Spiraling upward – history of internal auditing and the Institute of Internal Auditors

Spiraling upward – history of internal auditing and the Institute of Internal Auditors

Parveen P. Gupta

EVEN THOUGH Victor Z. Brink has written that “internal auditing as a concept has existed as early as there have been substantive human relationships,”‘ its origins can be documented and traced back to civilized communities that existed around 5000 B.C. The Chaldaean and Babylonian empires were the first to organize themselves as sovereign states and to advance economically and politically to the extent that Babylonian became the language of commercial and political influence throughout the whole civilized world. 112 The governments of these empires imposed a number of taxes on individuals and businesses. For the proper accounting and collection of these taxes an elaborate system of checks and counterchecks was established. Such early internal control systems were designed primarily to minimize errors and to safeguard state property from dishonest tax collectors.

The Mesopotamian civilizations, which existed about 3000 B.C., also utilized elaborate systems of internal controls. Summaries of the transactions were prepared by scribes who did not provide the original lists of receipts and payments. Documents of that period contain ticks, dots, and check-marks indicating the existence of the auditing function during those times.

The Bible contains an extensive discussion of internal audit functions in the modem sense of the term. It addresses limited access to assets, dual custody of liquid assets, surprise audits, care in selecting employees, and separation of duties. The Bible even explains the rationale behind such internal controls: the employees (i.e., agents) were likely to steal or misappropriate their master’s (i.e., principal’s) monies if given an opportunity to do so.

EARLY 2OTH CENTURY DEVELOPMENTS

Despite such ancient roots, it was not until the 1930s that internal auditing was recognized as important both by corporations and independent auditors. This recognition was primarily due to (1) establishment of the Securities and Exchange Commission (SEC) in 1934; and (2) changing external audit objectives and techniques. The SEC required that firms registered with it must provide financial statements certified by independent auditors. This requirement prompted corporations to establish internal auditing departments, but primarily to assist the independent auditor. At this time, independent auditors were placing more emphasis on expressing an opinion on the fairness of client financial statements than on detecting fraud and clerical errors. This change in objectives precipitated auditing based on a limited sample of transactions, along with greater reliance on internal control procedures.

Internal auditors were primarily concerned with checking accounting records and detection of financial errors and irregularities, and internal auditing was basically a shadow or echo of independent auditing. Walter B. Meigs, writing about the status of internal auditors during the 1930s, observed that “internal auditors were either clerks assigned to the routine task of a perpetual search for clerical errors in accounting documents, or they were traveling representatives of corporations having branches in widely scattered locations.” Some practitioners have even observed that the traditional internal auditor was many times used as a “spare” person in the organization to carry out routine accounting reconciliations, assist with installation of office systems, and serve as a clerical handyman.

FORMATION OF THE INSTITUTE OF INTERNAL AUDITORS – THE 1940s

The role and professional status of the internal auditor began changing as businesses decentralized and expanded their operations. Although corporations, financial executives, internal and external auditors, and the academic community all talked about an expanded and professionalized role for the internal auditor, the changes were slow and did not gain significant momentum until The Institute of Internal Auditors (IIA) was formed in 1941.

john B. Thurston, the head of the internal auditing department at North American Company was one of the organization’s pioneers and became The Institute’s first president. The formation of The Institute was the first step by a group of 24 forward-looking internal auditors. Since The Institute came into being to serve the special needs of its members, a major objective of The Institute was to project a better image and understanding of the profession of internal auditing to outside constituencies.

