Managerial Auditing Journal, Volume 17 Number 3 2002: Critical perspectives on accounting and finance

ISSN 0268-6902 Managerial Auditing Journal Volume 17, Number 3, 2002 Critical perspectives on accounting and finance ...

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ISSN 0268-6902

Managerial Auditing Journal Volume 17, Number 3, 2002

Critical perspectives on accounting and finance

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Paper format Managerial Auditing Journal includes nine issues in traditional paper format. The contents of this issue are detailed below.

Contents

110 Access to Managerial Auditing Journal online 111 Abstracts & keywords 113 Accounting and auditing requirements of the Sudan Companies Act 1925: time for change John A. Brierley, Hussein M. El-Nafabi and David R. Gwilliam

117 Re-engineering recruitment to the accounting profession Malcolm Smith and Christopher Graves

122 A critical evaluation of the effect of participation in budget target setting on motivation Pamela Reid

130 An assessment of the newly defined internal audit function Albert L. Nagy and William J. Cenker

138 Auditing the indirect consequences of rework in construction: a case based approach Peter E.D. Love

147 Corporate governance: communications from internal and external auditors Janet L. Colbert

153 Slack in public administration: conceptual and methodological issues Tor Busch

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Abstracts & keywords

Accounting and auditing requirements of the Sudan Companies Act 1925: time for change John A. Brierley, Hussein M. El-Nafabi and David R. Gwilliam Keywords The Sudan, Legal matters, Balance sheets, Profit and loss, Accounting The Sudan Companies Act 1925 is outdated. There is a need for substantial revision to the Act either in accordance with, for example, current UK legislation, or a framework more directly suited to the economic and legal environment of the Sudan. At a general level this should include the preparation of a profit and loss account, specific formats for the profit and loss account and balance sheet, notes to the accounts and an auditor’s report stating whether or not the accounts give a true and fair view of the state of a company’s affairs.

Re-engineering recruitment to the accounting profession Malcolm Smith and Christopher Graves Keywords Recruitment, Biodata, Forecasting, Performance, Modelling There can be few personnel techniques so lowly regarded as the recruitment interview. Yet we persevere with the use of the technique despite the overwhelming evidence of its deficiencies. The accountancy and auditing professions are as guilty as most in this regard, and suffer from rates of attrition and job turnover, which should be an embarrassment. But there are alternatives available, and this paper reports on the development of revolutionary techniques which might have a significant impact on recruitment to the accounting and auditing professions in the UK.

A critical evaluation of the effect of participation in budget target setting on motivation Pamela Reid Keywords Accounting, Theory, Target setting, Participation, Performance

Managerial Auditing Journal 17/3 [2002] Abstracts & keywords # MCB UP Limited [ISSN 0268-6902]

This paper critically evaluates the effect of participation in budget target setting in an effort to increase the probability of an organisation’s goals being achieved and, in so doing, considers some of the numerous theories of motivation. Such theories include Maslow through to equity and expectancy theories. However, given that there are a multiplicity of variables at work here, the author concludes that the effect of participation is situation specific and dependent upon such variables: there is no ‘‘perfect’’ budgeting system.

An assessment of the newly defined internal audit function Albert L. Nagy and William J. Cenker Keywords Internal audit, Committees, Risk management, Corporate governance, Competences The new definition of internal auditing defines the function as an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. The purpose of this paper is to summarize an assessment of this new definition obtained through structured interviews from 11 internal audit directors of large publicly traded companies. The responses from the directors indicate that there are wide differences in viewpoints and objectives; but a definite shift has occurred in the overall scope of internal audit towards operational activities. While most of the interviewees are in conceptual agreement with the new internal audit definition, an underlying warning is vocalized: ‘‘Don’t throw out the franchise’’. That is, the traditional role of the internal auditor should not be completely abandoned. These, along with other responses pertaining to related issues and suggestions for future research, are summarized throughout the paper.

Auditing the indirect consequences of rework in construction: a case based approach Peter E.D. Love Keywords Construction industry, Indirect costs, Contract, Defective premises There is little known about the indirect consequences of rework in construction projects, especially the financial costs. Therefore, this paper uses examples from a case study to demonstrate the potential indirect consequences and costs that are associated with undertaking rework in building construction projects. A novel taxonomy for categorising the indirect consequences at an individual level, organisational level and project level is presented. Based on the findings from examples derived from the case study, it is suggested that the incidence of rework can have a multiplier effect of up to six times the actual (direct) cost of rectification. To reduce these costs it is concluded that design and construction organisations must improve their quality management systems by including a quality system for continuously auditing, analysing and presenting direct as well as indirect rework costs.

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Abstracts & keywords Managerial Auditing Journal 17/3 [2002] 111–112

Corporate governance: communications from internal and external auditors Janet L. Colbert Keywords Corporate governance, Auditors, Communication, Finance International Standards on Auditing (ISAs) require external auditors to communicate with the client’s governance body regarding significant matters which came to the auditors’ attention during the engagement. Similarly, the authoritative Practice Advisories (PAs), issued by the Institute of Internal Auditors (IIA), mandate that internal auditors discuss certain items with the board. Thus, the governance body/board should be receiving information from two groups of auditors. Compares and contrasts the requirements of the ISAs and PAs with regard to communications with the governance body/board. The differences in the communications to the governance body/ board by the external and internal auditors derive mainly from the focus of each group. The external auditors serve those users external to the organization; in contrast, internal auditors serve the board, which is responsible for the internal aspects of the entity. Besides communication on financial issues, the board also desires information on operational and compliance matters. The comparison of the international external auditing and the internal auditing standards shows that some information received by the governance body/board is similar. However, much is unique. Both groups of auditors aid the governance body/board in achieving its objective of guiding the entity to carry out its mission effectively and efficiently

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Slack in public administration: conceptual and methodological issues Tor Busch Keywords Costs, Management, Efficiency, Public administration Ever since its introduction, the concept of organisational slack has constituted the basis for a considerable body of research within behavioural science. A great deal of this research has concentrated on budgetary slack, and within the field of public administration the focus has been on the slack- or budget-maximising bureaucrat. As the reduction of slack is the purpose of many of the techniques which are part of the new public management, there is a need to focus on how to measure changes in the level of slack. The objective of this paper is to discuss the relationship between three central concepts within the research on slack: organizational slack, budgetary slack, and the discretionary budget; to assess whether these concepts are suitable for public organizations; and to discuss problems of measurement.

Accounting and auditing requirements of the Sudan Companies Act 1925: time for change John A. Brierley Sheffield University Management School, The University of Sheffield, Sheffield, UK Hussein M. El-Nafabi Al-Madina Al-Munawarah College, Al-Madina Al-Munawarah, Saudi Arabia David R. Gwilliam School of Management and Business, University of Wales Aberystwyth, Aberystwyth, UK

Keywords The Sudan, Legal matters, Balance sheets, Profit and loss, Accounting

Abstract The Sudan Companies Act 1925 is outdated. There is a need for substantial revision to the Act either in accordance with, for example, current UK legislation, or a framework more directly suited to the economic and legal environment of the Sudan. At a general level this should include the preparation of a profit and loss account, specific formats for the profit and loss account and balance sheet, notes to the accounts and an auditor’s report stating whether or not the accounts give a true and fair view of the state of a company’s affairs.

Managerial Auditing Journal 17/3 [2002] 113–116 # MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900210419886]

Introduction The Sudan Companies Act 1925 (hereafter the Act) was modelled on the UK Companies Act 1908. Despite the Sudan gaining independence from the UK in 1956 it has not been amended. One of the reasons for this has been the distraction of the Sudanese civil war which broke out in 1955 and, except for ten years of peace following the 1972 Addis Ababa Agreement, has continued ever since. This has been exacerbated by seven different regimes (three civilian and three military) which have governed the country since independence. The common features shared by these regimes have been frequent changes of government, continuous cabinet reshuffles and high ministerial turnover. For example the Ministry of Economic Planning, which plays a major role in the management of the economy, has been led by 32 ministers since independence. The last multiparty democratic government, which came to office in 1986, saw four ministerial reshuffles in its three years in office with some ministerial offices changing hands on four occasions. These frequent cabinet reshuffles led to a lack of continuity in government which has been exacerbated by the lack of clear descriptions of ministerial posts, and of agreed policies or manifestos to be followed by the appointed ministers. Indeed, the lack of clear policies and strategies has made it the general norm in the Sudanese government’s history that every new minister starts his job by scrapping the policies adopted by his predecessor. This government instability affects the environment in which accounting and auditing operate and has contributed to the fact that no amendments have been made to the Act. Similarly, other acts established under British colonial rule have not been subsequently amended, these include the Bills of Exchange Act 1917 and the Insolvency Act 1929.

Furthermore, it has been argued that the establishment of a professional accounting body in the Sudan was necessary to develop accounting and auditing practice. To this end individuals who were members of professional accounting bodies outside the Sudan, notably the Institute of Chartered Accountants in England and Wales and the Association of Chartered Certified Accountants in the UK, made several attempts in the early 1980s with the government to establish a professional accounting body in the Sudan. Due to the rapid changes in the political system during the 1980s these efforts did not come to fruition until the Certified Accountants Act 1988, which established the Sudanese Association of Certified Accountants (SACA). Article 4 of the 1988 Act sets out the functions of the council of the SACA, which includes the enhancement of the role of accounts in the commercial environment. This has not led, however, to any changes in the Act. Thus government instability and the lack of influence of the accounting profession has meant that the Companies Act 1925 has never been amended. The Act was introduced to assist the formation of private and public limited liability companies, and provide rules for the governance of their operations and financial affairs, but today it is out of date. The objective of this paper is to illustrate the outdated nature of the Act’s provisions relating to accounting and auditing and offer suggestions for updating the legislation. The paper is divided into three sections. The first section discusses the Act’s accounting provisions, the second section discusses the Act’s auditing provisions, and the third section provides a brief discussion of necessary changes to the Act.

Accounting provisions The current issue and full text archive of this journal is available at http://www.emeraldinsight.com/0268-6902.htm

Section 123(1) of the Act requires that every company shall keep proper books of account

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John A. Brierley, Hussein M. El-Nafabi and David R. Gwilliam Accounting and auditing requirements of the Sudan Companies Act 1925: time for change Managerial Auditing Journal 17/3 [2002] 113–116

in which there shall be full, true and complete accounts of the transactions and affairs of the company. Section 124(1) states that every company has to prepare a balance sheet at least once a year and at intervals of not more than 15 months. Further, section 124(2) requires that the balance sheet has to be audited by the auditor of the company, and the auditor’s report should be attached to the balance sheet, or there should be inserted at the foot of the balance sheet a reference to the report. The auditor’s report should be read out at the general meeting and should be open to inspection by any member of the company. Section 125(1) requires that the balance sheet contains a summary of the property and assets, and the capital and liabilities of the company. Although no indication is provided as to the amount of disclosure, details should be provided of the ‘‘general nature’’ of assets and liabilities and ‘‘how the value of fixed assets has been arrived at’’. Details about the content of the balance sheet are stated in the Third Schedule Form C of the Act (see Appendix). There is no requirement to disclose comparative figures on the face of the balance sheet; hence it is not possible to make comparisons of amounts disclosed in the balance sheet with the previous year. The balance sheet does not require separate disclosure of the accounting policies used or further disclosure of items in the form of a note to the balance sheet. The balance sheet does not provide separate disclosure of a number of items, such as investments, like government securities, shares and debentures. Nor is there a requirement for a breakdown of stocks and work-in-progress and debtors (Tyagi, 1982). There is no detailed breakdown of liabilities, for example, Tyagi (1982) notes that disclosure is not required of proposed dividends and of the security for any loans received. There is no requirement to prepare a profit and loss account. The only requirement is to disclose the profit for the financial year on the face of the balance sheet, although this requirement does not apply if a separate profit and loss account is prepared. If a profit and loss account is prepared it does not have to follow any specific format, which may lead to difficulties when making comparisons between companies.

Auditing provisions Section 138 of the Act specifies the powers and duties of auditors. Section 138(1) states that auditors have the right of access at all

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times to the books, records and accounts of a company and are entitled to receive from the directors and officers of the company such information and explanations as may be necessary to carry out their work as auditors. Auditors are required to report on: . whether or not they have obtained all the information and explanations they require; . whether in their opinion the balance sheet has been drawn up in conformity with the law (presumably the Act); and . whether or not the balance sheet exhibits a ‘‘true and correct view of the state of the company’s affairs according to the best of their information and explanations given to them, and as shown by the books of the company’’ (emphasis added). The requirement to show a true and correct view is contrary to the concept of ‘‘true and fair view’’ in the UK. According to Tyagi (1982), the auditor is unable to certify whether the financial statements exhibit a ‘‘correct’’ view because the auditor is not connected with the management of the company. He argues that because the balance sheet is a summary statement of the activities of the whole company it is more appropriate for the auditor to assess whether the balance sheet shows a true and fair view. The Act does not require the auditor to state whether or not the profit and loss account, if prepared, gives a true and fair view of the profit (or loss) for the period, nor whether or not the accounts have been prepared properly in accordance with the provisions of the Act. Section 137 of the Act specifies the requirements regarding the qualifications and appointment of auditors. The Act does not specify the necessary qualifications of persons who are eligible to act as company auditors, although in order to preserve auditor independence section 137(5) does prevent certain persons from acting as auditors. These include: . a director or officer of the company; . a partner of such a director or officer; and . any person in the employment of a director or officer. Section 137(1) requires that an auditor should hold a certificate issued by the Minister of Finance and National Economy. Usually the auditor is appointed at the annual general meeting until the next such meeting. If for some reason an auditor is not appointed at the annual general meeting, section 137(4) states that the court may, following the application of any member of the company, appoint an auditor and fix their remuneration for the current year.

