Offshoring The Independent Audit Function

Copyright 2009 ProQuest Information and Learning CompanyAll Rights ReservedABI/INFORMCopyright 2009 New York State Society of Certified Public Accountants CPA Journal January 2009 SECTION: Pg. 60 Vol. 79 No. 1 ISSN: 0732-8435 ACC-NO: 1627954361 LENGTH: 4555 words HEADLINE: Offshoring the Independent Audit Function BYLINE: Daugherty, Brian; Dickins, Denise The offshoring of business processes has become increasingly popular. Fueled by advancements in technology, the benefits of offshoring are primarily attributable to the savings from lower personnel costs at foreign locations. According to the Global Financial Services Offshoring Report 2007 by Deloitte & Touche USA LLP, over 75% of major financial institutions report offshoring a portion of their operations. Some economists estimate that up to one-third of total US employment in services may ultimately be offshored. Audit firms choosing to offshore portions of the independent audit function should be mindful of public perceptions related to the exportation of professional services. The offshoring of audit procedures presents auditing firms with unique opportunities and challenges. Chief among the opportunities is the ability to reduce audit costs, increase profit margins, and share cost reductions with clients, while maintaining sufficiently high levels of quality. FULL TEXT: The offshoring of business processes has become increasingly popular. Fueled by advancements in technology, the benefits of offshoring are primarily attributable to the savings from lower personnel costs at foreign locations. According to the Global Financial Services Offshoring Report 2007 by Deloitte & Touche U.SA LLP, over 75% of major financial institutions report offshoring a portion of their operations. Some economists estimate that up to one-third of total U.S. employment in services may ultimately be offshored (Steve Lohr, "At IBM, a Smarter Way to Outsource," The New York Times, July 5, 2007). Offshore entities often operate in developing countries such as India, China, Pakistan, the Philippines, and Vietnam. The offshoring of business processes generally takes two forms: outsourcing to an unaffiliated offshore entity (offshore outsourcing), or ownership and operation of an affiliated offshore entity (AOE). Many multinational companies have AOEs. For example, Accenture has more employees in India than in the United States; IBM is projected to have more than one-quarter of its workforce in India by 2010; and companies like General Electric, Eli Lilly, Google, and Microsoft are expanding their R&D centers in India and China (House Committee on Science and Technology, June 12, 2002). Offshoring and the Auditing Profession The potential benefits of offshoring have not been ignored by the accounting profession. In past years, several large public accounting firms began using AOEs to perform certain nonaudit procedures for their U.S.-based clients. For example, Ernst & Young uses AOE employees to prepare client tax returns (Vanessa Houlder, "E &Y Sends Compliance Work Offshore," Financial Times, July 11, 2007), and a number of accounting firms use AOEs to print documents for delivery to clients. The largest international public accounting firms have recendy begun testing the offshoring of certain auditing procedures on very large U.S. audit engagements to their AOEs located in India. An important distinction must be made between the traditional referral of audit work to overseas affiliates and the pilot programs discussed above. Large public accounting firms often request that their foreign offices perform audit procedures on foreign subsidiaries of U.S. registrants because the subsidiaries' records are maintained at the overseas location. Along the same lines, large audit firms often refer audit work to a different office within the same country (both in the United States and abroad). Based on the authors' conversations with audit partners from two of the Big Four firms, the pilot programs currendy being tested represent the first time that U.S. firms have offshored me performance of certain audit procedures on the domestic records of U.S.-based clients to the firms' foreign affiliates. This practice raises unique audit quality and related issues, especially for audit firms subject to oversight and inspection by the Public Company Accounting Oversight Board (PCAOB). Firms have indicated that the testing relates primarily to audit procedures requiring little to no judgment. An example of a procedure provided by one firm is data extraction and performance of analytical procedures by the AOE, with selection parameters established by the U.S. engagement team. Another example cited by a different firm is the selection and preparation of confirmations on very large engagements, at times confirming many hundreds of accounts, with parameters, again, specified by the U.S. team. Nevertheless, audit procedures can be viewed as requiring a continuum of judgment on behalf of the auditor. For example, in a poll of auditors conducted by the audiors, the sending and receiving of confirmations for all cash accounts was viewed as requiring less auditor judgment than tracing a sample of property and equipment additions to vendor invoices, which in turn was viewed as requiring less auditor judgment than evaluating the adequacy of the allowance for doubtful accounts. Even in these simple examples, the level of judgment will obviously vary from engagement to engagement depending on the magnitude and complexity of transactions, interaccount activity, and so forth. In order