Independence and objectivity are key requirements for internal auditors. Boards should manage the internal audit function in ways that preserve and enhance internal audit's independence and objectivity. Remuneration of the HIA should be considered in that context, avoiding potentially harmful influences and incentivising wrong outcomes.
The board, where appropriate via an audit and / or remuneration committee, should ultimately determine the structure and size of the HIA's remuneration package alongside tasking and appraisal. This should be the case even where the Chief Executive Officer or Chief Financial Officer has day-to-day responsibility for pay and rations.
In considering the level of remuneration for the HIA, boards should have regard to the level at which the HIA is required to operate in relation to others in the organisation. It should not be set lower than those in equivalent functions, notably in senior executive management. This will be particularly sensitive if the HIA position is staffed from within the organisation.
HIAs should be remunerated according to the general principles of the organisation in which he/she works. Thus where there are variable as well as fixed components to remuneration, consideration should be given to the HIA receiving a comparablepackage to roles at the same level (e.g. Heads of Risk or Compliance), based on appropriate criteria.
Any variable remuneration component for the HIA should be decided on a basis that does not compromise internal audit's independence or objectivity. In particular the board should decide on a structure that does not undermine internal audit's willingness or ability to advise on risk, or make judgements based on promoting long term sustainability.
In practice boards may have to consider structuring the remuneration of the HIA differently to that of executive management. This may mean tying the variable component to different performance criteria to those for others, for example focusing on the performance of the internal audit team relative to the resources devoted to it or on the long term performance of the organisation.
The board will wish to consider the need for a different structure for the HIA's remuneration against the risk of alienating internal audit from the rest of the organisation, possibly undermining its ability to recruit the best people or perform its roles effectively. This would be particularly sensitive if internal audit were seen as being rewarded for actions that lead to others receiving a lower variable component.
Nevertheless, provided the remuneration process for internal audit is perceived as rational and fair, and appraisal is carried out at board or board committee level, a different remuneration structure for internal audit could be presented positively as helping promote the right corporate culture.
Boards could also consider an external review of remuneration structures to help overcome any potential hostility towards a different structure for internal audit. In its review of the Turnbull Guidance the FRC should consider expanding its coverage of how boards manage the internal audit function to preserve and enhance independence and objectivity. This should include the correct positioning of internal audit in the organisation, reporting lines, tasking and appraisal, remuneration and rotation of the HIA, skills and experience, and adherence to The IIA's International Standards.
Independence and objectivity are key principles for the internal audit function. The IIA Global Standards interpretation states:
Independence is the freedom from conditions that threaten the ability of the internal audit activity to carry out internal audit responsibilities in an unbiased manner" and "Objectivity is an unbiased mental attitude that allows internal auditors to perform ngagements in such a manner that they believe in their work product and that no quality compromises are made.
The IIA Global Code of Ethics states:
2. Objectivity Internal auditors: 2.2. Shall not accept anything that may impair or be presumed to impair their professional judgment.
Four recent examples where the effects of the system of remunerating internal control functions has caused concern are:
The IIA committee on internal audit in the financial services sector recommended that, "The Chairman of the Audit Committee should be responsible for recommending the remuneration of the Chief Internal Auditor to the Remuneration Committee.
The remuneration of the Chief Internal Auditor and Internal Audit staff should be structured in a manner such that it avoids conflicts of interest, does not impair their independence and objectivity and should not be directly or exclusively linked to the short term performance of the organisation"
This concluded that "Internal audit's independence is as important as that of the Chief Risk Officer and the Head of Group Compliance, and its preservation should similarly be the responsibility of a named individual non-executive director, usually the chairman of the audit committee."
"Boards must protect the independence of the Chief Risk Officer, and personal responsibility for this should lie with the chairman of the risk committee. The Chief Risk Officer should not be able to be dismissed or sanctioned without the agreement of the non-executive directors, and his or her remuneration should reflect this requirement for independence."
It concludes "The design of incentive schemes for the control functions should avoid potential conflicts of interest, such as an interest in business unit profitability; this may require a higher proportion of fixed remuneration. Barclays should develop specific performance measures related to successful achievement of the control functions' objectives and these should form a significant element of any incentive arrangements"
Ofgem's report of 03/04/2013 states "However, the auditing of both venue and doorstep Marketing Activities over the relevant period (i.e. from October 2009 to July 2011) was inadequate: in relation to doorstep sales, the main auditing was carried out by local managers who received commission on sales and therefore had a financial interest in not reporting misbehaviour and so were not sufficiently independent." While this is not directly related to internal audit, similar principles apply.
Since the financial crisis in 2008, some organisations have been structuring internal audit remuneration differently to that for others in the organisation. Some have done away with variable components for internal auditors, leaving only fixed salary. But most recognise that variable components are not wrong per se, and that tying the variable element to appropriate factors can help motivate HIAs and their staff while preserving independence and objectivity.
Setting the right performance objectives upon which appraisal is carried out is crucial, as is choosing a mix of variable elements, such as cash or deferred shares, that rewards sustainability rather than inappropriate, short term behaviour.
27 August 2013Download PDF