An Examination Of Whether Incentive Compensation And Stock Ownership Affect Internal Auditor...

The importance of internal auditing has been widely recognized during the past two decades. The Treadway Commission called internal auditing an "important element in preventing and detecting fraudulent financial reporting" (1987: 37). The Blue Ribbon Committee on Improving the Effectiveness of Corporate

Audit Committees indicated that "the internal auditor also plays a significant role in working with management, the outside auditor, and the audit committee in ensuring the effectiveness of internal controls and in bringing any weaknesses to the attention of the appropriate parties" (1999: 29). The Panel of Audit Effectiveness stated that "an internal audit function that focuses on financial reporting matters can improve the quality of financial reporting. It acknowledges the importance of this function . . ." (2000: 62).

Recent events in the corporate sector have increased the prominence of internal auditing. The bankruptcies, financial reporting irregularities, and fraudulent activities that took place in Enron, WorldCom and other firms have greatly increased scrutiny on corporate monitoring. Especially in light of the external audit failures associated with these events, internal audit's role in corporate monitoring is sure to be expanded.

While external auditors are concerned primarily with financial reporting, internal auditors typically do not spend most of their time dealing with financial reporting. A survey by Barrett et al. (1985) found that, on average, internal auditors spend 32 percent of their time on financial audits. Interestingly, though, a survey by KPMG Peat Marwick (1999) found that internal auditors were more likely to discover fraud than external auditors. The Treadway Commission points out, however, that internal auditors' full potential "often is not realized, in part because the role the internal auditors have in the audit of financial statements at the consolidated level is often limited . . . internal auditors often concentrate on the review of controls at the division, subsidiary, or other business component level, rather than at the corporate level. Independent public accountants, on the other hand, generally are responsible for the audit examination at the corporate level" (1987: 39).

In recent years, internal auditors have received incentive compensation in the form of bonuses tied to overall company performance (Stapp, 1991; DeZoort et al, 2000). Internal auditors are seen as adding value to the firm because of their role as business consultants in areas such as internal controls, effectiveness and efficiency of operations, and compliance with organizational policies and procedures. Hence, many organizations believe that internal auditors should be rewarded for the successes of the firm. Moreover, many believe that rewarding internal auditors with incentive compensation will increase their productivity and effectiveness as well as improve their morale and motivation (DeZoort et al, 2000).

According to a recent survey (Stewart, 1997), 51 percent of auditing department heads received incentive-based compensation. In a survey of 179 internal auditors, DeZoort et al. (2000) report that almost half of the respondents indicated that incentive compensation was available to internal auditors in their organizations. Of those reporting the availability of incentive compensation, 70 percent indicated that this compensation was based on overall company financial performance. A majority of these performance measures were related to reported earnings, such as net income, earnings per share, return on equity, and return on assets. Internal auditors also sometimes own stock in the companies in which they are employed (Simpson, 1999). In fact, the DeZoort et al. (2000) study reports that 23 percent of the internal auditors who received incentive compensation were awarded stock options.1

These types of situations could raise concerns about conflicts of interest (Heaston et al, 1993). For both situations, internal auditors would benefit when their company's earnings are high. Whether the incentive compensation is based on the company's earnings or on the company's stock price, the internal auditors might tend to overlook management actions that overstate earnings. Indeed, 56 percent of the internal auditors in the DeZoort et al. (2000) study felt that incentive compensation based on overall company performance potentially impairs internal auditor objectivity and independence. Also, since higher company earnings generally affect the company's stock price in a positive manner, internal auditors who own company stock might tend to overlook management actions that overstate earnings.

Objectivity is a key element in the effectiveness of an internal audit function. The Panel of Audit Effectiveness asserted that "internal auditors must be objective with respect to the activity being audited" (2000: 62). Many research studies attest to the importance of objectivity for internal auditors (e.g., Messier and Schneider, 1988; Church and Schneider, 1992; Brody and Kaplan, 1996). However, senior managers do not always appreciate the value of internal auditor objectivity. "The pressure to 'partner' with senior management and to serve as more of a 'team player' diminishes the auditor's ability to remain objective" (Haas, 2001: 88).

