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Answer the Discussion Questions on page 14 of the Schwan Food Company Case. (You need only to answer the questions on page 14, you do not have to answer the questions on pages 15 or 16.) Reminder: Use of case solutions/teaching notes is considered academic dishonesty. G. Randolph Just, CMA, CPA, CIA, CFE, CISA, CFSA, CCSA, was vice president, Audit Services, at Allina* Hospitals & Clinics in Minnetonka, Minnesota, USA when he died in January 2006. He was previously chief audit executive for The Schwan Food Company. 1 G lobal Perspectives on Accounting Education V olume 5, 2008, 1-16 ESTABLISHING AN INTERNAL AUDIT DEPARTMENT: THE CASE OF THE SCHWAN FOOD COMPANY Hugh Pforsich College of Business Administration California State University - Sacramento Sacramento, California USA Bonita K. Peterson Kramer College of Business Montana State University Bozeman, Montana USA G. Randolph Just* ABSTRACT An effective internal audit department adds value to its organization in numerous ways. It helps the organization to achieve its objectives, improves risk management, strengthens internal controls, and enhances overall corporate governance. This case describes the steps that The Schwan Food Company took to establish its internal audit department, including finding a highly qualified chief audit executive, defining the internal audit department’s mission, developing the audit charter, staffing the department, creating an overall audit strategy, and assessing the department’s effectiveness. The exhibits provided in this case are used with permission straight from the company’s files, and all the information in this case is factual. The case is appropriate for an auditing class or an internal audit class at the senior or graduate level. 2 Pforsich, Kramer, and Just BACKGROUND T he Schwan Food Company began in 1952 with one man and one truck. Marvin Schwan, the founder, was the son of German immigrants who came to the United States in 1920. He and his parents ran a creamery in Marshall, Minnesota, but were having trouble making ends meet. Marvin discovered that because of government pricing structures, he could sell ice cream for a few cents more in Yellow Medicine County, immediately north of Marshall. On March 18, 1952, he borrowed some dry ice bags and headed north in his used 1946 Dodge panel van with 14 gallons of ice cream. He knocked on farmhouse doors and sold all the ice cream. The next day he did the same thing again. Now, five decades later, The Schwan Food Company has gone from one man and one truck to 6,500 drivers in the Home Service business unit, and home delivery constitutes approximately 40 percent of the company’s total revenues. The pale yellow trucks that the delivery people drive are the most recognized components of The Schwan Food Company’s brand. Officially, the color is called “Inca Gold,” and it was supposedly the founder’s favorite color. “I think the legend is that he had a favorite tie with that color,” explains Mike Gunderson, manager of corporate communications for The Schwan Food Company. Examples of home delivery items are listed in Exhibit 1. In addition to home delivery, The Schwan Food Company’s primary business units have grown to include its Global Consumer Brands unit and its Food Services group. The Global Consumer Brands unit manufactures, markets, and delivers frozen foods to grocery, warehouse, club, and convenience stores across the country. The Food Services group manufactures, markets, and distributes value-added frozen food products to public and private schools, universities, healthcare facilities, convenience stores, and chain restaurants. Today, The Schwan Food EXHIBIT 1 Examples of The Schwan Food Company’s Home Delivery Items* Mini Deep Dish Cheese Pizza: 6 trays of 4 for $9.99 Oven Ready Breaded Shrimp: 1.5 pound bag for $12.99 Chicken Egg Rolls: 16 2-ounce portions for $11.99 Chicken and Broccoli Express Bowl: 2 12-ounce bowls for $7.49 Apple Cinnamon Flavored French Toast Sticks: Approx. 40 sticks for $6.79 Cheese and Herb Biscuits: 18 biscuits for $5.99 Stuffed Potatoes: 8 5-ounce portions for $8.99 Creamy, Rich Vanilla-Flavored Premium Ice Cream: half gallon for $5.69 Vanilla Sundae Cone: 24-count box for $12.99 *A complete list of home delivery items is available at www.schwans.com. http://www.schwans.com Establishing an Internal Audit Department 3 Company’s workforce consists of approximately 24,000 people, and grosses $3.5 billion in annual sales. IMPETUS FOR CHANGE At The Schwan Food Company, the establishment of an internal audit department (IAD) was driven by personnel changes at the top executive levels. The first non-family-member CEO, M. Lenny Pippin, came on board with nearly 30 years experience in the food industry. At about the same time, David Kidwell, Dean of the Carlson School of Management at the University of Minnesota, began his service as the new audit committee chairman. Three years later, Tracy Burr, formerly a partner at Ernst & Young as well as at Deloitte & Touche, was hired as the new CFO. This new leadership helped the company to slowly make changes, such as an improved governance structure with the establishment of an IAD, but at the same time allowed it to retain the positive aspects of the company’s corporate culture, including a high standard of ethics, values, and hard work. Thus, the creation of the IAD was part of a company-wide effort to improve the control and governance structures for a privately-held, but global, company that has the goal to double its size in five years. FINDING A CHIEF AUDIT EXECUTIVE The formation of The Schwan Food Company’s IAD began when, after conducting a regional and national search through a recruiting firm, the management