Increasing the Effectiveness of Internal Audit: Learn More From What You Ask

• In Event: Financial Statement Fraud, Internal Audit, and Risk Management Implications for Forensic Accountants

Abstract

Internal auditors perform audit checks to detect undesirable behaviors. Undesirable behaviors threaten a company’s assets directly, in case of negligence or misappropriation, or indirectly, in case of actions that increase a company’s legal risk. With global projected fraud losses estimated at $3.7 trillion, misappropriation is a significant problem (ACFE 2014). In retail settings, employee theft has been estimated to be responsible for 44% of inventory shrinkage, far exceeding losses due to shoplifting (Hollinger & Adams 2007).
When adverse audit findings result in corrective actions, the more effective an internal auditor is in detecting undesirable behaviors, the more powerful the deterrence to such behaviors. An auditor’s ability to detect fraud relies on the quality and, to a lesser extent, the quantity of information gathered. Ceteris paribus, better information should increase internal audit effectiveness. However, the internal audit function consumes valuable resources. Data collection has a cost that may outweigh its benefits, making an internal audit inefficient. Moreover, more information does not necessarily mean better information. Information can become overwhelming and contradictory, increasing ambiguity and paralyzing decision-making. When this happens, management may question the effectiveness and legitimacy of internal audits.
In this study, we provide information on one firm’s challenges with their internal audit function. The firm faced pressure to reduce corporate expenses. With cutbacks in audit staff, not every property could be audited yearly and audit score performance was therefore removed from managerial compensation. Unsurprisingly, author scores dropped annually. What intrigued us, as researchers, was whether the decline signaled greater levels of fraud, or simply negligence on the part of GMs (i.e., what gets done is what gets measured). With hundreds of locations dispersed throughout the country, a variety of assets subject to misappropriation and more than $500 million in cash sales, the potential for misappropriation is significant.
We examine multiple accounts at risk for misappropriation, developing models of abnormal spending. First, we find that the company’s audit score is weakly associated with abnormal spending. We then provide evidence on the development of better audit measures that help the firm learn more from the data gathered. Increasing audit effectiveness provides multiple benefits to the firm, by (1) targeting locations at greater risk of misappropriation; (2) reducing the audit workflow, ensuring that time is not lost on uninformative checks; and, (3) improving audit scoring to reduce noise, thereby increasing the ability to extract useful information.

Authors

• Thomas G Calderon, University of Akron

• James W Hesford, Ecole hôtelière de Lausanne

• Nicolas Mangin, Ecole hôtelière de Lausanne

• Mina Pizzini, Texas State University