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Does Incentive-based Compensation for Chief Internal Auditors Impact Objectivity? An External Audit Risk Perspective

Snapshot of Sally Chung

The internal audit function (IAF) is increasingly seen as a key component of corporate governance. Auditing standards emphasize the potential impact of the IAF on the financial statement audit and thus the importance of internal audit objectivity. Our study focuses on a relatively unexamined facet of IAF independence, namely the potentially nefarious effect of incentive-based compensation (IBC) linked to company performance on IAF objectivity. While IBC may align the interest of the IAF to that of shareholders, enhance the productivity and effectiveness, and improve the recruitment and retention of qualified internal auditors, it can also impair IAF objectivity. The internal auditors may be motivated to bias their audit evaluations in order to maximize performance measures and enhance their own personal wealth.

Despite proposed guidance on evaluating internal auditís remuneration policies, there is little empirical evidence on the impact of IBC for internal audit, due in large part to data limitation. Our study fills this void by examining whether external auditors charge higher fees when the IAF receives IBC linked to company performance. If external auditors perceive that IBC is an impairment to IAF objectivity, they may charge higher fees to compensate for perceived higher control risk.

Using a research design that combines both survey and archival methodology to identify whether companies provide IBC to their chief internal auditors, as well as information about the firmsí compensation and audit environments, we find that (1) external auditors charge higher fees when chief internal auditors receive IBC tied to company performance, and (2) external auditors charge higher fees when IBC is paid in stock or stock options as opposed to cash bonuses. We attribute this result to the external auditorsí perception that equity-based compensation provides a greater incentive to engage in self-serving opportunistic behaviors.

Our study provides insight into whether internal audit IBC impacts external audit risk assessments and if so, which types of remuneration might seem more problematic. Our findings have implications for auditors and practitioners seeking to better understand the assessment of IAF objectivity and increase IAF utilization by the external auditor. Professional policy makers could find our study helpful in informing deliberations about best practices and standards for internal auditors. Our study would be of interest to audit committees who are charged with determining the IAF compensation. With respect to the determination of ďappropriate remuneration policy,Ē our results suggest that the use of incentive compensation based upon company performance should be exercised with caution or at least monitored carefully by the audit committee in the context of the firmís overall governance environment.

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