Public Finance and Management Volume 11, Number 4, pp. 306-337 2011 AN EXAMINATION OF GOVERNMENT INTERNAL AUDITS’ ROLE IN IMPROVING FINANCIAL PERFORMANCE Stephen Kwamena Aikins, University of South Florida, USA ABSTRACT This research empirically examines how the work of government internal audits lead to improvements in government financial performance. Periodic economic downturn and dwin- dling state aid to local governments have left many public managers looking for ways to im- prove financial oversight and operational efficiency. Although internal audit is one area with the expertise to assess efficient utilization of financial resources and help improve oversight and financial performance, public administration research has paid little attention to the role of internal audit in the financial management process. A survey was sent to local government Chief Auditors to learn of audit’s examination of government operations and financial ma n- agement. Financial performance data were obtained from the Comprehensive Annual Finan- cial Reports (CAFRs) of survey respondents’ local governments and analyzed with the survey responses. Results show that in general, local government auditors perform more audits in operational areas that deal with fiscal receipts and outlays. Additionally, auditors’ work sig- nificantly influences local government financial performance both directly and indirectly through improvements in internal controls and efficiency of operations. Key Words: internal audit, financial management, financial performance, control adequacy, control effectiveness, documented policies, procedural guidelines, government 1. INTRODUCTION The financial challenges facing state and local governments across the United States in recent years have resulted in the inability of resources to keep up with citizens‟ increasing need for government services. The property tax accounted for 58.5% of tax revenue and 36.8% of own source revenue of all American municipal governments (including townships) in 1992. These prop- erty tax shares had fallen to 53.3 and 33.6%, respectively by 2007 (U.S. Cen- sus Bureau 2009). In a recent study of city government chief finance officers conducted by the National League of Cities (NLC), nearly 90% of respondents reported their cities are “less able to meet fiscal needs in 2010 than in previous year”, and 61% reported decreased state aid to cities as a leading factor affect- ing their budgets (Hoene & Pagano 2010). According to the NLC survey re- sults, city sales taxes declined in 2009 over previous year receipts by 6.6% in constant dollars, and city finance officers projected further decline in 2010 by 4.9%. When asked about the most common responses to prospective shortfalls
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Public Finance and Management
Volume 11, Number 4, pp. 306-337
2011
AN EXAMINATION OF GOVERNMENT INTERNAL
AUDITS’ ROLE IN IMPROVING FINANCIAL
PERFORMANCE
Stephen Kwamena Aikins, University of South Florida, USA
ABSTRACT
This research empirically examines how the work of government internal audits lead to
improvements in government financial performance. Periodic economic downturn and dwin-
dling state aid to local governments have left many public managers looking for ways to im-
prove financial oversight and operational efficiency. Although internal audit is one area with
the expertise to assess efficient utilization of financial resources and help improve oversight
and financial performance, public administration research has paid little attention to the role
of internal audit in the financial management process. A survey was sent to local government
Chief Auditors to learn of audit’s examination of government operations and financial man-
agement. Financial performance data were obtained from the Comprehensive Annual Finan-
cial Reports (CAFRs) of survey respondents’ local governments and analyzed with the survey
responses. Results show that in general, local government auditors perform more audits in
operational areas that deal with fiscal receipts and outlays. Additionally, auditors’ work sig-
nificantly influences local government financial performance both directly and indirectly
through improvements in internal controls and efficiency of operations.
Key Words: internal audit, financial management, financial performance, control adequacy,
control effectiveness, documented policies, procedural guidelines, government
1. INTRODUCTION
The financial challenges facing state and local governments across the
United States in recent years have resulted in the inability of resources to keep
up with citizens‟ increasing need for government services. The property tax
accounted for 58.5% of tax revenue and 36.8% of own source revenue of all
American municipal governments (including townships) in 1992. These prop-
erty tax shares had fallen to 53.3 and 33.6%, respectively by 2007 (U.S. Cen-
sus Bureau 2009). In a recent study of city government chief finance officers
conducted by the National League of Cities (NLC), nearly 90% of respondents
reported their cities are “less able to meet fiscal needs in 2010 than in previous
year”, and 61% reported decreased state aid to cities as a leading factor affect-
ing their budgets (Hoene & Pagano 2010). According to the NLC survey re-
sults, city sales taxes declined in 2009 over previous year receipts by 6.6% in
constant dollars, and city finance officers projected further decline in 2010 by
4.9%. When asked about the most common responses to prospective shortfalls
Aikins 307
in the 2010 fiscal year, by a wider margin the most common responses were
instituting some kind of personnel related cut (79%) and delaying or cancel-
ling capital infrastructure (69%). Two in five (44%) said their city is making
cuts in services other than public safety and human-social services that are in
higher demand during economic downturn.
