’s controls and the subservice organization’s controls as though they are part of one seamless operation. This method provides a full picture of the control environment, which can give auditors and report users greater transparency about the entire system of controls.
• Carve-Out Method: In contrast, the carve-out method excludes the subservice organization’s controls from the primary service organization’s SOC report. Instead of including these controls, the SOC report will rely on the subservice organization’s own SOC report, if available, or on assurances from the subservice organization. This approach allows the primary service organization to limit the scope of its report to only its direct controls, which may be necessary when there is limited oversight of the subservice organization.

Importance of Understanding Complementary Subservice Organization Controls (CSOCs)

Complementary Subservice Organization Controls (CSOCs) refer to controls at the subservice organization that are necessary for the primary service organization’s controls to operate effectively. Understanding CSOCs is crucial for both the service organization and the auditor, as these controls may influence risk assessments and overall control evaluations.

In practice, CSOCs are particularly relevant under the carve-out method, where subservice organization controls are excluded from the SOC report. Auditors must assess whether the service organization has properly considered these complementary controls and whether users of the SOC report can rely on them for completeness. Without adequately accounting for CSOCs, there is a risk of incomplete control evaluations, which can lead to significant gaps in the audit’s scope and increase the likelihood of material misstatements or control failures.

Subservice organizations and their related controls—whether included directly through the inclusive method or managed separately via the carve-out method—are fundamental components of SOC reporting. For auditors and report users, a deep understanding of how these controls function and interact with the service organization’s controls is essential for managing risk and ensuring the completeness of the audit process.

Defining Subservice Organizations and Their Role

Subservice Organization: What It Is and Its Significance in the Service Provider Ecosystem

A subservice organization is a third-party entity that performs services for a primary service organization, which, in turn, provides services to user entities. These subservice organizations play an integral role in the operational and financial processes of many businesses, especially those that outsource specialized tasks or functions such as data processing, payroll, or IT management. The significance of subservice organizations lies in their contribution to the overall functionality and control environment of the primary service organization.

For instance, if a primary service organization uses a cloud provider to host its data or an external company for processing payroll, those third parties are considered subservice organizations. The effectiveness and reliability of the subservice organization directly influence the ability of the primary organization to provide its own services efficiently and securely. As such, the performance of these subservice organizations becomes critical not only to operational success but also to the completeness and accuracy of financial reporting.

Interaction Between Subservice and Primary Service Organizations

Subservice organizations and primary service organizations are often interdependent, with subservice organizations providing essential infrastructure, technology, or processes that enable the primary organization to meet its service obligations. This interconnection means that the controls implemented by subservice organizations can have a direct effect on the overall control environment of the primary service organization.

In the context of SOC reporting, the relationship between a primary service organization and its subservice organization must be clearly defined and assessed. The primary service organization may either incorporate the controls of the subservice organization into its own control framework (the inclusive method) or rely on the subservice organization to manage its own controls independently (the carve-out method). Regardless of the method chosen, the interaction between these organizations affects the transparency and reliability of the control structures in place, which is crucial for auditors and users of SOC reports.

For example, in a situation where a primary organization uses an external IT provider (a subservice organization) for data storage, the security controls and data integrity protocols implemented by the IT provider are essential to the primary organization’s operations. If those controls are ineffective or compromised, the primary organization’s ability to maintain the integrity of its own services could be jeopardized. Therefore, understanding this interaction and ensuring adequate oversight is crucial for risk management.

Impact of Subservice Organizations on Internal Controls

The presence of subservice organizations can significantly influence the system of internal controls within the primary service organization. Internal controls are designed to safeguard assets, ensure the accuracy of financial reporting, and promote operational efficiency. However, when a primary service organization relies on a subservice organization, the effectiveness of those internal controls may partially depend on the subservice organization’s controls.

For auditors, this presents a challenge: they must determine whether the subservice organization’s controls are operating effectively and whether the primary service organization has implemented appropriate oversight mechanisms. The role of the subservice organization in the overall control environment can either strengthen or weaken the control framework, depending on how well both entities collaborate and manage their shared risks.

