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    Does Incentive-Based Compensation for Chief Internal...
    research summary posted June 22, 2017 by Jennifer M Mueller-Phillips, tagged 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 04.02 Impact of Fees on Decisions by Auditors & Management, 08.11 Reliance on Internal Auditors 
    Does Incentive-Based Compensation for Chief Internal Auditors Impact Objectivity? An External Audit Risk Perspective
    Practical Implications:

    The results of this study suggest that companies who offer incentive-based compensation to chief internal auditors, especially through equity, are more likely to be perceived as having a higher audit risk by external auditors. Consequently, external auditors may charge a higher fee for their services. This study gives a basis for the benefit/cost analysis of providing incentive-based compensation for chief internal auditors. While it is possible internal auditors will respond positively to an IBC and bring extra value to the organization, there is a risk that an external auditor could raise audit fees cancelling out this added benefit.   


    Chen, Lucy Huajing, H. H. Chung, G. F. Peters., and J. P. Wynn. (Jeannie).2017. Does Incentive-Based Compensation for Chief Internal Auditors Impact Objectivity? An External Audit Risk Perspective. Auditing, A Journal of Practice and Theory 36 (21): 21-44

    Incentive-based compensation; internal auditor objectivity; audit fees
    Purpose of the Study:

    The internal audit function (IAF) is increasingly seen as a key component of corporate governance. The extent to which external auditors can rely on information from the IAF depends largely on the internal auditor’s objectivity. The researchers question whether receiving incentive-based compensation (IBC) linked to company performance threatens internal audit employees’ objectivity. Subsequently, this threat would lead to a higher assessment of client audit risk and therefore higher audit fees. The authors also consider whether external auditors view stock- and option-based compensation differently from cash incentives. Finally, the authors examine whether the objectivity threat from IBC depends on the company’s financial reporting risks, alignment of IAF compensation with CEO compensation, and presence of any internal audit outsourcing arrangements.

    Design/Method/ Approach:

    The authors surveyed chief internal auditors of NYSE-listed firms in 2007. The participants were asked to rank the performance measures in order of their emphasis and to indicate the form of IBC payment. By asking survey respondents to provide their company names, the authors could match the financial, audit fee, governance, and incentive data from various databases (Compustat, Audit Analytics, proxy statements, etc.). The final sample included 183 companies. Authors used multivariate regression to analyze their research questions.


    The overall finding is that when a company offers incentive-based compensation to a chief internal auditor, external audit fees increase. This finding suggests that external auditors do consider IBC for chief internal auditors as a threat against objectivity.


    Additionally, the authors find that:

    • External auditors are more likely to charge higher fees for stock- and option-based compensation compared to cash bonuses. They attribute this result to employees placing more of an emphasis on personal wealth rather than firm value.
    • There is a stronger positive effect of chief internal auditors receiving IBC and external auditor fees increasing when inherent risk is higher in the audit. Specifically, the authors focused on inherent risk related to inventory levels.
    • In situations where the CEO’s equity incentives are aligned with IAF’s equity incentives there is an even greater rise in external auditor fees.
    Auditing Procedures - Nature - Timing and Extent, Client Acceptance and Continuance, Independence & Ethics
    Client Risk Assessment