The above stated situation has left many public administrators looking for
ways to improve financial oversight and operational efficiency within prevail-
ing budgetary constraints while providing reasonable levels of services to their
constituents. For this to happen, concrete measures should be put in place to
improve financial efficiency and performance. The internal audit function is
the key governmental unit with the expertise for assessing the effectiveness of
utilizing financial resources by identifying waste, inefficiencies and fraud in
budget items like the ones that the above referenced NLC survey respondents
like to cut or retain, and for making recommendations to enhance efficiency of
operations and improve financial performance. For this reason, understanding
audit‟s role in the financial management process is essential.
The inability of resources to keep up with citizens‟ increasing demand for
services can produce an expectation gap between what citizens expect and
what they receive from their government, and increase pressure on public offi-
cials to demonstrate a higher level of operational accountability over public
funds (Montondon 1995). Operational accountability is defined as the demon-
stration of responsibility for the efficiency and effectiveness of resource con-
version activities when measured against operating objectives (Henke 1992).
One way of ensuring operational accountability over public funds is through
effective use of internal monitoring mechanism like internal audit to improve
financial performance. Despite the importance of internal audit in the govern-
ment financial oversight process, public administration research has paid little
attention to the relationship between internal audits and efficient financial
management. Consequently, a scholarly investigation that examines the effects
of government internal audit on financial performance is greater than ever be-
fore.
The objective of this study is to investigate the extent to which internal
audits contribute to improvements in the adequacy and effectiveness of inter-
nal controls over government financial management, and to overall financial
performance. For the purpose of this research, internal controls refer to the
measures designed and implemented by the public sector manager to help ac-
complish the entity‟s financial goals and objectives, and to mitigate operation-
al and financial risks. Examples of these include the approval of invoices be-
fore payments, segregation of duties pertaining to the payment and recording
of financial transactions, and reviewing of recorded transactions for accuracy
and procedural compliance. Internal control adequacy means the design of the
control structure regarding the policies, procedural guidelines and related ac-
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tivities, provide enough guidance and direction for acceptable practices and
the performance of task to ensure that the entity‟s goals are achieved. Internal
control effectiveness means the implemented controls are operating as intend-
ed by management. Financial performance in this instance refers to the per-
centage change in government-wide net assets, which is a reflection of the
change in the government‟s operating surplus or deficit.
Studies of government audits have focused on comparative accounting and
auditing for local governments (Giroux et al. 2002), compliance reporting de-
cisions in municipal audits (Kidwell 1999), the emergence of performance au-
diting as the activist auditor (Wheat 1991), determinants of audit quality in the
public sector (Deis & Giroux 1992), and comparison of internal audits in the
private and public sectors (Goodwin 2004). More recently, others have fo-
cused on ethical implications of independent quality auditing (Walters & Dan-
gol 2006), the timeliness of school district audit (Carslaw et al. 2007), and the
effectiveness of internal auditing in Israeli private and public sector organiza-
tions (Cohen & Sayag 2010). While these studies contribute to the literature
on audit quality and effectiveness, they do not investigate the effects of audits
on government financial performance. Dwelling on the theory of transaction
cost economics, the internal control framework of the Committee of Sponsor-
ing Organizations (COSO), and the literature on fiscal health, this research
extends the literature on internal audit by establishing a theoretical foundation
to explain how the work of government internal audit contributes to financial
performance through improvements in internal controls over financial man-
agement practices, and efficiency of operations.
2. INTERNAL AUDIT AND PUBLIC FINANCIAL MANAGEMENT
The broad objectives of public financial management are to achieve fiscal
discipline, efficient and effective provision of public services, and efficient
allocation of resources to reflect priority needs (Asare, 2008). Public financial
management includes the legal and organizational framework for supervising
all phases of the budget cycle, including the preparation of the budget, com-
parison of actual and budgeted revenues and expenditures, procurement, moni-
toring and reporting, as well as related internal controls and audits. Controls
systems play important role in enhancing accountability and transparency in
the governance process (Szymanski 2007; Baltaci & Yilmaz, 2006).