John A. Brierley, Hussein M. El-Nafabi and David R. Gwilliam Accounting and auditing requirements of the Sudan Companies Act 1925: time for change Managerial Auditing Journal 17/3 [2002] 113–116

Discussion The 1925 Companies Act is outdated and does not reflect the changes and the worldwide developments in the areas of accounting and auditing practice. There is clearly a need for substantial revision of the Act either in accordance with, for example, current UK legislation or, perhaps more appropriately, in line with a framework more directly suited to the economic and legal environment

of the Sudan. At a general level this should include the preparation of a profit and loss account, specific formats for the profit and loss account and balance sheet, notes to the accounts and an auditor’s report stating whether or not the accounts give a true and fair view of the state of a company’s affairs.

Reference Tyagi, C.L. (1982), ‘‘Balance sheet reform needed’’, Sudanow, Vol. 7 No. 11, p. 29.

Appendix. Third Schedule Form C of the Sudan Companies Act 1925 . . . . . . . . . . . Limited

Balance-sheet As at . . . . . . . . 19 . . . . Capital and liabilities Capital

LS. m/ms

Authorized capital . . . . . . shares of LS . . . . . . each

........

Issued capital . . . . . . shares of LS . . . . . . each

........

Subscribed capital . . . . . . shares of LS. each

........

Amount called up at LS. per share

........

Less calls unpaid

........

Add – forfeited shares (amount paid-up)

........

Reserve fund or development fund

........

Any sinking fund

........

Any other fund created out of net profits

........

Any pension or insurance fund

........

Provision for bad and doubtful debts

........

Loans on mortgage or mortgage debenture bonds

........

Loans otherwise secured (stating the nature of security)

........

Loans unsecured

........

Interest

........

Accrued on mortgages, debentures of other secured loans

........

Unclaimed dividends

........

Liabilities For goods supplied

........

For expenses

........

For acceptances

........

For other finance

........

Advanced payments and unexpired discounts . . . . . . . . . . (For the portion of which value has still to be given, e.g. in the case of the the following classes of companies: Newspaper, fire insurance, theatre, club, banking, steamship companies, etc.)

........

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John A. Brierley, Hussein M. El-Nafabi and David R. Gwilliam Accounting and auditing requirements of the Sudan Companies Act 1925: time for change

Profit and loss

LS. m/ms

Balance brought forward

........

Managerial Auditing Journal 17/3 [2002] 113–116

Profit since last balance-sheet

........

Balance as per previous balance-sheet

........

Less – appropriation thereof

........

(N.B. – These details need not to be given if the same be contained in a profit and loss account attached to the balance-sheet.) Contingent liabilities – claims against the company not acknowledged as debts

........

Money for which the company is contingently liable

........

Arrears of cumulative preference dividends

........

Property and assets Fixed capital expenditure

........

(Distinguishing as far as possible between expenditure upon goodwill, land, buildings, leaseholds, railway sidings, plant, machinery, furniture, development of property, patents, trade marks and designs, interest paid out of capital during construction, etc., and stating in every case the original cost and the total depreciation written off under each head). Preliminary expenses

........

Commission or brokerage

........

(Commission or brokerage paid for underwriting or placing shares or debentures until written off)

........

Stores and spare gear

........

Loose tools

........

Live stock

........

(Stating mode of valuation, e.g. cost or market value.) Bills of exchange

........

Book debts

........

(Distinguishing in the case of a bank between those considered good and in respect of which the bank holds no security other than the debtor’s personal security, and distinguishing in all cases between debts considered goods and debts considered doubtful or bad. Debts due by directors or other officers of the company or any of them either severally or jointly with any other persons to be separately stated in all cases.) Advances

........

(Recoverable in cash or in kind or for value to be received, e.g. rates, taxes, insurance, etc.) Investments

........

(Nature of investment and mode of valuation, e.g. cost or market value.)

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Interest accrued on investments

........

Cash and other balances

........

Amount in hand

........

Balances with agents and bankers (in detail, showing whether on deposit or current etc.)

........

Profit and loss (giving in the case of a debit balance details as far as possible as in the case of a credit balance)

........

Re-engineering recruitment to the accounting profession Malcolm Smith School of Accounting and Information Systems, University of South Australia, Adelaide, Australia Christopher Graves School of Accounting and Information Systems, University of South Australia, Adelaide, Australia

Keywords Recruitment, Biodata, Forecasting, Performance, Modelling

Abstract There can be few personnel techniques so lowly regarded as the recruitment interview. Yet we persevere with the use of the technique despite the overwhelming evidence of its deficiencies. The accountancy and auditing professions are as guilty as most in this regard, and suffer from rates of attrition and job turnover, which should be an embarrassment. But there are alternatives available, and this paper reports on the development of revolutionary techniques which might have a significant impact on recruitment to the accounting and auditing professions in the UK.

During this decade, dramatic changes have occurred in the business environment. In order to remain competitive, accountancy firms now need to provide a diverse range of services to their clients, at low cost. To meet these challenges, it is critical that accountancy firms select their employees carefully, as failure to select the right staff can be costly. Some of the costs associated with poor recruitment decisions include: lower productivity and competitiveness, potential loss of clients, training costs, advertising costs, recruitment fees and redundancy packages. The US Department of Labour estimates that a poor recruitment decision can cost the employer an amount equal to 30 percent of the employee’s first year’s potential earnings (Hacker, 1997). KPMG state that ‘‘the current estimate of investment per student is £100,000’’ (KPMG-UK, n.d.). Recruiters face a difficult task as they need to make a decision that predicts the contribution that an individual will make to the organisation in the future based on the factual and personal information available now. As a result, any recruitment selection procedure adopted by the accounting profession will be an imprecise selection tool. Essentially, there is no real substitute for observing the performance of individuals in the field, hence the popularity of intern relationships. However, these may not always be available. Practical tests conducted at interview may be a less than satisfactory alternative, but are still not universally adopted.

Conventional approaches to recruitment Managerial Auditing Journal 17/3 [2002] 117–121 # MCB UP Limited [ISSN 0268-6902] [DOI 10.1108/02686900210419895]

Most frequently, recruiters adopt a two-stage procedure: The current issue and full text archive of this journal is available at http://www.emeraldinsight.com/0268-6902.htm

1 Select (or not) candidates for interview based on the contents of their application form requiring biographical information (biodata). 2 Make a final employment decision based on a personal interview; this itself may be a two-stage procedure if applicants are first used to draw up a short-list of potential appointees. Dipboye et al. (1984) suggest that ‘‘no other personnel technique is held in such low esteem in the research literature as the interview’’, yet despite its demonstrable lack of reliability and validity, the unstructured interview remains the prime assessment mechanism in graduate recruitment. This is despite the fact that, before the interview, applicants complete a form containing historic and verifiable information about the individual which would permit the development of scoring systems and the construction of models with potentially high predictive ability of eventual success. In the UK, around 30 percent of graduates entering the profession ultimately fail to qualify as accountants, a statistic which Harvey-Cook and Taffler (1987) attribute to failures of recruitment procedures. Harvey-Cook et al. (1998) and Gammie (1999) demonstrate that selection models using biographical data have value to recruiters and outperform conventional approaches; they suggest that significant benefits can be accrued by the accountancy profession through the adoption of formal statistical procedures at the selection stage.

Emerging recruitment techniques Harvey-Cook et al. (1998) Holland (1976) finds that people with similar background characteristics form six vocational types: realistic, social, investigative, creative, conventional and enterprising. Accountants are generally of the ‘‘conventional’’ type. Biographical data

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Malcolm Smith and Christopher Graves Re-engineering recruitment to the accounting profession Managerial Auditing Journal 17/3 [2002] 117–121

on personal characteristics and previous academic performance have been shown to be the best predictor of employee turnover (Gable et al., 1989), job performance (Hunter and Hunter, 1984) and voluntary withdrawal during training (Drakeley et al., 1988). In the UK, the most common cause of withdrawal from the profession during training is examination failure. As a result, Harvey-Cook et al. (1998) first developed a model for success in the professional examinations (Model 1) and then a model for ‘‘success’’ which incorporated both progress in examinations and good work performance (Model 2). Both of these models were constructed based on applicants to the profession employed by second-tier accounting firms (i.e. not the then Big 6).

The models The two models are described as follows: 1 Model 1: to predict examination success. Six significant variables were identified in trainee application forms that contributed to examination success. In descending order of importance: . number of grade As at ‘‘O’’ level; . a good first degree (first or upper second class); . number of arts or language ‘‘A’’ levels (a negative variable); . first degree in science or mathematics; . head boy or girl at school; . independent school background. The model’s overall probability of correct classification is 74 percent, with 78 percent of ‘‘pass’’ predictions correct and 69 percent of ‘‘fail’’ predictions correct in a sample of 229 applicants taking the professional examinations (see Table I). 2 Model 2: to predict good work performance. Again six significant variables were identified. In descending order of importance: . number of ‘‘A’’ levels in science subjects; . head boy or girl at school; . number of teams and societies at school; . exemption from the graduate conversion course specifically designed for non-accounting graduates; . degree class for first degree;

Table I Model 1: to predict examination success

Actual pass Actual fail Overall [ 118 ]

Predicted pass

Predicted fail

Correct (%)

Total

102 30 132

29 68 97

78 69 74

131 98 229

size of social interaction groups at university (a negative variable). The model’s overall probability of correct classification is 75 percent, with 75 percent of the ‘‘successful’’ predictions correct, and 76 percent of the ‘‘unsuccessful’’ predictions correct (see Table II). .

These two models were confirmed by applying them to a second group of applicants three years later.

Relevance to the accounting and auditing professions As both models are based on UK data, the important variables in each of the models provides a fair reflection of what might be important characteristics in a UK environment: . ‘‘O’’ level (now GCSE) grades are the most important feature in predicting examination success. These exams are undertaken at age 16 and provide the basic evidence of performance ability for university selection interviews in the following year. Although ‘‘A’’ levels are completed at age 18, in most cases these will only determine the particular university destination; with minimal performance at ‘‘A’’ levels, the ‘‘O’’ level performance may determine university entrance. . Students who choose electives in mathematics and science at school are likely to fare better than those choosing arts and languages. . Students who choose an accounting degree at university, and who are therefore not subjected to a graduate conversion course, or equivalent, should do better in the profession. . Interpersonal skills and social activities undertaken at school are important and positive – e.g. school dux, sports colours and team participation. The opposite appears to be true at university, where extra-curricula activities appear to have a negative effect. . The class of first degree awarded is significant, so the achievement of First Class Honours or a ranking in the top 5 percent of graduating students would be positively regarded. . This study showed that an independent school background was a positive factor, though one less important than the other factors.

Gammie (1999) Gammie (1999) constructed similar models for predicting success in the professional examinations. However, this study extends


prior research by developing and testing models within a Scottish environment. Second, the models are applicable to all professional training offices (i.e. first and second tier accountancy firms). Finally, the models are extended to incorporate honours graduates who complete an additional year of study (rather than the Year 3 categorisation common for honours awards within English universities). This study was based upon the biodata collected from recently qualified accountants, who trained within the whole spectrum of ICAS training offices. In Scotland, students can choose either to complete an ordinary degree (three years duration) or decide to complete a fourth year to obtain an honours degree. As a result, Gammie (1999) developed separate models for ordinary and honours graduates of fully accredited degrees.

The models The two models are described as follows: 1 Model 1: to predict examination success of fully-accredited honours graduates. Three significant variables were identified as indicators of examination success. In descending order of importance: . honours award; . number of jobs related to chartered accountancy whilst at school and university; . whether progressed directly from university to ICAS training. The model’s overall probability of correct classification is 69 percent, with 69 percent of ‘‘pass’’ predictions correct and 69 percent of ‘‘fail’’ predictions correct in a sample of 149 respondents taking the professional examinations (see Table III).

Table II Model 2: to predict good work performance

Actual success Actual leaver Overall

Predicted success

Predicted leaver

Correct (%)

Total

60 18 78

20 56 76

75 76 75

80 74 154

Table III Model 1: to predict examination success of fully-accredited honours graduates

Actual pass first time Actual fail one or more Overall

Predicted pass first time

Predicted fail one or more

Correct (%)

Total

68 16 84

30 35 65

69 69 69

98 51 149

2 Model 2: to predict examination success of fully-accredited ordinary graduates. Two significant variables were identified as indicators of examination success. In descending order of importance: . number of jobs related to chartered accountancy whilst at school and university; . number of resits in second and third year at university. The model’s overall probability of correct classification is 61 percent, with 77 percent of ‘‘pass’’ predictions correct and 43 percent of ‘‘fail’’ predictions correct in a sample of 225 respondents taking the professional examinations (see Table IV). These two models were confirmed by applying them to a second group of trainees one year later. Prior research in recruitment to the accountancy profession has usually defined success as ‘‘trainees who pass their examinations’’. Gammie (1999), however, adopted a more restrictive definition of success, being ‘‘trainees who pass their examination at their first attempt’’. As a result, the models developed by Gammie (1999) are not readily comparable with models developed by other researchers.

Relevance to the accounting and auditing professions As both models are based on data collected from Scotland, the important variables in each of the models provides a fair reflection of what might be important characteristics in the Scottish accountancy profession: . With regard to fully-accredited honours graduates, the most important predictor of ICAS examination success is the degree classification. This result suggests that the achievement of First Class Honours would be positively regarded. One practical limitation with using this variable arises from a timing issue. Recruitment of trainees often occurs early on in students’ honours year and therefore the degree classification is unknown (i.e. has not been awarded). Gammie argues that this can be overcome by using the academic staff’s prediction of the degree classification. . Regardless of the type of fully-accredited degree taken, a significant factor in predicting ICAS examination success is the number of chartered accountancyrelated jobs undertaken whilst at school and university. Clearly, this suggests that the more jobs undertaken by students which relate to the profession, the greater their chance in passing the ICAS examinations at their first attempt.

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Malcolm Smith and Christopher Graves Re-engineering recruitment to the accounting profession

.

Managerial Auditing Journal 17/3 [2002] 117–121 .

Fully-accredited honours graduates are more likely to pass the ICAS examinations at their first attempt if they commence the ICAS examination process straight after completing their degree. This study suggests that the greater number of resits encountered by university students studying fullyaccredited ordinary degrees, the less likely they are to pass ICAS examinations in their first attempt.

