Chapter 2

THEORETICAL BACKGROUND

Review of Related Literature

Internal Audit (IA) and Performance Measures

IA creates value added for the company either within the meaning of

revealing/detecting problems and issues or in the sense of preventive measures. In

Institute of Internal Auditors (IIA) opinion, the core function of the Internal Audit Function

(IAF) is the provision of impartial advice to the management with regard to risk

management and improvement of operational processes (IIA, 2004) with a task to

support the management in unveiling and controlling key risks and, moreover, ensure

the effectiveness of the internal control system and contribute to the avoidance of

critical developments and events within the company (Ge & McVay, 2005).

IA is theoretically considered as a key element of modern corporate governance.

In every sense, corporate control and audit issues can be improved by a proper

valuation and collaboration with other governance bodies. Eulerich et al. (2013)

revealed that design of the IAF's integration into the corporate organization crucially

determines numerous requirements to operate on the highest quality standard possible.

Based on 3,294 responses of the 2010 Common Body of Knowledge (CBOK) study

from 26 EU-member states, they proved the influence of the IA on the design and

achievement potential of corporate governance in the European Union. Sarens &

Abdolmohammadi (2011) further found evidence that IAF plays a monitoring role in

corporate governance which is useful in assessing the current size of IAF and the role
that it can play in corporate governance. Through the provision of effective support to

the management in the framework of bonding and monitoring, IA constitutes an

important element of the companys internal corporate governance. It turns out also that

a supportive control environment has a positive impact on the relative size of the IAF,

thereby proving that the establishment of this function is an economic requirement

supported by the principal-agent theory.

However, because of the new orientation that IAF has acquired through dynamic

years and due to the presence of essential information asymmetries and conflicts of

interest between management and shareholders that lead to a risk of adverse selection

and moral hazard (Jensen & Smith, 1985), the traditional concept of principal-agent

must be incorporated with the two-staged model by Tirole (1986), where it also extends

to being an independent supervising activity to consider IAF as an agent of the

management board which is responsible for the establishment and maintenance of IA.

On behalf of the management board, the IAF is assigned to supervise the boards

subordinate bodies and, among other things, evaluate the internal control system

(Schartmann & Lindner, 2006). Hence, the internal structure of the IAF and audit fields

must be organized analogously to the corporate organization to increase the quality of

audit and control units and optimally utilize this control function as the audit activities

performed are more target-oriented.

Being a part of the control framework of an organization also entails the

establishment and adoption of controls to ensure and track whether IAF performance is

in line with its roles and objectives and controls are consistent with the organizations

objectives and strategies as well. Zureigat & Al-Moshaigeh (2014) conducted an

empirical study to explore whether Saudi listed companies are using their performance

measures in evaluating the IAF and if, they are, what performance measures they used

from the perspective of the internal auditors. The results of the study significantly

contributed to the literature by identifying the key performance measures for the IAF and

thereby provided valuable information about how to measure internal auditing

performance. It has revealed that these companies are using both quantitative and

qualitative performance measures to assess the IAF performance.

Internal Audit in the Government

The main objective of internal audit in the government, specifically in the local

sector, is to promote accuracy and reliability in accounting and operating data, to

safeguard government resources against waste, fraud, and inefficiency, to measure the

extent of the operating departments' compliance with government policy and to evaluate

the overall efficiency of the operating functions (Adams, 2004). Basically, internal

auditing oversees the efficiency of the operations of governmental units.

In the study of Santiso (2013) regarding Center of Government (CoG), he found

out that it is becoming more and more relevant in a context where an increasing number

of crosscutting issues demand whole-of-government approaches and coherent

responses. In several countries, the CoG is also increasingly involved in promoting

innovations to improve government performance and support departments and

agencies in achieving results. (Santiso, 2013).

