Effect of Internal Audit on Governance

The purpose of internal audit, according to the Institute of Internal Auditors (IIA), is to evaluate and improve the effectiveness of an organization's risk management, control, and governance processes. Weaknesses in any of these areas pose a threat to the organization's legitimacy with its stakeholders. Many organizations worldwide are required to adopt internal audit. However, other institutions, like American municipalities, are not. A municipality's decision to adopt internal audit is the responsibility of local leadership. Current economic pressures require that leaders consider a cost/benefit analysis before making a decision. Defining the costs of internal audit is relatively easy, but measuring its benefits is more elusive. This research examines whether the results of external audits may be used as an objective measure of internal audit benefits. The literature on internal audit quality does not identify externally derived measures that are independent of the function. This dissertation fills this gap. A logit model is used with data from 162 Florida cities to determine whether the presence of an internal audit reduces the likelihood of a city receiving findings in the independent external annual audit of their financial reports. The results are evaluated using legitimacy theory. Examining internal audit through this framework explains the difficulty in measuring the effectiveness of internal audit. The results indicate that objectively defining the benefits of internal audit may not be possible. They indicate instead that internal audit benefits, while real, may largely be abstract or symbolic. The internal audit role is best viewed as deterrent in nature. This poses challenges to those attempting to identify objectively measurable benefits. The implication is that municipal leadership should seek to understand the conceptual nature of the internal audit function before making resource allocation decisions. The loss of benefits from cuts to or elimination of the internal audit function may not be evident until sometime after making those funding decisions. The results of this research demonstrate the importance of internal audit, as well as the need for more investigation to further understand the nature of its effects.