Applying these models in practice Harvey-Cook et al. (1998) used a decision matrix, based on appropriately weighted variables from Model 1, to generate a logit score with the following outcome probabilities. Table V is potentially invaluable to accountancy firms in formulating successful recruitment strategies. Based upon this matrix, nearly half of all applicants with scores < 0.20 fail, and the chances of individuals in this group passing are extremely low (5 percent). Conversely, only 6 percent of those with scores and > 0.80 are likely to fail. Application of a cut-off score of 0.70 for recruitment through Model 1 would have given a 14 percent probability of failure in the test group (rather than the 25 percent observed). Application of a cut-off score of 0.80 through Model 2 would have given a 7 percent probability of a ‘‘poor performer’’ (rather than the 24 percent observed). The models were further applied to a set of applicants (262 in total) to determine how closely their predictions conformed to

Table IV Model 2: to predict examination success of fully-accredited ordinary graduates

Actual pass first time Actual fail one or more Overall

Predicted pass first time

Predicted fail one or more

Correct (%)

Total

94 59 153

28 44 72

77 43 61

122 103 225

Table VI ‘‘Call for interview’’ decisions

Table V Outcome probabilities Score < 0.20 0.21 < 0.40 0.41 < 0.60 0.61 < 0.80 0.81 < 1.00 [ 120 ]

recruiters’ ‘‘call for interview’’ decisions. Applicants were assigned to one of three groups, based upon their combined scores from both models. Applicants were classified as ‘‘high’’ (highly desirable) if they scored above the suggested cut-offs for each model (0.7 for Model 1, 0.8 for Model 2). Applicants were classified as ‘‘low’’ (undesirable) if they scored below the cut-offs for both models. As Table VI shows, only 50 percent (19) of the applicants rated ‘‘desirable’’ by the models were actually called for interview, while almost a third (41) of those classified ‘‘undesirable’’ were. As a result, of the 38 ‘‘desirable’’ candidates, only 18 percent (7) received offers of employment, while 34 percent (13) of those classified as ‘‘undesirable’’ received employment offers. Recruiters could provide no adequate explanation of the differences, suggesting flaws in the interview process and/or indeterminate variables possibly associated with the corporate culture of the accounting firm. Gammie’s (1999) study has important implications for the structure of accounting degrees in the UK. These models suggest that incorporating accountancy placements and formal internships into the degree structure, as is already commonly the case with sandwich-type business studies degrees, will have a significantly positive influence on student success in professional accountancy programs. This is consistent with the findings of Eskew and Faley (1988) which suggest that previous related experience is significant for the prediction of student performance. Second, performance in undergraduate degrees (i.e. honours classification or number of resits in second and third year) continues to be a useful indicator for recruiters in their task of selecting the most appropriate graduates. Finally, honours graduates should be encouraged to progress directly from university into the professional accounting programs as this will maximise their chances of passing the professional exams at their first sitting.

Probability of failure (%)

Probability of pass (%)

49 38 30 16 6

5 20 30 35 46

Score

Interview n (%)

High Intermediate Low Total

19 40 41 100

50 46 30

Firm decision Reject Total n (%) n (%) 19 47 96 162

50 54 70

38 100 87 100 137 100 262


Summary The models developed by Harvey-Cook et al. (1998) and Gammie (1999) provide a viable alternative to the conventional ‘‘hit and miss’’ type approaches to recruitment. The adoption of these models will not only reduce the costs associated with poor recruitment, it may spare the applicant from the stress and loss of confidence associated with a mismatched career choice. Biodata techniques do not suffer from inherent interview bias, are arguably fairer to all candidates and are robust in their application. They do, however, need to be updated regularly to accommodate demographic changes, grade inflation in school and university examination results, and new sources of applicants, to ensure their continuing effectiveness over time. The nature of the models means that they are designed to exclude those candidates likely to fail examinations, leave the organisation during training, or underperform in practice (i.e. to identify ‘‘failures’’ in some sense). However, in order to do so they overcompensate and will exclude some candidates who may have made a positive contribution to the profession, on the basis that this is the least expensive error for recruiters to make.

References Dipboye, R.L., Stramler, G.A. and Fontenelle, V. (1984), ‘‘The effects of application recall of information from the interview’’, Academy of Management Journal, Vol. 27 No. 3, pp. 561-75. Drakeley, R.J., Herriot, P. and Jones, A.P. (1988), ‘‘Biographical data, training success and

turnover’’, Journal of Occupational Psychology, Vol. 61 No. 2, pp. 145-52. Eskew, R.K. and Faley, R.H. (1988), ‘‘Some determinants of performance in the first college level financial accounting course’’, Accounting Review, Vol. 63 No. 1, pp. 137-47. Gable, M., Hollon, C. and Dangello, F. (1989), ‘‘The relationship of application form information and performance to managerial trainee turnover’’, International Journal of Management, Vol. 6 No. 3, pp. 289-95. Gammie, E. (1999), ‘‘The use of biodata in the pre-selection of graduates for chartered accountancy training places: an evaluation’’, British Accounting Association Conference, Glasgow, April. Hacker, C. (1997), ‘‘The cost of poor hiring decisions . . . and how to avoid them’’, HR Focus, Vol. 74 No. 10, pp. S13(1). Harvey-Cook, J.E. and Taffler, R.J. (1987), ‘‘Graduate recruitment procedures in the UK accounting profession: a preliminary study’’, Accounting and Business Research, Vol. 17 No. 66, pp. 99-108. Harvey-Cook, J.E., Taffler, R.J. and Williams, A.P.O. (1998), ‘‘Improving graduate recruitment methods in the accounting profession’’, AAANZ Annual Conference, Adelaide, July. Holland, J.L. (1976), ‘‘Vocational preferences’’, in Dunette, M. (Ed.), Handbook of Industrial and Organizational Psychology, Rand McNally, Chicago, IL. Hunter, J.E. and Hunter, R. (1984), ‘‘Validity and utility of alternative predictors of job performance’’, Psychological Bulletin, Vol. 96, pp. 72-98. KPMG-UK (n.d.), ‘‘Graduate recruitment brochure’’, Online, URL: http:// jobs.kpmgcareers.co.uk/career/training.htm, accessed 1 June 1999.

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A critical evaluation of the effect of participation in budget target setting on motivation

Pamela Reid Seaford, UK

Keywords Accounting, Theory, Target setting, Participation, Performance

Abstract This paper critically evaluates the effect of participation in budget target setting in an effort to increase the probability of an organisation’s goals being achieved and, in so doing, considers some of the numerous theories of motivation. Such theories include Maslow through to equity and expectancy theories. However, given that there are a multiplicity of variables at work here, the author concludes that the effect of participation is situation specific and dependent upon such variables: there is no ‘‘perfect’’ budgeting system.


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Introduction The highly competitive global economy of today means that many, if not most, organisations’ productivity is constrained by cost pressures. Accordingly, as Drury (1999) has pointed out, standard costing systems and budgetary control endeavour to ensure that the overall aims and objectives of the organisation are efficiently and effectively achieved. Such planning and control measures focus on encouraging individuals within the organisation to tailor their behaviour towards the effective and efficient meeting of those goals.

Budget use Willsmore (1973, p. 11) noted that ‘‘. . . budgets have a very wide potential use’’. Areas in which budgets can be used to assist in management planning and control, including problem identification, co-ordination of the various parts of the whole, delegated authority to spend, controlling and measuring performance, and motivation have been identified by Atrill and McLaney (1999), to which Berry and Jarvis (1999) have added communication and providing a basis for responsibility accounting. Tensions, however, between these uses of budgets may exist, for example, in using a budget as a means of control and also as a means of authorisation. Authorised managers may be motivated to spend their entire allocated budget if, for example, they believe that the following year’s budget will be reduced if ‘‘under spending’’ occurs in the current year. Such behaviour, at least in the short term, is unlikely to be congruent with the organisation’s overall concerns with efficiency (both ‘‘pure efficiency’’[1] and ‘‘mixed efficiency’’[2] as described by The current issue and full text archive of this journal is available at http://www.emeraldinsight.com/0268-6902.htm

Wildavsky, 1975) and effectiveness, i.e. control. In view of such inherent tensions, Stedry (1960) has proposed that separate, different budgets be used for differing purposes for he believes that no one budget can meet the differing requirements. Thus one could be utilised for planning purposes and another for motivational purposes. Given that this was proposed in 1960, before the advent of notions of government transparency, accountability, and community participation, which are some of the objectives introduced in pluralistic best value (Burton, 1997), it would be difficult to see how this proposal could now gain credence in the public sector. Within the private sector too, it also easy to see that the existence of two (or more) budgets may have a negative impact on motivation and would militate against effective, open and honest participative management. To paraphrase Theodore Levitt, the wellknown American management guru, ‘‘if you don’t know where you are going, any road will take you there’’ (Johnson, 1998). Drucker (1954), likewise, advocated the use of setting clear, tangible, verifiable, measurable goals in order to motivate, rather than to ‘‘control’’, people. Evidence abounds to show that without such quantitative goals, performance suffers (see, for example, French et al., 1965).

Theories of motivation The maximisation of individuals’ motivation to achieve the organisation’s objectives can only really be obtained through a thorough understanding of theories of motivation. Such theories grew from a realisation that the principles of ‘‘scientific management’’ as advocated by Taylor (1911), involving the radical division of labour (Smith, 1904) by managers (the antithesis, one might argue, of participation), relied too much upon an assumption that economic reward motivates.

Pamela Reid A critical evaluation of the effect of participation in budget target setting on motivation Managerial Auditing Journal 17/3 [2002] 122–129

This realisation, combined with an emerging consciousness regarding the conditions of the working classes in the industrialised West (Mayo, 1933, 1945; Braverman, 1974), saw the birth of a new school of thought – the human relations movement – marked by the Hawthorne Study (Roethlisberger and Dickson, 1939). From this ‘‘industrial psychology’’ school developed two streams of work motivation theory generically known as ‘‘content’’ theories[3] and ‘‘process’’ theories[4] (Rollinson et al., 1998). Probably the most obvious starting point for a consideration of concepts of work motivation commences with Maslow’s (1954) ‘‘hierarchy of needs’’. However, it is somewhat unfortunate that such a widely promulgated hypothesis regarding factors that motivate people, thus far, appears to lack empirical backing (see, for example, Hall and Nougaim, 1968; Wahba and Bridwell, 1976) and appears to be peppered with untested assumptions. Nevertheless, it formed the basis of a revised hierarchy produced by Alderfer (1969) identifying the core needs of existence, relatedness and growth. Core learned and culturally sensitive needs of achievement, power and affiliation were proposed by McClelland (1967, 1975) as explaining motivation. However, it is fair to say that such needs, and hence their effect on motivation, are different for different people and, indeed, can vary over situations and time. Herzberg et al. (1959) moved on from hierarchical needs to examine what they termed ‘‘motivators’’ and ‘‘hygiene factors’’ in the workplace, postulating that where job satisfaction was high there would be correspondingly high motivation. Although one can argue that this work constituted an examination of job satisfaction rather than motivation, Robbins (1998, p. 173) believes that the recent growth of worker participation in planning and controlling their work is due to Herzberg et al.’s (1959) recommendation that those factors which they find intrinsically rewarding (achievement, recognition, the work itself, responsibility and growth) should be emphasised. Nevertheless, if one follows Herzberg et al.’s thinking to its logical conclusion, no matter how much emphasis is placed upon factors that staff find intrinsically rewarding, such as worker empowerment, supportive management, team work, delegated authority and responsibility, if hygiene factors, such as low pay, are not addressed their full effect will not be felt. The interdependence of intrinsic rewards with extrinsic rewards with consequences

for motivation has also been postulated (de Charms, 1968). However, it would appear that there is limited applicability of this cognitive evaluation theory in the world of work and that further research is required. Emphasis upon the manager’s essentially negative or essentially positive view of human nature comprises McGregor’s (1960) Theory X and Theory Y. McGregor himself subscribed to the more positive view of his fellow man as being creative; able to exercise self control and self direction; and likely to seek responsibility and to enjoy work. He recommended such behaviours as participative decision making in organisations. Theory X, though, would suggest that a more authoritarian style of management is required in order to push workers towards meeting organisational needs and meeting targets. Nevertheless, in the absence of rigorous empirical evidence to support his views, they must remain, surely, merely assumption X and assumption Y, dependent upon situational, and other, variables. One of the most popular theories of motivation is that of expectancy theory, whereby an individual’s motivation to work is affected by a wide range of both independent and interdependent variables (satisfaction associated with the work itself; satisfaction associated with the achievement of objectives; satisfaction with extrinsic rewards associated with the meeting of targets; and the individual’s perceived expectancy of linked reward). The most notable of these theories is Vroom’s (1964) model and the, perhaps, lesser known outside of academia, Porter and Lawler (1968) model which builds upon the previous model. The latter, one can argue, fits into current thinking regarding best practice surrounding the valuing of diversity, and open and honest communication in the workplace. However, Landy and Becker (1987) take the perhaps more cynical view that real choice does not exist in the workplace as factors such as coercion and insecurity ensure that workers’ performance is maintained. One variable that organisations are not able to affect directly is that which is intrinsic to the individual: the person’s ‘‘locus of control’’[5] and, obviously, any other personality traits. Interestingly, personality traits, it can be argued, may play a significant part in people’s career/ employer choice. Organisations need to understand that different variables, in different people, in different jobs, in different departments, at different levels in the hierarchy affect motivation and that

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measures to influence performance of those different individuals must reflect that. Another important factor in employee motivation can be seen in equity theory (Adams, 1965) with its notions of procedural and distributive justice in absolute and, in particular, relative rewards. If employees perceive that their inputs, in terms of their effort or performance, do not receive adequate reward, either on their own merit or in comparison with others, a perception of inequity will result. Attendant negative feelings of dissatisfaction will result in the individual being motivated to redress the inequity. Generally speaking, this is likely to affect their future performance in that organisation in an adverse manner. It is, of course, possible for the reverse situation to occur whereby the reward is overly generous in relation to the input (the ‘‘fat cat’’ scenario) and it is believed that guilt feelings may be felt. Interestingly, little is written on the effect upon motivation in the ‘‘fat cat’’ scenario! And finally, as far as this brief consideration of some of the large numbers of varying motivation theories are concerned, there is goal setting theory[6] (Locke, 1968), although this time focussing on the individual rather than the organisation.