to comply with the supervision standard of fieldwork (as well as an Interim Auditing Standard of the PCAOB), strict regimens are enforced in the pilot programs to ensure that the work has been appropriately supervised. Discussions with personnel at two firms indicate that audit procedures to be offshored to the AOE are performed by individuals possessing an appropriate bachelor's degree and supervised by chartered accountants or candidates eligible to sit for the chartered accountant exam. Furthermore, the work product received from the AOE goes through the same review process (senior, manager, partner, as applicable) as if the work had been performed by U.S. staff. Discussions with several Big Four partners suggest that the primary impetus for the offshoring of audit procedures is to fight "fee-fatigue" by clients, due in large measure to the increased reporting and compliance requirements mandated by the Sarbanes-Oxley Act of 2002 (SOX). One partner commented at a 2007 KPMG faculty symposium that the "all-in" cost of a chartered accountant at the firm's Inthan AOE is approximately one-quarter that of the employee's U.S. equivalent. This is in line with historical U.S.-Inthan wage gaps and trends in the real methan wages of U.S. graduates since 2000. A Big Four partner told the authors that he believes many audit procedures are relatively easy to standardize, and the process is more efficient - with a better quality work product - when performed by personnel who do the work on a repetitive basis. The partner confirmed that the cost savings are real - due to the wage differential - and do not result in incremental supervision on the domestic side. The offshore wage gap is forecast to narrow substantially, however, to approximately 70% by 2015 (Deloitte 2007). The offshoring of nonjudgmental audit procedures offers the prospect of freeing up experienced U.S. engagement personnel, enabling them to focus on other high-risk or value-added audit procedures. On the other hand, entry-level auditors may have reduced opportunities to gain experience in the performance of fundamental audit procedures. Two partners at separate Big Four firms have remarked that their perception of the quality of the work performed at AOEs is equal or superior to the work performed by staff domestically. It follows mat if offshoring predominantly nonjudgmental audit procedures is successful, the types of procedures outsourced may ultimately evolve to include audit procedures requiring increasing levels of judgment. For example, as many corporations have outsourced internal audit functions to public accounting firms in an effort to reduce costs, the audit firms themselves may in turn be motivated to offshore certain portions of the internal audit function. Discussions with a Big Four partner indicate that outsourced internal audit functions have not yet been offshored, but that would be a logical next move if the pilot program is successful. This same partner also suggested that there is no reason to believe that offshoring will not ultimately progress to audit procedures requiring higher levels of judgment. Although internal audit offshoring may be less subject to regulatory considerations than the offshoring of external audit functions, many of the potential offshoring ramifications discussed later would still apply. For years, independent auditors have faced unique auditing considerations when their attest clients outsource business processes. While historically concentrated around manufacturing processes, the last decade has seen outsourcing and offshoring expand to include service processes such as software programming, human resources, procurement, call centers, medical diagnosis, and legal services. This has taken on increased importance since the enactment of SOX, as both senior management and their independent auditors are now required to express an opinion on the effectiveness of an entity's internal controls over financial reporting. To the extent an outsourced process is a critical component of a client's financial reporting internal control structure, management and the auditor must be satisfied - either through direct testing or reliance on the reports of other auditors-that the internal controls in place at the outsourced or offshored location are sufficient to mitigate the risk of errors and irregularities occurring and going undetected. A number of recent PCAOB inspection reports have found that some auditing firms are deficient in obtaining sufficient competent evidential matter related to reports generated by similar service organizations. (PCAOB inspection reports are available at <a href="http://www.pcaobus.org">www.pcaobus.org</a>.) While recognizing that the offshoring of certain auditing procedures to an AOE has the potential to contribute positively to the audit function, the audiors suggest there are certain unique considerations and potentially negative implications - that might arise from the process. The discussion below of potential issues related to outsourcing is not necessarily dependent upon the type of audit tasks outsourced or the level of auditor judgment required, with respect to the procedures outsourced. Nevertheless, certain of the issues discussed' - for example, litigation - may have increasing importance, depending upon the perceived level of judgment required by the outsourced task. Considerations and Implications of Offshoring Public perceptions, public relations, and the expectation gap. Audit firms choosing to offshore portions of the independent audit function should be mindful of public perceptions