Relational contracting theory and internal audit: Chief audit executives' perspectives on creating and strengthening trust by building credibility and clarity

• Published date: 01 January 2024
• Author: Elnaz Vafaei,Hajinder Singh,Glennda Scully,David Gilchrist,Prerana Agrawal
• Date: 01 January 2024
• DOI: http://doi.org/10.1111/ijau.12314

ORIGINAL ARTICLE

Relational contracting theory and internal audit: Chief audit

executives' perspectives on creating and strengthening trust by

building credibility and clarity

Elnaz Vafaei

1

| Hajinder Singh

1

| Glennda Scully

1

| David Gilchrist

2

|

Prerana Agrawal

2

1

School of Accounting, Economics and

Finance, Curtin University, Perth, Western

Australia, Australia

2

Business School, University of Western

Australia, Crawley, Western Australia,

Australia

Correspondence

Elnaz Vafaei, School of Accounting, Economics

and Finance, Curtin University, Perth, WA,

Australia.

Email: elnaz.vafaei@curtin.edu.au

Funding information

This paper has been extracted from the first

author's PhD project that was funded by

Curtin University and Australian Government.

Using the lens of relational contracting, we examine internal auditors' efforts in build-

ing a relationship of trust with management within the context of operational audits.

We gain insights into the day-to-day practices of internal auditors by interviewing

28 chief audit executives of internal audit departments across Australia and find that

internal auditors undertake numerous measures to demonstrate credibility and pro-

vide clarity on their intentions in an attempt to gain managements' respect and confi-

dence. However, we also find that some of the measures auditors undertake in a

defensive corporate culture support the notion of ‘trust begets trust’. Consequently,

such measures may not only assist in establishing a relational contract with manage-

ment but also highlight the potential risks to internal auditor independence.

KEYWORDS

internal audit, independence, corporate governance

1|INTRODUCTION

One challenge faced by internal auditors is adding value to an organi-

sation (Institute of Internal Auditors [IIA], 2013), thus raising the issue

of effectiveness in researchers' minds and therefore the usefulness of

the internal audit function (IAF) itself (Ahmad & Taylor, 2009;

Colbert, 2002; Norman et al., 2010; Roussy, 2013,2014). IAF effec-

tiveness has been extensively researched in numerous quantitative

and qualitative studies (Arena & Azzone, 2009; Carcello et al., 2005;

Castanheira et al., 2010; Cohen & Sayag, 2010; Lenz & Hahn, 2015;

Roussy & Brivot, 2016; Soh & Martinov-Bennie, 2011; Trotman &

Duncan, 2018). These studies identified and refined the essential

attributes necessary to support effective internal audit including utility

inherent in internal audit reports, independence, effective identifica-

tion of internal control weaknesses and close working relationships

between internal audit and management (Roussy & Brivot, 2016).

Building a relationship of trust with management to gain their

support towards the function and its recommendations has been iden-

tified as a key element in IAF effectiveness (Chambers &

McDonald, 2013; Lenz et al., 2017; Vafaei, 2016). Management

support is considered vital for the effective performance of the IAF

(Baheri et al., 2017; Halimah et al., 2012; Turetken et al., 2019)as

internal auditors can identify areas of potential improvement, but

ultimately, it is management who decide whether and how to enact

the auditor recommendations (Arena & Azzone, 2009).

Although relationships with senior management and the board/

audit committee have been found to aid the IAF's pursuit of effective-

ness (Anderson, 2009; Barma, 2009; Cohen & Sayag, 2010; Lenz

et al., 2014; Mihret & Yismaw, 2007; Turetken et al., 2019), calls have

been made to improve our understanding of internal auditors'

relationships with other stakeholders and across different settings

(Lenz et al., 2014). Furthermore, research on how these relationships

Received: 13 April 2022 Revised: 7 February 2023 Accepted: 31 March 2023

DOI: 10.1111/ijau.12314

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and distribution in any

medium, provided the original work is properly cited, the use is non-commercial and no modifications or adaptations are made.

© 2023 The Authors. International Journal of Auditing published by John Wiley & Sons Ltd.

24 Int J Audit. 2024;28:24–43.

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are actually built is sparse (Calvin et al., 2021; D'Onza &

Sarens, 2018). As the auditor–management relationship is bidirec-

tional (D'Onza & Sarens, 2018), internal auditors can play an impor-

tant role in relationship-building to foster trust and credibility and

reduce conflict (Chambers & McDonald, 2013). In fact, the onus of

managing relationship and gaining management support often rests

with the auditors (McCracken et al., 2008; Perreault & Kida, 2011).

Hence, it is important to understand how internal auditors build and

manage a relationship of trust with management.

