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Managerial Auditing Journal

A comparison of internal audit in the private and public sectors


Jenny Goodwin
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Jenny Goodwin, (2004),"A comparison of internal audit in the private and public sectors", Managerial
Auditing Journal, Vol. 19 Iss 5 pp. 640 - 650
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MAJ
19,5 A comparison of internal audit in
the private and public sectors
Jenny Goodwin
640 School of Accountancy, Queensland University of Technology,
Brisbane, Australia
Keywords Internal auditing, Public sector organizations, Private sector organizations
Abstract This paper explores similarities and differences between public sector internal auditing
and its counterpart in the private sector. Features examined include organizational status,
outsourcing, using internal audit as a tour of duty function, activities and relationships with the
external auditor. The study is based on a survey of chief internal auditors in organizations in
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Australia and New Zealand. Results suggest that there are differences in status between internal
audit in the two sectors, with public sector internal auditors less likely to report to the chief financial
officer. While a similar amount of work is outsourced, public sector organizations are more likely
than those in the private sector to outsource to the external auditor. There is little difference
between internal audit activities and interactions with external audit in the two sectors. However,
private sector internal audit is perceived to lead to a greater reduction in audit fees compared to
that in the public sector.

The objective of this paper is to compare features of the internal audit function between
organizations in the private sector and those in the public sector. Aspects examined
include organizational status, using internal audit as a tour of duty function,
outsourcing, internal audit activities including involvement in risk management, and
interactions with external auditors. The data were collected by a questionnaire survey
sent to chief internal auditors who were members of the Institute of Internal Auditors
(IIA) in Australia and New Zealand. The study extends that reported in Goodwin
(2003) which focused on the relationship between internal audit and the audit
committee.
The study is motivated by the increasing emphasis on the role of internal audit as a
corporate governance mechanism in both sectors. It has been argued that there are
important differences between public sector internal auditing and its private sector
counterpart in terms of the orientation of the framework in which it operates and the
scope of its activities (Carhill and Kincaid, 1989; Coupland, 1993). However, public
sector reforms have lessened the differences between the two sectors, particularly with
regard to governance (Barrett, 2002a, b). An interesting research question, therefore, is
the current extent to which internal audit in the public sector differs from that in the
private sector with regard to its status, scope and activities.
The results of the study suggest that there are differences in status between internal
audit functions in the two sectors but that internal audit activities and interactions

The author thanks K. Raghunandan for his help in the development of the survey instrument for
Managerial Auditing Journal
Vol. 19 No. 5, 2004 this study. The assistance of the Institute of Internal Auditors Australia and the members who
pp. 640-650 completed the survey is also gratefully acknowledged. The paper has benefited from the helpful
q Emerald Group Publishing Limited
0268-6902
comments of participants in a seminar hosted by the Institute of Internal Auditors Queensland
DOI 10.1108/02686900410537766 Branch.
with external auditors are similar. Reliance on the work of internal audit by the Internal audit
external auditor is perceived to lead to a greater reduction in audit fees in the private
sector compared to the public sector.
The paper is structured as follows. The next section provides the background and
research questions. This is followed in the third section by a description of the research
method used. The fourth section reports the results of the study while in the final
section some conclusions are drawn, the limitations of the study noted and 641
opportunities for further research are discussed.

