No. 1, 2006


Oil of Russia magazine talks to Vagit Sharifov, Vice-President and Head of Control and Internal Audit Main Department of JSC LUKOIL

LUKOIL was one of the first Russian companies to start implementing a modern corporate governance system, similar to that used by many foreign companies, with internal audit procedures as an essential component. Despite some early stage organizational and technical difficulties, today one can state with certainty that the LUKOIL Group has a comprehensive internal audit system in place, and it is up and running.

Q: Mr. Vice-President, why did LUKOIL have to set up an internal audit system?

A: One of the principal reasons that caused LUKOIL to commence reforming its management and set up an effective internal audit system was the desire to operate according to the highest international standards. That has always been LUKOIL's strategy. The company seeks to be an equal partner to leading international petroleum companies and a reputable player in the world market, as well as to build international economic partnerships. To accomplish those goals, one has to know and follow the rules of the world market.

More specifically, the LUKOIL Group had to set up an internal audit system to comply with the requirements for companies trading their shares at international stock exchanges, including the London Stock Exchange. Sometimes, one can read in the press that international business activities are spontaneous and non-regulated. Well, that's not true. The world market operates according to certain laws that have evolved and been refined over decades. The requirement to set up an internal audit system is prescribed by a number of important regulations, such as the Combined Code on Corporate Governance, the London Stock Exchange Listing Rules, and many other rules and standards existing in the international stock market. The requirement is reasonable and justified, and ultimately it benefits the company. The existence of an internal audit system graphically illustrates the company's transparency, which builds shareholders confidence and, consequently, increases the share price.

However, stock exchange requirements are just one of the reasons. In fact, an internal audit service that is part of the internal control system is a multi-purpose tool. The functions of LUKOIL's internal audit service are not limited to auditing subsidiaries' operations and recommending measures to remedy defects. It is just as important to follow up on implementation, assess managers' performance in minimizing risks identified by internal auditors, and adjust corrective measures based on re-audits. So in our work internal auditing closely combines with internal controls, and audits are indispensably followed by implementation checks on decisions made by management pursuant to auditors' recommendations.

To ensure effective risk management, LUKOIL Group's internal auditors constantly monitor implementation of organizational and managerial orders. That function provides the corporate management with hands-on information on the complex holding structure and supervises implementation by LUKOIL Group organizations of management decisions resulting from previous audits. The corporate internal audit service, with its diversity of functions, contributes a lot to the effectiveness of corporate controls, which is extremely important for an organization like LUKOIL.

Q: How much foreign experience did LUKOIL use in building its internal audit system?

A: To be competitive in international markets, on a par with the leading international vertically integrated gas and petroleum companies, LUKOIL had to have a corporate management system in line with the generally accepted criteria, one of which is having an effective internal audit system. Therefore, the company had to move fast through all the stages of developing an internal audit system, a process which had taken leading international companies decades to build. Oil giants like Royal Dutch/Shell or British Petroleum started building internal audit systems some 40 years ago.

The task that faced LUKOIL was just as huge, but we had much less time and resources for doing the job.

Q: How and where did LUKOIL get auditors?

A: Most of them are LUKOIL employees with highest professional skills, who worked in various departments and units and had to be hand-picked. We also had to have people with strong learning skills, capable of development, moving into new fields of professional activities, and handling tasks new to them. The backbone of the corporate internal audit service personnel was provided by experienced and skilled specialists from finance and economics, as well as from engineering and operations sectors.

From the very outset, the internal audit service became active in upgrading skills of its personnel, implementing training and development programs on an on-going basis. Personnel development also benefits from the specialist exchange program we are implementing with our new strategic partner, ConocoPhillips.

Q: The Internal Audit Service had a predecessor a Control and Analysis Department. Did you use any of its experience?

A: The internal audit system as it exists today has been established in a phased process. Since early 2001, LUKOIL had a Control and Analysis Department, which performed a limited range of functions, some of them duplicated by other units in the holding company. It became obvious that for the corporate audit function to be effective, all the auditing powers had to be centralized and assigned to a single unit. Therefore, the LUKOIL Management Board passed an official decision in late 2001 to conduct a substantial transformation of the corporate control and supervision function and to set up an internal audit system as part of that function. In early 2002, in accordance with an order by the President of LUKOIL, the Control and Analysis Department and the Financial Control Main Department were reorganized into an Internal Audit Department, which comprised more than 50 experienced employees from LUKOIL. But most importantly, the Department was given a broader mandate, not only to conduct internal audits, but also to perform the entire range of auditing and consulting functions. The Department reports directly to President Vagit Alekperov.

