Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve theeffectiveness of risk management, control, and governance processes. Internal auditing is a catalyst for improving an organization's governance, risk management and management controls by providing insight and recommendations based on analyses and assessments of data and business processes. With commitment to integrity andaccountability, internal auditing provides value to governing bodies and senior managementas an objective source of independent advice. Professionals called internal auditors are employed by organizations to perform the internal auditing activity.
The scope of internal auditing within an organization is broad and may involve topics such as an organization's governance, risk management and management controls over: efficiency/effectiveness of operations (including safeguarding of assets), the reliability of financial and management reporting, and compliance with laws and regulations. Internal auditing may also involve conducting proactive fraud audits to identify potentially fraudulent acts; participating in fraud investigations under the direction of fraud investigation professionals, and conducting post investigation fraud audits to identify control breakdowns and establish financial loss.
Internal auditors are not responsible for the execution of company activities; they advisemanagement and the Board of Directors (or similar oversight body) regarding how to better execute their responsibilities. As a result of their broad scope of involvement, internal auditors may have a variety of higher educational and professional backgrounds.
The Institute of Internal Auditors (IIA) is the recognized international standard setting body for the internal audit profession and awards the Certified Internal Auditor designation internationally through rigorous written examination. Other designations are available in certain countries. In the United States the professional standards of the Institute of Internal Auditors have been codified in several states' statutes pertaining to the practice of internal auditing in government (New York State, Texas, and Florida being three examples). There are also a number of other international standard setting bodies.
Internal auditors work for government agencies (federal, state and local); for publicly traded companies; and for non-profit companies across all industries. Internal auditing departments are led by a Chief Audit Executive ("CAE") who generally reports to the Audit Committee of the Board of Directors, with administrative reporting to the Chief Executive Officer (In the United States this reporting relationship is required by law for publicly traded companies).
History of internal auditing
The Internal Auditing profession evolved steadily with the progress of management science after World War II. It is conceptually similar in many ways to financial auditing by public accounting firms, quality assurance and banking compliance activities. While some of the audit technique underlying internal auditing is derived from management consulting and public accounting professions, the theory of internal auditing was conceived primarily by Lawrence Sawyer (1911-2002), often referred to as "the father of modern internal auditing"; and the current philosophy, theory and practice of modern internal auditing as defined by the International Professional Practices Framework (IPPF) of the Institute of Internal Auditors owes much to Sawyer's vision.
With the implementation in the United States of the Sarbanes-Oxley Act of 2002, the profession's exposure and value was enhanced, as many internal auditors possessed the skills required to help companies meet the requirements of the law. However, the focus by internal audit departments of publicly traded companies on SOX related financial policy and procedures derailed progress made by the profession in the late 20th century toward Larry Sawyer's vision for internal audit. Beginning in about 2010, the IIA once again began advocating for the broader role internal auditing should play in the corporate arena, in keeping with the IPPF's philosophy.
Organizational independence
While internal auditors are not independent of the companies that employ them, independence and objectivity are a cornerstone of the IIA professional standards; and are discussed at length in the standards and the supporting practice guides and practice advisories. Professional internal auditors are mandated by the IIA standards to be independent of the business activities they audit. This independence and objectivity are achieved through the organizational placement and reporting lines of the internal audit department. Internal auditors of publicly traded companies in the United States are required to report functionally to the board of directors directly, or a sub-committee of the board of directors (typically the audit committee), and not to management except for administrative purposes.
The required organizational independence from management enables unrestricted evaluation of management activities and personnel and allows internal auditors to perform their role effectively. Although internal auditors are part of company management and paid by the company, the primary customer of internal audit activity is the entity charged with oversight of management's activities. This is typically the Audit Committee, a sub-committee of the Board of Directors. To provide independence, most Chief Audit Executives report to the Chairperson of the Audit Committee and can only be replaced with the concurrence of that individual.
Role in internal control
Internal auditing activity is primarily directed at evaluating internal control. Under the COSO Framework, internal control is broadly defined as a process, effected by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of the following core objectives for which all businesses strive:
· Effectiveness and efficiency of operations.
· Reliability of financial and management reporting.
· Compliance with laws and regulations.