The impact of subservice organizations on internal controls is most evident when evaluating areas such as IT security, data management, and financial transaction processing. If the subservice organization does not maintain adequate controls in these areas, the primary service organization may be exposed to heightened risks, including data breaches, financial inaccuracies, and non-compliance with regulations.

Subservice organizations play a pivotal role in shaping the control structures of primary service organizations. The interaction between these entities and the subservice organization’s influence on internal controls must be carefully evaluated by auditors and other stakeholders to ensure that risks are mitigated, and operational effectiveness is maintained.

Overview of SOC Reporting Types

SOC 1, SOC 2, and SOC 3: Brief Explanation of These Reports and When They Apply

System and Organization Controls (SOC) reports are designed to provide assurance regarding the controls in place at service organizations that could affect user entities’ operations, financial reporting, or data security. The three main types of SOC reports — SOC 1, SOC 2, and SOC 3 — are used for different purposes, depending on the nature of the service provided and the audience needing assurance.

• SOC 1: This report focuses on controls relevant to financial reporting. It is primarily used by auditors and regulatory bodies to assess how a service organization’s controls impact a user entity’s financial statements. SOC 1 reports are typically requested by organizations that outsource functions critical to financial reporting, such as payroll, transaction processing, or financial data hosting.
• SOC 2: SOC 2 reports focus on controls related to data security, availability, processing integrity, confidentiality, and privacy. These reports are often sought by entities concerned with the security and operational reliability of their service providers. SOC 2 is relevant for organizations providing cloud computing services, IT services, and other technology-driven solutions.
• SOC 3: This report is a simplified version of SOC 2, designed for a general audience. It includes the same information about controls related to security and availability but omits detailed descriptions of the testing performed. SOC 3 is intended for public distribution, offering assurance to stakeholders without divulging sensitive information.

How Subservice Organizations Impact SOC Reporting

Subservice organizations play an integral role in SOC reporting because their operations can significantly influence the effectiveness of a service organization’s internal controls. Whether the service organization outsources critical functions like IT management or data processing, the controls at the subservice organization directly impact the accuracy, security, and reliability of the service organization’s processes.

For example, in a SOC 1 report, if a subservice organization is responsible for handling financial data processing, the effectiveness of that entity’s controls will affect the service organization’s ability to ensure accurate financial reporting for its user entities. Similarly, in a SOC 2 report, a subservice organization providing cloud hosting services must maintain strong data security protocols to ensure the service organization meets its commitments to protect user data.

In SOC reporting, the degree of oversight the primary service organization exercises over the subservice organization is critical. Auditors must evaluate whether controls are properly coordinated between the two entities and whether potential risks arising from subservice organization activities have been addressed.

Relevance of Inclusive and Carve-Out Methods to SOC Engagements

The inclusive method and carve-out method are two approaches used to determine whether subservice organization controls are included in the scope of a service organization’s SOC report. Their relevance depends on the type of SOC report and the specific nature of the service provided.

• Inclusive Method: In a SOC engagement using the inclusive method, the controls of the subservice organization are included in the service organization’s SOC report. This method is often used when the service organization has significant oversight over the subservice organization or when the subservice organization’s controls are critical to the overall control environment. For instance, in a SOC 1 report, a payroll service provider might include its data processing vendor’s controls if they are integral to accurate financial reporting.
• Carve-Out Method: In contrast, the carve-out method excludes the subservice organization’s controls from the service organization’s SOC report. Instead, the service organization may reference a separate SOC report issued by the subservice organization or acknowledge the existence of complementary controls (CSOCs). The carve-out method is often used when the service organization has less direct control over the subservice organization or when obtaining detailed information from the subservice organization is impractical. In a SOC 2 engagement, a cloud service provider may rely on its subservice organization’s separate SOC 2 report for data hosting rather than including those controls in its own report.

Understanding when to use the inclusive or carve-out method is essential for ensuring that SOC reports accurately reflect the scope of controls and associated risks. The decision between these methods impacts the comprehensiveness of the SOC report and influences how user entities assess the reliability of the service and subservice organizations involved in providing critical services.