An audit helps to improve controls by discovering deviations from accept-
ed standards and instances of illegality, inefficiency, irregularity and ineffec-
tiveness in order to take corrective action, hold violators accountable, and take
steps to prevent further losses (Mikesell 2007). Internal audit is “an independ-
ent, objective assurance and consulting activity designed to add value and im-
prove an organization‟s operations. It helps an organization accomplish its ob-
jectives by bringing a systematic, disciplined approach to evaluate and im-
Aikins 309
prove the effectiveness of risk management, control and governance process-
es” (The Institute of Internal Auditors [IIA] 2006). Through the reviews and
reporting of the functioning of the internal control systems and offering of
recommendations for improvement, internal audit helps to enhance financial
accountability by providing governments and citizens much needed infor-
mation regarding the effectiveness and efficiency in the utilization of public
resources.
Government internal auditors bolster financial accountability through the
evaluation and improvement of internal control, risk management and govern-
ance processes. This role encompasses the policies and procedures established
to ensure the achievement of objectives (Asare, 2008). Government auditors‟
roles in financial accountability are also manifested by monitoring the effec-
tiveness of management‟s internal control structure to identify and reduce
conditions that breed corruption and misuse of resources by government offi-
cials. Therefore, as part of their financial oversight contributions, government
auditors detect and deter corruption, including misappropriation of funds, in-
appropriate or abusive acts and other misuses of power, to ensure judicious
utilization of public resources, efficiencies and cost savings. Internal auditors
also contribute to public sector governance by providing independent, objec-
tive assessment on the appropriateness of the organization‟s governance struc-
ture and operating effectiveness of specific governance activities, and by act-
ing as catalyst for change, advising or advocating improvements to enhance
the organization‟s governance structure and practices (IIA, 2006).
Government internal auditors contribute toward public sector risk man-
agement by assessing and monitoring organizational risks, recommending
controls to mitigate those risks, evaluating related trade-offs to enable the or-
ganization to accomplish its strategic and operational objectives (Asare, 2008)
thereby providing independent and objective assurance as to whether risks are
being mitigated to acceptable levels (Griffiths, 2006). For example, through
fraud risk evaluations, investigations and reporting of existing control practic-
es to mitigate fraud, internal auditors add value to the governance process
(Corain et al., 2007) by suggesting avenues for cost saving and improved fi-
nancial performance. For these reasons, there is the need for public adminis-
trators to recognize the value-added role of internal audit and to contribute to-
ward its effectiveness (Van Gansberghe, 2005) in order to help strengthen
public financial management.
As implied by the theory of transaction cost economics, operational effi-
ciency and cost economizing can lead to better financial management if a
monitoring mechanism such as internal audit helps management to gain better
control over resource allocation and have better access to cost information.
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3. THEORETICAL FRAMEWORK
Internal audit‟s role in improving public financial management can be ex-
plained using the theory of transaction cost economics (Williamson, 1975;
1985) and the COSO (1994) internal control framework. Transaction cost eco-
nomics theory argues the superiority of internal audit for cost economization
and outlines advantages, especially for hierarchical organizations. Additional-
ly, it conceptualizes intra-organization production as a series of activities
linked by transactions. An activity is the partial production of a good or ser-
vice, e.g. procurement for service provision, while a transaction is that stage in
the activity series where one activity ends and another begins, e.g. invoice
payment for the procurement. This theory argues that when the market is ex-
cluded to the preference of in-house production, internal organization must be
developed to replace market forces (Spraakman, 1997). Internal organization
consists of directing mechanisms for contracting, planning, coordinating and
setting standards for accomplishing activities. Likewise, there are monitoring
mechanisms concerned with reporting actual against expected activity perfor-
mance, and feedback from monitoring provides understanding of activities,
thereby facilitating the adapting of internal organization to changing condi-
tions (Spraakman, 1997). Directing and monitoring mechanisms are possible
with in-house production because of control over resource allocation and ac-
cess to better information about cost. When combined, directing and monitor-
ing mechanisms form a system of internal control for managing in-house pro-
duction and for reducing cost of activities (Spraakman, 1997).
Transaction cost economics is based on bounded rationality and opportun-
ism. Simon (1961) argues economic actors are “intendedly rational, but only
limitedly so”. In accepting bounded rationality and the limit of the human abil-
ity to process information, comprehensive contracting is excluded, resulting in
incomplete contract, as well as the possibility and desirability of intra activity
interventions. In this regard, transaction cost economics is primarily concerned
with designing internal mechanisms like internal controls and audit to reduce
bounded rationality. As employees of government agencies, internal auditors
are more able to easily gain the cooperation of other members of the organiza-
tion, receive crucial disclosures not available to external auditors, and able to
obtain important information regarding cost efficiency practices of the organi-
zation. For example, government internal auditors are able to obtain answers
to questions such as: are the best deals being obtained for procurement? Are
financial resources being used efficiently? Are the operations using these re-
sources effective? Through audit and reviews of internal controls aimed at an-
swering these questions, government internal auditors reduce bounded ration-
ality by furnishing public managers with the description of the effectiveness of
existing internal controls, the shortcomings of internal controls over financial
management process, and recommendations for improvement to ensure cost-
efficiency.
