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A critical analysis of the independence

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AAAJ
22,2
200
Received 12 October 2007
Revised 20 March 2008
Accepted 4 June 2008
Accounting, Auditing &
Accountability Journal
Vol. 22 No. 2, 2009
pp. 200-220
q Emerald Group Publishing Limited
0951-3574
DOI 10.1108/09513570910933942
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/0951-3574.htm
A critical analysis of the
independence of the internal audit
function: evidence from Australia
Joe Christopher
School of Accounting, Curtin University of Technology, Perth, Australia
Gerrit Sarens
Department of Finance, Louvain School of Management,
Université Catholique de Louvain, Louvain-la-Neuve,
Belgium and Department of Accounting and Finance, University of Antwerp,
Antwerp, Belgium, and
Philomena Leung
Faculty of Business and Law, School of Accounting, Economics and Finance,
Deakin University, Burwood, Australia
Abstract
Purpose – This study aims to critically analyse the independence of the internal audit function
through its relationship with management and the audit committee.
Design/methodology/approach – Results are based on a critical comparison of responses from
questionnaires sent out to Australian chief audit executives (CAEs) versus existing literature and best
practice guidelines.
Findings – With respect to the internal audit function’s relationship with management, threats
identified include: using the internal audit function as a stepping stone to other positions; having the
chief executive officer (CEO) or chief finance officer (CFO) approve the internal audit function’s budget
and provide input for the internal audit plan; and considering the internal auditor to be a “partner”,
especially when combined with other indirect threats. With respect to the relationship with the audit
committee, significant threats identified include CAEs not reporting functionally to the audit committee;
the audit committee not having sole responsibility for appointing, dismissing and evaluating the CAE;
and not having all audit committee members or at least one member qualified in accounting.
Originality/value – This study introduces independence threat scores, thereby generating analysis
of the internal audit function’s independence taking into account a combination of threats.
Keywords Internal auditing, Corporate governance, Audit committees, Managers, Australia
Paper type Research paper
The authors wish to acknowledge the contribution by Gordon Woodbine who provided
assistance in the administration and analysis of the survey instrument. In addition, the support
and assistance provided by the IIA Australia in administering the survey and the contribution
made by the respective CAEs in completing the survey are greatly appreciated. Earlier versions
of this paper have been presented at the 2007 AFAANZ Conference and the First Global
Academic Conference on Internal Audit and Corporate Governance (April 2008). The authors
also wish to thank Lee D. Parker (editor) and two anonymous referees for their comments and
suggestions.
Introduction Analysis of the
This study provides a critical analysis of the independence of the internal audit internal audit
function in Australian companies. Given the growing role of internal auditing in
contemporary corporate governance, independence has gained renewed attention. function
The Institute of Internal Auditors (IIA) has promoted the internal audit function as
an independent function that provides value-added assurance and consulting services.
Through this extended role, the function has been promoted as the cornerstone upon 201
which effective corporate governance is built (IIA Professional Guidance, 2002). This
view has been supported by academic and practitioner research. Ramamoorthi (2003),
in his research on the history and evolution on the internal audit function, indicated
that, over time, there has been a massive shift in focus to one that promotes and
supports effective organisational governance. This has been supported by Ruud (2003)
who noted that, in today’s business environment, the internal audit function has
become a major support function for management, the audit committee, the board of
directors, and other stakeholders.
The increased importance of the internal audit function in enhancing corporate
governance also has been reinforced indirectly through legislation, such as the
Sarbanes Oxley Act (2002) in the USA and the CLERP Act (2004) in Australia. Although
this legislation does not specifically address the corporate governance role of the
internal audit function, it provides for the expanded accountability requirements of
stakeholders, like the board (including the audit committee) and management. This, in
turn, would suggest an expanded role for the internal audit function given that it
comprises an integral component of the network of parties having corporate
governance responsibilities (Gramling, 2004).
This expanded role essentially would involve the provision of additional services,
which are initiated by the board (including the audit committee) and management as a
means of ensuring that accountability requirements are met. This raises the issues of
credibility and integrity, given the close relationship between these two parties.
Mutchler et al. (2001) touched on the importance of independence by suggesting that, as
the responsibilities of internal auditors grow, so does the demand for greater
accountability, independence and objectivity. They suggest that the broadened
responsibilities of the internal audit function within the environment of a changing
business world, coupled with increasing economic competition and globalisation, are
creating pressure on the internal audit function, which can jeopardise its independence.
They emphasise this by stating:
Independence and objectivity are to the profession of internal auditing what the Hippocratic
Oath is to the practice of medicine.
They go on to define independence as:
[. . .] freedom from material conflicts of interest that threaten objectivity. In other words, it is a
state where threats to objectivity are managed to the extent that the risks of ineffective
internal audit services are acceptably controlled.
The tension resulting from the pressure to provide value-added services while
maintaining independence prompts our primary research objective, which is to analyse
critically whether internal audit functions in practice are operating independently, in
line with theoretical best practice guidelines.
AAAJ The remainder of this paper is structured as follows. The first section provides a
22,2 brief outline of the underlying theories upon which this study is based. The second
section provides a background analysis of the components of corporate governance
and their impact upon the internal audit function’s independence. In addition, best
practice guidelines for internal auditing as promulgated by the IIA, academic
researchers and practitioners, are identified and discussed. This section forms the basis
202 for the formulation of two specific research questions. The third section outlines the
research method used, followed by the fourth section that provides the results of the
study and a critical analysis of the results relative to the theoretical position. The final
section presents the conclusions.

