The Effect of Incentive‐Based Compensation on Internal Auditors' Perceptions of Objectivity

• Author: Jenny Stewart,Hasni Mohd Hanafi @ Omar
• Date: 01 March 2015
• Published date: 01 March 2015
• DOI: http://doi.org/10.1111/ijau.12032

The Effect of Incentive-Based Compensation on Internal Auditors’ Perceptions

of Objectivity

Hasni Mohd Hanafi @ Omar1and Jenny Stewart2

1Multimedia University,Selangor, Malaysia

2Griffith Business School,Griffith University,Australia

A key threat to internal audit objectivity is the paymentof incentive-based compensation (IBC) to internal auditors.

This study uses an experimental approach to examine whether IBC paid to internal auditors based on company

performance and individual performance does impact their objectivity. The study also investigates whether the

cultural background of internal auditors affects their objectivity in the context of IBC by examining whether those

from an individualistculture (Australia) differ in their responses to those from a collectivist culture (Malaysia). The

descriptive results suggest that IBC is awarded to both internal auditors/chief audit executives in Australia and

Malaysia. The experimental results indicate that IBC is a threat to internal auditors’ objectivity when it is based on

company performance, but is less of a threat when it is based on individual performance. Culture does not appear

to impact perceptions of internal auditors’ behaviour but does affect perceptions of the appropriateness of adverse

behaviour.

Key words: Internal audit, objectivity, incentive-based compensation, economic interest threat, culture

INTRODUCTION

Incentive-based compensation (IBC) is widely used as a

mechanism to align employees’ interests with those of

the firm in order to maximise shareholder wealth (Baker,

Jensen & Murphy, 1988; Demski, 1994). Within an agency

framework, ‘a fundamental objective of an IBC scheme

is to motivate individuals to exert effort to improve

performance’ (Chong & Eggleton, 2007, p.313). However,

it is also recognised that this form of compensation

provides incentives to employees to bias measures of

performance in order to maximise individual wealth

(Watts & Zimmerman, 1990). Dysfunctional behaviour of

this kind is not only detrimental to the firm but is also

ethically questionable. This is particularly so when the

individuals concerned perform a role which depends on

their objectivity and they belong to a profession which

requires them to adhere to a code of ethics. Such is the

case with internal auditors (Chen, Chung & Wynn, 2009;

The Institute of Internal Auditors, 2011; The Institute

of Internal Auditors Global, 2013) and it is therefore

important to understand whether IBC payments

influence their ability to remain objective.

While evidence indicates that many organisations

reward their internal auditors with IBC (Stapp, 1991;

DeZoort, Houston & Reisch, 2000; Dickins & O’Reilly,

2009), research on the impact of such payments on

internal audit objectivity is sparse (Schneider, 2003). This

paper addresses this gap in the literature by examining

(i) the impact of IBC on internal auditors’ behaviour and

(ii) internal auditors’ perceptions of the appropriateness

of adverse behaviour. We use an experimental design

to examine two types of IBC, namely a cash bonus based

on company performance and a cash bonus based on

individual performance. We also contribute to the

literature by exploring the impact of cultural differences

with respect to individualism/collectivism on internal

auditors’ behaviourand perceptions in the context of IBC.

We do this by engaging participants from Australia

which is recognised as a highly individualist society

and Malaysia which is a regarded as a collectivist

society (Hofstede, 2001; House et al., 2004). A further

contribution of our study is that we provide up-to-date

evidence on the use of IBC to reward internal auditors in

both these countries. This is importantas prior studies are

somewhat dated and pertain only to the United States

(US).

We find that internal auditors’ objectivity appears to

be affected when they receive IBC based on company

performance but not when IBC is based on individual

performance. Further, we do not find evidence that

nationality affects behaviour but it does appear to have

some effect on participants’ tolerance of unethical

behaviour.A limitation of our study is that participantsin

Malaysia were less experienced than those in Australia

and, while we control for experience in our analysis, this

may have affected our results. Furthermore, the internal

auditing profession in Malaysia is less mature than

its Australian counterpart and this could also have

influenced our findings.

The remainder of this paper is structured as follows.

The next section provides the background to the study

including a discussion of prior literature and the

development of our hypotheses. The third section

explains the research design while the fourth reports

and discusses the results. In the final section, some

conclusions are drawn, the limitations of the study are

acknowledged and some suggestions for further research

are provided.

BACKGROUND AND HYPOTHESIS

DEVELOPMENT

The internal auditing profession in Australia

and Malaysia

The first chapter of TheInstitute of Internal Auditors (The

IIA) in Australia was formed in 1952, with a national

institute being formed in 1986 (The Institute of Internal

Auditors Australia, 2014). The Malaysian Institute is

somewhat younger, being formed as a chapter in 1977

Correspondence to: Professor Jenny Stewart,Department of Accounting,

Finance & Economics, Griffith Business School, Griffith University,

University Drive, Meadowbrook, Queensland, 4131, Australia. Email:

j.stewart@griffith.edu.au

International Journal of Auditing doi:10.1111/ijau.12032

Int. J. Audit. 19: 37–52 (2015)

© 2014 John Wiley & Sons Ltd ISSN 1090-6738

and becoming a national institute in 1988 (The Institute

of Internal Auditors Malaysia, 2014). More recently

however, internal auditing has grown significantly in

both countries and has become increasingly recognised

as a key corporate governance mechanism. The

Australian Securities Exchange (ASX) Corporate

Governance Council’s Corporate Governance Principles

and Recommendations (ASX Corporate Governance

Council, 2014) stresses that internal audit brings a

systematic, disciplined approach to evaluating and

improving the effectiveness of an entity’s risk

management and internal control processes. While the

use of internal audit is not mandatory,the ASX Corporate

Governance Council (2014) recommends that companies

with an internal audit function should disclose how the

function is structured and the role it performs. For

companies without an internal audit function, disclosure

of this fact should be made, together with details of the

alternativeprocesses in place to evaluate and improve the

effectiveness of its risk management and internal control

systems. In contrast, in Malaysia, all listed entities must

establish an internal auditfunction which is independent

of the activities it audits and which reports directlyto the

audit committee (Bursa Malaysia, 2013).