Targets As Lyne (1995) has stated, accounting measures and the use of budgets as targets is an obvious way in which individuals can be given clearly stated, measurable, specific goals. This, assuming that rewards are based on performance, the meeting of targets, rather than issues such as seniority for example, fits with expectancy theory. The question that then can be posed is at what level of difficulty should the budget target be set in order to maximise motivation? Expectancy theory dictates that there will be little motivating effect if the budget target is set so high that it is perceived to be unattainable, irrespective of the certainty of expected performance associated rewards on offer. Lyne (1995) has related equity theory to perceptions of the target set, either initially or upon revision if activity based budgeting is in operation. If the target is seen as irrelevant or unfair in some way then the likely effect is to de-motivate. Revision of budget targets may also be made following a comparison of the target set and actual performance. Indeed, Becker and Green (1962), in order to maximise continuous levels of motivation, advocated this. For example, if performance is meeting,

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or is even in excess of, expectation then, to prevent the worker ‘‘coasting’’, budget targets should be revised upwards. However, one can, at this point, issue a caveat for there is possibly a strong argument for a concurrent review of extrinsic rewards to prevent the worker with the revised target experiencing equity theory related tensions. Becker and Green (1962) also advocated the revision of budget targets downwards if there is significant under performance in order to increase motivation. Likewise, one should, perhaps, issue a caveat here. Natural justice dictates that one should recognise when perceived poor performance is due to factors beyond the control of the worker (e.g. unrealistic targets, unexpected changes in the external environment that could not have been reasonably foreseen and planned for). Equally, however, it may not be in the organisation’s best interests to be seen to be ‘‘carrying’’ under-achievers by the revision of budgetary targets. Capability proceedings should be considered in order to assist the situation.

Participation? According to Macintosh (1995, p. 211), a survey of managers and supervisors by the National Industrial Conference Board (USA) in the 1930s showed that there was considerable dissatisfaction with the setting of ‘‘top-down’’ budgets. This appeared to be having a negative effect upon motivation. Thus notions of participation in budget target setting were first proposed. A further study in the USA by Argyris (1952) examined the behavioural dynamics of budgeting in four firms. The study uncovered some very unhelpful attitudes and demotivating behaviours. For example, budgets were frequently used as an oppressive tool by an authoritarian, autocratic management with a focus on mistakes; an undue attention on their own departments, rather than on the whole organisation; the emergence of ‘‘budget slack’’; and a ‘‘blame culture’’. Supervisors, however, were able to see that the budgets included unrealistic targets; were backward looking; rigid and inflexible; and were used to apply pressure to increase production. All in all, the focus was upon outputs, not processes, and the result was de-motivating. Indeed, the supervisors tried to redress what they saw as an imbalance by not referring to budgetary targets and control. The main recommendations flowing from this work were those of the supervisors participating in the setting and revision of


their budget targets and of increased open communication amongst them. Other studies, however, lead one to conclude that, although participative management is seen as being rather ‘‘politically correct’’ currently, it may be that its value is situation-specific: there may be some organisations in which it is not necessarily a major motivational force. For example, Cherrington and Cherrington’s (1973) study found that the ‘‘top down’’ imposition of budget targets led to higher performance amongst the recipients as opposed to those managers who, more or less, set their own targets. Also, contrary to current popular belief, the setting of budget targets and budgetary control does not always lead to autocratic managerial behaviour (DeCoster and Fertakis, 1968). Managers can be motivated to respond to such pressures by exercising their authority in an inclusive, supportive, democratic, participatory way.

Performance Part of that exercising of authority includes the use of performance evaluation. In today’s world of Investors in People awards, performance related pay, and suchlike, the use of performance appraisals is widespread. Through marking performance against a set of measures, it is believed that, especially if this is linked to relevant rewards, greater individual and organisational goal congruence will be achieved and workers will engage in behaviour likely to result in greater efficiency and effectiveness in the meeting of organisational goals. Output, especially in the private sector, has, historically, appeared relatively easy to measure (sales; profit; units produced; budget targets met) but some outputs, especially in the public sector, have appeared to pose more of a challenge to quantify (Pendlebury, 1996). However, with the ‘‘new way of thinking about the state’’ (Ridley, 1995), including the introduction of market forces via a variety of initiatives coming under the catch-all term of ‘‘privatisation’’ (Ascher, 1993) and the devolvement of budgets, this challenge is increasingly being met. But what of those areas of performance that are not subjected to measurement and evaluation? One can argue that worker effort may be concentrated in those areas that are subject to scrutiny, possibly to the detriment of others. Effort may also include the use of behaviours incompatible with organisational values. Drury (1999) has also questioned the

lack of evaluation based on longer-term performance factors than against relatively short-term budgetary indicators. Dysfunctional behaviour associated with performance evaluation against budget targets includes the oft-reported creation of ‘‘budgetary slack’’ (see, for example, Lowe and Shawe, 1968; Schiff and Lewin, 1968). Essentially, this is where workers endeavour, through the participatory process, to ensure that the budget target is relatively easy to achieve. By so doing, the motivational properties of the budget clearly are reduced. Lyne (1995) has pointed out that the likelihood of slack being manipulated is dependent upon a lack of congruence between the individual’s and the organisation’s goals and a lack of open and honest information sharing and communication between worker and manager. Gamesmanship may result, however, in the setting of budget targets if the manager holds views compatible with Theory X! Despite the reduction in the motivational properties of the budget with the creation of slack, it should be pointed out that smoothing properties will be enhanced and stress experienced by the worker operating to such budgets reduced which, in turn, may prove to motivate. To search for, and identify, management techniques that lead to budget targets being achieved with minimal dysfunctional behaviour has been the quest, therefore, of some academics. Hofstede (1968) advocated the creation by managers of ‘‘game spirit’’ and effective upward communication in order to maximise motivation and acceptance of the targets set. He argued for balance. The manager needs to walk a tightrope in terms of ensuring adequate emphasis is placed upon the demanding, but not unachievable, target and sufficient opportunities for discussion around budgetary matters to increase motivation, whilst ensuring that unhelpful feelings of pressure or negative criticism are not engendered which prove to be de-motivating. The latter may sometimes be expressed in dysfunctional behaviours such as absenteeism, which militate against efficiency and effectiveness. Given managers’ need to evaluate efficiency and effectiveness, Hopwood (1974) identified four styles of employing budgetary and accounting information in the evaluation process. These were a budgetconstrained style; profit conscious style; and a non-accounting style. Although Hopwood (1974) did not explain the origin or development of these, styles that were linked to concerns around accountancy issues were

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also linked to a variety of dysfunctional behaviours and lower reported levels of job satisfaction. It would appear, however, that there is a lack of research into possible effects upon the motivation of workers who have higher budgetary and accounting awareness than do their managers, some of whom may have a non-accounting style in the Hopwood tradition. Contagion effects appear only to have been considered as possibly acting in a ‘‘top-down’’ fashion (Macintosh, 1995). One may hypothesise that frustration and consequent adverse effects upon motivation must surely result?

Variables Briers and Hirst (1990) have highlighted some of the wide-ranging variables, intervening, dependent, moderating and antecedent, upon performance as regards budget targets. Hopwood (1974) himself noted that participation in target setting acted as a moderating variable upon dysfunctional behaviours and negative job-related tension when effected in a situation where the manager was exhibiting a budget constrained style. Participation in the budget target setting process has traditionally been taken to mean the active involvement of the budget holders, at least, which goes beyond simple consultation. Anything else is, as Argyris (1952) called it, pseudo participation. Specifically from an accounting perspective, participation is seen as a way of increasing motivation by getting the staff to ‘‘own’’ the budget and associated targets and see its relevance to them. Brownell (1982) took the view that if staff were able to participate in the setting of their budgetary targets, then the emphasis given to the measure of this area of performance should be correspondingly higher, as opposed to when such participatory opportunities do not exist or if they do not represent true participation. However, if the participation is meaningful, the improved communication and (hopefully) control should have a knock-on effect of improving performance as the quality of life at work improves. The more cynical, though, would always, perhaps, question the extent to which workers in primarily hierarchical organisations in inequitable power relationships really have the ability to influence the setting of their budget targets. Effective participation itself is dependent on the structure of the organisation so, for example, it is likely that those working in decentralised environments will perceive themselves to have greater role in

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participative budget target setting and such like (Bruns and Waterhouse, 1975). Lyne (1995) reports that, by ensuring participation in the setting of budget targets, motivation of ‘‘low authoritarian persons with high independence needs’’ is stimulated. Such stimulation of motivation in participative situations thus varies according to personality type. Drury (1999) has pointed to the positive effects on motivation that participation produces, but only in those workers who have confidence in their ability to perform. This has implications for training and the onus is upon organisations to ensure that their selection and recruitment procedures result in staff being obtained with, and subsequently trained in, the skills required to perform effectively. A further hypothesis proffered by Lyne (1995) concerned the existence of favourable organisational attitudes. He expressed the view that unless there existed positive attitudes by workers to the organisation as a whole, management, and the performance measurement system employed, participation was unlikely to increase motivation. Indeed, it may offer an opportunity for destructive and manipulative behaviours to show themselves overtly. The incidence of manipulative behaviours such as the creation of budgetary slack was found by Onsi (1973) to reduce when participative management techniques were used. The environment in which the organisation finds itself operating may militate against the introduction of participatory practices on the grounds of overall economic efficiency, however, for it is a truism that true participation, as opposed to pseudo participation, involves a heavy investment of time . . . and time is money. However, equally, an impetus for the implementation of participation in budgeting may be the uncertain nature of the environment. Internal drivers for the implementation of participation may also come from uncertainty for, if senior managers lack knowledge and information (i.e. there is uncertainty) which is held by subordinates, then participation is likely to be pursued. From this, one can question as to whether motivation is affected by the participants’ understanding or perception as to why participation, be it real or pseudo, is pursued within certain organisations. Given the complexity of researching such a topic with all its interdependent variables, it is, perhaps, unsurprising that attempts to locate possible answers to this line of enquiry have drawn a blank thus far.


Carried to its logical conclusion, real participation would result in the ‘‘bottom-up employee empowerment’’ envisaged by Johnson (1992). Here, employees at the base of the pyramid would not only have access to detailed accounting information, but they would be encouraged and facilitated to use this, together with their knowledge of the fundamentals of the organisation, to progress and grow that organisation and ensure maximum efficiency and effectiveness in the meeting of its goals. This, it can be argued, is a somewhat Utopian vision, involving a strong belief in the efficacy of Barnard’s (1938) assertion that power in any organisation is held at its base and also that all have sufficient competence and motivation to analyse detailed accounting information. Much of the current literature concerning participation in budget target setting has tended, it seems, to focus on vertical participative budgeting. Shields and Young (1993), accordingly, have called for future research to examine horizontal participative budgeting which would, no doubt, stimulate interest given the flatter organisational structures of today and the growth of organisations working in partnership and utilising pooled budgets. The role of the supervisor and their style cannot be underestimated when considering participation in setting budget targets, and especially in their evaluation of performance. Fisher (1989) also highlighted the provision of accurate speedy feedback by the supervisor. Briers and Hirst (1990) called for greater research into various facets of this area, such as the selection of supervisory style.

Conclusion Clearly the strength of setting budget targets lies in their easily quantifiable, measurable form which removes some of the inherent subjectivity in evaluating performance. However, performance is generally also expected in areas other than those which can be measured via the accounting domain. There are many factors that influence motivation to perform overall and some of these have been examined here. The use of participation in the setting of budget targets is one such factor. It is hard to see, however, how participation can be isolated from its context, for in some circumstances where participatory practices are utilised motivation may be increased. There is an inherent danger, however, that, because of the politically attractive elements of

participation, it may become some kind of dogma, to be pursued as some sort of universal truth irrespective of the context.

Notes 1 ‘‘Pure efficiency’’ being defined as where an objective is met at the lowest cost or where the maximum amount of an objective is obtained for a specified amount of resources. 2 ‘‘Mixed efficiency’’ being defined as where an objective is changed to suit the available resources. 3 ‘‘Content’’ theories focus on the needs of people as the prime impetus for motivated behaviour. 4 ‘‘Process’’ theories focus on the mental processes which transform the motive force/ need into particular patterns of behaviour. 5 This being whether a person believes outcomes and events are under his or her control, or whether they are determined by external factors that cannot be controlled by the individual. 6 In goal setting theory behaviour that is motivated is considered to be a function of the individual’s set goals and the likelihood of achieving these.