Underlying theories: agency and institutional theory

The essential concern of corporate governance arises from the separation of ownership
and control in modern public corporations. This is the essence of the agency problem, as
articulated by early scholars like Berle and Means (1932) and Jensen and Meckling (1976).
Pursuant to this concept, the responsibility for control is vested in the board and
management, the shareholders’ agents. The board, which only meets a few times each
year, in turn, appoints management (as their agents), headed by the chief executive officer,
to manage the organisation. While the independent external auditors provide assurance to
the shareholders on the quality of the financial statements, it is the independent internal
audit function that provides assurance to the board, via the audit committee. Agency
theory, in this context, provides the basis for explaining the independent role and
responsibilities assigned to the internal audit function (Adams, 1994).
The interests of shareholders have been strengthened over time, especially through
efforts by the government and professional bodies. More specifically, there is increased
pressure on management to ensure that an organisation is governed efficiently, effectively
and economically for the benefit of shareholders. Much of this pressure has been a result
of social expectations in response to recent corporate scandals. This study draws on
institutional theory, which essentially posits that organisational management and control
structures tend to conform to social expectations (Di Maggio and Powell, 1983; Meyer and
Rowan, 1977; Scott, 1987). Based on this reasoning, this study takes the stand that
management control structures are put in place to respond to a range of control and
compliance requirements. An important component of the management control structure
is the internal audit function, which is used by the board (through the audit committee)
and management to fulfil responsibilities in line with social expectations.
This study draws on both agency and institutional theory to examine the
independence of the internal audit function in relationship to the audit committee (as a
sub committee of the board) and management.

Background analysis and research questions

Management
Cohen et al. (2002) recognise that management has a strong influence in setting the
overall tone for governance. Claybrook (2004) argued that upper management has the
broadest influence on stakeholders, and that management influences operations, as
well as the board of directors and even the internal audit function. Nagy and Cenker
(2002) confirm this, noting that management, and not internal auditors, ultimately
determines the orientation of the internal audit function. This is supported by Brody
and Lowe (2000), who assert that the internal audit function sometimes is requested by Analysis of the
management to assist it in advisory roles, such as in acquisitions, mergers and system internal audit
development and implementation. Bou-Raad (2000) further supports this by
suggesting that more can be accomplished with the internal audit function by function
reviewing and providing advice to management regarding business objectives. Sarens
and De Beelde (2006) also studied the internal audit function’s relationship with
management, and concluded that management requires the internal audit function to 203
take on an extended role to compensate for loss of control resulting from increased
organisational complexity. In addition, their study results infer that internal auditors
are expected to safeguard corporate culture through personal contacts with people in
the field. Drent (2002) adds to this management influence theory, noting that executive
and line management, by utilising the internal audit function for these various
extended roles, do not always appreciate the need for independence. Drent (2002)
argues that, in the minds of many executives and managers, internal auditors work for
them, and that reporting to the audit committee merely is a formality to satisfy
corporate governance requirements. It is in this area that the impairment of the internal
audit function’s independence poses a threat. This dilemma is expressed by the
argument that the internal audit function must add value to management, while at the
same time not become its servant, and faithfully report on the status to the board or
some other equivalent governing body (Van Gansberghe, 2005).
The IIA and other previous research studies have established best practice
guidelines for the internal audit function so that they can maintain independence.
Attribute Standard 1110 of the International Standards for the Professional Practice of
Internal Auditing (IIA, 2004) stipulates that the chief audit executive (CAE) should
report to a level within the organisation that allows the internal audit function to
accomplish its activities. With respect to previous research studies, Chapman (2001)
argues that the primary goal of the internal auditor is objectivity, which involves an
unbiased attitude and the avoidance of conflicts of interest. This only can be achieved
if the internal audit function is appropriately placed in the organisational structure.
Chapman (2001) describes organisational independence as the placement of the
internal audit function in the reporting structure so that it is free to determine the audit
scope and perform audit work without interference. Bariff (2003) underlines the way in
which the internal audit function can maintain independence from management by
noting the following quote from a PricewaterhouseCoopers report:
Internal audit departments need to ensure an organisational posture which allows them to
operate successfully on strategic issues. This means both the independence and mandate to
deal with significant strategic business risks and issues. If inappropriately positioned within
the company, internal audit deals with tactical issues and is viewed only at that level.
Inappropriate positioning can also raise serious concerns about the overall independence of
the function (PWC, 2002).
The above theoretical position on management influence and the effect an inappropriately
placed internal audit function can have on independence will be examined in relation to
the internal auditing practices of the Australian corporate sector. The above theoretical
position provides the basis for the formulation of the first research question:
RQ1. To what extent is the internal audit function in Australian companies
independent of management?
AAAJ Audit committee
22,2 With respect to the audit committee, Drent (2002) asserts that it, in contrast with
management, greatly values the internal audit function’s independence. Gwilliam and
Kilcommins (1998) found that the presence of audit committees creates a perception of
enhanced independence of the internal audit function, and more reliable financial
reporting among financial statement users. Krishnan (2005) supports this view by
204 asserting that, in essence, the audit committee’s status is enhanced because it can rely
on the work of the internal audit function.
Goodwin and Yeo (2001) found that an effective audit committee can strengthen the
position of the internal audit function by acting as an independent forum in which
internal auditors may raise matters affecting management (see also Turley and Zaman,
2004). This view is reiterated by Braiotta (1999), who argued that private meetings
between the audit committee and the CAE serve the purpose of enhancing and
protecting the independence of the internal audit function. These assertions regarding
independence being enhanced through accessibility of the internal auditors to the audit
committee supports the findings of earlier studies by Kalbers (1992), McHugh and
Raghunandan (1994), and Scarbrough et al. (1998) that the problem of internal auditor
reluctance to report problems to the audit committee is exacerbated by restrictions in
access to the audit committee.
In addition to the presence of audit committees, and access to them, is a requirement
that the internal audit function report directly to the audit committee to maintain
independence. Schneider and Wilner (1990) and Hansen (1997) suggest that, in settings
wherein the internal audit function is independent, in terms of reporting level, an
improved control environment and a reduction in reporting errors results. Gramling
(2004) confirms this by identifying that independence through an appropriate
reporting relationship typically is viewed as the most important criterion describing
objectivity. The importance of the independent status of the internal audit function
through an appropriate reporting line was reinforced by the IIA (2004), which strongly
insists that the CAE should report functionally to the audit committee. This reasoning
is based on the argument that the functional reporting line for the internal audit
function is the ultimate source of independence and authority.
Goodwin (2003) went one step further to indicate that independence is further
enhanced if the members of the audit committee, in addition to being independent, have
the technical expertise to understand the work of the internal audit function. This
supports the earlier study by Raghunandan et al. (2001) who found that committees
comprised solely of independent directors, and with at least one member having
accounting or finance expertise, were more likely to have longer meetings with the
CAE, to provide access to the CAE, and to review internal audit programs and results.
An important responsibility arising out of this reporting relationship, which can
have an effect on the independence of the internal audit function, is the responsibility
for hiring and firing the CAE. Bariff (2003) argues that the independence of the internal
audit function is at risk if an auditee is responsible for hiring and firing the CAE.
McHugh and Raghunandan (1994) found that a large majority of internal auditors
indicated that vesting hiring/firing authority with the audit committee would enhance
the independence of the internal audit function, reduce oversight by the audit
committee, and improve the ability of internal auditors to generate action on audit
findings. This is now reflected in the IIA’s (2004) advisory guidelines 1110-1 and
2060-5, wherein the Board Audit Committee is required to participate in these Analysis of the
responsibilities. internal audit
The above discussion regarding the influence of the structure and composition of
the audit committee, the reporting line of the internal audit function, and the function
responsibility for hiring and firing the CAE on the independence of the internal audit
function will be examined with regard to internal auditing practices within the
Australian corporate sector, to gauge if this is the case in practice. Hence, the second 205
research question is as follows:
RQ2. Does the relationship between the audit committee and the internal audit
function in Australian companies provide for independence of internal audit?