Inclusive vs. Carve-Out Method

Inclusive Method: Definition and Key Characteristics

The inclusive method refers to a reporting approach in which the controls of a subservice organization are integrated into the scope of the primary service organization’s SOC report. This means that the subservice organization’s operations, internal controls, and performance are examined alongside those of the primary service organization, providing a unified and comprehensive report. The inclusive method is particularly useful when the subservice organization’s controls are critical to the overall control environment and the primary service organization has sufficient oversight over these controls.

When Subservice Organizations Are Included in the Scope of the Primary Organization’s SOC Report

Subservice organizations are typically included in the scope of a SOC report under the inclusive method when:

• The primary service organization has direct oversight and control over the subservice organization’s processes.
• The subservice organization’s controls are integral to achieving the objectives of the primary service organization’s services.
• There is a high degree of operational interdependence between the service organization and the subservice organization.

For example, a financial services company that outsources its data processing to a third party might choose the inclusive method if the data processing vendor’s operations are crucial to maintaining accurate and compliant financial reporting. Including the subservice organization’s controls in the SOC report provides a more complete assessment of the control environment.

How Inclusive Method Facilitates a Full, End-to-End Picture of Controls

The key advantage of the inclusive method is that it offers a full, end-to-end picture of the control environment. By integrating the subservice organization’s controls into the report, stakeholders, auditors, and users of the SOC report can gain a comprehensive view of all controls that influence the service organization’s operations. This transparency allows:

• A complete evaluation of risks, reducing the potential for gaps in control assessment.
• Simplified reporting, as users do not need to obtain separate SOC reports from subservice organizations.
• Assurance that all critical components of the service are effectively monitored and controlled.

Ultimately, the inclusive method provides greater visibility into the entire system of controls, which can enhance trust in the primary service organization’s operations and reduce the burden on auditors to assess separate reports.

Carve-Out Method: Definition and Key Characteristics

The carve-out method, on the other hand, excludes the controls of the subservice organization from the scope of the primary service organization’s SOC report. Instead, the subservice organization’s controls are typically addressed separately, either by referencing the subservice organization’s own SOC report or by noting the existence of complementary controls. This method is commonly used when the primary service organization does not have direct control or significant oversight over the subservice organization’s operations.

When Subservice Organizations Are Not Included in the Scope, With Emphasis on User Entity Controls or CSOCs

Subservice organizations are not included in the scope of a SOC report under the carve-out method when:

• The primary service organization lacks the necessary visibility or control over the subservice organization’s internal processes.
• The subservice organization operates independently, with its own internal control system that is evaluated separately.
• User entity controls or Complementary Subservice Organization Controls (CSOCs) are deemed sufficient to ensure that the service organization’s overall objectives are met.

In such cases, the carve-out method allows the primary service organization to limit its SOC report to its own operations and controls, while acknowledging the subservice organization’s role through references or complementary control arrangements. This approach is often chosen when it is impractical or unnecessary to include the subservice organization’s controls in the same report.

The Reliance on Separate SOC Reports Issued by the Subservice Organization

When using the carve-out method, the primary service organization typically relies on the subservice organization’s separate SOC report to provide assurance about its controls. This reliance on a separate report:

• Allows the subservice organization to maintain control over its own SOC examination, independent of the primary service organization.
• Simplifies the scope of the primary service organization’s SOC report, focusing solely on its direct controls.
• Places responsibility on the users of the report to obtain and review the subservice organization’s SOC report, if necessary, for a complete understanding of the control environment.

While the carve-out method may reduce the reporting burden for the primary service organization, it also increases the need for users to ensure that all relevant SOC reports are obtained and reviewed. The method places emphasis on the existence and evaluation of Complementary Subservice Organization Controls (CSOCs) to bridge any potential gaps in the control environment.

Both the inclusive and carve-out methods provide distinct approaches to addressing subservice organization controls in SOC reports. The choice between these methods depends on the level of oversight, the operational relationship between the entities, and the practicalities of obtaining comprehensive control assessments.