References Adams, J.S. (1965), ‘‘Inequity in social exchange’’, in Berkowitz, L. (Ed.), Advances in Experimental Social Psychology, Vol. 2, Academic Press, New York, NY. Alderfer, C.P. (1969), ‘‘An empirical test of a new theory of human needs’’, Organisational Behaviour and Human Performance, May, pp. 142-75. Argyris, C. (1952), The Impacts of Budgets on People, Controllership Foundation, Cornell University, Ithaca, NY. Ascher, K. (1993), The Politics of Privatisation – Contracting out Public Services, Macmillan, Basingstoke. Atrill, P. and McLaney, E. (1999), Management Accounting for Non-specialists, Prentice-Hall, Hemel Hempstead. Barnard, C.I. (1938), The Functions of the Executive, Harvard University Press, Cambridge, MA. Becker, S.W. and Green, D. (1962), ‘‘Budgeting and employee behaviour’’, Journal of Business, Vol. 35 No. 4, October, pp. 392-402. Berry, A. and Jarvis, R. (1999), Accounting in a Business Context, International Thomson Business Press, London. Braverman, H. (1974), Labour and Monopoly Capital: The Degradation of Work in the Twentieth Century, Monthly Review Press, New York, NY. Briers, M. and Hirst, M. (1990), ‘‘The role of budgetary information in performance evaluation’’, Accounting Organisations and Society, Vol. 15 No. 4, pp. 373-98. Brownell, P. (1982), ‘‘The role of accounting data in performance evaluation, budgetary

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participation, and organisational effectiveness’’, Journal of Accounting Research, Spring, pp. 12-27. Bruns, W.J. and Waterhouse, J.H. (1975), ‘‘Budgetary control and organisation structure’’, Journal of Accounting Research, pp. 177-203. Burton, M. (1997), ‘‘Does Britain deserve best value?’’, Municipal Journal, 19 September. Cherrington, D.J. and Cherrington, J.O. (1973), ‘‘Appropriate reinforcement contingencies in the budgeting process’’, Journal of Accounting Research: Empirical Research in Accounting: Selected Studies, pp. 225-53. de Charms, R. (1968), Personal Causation: The Internal Affective Determinants of Behaviour, Academic Press, New York, NY. DeCoster, D.T. and Fertakis, J.P. (1968), ‘‘Budget induced pressure and its relationship to supervisory behaviour’’, Journal of Accounting Research, pp. 237-46. Drucker, P.F. (1954), The Practice of Management, Harper and Row, New York, NY. Drury, C. (1999), Management Accounting for Business Decisions, International Thomson Business Press, London. Fisher, I.G. (1989), ‘‘A study of the effectiveness of budgetary control in medium-sized firms’’, Occasional Research Paper, No. 1, The Technical and Research Department of the Chartered Association of Certified Accountants, London. French, J.R.P., Kay, E. and Meyer, H. (1965), ‘‘Split roles in performance appraisal’’, Harvard Business Review, January/February, pp. 123-9. Hall, D.T. and Nougaim, K.E. (1968), ‘‘An examination of Maslow’s need hierarchy in an organisational setting’’, Organisational Behaviour and Human Performance, February, pp. 12-35. Herzberg, F., Mausner, B. and Snyderman (1959), The Motivation to Work, John Wiley, New York, NY. Hofstede, G.H. (1968), The Game of Budgetary Control, Tavistock, London. Hopwood, A. (1974), Accounting and Human Behaviour, Haymarket, London. Johnson, B. (1998), Managing Operations, Institute of Management, ButterworthHeinnemann, Oxford. Johnson, T. (1992), Relevance Regained: From Top Down Control to Bottom-up Empowerment, Free Press, New York, NY. Landy, F. and Becker, W.S. (1987), ‘‘Motivation theory reconsidered’’, in Cummins, L.L. and Staw, B.L. (Eds), Research in Organisational Behaviour, JAI Press, Greenwich, CT. Locke, E.A. (1968), ‘‘Towards a theory of task motivation and incentives’’ Organisational Behaviour and Human Performance, May, pp. 157-89. Lowe, E.A. and Shawe, R.W. (1968), ‘‘An analysis of managerial biasing: evidence of a

company’s budgeting process’’, Journal of Management Studies, October, pp. 304-15. Lyne, S. (1995), ‘‘Accounting measures, motivation and performance appraisal’’, in Ashton, D., Hopper, T. and Scappens, R.W. (Eds), Issues in Management Accounting, Prentice-Hall, Hemel Hempstead. McClelland, D.C. (1967), The Achieving Society, Free Press, New York, NY. McClelland, D.C. (1975), Power: The Inner Experience, Irvington, New York, NY. McGregor, D. (1960), The Human Side of Enterprise, McGraw-Hill, New York, NY. Macintosh, N.B. (1995), Management Accounting and Control Systems, John Wiley, Chichester. Maslow, A. (1954), Motivation and Personality, Harper and Row, New York, NY. Mayo, E. (1933), The Human Problems of an Industrial Civilisation, Macmillan, New York, NY. Mayo, E. (1945), The Social Problems of an Industrial Civilisation, Harvard University Press, Cambridge, MA. Onsi, M. (1973), ‘‘Factor analysis of behavioural variables affecting budgetary slack’’, The Accounting Review, pp. 535-48. Pendlebury, M. (1996), ‘‘Management accounting in local government’’ in Drury, C. (Ed.), Management Accounting Handbook, Butterworth Heinemann, Oxford. Porter, L.W. and Lawler, E.E. (1968), Managerial Attitudes and Performance, Irwin, Homewood, IL. Ridley, F.F. (1995), ‘‘Towards a skeleton state? Changes to public sector management’’, in Wilson, J. (Ed.), Managing Public Services: Dealing with Dogma, Tudor, Eastham. Robbins, S.P. (1998), Organisational Behaviour: Concepts, Controversies, Applications, Prentice-Hall, NJ. Roethlisberger, F.J. and Dickson, W.J. (1939), Management and the Worker, Harvard University Press, Cambridge, MA. Rollinson, D., Broadfield, A. and Edwards, D.J. (1998), Organisational Behaviour and Analysis – An Integrated Approach, AddisonWesley Longman, Harlow. Schiff, M. and Lewin, A.Y. (1968), ‘‘Where traditional budgeting fails’’ Financial Executive, May, pp. 57-62. Shields, M. and Young, S.M. (1993), ‘‘Antecedents and consequences of participative budgeting: evidence on the effects of asymmetrical information’’, Journal of Management Accounting Research, Vol. 5, pp. 265-80. Smith, A. (1904), The Wealth of Nations, Cannan (Ed.), Vol. 1, Methuen, London. Stedry, A.C. (1960), Budget Control and Cost Behaviour, Prentice-Hall, Hemel Hempstead. Taylor, F.W. (1911), Scientific Management, John Wiley, New York, NY. Vroom, V. (1964), Work and Motivation, John Wiley, New York, NY. Wahba, M.A. and Bridwell, L.G. (1976), ‘‘Maslow reconsidered: a review of research on the


need hierarchy theory’’, Organisational Behaviour and Human Performance, April, pp. 212-40. Wildavsky, A. (1975), Budgeting – A Comparative Theory of Budgetary Processes, Little, Brown and Co., Boston. Willsmore, A.W. (1973), Business Budgets in Practice, Pitman Publishing, London.

Further reading Arnold, J. and Turley, S. (1996), Accounting for Management Decisions, Prentice-Hall, Hemel Hempstead. Bean, J. and Hussey, L. (1998), Managing the Devolved Budget, HB Publications, London. Caplan, E.H. (1971), Management Accounting and Behavioural Science, Addison-Wesley, Reading, MA.

Corry, D. (Ed.) (1997), Public Expenditure – Effective Management and Control, The Dryden Press, London. Dew, R.B. and Gee, K.P. (1973), Management Control and Information, Macmillan, London. Emmanuel, C. and Otley, D. (1985), Accounting for Management Control, Van Nostrand Reinhold, Wokingham. Madsen, V. and Polesie, T. (1981), Human Factors in Budgeting: Judgement and Evaluation, Pitman, London. Shields, J.F. and Shields, M.D. (1998), ‘‘Antecedents of participative budgeting’’, Accounting, Organisations and Society, Vol. 23 No. 1, pp. 49-76. Upchurch, A. (1998), Management Accounting – Principles and Practice, Pitman, London.

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An assessment of the newly defined internal audit function

Albert L. Nagy Department of Accountancy, John Carroll University, Cleveland, Ohio, USA William J. Cenker Department of Accountancy, John Carroll University, Cleveland, Ohio, USA

Keywords Internal audit, Committees, Risk management, Corporate governance, Competences

Abstract The new definition of internal auditing defines the function as an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. The purpose of this paper is to summarize an assessment of this new definition obtained through structured interviews from 11 internal audit directors of large publicly traded companies. The responses from the directors indicate that there are wide differences in viewpoints and objectives; but a definite shift has occurred in the overall scope of internal audit towards operational activities. While most of the interviewees are in conceptual agreement with the new internal audit definition, an underlying warning is vocalized: ‘‘Don’t throw out the franchise’’. That is, the traditional role of the internal auditor should not be completely abandoned. These, along with other responses pertaining to related issues and suggestions for future research, are summarized throughout the paper.


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Introduction In June 1999, the Institute of Internal Auditors (IIA) officially adopted a new definition of the internal auditing function. The new definition was developed by the Guidance Task Force (GTF) and defines the internal audit function as: an independent, objective assurance and consulting activity designed to add value and improve an organization’s 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, 2000).

The new definition shifts the focus of the internal audit function from one of assurance to that of value added and attempts to move the profession toward a standards-driven approach with a heightened identity (Bou-Raad, 2000; Krogstad et al., 1999). The overriding issue addressed in this paper is whether or not the new definition actually reflects the day-to-day activities of internal audit departments. That is, have the activities of internal auditors really changed? In addition, the new definition of internal audit elicits other issues worthy of examination. For example, do internal audit departments have sufficient resources and expertise to fulfill their role as consultants? Has there been adequate coordination with the other traditional corporate governance parties (e.g. audit committees and external auditors) in regard to the changing focus of internal audit? Where does the newly defined internal audit department fit in the company’s organizational structure? This article summarizes the responses and insights to these and other related questions from internal audit directors of large publicly traded companies. With the objective of obtaining meaningful insight, we conducted structured interviews The current issue and full text archive of this journal is available at http://www.emeraldinsight.com/0268-6902.htm

with the directors of internal audit of 11 large publicly traded companies (average revenues approximately $6.4 billion), most of which have their main offices located in northeast Ohio. The directors are perceived as highly motivated, well-seasoned professionals with tenures in their current positions ranging from two to 19 years, and internal audit staffs ranging from three to 70 individuals. The directors have an average of 17 years experience in internal audit, and 19 years with their present employer. We consider these individuals to be some of the leading professionals in the field of internal auditing, and believe that their opinions and insight would be valuable to the financial community. The structured interviews addressed the following four areas of interest: 1 Audit scope – what is the overall orientation of the internal audit department and has it changed? 2 Organizational structure – how is the internal audit department perceived and evaluated? 3 Risk management – how does the director assess business risk and identify audit areas to target? 4 Audit committee – what are the audit committee’s expectations of internal audit? The issues discussed with the directors are couched in terms of discussing the changes within their respective departments over a ten-year time frame. Those individuals who had not been with their respective companies for ten years represented to have a good understanding of their companies’ environment in the early 1990s. The remainder of this paper provides a summary of the responses provided by the directors to selected questions in the above stated categories, along with some general comments.

Albert L. Nagy and William J. Cenker An assessment of the newly defined internal audit function Managerial Auditing Journal 17/3 [2002] 130–137

The scope and orientation of internal audit The questions in this section of the interview address the overall orientation of the interviewee’s internal audit department, any recent shift in this orientation, and several surrounding issues arising from this shift. Based on our discussions and consistent with the new internal audit definition, the orientation of internal audit has shifted toward consulting and value added services and away from the traditional assurance services. Such a shift raises several interesting issues including: has the external auditor compensated for the reduction in assurance services previously provided by internal audit, and who determines the scope of activities for the newly defined internal audit function? The following is a summarization of the responses to these and other selected questions in this section of the interview.

Question: do you agree with the changing definition/role of the internal audit function? The directors interviewed generally agree that the changed internal audit definition focusing on value-added activities is appropriate. Those directors in support generally believe that ‘‘there are no costsavings for departments focusing on financials,’’ and that the ‘‘responsibility of financial reporting ‘watchdog’ falls mainly on the external auditor.’’ Although these directors agree with the new definition, the impact it has on their department’s scope and activities is minimal. A recurring observation from the directors was that their respective internal auditing departments have been focusing on value-added activities for years, and that ‘‘the definition has finally caught up with practice.’’ Interestingly, several directors take exception to the use of the term ‘‘consultants’’ to describe their internal auditors and are careful to distinguish between operational auditing and consulting. For example, one director defines operational auditing as ‘‘assessing business processes and controls against established criteria. Value-adding recommendations may or may not result from such audits.’’ In other words, operational auditing involves the assessment of the effectiveness of internal controls and systems in place, and is clearly a function of internal audit. Being a consultant, on the other hand, was viewed as ‘‘having a level of knowledge and expertise that most internal auditors do not possess.’’ Consultants are hired to solve problems or recommend

solutions, which is a different function than assessing controls or procedures against established criteria. Along with questioning the capabilities of internal auditors as consultants, several directors are weary of the longevity of the consultant’s role. That is, consultants are ‘‘hired to fix problems and then go away,’’ certainly not a desirable role for most internal auditors. Thus, despite the fact that the new internal audit definition includes consulting as an internal audit activity, most of the directors refuse to label the activities of their departments as ‘‘consulting.’’ A cautionary reminder to the internal audit community consistently given by the directors was to ‘‘not forget our roots.’’ These directors note that the traditional attestation function of internal audit has been useful to organizations for many years, and it is the area of expertise of internal auditors. Therefore, these directors believe that the traditional role of internal audit should not be completely abandoned in favor of the new ‘‘consulting’’ directive. The few directors who disagree with the new definition believe that any effort exerted by professional organizations to define the function of internal audit is fruitless. While commending the IIA and other organizations for offering useful guidance to the profession, one director notes that it is ‘‘foolish for the profession to stand up and say, this is what you have to be.’’ Another echoes this belief by suggesting that ‘‘the definition of internal audit should not fall into generalities because every company is different. Our current chairman does not feel that operational auditing has significant value, certainly not as much as traditional financial statement auditing does. Management does, and should, dictate what we do, not the profession.’’

Questions: given the new definition of the internal audit function, have the objectives of your department shifted to focus on value added activities? If so, who initiated the change? Most managers opine that the focus had shifted several years prior to the definitional change and that the new definition simply better reflects existing practice. However, only two managers indicate that the initiative for the change originated with the internal audit department. A consistent theme in the responses is that management, not the profession, ultimately determines the orientation of the internal audit department of a company. One comment perhaps best illustrates the actual status,

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even though the manager agrees with the changed definition: ‘‘We [internal auditors] are trying to dictate what we are; but actually it is dictated by management expectations.’’