Research method
Questionnaire
An e-mail-based questionnaire (Kiesler and Sproull, 1986) was used to collect data. An
e-mail questionnaire was selected over a postal questionnaire, due to the advantages of
rapid distribution and response cycles (Yun and Trumbo, 2000; Swoboda et al., 1997)
and the fact that the former affords the technical ability to track whether the delivered
questionnaire was opened, responded to, deleted, or undeliverable (Paolo et al., 2000).
The questionnaire was prepared in accordance with quality control requirements
for questionnaire design (Dillman, 2000; Oppenheim, 1992; Preece et al., 2002). This
included the format of the e-mail questionnaire, which was designed to accommodate
the principles of paper questionnaire design, such as the development of question
scales and multiple choice answers, minimisation of question bias through proper
wording, confidentiality requirements, and the use of unambiguous and concise
language. The quality control procedures undertaken extended to pretesting that was
done in accordance with established procedures (Dillman, 2000) to ensure question
completeness, efficiency and relevancy, and format appropriateness. It was pre-tested
by a number of colleagues and CAEs, and finally presented to the IIA Australia for
review and approval before distribution.

Data collection
The approved questionnaire was electronically distributed as an attachment to an e-mail
cover letter sent by IIA Australia to their list of CAEs in the corporate sector. This
represented a sample size of 206. A total of 34 responses were received, representing a
response rate of 17 per cent. Relative to typical response rates in surveys of a similar
nature targeting CAEs (Bariff, 2003 (22 per cent); Leung et al., 2004 (21.4 per cent)), this
response rate was deemed fairly reasonable, may be construed as a fair reflection of the
views of CAEs, and is adequate for a critical analysis of the independence of internal
audit functions in Australia. Those who responded belonged to the following sectors:
. Trade, Transport and Logistics – 9 per cent;
.
Production and energy – 22 per cent;
. Utilities – 6 per cent;
.
Telecom, IT and Media – 26 per cent; and
. Financial Services – 37 per cent.
AAAJ Questionnaire items
22,2 The research questions were addressed as follows.
RQ1. To what extent is the internal audit function in Australian companies
independent of management?. To address this research question and identify any direct
or indirect management influences that would impact upon the internal audit
function’s independence, various characteristics were explored through seven specific
206 survey questions (Questions 3-9, Appendix). These characteristics included:
. The organisational positioning of the internal audit function.
.
The management of the internal audit function, which includes staff movement,
budgets, and the impact of CEOs and CFOs on internal audit planning.
.
The perception of people within the organisation regarding internal auditors as
partners.