team hired G. Randolph Just as the Chief Audit Executive (CAE) who brought with him extensive Big Four public accounting and internal auditing experience. Coincidentally, Mr. Just grew up on a farm only 24 miles north of The Schwan Food Company’s headquarters in Minnesota, although he had no formal relationship with the company until his hiring. The well-known yellow delivery truck came to his farmhouse every week. “It was a great event for a kid on a farm to have this truck pull up full of pizza and ice cream. It was a wonderful thing!” he says. “I remember, as a young boy, having a toy truck and making roads around the farmyard, pretending that I was a Schwan route driver making stops throughout the countryside. I even drew a duckling on the Schwan truck! I always admired the company. So when the opportunity arose to join Schwan, I eagerly accepted.” DEFINING THE INTERNAL AUDIT DEPARTMENT’S MISSION One of Just’s first tasks as the new CAE was to develop the IAD’s mission statement. The new CAE chose the following mission statement for the IAD which is almost verbatim from the Institute of Internal Auditors’ (IIA) definition of the internal auditing function: “To provide independent, objective assurance services designed to add value and improve The Schwan Food Company’s operations. The internal audit department helps the organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of the overall control environment and the network of enterprise business risk management control and governance processes.” The Schwan Food Company’s overall mission, or defining goal, is that the company “will be the biggest, the best and the strongest provider of frozen food solutions on the face of the earth.” 4 Pforsich, Kramer, and Just More specifically, its core purpose is “to enrich the quality of lives through our food solutions.” Thus, the IAD’s newly defined mission corresponds with The Schwan Food Company’s overall mission in that the department exists to help the company reach its goals and achieve its business objectives in an ethical, legal, and well-governed manner. This mission is accomplished by helping to improve controls, business processes, and business risk management. DEVELOPING AN AUDIT CHARTER Crucial to the establishment of an IAD is the development of its written charter. The charter states the purpose, authority, and responsibility of the internal audit activity and establishes what senior management and the board of directors expect from the CAE and the internal audit staff. The Institute of Internal Auditors has developed International Standards for the Professional Practice of Internal Auditing, which begin with attribute standards, or standards that address the characteristics of organizations and parties performing internal audit activities. The first attribute standard states, “The purpose, authority, and responsibility of the internal audit activity should be formally defined in a charter, consistent with the Standards, and approved by the board.” A charter, which should be approved by the audit committee on behalf of the board of directors, is critical for sending the message throughout the organization that internal auditing is viewed as a priority and has the endorsement of both executive management and the audit committee. In addition to specifying the department’s mission statement, the charter should also clearly establish the independence of the department. It is critical that internal auditors be organizationally independent of management in order to enhance their effectiveness. This independence allows the auditors to perform their work objectively and without bias or concern that they will be unduly influenced by management on audit issues. The reporting relationships in The Schwan Food Company’s IAD are illustrated in Exhibit 2. EXHIBIT 2 Reporting Relationships for The Schwan Food Company’s Internal Audit Department* *A solid line indicates a direct reporting relationship, while a dotted line indicates an advisory reporting relationship. CFO (Tracy Burr) Internal Audit Department (CAE, G. Randolph Just) Audit Committee (Chair, David Kidwell) Establishing an Internal Audit Department 5 The CAE reports directly to the CFO for administrative purposes. For purposes of governance, an advisory relationship is established between the IAD and the audit committee of the board of directors. These relationships, however, whether direct reporting or advisory, are flexible, depending on the management styles of individual managers. At present, The Schwan Food Company’s audit committee chairman is very much a “hands on” chairman and views his relationship with the department to be as direct as the CFO relationship. The audit charter protects the IAD’s independence by ensuring full access by the CAE to the audit committee and protecting the CAE from removal without the approval of the audit committee. In addition, the charter of the The Schwan Food Company’s audit committee establishes that the IAD is accountable to the board of directors through the audit committee. The Schwan Food Company’s IAD charter is shown in Exhibit 3. The Schwan Food Company’s external auditor performed an analysis of the initial staffing level requirements for the IAD. Based on auditor recommendations, the audit committee and senior management decided to staff the department with 10 internal auditors supported by an annual budget allocation of approximately $1.63 million, although the size of the function is expected to increase as the company grows. Ideally, the CAE wanted people at the senior and manager level with public accounting experience, as well as internal auditing work in industry. At the entry staff level, the CAE recognized that it was not possible to find people with that combination