The Institute of Internal Auditors' Code of Ethics mandates that internal auditors maintain objectivity:

Internal auditors exhibit the highest level of professional objectivity in gathering, evaluating, and communicating information about the activity or process being examined. Internal auditors make a balanced assessment of all the relevant circumstances and are not unduly influenced by their own interests or by others in formingjudgments (2000:2).

In addition, the Institute's Standards for the Professional Practice of Internal Auditing state that "internal auditors should have an impartial, unbiased attitude and avoid conflicts of interest" (2001: 3). Neither of these pronouncements address the level of objectivity that the Institute's members should have. Presumably, it would not need to be quite the level required of external auditors due to the nature of the employee/employer relationship inherent with internal auditors. At any rate, neither incentive compensation nor stock ownership is prohibited by the Institute.

No prior research has examined whether internal auditor incentive compensation or stock ownership affects auditors' objectivity. Therefore, this study contributes toward the understanding of how conflict of interest situations such as incentive compensation or stock ownership might influence decisions made by internal auditors. To the extent that their objectivity is impaired by these situations, the effectiveness of the internal audit function is reduced. This would be of great concern to the company's investors and creditors, who increasingly rely on the monitoring activities of internal auditors, and perhaps of some concern to external auditors who rely on the work of internal auditors.

The remainder of this article is developed as follows. The following section reviews the relevant prior literature as well as the research questions addressed in this article. Afterwards, the experimental procedures are discussed, the method of analysis is presented, and the study's participants are described. The results are then examined and the article concludes with a discussion of interpretations and limitations of the study.

Literature and Research Questions

Positive accounting theory suggests that people act to maximize company performance when they have incentives to maximize their own personal wealth (e.g., through incentive-based compensation or through appreciation of stock owned in the company). In a review of this theory, Watts and Zimmerman (1990) discuss the bonus plan hypothesis, which posits that managers of firms with earningsbased bonus plans are more likely to use accounting methods that increase current period reported income. They state: "The choice studies to date find results generally consistent with the bonus plan hypothesis" (1990: 138). In addition to earnings-based bonus compensation, "agency theory implies that it is desirable to compensate executives on the basis of share price in order to give them incentives to control their expenditures and develop strategies that increase shareholder wealth" (Lambert and Larcker, 1985: 10).

In an audit-setting model, Antle (1982) represents external auditors as self-interested economic agents whose audit decisions are influenced by how those decisions affect their own wealth. Trompeter (1994) found that audit partner compensation schemes affected their objectivity. Partners who had compensation more closely tied to client retention were less likely to require downward adjustments to income. In another auditing study, DeZoort et al. (2001) conducted an experiment to examine how incentive compensation for internal auditors affected external audit planning. The authors manipulated internal auditor compensation (fixed salary versus incentive compensation) as well as audit task subjectivity (objective test of controls versus subjective inventory valuation). The study found that incentive compensation resulted in less reliance on internal auditors' work and greater budgeted hours, but only for the subjective audit task. The research reported in this article, in contrast, focuses on decisions made by internal auditors themselves rather than other auditors who may rely on them.

Using a positive model and presuming that internal auditors' behavior is similar to managers, executives, and external auditors, the literature discussed above suggests that internal auditors' reporting decisions may be influenced by extrinsic rewards such as incentive compensation and stock appreciation. This study examines this issue by addressing the following two research questions:

RQ1: Does internal auditor incentive compensation, either as a bonus tied to profits or as a bonus tied to the stock price, affect internal auditors' reporting decisions?

RQ2: Does stock ownership by internal auditors affect their reporting decisions?

In two instances, benefits accrue to internal auditors due to the stock price. For those internal auditors who receive a bonus tied to the company's stock price, the stock price affects their wealth indirectly through incentive compensation. For those internal auditors who own stock, the stock price directly affects their wealth because of their level of stock ownership. An interesting issue is whether internal auditors might tend to manipulate stock prices more so under conditions of incentive compensation based on stock price or under conditions where they own the stock.2 Hence, this study addresses a third research question:

RQ3: Does stock ownership by internal auditors affect their reporting decisions any differently than when they have incentive compensation based on stock prices?