Incentive-based compensation

There are no prior studies that have examined the

payment of IBC to internal auditors in Australia or

Malaysia. However, evidence from three US studies

indicates that in many organisations internal auditors

have the opportunity to receive IBC (DeZoort et al., 2000;

Chen et al., 2009; Dickins & O’Reilly, 2009). DeZoort et al.

(2000) report that the most common form of IBC at the

time of their study was a cash payment followed by stock

options or a combination of cash and stock options. Most

IBC plans were based primarily on overall company

performance, but also on individual performance and

internal audit department performance. When IBC plans

were linked to overall company performance, a majority

of the measures were based on reported income such as

net income, earnings per share, return on assets and

return on equity. IBC plans that depend on individual

performance set prescribed work goals and assessed

the individual’s overall contribution to their audit

departments. On the other hand, IBC plans thatare based

on internal audit performance were generally linked to

cost savings. More recently, a survey of Chief Audit

Executives (CAEs) in the post Sarbanes-Oxley period

indicated that 89 per cent of respondents receive either

stock-based awardsor bonuses based on operating results

(Dickins & O’Reilly, 2009). Chen et al. (2009) also report

that 62 per cent of firms in their sample paid IBC in the

form of cash only and a further 17 per cent paid a

combination of cash and stock.

Stapp (1991) suggests that IBC is the best way to add

value to an organisation and to instil a sense of

accomplishment in the individual, particularly for

internal auditors.Rewarding internal auditors with IBC is

expected to ‘increase their productivity and effectiveness

as well as improve their morale and motivation’

(Schneider, 2003, p. 487). Introducing or expanding

IBC can further assist in retaining talented and

high-achieving internal auditors (Moody, 2000; James,

2004). Furthermore, Barrier (2003) indicated in his

interview with the former vice president of internal audit

of WorldCom Inc. (now MCI) that, if internal auditors are

not allowed to participate in stock option or bonus

programmes, recruiting and retaining the best staff will

be more difficult.

Notwithstanding the benefits of IBC, Mutchler (2003,

p. 252) suggests that the threat of economic interest can

arise when ‘internal auditors have stock options or other

financial interests that might be threatened by negative

audit findings’. This view is endorsed by The IIA (2011)

which recognises the economic interest threat and

recommends that incentive pay for internal auditors

should be designed to encourage and reward objective

thinking. DeZoort et al. (2000) contend that, even though

IBC based on company performance measurement could

provide incentives to the internal auditors to maximise

shareholders’ wealth, it can also motivate internal

auditors to inappropriately maximise measures of

company performance to enhance their own personal

wealth. Schneider (2003) uses positive accounting theory

to argue that internal auditors’ behaviour is similar to

that of managers, executives and external auditors

(Antle, 1982; Watts & Zimmerman, 1990). Hence ‘internal

auditors’ reporting decisions may be influenced by

extrinsic rewards such as incentive compensation and

stock appreciation’ (Schneider, 2003, p. 489).

Empirical testing of the impact of IBC on internal

auditors’ objectivity is scant. DeZoort, Houston and

Peters (2001) found that, for subjective audit tasks,

external auditors planned less reliance on internal audit

work when internal auditors received IBC compared to

when they received only a fixed salary. Their findings

suggest that external auditors perceive that IBC can pose

a threat to internal audit objectivity. Schneider (2003)

found that internal auditors’ objectivity was impaired

when they received a bonus tied to the company’s stock

price, but not when it was tied to profits. He suggests a

possible reason might be that, when the causal

relationship is more evident, internal auditors are

cognisant that the risk of discovery is higher. However,

Schneider (2003) acknowledges that his finding is

counter-intuitive and that further research is needed to

resolve the issue.

This study examines both IBC tied to company

performance and IBC tied to individual performance.

Notwithstanding Schneider’s (2003) findings, we posit

that internal auditorswill bias their decisions in favour of

achieving their bonus payments for both types of IBC.

Accordingly, the following hypotheses are proposed:

H1: Relative to fixed salary, internal auditors who

receive IBC based on company performance are more

likely to bias their decisions to achieve company

performance targets.

H2: Relative to fixed salary, internal auditors who

receive IBC based on individual performance are more

likely to bias their decisions to achieve personal

performance targets.

Individualism/collectivism

No prior studies have directly compared internal audit

objectivity threats across more than one culture and

hence there is a gap in the literature concerning the effect

of cultural dimensions on internal auditors’ objectivity.

In this study we focus on the cultural dimension

of individualism/collectivism as this dimension is

particularly relevant to the payment of IBC based on

group performance and individual performance.

38 H. M. Hanafi @ Omar and J. Stewart

Int. J. Audit. 19: 37–52 (2015)© 2014 John Wiley & Sons Ltd