RQ2. Does the relationship between the audit committee and the internal audit function
in Australian companies provide for independence of internal audit?. Two survey
questions dealt with the reporting relationship between the internal audit function and
the audit committee, as required by existing guidelines (Questions 1 and 2 of the
Appendix). Three survey questions dealt with the composition of the audit committee
(Questions 11-13, Appendix). Five questions (Questions 14-18, Appendix) were posed
to determine if any direct influences exist through the internal audit function’s
relationship with the audit committee that could impact the independence of the
internal audit function. These questions provided insight into the level of audit
committee involvement relative to its role in the internal audit function.

Results and discussion

In this section, results will be critically analysed and discussed.

Management
As shown in Table I, all respondents reported that their internal audit function was
placed at the corporate/group level, as opposed to being placed at the intermediate or
local level. This is in line with best practice guidelines. While this indicates that, in
practice, internal audit functions are well placed in the hierarchy with respect to
maintaining independence, the study identified other potential indirect threats to their
independence.
When asked if it is common for internal auditors to move to other functions within
the company, 56 per cent of the respondents stated that there is a culture within the
organisation for internal audit staff to move to other management functions within the
organisation. This is corroborated by 47 per cent of the respondents indicating that, on
average, internal auditors stay between two and four years in the internal audit
function, with 13 per cent indicating that internal auditors stay for less than two years.
A long-term commitment was rare; in 60 per cent of the companies, internal auditors
stay less than four years. In 71 per cent of the cases where it is common to move to
other functions, internal auditors remain within the internal audit function, on average,
for less than four years. It thereby seems that only a small minority aspire to a career in
internal auditing. These results confirm that the internal audit function often is used as
a training ground or a stepping stone for future managers to further their careers. An
argument for this practice is that it also can be seen as an added value of the internal
 Analysis of the
Frequency
No. Questionnaire items No % internal audit
3 What is the hierarchical level of your internal audit function? (n ¼ 34)
function
Corporate group level 34 100.00
Intermediate level 0 0
Local level 0 0 207
4 Is it common for internal auditors to move to other functions within the
company? (n ¼ 34)
Yes 19 55.88
No 13 38.24
No comments 2 5.88
5 On average how many years does an internal auditor stay within your
internal audit function? (n ¼ 32)
Less than 2 4 12.50
Between 2-4 15 46.88
Between 5-7 7 21.88
Between 8-10 2 6.25
More than 10 4 12.50
6 Who approves the internal audit budget? (n ¼ 34)
AC 8 23.53
BOD 1 2.94
CEO 6 17.65
CFO 4 11.76
AC and CEO 6 17.65
AC and BOD 1 2.94
AC and CFO 2 5.88
BOD, CEO and CFO 2 5.88
AC and company secretary 2 5.88
Others 2 5.88
7 The CEO gives input for the internal audit planning (n ¼ 34)
Strongly agree 11 32.35
Somewhat agree 11 32.35
Neither agree or disagree 3 8.82
Strongly disagree 1 2.94
Somewhat disagree 5 14.71
No response 3 8.82
8 The CFO gives input for the internal audit planning (n ¼ 34)
Strongly agree 10 29.41
Somewhat agree 12 35.29
Neither agree or disagree 2 5.88
Strongly disagree 2 5.88
Somewhat disagree 5 14.71
No response 3 8.82
9 People within the organisation perceive internal auditors as their
partners (n ¼ 34)
Strongly agree 2 5.88
Somewhat agree 17 50.00 Table I.
Neither agree or disagree 11 32.35 Descriptive statistics –
Somewhat disagree 3 8.82 relationship with
Strongly disagree 1 2.94 management
AAAJ audit function. Internal auditors often are well-trained people, having a profound
22,2 understanding of the different functional domains within the company. Therefore, it is
not surprising that they are viewed as potential candidates for management positions.
What is of concern, however, is the effect that this might have on the independence of
the internal audit function, as it raises the question as to whether the internal auditor
can raise reports against management independently and objectively, knowing that he
208 or she is dependent on management for future career moves. It is reasonable to assume
that internal auditors, to some extent, will be biased when performing an audit
engagement in which the auditee is their potential future boss, given that they already
have specific career plans in mind.
Another noted potential negative influence on the independence of the internal audit
function is the possibility for management to influence the budget of internal audit
function. In 26 per cent of the companies, only the audit committee or the board of
directors approves the internal audit budget. According to IIA Standards, this should
be the best way to guarantee the independence of the internal audit function. On the
other hand, in 29 per cent of the companies, the CEO or CFO is responsible for
approving the internal audit budget. The internal audit function’s independence is
threatened in these companies. It can be assumed that CEOs or CFOs who do not want
the internal audit function to focus on specific areas in their company (e.g. areas in
which they know there are control deficiencies or, even worse, in which they want to
hide fraud) have the power to impose significant budget constraints on the internal
audit function, thus forcing it to reduce its auditing scope.
Another potential threat to the independence of the internal audit function emerges
when senior management becomes too heavily involved in influencing the internal
audit planning. Although it is recommended that input from the CEO and CFO be
solicited, given their ability to identify high risk areas in which audits are warranted,
the CAE and the audit committee should have sufficient autonomy to determine final
priorities. As soon as the CEO and CFO become too heavily involved in determining
the orientation of the internal audit function, its independence is indirectly threatened.
In this study, the survey results indicate that, in 65 per cent of the cases, the CEO
and/or CFO provide input for the internal audit planning. The results suggest that, in
almost one third of the cases, the CEO (32 per cent) and the CFO (29 per cent) have a
strong impact upon the planning. This would indicate a threat to the internal audit
function’s independence, especially if combined with other indirect threats, like the
CAE and audit committee not having the independence to determine final priorities.
It also was found that, in more than half of companies (56 per cent), people within
the organisation perceive internal auditors to be partners. A sufficient degree of
acceptance and appreciation of the internal audit function is crucial to allow for
internal audit findings and recommendations to have an impact. Nevertheless, it can be
argued that a culture in which the internal audit function is considered too much a
“partner” may put additional indirect pressure on internal auditors to work closely
with management to achieve a “common goal” rather than to act as an independent
body providing assurance on risk management, control and governance. A sufficient
degree of independence would prevent the internal audit function from becoming a
consulting partner for management.
In summary, while the results indicate that there is a trend towards internal audit
functions being organisationally positioned to maintain independence, evidence was
found that the independence of the internal audit function is potentially threatened by Analysis of the
management. This includes the indirect ability of management to influence the career internal audit
prospects of internal auditors, as well as the budget and planning of the internal audit
function. This is exacerbated by internal auditors themselves using the function as a function
stepping stone to further their career aspirations. It also can be argued that the
independence concept may be lost in such a culture, especially if it is combined with
people within the organisation perceiving internal auditors as partners, thereby 209
subjecting the internal audit function to pressures threatening its independence, rather
than recognising the internal audit function as an independent assurance function.
In order to obtain an overall perception of potential independence threats resulting
from the relationship between the internal audit function and management, an overall
score was generated, taking into account whether:
.
the internal audit function is a stepping stone to other functions;
.
people stay less than four years in the internal audit function;
.
only the CEO and/or CFO approve(s) the internal audit budget;
.
the CEO and CFO have a strong impact upon the internal audit planning; and
.
people perceive internal auditors as partners.
This score can range from 0 to 5, ranging from no independence threats to significant
independence threats. Table II shows that three independence threats were identified in
29 per cent of the companies, and more than three in 35 per cent of the companies.
Further analysis reveals that this score is significantly higher (F ¼ 8:923; p ¼ 0:006) in
companies wherein the internal audit function report functionally to the CFO instead of
to the audit committee. This confirms that establishing the correct reporting
relationships is a crucial component of safeguarding the independence of the internal
audit function.