Question: assuming a shift in your department’s focus, has there been a satisfactory coordination with the activities of the external auditor? The responses to this question fell on a spectrum from ‘‘total coordination’’ to ‘‘coordination just not being there.’’ Not surprisingly, the level of coordination with the external auditor seems to be dependent upon the focus of the internal audit department. That is, directors of departments with a significant orientation towards the traditional assurance/compliance services indicate far more extensive coordination with the external auditor. The directors whose departments have an operational focus generally consider their role (that of improving operational efficiency) quite different than that of the external auditor (assuring the financials), and thus believe that less coordination is necessary. A director from a ‘‘pure operational shop’’ indicates that the communication between the internal and external auditors is as if ‘‘the Great Wall of China exists between the two. We’ve got a long way to go and I am not sure that we will ever get there [coordination]. External auditors perform, at best, only a cursory review of the suggested internal audit plans.’’ On the other end of the spectrum, a director of a company that requires extensive compliance audits, because of many overseas divisions, indicates that total coordination exists between external and internal auditors. For this company, the external auditor ‘‘performs an extensive review of the internal audit program so that work will not be duplicated.’’ Several directors of departments focusing primarily on operational auditing express a general concern about the level of review being conducted on the quarterly reports (10-Qs). These directors note that the shift in focus toward operations coincides with a reduction of traditional attestation testing, and that the external auditors ‘‘had not increased their level of detailed testing to compensate.’’ When asked if the quarterly statements are being reviewed at an adequate level, many of the directors simply did not know. These responses raise additional questions that may be worthy of future empirical research. For example, has the shift towards

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operational auditing by the internal auditors created a gap in the attestation review function? Are important accounts receiving adequate attestation review? Are quarterly results receiving adequate attestation review?

Questions: based on your experience, what is the relative input from the following sources in determining what subject matter to audit: line manager, top management, audit committee, internal audit director, and other? Has this changed over the past ten years? Consistent with internal audit departments moving toward an operational/consulting orientation, the directors interviewed indicate that the relative input from the department’s ‘‘customers’’ (i.e. line managers and top management) has increased over the last ten years. The internal audit directors still possess significant input in determining what should be audited, but not nearly as much as ten years ago. One director, who labels his department of ten years past as a ‘‘graveyard’’ where ‘‘nothing was being done,’’ asserts that the department was run by a director who dictated 100 percent of the department’s activities without input of any kind from line managers or top management. An interesting, and perhaps disturbing, observation from the responses is that the audit committee has minimal-to-no input in determining the audit plan. Another observation consistent with internal audit departments moving toward an operational/consulting orientation is that directors are allotting significant amounts of budget time for unanticipated requests from customers. Arguably, consulting and valueadded activities are more reactionary than traditional assurance activities and thus are more difficult to plan. One director from a ‘‘purely operational’’ shop sets aside approximately one-half of his department’s time for unanticipated requests, and justifies this act by stating ‘‘in the 1980s our activities were driven internally. In the 2000s, I don’t do it if someone doesn’t want it done.’’

Organizational structure Some interesting organizational structure issues arise from the newly defined internal audit role. One such issue is how does management evaluate the activities of internal audit? That is, the traditional assurance function of internal audit, often perceived as a ‘‘necessary evil,’’ had a clear and distinct role within the organization and the value of these services often went


unquestioned. However, by migrating toward a consulting role within the organization, internal audit departments may lose the safety net of being labeled as a ‘‘necessary evil’’ and may now have to justify the value of their activities to top management on a continuous basis. By reaching an understanding with management of what makes internal audit services value-added, internal audit ensures that their services will be fully utilized and that their recommendations will be respected (Flesher and Zanzig, 2000). The following is a summarization of the responses to selected questions in this section of the interview.

Question: do you feel an increased need to justify the services of internal auditing to top management? Surprisingly, only one of the directors interviewed found it important to justify the services of internal audit to top management on a continuous basis. In general, the directors believe that their services are perceived within their organization as important and have never felt the threat of being outsourced or discontinued. Most directors cite a strong ‘‘tone at the top’’ in regard to quality reporting and controls, and thus feel no need to continuously justify their existence. The one director who perceives an ‘‘absolute’’ need to justify the department is in an organization whose management is committed to value-based management (VBM), and thus feels compelled to present cost savings or value added amounts from internal audit to top management and the audit committee. These responses reflect a potential inconsistency. Is it hypocritical for internal auditors, who assess the efficiencies and justification of organizational units’ services, to avoid the scrutiny of being evaluated themselves by others?

Question: do you measure the amount of value-added by your department? Consistent with the previous question’s responses, most of the directors interviewed do not attempt to quantify or measure the amount of value that is added from their department’s activities. These directors do not feel threatened or pressured to justify their department’s services, and thus believe that measuring the amount of value-added would be a pointless exercise. Additionally, these directors opined that the inherent difficulty in measuring value-added amounts makes quantifying them impossible or at best problematic. One director went so far as to indicate that it is ‘‘dysfunctional’’ to report such an amount because management may

use this number as a benchmark for future results. Despite the inherent difficulties in measuring value-added amounts, a few of the directors interviewed quantify and report this amount to top management on an annual basis. These directors believe that quantifying and reporting the value-added amount is a positive process that can be measured objectively. Annual cost savings captured by internal audit is the basis for this measurement. These directors view the process as ‘‘job security,’’ that helps promote a company-wide attitude of perceiving internal audit as a ‘‘resource.’’ Only one of the directors is required to formally establish a target goal as part of the operating budget (the one director subject to VBM). Reviews of fleet leasing arrangements (number of vendors, evaluating lease/purchase options), and healthcare (improved Medicare integration, use of generic drugs), were given as examples where ‘‘real dollar’’ savings were generated by the departments.

Question: do you survey your customers to obtain feedback about the performance of your audit staff? Two viewpoints emerged from the responses. One group of directors believes that surveying their customers is a useful technique in assessing the amount of value that their department is providing. These surveys typically ask for an evaluation of the individual auditor’s effectiveness and professionalism. Most of these directors (all but one) indicate that the survey results are not directly linked to the auditor’s compensation, but may be used as criteria when considering promotions. The one director whose company formally links the internal audit department’s annual bonus to survey results represents a department that is heavily operational in nature and the director believes that ‘‘customer satisfaction should weigh in compensation decisions.’’ The other group of directors believes that surveying customers is not a justifiable exercise for internal audit departments to perform. This group suggests that such information is ‘‘worthless’’ and could ‘‘potentially undermine the auditor’s objectivity and independence.’’ One director summarizes this group’s viewpoint by stating, ‘‘I want our auditors to do their job and not worry about ‘finding’ things or satisfying the customer. An auditor that does not find anything wrong or discover cost-savings did not necessarily do a bad job.’’

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Question: how receptive are your customers toward implementing your department’s recommendations? All of the directors interviewed insist that their customers (i.e. line managers) are very receptive toward implementing internal audit’s recommendations. One director’s comments are generally reflective of the responses to this question: ‘‘If we have more than one or two recommendations out of 100 not implemented it would be surprising.’’ The reasons given for the high implementation rates varied. One director stated that ‘‘internal audit works closely with the line managers to derive an effective and plausible plan to implement any recommendations.’’ Other directors rely on the backing and influence of upper management to ensure timely implementation of recommendations. For example, two of the directors post audit recommendations on the company-wide intra-net for all managerial employees (including upper management) to view. These recommendations are not removed until implemented.

Risk management The internal auditing profession suggests that ‘‘the internal auditing process provides assurance to management and the audit committee that risks to the organization are understood and managed appropriately’’ (IIA, 2000). The newly defined internal audit role requires the auditor, among other things, to identify and assess the risks of the company. This section of the interview addresses what types of techniques and support are available to the internal auditors in performing this function. The following summarizes the responses to two of the questions included in this section of the interview.

Question: how are problem areas identified within your company? This question generated a wide range of responses among the directors. Problem identification procedures range from judgmental (‘‘seat of the pants’’) selection and traditional audit universe coverage to using highly complex risk-assessment models. Those that use a judgmental process generally believe ‘‘that the expertise and experience of the people in our department makes internal audit the logical source to identify the areas within the company to examine.’’ Criteria such as management changes, previous audit results, and time since last audit were often noted as important judgmental factors.

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Several of the directors interviewed use sophisticated risk models to identify potential problem areas (areas of high risk) within their company. These models consider upward to 100 variables (e.g. size, management change, system change, last time audited), primarily driven by the COSO criteria, when identifying risk areas. Three of the directors indicate that their companies had created formal risk management departments. However, surprisingly, the level of interaction between internal audit and these risk management departments is considered to be minimal. Whether risk areas are identified through a ‘‘matrix model’’ or by ‘‘seat of the pants’’ decisions, the ultimate responsibility for risk identification lies with the internal audit director. Although the opinions among the interviewed directors differed with respect to what are the best techniques available in identifying risks, most of the directors indicate that the overall process has become more standardized and more effective. One director suggests that ‘‘the risk models drive you to the key risk areas. Thus, overall audit time is more efficiently being spent.’’ The directors often mentioned the 1992 Committee on Sponsoring Organizations (COSO) report on internal control as being an ‘‘overriding drive’’ for risk management activities. That is, several of the directors attempt to formally integrate the COSO criteria in their risk management processes. The level of integration varied from discussing the COSO concepts with line management on a periodic basis to incorporating the COSO criteria in formal risk models. Consistent with the new internal audit definition, all of the internal audit directors are performing risk assessment activities. However, the risk assessment techniques being used by the directors vary significantly. We encourage future research to identify and assess common parameters and methods being employed by internal audit departments in their risk assessment function. This research would aid in determining a ‘‘best practices’’ model that auditors could use in identifying potential problem areas. In addition, the extent of coordination between internal audit and formal risk assessment departments should be addressed by future research.

Question: to what extent does your company use a control self-assessment (CSA) process? Control self-assessment (CSA) has been promoted as an effective tool for risk assessment (Figg, 1999). Although the


directors interviewed share this same sentiment, only one indicates that CSA is currently being used within his company (and at a very minimal level). Generally, the directors suggest that CSA is difficult and costly to implement and monitor, and thus have not used this tool to date. The following director’s comment reflects the underlying weariness of the group about CSA: ‘‘I don’t fully believe in it [CSA] or understand it. The jury is still out as to its value at the end of the day.’’ Another director adds that ‘‘CSA doesn’t really train anybody about internal controls.’’ Despite its underlying complications, several directors predict that CSA is going to be implemented in the near future. One director emphasizes that ‘‘a benefit [of CSA] is that it makes the business unit stand up and recognize that they are responsible for internal controls.’’ Another notes that ‘‘if we can become truly good at it [CSA], it could add value.’’

Audit committee Recently, the SEC finalized rules to improve the effectiveness of audit committees. These rules were in response to the recommendations from the Blue Ribbon Committee and generally increase the independence and financial literacy requirements of audit committee members (NYSE, 1999). In addition, the new rules require more meaningful communication between the external auditor and the audit committee. It should be noted that all of the interviewed directors consider their audit committees’ expertise in financial accounting matters as either good or excellent. Given the new requirements of audit committees, several issues arise concerning the newly defined internal audit function. Specifically, how coordinated are the efforts of the newly defined internal audit function and the apparently more effective audit committee? For example, how do these apparently improved audit committees view the internal audit function? And, are the audit committees’ perceptions of internal audit consistent with the new definition? Finally, has the communication and coordination with audit committees changed as a result of the newly defined internal audit role and increased audit committee requirements? These and other issues are addressed in this section of the interview.

Question: what are your perceptions of the expectations of the audit committee in regard to your department’s oversight of financial reporting matters? The responses to this question were divided. Most of the directors believe that the audit committee expects internal audit to either ‘‘improve the efficiency of operations,’’ or act primarily in an ‘‘operational role,’’ and that assuring the integrity of the financial statements is the responsibility of the external auditor. The remaining directors believe that the audit committee expects internal audit to evaluate the fairness of the financial statements (i.e. traditional assurance service) and that this evaluation is to be done at a more detailed level than that of the external auditor. One director suggests that the audit committee’s expectation of internal audit is not ‘‘in sync’’ with what is being done. That is, the audit committee expects financial statement audits from internal audit, when in fact internal audit is operationally focused and does not perform financial statement audits. Despite this observation, the director does not feel threatened because he has always received positive feedback from the audit committee.

Question: has your role in assisting the audit committee in their function of overseeing the company’s financial reporting changed in the past few years? This question was derived from the supposition that the new audit committee requirements are consistent with the new definition of internal audit, and that the new internal audit function will provide greater assistance to the audit committee in its oversight of reporting and risk management and control (Bishop et al., 2000). The responses to this question from the directors do not support this supposition, at least in regard to internal audit assisting the audit committee in its role of overseeing financial reporting. Most of the directors indicate that their role in assisting the audit committee of overseeing financial reporting has not changed in the past few years, and several directors indicate having assumed a lesser role in regard to this function. None of the directors anticipate this changing anytime in the near future.

Questions: how often do you communicate directly with the audit committee? Has this changed in the last ten years? In general, the directors meet with the audit committee at every audit committee meeting, which usually occurs three-to-four times a year. The frequency of direct

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meetings has generally stayed the same or increased slightly over the past ten years. All of the directors have direct access to the chairman of the audit committee, and several indicate that they often meet throughout the year on an informal basis. Additionally, all of the directors state that they meet, or have the option to meet, with the audit committee without members of management or the public accountants present.

