Using the Internal Audit Function as a Management Training Ground: Is the Monitoring Effectiveness of Internal Auditors Compromised?

Abstract:     
Prior studies report that a majority of Fortune 500 companies systematically rotate internal auditors out of the internal audit function and into operational management. We examine how using the internal audit function as a management training ground affects internal audit’s ability to monitor management by examining the propensity for management to: (1) manipulate the financial reporting system as indicated by the company’s accounting risk (i.e., the risk that financial statements contain intentionally misleading or fraudulent information); (2) extract more lucrative compensation from the company; and (3) decouple compensation from performance. We find that companies that use the internal audit function as a management training ground experience significantly higher accounting risk than companies that do not. Furthermore, we find that CEOs of companies that use internal audit as a management training ground extract higher excess compensation and have lower pay-performance sensitivities than CEOs of companies that do not use this practice. Overall, our findings suggest that using the internal audit function as a management training ground can compromise internal auditors’ monitoring effectiveness. Therefore, when designing internal audit functions, firms should consider the potential costs of using the internal audit function as a training ground from which to promote managers.

Number of Pages in PDF File: 51

Keywords: internal audit function, accounting risk, executive compensation, management training ground

JEL Classification: M41, M43, G34, M52

working papers series