In line with such, Mendoza (2008) in her paper stated that the Philippines does

not lack initiatives pertaining to internal auditing. As early as 1962, the Philippines
already had a law for internal auditing the Republic Act (RA) 3456 or the Internal

Auditing Act of 1962 .The Department of Budget and Management (DBM), together with

the Commission on Audit (COA), and the Internal Audit Office of the Office of the

President, has recently launched the Philippine Government Internal Audit Manual

(PGIAM) on October 2011 to complement the National Guidelines on Internal Control

Systems (NGICS) that was issued by DBM in 2008 (The Official Gazette, 2011).Budget

and Management Secretary Florencio B. Abad under Aquinos Presidency said the

issuance of the PGIAM will improve the roll-out and implementation of internal control

and internal audit systems in government institutions and stressed out how internal

audit plays a crucial role in reform, especially in recommending courses of action to

ensure effective, efficient, ethical, and economical operations of agencies, and in

enhancing the performance of public institutions, especially in the use of public

resources (The Official Gazette, 2011).

The Internal Audit in the public sector faces a lot of challenges which inhibits the

functions ability to manifest its duties within the organization. Modibbo (2015), in his

study, cited three common problems relating to internal audit efficiency which exist in

the government, specifically in the local sector. These problems are:

1. Appropriate recognition is not given to internal audit department

2. Lack of training and knowledge by internal audit staff and
3. Internal audit department are often poorly funded by those who are in position of

authority.
 Modibbo (2015) believed that in order for an internal audit to be effective, all the

features of internal audit (independence, reporting, audit plan, structure, resources etc.)

should all be put in place. Also, in the research conducted by Sahdan et al. (2007), it

has been concluded that there exists a continually increasing failure and

mismanagement in the organizations in Malaysia which shows how ineffective internal

audit is in both public sectors and private sectors. Thus, with such finding, it

emphasized and signaled the great importance of internal audit to both sectors.

Furthermore, the two greatest inhibitors to efficient and effect operations are the lack of

audit personnel and audit personnels lack of appropriate skills and competency for the

tasks required and expected of them (Sahdan et al., 2007). In support to the various

studies aforementioned, Ogechi (2013) concluded in her paper regarding the challenges

of internal audit in Nigerian public sectors that the internal control system is not effective

enough to detect the incidence of fraud among public officials and consequently, this

has a negative effect on the efficiency of the internal audit function. On top of that, the

lack of numbers of audit personnel, insufficient funds and lack of segregation of duties

in the internal audit department is also a hindrance to the effectiveness of the internal

audit in the Nigerian public sector (Ogechi, 2013). Having enumerated a catalogue of

some of the impediments that the internal audit function faces, Nwannebuike and

Nwadialor (2016) have enumerated the following, to remedy some of the problems, and

these includes:

1. The recruitment process for internal audit staff should be thorough and

transparent to ensure the enlistment of only qualified personnel.

2. Management of Organizations should motivate staff of internal audit departments

to painstakingly implement internal audit procedures.

 3. Management of Organization should co-operate with internal audit staff to

promote effectiveness of the various control measures put in place.

4. Regular training of the staff of internal audit departments is necessary to sharpen

their skills of implementation of necessary procedures.

Davies (2001) states in his research that in the public sector, internal audit seems to

be having a facelift, in the sense that there has been an increased emphasis on

corporate governance and public reporting has placed the internal auditor into a more

focused position. With regard to the important role of internal audit in corporate

governance, Davies (2001) elaborated that far more authorities now either had an audit

committee or were in the process of establishing them as compared to the situation

before. Further, IIA (2012) remarked that governance principles are critical to the public

sector since the latter holds coercive powers over citizens and economic enterprises,

and thus they must enact protections to ensure fairness and accountability in the use of

such powers and in the delivery of the expected services. Good public governance

requires fair and impartially enforced laws and regulations (IIA, 2012). In a nutshell,

internal audit needs to be a part of it.

Perceived Value of Internal Audit

Over the years, the role of internal auditors inside the organization has

progressed. But until now, there are still some who struggle to prove their relevance and

necessity within the organization (Palfi & Bota-Avram, 2009). The perceptions and

expectations of other organizational parties affect the value of Internal Audit Function.

Expectations of other organizational parties affect the value of Internal Audit Function.