of experience. As a result, the IAD was staffed with a fairly broad-based assortment of expertise in financial, operational, compliance, and information systems auditing. STAFFING Initially, the greatest challenge faced by The Schwan Food Company in staffing its new department was convincing qualified people to relocate to corporate headquarters in Marshall, Minnesota – a community that is a three-hour drive from Minneapolis and with a population of approximately 12,000. While this is an attractive community for individuals with a family-based lifestyle, it was a hurdle to overcome in seeking to completely staff a new department. The company used industry contacts to recruit staff, in addition to receiving assistance from outside recruiting organizations. Within a few months, the company was able to fill all of its internal audit positions. DEPARTMENT’S OVERALL STRATEGY With the staffing completed, the CAE then worked with two of his audit managers in developing an appropriate overall strategy for the IAD. To determine the scope of the department’s services, they decided to use: 1) a risk-based assessment methodology that is tied to the Committee of Sponsoring Organizations of the Treadway Commission (COSO) internal control framework and 2) a consumer products business process model that the CAE had previously used when he worked for KPMG LLP. The consumer products business model describes how a company translates strategic objectives into business goals, processes and tactics to achieve those objectives. The model presented in Exhibit 4 outlines the following factors: First, External Business Drivers and Stakeholders, which are the outside factors and pressures that can prevent an entity from attaining its objectives. These may include the political and legal environment, actions of competitors, customers, trade regulations and others. The next factor is the set of various Markets that are relevant to the company’s business. Finally, the Business http://bryant1.bryant.edu/~gpae/Vol5/Internal_Audit/Exhibit4.doc 6 Pforsich, Kramer, and Just EXHIBIT 3 The Schwan Food Company Internal Audit Services Charter PURPOSE The purpose of The Schwan Food Company’s Audit Services department is to provide independent, objective assurance services designed to add value and improve the organization's operations. It helps the organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of the overall control environment and the network of enterprise business risk management, control, and governance processes. SCOPE OF WORK The scope of work of The Schwan Food Company’s Audit Services department is to determine whether the organization’s network of enterprise business risk management, control (including reporting and disclosure controls), and governance processes, as designed and represented by management, is adequate and functioning in a manner to ensure: • Risks are appropriately identified and managed. • Interaction with the various governance groups occurs as needed. • Significant financial, managerial, and operating information is complete, accurate, reliable, and timely. • Employees’ actions are in compliance with policies, standards, procedures, and applicable laws and regulations. • Resources are acquired economically, used efficiently, and adequately protected. • Programs, plans, and objectives are achieved. • Quality and continuous improvement are fostered in the organization’s control processes. • Significant legislative or regulatory issues impacting the organization are recognized and addressed appropriately. Opportunities for improving management control, profitability, and the organization’s image may be identified during audits. They will be communicated to the appropriate level of management. INDEPENDENCE To provide independence, the reporting relationships, authority and responsibility of The Schwan Food Company’s Audit Services department are established by the Audit Committee on behalf of the Board of Directors. The chief audit executive reports to the chief financial officer for administrative purposes and also has full and independent access to the chief executive officer and the Audit Committee. Personnel in The Schwan Food Company’s Audit Services department report to the chief audit executive. The approval of the Audit Committee is required for the removal or replacement of the chief audit executive. It is the policy of the Audit Committee to devote a portion of each meeting to an executive session at which only the chief audit executive is present. In at least two meetings per year, outside director members of the Audit Committee shall consult privately with (continued) Establishing an Internal Audit Department 7 EXHIBIT 3 (continued) the external auditors and with the chief audit executive and report the results of the private consultations to the Board of Directors. In addition, the senior internal audit executive will have opportunity to meet with independent directors on the Audit Committee at each committee meeting. ACCOUNTABILITY The chief audit executive, in the discharge of his duties, shall be accountable to management and the audit committee to: • Provide annually an assessment on the adequacy and effectiveness of the organization’s processes for controlling its activities and managing its risks in the areas set forth under the purpose and scope of work. • Report significant issues related to the processes for controlling the activities of the organization and its affiliates, including potential improvements to those processes, and provide information concerning such issues through resolution. • Periodically provide information on the status and results of the annual internal audit plan and the sufficiency of department resources. • Coordinate with and provide