Background and research question


There is no requirement in either Australia or New Zealand for private sector entities to
use internal audit. However, the Australian Stock Exchange (ASX) Corporate
Governance Council (2003) encourages companies, particularly large companies, to
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have an internal audit function. Public sector requirements are less clearcut. In
Australia, government agencies are generally created by statute and whether they are
required to have an internal audit function depends on the specific legislation
governing them. For example, local government acts generally require councils to have
an internal audit function. In New Zealand, there is no formal requirement for
government agencies to have an internal audit function.
It has been argued that there are important differences between internal audit in the
private sector and its counterpart in the public sector. Carhill and Kincaid (1989), for
example, suggest two reasons for these differences. First, public sector agencies
operate in a rigid framework where activities are authorized by legislation. Second,
these agencies are service-oriented and hence attach lower priority to cost factors and
issues associated with profitability. Because of this, it is argued that public sector
internal audit activities need to be of a much broader scope than in the private sector.
Malan (1991) discusses two types of audit that are relevant to the public sector:
financial-related audits and performance audits. Financial-related audits examine the
degree to which public resources are used by the organization to achieve its objectives.
As such, they extend beyond the normal attestation function of audit. Performance or
value-for-money audits focus on whether public resources are being used efficiently
and effectively, with an objective of identifying and reducing wastage. Coupland (1993)
argues that this type of audit has resulted in the adoption of a more sophisticated
approach to internal audit work, requiring internal auditors in the public sector to
broaden their skills and the techniques used.
Spraakman (1985), in a comparison of public and private sector internal audit in
Canada, found that, while efficiency and effectiveness audits had increased in both
sectors, the focus was considerably stronger in government organizations. Since the
time of that study, in both Australia and New Zealand, there have been extensive
reforms in the public sector that have led to a strengthening of corporate governance.
New Zealand, in particular, has gained an international reputation for its early
initiatives in the reform process (Schick, 1998; Bale and Dale, 1998) and it was one of
the first countries to move to full accrual based accounting for public sector entities.
Australia has since followed this lead. The reforms have led to a focus on corporate
governance and while it is recognized that governance in the public sector can involve
more complex relationships than in the private sector, most public sector agencies are
now more closely aligned to the private sector with regard to their use of internal audit
MAJ (Barrett, 2002a, b). This is demonstrated by the revised definition of internal audit
19,5 promulgated by the Institute of Internal Auditors (IIA):
Internal auditing is an independent, objective assurance and consulting activity designed to
add value and improve an organizations operations. It helps an organization accomplish its
objectives by bringing a systematic, disciplined approach to evaluate and improve the
effectiveness of risk management, control, and governance processes (IIA, 1999).
642 This definition suggests that internal audit has continued to move away from financial
and compliance audits to a broader value-adding role, embracing both assurance and
consulting activities and focusing on improving performance and effectiveness. Since
the definition is designed to embrace organizations in both the private and the public
sectors, it is both timely and interesting to identify similarities and differences between
internal audit in the two sectors since its release. This leads to following research
question:
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RQ1. To what extent does internal audit in the public sector differ from that in the
private sector with regard to:
Its organizational status?
The size of the budget and the percentage of the budget that is outsourced?
The nature of its activities?
Its interaction with external auditors?

Research design
The data were collected by means of a questionnaire sent to all chief internal auditors
in Australia and New Zealand who were registered as members of the IIA
Australia[1]. The IIA processed the mailing of questionnaires with responses being
mailed directly to the researcher. A copy of the questions asked is included in the
appendix.
Questionnaires were mailed to 370 heads of audit and 120 responses were received,
generating a response rate of 32 per cent. There were 32 responses from private sector
entities in Australia and 16 from New Zealand, giving a total of 48 private sector
responses. Public sector responses totalled 72, with 53 from Australia and 19 from New
Zealand. There were only two minor differences based on country, and these are noted
in the next section.
To test for a non-response bias, responses were compared between early and late
respondents. There were no significant differences in responses on any of the variables
in the study[2], suggesting that non-response bias is not a problem (Scarbrough et al.,
1998).

Results
Status of internal audit
The IIA stresses the importance of organizational independence of the internal audit
function (IIA, 2001), with the chief internal auditor reporting to a level within the
organization that allows the function to fulfill its responsibilities (IIA 2001, para 1110).
External auditing standards (e.g. AUS 604 (AuASB, 1995) and ISA 610 (IFAC, 1994))
argue that, ideally, internal auditing will report to the highest level of management and
be free of any other operating responsibility. Table I reports the results of a Chi-square
test to determine whether reporting lines differ between private sector entities and
those in the public sector. The table shows that 17 chief internal auditors in the private Internal audit
sector (36 per cent) indicated that they report to the chief financial officer compared to
only five (6.9 per cent) in the public sector. The difference is statistically significant at
p 0.000. This result is of some concern as it suggests that many private sector
internal auditors may not enjoy the day-to-day objectivity required to adequately fulfill
their responsibilities. While Goodwin (2003) reports that most chief internal auditors
appear to have good access to the audit committee, day-to-day reporting lines remain 643
important for internal audit to be recognized as having a high status in the
organization.
A further test of status is whether the internal audit function is staffed by
permanent employees or whether it is considered to be a tour of duty function in the
organization. In the latter case, internal audit is frequently considered to be a training
ground for future managers, with a stint in internal audit providing them with a good
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understanding of organizational systems and accounting functions (Goodwin and Yeo,


2001). While this practice can have many advantages for the organization, it can also
have negative implications for internal audit independence, particularly when it
involves senior personnel (Chadwick, 1995). A chief internal auditor who is expecting
to be transferred to a line management position may have little incentive to enhance the
quality of the internal audit function and may also be unwilling to take a strong
position on issues that arise (Goodwin and Yeo, 2001; Chadwick, 1995). Table II reports
responses to questions concerning whether, first, the chief internal audit position is a
tour of duty position and, second, whether internal audit is considered a tour of