Research by Sarrens & De Beelde (2005) concluded that the top management and
audit committee have high expectations for the IAF. However, it was pointed out by

Gupta (2004) that line managers have negative perceptions about the IAF. Furthermore,

Gupta (2004) expressed that line managers are unwilling to cooperate with the IAF and

that they are afraid that the works of the internal auditors would divulge their faults and

errors.

Inasmuch as internal audit can add significant value to the entity, it is perceived

that management and internal auditors have a close relationship with each other

(Shamsuddin et al., 2015). That is why; it is necessary and important for public sector

entities to establish guidelines and safeguards to ensure the independence of their

reports (IIA, 2012).

The IAF has also been acknowledged because of its unique role in risk

management. Further, IAF has been recognized to reduce risks, improve control risks,

lessen fraud risks, reduce opportunistic behaviors and perform other non-financial

statement related task within an organization (Ege, 2015; Prawitt, et al., 2009). The

study conducted by Coetzee & Fourie (2009) regarding the role of internal audit function

in terms of risk, concluded that the perceptions of Chief Executives (CE) and

Chairperson of Audit Committee (CAC) should increase with regard to the value that IAF

can provide, which is an indication that the IAF has been expected to provide greater

utilization in terms of minimization of risk.

The internal audit plays a valuable role to an organization and its functions and

roles are said to have made a great impact to overall performance. This might not be

made certain to the senior management. Thus, Coetzee & Fourie (2009) conducted a
study to know whether the perceptions of the senior management, including the audit

committee, on the value that IAF can provide corresponded to the activities that it

currently performs in the organization.

Research by Khoury (2011) stated that internal auditing in the public sector

served as a simple administrative procedure comprised mainly of checking accuracy of

transactions, pre-payment verification and control, counting assets and reporting on

past events to various types of management. But in recent times and due to modern

technology, there is a quiet revolution in the profession. Governments moving toward

higher levels of transparency must demonstrate accountability in the use of public

money and efficiency in the delivery of services. Larger and more complex operations

demand greater competency and professionalism from internal auditors to minimize and

manage risk (Khoury, 2011). Ever more larger and complex systems require greater

competitiveness, thus internal audit has had to become ever more professional

(Gansberghe, 2005).

Government operations are being managed by the line or operating managers of

each department who have the primary responsibility of supervising their staff.

Consequently, their perception as to the value provided by the provinces internal audit

function affects their performances. By providing unbiased, objective assessments of

whether public resources are managed responsibly and effectively to achieve intended

results, auditors help public sector organizations achieve accountability and integrity,

improve operations, and instill confidence among citizens and stakeholders (Goodson et

al., 2012). Internal auditors which are the focus of this study and also the key employee

of public offices, are expected to work independently and objectively to enhance high
quality of public services, achieve good internal control system, avoid corruption, ensure

good corporate governance system, promote accountability and greater transparency

(Coram et al, 2008; Van Peursem 2005).

Roles of Internal Audit Function

Various theories are used to support the perceived value of internal audit function

as seen through its roles in the organization. As written by Garitte (2015), he defined the

value of internal audit through its abilities to tell whether or not the company is poorly

managed, to identify the areas where the critical risks are being poorly managed or not

identified, and to determine if the company objectives are being met. The roles of the

internal audit function may differ depending on the needs of a particular entity. However,

its roles in the government may differ from its roles in the commerce and industry.

As an example, in one of its published supplemental guidance, the Institute of

Internal Auditors Global (2012) has strengthened the value of internal audit in the

public sector by justifying the inherent need for internal audit in the government by

stating that the inherent risks in the principal-agent relationship between the

government and the public are reduced through effective audit activities. The

organizations said that as the public needs a third party to attest the credibility of the

governments assertions, the higher is the perceived value of internal audit functions

within the government. Not only did the IIA (2012) provided the roles of oversight and

insight of government activities but had also supplemented other perceived roles of

public sector auditors like detection, deterrence, and foresight of governmental

functions. In addition to this, the Department of Budget and Management (DBM),

through the Philippine Government Internal Audit Manual (2011), has also provided the

activities that are interrelated with the other government entities and are essential to the

effectiveness and efficiency of the said entities.