These issues are important because if objectivity is impaired, the effectiveness of the internal audit function is reduced. This would concern investors and creditors, who increasingly rely on the monitoring activities of internal auditors, and also those external auditors who rely on the work of internal auditors. It should be stressed that this exploratory study is merely a first step in addressing these issues.

Methodology

Research Design

To address these issues, this study uses an experiment in which practicing internal auditors are asked to make reporting decisions for a case involving the manipulation of variables pertaining to incentive compensation and stock ownership. To test RQl, three groups are formed where the incentive compensation is manipulated as follows:

Control group-compensation is straight salary only.

Earnings group (Group IA)-compensation is a salary plus a significant bonus tied to accounting earnings.

Stock price group (Group IB)-compensation is a salary plus a significant bonus tied to the company's stock price.

To test RQ2, two groups are formed where stock ownership is manipulated as follows:

Control group-no stock ownership in the company.

Stock ownership group (Group 2)-a significant number of shares of company stock are owned.

To test RQ3, groups IB and 2 are used. The control group participants are the same for RQl and RQ2, resulting in a total of four groups of internal auditors for this study.

Experimental Task

Participants received background information about a hypothetical company (XYZ Corporation) that manufactures office equipment. They were instructed to presume that they are internal auditors for XYZ Corporation. all participants received the same information except for the type of compensation they would receive by XYZ Corporation and whether they had stock ownership in XYZ Corporation. The control group was informed that their compensation is straight salary and they had no stock ownership. The treatment groups for RQl were told that they had no stock ownership and that in addition to salary, they would receive a bonus tied to either the accounting earnings (Group IA) or to the company's stock price (Group IB). The treatment group for RQ2 (Group 2) was informed that the compensation is straight salary and that they did have stock ownership.

Participants were then given a case scenario about defective equipment inventory and were asked if they would report the failure to take a loss on this inventory (see Appendix).3 The case clearly involves a violation of generally accepted accounting principles (GAAP), so it should be reported by the internal auditors. However, incentive compensation or stock ownership may influence internal auditors to not report the GAAP violation. Hence, this research examines both incentive compensation and stock ownership to see if either one impaired internal auditors' objectivity. The research instrument was pretested with a former internal auditor.

Since the cases involve a sensitive matter (i.e., reporting something that conflicts with one's self-interest), elicitation of truthful responses is a major concern. Without some form of "protection," many participants might be reluctant to admit that they would not report the failure to take a loss on the inventory. Therefore, the randomized response technique (RRT) was used to elicit responses.

The RRT, developed by Warner (1965), is a process of obtaining responses to sensitive questions that assures anonymity. Participants are instructed to respond either to a sensitive question or to an unrelated innocuous question, depending on the outcome of a randomization process controlled by the participant. Although the researcher does not know which question (innocuous or sensitive) an individual has answered, an unbiased estimate of the mean response to the sensitive question can be determined. Most studies that have compared the RRT to traditional direct response elicitation (e.g., see Fidler and Kleinknecht, 1977; Tracy and Fox, 1981) have found that the RRT reduces response bias and promotes more reporting of behaviors that could be perceived unfavorably. The RRT has been used in several accounting and auditing studies (e.g., Buchman, 1983; Schneider and Wilner, 1990; Schneider, 1995).

Analysis

A response of "no" to the sensitive question-"Would you report this?"-would indicate a breach of internal audit responsibility. The formula to obtain an estimate of the proportion of participants that respond "no" to the sensitive question is (see Tracy and Fox, 1981: 189):

[pi]^sub i^ = [(1-L) - (1-p)(1-Y)]/p

where:

[pi]^sub i^ = proportion of subjects in group i who respond "no" to the sensitive question (i = Control, 1A, 1B, 2)

L = proportion of "yes" responses given in group i

p = probability of answering the sensitive question

Y = probability of responding "yes" to the innocuous question

Soeken and Macready (1982) recommend that the probability of answering the sensitive question be between .7 and .85. Greenberg et al. (1969) suggest that the probability of responding "yes" to the innocuous question be on the same side of .5 as [pi]^sub i^ is expected to be (in this case, below .5), but not too close to zero. Consistent with these recommendations and prior accounting research (e.g., Schneider, 1995; Schneiderand Wilner, 1990), this study used p = 70 percent and Y = 33 percent.

