Internalization versus externalization of the internal audit function: an examination of professional and organizational imperatives
Introduction
A marketing brochure of Arthur Andersen (1995) stated that the outsourcing of internal audit services is a “strategic concept — a way to add value to a business — that converts an in-house cost center into a customer-focused service operation with you as the customer.” The firm appealed to corporations to focus on the critical “core” areas of the business that create and sustain competitive advantage and outsource non-core competencies such as internal auditing. The alternative view to these alleged advantages of the outsourcing of internal audit services comes from, as might be expected, in-house internal audit departments such as the one at J. C. Penney. The internal audit department at this company espoused its commitment to “value-added services” and argued that their internal audit department achieves a competitive advantage through knowing the business and performing comparative analysis and benchmarking within units. In fact, J. C. Penney has an Internal Auditor's Bill of Rights which states that its internal auditors have “the right to feel important — indispensable, in fact — to corporate management.”
To some extent, these opposing views as to the appropriate manner in which to have internal audit services provided — to have such services outsourced to a public accounting firm (as argued by a public accounting firm providing these services) or to have such services maintained in-house (as argued by an in-house internal audit department) — are no surprise. Such self-serving expressions of optimal internal audit practices are a reflection of Hopwood's recent (1998, p. 515) observation as to the changing nature of the audit industry:
…changes afoot are taking place in the audit industry, including the audit itself. Ernst & Young, for example, now claim that it “has challenged all aspects of the traditional audit”. Professionalism has been replaced by business acumen. Notions of independence seem curiously antiquated in a world where audit is conducted in the very same business unit as the promotion of consultancy products and services. Even ideas of “paper walls” between the professional and the commercial are now remnants of the past in audit organizations that pro-actively structure their operations to facilitate the commercial potential of the joint operation of the two.
At a very general level, these contrasting views as to the provision of internal audit services provide a meaningful arena for more research which addresses some of the more macro behavioral issues which are shaping the internal auditing profession (Kalbers & Fogarty, 1995). At the heart of the development of the internal auditing profession are such issues as the battle for professional turf (Abbott, 1988, Freidson, 1986, Reed, 1996) in terms of efforts towards self-motivated market control, as well as changing organizational structures and processes such as outsourcing (Bettis & Hitt, 1995, Davis-Blake & Uzzi, 1993, Halal, 1994, Matusik & Hill, 1998, Wallace, 1995) within which internal auditing is embedded.
The purpose of our paper is to draw from two dominant literature perspectives to examine the changing nature of the internal auditing profession. The next section of this paper presents these theoretical arguments supporting the paper and the resultant research propositions to be examined: the sociology of professions literature which provides a theoretical basis from which the volitional behavior of both the public accounting firms and the corporate internal audit departments can be recognized and the outsourcing literature which frames the organizational arguments (changing organizational structures and processes) which are challenging all internal support services — not just internal auditing — in terms of their inherent “value-added” relative to the outsourcing of such services.
The third section of the paper provides a discussion of the research methods used in this study. The fourth section will be guided by the first research proposition which presents observations related to the efforts of the public accounting profession to stake to claim internal auditing work (see Fig. 1). Here we will consider both the volitional professional behavior of the public accounting profession (as espoused in the sociology of professions literature) and organizational arguments (inherent advantages of the externalization of organizational processes as espoused by the outsourcing literature). This public accounting profession perspective will be grounded by observations from recent positions taken by the AICPA and the active role of three public accounting firms (Arthur Andersen, Ernst & Young, and KPMG) which have taken aggressive positions in the effort to market their delivery of internal audit services. The second research proposition which pertains to the internal audit profession perspective (see Fig. 1) will then be presented in section five both in terms of the volitional professional behavior of the internal audit profession as well as the organizational arguments as to the inherent advantages of the internalization of organizational processes. This internal audit profession perspective will be grounded by observations from: early IIA positions on this issue as well as the advocacy from internal audit departments (S.C. Johnson Wax and J. C. Penney) which have thus far successfully defended their delivery of internal audit services. The sixth section of the paper offers additional observations and suggestions for future research revolving around some of the dynamics identified in this research pertaining to other critical social actors (the IIA and the SEC — see Fig. 1) who, although not the major focus of the study, seemed to be making a significant impact on the changing public accounting and internal audit professions. The final section of the paper provides a closing discussion.
Section snippets
Two major forces: inter-professional competition and organizational imperatives
The tension that was apparent in the differing views of Arthur Andersen versus J. C. Penney as to the nature of the internal audit function can be addressed from the sociology of professions literature which recognizes that both sides (the internal and external auditors) are capable of engaging in volitional professional behavior in the protection and/or advancement of their respective professional turf. These differing views can also be addressed through the outsourcing literature which
Research methods
Consistent with our theoretical perspective that professional jurisdiction is socially constituted through the interactions of various constituent groups, evidence was gathered through qualitative analysis of archival material from both side of the professional dispute. This evidence was supplemented with extensive interviews with key organizational actors from the two professional sides to elicit their views and their guidance on accessing relevant material. Archival material took the form of
Analysis: efforts by the public accounting profession to re-define the boundaries between the external and internal audit function
The AICPA Professional Ethics Division released an exposure draft in February 1996, proposing several interpretations and guidelines for the performance of extended audit services (such as internal auditing) for external audit clients. The 1996 AICPA Professional Ethics Committee's Exposure Draft effectively codified “best practices,” affirming that extended audit services such as the provision of internal audit services would not impair independence with respect to attest clients. As the AICPA
Analysis: efforts by the internal audit profession to re-affirm the boundaries between the external and internal audit function
The Institute of Internal Auditors (IIA) (1978) developed a codified set of Standards for the Professional Practice of Internal Auditors that includes the association's definition of internal auditing. Here, the IIA presented the case for internal audit services remaining a strictly in-house function and established the point that keeping the internal auditing function as an integral part of the organization offers clear advantages. Extending this view, the IIA's (1994, p. 2) own white paper
Beyond the public accounting firms and in-house internal auditors: implications for future research
As suggested in Fig. 1, although the major focus of this research has been to draw from the sociology of professions and the outsourcing literature to theoretically motivate the study of the tensions between the public accounting and internal audit professions over the internal audit function (research propositions 1 and 2), additional social actors were implicated in our analysis and need to be subject to more systematic analysis in future research for deeper understanding of their roles in
Closing discussion
Our paper has attempted to advance several critical issues pertaining to the current turmoil surrounding the trend toward the provision of internal audit services on an outsourced basis to the external financial auditors. At the most general level, this study attempted to provide some initial effort towards Hopwood's (1998) charge that if auditing research “…is to be meaningful in the modern era the world view of the research community must change.” Our study took serious the various WSJ
Acknowledgments
The authors wish to thank two anonymous reviewers, Anthony Hopwood, and participants at the doctoral seminar at the University of Wisconsin-Madison for their many thoughtful comments on earlier versions of this paper.
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