oversight of other control and monitoring committees and functions (for example, enterprise risk management, controllership, treasury, governance, finance, disclosure, ethics and quality committees; risk management, quality assurance, regulatory compliance, security, legal, environmental, and external audit functions). RESPONSIBILITY The chief audit executive and staff of The Schwan Food Company’s Audit Services department have responsibility to: • Develop a flexible annual internal audit plan using an appropriate risk-based methodology, including any risks or control concerns identified by management, and submit that plan to the audit committee for review and approval as well as periodic updates. • Implement the annual internal audit plan, as approved, including as appropriate any special tasks or projects requested by management and the audit committee. • Maintain a professional audit staff with sufficient knowledge, skills, experience, and professional certifications to meet the requirements of this Charter. • Evaluate and assess significant merging/consolidating functions and new or changing services, processes, operations, and control processes coincident with their development, implementation, and/or expansion. • Issue periodic reports to the audit committee and management summarizing results of audit activities, including significant audit issues and management action plans. • Keep the audit committee informed of emerging trends and successful practices in internal auditing. (continued) 8 Pforsich, Kramer, and Just EXHIBIT 3 (continued) • Provide a list of significant measurement goals and results to the audit committee. • Assist in the investigation of significant suspected fraudulent activities within the organization and notify management, the external auditors and the audit committee of the results. • Consider the scope of work of the external auditors and regulators, as appropriate, for the purpose of providing optimal audit coverage to the organization at a reasonable overall cost. AUTHORITY The chief audit executive and staff of The Schwan Food Company’s Audit Services department are authorized to: • Have unrestricted access to all functions, records, property, and personnel. • Have full and free access to the audit committee. • Allocate resources, set frequencies, select subjects, determine scopes of work, and apply the techniques required to accomplish audit objectives. • Obtain the necessary assistance of personnel in units of the organization where they perform audits, as well as other specialized services from within or outside the organization. The chief audit executive and staff of The Schwan Food Company’s Audit Services department are not authorized to: • Perform any operational duties for the organization or its affiliates. • Initiate or approve accounting transactions external to The Schwan Food Company’s Audit Services department. • Direct the activities of any organization employee not employed by The Schwan Food Company’s Audit Services department, except to the extent such employees have been appropriately assigned to auditing teams or to otherwise assist internal auditors. STANDARDS OF AUDIT PRACTICE The Schwan Food Company’s Audit Services department will meet or exceed the Standards for the Professional Practice of Internal Auditing of The Institute of Internal Auditors. _________________________________ _________________________________ Chief Audit Executive Chief Executive Officer ________________________________ Audit Committee Chairman Processes define how work is done in the company and how outputs of one process become the inputs of the next. Business processes are broken down into three sections: Establishing an Internal Audit Department 9 1. The Strategic Management Process, which defines the company’s mission and objectives, as well as the risks that threaten the objectives, and establishes processes to monitor and manage those risks and achieve the objectives; 2. Core Business Processes, which develop, produce, sell and distribute the company’s products; 3. Resource Management Processes, which support the other processes. These include functions such as human resources, information technology, accounting and others. Included in the overall consumer products business model are lists of the company’s Alliances, Core Services/Products, and Potential Customers. As part of this risk assessment methodology, the CAE reviews the strategic plans of the company and all the business units. The department’s efforts are then targeted toward the key areas and objectives upon which the company and each of the business units are focusing. To accomplish this objective, the auditors meet with executives at the various business units and walk through a questionnaire that they have developed as part of the risk-based assessment approach (see Exhibit 5 for the questionnaire and the particular business risks and factors discussed). EXHIBIT 5 Business Risk Assessment Interview Topics The following questions and topics are intended as an overview of the type of discussion we would like to foster through our risk assessment interview process. Please use this information as a guide for our discussion. It does not have to be filled out in advance. Overview 1) Discuss business strategies for your area of responsibility. 2) Discuss key business processes performed within your area of responsibility. 3) Discuss key business initiatives: current, upcoming, and/or ongoing. Risks 1) What business risks do you see within your area? (See attached list of potential business risk factors.) 