Audit committee
Aspects relative to the composition of the audit committee were examined. Table III
shows that all responding companies have an audit committee. According to Table IV,
audit committee membership ranges from 2 to 15 members, with a mean of 4.8
(standard deviation ¼ 2:6). On average, 78 per cent of the audit committee members
are independent (standard deviation ¼ 32:1 per cent). In 60 per cent of companies, all
audit committee members are independent; meanwhile, in 83 per cent, at least half of
the members are independent. In addition to the independence of audit committee
members, prior research has identified that member backgrounds are of importance. It
was found that, on average, 43 per cent of the audit committee members have an

Number of independence threats Frequency

(n ¼ 34) No %

1 7 20.59
2 5 14.71 Table II.
3 10 29.40 Overall score of
4 6 17.65 independence threats at
5 6 17.65 management level
AAAJ
Frequency
22,2 No. Questionnaire items No %

10 Does your company have an audit committee? (n ¼ 34)

Yes 34 100.00
No 0 0
210 14 Who is mandated to appoint, dismiss and evaluate the head of the
internal audit function? (n ¼ 34)
CEO 5 14.71
CFO 1 2.94
CEO and CFO 1 2.94
AC 17 50.00
AC, BOD and CEO 2 5.88
AC and CFO 3 8.82
AC and CEO 2 5.88
Did not respond 3
15 Is the CAE regularly invited to the audit committee meetings? (n ¼ 34)
Yes 33 97.06
No 1 2.94
16 The CAE has regular private contacts with the audit committee (chair or
individual members) (n ¼ 34)
Strongly agree 23 67.65
Somewhat agree 5 14.71
Neither agree or disagree 2 5.88
Strongly disagree 2 5.88
Somewhat disagree 2 5.88
17 The audit committee gives input to the internal audit planning (n ¼ 34)
Table III. Strongly agree 19 53.00
Descriptive statistics Somewhat agree 12 35.29
(frequencies) – Neither agree or disagree 2 5.88
relationship with the Strongly disagree 1 2.94
audit committee Somewhat disagree 0 0

No. Questionnaire items Min. Max. Mean St. dev.

