The Role of Internal Auditors in the Corporate Governance Framework - Essay Example

The Role of Internal Auditors in the Corporate Governance Framework 1. Introduction The control of business operations can be one of the most challenging organizational activities especially due to the following fact: each business, as part of a country’s economic framework, is obliged to follow a series of rules. These rules tend to change periodically under the influence of global economic pressures, the local market instability and the changes in priorities set by local governors. In each organization top managers need to ensure that all business activities are aligned with these rules. For achieving this target, managers have to be supported by an appropriately designed mechanism (Fraser and Simkins 2009). Internal auditing, as a framework, has been established for serving the particular organizational need. This study focuses on the role of internal auditors in the corporate governance framework. This issue is explored by referring primarily to corporate governance, as part of modern businesses. Then the role of internal auditors in corporate governance is analyzed taking into consideration the following fact: in each business the tasks developed by internal auditors may be differentiated. Still, the power of internal auditors to check business processes is standardized; internal auditors have access to all business operations, meaning that the full authorization of the auditors by the top management is considered as guaranteed (Rittenberg et al. 2011). However, despite the fact that the role of internal auditors is closely related to Corporate Governance, the involvement of the auditors in the activities and data of firms is often not welcomed, a phenomenon resulted from certain events, as analyzed below (Cascarino 2007). On the other hand, the accountability of internal auditors for the tasks assigned to them is full; this means that failures and mistakes while performing the internal auditing can lead to severe consequences for the auditors even if the latter have taken all appropriate measures for avoiding such outcome (Ridley 2008). These issues are discussed below with reference to the literature that has been published in this field. It is proved that internal auditing is a complex process and for this reason the evaluation of its performance can be a difficult task, especially in countries where the regulatory framework for businesses is unclear. 2. Internal Auditors in Corporate Governance 2.1 Corporate governance – overview The term ‘corporate governance’ is quite broad. Indeed, in a relevant definition the term ‘is defined as the total of operations and controls of an organization’ (Fama and Jensen 1983, in Karagiorgos et al. 2010, p.17). Through another approach, the term can be used for showing the rules on which business plans and business operations are based (Karagiorgos et al. 2010). According to the above view the Corporate Governance is a key tool for securing the respect of ethics within organizations. Indeed, the rules of Corporate Governance are highly based on ethics, as held in the market and in the society (Fernando 2010). This means that by aligning fully its operations with the rules of Corporate Governance an organization performs high in terms of ethical standards; otherwise, the violation of ethics, in regard to one or more aspects of business activities, is quite possible (Cohen and Sayag 2010). The relationship between Corporate Governance and ethics is highlighted in the study of Kilikaa and Mutua (2013). In the above study it is explained that the term of Corporate Governance is broader than Governance itself. Governance, as a concept, can refer just to the use of an organization’s assets for securing the interests of shareholders. Instead, Corporate Governance is a concept denoting the obligation of each organization to plan its administration/ management based on ‘fairness, transparency and efficiency’ (Kilikaa and Mutua 2013, p.34). The Corporate Governance, as a process, requires the participation of specific organizational groups, such as: top managers, secretaries in various business departments, managers at lower levels of the organizational hierarchy and auditors, both internal and external (Kilikaa and Mutua 2013, p.36). According to the above, internal auditors participate actively in the development of activities incorporated in Corporate Governance; it is for this reason that the choice of persons that will constitute the Internal Auditing team of an organization is a critical task (Kilikaa and Mutua 2013, p.36). Enron is an example; the failure in choosing appropriate internal auditors in Enron led the organization to severe failures, a fact that severely affected the interests of all stakeholders (Kilikaa and Mutua 2013). 2.2 Internal Auditors in Corporate Governance – role 2.2.1 Internal Auditing – elements of the concept Internal auditing is a term used for describing the ‘independent appraisal function, established within an organization to examine and evaluate its activities’ (Karagiorgos et al. 2010, p.16). In addition, it has been noted that internal audit should primarily focus on the control of a business but it should be also involved in the evaluation and management of risk related to all business activities (Karagiorgos et al. 2010). Trough the decades internal auditing, as a process, has been transformed. Initially, i.e. around 1970s, internal auditing was limited to control of business operations (D’Silva and Ridley 2007). Gradually, the role of internal auditing was expanded, including the intervention in addressing critical business problems and, recently, the cooperation with management for ensuring ‘the achievement of organizational objectives’ (D’Silva and Ridley 2007, p.116). The last type of internal auditing is also known as the ‘participative teamwork approach’ (D’Silva and Ridley 2007, p.116) and is based on the idea that a business would be more able to follow strictly the rules and principles of Corporate Governance when its operations are well planned and carefully monitored, as of all their phases (D’Silva and Ridley 2007). Today, the pressures in industries are quite strong, under the influence of continuously increasing competition but also because of financial crisis in global markets (Tricker and Tricker 2012). In such environment, internal audit needs to be periodically updated so that it is able to meet the increased needs of organizations in terms of the threats they have to face from their external environment (Morris et al. 2009). An effective internal control is able to increase an organization’s integrity, a fact that limits risks and failures. Indeed, according to Suyono and Hariyanto (2012) internal auditing, as a process, serves a variety of needs, such as the protection of the organization’s assets, the verification of the validity of information used across the organization, the guarantee of high performance of various organizational departments and the alignment of all business operations with ethics and law (Suyono and Hariyanto 2012). 