When to Use the Inclusive Method

Factors That Support the Decision to Use the Inclusive Method

The decision to use the inclusive method in SOC reporting is influenced by several key factors that revolve around the level of collaboration between the primary service organization and the subservice organization. Opting for the inclusive method is often advantageous when certain conditions are met, ensuring that the controls of both entities can be thoroughly evaluated in a unified report. Below are the main factors that support the use of the inclusive method:

Availability of Sufficient Information and Cooperation from the Subservice Organization

One of the primary considerations for using the inclusive method is whether the subservice organization is willing and able to provide sufficient information about its internal controls. The success of the inclusive method depends heavily on transparency and cooperation between the service organization and the subservice organization.

The subservice organization must:

• Share detailed information about its control environment.
• Provide access to documentation, records, and audit trails.
• Facilitate the examination of its controls as part of the SOC report preparation process.

When this level of cooperation is available, the inclusive method allows the auditor to include the subservice organization’s controls directly in the report, ensuring that all relevant systems and processes are covered comprehensively.

Benefits of Including Subservice Organizations to Provide Transparency to Users and Reduce the Need for Separate Reports

Using the inclusive method brings significant benefits, particularly in terms of transparency. Including the subservice organization’s controls in the SOC report provides a full picture of the control environment, which is valuable to users of the report. This approach reduces complexity by:

• Allowing stakeholders to assess both the primary and subservice organizations’ controls in one report.
• Eliminating the need for separate SOC reports from the subservice organization, which can save time and reduce the burden on users who would otherwise need to obtain and review multiple reports.
• Enhancing the clarity of the control environment by providing a single source of information regarding all relevant processes and controls.

By offering a consolidated view of the control landscape, the inclusive method improves user confidence in the overall system, as they can more easily understand how both organizations interact and manage risk.

Increased Control and Oversight by the Primary Service Organization

Another important factor supporting the use of the inclusive method is the level of control and oversight that the primary service organization has over the subservice organization. The inclusive method is particularly appropriate when the primary organization exercises significant influence over the subservice organization’s operations, such as:

• Having a direct role in managing or supervising key processes carried out by the subservice organization.
• Sharing infrastructure, systems, or platforms that make the subservice organization’s controls integral to the primary organization’s own controls.
• Establishing governance structures or monitoring activities that ensure the subservice organization’s adherence to the primary organization’s control objectives.

In these scenarios, the inclusive method allows the primary organization to demonstrate its responsibility for the overall control environment, as it can show how it actively monitors and influences the subservice organization’s performance. This increased oversight strengthens the case for including the subservice organization’s controls in the SOC report, as it provides a clearer, more accountable representation of how risks are managed across both entities.

The inclusive method is most effective when there is a high level of cooperation, transparency, and oversight between the primary service organization and the subservice organization. By including the subservice organization’s controls in the SOC report, the primary organization can provide a more transparent, streamlined, and accountable view of its control environment, which benefits both auditors and report users.

When to Use the Carve-Out Method

Factors Supporting the Use of the Carve-Out Method

The carve-out method is often the preferred choice in SOC reporting when certain conditions make it impractical or unnecessary to include the subservice organization’s controls in the primary service organization’s SOC report. This method is particularly useful when there is limited control, access, or oversight between the primary service organization and the subservice organization. The following factors support the decision to use the carve-out method:

Instances Where the Subservice Organization Is Unwilling to Participate in the Primary Organization’s SOC Examination

A primary reason for choosing the carve-out method is when the subservice organization is either unwilling or unable to participate in the primary service organization’s SOC examination. This lack of participation may arise due to:

• Confidentiality concerns or legal restrictions that prevent the subservice organization from sharing sensitive control-related information with the primary service organization.
• The subservice organization opting to conduct its own separate SOC report instead of being included in the scope of the primary service organization’s report.

In these instances, the carve-out method allows the primary service organization to proceed with its SOC examination while acknowledging the subservice organization’s controls through reliance on a separate SOC report or by referencing complementary controls. This approach helps maintain the integrity of the primary organization’s SOC report without requiring cooperation from the subservice organization.