· Safeguarding of Assets
Management is responsible for internal control, which comprises five critical components: the control environment; risk assessment; risk focused control activities; information and communication; and monitoring activities. Managers establish policies, processes, and practices in these five components of management control to help the organization achieve the four specific objectives listed above. Internal auditors perform audits to evaluate whether the five components of management control are present and operating effectively, and if not, provide recommendations for improvement.In the United States, internal auditors may assist management with compliance with the
Sarbanes-Oxley Act (SOX).
Role in risk management
Internal auditing professional standards require the function to evaluate the effectiveness of the organization's Risk managementactivities. Risk management is the process by which an organization identifies, analyzes, responds, gathers information about, and monitors strategic risks that could actually or potentially impact the organization's ability to achieve its mission and objectives.
Under the COSO enterprise risk management (ERM) Framework, an organization's strategy, operations, reporting, and compliance objectives all have associated strategic business risks - the negative outcomes resulting from internal and external events that inhibit the organization's ability to achieve its objectives. Management assesses risk as part of the ordinary course of business activities such as strategic planning, marketing planning, capital planning, budgeting, hedging, incentive payout structure, credit/lending practices, mergers and acquisitions, strategic partnerships, legislative changes, conducting business abroad, etc. Sarbanes-Oxley regulations require extensive risk assessment of financial reporting processes. Corporate legal counsel often prepares comprehensive assessments of the current and potential litigation a company faces. Internal auditors may evaluate each of these activities, or focus on the overarching process used to manage risks entity-wide. For example, internal auditors can advise management regarding the reporting of forward-looking operating measures to the Board, to help identify emerging risks; or internal auditors can evaluate and report on whether the board and other stakeholders can have reasonable assurance the organization's management team has implemented an effective enterprise risk management program.
In larger organizations, major strategic initiatives are implemented to achieve objectives and drive changes. As a member of senior management, the Chief Audit Executive (CAE) may participate in status updates on these major initiatives. This places the CAE in the position to report on many of the major risks the organization faces to the Audit Committee, or ensure management's reporting is effective for that purpose.
Internal auditors may help companies establish and maintain Enterprise Risk Management processes. Internal auditors also play an important role in helping companies execute a SOX 404 top-down risk assessment. In these latter two areas, internal auditors typically are part of the risk assessment team in an advisory role.
Role in corporate governance
Internal auditing activity as it relates to corporate governance has in the past been generally informal, accomplished primarily through participation in meetings and discussions with members of the Board of Directors. According to COSO's ERM framework, governance is the policies, processes and structures used by the organization’s leadership to direct activities, achieve objectives, and protect the interests of diverse stakeholder groups in a manner consistent with ethical standards. The internal auditor is often considered one of the "four pillars" of corporate governance, the other pillars being the Board of Directors, management, and the external auditor.
A primary focus area of internal auditing as it relates to corporate governance is helping the Audit Committee of the Board of Directors (or equivalent) perform its responsibilities effectively. This may include reporting critical management control issues, suggesting questions or topics for the Audit Committee's meeting agendas, and coordinating with the external auditor and management to ensure the Committee receives effective information. In recent years, the IIA has advocated more formal evaluation of Corporate governance, particularly in the areas of board oversight of enterprise risk, corporate ethics, and fraud.
Audit project selection or "annual planning"
Based on a risk assessment of the organization, internal auditors, management and oversight Boards determine where to focus internal auditing efforts. This focus or prioritization is part of the annual/multi-year audit planning. The audit plan is typically proposed by the CAE (sometimes with several options or alternatives) for the review and approval of the Audit Committee or Board of Directors. Internal auditing activity is generally conducted as one or more discrete assignments. A typical internal audit assignment involves the following steps:
1. Establish and communicate the scope and objectives for the audit to appropriate management.
2. Develop an understanding of the business area under review. This includes objectives, measurements, and key transaction types. This involves review of documents and interviews. Flowcharts and narratives may be created if necessary.
3. Describe the key risks facing the business activities within the scope of the audit.
4. Identify management practices in the five components of control used to ensure each key risk is properly controlled and monitored.
5. Develop and execute a risk-based sampling and testing approach to determine whether the most important management controls are operating as intended.
6. Report issues and challenges identified and negotiate action plans with management to address the problems.
7. Follow-up on reported findings at appropriate intervals. Internal audit departments maintain a follow-up database for this purpose.
