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    Rotational internal audit programs and financial reporting...
    research summary posted September 16, 2015 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors 
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    Title:
    Rotational internal audit programs and financial reporting quality: Do compensating controls help?
    Practical Implications:

    The authors conclude that companies should consider the potential costs of using a rotational staffing model in the internal audit function and, if adopting this practice, should ensure the appropriate compensating controls are in place to mitigate such costs. The evidence on the consequences of systematic rotation will also be interesting to investors, boards of directors, audit committees, and management. These stakeholders rely on the IAF to monitor financial reporting, and they can benefit from evidence about how systematic rotation affects financial reporting quality. Furthermore, regulators and standard setters, such as the IIA, would benefit from understanding how these rotational assignments affect financial reporting quality and what organizations can do to address the potential consequences.

    Citation:

    Christ, M. H., A. Masli, N. Y. Sharp, and D. A. Wood. 2015. Rotational internal audit programs and financial reporting quality: Do compensating controls help? Accounting, Organizations & Society 44: 37-59.

    Keywords:
    internal auditing, financial statements, internal auditors, financial reporting qualities, internal controls
    Purpose of the Study:

    A report from the Institute of Internal Auditors finds that approximately two-thirds of Fortune 500 companies report that they systematically rotate their internal auditors into management positions outside of internal audit, this practice potentially causes the internal audit function (IAF) to be used or viewed as a training ground for future managers. This practice is somewhat perplexing given evidence from prior research suggesting it diminishes internal auditors’ objectivity.

    The authors extend prior research on the effects of systematically rotating internal auditors into operational management by conducting interviews with chief audit executives and audit committee chairpersons to develop an initial framework of how this practice is thought to impact financial reporting outcomes. The authors then use this initial framework to guide an archival analysis that tests for the presence of key associations between such rotation and financial reporting quality. They posit that specific types of rotational programs have the potential to reduce financial reporting quality. Consistent with prior research, the authors focus on the systematic rotational programs that result in internal auditors later obtaining management positions because these practices are most prevalent and have the potential to impair financial reporting quality. Hereafter, the authors refer to these practices as “systematic rotation.”

    Design/Method/ Approach:

    The authors interviewed heads of internal audit (CAEs) from 11 companies of varying sizes and industries and two audit committee chairpersons who (combined) have worked with 12 unique companies. Interviews lasted an average of 46 min. Six of eleven (55%) interviewees are from Fortune 500 companies. Eight of eleven companies use formal rotation programs, one uses informal rotation, and two do not use rotation. The authors collected this data prior to June 2015.

    Findings:

    The authors find that use of systematic rotation is associated with higher accounting risk. This result suggests that systematic rotation weakens the effectiveness of internal audit’s monitoring of financial reporting within the organization. This result is also consistent with the view from prior research that some rotational IAFs operate primarily as a management training ground, at the expense of the effectiveness of traditional internal audit activities.

    However, consistent with their predictions, other organizations implement compensating controls that mitigate this negative relation. Specifically, organizations that (1) rotate only staff internal audit positions (e.g., not the head of internal audit), (2) have more effective audit committees, or (3) have management who directs internal audit to focus on financial reporting (as opposed to operational or IT audits) are able to reduce the negative financial reporting effects associated with systematic rotation of internal auditors into management positions.

    Further, at least in this data, when all three types of compensating controls are present, the negative association between systematic rotation and financial reporting quality is eliminated. Thus, the results suggest that control-conscious organizations can use compensating controls to prevent systematic rotation from reducing financial reporting quality.

    Category:
    Auditing Procedures - Nature - Timing and Extent
    Sub-category:
    Reliance on Internal Auditors