It is not an uncommon occurrence for companies to face operational and accounting failures at some point in their journey. When such events occur, these companies often find themselves seeking ways to salvage their reputations and regain the trust of their stakeholders. According to a recent study published in The Accounting Review by Matthew S. Ege, Young Hoon Kim, and Dechun Wang, firms could utilize internal auditing as an instrument for reputation repair.
In their study, the authors propose that an Internal Audit Function (IAF) can help to mitigate both accounting and operational risks. IAFs are often called upon by management to identify, monitor, and mitigate organizational risks while also ensuring the efficiency of organizational processes. As such, when corporate failures occur, it’s likely that firms might increase their demand for internal auditors, considering their assessment skills that can aid in preventing future failures and rebuilding corporate reputation.
However, the study recognizes that not all companies might respond to accounting and operational failures by increasing their demand for internal auditors. Some may instead opt to revamp other areas of their management or governance, such as the board of directors, CFO, or external auditors. There’s also the potential challenge of hiring high-quality internal auditors, given the often-negative perceptions associated with these positions.
The authors use a proprietary database of online job postings to explore the demand for internal auditors before and after accounting and operational failures. The findings suggest that, on average, firms are more likely to post at least one internal auditor job after a failure revelation compared with years without one.
The study also reveals that the internal auditor positions posted by firms after failures require candidates to be more qualified compared with those posted at other times. This implies that firms might be keen on strengthening their IAFs following failure revelations.
The research explores how board connections between firms can influence internal audit hiring decisions. If a director at one firm advocates for hiring internal auditors in response to a failure, they are likely to propose the same at other firms where they serve as a director. As such, demand for internal auditors can increase when connected directors advocate for their hiring in response to failures.
The study concludes by examining whether hiring internal auditors in response to failures helps prevent future ones. It suggests that hiring internal auditors following an accounting failure is associated with fewer subsequent accounting failures. However, this effect is most pronounced in firms with strong governance, as the effectiveness of an IAF is largely dependent on its organizational independence, which is often supported by a strong board of directors.
This study makes significant contributions to the literature on the effects of IAFs on financial reporting and operational outcomes, decision-makers‘ perceptions about investing in internal auditing, and the demand for human capital after negative events. Importantly, it also provides relevant insights for practitioners and underlines the role of the IAF as an integral part of corporate governance and the information supply chain.
In essence, the study makes a strong case for the value of internal auditors in a corporate setting, especially in the wake of operational or accounting failures. While the decision to increase demand for internal auditors may vary from firm to firm, the study underlines their potential effectiveness in preventing future failures and restoring corporate reputation.
Find the article here.