11 Number of audit committee members (n ¼ 34) 2 15 4.80 2.57

12 Percentage of independent audit committee members (n ¼ 34) 0 100 78.22 32.08
Table IV. 13 Percentage of audit committee members with an accounting
Descriptive statistics – background (n ¼ 34) 0 100 43.10 24.23
relationship with the 18 Average percentage of audit committee time spent (on annual
audit committee basis) on internal audit topics (n ¼ 34) 10 80 38.91 24.98

accounting background (standard deviation ¼ 24:2 per cent). It is worth mentioning

that, in 41 per cent of companies, at least half of the members have an accounting
background. These results indicate that, while there is a trend towards moving to best
practices that promote independence, with regards to having suitably independent and
qualified members on the audit committee, this is not consistently applied.
 Aspects relative to the relationship between the audit committee and the internal Analysis of the
audit function were examined next. internal audit
Table V provides an overview of the reporting relationships of the responding
internal audit functions. It is shown that, in only 38 per cent of cases, the internal function
auditor function reports functionally to the audit committee, as recommended by the
IIA. Almost half of the respondents (47 per cent) indicated that, besides the audit
committee, they also report functionally to one or more senior managers (CEO, CFO). 211
Consistent with IIA recommendations, 32 per cent of the respondents indicated an
administrative reporting relationship with the CEO. About one-quarter (26 per cent) of
the respondents indicated that they report administratively to the CFO. It should be
noted that there is no consensus as to whether reporting administratively to the CFO
threatens the internal audit function’s independence. In 18 per cent of cases, the audit
committee or the board of directors are involved in administrative reporting. These
results indicate that best practice guidelines in this regard are not being applied
consistently.
Table III shows that, consistent with recommended best practices, in half of the
cases (50 per cent), the audit committee is mandated to appoint, dismiss and evaluate
the head of the internal audit function, while a further 21 per cent indicated that the
audit committee carries out these duties in conjunction with the CEO, CFO or board of
directors. Consequently, in almost three-quarters of companies, the audit committee is
involved in appointing, dismissing and evaluating the head of the internal audit
function. Nevertheless, in 21 per cent of companies, this responsibility lies with the
CEO and/or CFO, which is a significant threat against the independence of the internal
audit function. One could question whether the internal audit function could be
independent if the continuity of the CAE’s position is significantly determined by
senior management. If there is a significant risk of being dismissed, it is reasonable to
assume that the CAE would be biased towards management and would avoid sensitive
issues in audit reports.

Frequency
No Questionnaire item No %

1 To whom does the internal audit function report functionally? (n ¼ 34)

AC only 13 38.24
AC and CEO 6 17.65
AC and CFO 3 8.82
AC, CEO and CFO 3 8.82
AC, CEO,CFO and BOD 4 11.76
CEO Only 2 5.88
Others 3 8.82
2 To whom does the internal audit function report administratively? (n ¼ 34)
CEO 11 32.35
CFO 9 26.47
CEO and BOD 2 5.88
AC 4 11.76 Table V.
Corporate secretary 1 2.94 Functional and
Others 3 8.82 administrative reporting
Did not respond 4 11.76 relationship
AAAJ Except for one case, all CAEs are invited regularly to audit committee meetings. These
formal contacts enable them to present and discuss the internal audit plan, results and
22,2 recommendations, as well as the follow-up of agreed action plans. It should be noted
that this is a basic condition for the independence of the internal audit function.
Furthermore, two-thirds (68 per cent) of the responding CAEs had regular private
contact with the audit committee chair or individual members. Private contacts,
212 allowing the CAE to raise matters affecting management without management being
present, are one highly effective way of guaranteeing the internal audit function’s
independence.
In a large majority of cases (88 per cent), the audit committee seems to provide input
for the planning of the internal audit function. We can assume that, in more than half of
the cases (53 per cent), this input is quite significant. Compared to the input given by
management, the audit committee’s involvement strengthens the independence of the
internal audit function. This is especially true given the (more or less) independent
status of the audit committee and its growing monitoring responsibilities. A close
relationship with the internal audit function would benefit both parties. On one hand, it
strengthens the internal audit function’s independence; on the other hand, it provides
audit committee members with the necessary support to fulfil their responsibilities.
Finally, Table IV indicates that, on an annual basis, audit committees spend, on
average, 39 per cent of their time on internal audit topics. This finding supports the
trend, identified in the results discussed above, that internal audit functions have a
well-developed relationship with the audit committee, enabling them to present and
discuss their work without fearing management interference. Furthermore,
independent audit committee members with an adequate professional background
will be able to respond to the work and requests of the internal audit function in an
appropriate way, ensuring the independence of the internal audit function. The results,
however, do indicate that not all organisations are complying with best practice
principles in this area and, as such, are exposed to indirect independence threats.
In order to obtain an overall perception of potential independence threats resulting
from the relationship between the internal audit function and the audit committee, an
overall score was developed, taking into account whether:
. fewer than 50 per cent of audit committee members are independent;
.
fewer than 50 per cent of audit committee members have an accounting
background;
.
the audit committee is not involved in appointing, dismissing and evaluating the
CAE;
.
the CAE is not invited to audit committee meetings;
.
the CAE has no private meetings with the audit committee;
.
the audit committee provides no input regarding the internal audit plan; and
.
less than 20 per cent of audit committee time is spent on internal audit topics.