related to the exportation of professional services. A number of large corporations have been criticized for moving domestic work to foreign locations, notably in the manufacturing and service sector arenas. For example, in 2003, Dell moved customer service calls from its business customers back to the United States after receiving a large number of complaints about the quality of service at its Indian call center (J. Light, "Overseas Service Calls Come Home," Boston Globe, August 20, 2005). Although many companies have been able to demonstrate substantial cost savings through outsourcing and offshoring to foreign locations, the public concern over the loss of domestic jobs has been significant, at times prompting the intervention of federal and state regulators and lawmakers. For example, in 2004, the Senate passed Bill No. 1637, blocking federal government contracts from being awarded to companies that would carry out the work with foreign labor. Certain state governments have addressed the issue. For example, Michigan has two executive directives on outsourcing, including one that restricts the use of state funds to provide incentives to relocate any jobs overseas. Michigan also requires that state contractors specify where all work is to be performed. Florida requires that all state outsourcing contracts be reviewed and monitored (Karyn-Siobhan Robinson, "State 'Offshoring' Laws Come Under Scrutiny," HR Magazine, June 2004, http://findarticles.eom/p/articles/ mi_m3495/is_6_49/ai_n6076888). The offshoring of audit procedures to an AOE may influence the magnitude of the expectation gap as well. The expectation gap in auditing has been defined by the AICPA as "the difference between what the public and financial statement users believe auditors are responsible for and what auditors themselves believe their responsibilities are." Even though cost savings and retention (or improvement) of quality related to the offshoring of certain audit services may be realized, public perceptions of these advantages may differ, or may not adjust on a timely basis, potentially contributing to a wider expectation gap. A Big Four partner said that the expectation gap is not perceived internally as a concern with respect to offshoring. Potential client concerns, confidentiality, and data protection laws. On the surface, it seems reasonable to conclude that clients would be fully supportive of any initiative that could simultaneously reduce audit fees without sacrificing the quality of audit procedures performed. Nevertheless, there is the possibility of resistance from clients on at least two fronts. First, from a practical perspective, some clients - especially those that have historically resisted outsourcing portions of their own operations due to political and perception concerns- may desire that their external service providers not engage in offshoring. Second, client information that is exported (electronically or otherwise) is likely to contain some degree of confidential information that clients may not want disclosed. There are potential ramifications related to offshoring and auditors' compliance with various codes of professional conduct Ethics Ruling 112 of Section 191 of the AICPA's Code of Professional Conduct makes it clear that members must disclose the use of third-party service providers to their clients, and must obtain their clients' permission prior to disclosing any confidential information to third-party service providers. Accordingly, any offshore outsourcing (versus offshoring to an AOE) clearly requires client notification. Less clear is the auditor's notification responsibilities when audit work is performed by an AOE. Beyond Ruling 112, Rule 301 of the Code of Professional Conduct states that "a member in public practice shall not disclose any confidential client information without the specific consent of the client." Furthermore, the Health Insurance Portability and Accountability Act of 1996 (HIPAA) directly impacts data privacy: Privacy Rule 46 pertains to the disclosure of personally identifiable health information, while Security Rule 47 describes certain administrative, physical, and technical security safeguards that are required for compliance. Legislation has been proposed in Congress concerning notification and consent of the transfer of private information to offshore entities, and various states are in the process of enacting data privacy and security laws. Holder and Grimes provide a recent summary of various state actions [James T. Holder, and David E. Grimes, "Government Regulated Data Privacy: The Challenge for Global Outsourcers," Georgetown Journal of International Law, 38 (3), 2007]. This issue has important policy implications. An argument could be made that if an auditor engages in offshore outsourcing, Rule 301 may require audit firms to inform clients that a portion of the audit will be outsourced, and that the process will entail the transmission of the client's proprietary information to the unaffiliated entity. Even the transfer of confidential client information from an auditor's U.S. engagement team to an AOE may be impacted by future legislation or professional conduct rulings. Some clients may be uncomfortable having their confidential information in the hands of foreign entities that are subject to different legal jurisdiction and privacy laws - even if current confidentiality rules are adhered to. Data protection rules appear to be most advanced in the European Union (EU), where the Data Protection Act of 1998 prohibits the transfer of personal information outside of me EU [M. Ball, 