Chief executive Chief financial Other senior


officer officer management* Total
n % n % n % n %

Public sector 41 57 5 7 26 36 72 100


Private sector 18 38 17 35 13 27 48 100
Total 59 49 22 18 39 33 120 100 Table I.
Chi-square = 15.672; p 0.000 Day-to-day reporting
Note: *Includes second-in-command, general manager corporate services, company secretary and lines for chief internal
other senior management auditor

Tour of duty Permanent position Total


n % n % n %

Panel A. Chief internal auditor position


Public sector 2 3 70 97 72 100
Private sector 9 19 39 81 48 100
Total 11 9 109 91 120 100
Chi-square = 8.824; p 0.007 (Fisher exact adjustment as 1 cell has expected count , 5)
Panel B. Internal audit staff
Public sector 4 6 68 94 72 100
Private sector 16 33 32 67 48 100 Table II.
Total 20 17 100 83 120 100 Internal audit as a tour
Chi-square = 16.000; p 0.000 of duty function
MAJ duty function for other staff. This table indicates that 91 per cent of all organizations
19,5 in the sample have a permanent chief internal auditor while 83 per cent staff the
internal audit function with permanent employees[3]. However, there are significant
differences between organizations in the private sector and those in the public sector,
with more private sector entities using internal audit as a tour of duty function for
both the chief internal auditor and internal audit staff compared to those in the public
644 sector ( p 0.007 and p 0.000 respectively).
Where internal audit is used as a tour of duty function, respondents were asked to
indicate the length of time spent in internal audit. For the chief internal auditor, the
mean is 39 months for the two public sector chiefs and 31 months for the nine private
sector chiefs. The difference is not statistically significant ( p 0.536). For internal
audit staff, the mean for the four public sector organizations is 42 months, while for the
16 private sector entities, it is 27 months. This difference is statistically significant at
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p 0.030. Respondents were also asked to indicate the departments to which staff are
most frequently transferred after spending time in internal audit. The most common
department is finance and accounting (17), followed by operations (10) and corporate
services (6).
Overall, it appears that internal audit has a higher status in the public sector than in
private sector entities. Public sector internal audit functions tend to report to the chief
executive or second-in-command and they also tend to be staffed by more permanent
employees compared to their private sector counterparts.

Size of internal audit and percentage outsourced


The size of the internal audit budget for public sector organizations ranged from
$10,000 to $6 million with a mean of $804,896. For private sector entities, budget size
ranged from $12,000 to $4.5 million with a mean of $927,727. The number of employees
ranged from 1 to 65 for both sectors, with a mean of 6.44 for the public sector and 7.56
for the private sector. None of these differences are statistically significant ( p values all
exceed 0.10).
In view of the growing trend towards outsourcing internal audit activities (Caplan
and Kirschenheiter, 2000; Widener and Selto, 1999) and the controversy about
outsourcing to the external auditor (Goodwin and Seow, 2002; Geiger et al., 2002),
respondents were asked to indicate the percentage of the internal audit budget that is
outsourced to their auditor and to other consultants. A total of 49 (68 per cent) public
sector entities and 31 (65 per cent) private sector entities indicated that they engage in
some outsourcing of internal audit activities. For those public sector organizations that
engage in outsourcing, the mean percentage of the budget outsourced to the external
auditor is 24.43 per cent while the mean percentage to other consultants is 25.41 per
cent. Private sector entities engaging in outsourcing obtain 10.82 per cent of internal
audit services from their external auditor and 30.54 per cent from other consultants.
The difference between the two sectors with regard to outsourcing to the external
auditor is statistically significant (t 2.321; p 0.027) while the difference in level of
outsourcing to independent consultants is not significant (t 2 0.789; p 0.433). The
combined level of outsourcing is also not significant (t 0.359; p 0.721). Thus, while
approximately two-thirds of entities in both sectors engage in some outsourcing, public
sector entities are more likely than private sector entities to use their external auditor to
provide internal audit services.
Respondents were asked to indicate which activities were most commonly Internal audit
outsourced. In both sectors, information technology and systems rank as the most
frequently outsourced area (45 per cent of all public sector outsourcing and 52 per cent
of private sector outsourcing). Interestingly, financial and internal control audits
comprise 32 per cent of public sector and 19 per cent of private sector outsourcing
while performance audits comprise only 7 per cent of public sector outsourcing and 8
per cent of that in the private sector. 645

