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Managerial Auditing Journal A comparison of internal audit in the private and public sectors Jenny
Managerial Auditing Journal A comparison of internal audit in the private and public sectors Jenny

Managerial Auditing Journal

A comparison of internal audit in the private and public sectors

Jenny Goodwin

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Jenny Goodwin, (2004),"A comparison of internal audit in the private and public sectors", Managerial Auditing Journal, Vol. 19 Iss 5 pp. 640 - 650 Permanent link to this document:

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Gadjah Mada At 03:00 29 March 2016 (PT) MAJ 19,5 640 A comparison of internal audit

A comparison of internal audit in the private and public sectors

Jenny Goodwin

School of Accountancy, Queensland University of Technology, Brisbane, Australia

Keywords Internal auditing, Public sector organizations, Private sector organizations

Abstract This paper explores similarities and differences between public sector internal auditing and its counterpart in the private sector. Features examined include organizational status, outsourcing, using internal audit as a “tour of duty” function, activities and relationships with the external auditor. The study is based on a survey of chief internal auditors in organizations in Australia and New Zealand. Results suggest that there are differences in status between internal audit in the two sectors, with public sector internal auditors less likely to report to the chief financial officer. While a similar amount of work is outsourced, public sector organizations are more likely than those in the private sector to outsource to the external auditor. There is little difference between internal audit activities and interactions with external audit in the two sectors. However, private sector internal audit is perceived to lead to a greater reduction in audit fees compared to that in the public sector.

The objective of this paper is to compare features of the internal audit function between organizations in the private sector and those in the public sector. Aspects examined include organizational status, using internal audit as a “tour of duty” function, outsourcing, internal audit activities including involvement in risk management, and interactions with external auditors. The data were collected by a questionnaire survey sent to chief internal auditors who were members of the Institute of Internal Auditors (IIA) in Australia and New Zealand. The study extends that reported in Goodwin (2003) which focused on the relationship between internal audit and the audit committee. The study is motivated by the increasing emphasis on the role of internal audit as a corporate governance mechanism in both sectors. It has been argued that there are important differences between public sector internal auditing and its private sector counterpart in terms of the orientation of the framework in which it operates and the scope of its activities (Carhill and Kincaid, 1989; Coupland, 1993). However, public sector reforms have lessened the differences between the two sectors, particularly with regard to governance (Barrett, 2002a, b). An interesting research question, therefore, is the current extent to which internal audit in the public sector differs from that in the private sector with regard to its status, scope and activities. The results of the study suggest that there are differences in status between internal audit functions in the two sectors but that internal audit activities and interactions

Managerial Auditing Journal Vol. 19 No. 5, 2004 pp. 640-650 q Emerald Group Publishing Limited

0268-6902

DOI 10.1108/02686900410537766

The author thanks K. Raghunandan for his help in the development of the survey instrument for this study. The assistance of the Institute of Internal Auditors – Australia and the members who completed the survey is also gratefully acknowledged. The paper has benefited from the helpful comments of participants in a seminar hosted by the Institute of Internal Auditors – Queensland Branch.

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with external auditors are similar. Reliance on the work of internal audit by the external auditor is perceived to lead to a greater reduction in audit fees in the private sector compared to the public sector. The paper is structured as follows. The next section provides the background and research questions. This is followed in the third section by a description of the research method used. The fourth section reports the results of the study while in the final section some conclusions are drawn, the limitations of the study noted and opportunities for further research are discussed.

Internal audit

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Background and research question There is no requirement in either Australia or New Zealand for private sector entities to use internal audit. However, the Australian Stock Exchange (ASX) Corporate Governance Council (2003) encourages companies, particularly large companies, to have an internal audit function. Public sector requirements are less clearcut. In Australia, government agencies are generally created by statute and whether they are required to have an internal audit function depends on the specific legislation governing them. For example, local government acts generally require councils to have an internal audit function. In New Zealand, there is no formal requirement for government agencies to have an internal audit function. It has been argued that there are important differences between internal audit in the private sector and its counterpart in the public sector. Carhill and Kincaid (1989), for example, suggest two reasons for these differences. First, public sector agencies operate in a rigid framework where activities are authorized by legislation. Second, these agencies are service-oriented and hence attach lower priority to cost factors and issues associated with profitability. Because of this, it is argued that public sector internal audit activities need to be of a much broader scope than in the private sector. Malan (1991) discusses two types of audit that are relevant to the public sector:

financial-related audits and performance audits. Financial-related audits examine the degree to which public resources are used by the organization to achieve its objectives. As such, they extend beyond the normal attestation function of audit. Performance or value-for-money audits focus on whether public resources are being used efficiently and effectively, with an objective of identifying and reducing wastage. Coupland (1993) argues that this type of audit has resulted in the adoption of a more sophisticated approach to internal audit work, requiring internal auditors in the public sector to broaden their skills and the techniques used. Spraakman (1985), in a comparison of public and private sector internal audit in Canada, found that, while efficiency and effectiveness audits had increased in both sectors, the focus was considerably stronger in government organizations. Since the time of that study, in both Australia and New Zealand, there have been extensive reforms in the public sector that have led to a strengthening of corporate governance. New Zealand, in particular, has gained an international reputation for its early initiatives in the reform process (Schick, 1998; Bale and Dale, 1998) and it was one of the first countries to move to full accrual based accounting for public sector entities. Australia has since followed this lead. The reforms have led to a focus on corporate governance and while it is recognized that governance in the public sector can involve more complex relationships than in the private sector, most public sector agencies are now more closely aligned to the private sector with regard to their use of internal audit

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(Barrett, 2002a, b). This is demonstrated by the revised definition of internal audit promulgated by the Institute of Internal Auditors (IIA):

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 the effectiveness of risk management, control, and governance processes (IIA, 1999).

This definition suggests that internal audit has continued to move away from financial and compliance audits to a broader value-adding role, embracing both assurance and consulting activities and focusing on improving performance and effectiveness. Since the definition is designed to embrace organizations in both the private and the public sectors, it is both timely and interesting to identify similarities and differences between internal audit in the two sectors since its release. This leads to following research question:

RQ1. To what extent does internal audit in the public sector differ from that in the private sector with regard to:

Its organizational status?

The size of the budget and the percentage of the budget that is outsourced?

The nature of its activities?

Its interaction with external auditors?

Research design The data were collected by means of a questionnaire sent to all chief internal auditors in Australia and New Zealand who were registered as members of the IIA – Australia[1]. The IIA processed the mailing of questionnaires with responses being mailed directly to the researcher. A copy of the questions asked is included in the appendix. Questionnaires were mailed to 370 heads of audit and 120 responses were received, generating a response rate of 32 per cent. There were 32 responses from private sector entities in Australia and 16 from New Zealand, giving a total of 48 private sector responses. Public sector responses totalled 72, with 53 from Australia and 19 from New Zealand. There were only two minor differences based on country, and these are noted in the next section. To test for a non-response bias, responses were compared between early and late respondents. There were no significant differences in responses on any of the variables in the study[2], suggesting that non-response bias is not a problem (Scarbrough et al.,

1998).

Results Status of internal audit The IIA stresses the importance of organizational independence of the internal audit function (IIA, 2001), with the chief internal auditor reporting to a level within the organization that allows the function to fulfill its responsibilities (IIA 2001, para 1110). External auditing standards (e.g. AUS 604 (AuASB, 1995) and ISA 610 (IFAC, 1994)) argue that, ideally, internal auditing will report to the highest level of management and be free of any other operating responsibility. Table I reports the results of a Chi-square test to determine whether reporting lines differ between private sector entities and

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those in the public sector. The table shows that 17 chief internal auditors in the private sector (36 per cent) indicated that they report to the chief financial officer compared to only five (6.9 per cent) in the public sector. The difference is statistically significant at p ¼ 0.000. This result is of some concern as it suggests that many private sector internal auditors may not enjoy the day-to-day objectivity required to adequately fulfill their responsibilities. While Goodwin (2003) reports that most chief internal auditors appear to have good access to the audit committee, day-to-day reporting lines remain important for internal audit to be recognized as having a high status in the organization. A further test of status is whether the internal audit function is staffed by permanent employees or whether it is considered to be a “tour of duty” function in the organization. In the latter case, internal audit is frequently considered to be a training ground for future managers, with a stint in internal audit providing them with a good understanding of organizational systems and accounting functions (Goodwin and Yeo, 2001). While this practice can have many advantages for the organization, it can also have negative implications for internal audit independence, particularly when it involves senior personnel (Chadwick, 1995). A chief internal auditor who is expecting to be transferred to a line management position may have little incentive to enhance the quality of the internal audit function and may also be unwilling to take a strong position on issues that arise (Goodwin and Yeo, 2001; Chadwick, 1995). Table II reports responses to questions concerning whether, first, the chief internal audit position is a “tour of duty” position and, second, whether internal audit is considered a “tour of