Aikins 311
It is important to note that despite the advantage of organizational coopera-
tion and information disclosure internal auditors have over external auditors,
the lack of independent reporting structure could hinder the former‟s effec-
tiveness. In an analysis of the range of internal audit units in 258 local gov-
ernment entities in the United States, Friedberg & Lutrin (2001) found varia-
tions in organizational positions of the heads of audit units, and suggested ac-
tual position and status of the internal audit unit are among the main factors
determining the measure of government internal audit independence. As ar-
gued by Bou-Raad (2000), the strength of an internal audit department must be
assessed with respect to the level of independence it enjoys from management
and from operating responsibilities. Although external auditors‟ independence
could be impaired by comingling of auditing and consulting activities, as evi-
denced in the erstwhile Arthur Andersen and the Enron debacle, and by con-
siderations of retention in subsequent years, they are generally not subject to
internal managerial manipulations as internal auditors. Therefore, depending
on the level of independence enjoyed by government internal auditors, their
ability to render objective opinions on the adequacy and effectiveness of exist-
ing internal controls may be limited.
Internal controls include financial accounting controls and operational con-
trols (Brown 1994). Examination of controls over financial accounting helps
to determine the validity of financial statements, and reviews of operational
controls over financial transactions determines whether operations are man-
aged and controlled as senior management and the audit committee expect
them to be (Sawyer & Vinten 1996, p. 196-9). Recommendations from these
audits give public managers the opportunity to strengthen controls over finan-
cial transactions and operations and minimize losses to the public agency. The
more internal auditors review the controls over financial transactions and op-
erations, the more able they are to provide information to management about
the control weaknesses and the needed improvements. Therefore, we should
expect a positive relationship between the frequency of audits and the overall
adequacy and effectiveness of operational and financial management controls.
Fadzil et al. (2005) argue that the primary objectives of an organization‟s
system of internal controls are to provide administrative management reasona-
ble assurance that financial information is accurate and reliable: that the or-
ganization complies with policies, plans, procedures, laws, regulations and
contracts; assets are safeguarded against loss and theft; resources are used
economically and efficiently; and established objectives and goals for opera-
tions or programs can be met. The COSO (1994) internal control framework
outlines three objectives of internal control as: effectiveness and efficiency of
operations; reliability of financial information; and compliance with applicable
laws and regulations. When these objectives are properly achieved, internal
control should be deemed effective (Agbejule & JokiPii, 2009). Audit evalua-
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tion of management‟s achievement of the internal control objectives, and rec-
ommendation for improvements, help to minimize bounded rationality and
provide management the basis to put in place the mechanisms to ensure the
internal controls over financial management practices are operating as intend-
ed. Therefore, we should expect a positive relationship between auditors‟
evaluation of the internal control objectives and internal control effectiveness.
The five components of the COSO (1994) internal control framework are
control environment, risk assessment, control activities, information and
communication and monitoring. Control activities refer to the practices in re-
gard to policies and procedural compliance that assure management that objec-
tives are achieved, and risk mitigation strategies are carried out effectively.
COSO suggests that control activities relate to the policies and procedures per-
taining to the segregation of duties, information processing, physical control
and performance reviews (Arens et al., 2006). A typical government finance
department seeking to properly manage its financial operations should have
documented policy and procedural guidelines that spell out acceptable practic-
es and steps for budgeting, receivables, expenditures, accounting and financial
reporting, investments and cash management. Properly documented policies
and procedural guidelines in these areas help to determine not only how the
control activities are to be carried out but also provide thorough information
for auditors‟ assessment of the overall adequacy of control design over finan-
cial management practices. If auditors review and recommend improvements
in the existing policies and procedural guidelines to mitigate risks to the or-
ganization, management is likely to respond in the affirmative. Therefore, I
posit that there is a positive relationship between auditors‟ recommendations
to improve documented financial polices and procedural guidelines and the
adequacy of financial management control.
Government Internal auditors monitor control adequacy and effectiveness
by assessing the quality of controls. Monitoring covers ongoing and periodic
evaluations of external supervision of internal control by management or other
parties outside the process. It ensures that controls are operating as intended
and that they are modified appropriately to cater for changes in conditions
(Arens et al., 2006, p.283). Transaction cost economics also suggests that by
comparing actual against expected activity performance, a monitoring mecha-
nism facilitates the adaption of internal organization to changing conditions
and reduction of cost of activities. This view is also echoed by Wang (2006, p.