Nature of internal audit activities


As previously noted, the role of internal audit in recent times has moved away from a
traditional focus on controls to a value adding function that includes risk management,
operational audits and consultancy projects (IIA, 1999). Respondents were asked to
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allocate the proportion of time that the internal audit function spends on four
categories of activity:
(1) Financial audit and internal controls.
(2) Risk management.
(3) Operational and systems audits.
(4) Special projects and other work.
Percentages for each sector are shown in Table III. While not reported, t-tests indicate
that there are no significant differences between the two sectors (all p values are
greater than 0.10).
Table III shows that slightly more than one-third of time is spent on operational and
systems audits while slightly less than one-third is spent on financial audits and
internal controls[4]. Risk management activities and special projects each take up less
than 20 per cent of internal audit time in both sectors. Thus, these results suggest that
the activities of internal audit in the two sectors are not far removed from each other,
supporting the view that differences have lessened in recent years (Barrett, 2002a, b).
Because of the recent emphasis on internal audit participation in risk management
activities (Walker et al., 2003; Lindow and Race, 2002; Leithhead, 1999), respondents
were asked to provide more details about their functions involvement in this area.
Specifically, they were asked to indicate whether internal audit is involved in
operational, financial, environmental and strategic risk management activities. A
category of other areas of risk management was also included, with respondents
being asked to specify the area if selecting this category. Results are reported in
Table IV.

Financial
audit/internal Operational/ Special
controls Risk management systems audits projects/other
Mean % SD Mean % SD Mean % SD Mean % SD
Table III.
Public sector 31.31 15.84 15.50 14.60 33.73 15.57 19.03 14.76 Mean percentage
Private sector 30.31 12.69 18.02 13.48 36.75 15.72 15.44 11.86 (standard deviation) of
Total 30.91 14.61 16.51 14.16 34.94 15.63 17.59 13.74 time spent on activities
MAJ Yes No Total
19,5 n % n % n %

Panel A. Operational risk


Public sector 63 88 9 12 72 100
Private sector 45 94 3 6 48 100
646 Total 108 90 12 10 120 100
Chi-square = 1.250; p 0.358 (Fisher exact adjustment as 1 cell has expected count , 5)
Panel B. Financial risk
Public sector 24 33 48 67 72 100
Private sector 24 50 24 50 48 100
Total 48 40 72 60 120 100
Chi-square = 3.333; p 0.068
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Panel C. Environmental risk


Public sector 27 38 45 62 72 100
Private sector 16 33 32 67 48 100
Total 43 36 77 64 120 100
Chi-square = 0.217; p 0.641
Panel D. Strategic risk
Public sector 47 65 25 35 72 100
Private sector 31 65 17 35 48 100
Total 78 65 42 35 120 100
Chi-square = 0.006; p 0.938
Panel E. Other risks
Table IV. Public sector 17 23 55 77 72 100
Internal audit Private sector 8 17 40 83 48 100
involvement in risk Total 25 21 95 79 120 100
management activities Chi-square = 0.749; p 0.387

The table shows that there is a marginally significant difference between the two
sectors with regards to financial risk management, with 50 per cent of private sector
internal audit functions being involved with this type of risk management compared
to only 33 per cent of public sector internal audit functions ( p 0.068). This no
doubt reflects the lower emphasis placed on financial risk in the public sector. There
are no other statistically significant differences between the two sectors.
Approximately 90 per cent of internal audit functions are actively involved in
operational risk management while 65 per cent are involved in strategic risk
management. Slightly over 30 per cent of functions are engaged in environmental
risk management. Approximately 20 per cent indicated that they are involved in
other areas of risk management. These areas included risk management of special
projects (9), health and safety (8), information technology (7) and fraud (4). Thus, in
spite of spending a relatively small amount of their total time on risk management
activities, it does appear that internal auditors are actively involved in a wide range
of these activities.

Relationship with external auditors


There has been considerable research on external auditor reliance on the work of
internal audit (Brody et al., 1998; Lampe and Sutton, 1994; Stein et al., 1994; Carey et al.,
2000; Felix et al., 2001) but this has generally been from the point of view of the external Internal audit
auditors. It is therefore interesting to explore internal audit interaction with external
auditors from the perspective of the chief internal auditor. Table V reports responses
concerning the coordination of work and external auditor access to workpapers and
reports. There are no significant differences between public and private sector
responses. More than 85 per cent of internal audit functions coordinate the areas of
audit coverage with the external auditor while approximately two-thirds coordinate 647
their work schedule. Further, in both sectors, external auditors have a high level of
access to internal audit workpapers and reports.
Table VI shows the perceived impact of the auditors reliance on the work of
internal audit on the cost of the external audit, indicating statistically significant
differences between the two sectors ( p 0.021). In the public sector, 30 per cent of
respondents are unsure of the impact, compared to 19 per cent in the private sector.
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Yes No Total
n % n % n %