On the other hand, the rapid change that is happening in the business sector has

forced the internal auditors to evolve from their traditional roles. KPMG (2007) has

stated that in order to regain its historical influence as an independent adviser to

management, it must be able to open new doors of opportunities. In one of its published

advisories, KPMG (2007) has provided three new roles that could help the internal audit

to function more effectively, namely: supporting top managements goals, monitoring

enterprise risk, and enhancing regulatory compliance efforts. In relation to this,

Ljubisavljevi, S. & Jovanovi, D. (2011) ascertained that successful implementation of

internal audit tasks means that it must be sovereign in a way company management

should never influence its work, information, conclusions, and evaluations. In this way

the internal audit report becomes a means of communication between internal audit and

management, and an important guideline for the successful management of the

company. In addition, Odoyo et al. (2014) found out that the core role of internal audit in

relation to enterprise risk management is to provide assurance to the organization about

the effectiveness of risk management. When internal auditing extends its activities

beyond this core role, it should apply certain safeguards, including treating the

engagements as consulting services and, therefore, applying all relevant standards.

Internal audit determines the reliability, reality, and integrity of financial and operational

information that comes from different organizational units, on which appropriate

business decisions at all levels of management are based.

Theoretical Framework

The perceived value of an internal audit function (IAF) may be different among

organizations. It highly depends on what roles they partake on a particular entity. As

defined by Garitte (2015), the value of internal audit is the ability to tell whether or not

the company is poorly managed, to identify the areas where the critical risks are being

poorly managed or not identified, and to determine if the company objectives are being

met. In the situation of any government, the need for internal auditors in the public

sector is justified by the risks in the principal-agent relationship between the government

(agent) and the public (principal). These risks are being reduced through effective audit

activities. Internal audit, being a separate component of internal control, is instituted to

determine whether internal controls are well designed and properly operated (PGIAM,

2011). Because of these risks, the Department of Budget and Management created the

internal audit function in the government as mandated under Republic Act No. 3456 or

the Internal Auditing Act of 1962, as amended by Republic Act No. 4177.

This research study is anchored based on the roles of the internal audit function

given by the Department of Budget and Management through the Philippine

Government Internal Audit Manual (PGIAM). PGIAM (2011) gives the five functions or

roles of the internal auditors in the Philippine government setting. It involves advising

the department heads/heads of agency on all matters relating to management control

and operations audit, conducting management and operations audit of the government

functions, programs, projects, activities with outputs and determining the degree of

compliance for each, & reviewing and appraising systems and procedures,

organizational structures, and accounting-related documents and practices.

Furthermore, government internal auditors also analyze and evaluate management

deficiencies and assist top management by recommending realistic courses of action.

Lastly, they perform other related duties and responsibilities as may be assigned or

designated.

Review and
appraise systems
and procedures,
organizational
structures, and Analyze and
Conduct accounting-related evaluate
management and documents and management
operations audits of practices deficiencies and
functions and assist top
determine the management by
degree of recommending
compliance realistic courses of
action

Advise the
Department Functions/Roles of Perform other
Head/Heads of Government Internal related duties and
Agency on all Auditors
Auditors responsibilities as
matters relating to [PGIAM]
[PGIAM] may be assigned or
management
(DBM, 2011) designated
control and
operations audits

Figure 1 Theoretical Framework

Conceptual framework

The main concern of this study is the perceived value of IAF in Cebu Provincial

Capitol. The conceptual framework shows the process on how the researchers will

determine the proposed improvements that will increase the operating managements

perceived value of IAF. The primary respondents of this research were the line or

operating managers and IAF personnel of Cebu Provincial Capitol. The researchers

conducted survey questions related to the problem of the study and also to know the

perceptions of the respondents about IAF. Further, the answers from the respondents

were gathered for the classification of data in order for the researchers to process the

received information. Thereafter, there will be a treatment of the data where it is

processed to: Gathering, tabulation, analysis and interpretation of data.

Figure 2 Conceptual Framework