The Need for Operational Efficiency by Relying on the Subservice Organization’s Own SOC Report

Another factor supporting the use of the carve-out method is the desire for operational efficiency. When a subservice organization already produces its own SOC report, it can be more efficient for the primary service organization to rely on that report rather than include the subservice organization’s controls within its own SOC scope. This approach simplifies the reporting process by:

• Reducing the complexity of the primary service organization’s SOC report, as it focuses only on its own internal controls.
• Avoiding duplication of audit efforts, as the subservice organization’s SOC report already provides assurance regarding its controls.
• Allowing report users to obtain both the primary service organization’s SOC report and the subservice organization’s SOC report, providing a comprehensive picture of the overall control environment without the need for the primary organization to audit or disclose the subservice organization’s controls.

Relying on the subservice organization’s SOC report in this manner streamlines the audit process, enabling both organizations to maintain operational independence while still providing users with the necessary assurance over the entire system.

Challenges in Including a Subservice Organization Due to Lack of Direct Control or Visibility Over Its Operations

The carve-out method is particularly useful when the primary service organization has limited direct control or visibility over the subservice organization’s operations. In many cases, the subservice organization operates independently, managing its own internal controls and governance structures. This lack of oversight makes it difficult for the primary service organization to fully assess or include the subservice organization’s controls in its own SOC report. The following challenges often arise in these situations:

• Limited access: The primary service organization may not have the authority or capability to review the subservice organization’s control documentation, audit results, or operational processes.
• Operational independence: The subservice organization may operate under different management, systems, or policies that do not align with the primary service organization’s control environment.
• Risk management: The primary service organization may rely on complementary controls (CSOCs) to mitigate risks related to the subservice organization, but it does not have direct involvement in the execution of those controls.

In such scenarios, the carve-out method is an effective solution because it allows the primary service organization to focus on its own controls while referencing the subservice organization’s SOC report or complementary controls. This approach reduces the burden on the primary organization and ensures that its SOC report remains accurate without overextending its scope to include controls that it cannot directly manage or verify.

The carve-out method is a practical choice when the primary service organization lacks control, access, or cooperation from the subservice organization. By relying on the subservice organization’s SOC report or referencing complementary controls, the carve-out method allows the primary service organization to maintain operational efficiency while still providing a clear and accurate SOC report. This approach is particularly useful when dealing with independent subservice organizations that operate outside the direct oversight of the primary organization.

Impact on Audit Risk and Control Assessments

Audit Risk Considerations

The choice between the inclusive and carve-out methods has significant implications for the auditor’s risk assessment. Since subservice organizations often handle critical operations that affect financial reporting and internal controls, the approach taken to address their controls will influence how an auditor evaluates audit risk.

Implications of Choosing the Inclusive vs. Carve-Out Method on the Auditor’s Risk Assessment

When using the inclusive method, the subservice organization’s controls are part of the primary service organization’s SOC report, which means that the auditor has direct insight into the entire control environment. This approach generally reduces audit risk because:

• The auditor has a full understanding of the control environment, including both the primary and subservice organizations.
• The auditor can directly assess the effectiveness of the subservice organization’s controls, ensuring that they align with the primary organization’s objectives.

On the other hand, the carve-out method introduces additional audit risks. Since the subservice organization’s controls are excluded from the primary organization’s SOC report, the auditor must:

• Rely on a separate SOC report issued by the subservice organization, which may not provide as detailed or specific assurance as a fully integrated report.
• Consider the possibility that the subservice organization’s controls are not as robust or effective as the primary organization’s controls, which could lead to gaps in risk management.
• Be vigilant about potential risks that may not be fully addressed if there is limited visibility into the subservice organization’s operations.

The Need for Additional Assurance or Testing When Subservice Organizations Are Carved Out

When the carve-out method is used, auditors may need to perform additional testing or seek further assurance to compensate for the exclusion of the subservice organization’s controls. This often involves:

• Reviewing the subservice organization’s separate SOC report to ensure that its controls are designed and operating effectively.
• Evaluating whether the Complementary Subservice Organization Controls (CSOCs) adequately mitigate the risks associated with carving out the subservice organization’s controls.
• Conducting additional inquiries, testing, or walkthroughs to confirm that the primary service organization has appropriate measures in place to manage risks related to the subservice organization.

The carve-out method generally requires auditors to exercise a higher degree of professional skepticism, as they must rely on indirect evidence and complementary controls to assess the completeness of the control environment.