Participants

Questionnaires were sent to companies throughout the United States. Companies were randomly selected from the Fortune 1000 list from a website directory of internal auditors and from a newspaper listing of that state's top 100 companies. Before sending out the questionnaires, phone calls were made or emails were sent to one contact person per company, typically the head of internal auditing. For the 59 companies that agreed to participate in the study, the questionnaires were sent to the contact person, who distributed the questionnaires to the internal audit staff. In total, 400 questionnaires were sent to these companies. The respondents returned the completed questionnaires directly to the researcher. Completed questionnaires were received from 172 internal auditors (response rate of 43%) in at least 42 different companies, with a cross-section of industries represented such as manufacturing, transportation, utilities, and financial services. The response breakdown by group was as follows: Control group-54, Group IA-43, Group IB-33, and Group 2-42.

IMAGE TABLE 1

Table 1

Data on Questionnaires and Demographics

The participants' average age was 38, they averaged 7.9 years of internal audit experience, and averaged 9.3 years of total internal plus external audit experience. As internal auditors, 59 percent of the respondents had received incentive compensation based on earnings, 18 percent had received incentive compensation based on stock price, and 81 percent had owned stock in a company in which they were employed as an internal auditor. These demographics were similar across all four groups of participants. Ninety-six percent of the participants found the instructions and other information in the questionnaire to be clear. Table 1 summarizes the questionnaire data and demographics.

Results

To ensure that the respondents fully attended to the information in the questionnaires, two manipulation checks were performed. The first asked the respondents to recall the method of incentive compensation in the internal auditor contract and the second asked them to recall the information about stock ownership in XYZ Corporation. The first manipulation check was inaccurate for 10 percent of the respondents, while the second one was inaccurate for four percent of them.4 When these respondents were deleted from the data analysis, the results obtained were virtually identical to those for the full data set. Hence, the full data set is used for the remaining analysis.5

IMAGE TABLE 2

Table 2

Estimated Proportions of "No" Responses

Table 2 reports, for each of the four groups, the estimates of proportion of participants who responded "no" to the question of whether they would report the GAAP violation. The estimated proportions range from 0 to 10 percent.

To test RQ1 (the effect of internal auditor incentive compensation), a chi-square test was performed comparing the percentages among the following three groups: Control, 1A, and 1B. The test yielded a chi-square statistic of 7.74, which was statistically significant with a p-value of 0.02. Thus, when compensation was tied to the stock price, a significantly higher percentage of internal auditors would not report the GAAP violation than when the compensation was tied to earnings or when it was a fixed salary only.

RQ2 was tested by comparing the percentages for the Control group and Group 2. The chi-square statistic for this test was 1.41, resulting in a non-statistically significant p-value of 0.23. Thus, there is insufficient evidence to conclude that stock ownership affected the reporting decisions of the internal auditors.

RQ3 tested whether internal auditors tend to manipulate stock prices more so because of incentive compensation (Group IB) or because of stock ownership (Group 2). Results revealed a chi-square statistic of 0.69 and a p-value of 0.41. Thus, there is insufficient evidence to conclude that there is any difference in the degree to which either of these two groups tend to manipulate stock prices. Table 3 summarizes the statistical test results.

Discussion and Implications

This article reports the results of an exploratory study which attempts to determine whether incentive compensation and stock ownership affect internal auditors' reporting decisions. The results indicated that stock ownership did not affect these decisions. Perhaps the internal auditors viewed their stock ownership as long-term. If so, they may have believed that even if the GAAP violation were not reported in the current period, the inventory loss would surface in a later period's financial statements and not reporting the GAAP violation now would just postpone the inevitable.

Another finding was that when incentive compensation was tied to stock prices, internal auditors tend to indicate that they would report GAAP violations less frequently. It is not clear, however, why this same effect was not found when incentive compensation was tied to earnings. Intuitively, one might think that a bonus tied to earnings would have more of an effect on internal auditors since the case scenario dealt with a direct manipulation of earnings, whereas the effect on stock price is indirect. A possible explanation is that when the causal relationship is more evident, and therefore the risk of discovery is higher, the internal auditors are more apt to report GAAP violations. Along these same lines, it could be argued that members of Group 2 receive benefits that are not likely to be picked up by the market immediately, yet that group was more willing to not report a GAAP violation than members of Group IA who would receive more immediate benefit. Again, the same explanation about risk of discovery could be offered. Further research is needed to resolve these issues.

