Why internal auditors are the naysayers companies need

Mason research shows that hiring internal auditors, and giving them proper organizational authority, can be the first steps toward addressing the root causes of business failure. 

Naysayers are often unpopular, for obvious reasons. Sometimes, though, they’re the only thing standing between a group of people and a disastrous decision. 

In the business world, internal auditors are in an analogous position. As the in-house watchdogs tasked with ensuring financial reporting and business operations are above board, they’re often seen as a necessary evil at best. “There is negative stigma,” says Young Hoon Kim, an assistant professor of accounting at George Mason University School of Business. “Job candidates are told, ‘you don’t really want to become an internal auditor–you become the enemy. You’re not going to enjoy that life.’”  

“Consistent with this notion, job postings for internal auditors relative to job postings for general accountants have decreased from 2010 to 2019.” 

Since 2004, an internal-audit function has been mandatory for NYSE-listed companies. But when NASDAQ attempted to follow suit in 2013, outcry from the business community forced the agency to withdraw the proposed rule. Kim’s new research paper, forthcoming in The Accounting Review, shows that demand for qualified internal auditors runs high for at least one kind of company–the embarrassed kind.  

With co-authors Matthew Ege and Dechun Wang of Texas A&M University, Kim analyzed about 49,000 corporate online job postings for internal auditors for the years 2010-2019, as well as corporate governance data for the advertiser firms. To complete their sample set, the research team gathered data covering a wide range of operational failures–from environmental pollution to employee mistreatment–and information on restatements and other financial reporting failures. 

The researchers found that in the year following a public failure, offending companies were 9.6 percent more likely to seek an internal auditor than their non-incriminated peers. The demand was contagious, spreading to non-accused firms with board directors in common. Additionally, the effect was present only in cases of more severe failure–for example, material weaknesses in internal controls as opposed to a mere filing do-over. 

The more severe the failure, the more stringent were the qualifications listed in the job posting. Specifically, firms that had just been caught up in a serious failure were more likely to name CPA and CISA certifications as requirements for the internal auditor position. 

Perhaps most meaningfully, the hiring of internal auditors reduced the probability of experiencing another failure by 17.3 percent, compared to failed firms that didn’t hire an auditor. “Since high-quality internal auditors were beneficial in terms of preventing accounting and operational failures, it seems there’s a benefit to having this position,” explains Kim. 

Not every firm in this category benefited, however. Firms that beefed up their internal audit function, but lacked a structurally powerful audit committee and adequate board independence, were no less likely to fail again in the near future. “The governance structure should be able to protect internal auditors from other employees,” Kim concludes. “There’s a need for a strong audit committee to back up internal auditors.” 

For Kim, these findings should warn firms away from going through the motions or doing the perceived bare minimum in the wake of a failure. “Some firms just do cheap talk,” he says. “They’ll do an analyst conference call, and the analyst will ask them what they’re doing to address an issue. The easiest thing is to pledge to hire an internal auditor. But they may not actually give the auditor authority to do their jobs.” 

Internal auditors are the naysayers companies need, especially after taking a reputational hit, Kim suggests. Giving them positions of real autonomy can be the first step toward addressing the root causes of failure. It’s a message that policymakers and investors should remember when dealing with companies in need of rehabilitation.  

“We find that firms that experience failures and engage in reactive hiring of internal auditors tend to remediate problems because of that hiring,” he says. “If you have a problem, hiring internal auditors will help you fix the problem. But this is contingent upon firms having a strong governance structure.”