'Ts Offshoring Really Under Threat from the Data Protection Act?" Strategic Direction, 21 (2), 2005]. On the other hand, India currendy lacks data protection laws, and the Philippines are just in the process of developing data protection legislation (Holder and Grimes 2007). The EUs Data Protection Act served as the basis for a lawsuit against Lloyds TSB, which transferred certain customer information to its Inthan processing center. The case serves as an example of potential challenges accounting firms may face as new legislation is developed. The data security issue is real. In 2005, High Street banks announced that some of their customer identities had been stolen by call center workers located in India [Sam Greenhill, and Richard Shears, "Banks May Be Charged over Theft of Customer Identities," Daily Mail (London), June 24, 2005]; in 2006, $350,000 was stolen from accounts of U.S. Citibank customers by an Inthan call center employee [Tom Rowland, "Inthan Call Centres in a Pickle," The Tones (London), February 21, 2006]. To retain their independence, auditors may not allow clients to dictate the scope or timing of audit procedures, nor the personnel assigned to the audit; hence, the process of offshoring to an AOE requires auditing firms to walk a tightrope. Audit firms will need to assure clients that procedures are in place to appropriately safeguard offshored client information during and after completion of the audit. PCAOB inspections and audit quality. To date, the PCAOB inspection reports that have been publicly released make no mention of offshoring domestic auditing processes to AOEs. This is not surprising, given the recent emergence of offshoring in the auditing profession and the delayed issuance of PCAOB inspection reports. The impact, if any, of offshoring to an AOE on the PCAOB inspection process is not known. The PCAOB is fully informed of the offshoring pilot programs mentioned above, according to a Big Four audit partner, but offshoring has not yet been a focus of inspections. The audiors suggest four areas that may ultimately become the subject of PCAOB scrutiny. First, it is logical that the PCAOB will focus broadly on the quality control implications of offshoring. It is unlikely, however, that their observations related to quality control will be widely known in the near future, given the confidential treatment afforded quality control matters in the inspection reports of registered accounting firms. Second, the authors believe that the PCAOB will look closely at the audit documentation ramifications of offshoring. Audit documentation must be retained in accordance with the requirements of Auditing Standard (AS) 3, Audit Documentation. A potential issue may be an auditing firm's ability in its U.S. working papers to demonstrate the completeness of audit documentation of procedures performed at AOEs or by foreign unaffiliated entities. A third consideration involves the inspections of foreign registered public accounting firms. PCAOB Rule 4012 allows the board "to adjust its reliance on the inspections of auditor oversight entities located in the home countries of registered non-U.S. audit firms, based upon the level of independence and rigor of those entities." Thus, it will be important for auditors to understand the likely level of reliance the PCAOB will place on the AOE' s oversight entity. In December 2007, the PCAOB issued for public comment proposed guidance regarding the implementation of Rule 4012 that would allow the PCAOB to place full reliance on the inspections of qualified non-U.S. auditor oversight entities if certain essential criteria are met. A Big Four partner doubted that foreign regulators would have the reach to inspect work offshored to an AOE for a U.S. registrant. Finally, given the PCAOB's recent focus on improving the efficiency of integrated audits, as highlighted by the issuance of AS5, An Audit of Internal Control over Financial Reporting that Is Integrated with an Audit of Financial Statements, it is possible there will be some level of dialogue between auditors and their clients regarding the extent to which cost savings realized from offshoring are shared. Litigation management issues. All other things being equal, an improvement in audit quality should reduce detection risk, resulting in a reduced likelihood of audit failure. To the extent there is an audit failure related to inadequate audit procedures offshored to an AOE or an unaffiliated foreign entity, auditing firms run the risk that judges and juries may, after the fact, inappropriately attribute a disproportionately large causal factor to the offshoring process itself and render negligence verdicts that otherwise may have been avoided or minimized. Auditing firms suggest this risk is being addressed through the credentialing requirements of AOE personnel (bachelor's degrees at lower levels, chartered accountants at supervisory levels), the foreign and domestic review processes, and limiting offshoring to audit areas requiring limited judgment. The importance of this issue (and litigation exposure) may increase if audit firms begin offshoring increasingly judgmental audit processes, or if audit procedures are performed by unaffiliated foreign entities. The ability to clearly demonstrate quality control safeguards, such as supervision and review procedures, will be critical. (One Big Four partner viewed the litigation risk to be neutral, with respect to offshoring, and indicated that all Big Four firms carefully considered litigation implications before testing the pilot programs. Staff development. On