2.2.2 The choice and role of internal auditors The appointment of internal auditors for the development of controlling tasks in organizations is based on ‘the principal agent theory’ (Anderson et al. 1993 in Eulerich et al 2013, p.57). This theory requires the existence of ‘both a principal and an agent’ (Anderson et al. 1993 in Eulerich et al. 2013, p.57). When having to appoint internal auditors an organization’s top management team, usually the Board of Directors, has two options: a) it can either appoint a team of executives or b) it can assign this task to the Board of Directors (Eulerich et al. 2013). In both cases, supervision is secured, i.e. there is a principal, while associates can be chosen for completing certain tasks; in the last case, the organizational body that assigned internal control tasks to associates acts as an agent (Eulerich et al. 2013). The system used for the appointment of internal auditors has been often criticized as of its credibility; due to the involvement in the process both of ‘managers and of shareholders a conflict of interests may appear’ (Eulerich et al. 2013, p.58). In any case, in each organization, internal auditors are chosen using specific criteria. Apart from their professional qualifications and experience, internal auditors need to align their practices with the rules set by the relevant professional body, the ‘Institute of Internal Auditors, IIA’ (Stewart and O’Leary 2007, p.4). The institute has developed a Code where the rules/ ethics related to the specific profession are incorporated (Stewart and O’Leary 2007). The Code ensures that internal auditing process is ethical; in this way, the above process helps to promote ‘integrity and ethics within organizations’ (Stewart and O’Leary 2007, p.5). It should be noted that although internal auditors are obliged to promote ethics, their willingness to do so may be reduced under the negative influence of the business environment. For example, in a study developed by Stewart and O’Leary (2007) internal auditors, about 66, were asked to state their view in regard ‘to their potential response to five ethical dilemmas related to specific business activities’ (Stewart and O’Leary 2007, p.2). The results of the study revealed that most internal auditors support the promotion of ethics but when having to face a situation where ethics are violated their response is not always dynamic, under ‘the fear that their peers might not behave ethically’ (Stewart and O’Leary 2007, p.19). On the other hand, the role of internal auditors can be differentiated between organizations of the public sector and those of the private sector. In public organizations emphasis internal auditing is influenced by the following factors: a) the activities of these organizations are fully aligned with specific legislative rules; in other words, public organizations need to have specific structure and activities, as described in the legislative texts through which these organizations were established (Cohen and Sayag 2010) and b) in public organizations profit is not set as a priority; rather emphasis is given ‘to the quality of services provided to the public’ (Cohen and Sayag 2010, p.298). In opposition, private organizations are structured and operate according to the decisions of their owners/ top managers; also, in these organizations profit is the priority so costs and risks need to be carefully checked and evaluated in order to take any critical decision (Cohen and Sayag 2010). From a different point of view, Bortolon et al. (2013) supported that when having to choice internal auditors top managers should take into consideration the following fact: the compensation of these auditors is likely to be at average levels, usually at same levels with the organization’s supervisory managers. Moreover, if these individuals would work as independent consultants, their compensation would be quite higher (Bortolon et al. 2013). This means that the level of compensation given to internal auditors should be kept high, so that there are no incentives for finishing the relevant project fast or for altering figures under the promise of extra bonuses (Bortolon et al. 2013). 2.2.3 Internal Auditing and Corporate Governance In order to understand the role of internal auditors in the Corporate Governance framework it is necessary to understand the relationship ‘between the internal auditing and each of the elements of Corporate Governance’ (Karagiorgos et al. 2010, p.18). Reference should be primarily made to the Board of Directors. The Board is a key part of Corporate Governance since it is this Board that monitors the alignment of business activities with the rules of Corporate Governance; in addition, the Board has a critical role in setting the rules that will be incorporate in the Corporate Governance framework of the organization (Karagiorgos et al. 2010). Internal auditors provide to the Board of Directors the information that the Board requires for checking business performance (Karagiorgos et al.2010). In addition, internal auditors are likely to support the Board while checking its own performance in regard to the control of the business (Karagiorgos et al. 2010). It should be noted here that the provision of information by internal auditors to top managers and the Board of each business is a key part of internal auditing, as a function (D’Silva and Ridley 2007). The term ‘information’ in the above case, includes figures and statistics related to the performance of various business departments but