Conclusion The purpose of this paper is to present some insight and opinions about the newly defined internal audit function and related issues from several internal audit directors of large companies. As the above responses reflect, the internal audit function varies significantly among companies from a traditional assurance orientation to that of a value-added and consulting orientation, with most companies landing somewhere in the middle. Furthermore, the orientation or role of internal auditing appears to be determined primarily by management, and not from the profession, internal audit professionals, or the audit committee. Some of the interviewed directors raise the question of whether the internal audit function could and/or should be defined by the profession in the first place. These directors believe that top management is appropriately defining their organization’s internal audit function, and that the profession should concentrate its efforts on providing guidance and support. Despite this viewpoint, the directors’ responses suggest that most of their internal audit departments have shifted toward a more value-added or operational focus, which is consistent with the new definition. Therefore, the new internal audit definition appears to better describe the current practice of internal auditing, at least among the organizations included in this study, even if it may be a few years late in coming. A concern expressed by several of the directors is whether the internal audit department and the external auditor adequately coordinated their efforts to address the recent shift in internal audit’s focus toward operations. That is, because of limited resources most internal audit departments were forced to reduce their level of traditional assurance services as a result of their shift in orientation. Ideally, the external auditor would increase their level of assurance testing in order to compensate for internal audit’s reduction in this area. Unfortunately, most of the interviewed

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directors believe that this is not occurring, especially in the area of reviewing the quarterly statements (i.e. the external auditor has not increased, or not increased enough, their assurance testing). We encourage future research to address this area. All but one of the directors do not feel threatened or feel an increased need to justify their services to top management and believe that management respects and understands the value of the services that internal audit provides. The directors support the new internal audit definition’s suggestion that risk assessment is a key function of internal audit. Interestingly, however, those directors from companies that have formal risk assessment departments indicate that the level of coordination between internal audit and the risk assessment department is minimal at best. The responses also suggest that the internal audit departments are capable and have an adequate level of expertise to carry out proper risk assessment procedures. Given the wide variety of risk assessment techniques employed by the sampled companies, the directors are apparently still searching for the most effective risk assessment method. We encourage future research to aid the internal auditing profession in identifying and assessing effective risk assessment methods and techniques. Consistent with recent SEC rulings to improve the effectiveness of audit committees, all of the directors believe that the financial literacy of their company’s audit committee members is either good or excellent. Additionally, the audit committees meet rather frequently throughout the year, and all of the directors indicate that a strong communication channel exists between the chairman of the audit committee and the internal audit director. The vast majority of the directors believe that the activities of their department coincide with the audit committee’s expectation. Surprisingly, despite the new responsibilities recently bestowed on audit committees concerning financial reporting oversight, none of the directors indicate an increased role in assisting their audit committee with this function. Additionally, none of the directors anticipate this changing in the near future. Perhaps the audit committees are looking elsewhere for assistance in fulfilling their role as financial statement overseer. Regardless of the orientation of the internal audit department, the internal auditor should be a valuable resource to the audit committee in helping them meet their responsibilities. Perhaps internal auditors need to better express exactly how they can be of assistance to their audit committees.


The authors would like to acknowledge the contribution of the members of the Northeast Ohio Roundtable Group, The Cleveland/Akron Chapter of the Institute of Internal Auditors, and especially Dave Richards of FirstEnergy. The authors further appreciate the helpful comments by participants at the 2000 IIA’s Industry Audit Series: Utilities Conference.

We hope that the opinions and insights provided in this article stimulate further discussion and research in the areas surrounding the newly defined internal audit function. Although the number of directors interviewed is relatively small (11), which raises concerns about generalities of the responses, we believe that the responses presented are both insightful and thought provoking. By having a limited sample size, we were able to perform structured interviews that resulted in more detailed responses to specific questions. We found that, given the high variation of the scope and activity of internal audit departments in our sample, face-to-face interviews was the appropriate technique to obtain reasonable and meaningful responses. Such interviews would not have been feasible with a larger sample size. In summary, we hope that the detailed responses presented help bring awareness to the issues and concerns associated with the implementation of the newly defined internal audit role, and that the internal audit profession will be better equipped to aid internal auditors in providing value-enhancing service to the business community.

References Bishop, W., Hermanson, D., Lapides, P. and Rittenberg, L. (2000), ‘‘The year of the audit committee’’, Internal Auditor, April, pp. 46-51. Bou-Raad, G. (2000), ‘‘Internal auditors and a value-added approach: the new business regime’’, Managerial Auditing Journal, Vol. 15 No. 4, pp. 182-6. Figg, J. (1999), ‘‘The power of CSA’’, Internal Auditor, August, pp. 28-35. Flesher, D. and Zanzig, J. (2000), ‘‘Management accountants express a desire for change in the functioning of internal auditing’’, Managerial Auditing Journal, Vol. 15 No. 7, pp. 331-7. Institute of Internal Auditors (IIA) (2000), Internal Auditing: Adding Value across the Board, Corporate Brochure, IIA. Krogstad, J., Ridley, A. and Rittenberg, L. (1999), ‘‘Where we’re going’’, Internal Auditor, October, pp. 27-33. New York Stock Exchange (NYSE) (1999), Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, NYSE, New York, NY.

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Auditing the indirect consequences of rework in construction: a case based approach

Peter E.D. Love Department of Information Systems, Edith Cowan University, Churchlands, Perth, Australia

Keywords Construction industry, Indirect costs, Contract, Defective premises

Abstract There is little known about the indirect consequences of rework in construction projects, especially the financial costs. Therefore, this paper uses examples from a case study to demonstrate the potential indirect consequences and costs that are associated with undertaking rework in building construction projects. A novel taxonomy for categorising the indirect consequences at an individual level, organisational level and project level is presented. Based on the findings from examples derived from the case study, it is suggested that the incidence of rework can have a multiplier effect of up to six times the actual (direct) cost of rectification. To reduce these costs it is concluded that design and construction organisations must improve their quality management systems by including a quality system for continuously auditing, analysing and presenting direct as well as indirect rework costs.


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Introduction Rework can adversely affect the performance and productivity of design and construction organisations. In addition, it is a major contributing factor to time and cost overruns on construction projects (Chan and Kumaraswamy, 1997; Love, 2001). Numerous studies have attempted to quantify the direct costs of rework in building and engineering projects (Burati et al., 1992). These direct costs (of rework) have been found to be as high as 25 percent of contract value (Barber et al., 2000). A number of factors contribute to such large variance in these reported findings. These include the extent of quality management practices implemented, the type of project, the form of procurement method used, and project complexity. Moreover, there is a lack of uniformity in the way in which rework cost data have been collected because of the various interpretations as to what constitutes rework. Consequently, the rework costs that have been reported in the normative literature should not be considered to be indicative but rather used as a source of reference (Burati et al., 2000). Noteworthy, the measurement of rework costs in itself does not cause improvement – it is merely the starting point for establishing new knowledge (Love and Holt, 2000). Thus, the success of management is based upon an ability to become scientific, where knowledge is characteristically acquired through systematic observation, experiment and deductive reasoning. To date there has been limited research that has sought to determine the indirect costs of rework in Australian construction projects. Therefore, examples are drawn from a case study to demonstrate the indirect consequences and costs that can be associated with rework in building The current issue and full text archive of this journal is available at http://www.emeraldinsight.com/0268-6902.htm

construction projects. A novel taxonomy for categorising the indirect consequences at an individual level, organisational level and project level is presented. Based on the findings from examples derived from the case study, it is suggested that the incidence of rework can have a multiplier effect of up to six times the actual (direct) cost of rectification. To reduce the costs of rework it is suggested that design and construction organisations implement a quality management system, which is supported by a quality cost system. Only when organisations begin to measure (and therefore really understand) their rework costs, will they fully appreciate the economic benefits of achieving quality. That is, ‘‘getting it right first time’’ provides tangible economic benefit to the entire project coalition, as well as satisfying the client’s aspirations.

Defining rework Terms such as quality deviations (Davis et al., 1989; Burati et al., 1992), nonconformances (Abdul-Rahman, 1995), defects (Josephson and Hammarlund, 1999), quality failures (Barber et al., 2000) and repairs are often used to infer rework. Ashford (1992) defines rework as ‘‘the process by which an item is made to conform to the original requirement by completion or correction’’. The Construction Industry Development Agency (CIDA) (1995), however, defined rework as ‘‘doing something at least one extra time due to non-conformance to requirements’’. Similarly, Love and Li (2000a) defined rework ‘‘as the unnecessary effort of re-doing a process or activity that was incorrectly implemented the first time’’. Repairs, which are defined as ‘‘the process of restoring a non-conforming characteristic to an acceptable condition even though the item may still not conform to the original requirement’’, may also involve rework. Essentially, rework can result from errors,

Peter E.D. Love Auditing the indirect consequences of rework in construction: a case based approach Managerial Auditing Journal 17/3 [2002] 138–146

omissions, failures, damage, and change orders throughout the procurement process (Love and Li, 2000a).

Rework costs Josephson and Hammarlund (1999) reported that defect costs of residential, industrial and commercial building projects range from 2 percent to 6 percent of their contract values. Similarly, Love and Li (2000a), in their study of rework costs for a residential and industrial building, found the costs of rework to be 3.15 percent and 2.40 percent of contract value respectively. In addition, Love and Li (2000a) found that when a contractor implemented a quality assurance system in conjunction with an effective continuous improvement strategy, rework costs were found to be less than 1 percent of the contract value. Love and Li (2000b) suggested a contractor will invariably always try to offload any additional costs that they may incur onto their client and subcontractors. Furthermore, Love and Li (2000b) noted that a contractor’s estimate/tender figure might also allow for some degree of rework (in the form of a contingency) based on their knowledge and experience from previous and similar projects that they have undertaken. Thus, according to Love and Li (2000b) the actual cost of rework to a contractor may even be negligible, especially for projects procured under a design and construct arrangement with a guaranteed maximum price. The costs of quality deviations in civil and heavy industrial engineering projects, however, have been found to be significantly higher. For example, Burati et al. (1992) studied nine major engineering projects to determine the cost associated with correcting deviations to meet specified requirements. The results of their study indicated that, for all nine projects, quality deviations accounted for an average of 12.4 percent of the contract value. A significantly lower figure was reported by Abdul-Rahman (1995), who found non-conformance costs (excluding material wastage and head office overheads) in a highway project to be 5 percent of the contract value. Abdul-Rahman (1995) specifically makes the point that the nonconformance costs may have been significantly higher in projects where poor quality management is implemented. Notably, Nyleń (1996) found that when poor quality management practices were implemented in a railway project, quality failures were found to be 10 percent of the contract value. Nyleń (1996) further found

that 10 percent of the quality failures that were experienced accounted for 90 percent their total cost. Here significant proportions of the quality failures were attributable to design-related (76 percent) issues, such as erroneous documentation and poor communication between project team members. As mentioned above, rework can also originate from change orders (Knocke, 1993; Love and Li, 2000a). However, the extent to which change orders contribute to rework costs remains relatively unexplored. Research undertaken by Zeitoun and Oberlander (1993) found that the median costs of change orders for 71 fixed price projects were 5.3 percent of the contract value and 6.8 percent for 35 cost reimbursable projects. Similarly, research undertaken by Cox et al. (1999) in the UK revealed that the costs of design-related change orders could range from 5 percent to 8 percent of the contract value even when projects are managed effectively, as most of the changes are initiated by clients. The costs of change orders in the research reported by Zeitoun and Oberlander (1993) and Cox et al. (1999) are similar to the rework costs previously reported. A degree of change can be, and to a certain extent, should be, expected in construction, as it is difficult for clients to visualise the end product that they procure. However, almost all forms of rework (with exception of those caused by weather) are preventable with the implementation of quality management concepts (Ashford, 1992; CIDA, 1995; Love and Li, 2000a), since poor management of the design and construction process typically causes such costs to occur. While there has been a plethora of research that has sought to determine the direct (tangible) costs of rework, the indirect (intangible) costs of it remain unexplored in construction. This is because it is difficult, if not impossible, to quantify such costs in pure monetary terms. Campanella (1990) reported that the Westinghouse Electric Corporation found that a multiplier effect of at least three to five was directly related to the indirect effects of a quality failure (e.g. rework). CIDA (1995), for example, estimated the direct cost of rework in construction to be greater than 10 percent of project cost. Thus, if a 10 percent rework value was applied to the annual turnover of the Australian construction industry in 1996, which was estimated at $A43.5 billion per annum (DIST, 1998), then the direct cost of rework can be approximated at $A4.3 billion per annum. Bearing this in mind, and assuming the indirect costs of rework are three to five times the actual cost of rectification, then the

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indirect cost of rework could range from $A12 to $A20 billion. The negative impact of indirect rework on profits can have serious consequences on projects’ and an organisations’ costs. For example, once design errors or omissions are identified in contract documentation, rework will occur. This process may continue to magnify until ultimately, the design firm finds itself in serious financial difficulties due to the prolonged impact of an unheeded increase in rework costs, coupled with a declining professional image and low morale.

Research methodology Besides the research undertaken by Josephson and Hammarlund (1999) and Love and Li (2000a), little is known about the causes and costs of rework in building projects, particularly the indirect consequences and costs. In fact, most rework related research has tended to focus on civil engineering projects (Davis et al., 1989; Burati et al., 1992; Abdul-Rahman, 1995; Barber et al., 2000) and housing projects (BRE, 1982; NEDO, 1987; Hammarlund and Josephson, 1991). So in order to determine the indirect costs of rework in building projects there was a need for a methodology that would enfranchise those project participants that had been involved with a particular rework event so that the full impact of rework could be assessed. Considering the originality of the research, a case study was adopted (Hakim, 1987; Yin, 1989). A description of the case study project used is presented below.

Case description The case-study project consisted of two, sixstorey residential apartment blocks, which contained a total of 43 units. Underground parking, a landscaped podium and swimming pool were among the facilities incorporated into this development. The contract value for the development was $A10.96m, with a contract period of 43 weeks. The project was procured using a traditional lump sum contract, with the client employing a project manager to act as their development representative.

was visited three times a week throughout its duration. Two block visits of four days to each project were included. These block visits were undertaken during times of increased site activity. Interviews were primarily used to determine those causes and effects of rework. Direct observations, and documentary sources provided by the contractor, consultants, subcontractor and suppliers were also used to derive data. Numerous other sources such as variation lists, site instructions, day work sheets, extension of time claims and nonconformances contributed also to identifying rework events, which were used to determine the costs associated with rework.