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Chief executive

Chief financial

Other senior

officer

officer

management*

Total

 

n

%

n

%

n

%

n

%

Public sector

41

57

5

7

26

36

72

100

Private sector

18

38

17

35

13

27

48

100

Total

59

49

22

18

39

33

120

100

Chi-square = 15.672; p ¼ 0.000

Note: *Includes second-in-command, general manager corporate services, company secretary and other senior management

Table I. Day-to-day reporting lines for chief internal auditor

 

n

Tour of duty %

Permanent position

 

Total

n

%

n

%

Panel A. Chief internal auditor position

 

Public sector

2

3

70

97

72

100

Private sector

9

19

39

81

48

100

Total

11

9

109

91

120

100

Chi-square = 8.824; p ¼ 0.007 (Fisher exact adjustment as 1 cell has expected count , 5)

Panel B. Internal audit staff

 

Public sector

4

6

68

94

72

100

Private sector

16

33

32

67

48

100

Table II. Internal audit as a “tour of duty” function

Total

20

17

100

83

120

100

Chi-square = 16.000; p ¼ 0.000

 

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duty” function for other staff. This table indicates that 91 per cent of all organizations in the sample have a permanent chief internal auditor while 83 per cent staff the internal audit function with permanent employees[3]. However, there are significant differences between organizations in the private sector and those in the public sector, with more private sector entities using internal audit as a “tour of duty” function for both the chief internal auditor and internal audit staff compared to those in the public sector ( p ¼ 0.007 and p ¼ 0.000 respectively). Where internal audit is used as a “tour of duty” function, respondents were asked to indicate the length of time spent in internal audit. For the chief internal auditor, the mean is 39 months for the two public sector chiefs and 31 months for the nine private sector chiefs. The difference is not statistically significant ( p ¼ 0.536). For internal audit staff, the mean for the four public sector organizations is 42 months, while for the 16 private sector entities, it is 27 months. This difference is statistically significant at p ¼ 0.030. Respondents were also asked to indicate the departments to which staff are most frequently transferred after spending time in internal audit. The most common department is finance and accounting (17), followed by operations (10) and corporate services (6). Overall, it appears that internal audit has a higher status in the public sector than in private sector entities. Public sector internal audit functions tend to report to the chief executive or second-in-command and they also tend to be staffed by more permanent employees compared to their private sector counterparts.

Size of internal audit and percentage outsourced The size of the internal audit budget for public sector organizations ranged from $10,000 to $6 million with a mean of $804,896. For private sector entities, budget size ranged from $12,000 to $4.5 million with a mean of $927,727. The number of employees ranged from 1 to 65 for both sectors, with a mean of 6.44 for the public sector and 7.56 for the private sector. None of these differences are statistically significant ( p values all exceed 0.10). In view of the growing trend towards outsourcing internal audit activities (Caplan and Kirschenheiter, 2000; Widener and Selto, 1999) and the controversy about outsourcing to the external auditor (Goodwin and Seow, 2002; Geiger et al., 2002), respondents were asked to indicate the percentage of the internal audit budget that is outsourced to their auditor and to other consultants. A total of 49 (68 per cent) public sector entities and 31 (65 per cent) private sector entities indicated that they engage in some outsourcing of internal audit activities. For those public sector organizations that engage in outsourcing, the mean percentage of the budget outsourced to the external auditor is 24.43 per cent while the mean percentage to other consultants is 25.41 per cent. Private sector entities engaging in outsourcing obtain 10.82 per cent of internal audit services from their external auditor and 30.54 per cent from other consultants. The difference between the two sectors with regard to outsourcing to the external auditor is statistically significant (t ¼ 2.321; p ¼ 0.027) while the difference in level of outsourcing to independent consultants is not significant (t ¼ 2 0.789; p ¼ 0.433). The combined level of outsourcing is also not significant (t ¼ 0.359; p ¼ 0.721). Thus, while approximately two-thirds of entities in both sectors engage in some outsourcing, public sector entities are more likely than private sector entities to use their external auditor to provide internal audit services.

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Respondents were asked to indicate which activities were most commonly outsourced. In both sectors, information technology and systems rank as the most frequently outsourced area (45 per cent of all public sector outsourcing and 52 per cent of private sector outsourcing). Interestingly, financial and internal control audits comprise 32 per cent of public sector and 19 per cent of private sector outsourcing while performance audits comprise only 7 per cent of public sector outsourcing and 8 per cent of that in the private sector.

Internal audit

645

Nature of internal audit activities As previously noted, the role of internal audit in recent times has moved away from a traditional focus on controls to a value adding function that includes risk management, operational audits and consultancy projects (IIA, 1999). Respondents were asked to allocate the proportion of time that the internal audit function spends on four categories of activity:

(1)

Financial audit and internal controls.