Calls have also been made for research examining the day-to-day

practice of internal audit. Roussy and Perron (2018) highlight the need

for insights into how internal auditors behave and address conflict

situations. According to the authors, given the scarcity of research

and lack of understanding on the day-to-day practice of internal audit,

research using methodologies such as interviews to gain better

insights is required. We address these gaps in the literature by

examining the IAF's relationship with management within the context

of operational audits.

Using semi-structured interviews with 28 chief audit executives

(CAEs), we examine the internal auditors' relationship with manage-

ment through the lens of relational contracting theory. Relational con-

tracts are incomplete agreements with agreed common goals but

without detailed plans (Macneil, 1978; Milgrom & Roberts, 1992). We

examine how internal auditors address the two key attributes of a

relational contract being ‘credibility’and ‘clarity’. Our study identifies

potential drivers of a relational contract and measures undertaken by

internal auditors in practice to initiate and develop an effective rela-

tionship with management. In doing so, we also identify resultant

potential adverse consequences from the relationship-building mea-

sures undertaken by internal auditors.

Our study makes the following contributions. First, it contrib-

utes to the emergent literature examining the day-to-day practice of

internal audit. Insights from the study build on the existing fragmen-

ted knowledge and assist ongoing efforts in gaining a more

comprehensive picture of how internal auditors work (Roussy &

Perron, 2018). As management support is key to an efficient and

effective operational audit, our findings highlight the various

mechanisms adopted by internal auditors to gain management

co-operation in practice. The risks some of these measures pose to

the IAF's independence signal the need for practitioners to exercise

caution while considering such adoption, that is, the IAF walks a

fine line between being management's trusted advisory and the

boards' eyes and ears.

Second, our study contributes to the discussion on understanding

the core role of an IAF where internal auditors are required to deliver

value beyond assurance by managing conflicting stakeholder expecta-

tions (i.e., expectations of a consultative approach by management

and governance expectations of overseeing bodies) without

compromising the IAF's independence (Roussy & Perron, 2018; Soh &

Martinov-Bennie, 2011). By examining how internal auditors work

towards establishing a relational contract with management, our study

informs researchers, professional bodies and standard setters of the

current practices undertaken within an inherently conflicted

environment; identifies training and professional development needs

of internal auditors, external auditors and directors; and provides

guidance to standard setters relating to the potential changes needed

in internal audit guidance and in auditing standard-setting.

Finally, our study extends the scarce literature that examines the

establishment of relational contracts in a ‘within-firm’context. Baker

et al. (2002) emphasise that the formal process of internal auditing

cannot be completely understood without considering the various

informal agreements (i.e., relational contracts) that the IAF has with

various stakeholders. These relational underpinnings can encourage

communication and minimise managements' negative reactions, resis-

tance and uncooperative behaviours towards audit and consequently

enable a more efficient and effective internal audit (Carmeli &

Zisu, 2009). Our findings shed light on how internal auditors pay

attention to cooperation and collaboration, occasionally subordinating

short-term self-interest to meet their long-term objectives

(i.e., establish a trusted relationship with management). By highlighting

the risk to auditor independence, our findings also inform practi-

tioners, researchers and regulators of potential adverse impacts on

audit quality. Trotman and Duncan (2018) confirm that building a

strong relationship with management and enhancing the likelihood of

acceptance and implementation of auditor recommendations are key

indicators of audit quality. Hence, our findings also support practi-

tioners, the professional bodies, researchers and regulators in their

efforts to enhance audit quality.

The structure of the paper is as follows. Section 2provides back-

ground information on IAF and operational audits, discusses the theo-

retical framework, provides an overview of prior literature and

identifies the research questions. Section 3outlines the research

methodology. Section 4presents the research findings, and Section 5

provides limitations and concluding remarks.

2|BACKGROUND AND LITERATURE

REVIEW

2.1 |Operational audit

Traditionally, IAF has been viewed as an organisational watchdog.

However, pressure has been placed on internal auditors to value-add

(Institute of Internal Auditors, 2017; Roussy, 2013), and one way this

can be accomplished is via operational audits. This need is important

as key stakeholders are more concerned about operational and busi-

ness risks compared with financial risks (Clark, 2003; Danescu

et al., 2010; Ernst & Young, 2007; Khalili et al., 2012; Paape

et al., 2003; Soh & Martinov-Bennie, 2011; Tooley et al., 2010). The

purpose of an operational audit is to provide management with strate-

gic information to support the achievement of the organisation's

broader goals (Flesher & Zarzeski, 2002; Jin'e & Dunjia, 1997), thus

meeting stakeholders' expectations in operational and non-financial

risk areas (Khalili et al., 2012; Paape et al., 2003; Soh & Martinov-

Bennie, 2011; Tooley et al., 2010). Accordingly, operational audit is

defined in this study as the process of evaluating an organisation's

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