Control Assessments

The presence of subservice organizations complicates control assessments, especially when complementary controls (CSOCs) are involved. Auditors must carefully evaluate how these controls interact with the primary service organization’s controls to ensure that risks are adequately managed.

Impact of Complementary Subservice Organization Controls (CSOCs) on Risk Management

Complementary Subservice Organization Controls (CSOCs) play a critical role in risk management, particularly when the carve-out method is used. These are controls implemented by the subservice organization that complement or support the effectiveness of the primary service organization’s controls. CSOCs can mitigate risks, but they require careful evaluation by the auditor to ensure they are functioning properly.

For example, a subservice organization providing data hosting services may implement security controls such as encryption, while the primary service organization manages user access. In such cases, the success of the overall control environment depends on both organizations fulfilling their respective roles. The auditor must assess:

• Whether the CSOCs are appropriately designed to address specific risks.
• How well the primary service organization monitors and relies on the subservice organization’s controls.
• Whether the service organization’s internal controls are aligned with the subservice organization’s controls to create a cohesive risk management framework.

How an Auditor Ensures Completeness of the Control Environment When CSOCs Are Present, Especially Under the Carve-Out Method

Ensuring the completeness of the control environment when CSOCs are present requires auditors to take a holistic approach to control assessments. This is especially important under the carve-out method, where the subservice organization’s controls are not directly included in the SOC report. Auditors ensure completeness by:

• Evaluating the adequacy of user entity controls: Since the carve-out method often places responsibility on user entities to manage certain risks, auditors must ensure that these controls are adequate and appropriately designed to fill any gaps left by the carved-out subservice organization.
• Reviewing the subservice organization’s SOC report: Auditors should examine the subservice organization’s SOC report to verify that the subservice organization’s controls are properly designed and tested. Any deficiencies or gaps noted in the subservice organization’s report should be considered when evaluating overall audit risk.
• Assessing the effectiveness of CSOCs: Auditors should conduct detailed assessments of the complementary controls to confirm that they are operating effectively and are sufficient to mitigate the risks posed by the exclusion of the subservice organization’s controls. This might involve reviewing policies, procedures, and testing performed by the subservice organization.

The carve-out method introduces additional complexities into the audit process, particularly regarding risk management and control assessments. Auditors must adopt a thorough approach to evaluating complementary controls and the sufficiency of external SOC reports to ensure that all relevant risks are accounted for and that the control environment remains robust and complete.

Complementary Subservice Organization Controls (CSOCs)

Definition of CSOCs and Their Importance in an Audit

Complementary Subservice Organization Controls (CSOCs) are controls established by a subservice organization that are essential for the effectiveness of the primary service organization’s controls. These controls often support or complement the primary service organization’s operations, helping to mitigate risks and ensure that overall system and operational objectives are met. CSOCs are particularly important in the context of SOC reporting because they provide assurance that both organizations are collectively managing risks related to financial reporting, data security, or operational integrity.

In an audit, CSOCs play a crucial role because they fill gaps that might otherwise exist if the subservice organization’s controls were not properly aligned with the primary organization’s. Their presence helps ensure that user entities relying on both organizations receive a seamless and comprehensive control environment. Without effective CSOCs, the risk of control deficiencies, operational inefficiencies, or financial misstatements could increase, making it vital for auditors to assess these controls thoroughly.

The Relationship Between User Entity Controls and CSOCs

User entities—companies that rely on the services of a primary service organization—also have responsibilities when it comes to ensuring the effectiveness of the overall control environment. This responsibility is shared with both the primary service organization and the subservice organization. In the context of CSOCs, the relationship between user entity controls and CSOCs is symbiotic, meaning that these controls often work together to manage risks effectively.

For example, a subservice organization may provide IT infrastructure and security, while the primary service organization handles data processing. The user entity might be responsible for ensuring that only authorized personnel access the system, thereby complementing the subservice organization’s access control measures. In such cases, the overall effectiveness of the control environment relies on all three parties fulfilling their respective roles:

• CSOCs ensure that the subservice organization’s controls support the primary service organization’s objectives.
• User entity controls are critical for ensuring that any gaps left by the subservice organization are adequately covered at the user level.