2) Can you estimate the likelihood of these risks occurring? (Example: high – very likely this will happen; medium; low) 3) Can you estimate the impact of these risks? (Example: high impact; medium; low) 4) Do you have a process for measuring and identifying these risks? Controls 1) Briefly describe what controls are in place to protect against these risks. Other Items 1) Do you have other areas of concern outside your immediate responsibilities? (continue) 10 Pforsich, Kramer, and Just EXHIBIT 5 (continued) Business Risk Categories and Risk Factors (for discussion) Risk Category Risk Factors External Environment • competition • industry • financial markets • owner relations • political • business interruption • regulatory Control Environment • support • legal • measurements • strategic Infrastructure • leadership • information management • human resources Marketing & Selling • product branding • product development • satisfaction • products • services • marketing • competition • distribution channels Supply Chain • purchasing • raw material management • cost • vendor management Liquidity • cash flow • exchange rates • assets • taxation • cost of capital • funding requirements Operations • processes • finished product management • production cycle • contingency planning • capacity • incentives Next, the CAE weighs and prioritizes potential projects across all the business units, while giving consideration to the volume of their activities and their importance to the company’s overall strategic plan (see Exhibit 6 for a graphical representation of an overview of the risk assessment objectives, process, and results). RISK-BASED METHODOLOGY The risk assessment framework closely incorporates the concepts of risk and control. The Schwan Food Company establishes business objectives at all levels of the company, from the corporate level down through each business unit. To achieve these objectives, the company puts in place core business processes, which are groupings of related business activities (e.g., procure materials, manufacture products, distribute products, sell products, serve customers). The core business practices are upheld by support processes that provide resources and services to the core business processes. Risks threaten the achievement of business objectives at all levels, while Establishing an Internal Audit Department 11 EXHIBIT 6 Risk Assessment Overview Objectives Identify business risks and controls (operational, financial reporting, and compliance) Measure and prioritize the identified risks Obtain management consensus Process Focused interviews with multiple levels of management Review of business plan Analysis of financial and operational reports and other company information Review of audit reports, management letters, industry information and other items Results Risk profile: A profile of key business risks by business unit, key business objectives, and core business processes - ranked Risk Treatments: An initial set of recommendations for management consideration arising from the risk assessment process Internal Audit Plan: A proposed set of audits for the coming year, focusing on areas of risk most appropriate for internal audit to address and key controls that should be tested controls are the activities Schwan puts into place to manage or mitigate the risks. Controls are often built into the core business processes and support processes (see Exhibit 7 for a graphical representation of the risk assessment framework). Within each process, the internal audit personnel assess gross risk (threats or impediments to the accomplishment of corporate or process objectives), the strength of relevant controls and of management’s response to the identified risks, and residual risk (a re-evaluation of risk in light of controls and management’s response). At the end of this process, residual risks are compared to gross risks for reasonableness. See Exhibit 8 for a graphical representation of this risk assessment. The risks are rated based on the magnitude of the impact to the organization of the risk occurring, as well as on the probability of occurrence. Residual risk assessments are conducted through focused interviews with multiple levels of management, a review of business plans, analysis of financial and operational reports, and a review of miscellaneous information (e.g., industry information, process documentation, etc.). For validation, the assessment results are discussed with the appropriate levels of management. http://bryant1.bryant.edu/~gpae/Vol5/Internal_Audit/Exhibit8.doc 12 Pforsich, Kramer, and Just EXHIBIT 7 Risk Assessment Framework RISKS RISKS RISKS RISKS For example, at The Schwan Food Company food quality and food safety are two areas of continual vigilance. The internal audit personnel will assess a gross risk of raw materials contamination at a certain level, but to control this very serious risk, every single batch of raw materials or product that comes into The Schwan Food Company’s factories is tested for contamination. As a result of these very stringent controls that are in place, the residual risk is assessed as extremely low. For additional examples of residual risk ratings, see Exhibit 9. Those business functions or processes with residual risk above a certain level are considered candidates for potential internal audit projects. The first question, however, is what expertise or resources are needed to best address the residual risk. Can management address the risk directly without an intervening internal audit project? In some cases, risks identified during the assessment process can be directly addressed by management. In other cases, either the legal department, the compliance department, or the external auditors, may be the most appropriate resource. Those functions or processes most appropriately addressed by the IAD are entered into the internal audit plan. That plan is reviewed with senior and business unit …