OUTSOURCING INTERNAL AUDIT ISN'T ONLY THE BIG FIRMS' GAME

By Simon Petravick, PhD, CPA, assistant professor of accounting, Bradley University

Outsourcing of internal audit services has often been discussed in the context of activities of the Big Six and the large organizations they typically serve. In fact, public accounting firms of all sizes conduct outsourcing. Further, nonpublic accounting firms that specialize in providing internal auditing services (outsourcing firms) hold many outsourcing engagements. Finally, the findings show that many small institutions use outsourcing. To further understand the outsourcing activities of public accountants and outsourcing firms, this article examines the numbers and sizes of their clients and the length of time they have offered outsourcing. A recent survey provides insights into who the players are and who are their clients.

Senior executives at 232 financial institutions responded to this survey. Financial institutions (banks, thrifts, and credit unions) were selected for this study because outsourcing the internal audit function is active in their industry.

Outsourcing of Internal Audit Is Frequently Used

Table 1 describes the organization of the respondents' internal audit functions and shows the widespread use of outsourcing. Approximately 34% (79 of 232) have outsourced while 35% (81 of 232) use in-house internal auditors. The remaining institutions have their internal auditing provided by an affiliate (such as a parent company) or do not use an internal auditor at this time.

While the number of in-sourcers and outsourcers are approximately equal, they are considerably different in size. Table 1 shows that the median size of institutions that use an in-house internal audit function is nearly four times larger than those that use outsourcing. Regardless of size, managers of outsourcing institutions indicated that the primary reasons for outsourcing were having access to auditors with specialized expertise and improving management of internal audit costs.

The median sizes shown in Table 1 may seem relatively small compared to the largest institutions found in each range. This is due to the fact that approximately 71% of financial institutions have less than $100 million in assets. Therefore, the results are skewed toward smaller sizes since the sizes of all financial institutions are skewed that way.

Many Firms Provide Outsourcing

Table 2 shows that a wide variety of firms provide outsourcing. Local public accounting firms are the largest providers of outsourcing, holding 39.3% of the outsourcing engagements. Outsourcing firms are second largest, retaining 21.5% of the engagements. National public accounting firms hold 17.7% and the Big Six hold 10.1%. "Other" consists of institutions that outsourced to an entity not listed above or did not indicate who their outsourcing provider was.

Even though local and outsourcing firms are the two largest providers of outsourcing, their actions have not been discussed in the literature. This may be due to the fact these firms generally deal with smaller and privately held clients, where activity occurs outside the public's eyes.

Table 2 also describes the sizes of the firms' clients. The median sizes of the Big Six's, national firms' and local firms' clients were $105, $85, and $25 million, respectively. It should be expected that the smaller organizations might favor the local firms, since the pricing structure of Big Six and national firms would not be attractive to institutions of that size.

The median size of outsourcing firms' clients was $55 million. They hold a significant number of outsourcing clients and have obtained clients of several different sizes. To further understand the popularity of these firms, I interviewed the president of an outsourcing firm. He offered three reasons for their success.

First, many clients wish to have their internal audit work done by someone other than their independent auditor. When sensitive information such as irregularities or fraud must be investigated, users of outsourcing firms feel this arrangement gives them more control over the flow of information to their independent auditor.

Second, when managers decide to outsource, and do not wish to outsource to their public accountants, they may still ask their public accountants for recommendations. Public accounting firms may be reluctant to recommend other public accounting firms for fear of giving those firms inroads to their clients. Therefore, public accountants often recommend outsourcing firms since they do not directly compete on other fronts.

The third reason for the popularity of the outsourcing firms is price. Most of these firms are small and operate without a great deal of overhead. Therefore, their billing rates are lower and the overall prices of the engagements are attractive to small and large institutions.

Two Trends in Outsourcing

Table 3 shows the number of years respondents have used outsourcing. Two changes have occurred in the last five years. First, the number of institutions using outsourcing has greatly increased. Second, while actions of the Big Six have received the most publicity, many other firms have recently become providers of outsourcing.

Outsourcing the internal audit function has been used for more than 20 years. However, its use has dramatically increased in the last five years. Approximately 55% of the outsourcing decisions were made in this period. Without doubt, the increase in activity has sparked many of the professional debates.

There also have been changes in who provides outsourcing. Table 3 shows that, until five years ago, the primary providers of outsourcing were local public accounting firms. In the last five years, Big Six, national, and outsourcing firms have made significant inroads.

No single reason can fully explain this increase in outsourcing. Part of the increase is due to some managers' desire to focus on core businesses activities and outsource support activities such as internal auditing or information processing. Another reason is that the audit revenues of many public accounting firms have remained relatively flat. In a market where an audit is believed to be a commodity, new sources of revenue are needed. One avenue is to leverage the experience gained from financial statement audits and conduct outsourcing engagements.

Until recently, most outsourcing firms have been relatively small. In some cases, the individuals who started these firms were themselves victims of corporate downsizing. Unable to find comparable positions, they offered internal auditing on an engagement-by-engagement basis.

The newest and most active of outsourcing firms is AuditForce, which was formed in December 1995. AuditForce provides three types of services: assistance to existing internal audit departments, execution of special internal audit projects, and outsourcing of a complete internal audit function. In March 1996, AuditForce received a $3.15 million capital commitment from Brinson Partners, a $53 billion global investment firm. AuditForce currently operates in Milwaukee and Cleveland and plans an aggressive rollout in 1997. AuditForce plans to have offices in 25 cities within five years.

The Future

These results show that public accountants have been very successful in developing an outsourcing practice in the financial services industry. Others have presented case studies that show
outsourcing is widely used in other industries.

A factor that may impact future outsourcing activities is whether large outsourcing firms such as AuditForce will achieve success. In this area, outsourcing firms have an advantage since they operate without the regulatory constraints that public accountants must follow. Their size permits them to employ staffs with diversified expertise, and offer a wide range of services. If the market accepts one large outsourcing firm, demand dictates that other, well-capitalized groups will follow. A potential participant could be American Express Tax and Business Services, which has already developed a nationwide practice in other areas. However, as this survey shows, smaller CPA firms have been very successful in outsourcing.

Outsourcing isn't only the big firms' game. *

Editor:
Douglas R. Carmichael, PhD, CPA
Baruch College

TABLE 1

ORGANIZATION OF INTERNAL AUDIT DEPARTMENTS

---

TABLE 2

PROVIDERS OF OUTSOURCING AND THEIR CLIENTS

---

TABLE 3

NUMBER OF YEARS THAT OUTSOURCING HAS BEEN USED