Companies seek internal auditors when they get in trouble

Internal auditors are in especially high demand by businesses that have faced recent public failures, according to a new study. 

The study, co-authored by Young Hoon Kim, an assistant professor of accounting at George Mason University's School of Business in Fairfax, Virginia, analyzed 49,000 corporate online job postings for internal auditors for the years 2010 through 2019 and found that when companies experienced a public failure the previous year, they were nearly 10% more likely to seek an internal auditor. The researchers found a strong correlation between the level of failure and the qualifications listed in the job posting, with companies who faced more serious public failures being more likely to require CPA and Certified Information Systems Auditor certifications.

The paper, co-authored by Matthew Ege and Dechun Wang of Texas A&M University, is expected to appear in the Accounting Review.

Hiring internal auditors reduced the probability of the firm experiencing another failure by more than 17%, compared to failed companies that didn't hire an auditor. Not every company saw that much success, however, as those that hired internal auditors without providing appropriate governance structures were just as likely to fail again. 

The researchers pointed out that since 2004, an internal audit function has been mandatory for companies listed on the New York Stock Exchange. But when Nasdaq tried to impose a similar requirement in 2013, backlash from companies forced the agency to withdraw the proposed rule. 

To conduct the study, the researchers enlisted Burning Glass Technologies, a labor market analytics firm, to collect all online job postings made from 2010 to 2019 for analysis. "We were interested in internal auditor job postings because as researchers, we cannot obtain really great data on internal auditors," said Kim. "That was a black box. We don't know which firms are hiring internal auditors, so what we first did was to investigate when firms hire internal auditors. The New York Stock Exchange has a mandatory requirement that listed firms have to have an internal audit function. But Nasdaq tried that and had to withdraw the proposal. We were just interested in whether firms do value internal auditors."

The researchers found a negative stigma attached to in-house internal auditor jobs, but a desire to post such positions when businesses needed to clean up their operations. "We found that when a company has a publicly revealed failure — either accounting or operational failure — they had a higher likelihood of hiring," said Kim. "We could not see whether they actually hired, but we could see when they posted these internal audit positions. We found that firms after experiencing failures had a 10% higher likelihood of hiring internal auditors. We also found the severity of failures were more associated with internal auditor job postings, etc. Then we wanted to see the outcome. If they hired internal auditors, what happened? And we found that these 'failure firms' that decided to hire internal auditors had a lower likelihood of having similar problems in accounting, such as internal control weaknesses."

Companies that experience high-profile failures may be shamed by the negative fallout and publicity into hiring internal auditors. "Those high-profile failure firms tend to switch their CFOs, audit committee members and external audit firms because their reputation was impaired, so they try to show that they are doing something," said Kim. "We were not sure about the internal auditor, which was one of the key pillars of corporate governance structure, so this is the first study that shows that."

The researchers didn't pinpoint any specific companies where internal auditors were hired for the study. Instead they used an overall set of all U.S. public companies that were listed on the NYSE, Nasdaq or another exchange from 2010 to 2019. They then looked at the set of companies with accounting failures, financial misstatements and the like.

"We first used accounting failures: misstatements or material weaknesses in internal control over financial reporting," said Kim. "Also we used operational failures that can be seen as compliance failures too. There was a data provider that collected all the federal and local-level violations, the companies that had to pay penalties or fines to all those regulators due to various reasons, including environmental issues, employee-related issues, consumer-related issues, etc. Not just accounting failures, but also operational failures were associated with companies' demand for internal auditors."

Companies of all sizes were experiencing such failures and most received little publicity. "It's not just the high-profile companies," said Kim. "Out of all U.S. publicly traded companies we had in our sample, 14% had an accounting failure, and 20% had to pay fines or penalties to agencies due to operational failures. So it's not just one or two companies that had a huge well-known failure."

Whether or not the failure was widely publicized, investors could still penalize them in the market by not investing in them, so the companies took action, in many cases by hiring internal auditors, even if they weren't ordered to do so by regulators like the Securities and Exchange Commission or the Public Company Accounting Oversight Board.

"I'm not sure if financial regulators, the SEC or PCAOB, would directly tell the firms to retain or hire new internal auditors," said Kim. "I haven't seen such a case. But if this failure is revealed, the company should start doing something to fix this problem. There can be many other alternative actions they can choose, but U.S. firms tend to increase their demand for internal auditors."