The unraveling of the United Kingdom's second-largest builder created a firestorm of controversy over warning signs that were missed or ignored. Few associated with the downfall of construction behemoth Carillion have escaped criticism, including its directors and auditors, as well as government overseers, from the Financial Reporting Council to The Pensions Regulator.
As Parliament and others seek accountability for Carillion's demise, their inquiries offer a sobering look into internal audit's role in the disaster.
Carillion's internal audit services were fully outsourced to Deloitte, while KPMG was the financial statement auditor. A February hearing before a pair of House of Commons committees put representatives from both firms on the hot seat. As I've written on numerous occasions, I worry when the question, "Where was internal audit?" is raised in the aftermath of a scandal, and frankly, reading some of the answers provided by the Deloitte representative made me extremely uncomfortable.
As I outline below, Deloitte's services to Carillion were narrowly focused, did not provide the audit committee a complete picture of the control environment, and appeared not to be focused on some of the most significant risks to the company. Based on my reading of hearing transcripts, Deloitte's position is that it did its job well and was not tasked with questioning or alerting the audit committee to growing debt-collection or other emerging issues.
Deloitte Internal Audit Partner Michael Jones told the committees: "Our role is to assess and make recommendations with regard to the company's control environment. The way we do that is we put together a plan, and we typically do that on a three-year basis and then we have a plan for each year. We do that in discussion with the company and ultimately we take that to the audit committee, and we set out to the audit committee what we are doing and what we are not doing."
It is troubling that any company doing business in today's dynamic business environment would have a three-year audit plan. Most modern corporations have annual audit plans that are updated throughout the year. What's more, while assessing and making recommendations on the control environment can provide value, most high-performing internal audit functions are also focused on key financial, operational, compliance, and strategic/business risks facing their companies.
Other testimony affirms Deloitte's constrained view of its job as Carillion's internal audit provider. It didn't attend all audit committee meetings. It did not think it necessary to learn more about a topic (debt collection) that the CEO was spending a great deal of time on. It did not raise questions when it found that peer reviews of numerous projects painted more pessimistic profit-and-loss projections.
To be fair, Deloitte was not alone in this myopic view of internal audit. Carillion's management and audit committee were responsible for the scope of internal audit's work. I suspect Carillion's decision to outsource the function to a respected member of the Big 4 created a false sense of security. The important lesson here for management and audit committees everywhere is that internal audit doesn't function best on autopilot. There must be real engagement that leverages the insight and foresight internal audit can provide.
The controversy over Deloitte's execution of Carillion's internal audit engagement is not unprecedented. In the United States, the Federal Deposit Insurance Corp. (FDIC) had litigation pending against Crowe Horwath, which delivered internal audit services for the subsequently failed Colonial Bank. In its suit, the FDIC accused the firm of "professional malpractice, gross negligence, and negligent misrepresentation" in connection with its delivery of internal audit services at Colonial Bank. Among other things, it accused the firm of failure to conform to a number of IIA standards in delivering the engagement. MarketWatch reports that the FDIC has reached a settlement in the case against Crowe, pending court approval.
Since at least the 1990s, The IIA has been supportive of deployment of sourcing strategies that rely on service providers. I have gone so far as to suggest that reliance on an effective cosourcing strategy is a leading practice. According to an IIA survey, more than half of Fortune 500 internal audit functions leverage the services of one or more third-party providers.
There may be times when a fully outsourcing model is appropriate, such as when a company wants to dramatically transform its internal audit function with all new staff, or a new internal audit function is being established. While full outsourcing is not an ideal model for delivery of internal audit services, The IIA recognized the need to provide additional guidance in a position paper that outlines challenges and offers important precautions related to outsourcing the internal audit function. The IIA believes, "oversight and responsibility for the internal audit activity cannot be outsourced."
There are at least two absolutely critical requirements that should be in place for fully outsourced internal audit engagements: (1) An in-house liaison, preferably an executive or senior management-level employee, should be assigned responsibility for "management" of internal audit; and (2) the engagement should be staffed with competent professionals who execute their responsibilities in conformance with The IIA's International Standards for the Professional Practice of Internal Auditing. In both the Carillion and Colonial Bank cases, the issue is not that internal audit was outsourced. The issue is whether the internal audit function did the job properly, and under the right oversight of the organization.
Having had some experience with the risk management culture of the big accounting firms that often perform these engagements, there are at least two reasons why I believe high-profile accusations against outsourced internal audit providers will cause consternation: (1) exposure to litigation; and (2) potential reputational damage to the firm's brand. As cases like these surface, I anticipate extensive scrutiny by the firms of clients seeking an outsource provider, and more extensive controls and conformance with professional standards in executing the engagements.
Otherwise, I wouldn't be surprised to see firms backing away from fully outsourced engagements, which carry so much more risk than the more common model of cosourcing. In other words, if high-profile accusations and litigation against firms continue, fully outsourced engagements could become victims of their own demise.
Let me close by acknowledging that there are many outstanding service providers around the world that provide cosourcing and outsourcing internal audit engagements. I know firsthand that the professional men and women who staff these engagements are passionate about delivering quality services for their client. I would encourage the firms, their partners, and their staff to take away lessons from Carillion and Colonial Bank and deliver internal audit services that are unassailable.
As always, the views expressed in this blog are my own, and do not necessarily reflect official positions or guidance of The IIA.
I look forward to your comments.