This interconnected control framework ensures that risks are managed across the entire service delivery chain.

How Auditors Need to Evaluate Both Primary and Subservice Organization Controls for SOC Compliance

For SOC compliance, auditors must evaluate the controls of both the primary service organization and the subservice organization, especially when CSOCs are in place. The auditor’s objective is to ensure that the combination of these controls provides sufficient risk mitigation and operational reliability. This evaluation requires auditors to:

• Identify and assess CSOCs: Auditors must understand the specific controls implemented by the subservice organization that are necessary for the primary service organization’s operations to function effectively. This involves reviewing documentation, policies, and testing procedures for the subservice organization’s controls.
• Evaluate the integration of controls: It is critical for auditors to assess how well the controls of the subservice organization and primary organization are integrated. This includes determining whether the primary organization has oversight mechanisms in place to monitor the performance of CSOCs.
• Examine user entity controls: When complementary controls are shared between the subservice organization and the user entity, auditors need to verify that user entity controls are adequate and functioning as intended. This may involve testing user entity controls to ensure they are capable of filling any gaps left by the subservice organization.

In cases where the carve-out method is used, auditors may also need to review the subservice organization’s SOC report separately to ensure that its controls are operating effectively. The auditor must consider any limitations in scope or exclusions related to CSOCs and determine whether those omissions pose additional risks to the overall control environment.

By thoroughly evaluating both the primary and subservice organization’s controls, auditors ensure that the SOC report provides a complete and accurate representation of the entire system of controls, ensuring compliance and managing audit risks effectively.

Common Pitfalls and Best Practices

Common Pitfalls

When managing subservice organizations and their controls in SOC reports, several common pitfalls can arise, particularly when communication or coordination is inadequate. These pitfalls can lead to incomplete or inaccurate SOC reports, which in turn affect audit outcomes and user confidence.

Miscommunication Between Service and Subservice Organizations Leading to Incomplete SOC Reports

One of the most common pitfalls is miscommunication between the service organization and the subservice organization. If the two entities do not maintain clear, ongoing communication about their respective control responsibilities, gaps can emerge. Miscommunication may result in:

• Controls being overlooked or improperly documented in the SOC report.
• An incomplete assessment of the subservice organization’s control environment, leading to higher audit risks.
• Delayed or inaccurate SOC reports due to insufficient coordination between the organizations.

This lack of clarity can compromise the integrity of the SOC report, leaving auditors and report users without a full understanding of the control environment.

Over-Reliance on the Subservice Organization’s SOC Report Without Appropriate Complementary Controls at the User Level

Another significant pitfall is over-reliance on the subservice organization’s SOC report without ensuring that appropriate complementary controls are in place at the user level. When the carve-out method is used, the primary service organization may depend too heavily on the subservice organization’s SOC report without taking steps to assess whether its own controls or the user entity’s controls are sufficient to mitigate risks. This can lead to:

• Gaps in the control environment if the subservice organization’s SOC report does not adequately cover all risk areas.
• A false sense of security about the robustness of the controls if complementary controls are not well understood or effectively implemented.
• Increased exposure to risks related to security, financial reporting, or operational reliability.

Auditors and users must ensure that all controls, including those at the user entity level, are working together to create a comprehensive risk management framework.

Best Practices

To avoid these common pitfalls, service organizations, subservice organizations, and auditors should follow best practices that promote transparency, collaboration, and proper documentation of controls. These practices help ensure that SOC reports are accurate, comprehensive, and effective in managing risks.

Establish Clear Lines of Communication Between Service Organizations, Subservice Organizations, and Auditors

Clear and consistent communication between the service organization, subservice organization, and auditors is critical to producing a reliable SOC report. Best practices for maintaining strong communication include:

• Regular meetings between the service and subservice organizations to review control responsibilities and performance.
• Clear documentation of control ownership, ensuring that all parties understand which controls are the responsibility of the service organization, the subservice organization, and the user entity.
• Ongoing collaboration with auditors to ensure that any changes in processes, systems, or risks are addressed and reflected in the SOC report.