Panel A. Coordinating areas of audit coverage


Public sector 61 85 11 15 72 100
Private sector 42 88 6 12 48 100
Total 103 86 17 14 120 100
Chi-square = 0.183; p 0.669
Panel B. Coordinating work schedule
Public sector 46 64 26 36 72 100
Private sector 34 71 14 29 48 100
Total 80 67 40 33 120 100
Chi-square = 0.625; p 0.429
Panel C. External auditor access to all internal audit workpapers
Public sector 67 94 5 7 72 100
Private sector 42 88 6 12 48 100
Total 109 91 11 9 120 100
Chi-square = 1.068; p 0.344 (Fisher exact adjustment as 1 cell has expected count , 5)
Panel D. External auditors access to all internal audit reports
Public sector 68 94 4 6 72 100
Private sector 46 96 2 4 48 100 Table V.
Total 114 95 6 5 120 100 Internal audit interaction
Chi-square = 0.112; p 1.000 (Fisher exact adjustment as 2 cells have expected count , 5) with external auditors

Reduction in
Reduction in cost more
cost 10 per than 10 per Unsure of
cent or less cent impact Total
n % n % n % n %

Public sector 33 46 17 24 22 30 72 100 Table VI.


Private sector 16 33 23 48 9 19 48 100 Impact of internal audit
Total 49 41 40 33 31 26 120 100 on the cost of external
Chi-square = 7.760; p 0.021 audit
MAJ Only 24 per cent of public sector auditors believe that the cost reduction is more than
19,5 10 per cent of audit fees compared to 48 per cent in the private sector. This may reflect
the greater level of competition in the private sector audit market compared to that in
the public sector.

Perceptions of the work and stature of internal auditing


648 The final question in the survey was an open-ended one soliciting comments on the
work and stature of internal auditing. A variety of comments were received, with no
statistically significant differences between respondents from the two sectors.
Almost 30 per cent of respondents commented on the changing status of internal
audit in recent years, with the majority of these of the view that internal audit is
steadily increasing in status. However, 10 per cent suggested that internal audit
needs a higher profile and greater management support than presently exists. More
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than 15 per cent commented on the need for internal audit to add value to the
organization while a similar number expressed concern about the trend towards
outsourcing.

Concluding comments
This paper has explored similarities and differences in the status, scope and
activities of internal audit between organizations in the public sector and those in
the private sector. The study is based on a survey of chief internal auditors in
organizations in Australia and New Zealand. Results suggest that, overall, public
sector internal audit functions have a higher status than their private sector
counterparts, where more than a third of chief internal auditors report to the chief
financial officer. Further, the internal audit function is less likely to be used as a
tour of duty function in the public sector. While a similar percentage of entities in
each sector engage in outsourcing some of their internal audit activities, public
sector organizations are more likely to use their external auditor to provide these
services. The time spent on different internal audit activities is similar in both
sectors. Interactions with the external auditor also do not differ significantly
between the two sectors. However, public sector internal auditors are less convinced
than their private sector counterparts that the external auditors reliance on their
work leads to a reduction in audit fees.
There are a number of limitations of the study. The sample size is relatively small,
particularly with regard to the private sector. Generalizability of the results may be
limited as both Australia and New Zealand have had significant reforms in the public
sector, bringing the two sectors closer together with regard to governance and financial
accountability. As with all surveys, a further limitation is that the results rely on the
self-reports of respondents and are therefore open to misinterpretation of the questions
as well as to subjectivity in the responses.
In spite of the limitations, the study makes an interesting contribution to our
understanding of internal audit in both sectors. Additional research could be conducted
in other regulatory frameworks where, for example, internal audit is mandatory or
where there has not been the same level of public sector reforms. Other aspects of
internal audit such as the extent of consulting work compared to assurance activities
could also be explored.
Notes Internal audit
1. The IIA Australia covers members in both Australia and New Zealand.
2. The sample was divided into two, based on surveys postmarked within four weeks of
mailing (82 responses) and those postmarked later (38 responses). Chi-squared tests for
dichotomous responses and t-tests for continuous responses indicated that there were no
statistically significant differences between the two groups. All p values exceeded 0.15.
3. The use of internal audit as a tour of duty function for staff was also more prevalent in 649
New Zealand (29 per cent) than in Australia (10 per cent) ( p 0.025).
4. The mean percentage of time spent on financial audits differed between Australia and New
Zealand, with New Zealand internal audit functions spending 27 per cent of time on this
activity compared to 33 per cent for those in Australia ( p 0.034).
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