(2)

Risk management.

(3)

Operational and systems audits.

(4)

Special projects and other work.

Percentages for each sector are shown in Table III. While not reported, t-tests indicate that there are no significant differences between the two sectors (all p values are greater than 0.10). Table III shows that slightly more than one-third of time is spent on operational and systems audits while slightly less than one-third is spent on financial audits and internal controls[4]. Risk management activities and special projects each take up less than 20 per cent of internal audit time in both sectors. Thus, these results suggest that the activities of internal audit in the two sectors are not far removed from each other, supporting the view that differences have lessened in recent years (Barrett, 2002a, b). Because of the recent emphasis on internal audit participation in risk management activities (Walker et al., 2003; Lindow and Race, 2002; Leithhead, 1999), respondents were asked to provide more details about their function’s involvement in this area. Specifically, they were asked to indicate whether internal audit is involved in operational, financial, environmental and strategic risk management activities. A category of “other” areas of risk management was also included, with respondents being asked to specify the area if selecting this category. Results are reported in Table IV.

Financial

audit/internal

controls

Risk management

Operational/

systems audits

Special

projects/other

 

Mean %

SD

Mean %

SD

Mean %

SD

Mean %

SD

Public sector

31.31

15.84

15.50

14.60

33.73

15.57

19.03

14.76

Table III. Mean percentage (standard deviation) of time spent on activities

Private sector

30.31

12.69

18.02

13.48

36.75

15.72

15.44

11.86

Total

30.91

14.61

16.51

14.16

34.94

15.63

17.59

13.74

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Table IV. Internal audit involvement in risk management activities

Yes

No

Total

 

n

%

n

%

n

%

Panel A. Operational risk Public sector Private sector

63

88

9

12

72

100

45

94

3

6

48

100

Total

108

90

12

10

120

100

Chi-square = 1.250; p ¼ 0.358 (Fisher exact adjustment as 1 cell has expected count , 5)

Panel B. Financial risk Public sector Private sector Total

24

33

48

67

72

100

24

50

24

50

48

100

48

40

72

60

120

100

Chi-square = 3.333; p ¼ 0.068

 

Panel C. Environmental risk

Public sector

27

38

45

62

72

100

Private sector

16

33

32

67

48

100

Total

43

36

77

64

120

100

Chi-square = 0.217; p ¼ 0.641

 

Panel D. Strategic risk Public sector Private sector Total

47

65

25

35

72

100

31

65

17

35

48

100

78

65

42

35

120

100

Chi-square = 0.006; p ¼ 0.938

 

Panel E. Other risks Public sector Private sector Total

17

23

55

77

72

100

8

17

40

83

48

100

25

21

95

79

120

100

Chi-square = 0.749; p ¼ 0.387

The table shows that there is a marginally significant difference between the two sectors with regards to financial risk management, with 50 per cent of private sector internal audit functions being involved with this type of risk management compared to only 33 per cent of public sector internal audit functions ( p ¼ 0.068). This no doubt reflects the lower emphasis placed on financial risk in the public sector. There are no other statistically significant differences between the two sectors. Approximately 90 per cent of internal audit functions are actively involved in operational risk management while 65 per cent are involved in strategic risk management. Slightly over 30 per cent of functions are engaged in environmental risk management. Approximately 20 per cent indicated that they are involved in other areas of risk management. These areas included risk management of special projects (9), health and safety (8), information technology (7) and fraud (4). Thus, in spite of spending a relatively small amount of their total time on risk management activities, it does appear that internal auditors are actively involved in a wide range of these activities.

Relationship with external auditors There has been considerable research on external auditor reliance on the work of internal audit (Brody et al., 1998; Lampe and Sutton, 1994; Stein et al., 1994; Carey et al.,

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2000; Felix et al., 2001) but this has generally been from the point of view of the external auditors. It is therefore interesting to explore internal audit interaction with external auditors from the perspective of the chief internal auditor. Table V reports responses concerning the coordination of work and external auditor access to workpapers and reports. There are no significant differences between public and private sector responses. More than 85 per cent of internal audit functions coordinate the areas of audit coverage with the external auditor while approximately two-thirds coordinate their work schedule. Further, in both sectors, external auditors have a high level of access to internal audit workpapers and reports. Table VI shows the perceived impact of the auditor’s reliance on the work of internal audit on the cost of the external audit, indicating statistically significant differences between the two sectors ( p ¼ 0.021). In the public sector, 30 per cent of respondents are unsure of the impact, compared to 19 per cent in the private sector.