Audit assignment length varies based on the complexity of the activity being audited and Internal Audit resources available. Many of the above steps are iterative and may not all occur in the sequence indicated.
In addition to assessing business processes, specialists called Information Technology (IT) Auditors review information technology controls.
Internal audit reports
Internal auditors typically issue reports at the end of each audit that summarize their findings, recommendations, and any responses or action plans from management. An audit report may have an executive summary; a body that includes the specific issues or findings identified and related recommendations or action plans; and appendix information such as detailed graphs and charts or process information. Each audit finding within the body of the report may contain five elements, sometimes called the "5 C's":
1. Condition: What is the particular problem identified?
2. Criteria: What is the standard that was not met? The standard may be a company policy or other benchmark.
3. Cause: Why did the problem occur?
4. Consequence: What is the risk/negative outcome (or opportunity foregone) because of the finding?
5. Corrective action: What should management do about the finding? What have they agreed to do and by when?
The recommendations in an internal audit report are designed to help the organization achieve effective and efficient governance, risk and control processes associated with operations objectives, financial and management reporting objectives; and legal/regulatory compliance objectives.
Audit findings and recommendations may also relate to particular assertions about transactions, such as whether the transactions audited were valid or authorized, completely processed, accurately valued, processed in the correct time period, and properly disclosed in financial or operational reporting, among other elements.
Under the IIA standards, a critical component of the the audit process is the preparation of a balanced report that provides executives and the board with the opportunity to evaluate and weigh the issues being reported in the proper context and perspective. In providing perspective, analysis and workable recommendations for business improvements in critical areas, auditors help the organization meet its objectives.
Measuring the internal audit function
The measurement of the internal audit function can involve a balanced scorecard approach.
Internal audit functions are primarily evaluated based on the quality of counsel and information provided to the Audit Committee and top management. However, this is primarily qualitative and therefore difficult to measure. "Customer surveys" sent to key managers after each audit engagement or report can be used to measure performance, with an annual survey to the Audit Committee. Scoring on dimensions such as professionalism, quality of counsel, timeliness of work product, utility of meetings, and quality of status updates are typical with such surveys. Understanding the expectations of senior management and the audit committee represent important steps in developing a performance measurement process, as well as how such measures help align the audit function with organizational priorities.
Reporting of critical findings
The Chief Audit Executive (CAE) typically reports the most critical issues to the Audit Committee quarterly, along with management's progress towards resolving them. Critical issues typically have a reasonable likelihood of causing substantial financial or reputational damage to the company. For particularly complex issues, the responsible manager may participate in the discussion. Such reporting is critical to ensure the function is respected, that the proper "tone at the top" exists in the organization, and to expedite resolution of such issues. It is a matter of considerable judgment to select appropriate issues for the Audit Committee's attention and to describe them in the proper context.
Audit philosophy
Some of the philosophy and approach of internal auditing is derived from the work of Lawrence Sawyer. His philosophy and guidance on the role of internal audit was a forerunner of the current definition of internal auditing. It emphasized assisting management and the Board in achieving the organization’s objectives through well-reasoned audits, evaluations, and analyses of operational areas. He encouraged the modern internal auditor to act as a counselor to management rather than as an adversary. Sawyer saw auditors as active players influencing events in the business rather than criticizing all degrees of errors and mistakes. He also foresaw a more desirable auditor future involving a stronger relationship with members of Audit Committee and the Board and a divorce from direct reporting to the Chief Financial Officer.
Sawyer often talked about “catching a manager doing something right” and providing recognition and positive reinforcement. Writing about positive observations in audit reports was rarely done until Sawyer started talking about the idea. He understood and forecast the benefits of providing more balanced reporting while simultaneously building better relationships. Sawyer understood the psychology of interpersonal dynamics and the need for all people to receive acknowledgment and validation for relationships to prosper.
Sawyer helped make internal auditing more relevant and more interesting through a sharp focus on operational or performance auditing. He strongly encouraged looking beyond financial statements and financial-related auditing into areas such as purchasing, warehousing and distribution, human resources, information technology, facilities management, customer service, field operations, and program management. This approach helped catapult the chief audit executive into the role of a respected and knowledgeable adviser who was thought to be reasonable, objective, and concerned about helping the organization achieve the stated goals.
