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Thinking Like an Auditor

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    November 16, 2015 | By Claudio de los Rios, CPA, CA

    I’ve often been asked, “What do you do”? Sometimes I reply simply, “I’m an internal auditor.” Other times, I might feel like stirring the conversation and say something along the lines of how I try and help keep the CEO and CFO out of prison. Ultimately though, what we do as auditors is communicate. We help put into words what is happening in an organization and make sure the right people are aware of it. But we need to do more than simply relay the facts. We need to interpret those findings in such a way, as our audience understands why it matters.

    One of the things I’ve always appreciated within Internal Audit is our freedom. Internal audit organizations benefit by being free from most organizational constraints. As internal auditors, we are tasked not only with the identification and communication of significant issues, but also reporting on the root causes so that corrective action takes place at the right level and the company isn’t merely addressing symptoms.

    Several years ago I ran a global audit project whose scope was “supply chain”. Early on in the process of planning the audit, it became clear that the term, “supply chain” was not consistently understood across the organization. Some people within parts of the company felt that supply chain began with the acceptance of an order. Others believed it began with the manufacturing of product. There were compelling reasons for all the arguments we heard, but the only consistent element was its inconsistency.

    Since there was no one specific supply chain organization, internal audit was able to freely determine what would be looked at, at least for the purposes of conducting our audit.

    I’d heard an expression early in my career: you get what you measure. These words can haunt organizations. What it really means is to be careful what you wish for. Operating in silos can lead to negative consequences for the organization as a whole.

    Back to the global supply chain audit… given that we could determine for ourselves the scope of the audit, we decided to take a broader, holistic approach to understand inputs into the function, and adopted a risk based auditing approach. In so doing, we looked at organizations that might not have been traditionally considered to be part of the supply chain organization, but nonetheless, had touch points within supply chain and could provide some insight into how that function was operating. We looked at Human Resources to understand turnover within that function as an indicator of risk. We looked at accounts receivable to understand aging and turnover. And, we looked at accounts payable to understand direct procurement. We performed a battery of analytic procedures to look at the various sets of data to identify trends and develop points of inquiry. At the time, we didn’t have a name for it, but we were performing data analytics… to which our manager at the time asked, what is data analytics? Data analytics, as defined in various Internet sources, is the science of examining raw data with the purpose of drawing conclusions on that data. In terms of internal audit, it includes inspecting, cleaning, transforming and modeling data.

    It was when we analyzed accounts payable (AP) data that we noticed an interesting phenomenon. One of our component suppliers was charging us large amounts for interest on unpaid invoices and there had been a lengthy process underway to try and resolve the discrepancies. Amongst the sea of AP data across the organization, it could have been like looking for a needle in a haystack. However, use of data analytic techniques allowed us to stratify, age and examine the data in such a way that we had something interesting to investigate.

    As it turns out, objectives in supply chain had not been aligned because the process as a whole had not been planned end-to-end. Much to our chagrin, we’d gotten what we’d measured.

    We observed that the direct procurement organization was tasked with procuring raw materials and components for manufacturing at the best prices possible. They were incentivized to procure at the steepest discounts. This makes complete sense.

    A few organizations removed from procurement was the manufacturing and postponement organization, largely comprised of third-party manufacturers. Apart from being rewarded for producing quality products, timeliness was also an attribute the company felt should be rewarded. Manufacturing turnaround, i.e. the time between when an order is entered into the system and when finished goods are delivered was a rewarded metric. However, since the order and inventory systems were separate, a different measure was used as the starting point. Receipt of raw material into the production process was used as the first data point in the 3rd-party production process. In case you’re not seeing how these two measures are incompatible, this is what happened:

    The procurement department negotiated a mass purchase deal with the supplier by ordering the annual component requirements for the year all at once. The supplier then shipped the goods to the port of delivery, at which point, the 3rd party contract manufacturer would receive the goods into inventory. Now, the 3-way match process we’re familiar with in procurement would take place and accounts payable could process/pay the invoice when it arrives from the supplier. However, the 3rd party contract manufacturer realized that if they received the goods into raw material inventory, then the clock on their own metric would start to tick, and they would be penalized for a slow turn-around since there were no orders for manufactured goods.

    It became more economical for them to pay out of pocket for off-site storage of the goods as opposed to receiving them into inventory and forgoing the turnaround bonuses… and that’s exactly what happened. We got what we measured.

    Neither organization could be blamed for their behavior. They simply did what they were asked to do in the way that was most rewarding for them.

    Our freedom and independence as internal auditors allowed us to effectively move across organizational boundaries and trace the symptom (in this case, excessive penalties for late payment on invoices) to the root cause (the creation of department-level performance incentives without consideration of the end-to-end process). Our ability to observe, describe and communicate ultimately had a profound effect on the organization. The creation of an oversight group for supply chain with cross-organizational representation was a byproduct of the successful audit.

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