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Yes

No

Total

 

n

%

n

%

n

%

Panel A. Coordinating areas of audit coverage

 

Public sector

61

85

11

15

72

100

Private sector

42

88

6

12

48

100

Total

103

86

17

14

120

100

Chi-square = 0.183; p ¼ 0.669

 

Panel B. Coordinating work schedule

 

Public sector

46

64

26

36

72

100

Private sector

34

71

14

29

48

100

Total

80

67

40

33

120

100

Chi-square = 0.625; p ¼ 0.429

 

Panel C. External auditor access to all internal audit workpapers

 

Public sector

67

94

5

7

72

100

Private sector

42

88

6

12

48

100

Total

109

91

11

9

120

100

Chi-square = 1.068; p ¼ 0.344 (Fisher exact adjustment as 1 cell has expected count , 5)

 

Panel D. External auditors access to all internal audit reports

 

Public sector

68

94

4

6

72

100

Private sector

46

96

2

4

48

100

Table V. Internal audit interaction with external auditors

Total

114

95

6

5

120

100

Chi-square = 0.112; p ¼ 1.000 (Fisher exact adjustment as 2 cells have expected count , 5)

 

Reduction in cost 10 per cent or less %

n

 

Reduction in cost more than 10 per cent

Unsure of

 
 

impact

Total

n

%

n

%

n

%

Public sector

33

46

17

24

22

30

72

100

Table VI. Impact of internal audit on the cost of external audit

Private sector

16

33

23

48

9

19

48

100

Total

49

41

40

33

31

26

120

100

Chi-square = 7.760; p ¼ 0.021

 

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Only 24 per cent of public sector auditors believe that the cost reduction is more than 10 per cent of audit fees compared to 48 per cent in the private sector. This may reflect the greater level of competition in the private sector audit market compared to that in the public sector.

Perceptions of the work and stature of internal auditing The final question in the survey was an open-ended one soliciting comments on the work and stature of internal auditing. A variety of comments were received, with no statistically significant differences between respondents from the two sectors. Almost 30 per cent of respondents commented on the changing status of internal audit in recent years, with the majority of these of the view that internal audit is steadily increasing in status. However, 10 per cent suggested that internal audit needs a higher profile and greater management support than presently exists. More than 15 per cent commented on the need for internal audit to add value to the organization while a similar number expressed concern about the trend towards outsourcing.

Concluding comments This paper has explored similarities and differences in the status, scope and activities of internal audit between organizations in the public sector and those in the private sector. The study is based on a survey of chief internal auditors in organizations in Australia and New Zealand. Results suggest that, overall, public sector internal audit functions have a higher status than their private sector counterparts, where more than a third of chief internal auditors report to the chief financial officer. Further, the internal audit function is less likely to be used as a “tour of duty” function in the public sector. While a similar percentage of entities in each sector engage in outsourcing some of their internal audit activities, public sector organizations are more likely to use their external auditor to provide these services. The time spent on different internal audit activities is similar in both sectors. Interactions with the external auditor also do not differ significantly between the two sectors. However, public sector internal auditors are less convinced than their private sector counterparts that the external auditor’s reliance on their work leads to a reduction in audit fees. There are a number of limitations of the study. The sample size is relatively small, particularly with regard to the private sector. Generalizability of the results may be limited as both Australia and New Zealand have had significant reforms in the public sector, bringing the two sectors closer together with regard to governance and financial accountability. As with all surveys, a further limitation is that the results rely on the self-reports of respondents and are therefore open to misinterpretation of the questions as well as to subjectivity in the responses. In spite of the limitations, the study makes an interesting contribution to our understanding of internal audit in both sectors. Additional research could be conducted in other regulatory frameworks where, for example, internal audit is mandatory or where there has not been the same level of public sector reforms. Other aspects of internal audit such as the extent of consulting work compared to assurance activities could also be explored.

Notes

1. The IIA – Australia covers members in both Australia and New Zealand.

2. The sample was divided into two, based on surveys postmarked within four weeks of mailing (82 responses) and those postmarked later (38 responses). Chi-squared tests for dichotomous responses and t-tests for continuous responses indicated that there were no statistically significant differences between the two groups. All p values exceeded 0.15.

3. The use of internal audit as a “tour of duty” function for staff was also more prevalent in New Zealand (29 per cent) than in Australia (10 per cent) ( p ¼ 0.025).

4. The mean percentage of time spent on financial audits differed between Australia and New Zealand, with New Zealand internal audit functions spending 27 per cent of time on this activity compared to 33 per cent for those in Australia ( p ¼ 0.034).

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