Similar to the overall score developed for the management level, answers to these
questions provide a summation score, which can range from 0 to 7, meaning from no
independence threats to significant independence threats. Table VI shows that, in more
than half of the cases (56 per cent) no or only one independence threat was identified.
These results are much more favourable, from an independence standpoint, than the
overall independence threat scores observed at the management relationship level, Analysis of the
suggesting that the internal audit function’s relationship with the audit committee is a internal audit
stronger guarantee of independence than its relationship with management.
function
Total number of independence threats
Further analysis suggests that the large number of independence threats at the 213
management relationship level (overall score ¼ 4 or higher) is compensated by a low
number or even the absence of independence threats at the audit committee
relationship level (overall score ¼ 0 or 1). More specifically, in 72 per cent of companies
wherein management creates independence threats, the audit committee compensates
by creating (almost) no independence threats. Moreover, the number of independence
threats at management level is significantly lower (F ¼ 3:586; p ¼ 0:068) in those
companies wherein audit committees impose two or more independence threats. This
could mean that independence threats at the two different levels tend to compensate for
each other, the net result being that companies generally are exposed to a reasonably
low number of independence threats.
Unfortunately, Table VII shows that, in one-quarter (24 per cent) of all companies,
six or more independence threats (at aggregate level) exist. This is the group of
companies in which the independence of the internal audit function is most threatened,
and should become the target for potential new guidelines or legislation with which to
strengthen independence. It should be noted that the aggregate number of
independence threats is not correlated with stock exchange listings, company age or
industry.

Number of independence threats Frequency

(n ¼ 34) No. %

0 9 26.47
1 10 29.41 Table VI.
2 8 23.53 Overall score of
3 4 11.76 independence threats at
4 3 8.82 audit committee level

Number of independence threats Frequency

(n ¼ 34) No. %

1 1 2.94
2 2 5.89
3 7 20.59
4 7 20.59
5 9 26.47 Table VII.
6 4 11.76 Overall score of
7 3 8.82 independence threats at
8 1 2.94 aggregate level
AAAJ Conclusions
22,2 This study critically examined the independence of the internal audit function, using
data collected from Australian companies. More specifically, this study analysed to
what extent the relationships between the internal audit function and management and
the audit committee create threats to independence.
In addressing the first research question, potential independence threats stemming
214 from the relationship with management were examined.
The first independence threat refers to the well-known practice of using the
internal audit function as a training ground and stepping stone for future managers.
Although there are arguments supporting this practice, it can be argued that internal
auditors will not be able to operate objectively and independently when they are
dependent upon their auditees for future career moves. The second independence
threat identified refers to approval of the internal audit budget. This study revealed
that Australian companies exist at which the CEO or CFO is responsible for
approving the internal audit budget. This may be considered a serious threat to the
independence of the internal audit function, as imposing budget constraints is a
powerful tool with which management can reduce the scope and impact of the
internal audit function. The third independence threat relates to senior management
being heavily involved in developing the internal audit plan. While senior
management’s input is essential for setting internal audit priorities, the CAE and
audit committee should monitor the impact of senior management’s input. If their
requests are considered unconditional priorities, internal auditors are viewed as
management consultants, which invariably threaten the independence of the internal
audit function. This threat can be linked with the fact that, in more than half of the
responding companies, internal auditors are perceived by staff members to be
“partners”. Questions may be raised as to whether this “partner role” imposes
pressure on internal auditors to assume a subservient management role, thus
threatening the independence of the internal audit function.
While some of these individual threats may not necessarily create a major
threat to the internal audit function’s independence on their own, the collective
effect of these practices has the potential to significantly threaten independence.
Based on a global score, taking into account all threats discussed, it can be
concluded that the majority of the internal audit function in this study are
confronted by a combination of indirect independence threats resulting from their
relationship with management.
In addressing the second research question, potential independence threats
stemming from the relationship between the internal audit function and the audit
committee were examined, and a number of independence threats resulting from this
relationship identified.
The first independence threat relates to non-compliance with best practices
recommending the internal audit function to report functionally to the audit committee
and administratively to the CEO. It was found that this practise is not applied
consistently and, hence, can be considered a potential independence threat. The second
indirect independence threat relates to the composition of the audit committee. While it
was identified that the majority of audit committees have the right composition to
guarantee the independence of the internal audit function, it was noted that this also is
not consistently adhered to. The third independence threat relates to management
having the power to appoint and dismiss the head of the internal audit function. In Analysis of the
almost one-quarter of companies, it is not the audit committee, but the CEO and/or CFO internal audit
who is responsible for appointing, dismissing and evaluating the head of the internal
audit function. It is suggested that such practices could impair the internal audit function
function’s independence.
With respect to positive aspects, the analysis revealed that almost all responding
CAEs are regularly invited to audit committee meetings, and that two thirds have 215
regular private meetings with the audit committee chair or individual members. These
regular contacts are important for the independence of the internal audit function, as
they allow internal auditors to discuss their work with an independent party, which
often is necessary to initiate the appropriate corrective action. Another positive aspect
relates to audit committees spending, on average, more than one-third of their annual
working time addressing internal audit topics. It is suggested that having a
relationship with an audit committee that wants to spend a significant part of its
working time addressing internal audit matters enhances the independence of the
internal audit function.
Similar to how it was done at the management level, a global score of potential
independence threats was computed. Relative to management level, lower scores were
found, suggesting that the relationship of the internal audit function with the audit
committee appears to provide a stronger guarantee for its independence.
Further analysis demonstrates that independence threats at the two levels,
management and audit committee, to some extent compensate for each other. Evidence
was found that independence guarantees provided by the audit committee are more
prevalent in companies wherein management imposes more independence threats, and
vice versa. This compensation effect suggests that the independence of the internal
audit function needs to be judged in a broader context, specifically taking into account
the relationship both with management and the audit committee rather than each
individually. The analysis also points towards one-quarter of all companies in the
study having six or more independence threats, which indicates that, despite the
compensation effect, not all internal audit functions are complying with best practice
guidelines.
It can be suggested that the main reason for these findings appears to be a mix of
internal audit function structures, brought about by a lack of statutory backing to
provide consistency in the implementation of best practices. This is exacerbated by
internal auditors being viewed as partners, thus widening the gap between the
advisory role of the internal audit function and its independent status.

