This episode will be a slight departure from my prior shows. This one is an opinion piece.   #InternalAudit #Audit #Independence #bonus

Two weeks ago, I watched video podcast by Tom McLeod (@tom_mcleod) of McLeod Governance, Should Auditors Receive Bonuses? (http://www.mcleodgovernance.com/weekly-wrap-9th-october-2014/). He started a thread on LinkedIn, to which I provided a brief response. As I’ve thought about the issue more, the more I thought about the trigger point for contention. Is it really a problem for internal auditors to receive bonuses? If we do receive bonuses, what form should those bonuses take?

Why shouldn’t internal auditors receive bonuses? At a rudimentary level, the answer would be because it could impair their independence. Why do internal auditors need to be independent? I’ll get to that question, but I want to start with a more direct question, “Are we independent?”

Are Internal Auditors Independent?

I think everyone will agree that external auditors are independent. I’d like to explore how they achieve independence and then compare and contrast that with the role of the internal auditor.

Key independence factors for external auditors:

• The external audit firm is paid by the company
• The external audit firm has multiple clients
• External audit Partners are rotated
• The external auditor is paid by the firm, not the company
• The PCAOB monitors external auditor’s work
• The external audit firm is not affected by the financial statement results.

As an internal auditor, things are quite different.

• The CAE is paid by the company.
• The internal auditor is employed by the company (only client)
• There is no rotation requirement for the CAE or internal audit managers
• All of the internal auditors are paid by the company, even in co-source and outsource models
• The Audit Committee (a function of the Board of Directors) monitors the internal auditor’s work
• The internal auditor’s compensation and job security are affected by the financial strength of the company

I cannot separate my well being or that of my staff from the performance of the company. I have a vested interest in helping management succeed operationally and financially. If the company fails to produce, I won’t prosper and I may be forced to reduce headcount. The results matter to me. I am not independent of the company I am auditing.

But this really only addresses independence as it relates to financial statement reporting. Clearly, an external auditor is independent and, in fact, must be independent of the financial statement reports because that is what we are asking them to opine on. Internal audit is not opining on the financial statement reports, but rather is providing assurance on the controls and risk management conducted by management. So, to provide the right level of objectivity, the internal auditor needs to be independent of the operations and finance management.

That is generally accomplished through a solid reporting to the audit committee. This has to be more than just an organization chart thing. To build in the right level of objectivity, the following is required:

• The responsibility and authority of the internal audit department is spelled out in a charter
• The CAE must have direct interaction with the audit committee, especially the chairman of that committee
• The compensation (base and bonus) must be determined by the Board of Directors (Audit Committee, Compensation Committee)
• The Chief Audit Executive must have the backbone necessary to carry out their function

If the requirements for independence aren’t there, bad things can happen.

Paying Bonuses To Internal Auditors

Now the question comes up. Can the bonus paid to internal audit staff undermine their independence and objectivity? The short answer is yes. If the bonuses aren’t directed by the Board of Directors, or aren’t based on the right metrics.

I want the bonuses paid to my internal audit staff to align with the long-term results of the company. I believe we contribute to that success when we assist management in identifying risks and establishing solid control environments. Bonuses should not be based on meaningless metrics such as how many audits are completed, compliance to time budgets, or how many audit findings the auditors bring up. You can monitor these metrics, but the behavior you should be rewarding is the dedication to bring about positive change. Quality, not quantity of audit services will lead to long-term business success.   That is what our shareholders care about and what they pay us to bring about.

It may seem like a daunting task to ensure the bonus structure is properly aligned and fair. But don’t let that stop you from pursuing bonuses for Internal Audit. If you don’t pay competitively, you won’t get the talent you need. That would be far worse than having a few alignment issues. Talent management is one of the hallmarks of a world-class audit department. Great talent management requires a competitive compensation program.

I hope you enjoyed this episode. I would like for you to do me a favor. Please go to itunes and rate this podcast. Your rating will help Internal Audit Mastery get noticed by others and reach more people. Thank you.