85) who argues that a government financial monitoring system provides an
ongoing check on the budget, helps to uncover inefficient practices in opera-
tion, and to avoid further deterioration in financial condition. Thus, by com-
paring actual financial results against budgets to determine how well financial
objectives have been achieved, public managers will be in a position to identi-
fy unreasonable variances and take corrective actions to improve financial per-
formance. Most importantly, when public agency management realize that in-
Aikins 313
ternal auditors evaluate financial performance monitoring practices, they are
likely to institutionalize those practices to enhance internal controls over fi-
nancial transactions and operations. Therefore, I postulate that there is a posi-
tive effect of audit‟s evaluation of financial performance monitoring practices
on control effectiveness and financial performance.
In addition to feedback from financial performance monitoring, internal
audit evaluations pertaining to control adequacy and control effectiveness
could provide management with vital information about the fiscal health of
local governments and help improve financial performance. Knowledge of fis-
cal health is very important because it enables the jurisdiction to finance need-
ed services, improves officials‟ chances of re-election or bid for higher offices,
influences homeowner and business location decisions and economic devel-
opment, local government organization flexibility and human resource quality,
local government competitiveness, quality of service provision, long-term
credit worthiness, and tax cost of local government on citizens (Honadle et al.
2004). A formal warning system for local financial condition and fiscal health
would help states and local governments to predict local fiscal distress and
help avert fiscal crisis. This is critical due to the severe fiscal constraints from
state imposed tax and expenditure limitations and periodic economic down-
turn. Although various useful indicators (indices) have been developed by ac-
ademics and practitioners to measure fiscal condition and fiscal health (Brown
1993, Kloha et al. 2005, Nollengerger 2003, Hendrick 2004) there are almost
no systematic studies that demonstrate whether state and local governments
regularly assess fiscal health, whether states require local governments to con-
duct fiscal health assessments, or how states monitor financial performance of
local governments (Jung 2008). This situation creates information gap as to
whether local management makes informed decisions based on prudent finan-
cial analysis. The traditional monitoring role of internal audits regarding eval-
uation of the adequacy and effectiveness of financial and operational controls
enables them to fill this gap by identifying any control weaknesses and rec-
ommending corrective actions. Therefore, we should expect a significant posi-
tive effect of adequate and effective controls over operational and financial
management, on local government financial performance.
4. METHODOLOGY
This research utilizes mixed methodology that combines analysis of survey
data and data obtained from the Comprehensive Annual Financial Reports
(CAFR) of survey respondents. An online survey was sent to all the 387 audit
department heads of the Association of Local Government Auditors (ALGA)
as of June 2008. Heads of audit departments were chosen as the unit of analy-
sis because they occupy the highest level of the audit function and are in a bet-
ter position to provide professional assessment of the adequacy and effective-
ness of local governments‟ internal controls over financial management. A
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report of the initial results was generated using responses from 89 respondents
and shared with ALGA members. Additional follow-ups increased total partic-
ipation to 178, representing 46% response rate, which is typical for survey in
general and quite good for an online survey.
Among those who participated in the study, 89% were audit directors and
managers and the rest had other titles. Fifty percent had staffing level of up to
5 auditors, 32% had from 6 to 10 auditors and 18% had more than 10 auditors.
Of the returned surveys, 75% were from municipalities, 23% from counties
and 2% from other local governments. Jurisdictions of all sizes were repre-
sented, with 50% of the cities having population of less than 100,000 and 80%
of the counties having population of more than 500,000. Eighty percent of re-
spondents indicated their departments conduct performance and programmatic
audits, and 78% perform financial audits. Thirty percent of the responses came
from the north-ease census region, 20% from the south, 27% from the mid-
west and 23% from the west. Therefore, it can be argued that the survey re-
spondents were a good representation of the target population, jurisdictions
audited and types of audits performed.
The survey was conducted from early June 2008 through late October
2008. Once the online survey questionnaires were completed, financial per-
formance data for five fiscal years, 2005 through 2009, were obtained from the
CAFRs of survey respondents‟ local governments and used in the analysis to
determine the impact of internal audit examinations on local government fi-
nancial performance.
The survey questionnaires were designed to ascertain information pertain-
ing to the areas audited, the years between audits, evaluation of internal con-
trol objectives and financial performance monitoring practices, the adequacy
and effectiveness of financial and operational controls, and recommendation to
improve documented financial policies and procedural guidelines.
Audited areas were measured by asking respondents to select the areas
they audit from a list of auditable areas. These areas include budgeting, reve-
nue collection, cash management, cash and cash equivalents, investments, ac-