An Examination of Whether Incentive Compensation and Stock Ownership Affect Internal Auditor Objectivity

Abstract

Recent events in the corporate sector have increased the prominence of auditing. The bankruptcies, financial reporting irregularities, and fraudulent activities that took place in Enron, WorldCom and other firms have greatly increased scrutiny on corporate monitoring. Especially in light of the external audit failures associated with these events, audit's role in corporate monitoring is sure to be expanded. While external auditors are concerned primarily with financial reporting, auditors typically do not spend most of their time dealing with financial reporting. A survey by Barrett et al. (1985) found that, on average, auditors spend 32 percent of their time on financial audits. Interestingly, though, a survey by KPMG Peat Marwick (1999) found that auditors were more likely to discover fraud than external auditors. The Treadway Commission points out, however, that auditors' full potential is not realized, in part because the role the auditors have in the audit of financial statements at the consolidated is often limited ... auditors often concentrate on the review of controls at the division, subsidiary, or other business component level, rather than at the corporate level. Independent public accountants, on the other hand, generally are responsible for the audit examination at the corporate level (1987: 39). In recent years, auditors have received incentive compensation in the form of bonuses tied to overall company performance (Stapp, 1991; DeZoort et al., 2000). Internal auditors are seen as adding value to the firm because of their role as business consultants in areas such as controls, effectiveness and efficiency of operations, and compliance with organizational policies and procedures. Hence, many organizations believe that auditors should be rewarded for the successes of the firm. Moreover, many believe that rewarding auditors with incentive compensation will increase their productivity and effectiveness as well as improve their morale and motivation (DeZoort et al., 2000). According to a recent survey (Stewart, 1997), 51 percent of auditing department heads received incentive-based compensation. In a survey of 179 auditors, DeZoort et al. (2000) report that almost half of the respondents indicated that incentive compensation was available to auditors in their organizations. Of those reporting the availability of incentive compensation, 70 percent indicated that this compensation was based on overall company financial performance. A majority of these performance measures were related to reported earnings, such as net income, earnings per share, return on equity, and return on assets. Internal auditors also sometimes own stock in the companies in which they are employed (Simpson, 1999). In fact, the DeZoort et al. (2000) study reports that 23 percent of the auditors who received incentive compensation were awarded stock options. (1) These types of situations could raise concerns about conflicts of interest (Heaston et al., 1993). For both situations, auditors would benefit when their company's earnings are high. Whether the incentive compensation is based on the company's earnings or on the company's stock price, the auditors might tend to overlook management actions that overstate earnings. Indeed, 56 percent of the auditors in the DeZoort et al. (2000) study felt that incentive compensation based on overall company performance potentially impairs auditor objectivity and independence. Also, since higher company earnings generally affect the company's stock price in a positive manner, auditors who own compaW stock might tend to overlook management actions that overstate earnings. Objectivity is a key element in the effectiveness of an audit function. The Panel of Audit Effectiveness asserted that internal auditors must be objective with respect to the activity being audited (2000: 62). …

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