The development of a full-fledged organizational structure was completed in December 2002, when the Department was transformed into a Control and Internal Audit Main Department. The new Main Department had many more functions to perform than its predecessor, the Control and Analysis Department, but it had more powers, too. The internal auditors work not only with the company's structural units, but also with its affiliates and their divisions and operating units.

The establishment of a single corporate auditing service was part of a wide-ranging restructuring, which affected just about every unit of LUKOIL and every area of its activities, for the purpose of defining responsibilities more clearly and optimizing the management system in accordance with the new economic reality and market requirements.

Q: LUKOIL has operations all over Russia and in several other countries. How does the executive management control and supervise all those units and operations?

A: Well, it was not easy at the beginning. We had to cover several major areas at once: organizational work, development of standards and methodologies and, at the same time, performance of full audits of LUKOIL Group subsidiaries. Information gathered during the initial period was then integrated, analyzed, and used as a basis for developing corporate methodologies for performing internal control and audit functions. Later, when the system was in place and operating, everything worked as intended. We work according to a clear-cut plan approved by the President of LUKOIL. The department audits up to 30 subsidiaries every year. The audit reports provide a comprehensive picture of the operations of the affiliates audited, highlighting any deviations from corporate, industry, and process rules and standards.

Organizationally, our service has a special place, all by itself, but it closely cooperates with all the units and organizations of LUKOIL, external partners, and government supervisory bodies. Such diversity of contacts is one of the factors promoting our high performance. We operate in close interaction with company units, continuously exchanging information about risks identified and risk assessment and management methods used. Units' information about major risks in specific business areas and their recommendations on subjects of audits are widely used in planning our work. Internal auditors' recommendations based on summarizing and analyzing audit results are taken into account in improving corporate regulations and developing programs to raise the effectiveness of internal controls. Implementing such recommendations improves planning and cost accounting, sets uniform investment efficiency evaluation rules and criteria. In the long run, all that enhances internal controls and mitigates the risks of financial losses for the entire LUKOIL Group.

Q: The experience of the Soviet command economy shows that total supervision has its benefits, but also clear risks too much red tape and unwieldy bureaucracy. How does LUKOIL address the problem?

A: We try to make use of the positive elements of managerial experience gained in this country and in other countries. So we focus on efficiency of the system, rather than system's size. The LUKOIL Group's current system of internal controls is large and sophisticated in terms of organization, but it does not comprise cumbersome multiple control levels or restrict the operations of structural units or affiliates. In fact, the system enables managers of all levels to run LUKOIL units and organizations more efficiently by using internal control and audit capabilities.

As the Company's management system is transformed in accordance with international standards, this certainly affects the organization of the internal audit function. We adjust our work in accordance with LUKOIL's needs and objectives. This has enabled the internal audit service to implement interventions required by annual plans and the LUKOIL President's management orders in a timely and efficient manner, since its very outset. Its employees promptly identify risks in various business areas and help to develop effective managerial solutions to minimize those risks.

It should be pointed out that the LUKOIL Group's internal control and audit system continues to develop; in fact, the process essentially means constant progress and on-going improvement. It involves creative work to design unique methodologies suited to the Russian environment and LUKOIL's needs. So we continue to work hard to bring the corporate audit system into accordance with the generally accepted international business rules. But even today, the corporate control and internal audit service provides convincing evidence that such system can be an effective tool for the company to demonstrate its transparency, successful performance, reliability, and profitability to shareholders and investors.

Vagit Sharifov, PhD, was born on December 29, 1945 in the village of Pantiani (Georgia). After his graduation in 1968 from the Azizbekov Institute for Oil and Gas of Azerbaijan as a production engineer specializing in refining, he began to work at the Yaroslavl petroleum oil pilot production plant. From 1973 to 1981 he worked in the Volgograd petroleum storage depot of the State Committee for Petroleum Products of the RSFSR, rising from Chief Engineer to General Director. From 1988 to 1994, Vagit Sharifov was Chief Engineer and then General Director of the Volgogradnefteprodukt association. In 19951996 he was General Director of the Volgograd affiliate of JSC Finance Company LUKOIL. From 1996 to 2003 Vagit Sharifov was Vice-President and Head of the Petroleum Products Marketing Main Department of JSC LUKOIL. From 2003 he is Vice-President and Head of Control and Internal Audit Main Department of JSC LUKOIL .

Vagit Sharifov is Member of the Russian Academy of Natural Sciences.

He is awarded the Sign of honor and Friendship of peoples orders, state medals and the title of Merited worker of the oil and gas industry of the Russian Federation.

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Oil of Russia, No. 1, 2006
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