Within a few years after its formation, The Institute made remarkable progress, establishing itself as a legitimate body to oversee the professional interests of internal auditors. The IIA initiated many conferences and public meetings, emphasized research in internal auditing with a new journal The Internal Auditor, and published several monographs on internal auditing. These efforts succeeded in increasing the membership base of The Institute and in increasing public awareness of the internal audit function.,

In ensuing years, a number of inter-related forces (such as increased inflation; the growing complexity of the business environment; widespread decentralization and diversification of corporations; increased emphasis on corporate ethics and passage of the Foreign Corrupt Practices Act of 1977; establishment of audit committees; and internationalization of businesses), as well as the continuing efforts of The Institute itself, shaped the role and image of the traditional internal audit function. This gradual shift is evident in various statements issued by The Institute on the responsibilities of the internal auditor in 1947, 1957, 1971, 1976, 1981, and 1990. 1947 STATEMENT

By 1947 The Institute was “properly poised for a new period of growth and professional integration.”10 During 1946 and early 1947 The Institute’s Research Committee surveyed the current practice of internal auditing and concluded that there was an urgent need to define explicitly the role and responsibilities of the internal auditor. Therefore, on july 15, 1947, The Institute issued its first Statement of Responsibilities of the Internal Auditor [hereafter called “the Statement”]. The issuance of this statement is considered a milestone in the history of the internal auditing profession. This initial statement defined internal auditing as [An] independent appraisal activity within an organization for the review of the accounting, financial, and other operations as a basis for protective and constructive service to management. It deals primarily with accounting and financial matters but it may also properly deal with matters of an operating nature.”

By giving a provisional nod to the internal auditor’s involvement with activities of an operational nature, the Statement’s drafters clearly envisioned a broader role for the internal auditor.” Although it emphasized the internal auditor’s strong association with accounting and financial matters, the statement intended to do away with the traditional image of an internal auditor as an accounting clerk or “spare” employee.

The Institute’s first statement was issued shortly after the end of World War II. This was a time of tremendous growth and opportunity for the internal auditing profession. During the post-war period a number of corporations were looking for ways to utilize their excess plant capacity. Due to increased competition (in the absence of sharply reduced military production), corporations were interested in trimming down their operating costs and increasing market share. Corporate managements turned to their internal audit departments for help.

Unfortunately, internal auditors could not provide much help at that time and a golden opportunity to expand their role and influence in corporate affairs was lost. This failure can be attributed primarily to four major causes: (1) internal auditors did not have free access throughout the corporation and could not question the higher management’s decisions; (2) the majority of internal audit departments lacked trained professional accountants; (3) most internal audit departments were allowed to concern themselves only with matters of accounting and financial nature; and (4) the majority of internal audit departments reported to lower-level management. This arrangement resulted in many ineffective audit recommendations, and many were not acted upon.

However, corporate managements soon started to realize that the reason their internal audit staffs were not able to make a much larger contribution was due to their lack of stature in the organization. Accordingly, managers began to elevate the professional status of their internal auditing staff by removing many obstacles. This elevation in the role of internal auditor is reflected in the second revision – the 1957 statement. 1957 STATEMENT

Due to the widening interest of corporate management in utilizing the internal auditor in the audit of operations, The Institute’s research committee felt the need to revise the 1947 Statement to reflect the current position. As a result, The Institute issued a revised Statement in 1957. This Statement defined internal auditing as [An] independent appraisal activity within an organization for the review of accounting, financial, and other operations as a basis for service to management. It is a managerial control, which functions by measuring and evaluating the effectiveness of other controls.

Although the Statement emphasized the association of internal auditors with accounting and financial information, the Statement, unlike its predecessor, also links the internal auditor with the evaluation and review of “other operations.” The element of discretion (indicated by may” in the 1947 Statement, with regard to the evaluation of “other operations” of an enterprise) was eliminated. Rather, the Statement unequivocally incorporated such activity as part of the evolving role of internal auditor.

By now, The Institute’s efforts to professionalize the discipline of internal auditing were well recognized by other special interest groups. The Institute was regularly invited to participate in the summit meetings held by the American Institute of Certified Public Accountants (AICPA), the American Accounting Association (AAA), the Financial Executives Institute (FEI), the National Association of Accountants (NAA), and The International Federation of Accountants (IFAC). However, The Institute made greatest strides in furthering the role and image of internal auditors in 1968 and 1970, when it adopted the code of ethics and instituted a formal program to certify internal auditors.