Limitations of the study

When interpreting the findings of this study, a number of limitations need to be
taken into account. First and consistent with general trends in questionnaire-based
research, the limited number of respondents could be an impediment to
generalisation of the results, thereby necessitating careful interpretation of
findings. Second, the questionnaire only was sent to IIA members. Given that, in
Australia, there is no statutory or professional requirement for internal auditors to
be members of the IIA, it is possible that a meaningful segment of the population
has been omitted. Third, respondents were not asked directly whether they were
independent; rather, the independence of the internal audit function was gauged
AAAJ through trends established from a series of questions that examined the relationship
22,2 of the internal audit function with relevant parties. Fourth, the different levels of
independence threats were considered to exert the same level of impact, though it
could be reasonably assumed that some threats exert a stronger influence than
others.

216
Suggestions for future research
By introducing the concept of independence threat scores, this study opens new
avenues for future research. It would be interesting, for example, to identify
variables to explain variation in these scores. Furthermore, these scores can be
introduced to internal audit quality assessment practices. In addition, further
research on the independence of the internal audit function may be undertaken in
other countries to identify whether the findings of this study are a worldwide
phenomenon or a localised issue. Findings consistent with this study would help to
assist the IIA to initiate improvements in this area. Future research also is
recommended on specific aspects pertaining to the independence threats identified.
For example, with respect to the threat of using the internal audit function as a
stepping stone for management roles, it may be interesting to study the effects of
this practice on the behaviour of internal auditors, using field observations or even
experimental research methods.

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Appendix. Survey questions Analysis of the
(1) To whom does the internal audit function report functionally? (Five answering internal audit
categories.)
(2) To whom does the internal audit function report administratively? (Five answering
function
categories.)
(3) What is the hierarchical level of your internal audit function? (Three answering
categories.) 219
(4) Is it common for internal auditors to move to other functions within the company? (Yes,
no, no comments.)
(5) On average, how many years does an internal auditor stay within the internal audit
function? (Five answering categories.)
(6) Who approves the internal audit budget? (Five answering categories.)
(7) The CEO gives input for the internal audit planning. (Five-point answering scale.)
(8) The CFO gives input for the internal audit planning. (Five-point answering scale.)
(9) People within the organisation perceive the internal audit function as their partner.
(Five-point answering scale).
(10) Does your company have an audit committee? (Yes, no.)
(11) How many members are there in the audit committee? (Open question.)
(12) How many of the audit committee members are independent members? (Open question.)
(13) How many of the audit committee members have an accounting background? (Open
question.)
(14) Who is mandated to appoint, dismiss and evaluate the head of the internal audit
function? (Five answering categories.)
(15) Is the CAE regularly invited to the audit committee meetings? (Yes, no.)
(16) The CAE has regular private contacts with the audit committee (Chair/or individual
members). (Five-point answering scale.)
(17) The audit committee gives input to the internal audit planning. (Five-point answering
scale.)
(18) On an annual basis, what percentage of the audit committee’s time is spent on internal
audit topics? (Open question.)

About the authors

Joe Christopher is a Lecturer in Auditing at the School of Accounting, Curtin University of
Technology, Western Australia. He comes from a background as an Internal Audit Practitioner
and has spent a considerable period employed in the internal audit field in both the private and
university sector prior to embarking in an academic career. He is currently undertaking his PhD
studies with Curtin University and his research interests are in the area of governance and
internal auditing.
Gerrit Sarens is Assistant Professor of Auditing and Management Accounting at the
Université Catholique de Louvain (Belgium) and visiting Assistant Professor of Risk
Management and Internal Control at the University of Antwerp (Belgium). He obtained a PhD
degree in Business Administration at Ghent University (Belgium). He has published articles in
international journals such the International Journal of Auditing; Managerial Auditing Journal,
Qualitative Research in Accounting and Management, the International Journal of Accounting,
Auditing and Performance Evaluation, Production Planning & Control, Corporate Ownership &
Control and The International Journal of Physical Distribution & Logistics Management. His
AAAJ research interests include internal auditing, corporate governance and outsourcing. Gerrit Sarens
is the corresponding author and can be contacted at: gerrit.sarens@uclouvain.be
22,2 Philomena Leung is Professor and Head of the School of Accounting, Economics and Finance
at Deakin University, Victoria, Australia. Her research interests are in the areas of auditing,
ethics and corporate governance. Her PhD thesis entitled “Ethics in the Australian accountancy
profession – an empirical analysis of accountants’ perceptions”, is a seminal work providing
empirical evidence on accounting ethics in Australia. Philomena also pioneered in accounting
220 ethics education in Hong Kong and Australia, having developed compulsory courses in ethics for
accounting curricula. Philomena was the inaugural chair of the Australia and New Zealand
Centre for the Association of Chartered Certified Accountants (ACCA) and has been council
member of ACCA since 1998. She has presented at numerous international and national
accounting conferences on topics of ethical issues, ethics education, earnings management, and
professional issues, published articles in several journals and undertaken several sponsored
research projects.

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