What Is a SOC 1 Type 2 Audit Report?

System and Organization Controls (SOC) reports provide a structured way to evaluate the effectiveness of internal controls within service organizations. These reports are particularly relevant for businesses that outsource functions impacting their financial statements, such as payroll processing, data hosting, or cloud services. Understanding these reports is important for ensuring the accuracy and reliability of financial information. This article clarifies what a SOC 1 Type 2 report is and its significance in financial reporting.

Understanding SOC 1 Reports

A SOC 1 report specifically focuses on controls at a service organization that are relevant to a user entity’s internal control over financial reporting (ICFR). User entities are clients who rely on the service organization’s processes for their financial data. The primary objective of a SOC 1 report is to provide assurance to these user entities and their auditors regarding the suitability of the design of controls at the service organization that could impact the user entity’s financial statements.

Service organizations, like payroll processors, cloud service providers, or financial technology companies, perform functions that directly affect their clients’ financial records. For example, a payroll processor handles sensitive salary and tax withholding data that feeds directly into a client’s financial statements. Similarly, a data center might host financial applications, making its security controls relevant to the integrity of financial data.

These reports are prepared in accordance with the American Institute of Certified Public Accountants’ (AICPA) Statement on Standards for Attestation Engagements (SSAE) No. 18, specifically AT-C section 320. This standard provides the guidelines for auditors to examine and report on a service organization’s internal controls and business processes.

The Distinction of a Type 2 Report

SOC 1 reports come in two types: Type 1 and Type 2. A Type 1 report describes the service organization’s controls at a specific point in time and includes management’s assertion regarding their design. It assesses whether the controls are suitably designed to achieve their objectives as of a particular date. This report offers a “snapshot” of the control environment.

A Type 2 report goes further by including the auditor’s opinion on the operating effectiveness of those controls over a specified period, typically a minimum of six months, and often 12 months. This means the auditor not only assesses if the controls are designed appropriately but also tests whether they consistently operated as intended throughout the audit period. This extended evaluation provides a higher level of assurance.

Operating effectiveness provides evidence that controls not only exist on paper but are actively working to mitigate risks to financial reporting. Without a Type 2 report, user entity auditors would need to perform their own extensive testing of the service organization’s controls, which can be time-consuming and costly. This allows user entity auditors to better assess risks and plan their own audits, helping them determine the extent to which they can rely on the service organization’s controls when auditing their client’s financial statements.

Key Elements of the Report

A SOC 1 Type 2 report includes several distinct sections that provide comprehensive information about a service organization’s control environment. The report typically begins with an independent service auditor’s report, which presents the auditor’s opinion on the service organization’s controls. This opinion addresses both the fairness of management’s description of its system and the suitability of the design and operating effectiveness of its controls over the specified period. An unmodified opinion indicates that the controls are operating as intended.

Following the auditor’s report is management’s assertion, a written statement from the service organization’s management. In this assertion, management takes responsibility for establishing and maintaining effective controls over financial reporting. They also assert that the description of their system is fairly presented, and that the controls are suitably designed and operated effectively.

The report then provides a detailed description of the service organization’s system. This section outlines the processes, policies, and controls implemented by the organization that are relevant to financial reporting. This section helps user entities understand how the service organization manages their financial data.

A key component of a Type 2 report is the section detailing the tests of controls and results. This part describes the methodology the auditor used to test the operating effectiveness of the controls over the specified period. It includes the specific tests performed, the sampling methods used, and the findings, including any identified control deviations or exceptions. This section offers transparency into the auditor’s work and control performance.

Finally, a SOC 1 Type 2 report may include other optional information that the service organization chooses to provide. This could include additional context, explanations of any exceptions found, or other relevant details. The report also includes a description of complementary user entity controls (CUECs), which are controls the service organization assumes the user entity has in place for the overall system of controls to function properly.

How SOC 1 Type 2 Reports are Utilized

SOC 1 Type 2 reports are extensively used by user entities and their financial statement auditors. User entity auditors rely on these reports to evaluate the effectiveness of controls at service organizations that handle their clients’ financial data. This reliance can significantly reduce the need for the user entity’s auditor to perform duplicate testing of controls that are already covered by the service organization’s SOC 1 Type 2 report, leading to efficiencies in the audit process.

Beyond financial statement audits, user entities leverage these reports for risk management and vendor oversight. By reviewing a service organization’s SOC 1 Type 2 report, a user entity can assess and monitor the risks associated with outsourcing functions that impact their financial operations. It provides assurance that the service provider has robust controls in place to protect sensitive financial information and maintain data integrity.

These reports also assist user entities in meeting their own regulatory and compliance obligations. For example, publicly traded companies often need to comply with the Sarbanes-Oxley Act (SOX) of 2002, which requires them to have proper internal control structures for accurate financial reporting. A SOC 1 Type 2 report helps user entities demonstrate that they have evaluated and are relying on service organizations with appropriate controls, contributing to their overall SOX compliance efforts.

Ultimately, obtaining and providing a SOC 1 Type 2 report fosters trust and assurance between service organizations and their clients. It demonstrates a service organization’s commitment to strong internal controls and the reliability of their services, which can enhance client confidence and support long-term business relationships.