the one hand, offshoring domestic audit work to an AOE seems, in part, to address the current shortage of qualified professionals entering the auditing profession in the United States. On the otiier hand, offshoring may lead to unforeseen domestic recruiting and retention issues. As offshoring gains wider acceptance, U.S. entry-level candidates may question whether the process will negatively impact their career progression and promotion opportunities. At the extreme, domestic staff would lose exposure to the intricacies of basic auditing if nonjudgmental auditing procedures were completely offshored. These relatively straightforward auditing procedures provide the foundation that enables interns and first-year staff to be prepared for increasingly complex and judgmental auditing tasks as their careers progress. One partner at a Deloitte seminar for accounting professors in 2008 reported that offshoring currendy represents a very small percentage of domestic audit hours. Another firm indicated that it is cognizant of the importance of new hires mastering basic auditing procedures and that domestic staffing and training are carefully monitored to ensure that interns and first-year staff receive appropriate levels of instruction and hands-on experience. Anecdotally, the authors were informed that the offshoring concept is generally embraced by younger partners and the rest of the engagement team, though there is some resistance by longer-tenured partners. Furthermore, if the concept of offshoring continues to grow, both within the audit profession and in other sectors, firms run the risk of facing staffing shortages at the foreign affiliate itself. Deloitte' s Global Financial Services Offshoring Report 2007 cites sources projecting a potential shortfall of up to 500,000 qualified personnel in India as soon as 2010. One audit partner reported that an advantage of AOEs is that unlike U.S. office personnel who tend to have "up or out" career paths, lower-level AOE personnel tend to be career staff. This custom may or may not change in the future. Another audit partner told the authors that he does not anticipate any wage inflation for lower-level personnel (with bachelor's degrees), based on reports that India has about 25 million college graduates and approximately 75% of the population is still rural. This partner viewed wage inflation as a greater possibility at the chartered accountant level, as this group is more likely to receive higher salary offers from other employers, including other firms' AOEs. Other considerations. It is unlikely that smaller auditing firms will be able to achieve the anticipated cost savings from offshoring audit-related tasks by the largest international accounting firms. A member of senior management at a non-Big Four firm suggested to the authors that there was no incentive to offshore audit work to lower-priced foreign affiliates, citing supervisory concerns by tile lead firm. Smaller firms lacking foreign affiliations would likely find it cost-prohibitive to establish an AOE while maintaining appropriate supervisory and quality control capabilities. Questions and Opportunities The offshoring of audit procedures presents auditing firms with unique opportunities and challenges. Chief among the opportunities is the ability to reduce audit costs, increase profit margins, and share cost reductions with clients, while maintaining sufficiently high levels of quality. Conversely, offshoring should not be entered into without awareness of the challenges it presents, including public perception, client confidentiality, litigation management, and staff development. To date, large accounting firms that have taken up offshoring have largely used AOEs to perform non-audit procedures like tax-return preparation. Only recently has the offshoring of domestic audit procedures^ - requiring UtUe to no judgment to AOEs begun. If audit quality is retained, and appropriate levels of domestic supervision and review are employed to ensure compliance with U.S. auditing standards, it is likely that economic considerations will result in the offshoring of audit procedures to AOEs that involve increasing levels of judgment - as well as offshoring of other services such as outsourced internal audit engagements. The large international accounting firms are at the forefront of exploration in the offshoring of domestic audit procedures. Offshoring is intuitively appealing on many levels, but it leads to yet-unanswered questions, many of which can be addressed empirically as the process expands. For example, after consideration of all maintenance, monitoring, and quality control processes, how incrementally profitable is the offshoring of audit procedures? What types of procedures are appropriate for offshoring? Do third parties - clients, investors, standards setters, regulatory agencies, judges, jurors - perceive differences in audit quality when companies offshore domestic audit procedures? What are the impacts of offshoring on accounting firms' domestic and foreign recruiting and staff development efforts? We suggest that accounting firms prepare for each of these considerations as they expand dieir use of offshoring, and that academics and standards setters add this important topic to their research agendas. GRAPHIC: Illustrations LOAD-DATE: January 17, 2009 <div> <div class="x_nshr"> <center></center> <center><a href="http://www.lexis-nexis.com/lncc/about/copyrt.html" target="_new" class="x_pagelinks">Copyright © 2009 LexisNexis, a division of Reed Elsevier Inc. 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