Several limitations should be noted in this study. First, the questionnaire did not specify to whom the internal auditors should report (e.g., VP-Manufacturing, CEO, Board of Directors) . There might be a difference in reporting decisions depending on the party to which they report. Also, different interpretations could have been made as to what was meant by reporting. Since in most audits findings are discussed with the auditee first before a final report is issued (so that the auditee can have an opportunity to reconcile or provide an explanation for the audit finding), participants could have thought that discussion with management was first necessary rather than reporting directly to the Board of Directors.

IMAGE TABLE 3

Table 3

Results of Statistical Tests

Another potential limitation of this study is common to many other behavioral studies-the actions of auditors in a simple case scenario may not be the same as if the auditors encountered the situation in real life. A hypothetical case scenario is devoid of personal repercussions from reporting the GAAP violation (e.g., loss of job, not being seen as a team player, being assigned less desirable engagements).

This research manipulated stock ownership in a fictitious company to exercise control over the stock ownership variable. The downside of this design is that external validity was sacrificed by not having participants base their decisions on current stock holdings relating to the companies for which they actually work. One other concern is that the relative size of one's holdings of stock of one's employer could affect the degree of risk-averse behavior. This issue was not considered in this study.

With these limitations in mind, this study contributes to the understanding of the effects of incentive compensation and stock ownership on internal auditor reporting behavior. These issues have not been addressed in the research literature, yet they have become important because of the current levels of internal auditor stock ownership and incentive compensation as well as the heightened role of internal auditing in today's environment. This study's results would seem to suggest that despite concerns that have been raised about conflicts of interest (e.g., Heaston et al., 1993), stock ownership by internal auditors does not seem to impair their objectivity. However, incentive compensation based on stock prices was found to impair internal auditors' objectivity, so companies may wish to consider this finding when designing compensation plans for internal auditors. Yet, it should be emphasized that this study is a first attempt to address these issues and that further research is necessary before definitive conclusions can be made. The next step might be to have internal auditors make reporting decisions in the context of the actual companies for which they work and based on their actual stock holdings and actual compensation schemes.

FOOTNOTE

1 Other types of incentive compensation reported were based on internal audit department performance (notably cost savings) and individual auditor performance (e.g., relating to prescribed work goals and the individual's contributions to the internal audit department).

2 It should be emphasized that internal auditors cannot directly manipulate stock prices or affect earnings, since they are not the ones who prepare financial statements. However, they do have the power to "blow the whistle" on improper financial reporting, and it is that role which enables them to affect earnings and stock prices.

3 A second case scenario was also given to subjects, but its ambiguity caused confusion and therefore it was discarded.

4 Since some participants failed both manipulation checks, a total of 13% failed at least one of the manipulation checks.

5 An analysis was also conducted using only those participants who indicated that they had at some time received incentive compensation as an internal auditor. The results obtained from this data set were similar to those of the full data set.

REFERENCE

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AUTHOR_AFFILIATION

Arnold Schneider

Professor of Accounting

Georgia Institute of Technology

APPENDIX

APPENDIX

CASE SCENARIO GIVEN TO PARTICIPANTS

Your workpaper file contains a memo from XYZ's VP-Manufacturing to the company's CEO. The memo informs him/her that a batch of equipment recently manufactured by XYZ is severely defective. This equipment, which had cost $95,000 to manufacture, is currently in inventory. According to this VP, the equipment could not be sold in its current condition and re-work would not be financially feasible. He/She has concluded that the equipment will have to be discarded with no salvage value. According to generally accepted accounting principles, a loss of $95,000 should be recognized on this inventory. A loss would reduce pre-tax earnings below the company's $1.2 million target. Without recognizing this loss, the pretax earnings for the current year would be $1.25 million. You now see a draft of the company's annual income statement and it does not show this loss.