also reports prepared by internal auditors in regard to the current status of business and its perspectives/ challenges in the future (D’Silva and Ridley 2007). Another element of the Corporate Governance that can be used for evaluating the role of internal auditors is the checking of financial statements and the production of relevant reports (Schartmann 2007). In organizations where the control of the business activities has been assigned to internal auditors, transparency is higher and the phenomena of corruption are limited. This view can be based on the findings of the study of Mansor et al. (2013). The above researchers developed a research among Indian enterprises; the enterprises chosen were of two types: family owned and non-family owned. In the first category, the lack of a corporate governance framework and of internal auditors led to the excessive use of Earnings Management (EM) techniques (Mansor et al. 2013, p.221). These techniques are used for alternating the figures representing the profits of a business; in this way, shareholders are not aware of the actual status of the business, in terms of its performance (Mansor et al. 2013). Moreover, in the non-family owned firms where a Corporate Governance scheme was established, as supported by internal auditors, the use of EM techniques was quite limited (Mansor et al. 2013). Through the above example, the interaction between internal auditing and Corporate Governance for promoting transparency and ethics in organizations is made clear. When evaluating the relationship between Corporate Governance and internal auditing particular reference should be made to financial reporting. According to Bekiaris et al. (2013) non effective systems of financial reporting can lead to severe Corporate Governance failures. This fact was made clear in the case of recent recession; this recession was highly caused because of extensive CG failures, especially in regard to financial reporting (Bekiaris et al. 2013). More specifically, the review of the practices followed by US firms in the pre-recession period led to the following assumption: most of the US firms that were involved in the beginning of the crisis, failed in promoting transparency in regard to their financial reporting (Bekiaris et al. 2013). Indeed, managers at lower level of the organizational hierarchy avoided reporting ‘their managers’ significant oversights’ (Bekiaris et al. 2013, p.57). The lack of educational background for understanding the effects of such activity has been considered as the prior reason of the particular problem (Bekiaris et al. 2013). The above case highlights the risks related to the lack of appropriately skilled internal auditors. These risks can affect the performance of an organization in regard to Corporate Governance. If viewed from the opposite side, the above case shows that the lack of mechanisms for support Corporate Governance can lead an organization to severe failures even if the internal auditors of the organization are highly skilled. The establishment in each organization of mechanisms for supporting the self-assessment of internal auditors (Cascarino 2007) would help to reduce the relevant risks but only if the relevant process would be appropriately planned. The existence of an integrated Internal Control System (Cascarino 2007) would increase the validity of the findings of internal auditing, in regard to all the phases of the process. 3. Conclusion In each organization, the success of internal auditing, as a business activity, cannot be secured. As explained above, internal auditors need to be appropriately skilled, so that they can respond to the demands of their position. In addition, these auditors should be willing to promote ethics, as a key framework for evaluating business activities. Otherwise, they would not be able to promote transparency. At this point, reference should be made to the following fact: internal auditors are not always supported, at least not adequately, by organizational staff (Rezaee 2008). This phenomenon can cause severe delays in the development of internal auditing, a fact that can adversely affect the governance of the organization. Indeed, without having the reports of internal auditors, top managers are not able to address the various business problems; when the report of internal auditors is delivered to the top management team with delay there is, usually, no time for resolving the problem (Davies 2012). In this context, top managers should continuously check the progress of internal auditing and intervene to terminate disputes/ conflicts that cause delays in the process. In other words, the success of internal auditors, as members of an organization, is highly depended on the support offered by other members of the organization and especially by the top management team (Tricker and Tricker 2012). In any case, it has been made clear that internal auditors have a key role in the success of Corporate Governance. Indeed, internal auditors are responsible for two, key, tasks: a) for the control of all business activities and b) for the provision of information in regard to these activities to the organization’s top management. This means that within each organization internal auditors have significant power. Can this fact set an organization in risk? The answer should be positive. It is for this reason that governments worldwide have introduced specific rules for regulating the activities of internal auditing teams. Also, international accounting standards are also used for controlling risks in regard to internal auditing. Still, failures are not avoided. At this point, the following dilemma appears: should current status of internal auditors be updated? Should their powers be decreased? Such attempt would set important barriers in the internal auditing process. Without having fully access to organizational processes internal auditors would not be able to retrieve the data required for assessing the performance of business activities. Therefore, concerns could appear in regard to the credibility of the report produced by the internal auditors and on which all decisions of top management are based. Without this report, the development of Corporate Governance, as a business process, becomes impossible. 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