1971 REVISION

By 1970 many significant changes had occurred in the internal auditing profession. More corporations were utilizing their internal auditing departments to conduct operational audits. The organizational status of internal auditors was considerably upgraded, and a growing number of independent auditors were coordinating their audit efforts with the internal auditors.”

These changes led many members of The Institute to believe that the Statement of the Responsibilities of the Internal Auditor should again be revised to reflect the changed stature of the internal auditor. The organizational review report of The Institute in 1966 strongly recommended such a revision. 16 Soon a special subcommittee was appointed under the supervision of The Institute’s permanent Research Committee. The subcommittee’s revision, which was adopted by The Institute’s Board of Directors on june 30, 1971, represented a giant step. It made many substantive changes and altogether redefined the nature of the internal auditing as [An] independent appraisal activity within an organization for the review of operations as a service to management. It is a managerial control which functions by measuring and evaluating the effectiveness of other controls.

This change in the wording of the 1971 statement clearly reflected the growth that had occurred in the internal auditing profession since 1941 and was also indicative of the changes that would occur in ensuing years. According to Sawyer , the word “operations” in the 1971 statement was meant to cover “the entire spectrum of activities that are engaged in by an organization and that are subject to the internal auditor’s appraisal.” In other words, the 1971 revision intended that a contemporary internal auditor be concerned with every significant aspect of an organization’s activity.

Some readers of the 1971 statement may infer that an internal auditor had no longer had anything to do with the accounting and financial matters of an organization. In this regard, Sawyer notes:

.. (T)he words that imply a special interest in financial and accounting matters have been removed. This does not by any means exclude the activities of the auditor who is concerned primarily with financial and accounting matters, because these functions are completely covered by the generic term “operations. ” But it does proclaim the afl inclusive interest of the internal auditor in whatever activities affect the enterprise. 10

In addition to these significant changes, the 1971 revision also makes numerous alterations in the objective, scope, responsibility, authority, and independence of internal auditors. Together, all these changes reflect the activities that had emerged or gained more significance since the 1957 revision.

CHANGES IN THE 1980s

After the third revision in 1971, the Statement was revised twice within a 10-year period. The fourth revision was made in 1976 to reflect the entry of women into the internal auditing profession. In an era when women were expanding their role in business, increasing numbers of women were joining professions that had traditionally been dominated by men. By 1970 one out of every four accountants in the United States was a woman.

The Institute also felt the impact of this growing presence of women. By 1974 The Institute had l00 women members and a number of them were chapter presidents. The Institute reacted positively to these changes by amending its Bylaws, the Code of Ethics, and the Statement of Responsibilities of the Internal Auditor to avoid any references to an internal auditor in any manner that would denote sex.

The fifth revision came about 1981. This revision did not propose any changes in the definition and nature of internal auditing. However, the objective and scope paragraph of the statement was rewritten to state that the scope of internal auditing also includes economy and efficiency, as well as program evaluation audits.

When The Institute issued the Standards for the Professional Practice of Internal Auditing in 1978, it further broadened the scope of internal auditing by redefining it as “an independent appraisal function established within an organization to examine and evaluate its activities as a service to the organization. These Standards emphasize and perceive the role of the contemporary internal auditor as a service to the organization rather than only to the management. This broadened scope of internal auditing is now formally recognized in the 1990 revision of the Statement of Responsibilities of the Internal Auditor.

During the 1980s a number of events took place in the business environment which have underscored the usefulness of operational audits to corporate managements. The Foreign Corrupt Practices Act of 1977 and the evolution of corporate audit committees have emphasized management’s responsibility for the way in which it chooses to manage the company. As a result, an increasing number of corporate managers are now relying on their internal audit departments to help them govern the company more efficiently and effectively.

CONCLUSION

These revisions in the Statement of Responsibilities of the Internal Auditor clearly demonstrate the progress of the internal auditing profession over the last 50 years. internal auditors with vision and commitment can ensure that the history of the profession will continue its upward spiral.

COPYRIGHT 1991 Institute of Internal Auditors, Inc.

COPYRIGHT 2004 Gale Group