5 Future Developments That Could Elevate Internal Audit’s Stature

I have written extensively about the work internal auditors must do to fulfill their own potential and that of the profession in enhancing and protecting the value of the organizations they serve. As the risk landscape changes and the speed of risk increases, internal auditors must expand their skills, update their processes, and embrace a mindset of being flexible, agile, and open to responding quickly to disruptive threats and to​ new and emerging risks.

Of course, internal audit cannot do this on its own. It is, after all, one part of a complex governance process that relies on others, including risk managers, senior management, and the board. Successful governance relies on all components being as effective and efficient as possible. Effective governance requires mutual respect, understanding, and appreciation of the role each component plays.

I am often asked about the future of internal audit, and what I see as keys to its continued ascendency as a vital component in an organization’s risk management and control structure. For too long, internal auditors around the world have been hamstrung by organizational constraints, including independence, access, and resource limitations. It’s time to state clearly and unapologetically what those are, how they hamper internal audit’s effectiveness, and what can be done to remove those impediments.

While these are my own views, and not necessarily official positions of The IIA, I nonetheless believe at least five future developments merit consideration and debate going forward.

A condition of being publicly traded: Have an internal audit function.

Most publicly traded companies likely have an internal audit function. However, many do not – especially small ones, or small companies that are new. The New York Stock Exchange requires its listed companies to have an internal audit function. The Nasdaq does not. What is unfortunate is that investors often cannot tell whether a company even has an internal audit function, because there is not any reporting requirement. 

When publicly traded companies fund and support an independent, healthy, and robust internal audit function, they commit to having a systematic, disciplined approach to evaluating and improving the effectiveness of risk management, control, and governance processes. Without such a commitment, investors are left to wonder how the board and management receive independent and objective assurance and insight regarding how well risks are being managed. 

When any organization, publicly traded or not, operates without an independent and objective assessment of its risk management, its board must rely solely on management for such assurances. On its face, a self-assessment system is vulnerable to manipulation and deceit. Without internal audit, management may try to convince itself and the board that everything is fine.

While the presence of an internal audit function does not guarantee success for a company, the absence of one suggests the organization’s leadership may not see the value in assuring strong, effective risk management, internal control, and governance. This is a self-imposed risk about which potential investors should be aware. In the future, publicly traded companies should be required to have an internal audit function — or, at a minimum, to disclose that they do not.

Internal audit must report to the CEO.

Having the right reporting relationships is vital to internal audit’s success. IIA Standard 1110: Organizational Independence from The IIA’s International Standards for the Professional Practice of Internal Auditingexplains clearly the importance of having a direct reporting line to a level within the organization “that allows the internal audit activity to fulfill its responsibilities.”

This means a functional reporting line to the board and an administrative reporting line to management. For the most part, organizations support and appreciate the value of this effective dual reporting line, though combined CEO/chairman positions render the dual reporting line moot. 

But the biggest threat to an effective dual reporting line is when the chief audit executive (CAE) reports to a positon other than the CEO, such as the chief financial officer (CFO) or chief risk officer (CRO). Over more than four decades of experience in the profession, I have witnessed an undeniable correlation between the level to which internal audit reports in organizations and the stature it enjoys. The U.S. Federal Reserve has taken the right position in mandating that internal audit in large financial institutions over which it has responsibility either report administratively to the CEO or the audit committee must explain why not.

Independence is the cornerstone of internal audit and anything that threatens to introduce bias — or even the appearance of bias — erodes internal audit’s effectiveness and credibility.

The board/audit committee must directly oversee CAE hiring, firing, review, and compensation.

The interpretation of Standard 1110 explains the importance of the board’s role in protecting internal audit’s impartiality and objectivity. This includes, among other things, approving an internal audit charter, approving a risk-based internal audit plan, and approving the internal audit budget and resource plan.

It also addresses the board’s role in the appointment, removal, and compensation of the CAE. However, this responsibility is too often overlooked or delegated to management by busy boards and audit committees. This practice may be the single biggest threat to internal audit independence.

The dual reporting line is designed to protect internal audit independence by providing a check to any inappropriate limitations to internal audit’s scope or resources. It recognizes that management can influence internal audit’s effectiveness and independence by manipulating how the CAE is hired, fired, and compensated. When the board or audit committee allows management to take on those responsibilities and simply rubber stamps management’s recommendation for a new CAE, internal audit’s independence is threatened. Even more disappointing is how often audit committees are absent from the CAE’s performance assessment process and the determination of compensation — including incentive compensation such as performance bonuses.

Audit committees must step up to their responsibilities when it comes to CAEs. After all, as the old expression goes, “you work for those who pay you!”

Internal audit should assist the audit committee with oversight of the external auditors.

OK, I know that this one will raise a lot of eyebrows. I am not suggesting that the internal auditors audit the external auditors. After all, their independence is paramount to trust in the capital markets. However, audit committees have an oversight obligation when it comes to the external auditors. Internal auditors can and often do assist in this process — particularly when it comes to assessing whether the external auditors are conforming to the terms of their engagements and whether engagement fees are appropriately calculated and billed. If these responsibilities are delegated by the audit committee to management, the appearance of the external auditors’ independence could be compromised.

Internal audit should have a permanent seat at the table.

Most areas of the organization have their champions in the boardroom. The finance function has the CFO, information technology has the CIO, and risk management has the CRO. But there is often no seat for internal audit.

Over nearly a century of modern internal auditing, the profession has progressed from providing simple assurance on financial reporting to becoming an integral contributor to organizational success. Yet, the CAE is rarely considered a “true” member of the C-suite.

In my book, Trusted Advisors: Key Attributes of Outstanding Internal Auditors, I​ define trust as “the firm belief in the reliability, truth, ability, or strength of someone or something.” When properly resourced and allowed to operate independently, internal audit is all those things: reliable, truthful, able, and strong.

Strong and effective internal audit functions led by a seasoned CAE should be recognized as a respected and vital player in good governance. And it should enjoy the stature that comes with it. This includes a permanent seat at the management table.

As always, I look forward to your comments.