This proactive approach to communication helps prevent misunderstandings and ensures that the final SOC report is comprehensive.

How to Document Reliance on CSOCs Effectively in the SOC Report

When using the carve-out method or when complementary subservice organization controls (CSOCs) are in place, it is essential to document reliance on these controls effectively in the SOC report. Best practices for documenting CSOCs include:

• Clearly identifying the specific controls at the subservice organization that complement the service organization’s controls.
• Detailing how CSOCs align with the service organization’s control objectives and how they mitigate specific risks.
• Providing transparency regarding testing or monitoring activities that assess the effectiveness of CSOCs, including any reliance on the subservice organization’s own SOC report.

Proper documentation of CSOCs ensures that users of the SOC report understand the role and significance of the subservice organization’s controls in the broader control environment.

Guidelines for Deciding Which Method to Apply Based on Scope, Risk, and Control Needs

Choosing between the inclusive method and the carve-out method requires careful consideration of scope, risk, and control needs. Best practices for making this decision include:

• Assessing the level of oversight the primary service organization has over the subservice organization. The inclusive method is preferable when the primary organization has significant control or influence over the subservice organization’s processes.
• Evaluating the complexity of the service arrangement. If the subservice organization plays a critical role in the service delivery process, the inclusive method may provide better transparency. Conversely, if the subservice organization operates independently and has its own SOC report, the carve-out method may be more efficient.
• Considering the audit risk: The carve-out method may introduce additional risks if the subservice organization’s controls are not fully understood or tested. Therefore, higher-risk environments may benefit from the more comprehensive inclusive method.

These guidelines help organizations and auditors select the most appropriate method for their SOC reports, ensuring that all relevant controls are considered and documented appropriately.

By following best practices and avoiding common pitfalls, organizations can ensure that their SOC reports accurately reflect their control environments, provide the necessary assurances to users, and effectively manage audit risks.

Conclusion

Recap of Key Points on When and Why to Choose Either the Inclusive or Carve-Out Method

Choosing between the inclusive method and the carve-out method is a critical decision in SOC reporting that directly impacts audit outcomes and the completeness of control assessments. The inclusive method is ideal when the primary service organization has significant oversight and control over the subservice organization, and when full transparency of all controls is desired. It provides a comprehensive view of both organizations’ controls, making it easier for auditors and report users to assess the entire control environment without the need for multiple reports.

On the other hand, the carve-out method is more suitable when the subservice organization operates independently, or when the primary organization lacks direct access or control over the subservice organization’s operations. While this method streamlines the primary service organization’s report, it requires auditors and users to rely on the subservice organization’s own SOC report, potentially necessitating additional assessments of complementary controls.

Final Thoughts on the Importance of Understanding CSOCs in Relation to Subservice Organizations

Complementary Subservice Organization Controls (CSOCs) play a pivotal role in ensuring that the risks associated with subservice organizations are properly managed, particularly when the carve-out method is used. Understanding how these controls interact with both the service and subservice organizations’ control environments is essential for auditors to assess whether all relevant risks are mitigated. The effectiveness of CSOCs is crucial for ensuring that any gaps left by the exclusion of subservice organization controls are adequately filled, safeguarding the integrity of the overall control environment.

Encouragement for CPA Candidates to Grasp the Implications of These Decisions on Audit Outcomes and Financial Reporting

For CPA candidates preparing for exams or professional roles, a deep understanding of the inclusive and carve-out methods and their implications is essential. These decisions affect not only audit risk but also the transparency and reliability of financial reporting. By mastering the concepts of SOC reporting, subservice organization controls, and the role of CSOCs, candidates can ensure they are well-equipped to handle complex audit scenarios. The ability to assess and apply the appropriate method based on the organization’s structure and risk profile will be a valuable skill in delivering accurate and complete audit reports, ensuring regulatory compliance, and providing stakeholders with the assurance they need.

In the end, these decisions are not just technical; they have real-world implications for how audits are conducted, how risks are managed, and how financial information is reported and relied upon by investors, regulators, and other stakeholders. Understanding the nuances of SOC reporting and control assessment is a critical component of being an effective CPA.