The Ethical Climate

According to The IIA's International Standards for the Professional Practice of Internal Auditing (Standards), the internal audit function is expected — or rather required, as the Standards use the word "must" — to assess the ethical climate at their organization. Not only does this include the tone at the top, but also whether the compensation and other programs incent appropriate or inappropriate behavior.

It is easy to point to the bonuses that led whole organizations to take on more and more risk to achieve their numbers. Today's news is full of reporters' horror at the bonuses granted and the risks taken, which apparently led to the downfall of so many (formerly) great companies.

But do we have a similar issue at most companies? Do the bonus and commission programs offered to sales personnel incent them to generate top-line revenue at the expense of bottom-line profits? Are they offering large discounts to generate short-term results at the expense of longer-term value — in addition to the motivation to create side deals that promise additional off-the-books benefits if only the customer would sign now.

So my questions for internal auditors are these:

  1. Does your audit plan include assessments of the ethical climate, and in particular whether compensation programs from the board of directors and the chief executive officer down to junior sales personnel incent behavior detrimental to the organization? By the way, just because the board approves a program doesn't mean it is appropriate, especially if the board does not understand the risks of inappropriate behavior.
  2. If you were to perform such an assessment and find the ethical climate lacking and the compensation program incenting short-term achievements at the expense of longer-term value, would your opinion be heard? Or would it create political problems with executive management and the board?
  3. If you perform such assessments, how do they work for you?

Posted on Feb 7, 2009 by Norman Marks

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  1. 1. Most audit plans probably contain some overall assessment of culture including the "ethical temperature" of and "integrity risks" to an organization--this is part of the internal control environment in the COSO 1992 internal control-integrated framework. I am not sure whether they look at compensation structure and incentives, though, leaving it to HR, or in the case of the C-level suite, the compensation committee of the Board (and their compensation consultants--stock options, for instance are a complex area to audit or even review; consider FAS 123R--no wonder that it wasn't internal auditors who discovered the stock options backdating problems!).

    2. One important reason why internal auditors have stayed far away from reviewing the compensation/incentives area is the potential for political problems, and possibly a sense of embarrassment and awkward interpersonal relations (with their boss, if they are directly reporting to the CFO, who may not even want them to know the details of his/her pay!!!) This is further complicated if internal auditors are themselves issued stock options, and it is the CFO who awards them the bonuses or incentive compensation...they are clearly not independent of such audit activities, because of the potential, inherent bias/conflict.

    3. Would not recommend internal auditors performing such assessments unless they have the technical competence, and a clear mandate exists in audit charter fully endorsed by audit committee chair, and supported by compensation committee of the Board of Directors. For stock options, IRS sections 162(m), 409A, etc. need to be mastered, and having the general counsel's input would be most helpful too... 

  1. Every internal audit group should take a fresh look at their audit universe as well as the individual audits in the current plan to determine what changes, if any, are need to address the Standards.  Auditors will need guidance on methodology (and tools) that would be useful in helping them in these areas, if not already being addresses.

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