Case study validity The use of interviews, documentary sources, and observations indicates that internal validity needed to be addressed. Interviews, in particular, were used to identify rework events, which had been discovered during the interviews and through observations that had been made by the researcher. Each interview was tape-recorded and subsequently transcribed. These were given to each person that had been interviewed to check and resolve any discrepancies that may have arisen and eliminate any interviewer bias. Bearing in mind the array of evidence that was accumulated, great care was undertaken by the author to ensure that the data collected converged on similar facts as described by Jick (1979).

Findings and discussion The direct cost of rework that occurred in the project was found to be 3.15 percent of contract value. Details about how this cost was derived can be found in Love and Li (2000a). To illustrate the multiplier effect, examples of rework that occurred as a result of poor contract documentation and workmanship are presented in detail below. With the exception of the contractor, all organisations involved in the project did not have a quality management system or quality cost system in place.

Poor contract documentation Data collection Data were collected from the time construction commenced on-site until the completion of the defects liability period. Interviews (unstructured and semistructured) were conducted with the site management team, consultants, subcontractors and suppliers. The project

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Requests for information (RFIs) in terms of time were costly for all concerned with the procurement of the structural steel subcontract, as a result of errors, omissions and inconsistencies in the contract documentation. For example, the draftsman raised a total of 90 RFIs; the sub-contractor raised 20; and the contractor 15. In total, 125


RFIs were raised and the number of queries on each RFI varied from one to 20. Over a two-month period, the contractor estimated that they had spent a total of one week dealing with the problems associated with the structural steel sub-contract. In addition, the project architect estimated that they had employed a graduate for two months, working full time, answering RFIs. Similarly, the structural engineer had a graduate engineer provide answers to RFIs throughout this period. These costs can be quantified to some degree, but the costs associated with losses in productivity, the negative effects on morale and stress, loss of income, etc., are more difficult to obtain and even more difficult to quantify. For reasons of confidentiality, both the architect and engineer were reluctant to comment in detail about the impact that rework had had on their organisations’ indirect costs. However, considering the time that was spent addressing RFIs for each of the aforementioned participants, and using the costs for staff provided by the contractor, the direct cost of labour was estimated to be: Project manager @ $11,000 (on-costs) per month 6 1 week $A2,500; Graduate architect @ $4,000 (on-costs) per month 6 2 month $A8,000; Graduate structural engineer @ $6,000 (on costs) per month 6 1 month $A6,000. Total $A16,500 Simply spending additional monies in correcting and modifying design changes, errors and omissions during the contract will inevitably reduce a firm’s profit margin. Both the architect and structural engineer stated that their fees for the case-project were low (they had tendered competitively for their commission), though this should not have influenced the quality of service provided. Hoxley (2000) has stated that while fee levels have fallen since the introduction of competitive fee scales, service quality has not declined, which suggests that profitability has fallen and/or consultants have become more efficient. In fact, poor documentation has always been an area of concern in projects, prior to the introduction of compulsory competitive tendering for professional services (Dalty and Crawshaw, 1973; Crawshaw, 1976). The contract documentation that was produced for the case-project contained errors and omissions, primarily because the documentation process was not co-ordinated by the client’s representative. When these errors were identified, design documentation was revised on a sporadic basis, that is, as and when there was spare capacity in the

drafting office, in terms of resources. The proliferation of administrative costs was considered to be a symptom of poor documentation for all parties involved (in the procurement of the structural steel subcontract). These particularly took the form of costs relating to additional telephone calls, faxes, letters and duplication of drawings, and couriers. While these costs may appear to be relatively minor, they can have an adverse impact on a firm’s cash flow, especially if it is a small firm. In the case of the drafting firm, it estimated that the costs for copying and couriering drawings to the contractor, architect and structural engineer increased its typical monthly expenditure threefold for these items. The architect and structural engineer suggested that productivity and employee morale had been adversely affected by having to constantly revise their documentation. The architect suggested that in some instances they found themselves having to re-design elements because of errors in the structural documentation. This could have been avoided if the documentation process had been effectively managed from the outset. The drafting firm also experienced a decrease in productivity and morale as a result of having to constantly ask for more information from the architect. Some staff, who were employed on a part-time contract basis, resigned and obtained jobs with another drafting organisation because they were frustrated with having to rework their drawings and wait for information to arrive. For the drafting firm, the most significant indirect cost related to the extension of its original contract period for the project. This affected its capacity to take on new contracts. In addition, when information was made available, additional resources had to be employed and overtime paid, as deadlines needed to be met. This subsequently had a negative impact on the morale of all employees within the drafting office. In total, it was estimated that an additional direct cost of rectifying the shop drawings due to design changes, errors and omissions, was $16,000. The contractor and draftsman stated that the production of poor quality documentation was not an industry problem, but rather, an organisation-specific one. The draftsman stated that before tendering its services the firm takes into account its previous experience with the consultants involved. The draftsman stated that it often refuses to tender for a project if it is to work with a particular consultant, or if the consultant has a record of producing poor quality documentation. In such instances it typically adds 10 percent to the value of its

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tender. In this particular case, the drafting firm was not familiar with the consultants involved. The drafting firm stated that in future it would only deal with consultants and contractors it had worked with previously (thereby underlining its dissatisfaction in this instance). There may be a danger that recurring documentation errors will creep up and settle in at an insidiously comfortable level, which may be accepted as an industry ‘‘norm’’. An analogy with plant management can be drawn here: if plant maintenance costs do not increase significantly on the last year’s costs, then they are generally accepted as ‘‘normal’’ – regardless of whether they are artificially high – or not (Edwards et al., 1998). If design consultants repeatedly produce errorinduced rework, they may become invisible or come to be regarded with complacency, as the cost of doing business. Whatever percentage increase is taken up by rework, that percentage will be added to a design firm’s costs. Thus, if rework accounts for 10 percent of regular work of a design firm, this would lead to everything being increased by 10 percent: supervision, cycle time for administrative procedures, answering RFIs and so on. The time element obviously translates into costs, which are then buried in what would be considered normal operating costs.

Poor workmanship It was found that defects due to poor workmanship accounted for 1.5 percent of the total cost of rework experienced in the casestudy project. While this may appear to be a relatively minor cost, the indirect costs and consequences of having to rectify the work were significant for those concerned. Defects were those items that were identified by the architect and project manager during their walk around the site prior to issuing the certificate for practical completion. In total, 100 minor defects were identified. Table I denotes the costs and magnitude of defects for various sub-contract trade packages. The defects that were considered to be the responsibility of the contractor, are denoted by (a) in Table I. Essentially, these related to the cleaning and removing of stains to the parquetry flooring in units, replacing damaged tiles to the suspended ceiling in the foyer area, and replacing damaged ferns to landscaped areas. The project manager estimated the cost of rectifying these to be $5,000 and suggested that each defect would cost approximately $50 to rectify. The defects identified may appear minor and relatively inexpensive to rectify, but the

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Table I The cost and magnitude of defects Subcontract package Structural steel Metalwork Aluminium windows Balustrades Timber doors Toilet partitions Parquetrya Roofing Plumbing and drainage Ceiling and partitionsa Mechanical Electrical and fire Painting Landscapea Total

Number of Defect costs defects ($) 6 6 3 6 6 6 7 4 9 9 7 16 10 5 100

300 300 150 300 300 300 350 200 450 450 350 800 500 250 5,000

Note: a Defects considered to be the responsibility of the contractor indirect costs associated with them were significant. For example, while walking round the site with the project manager prior to the issue of the certificate of practical completion, numerous marks and unpainted patches could be seen on the walls of various units. As a result, the foreman requested that the sub-contractor return to site, because the purchaser was eager to move into the now ‘‘finished’’ apartment. The subcontractor complained to the project manager that he had to travel over 25 km to rectify the damage that another subcontractor had done, while ignoring the fact that they had also to return to attend to some patches of their own work, which were considered of poor quality. The subcontractor stated ‘‘it’s taken nearly half a day to fix this up. An hour-and-a-half here in peak hour traffic and an hour back just for an hour’s work, and nobody pays for your travelling time’’. When the sub-contractor was probed they estimated the indirect cost of rectifying the defect to be: Waiting and travelling time (3 hours @ $35 per hour) $A115 Additional materials (1½ litres of paint @ $20 per litre) $A30 Loss of productivity (4 hours @ $35 per hour) $A170 Total $A315 Considering the direct cost of rectification was $50, then the indirect cost was found to be six times this amount. Assuming that was the case for each defect, the indirect cost for defects identified for the case-study project may well have exceeded $25,000. However, most contractors acknowledge and


understand the difficulties of asking subcontractors to return to site to rectify defects. Thus, to minimise any disruption to a subcontractor’s workload they invariably attempt to package defects so that as many as possible can be rectified in one visit. There are also physiological and psychological consequences associated with undertaking rework. For example, increased stress due to the additional financial burden and the loss of profit, as well as having to do something again, can have de-motivating consequences. This is especially true when a sub-contractor has to rectify somebody else’s poor or unfinished work. In fact, once practical completion was issued most purchasers requested to move into their units. It was revealed that the development’s sales staff had encouraged purchasers to do this without consulting with the contractor. Once practical completion is granted the contractor’s liability with respect to time and liquidated damages and public liability ceases, and also the defects liability period commences. In effect this is the date upon which the transfer of the risk of the property to the client is effected. The contractor found it difficult to organise many of the subcontractors to return to site to rectify defective and incomplete work, as most were working on other projects. Consequently, some work such as re-installing general purpose outlets, sanitary appliances, re-installing locks to doors, and painting, had to be undertaken after purchasers had moved into their units. Many of the purchasers found this to be an inconvenience and consequently blamed the contractor for the incomplete and poor quality work. The intangible costs in this respect, i.e. to the contractor’s image, are greater than may at first be appreciated. Ineffective communication on behalf of the client’s representative was the primary contributing factor that caused this disruption to purchasers. The need for effective intra-and inter-organisation communication in construction has been previously underlined (Nesan and Holt, 1999; Holt et al., 2000); the case in point is evidence of such assertion. If, in advance, the contractor had been given a schedule of dates for when purchasers wanted to move in, then completion of their respective units could have been programmed better. As it was, many sub-contractors had to re-visit the site to rectify work on an ad hoc basis, which had an adverse effect on their productivity and morale. A summary of the indirect consequences of rework experienced in the examples from the case study project can be seen in Figure 1.

It is impossible to set aside a monetary value for each of the factors that have been identified. However, it is important to realise that the rework can seriously affect an individual, an organisation and a project’s performance. At the individual level, stress, fatigue, absenteeism, de-motivation, and poor morale were found to be the primary indirect consequences of rework. In fact, when an individual is subjected to having to work longer because of errors, changes or omissions, fatigue and stress may emerge, which can increase the likelihood of further rework occurring (Abdul-Hamid and Madnick, 1991; Love et al., 2000). At the organisation level, reduced profit, diminished professional image, interorganisational conflict, loss of future work and poor morale were identified as indirect consequences of rework. At the project level, work inactivity (e.g. waiting time, idle time, travelling time etc) and end-user dissatisfaction were identified as indirect consequences of rework. It is suggested that the indirect costs identified in the case study will invariably be experienced by almost all projects that experience rework, though the degree to which they occur will depend on the management practices of those organisations involved in the project coalition.

Rework cycle To understand the multiplier effect better, Cooper’s (1993) rework cycle will be used to demonstrate how and why rework can occur during the design stage of a project with respect to the production of contract documentation. Figure 2 illustrates the rework cycle for the production of contract documentation. The boxes in Figure 2 represent activities that are undertaken during the contract documentation process. At the start of the documentation phase, all activities will invariably reside in a pool of work to be undertaken. As designers begin the documentation process, changing levels of staff (people) working at varying productivity (output) levels may determine the progress of the work being undertaken (Abdul-Hamid and Madnick, 1991). This is especially the case when staff involved in the documentation process either leave the design organisation (turnover) or become unavailable (due to illness or recreational leave) and replacement staff are needed to complete the documentation process. The discontinuity of design staff can have a significant impact on the performance of the design process (Chapman, 1999). This is

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because all knowledge and information that a staff member has acquired about the project cannot be passed directly from one individual to the next, even if a hand-over period and/or de-briefing occurs from the departing staff member (Chapman, 1999). Even staff recruited from the same office cannot acquire project knowledge immediately they commence on the project. In practice, documentation activities are executed at varying levels (due to the skill and experience of the designer) and as a result this is likely to affect the quality of documentation that is produced. Noteworthy, however, is that the completeness and level of documentation quality that is achieved depends on many factors and conditions in the organisation and the project environment (Love et al., 2000). For example, these may

Figure 1 Taxonomy of the indirect consequences of rework

Figure 2 The structure of the rework cycle

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include the design firm’s workload, the design fee value, time allowed for the design process, staffing levels, the amount of time allocated to prepare documentation and the procurement method. Documentation that is considered to be of adequate quality will enter the pool of documentation that is completed, which may not need re-doing unless the client or contractor requests changes to the design. Design changes may cause schedule pressures and place designers under considerable stress, which can result in poor morale, conflict and fatigue due to overtime. Detailed explanations as to the impact that rework (or changes) can have on productivity can be found in Moselhi et al. (1991). The remaining completed documentation will subsequently need some rework, but for a period of time the documentation remains in the pool known as ‘‘undiscovered rework’’. This pool contains undetected errors and is therefore perceived to be error free. However, errors and omissions may be discovered in several ways. For example, through design checks and reviews during the preparation of bills of quantities by the quantity surveyor or on-site by contractor/subcontractor. The rework discovery period may occur over weeks, months or even years later (depending on the size of the project) during which time dependent work may have incorporated these errors. Once discovered, the known rework will have to be addressed, which may require additional resources or overtime to be undertaken. This may lead to an individual becoming fatigued and stressed, which can lead to more errors being made. In addressing the identified rework, the work to be undertaken will enter the flow of work in progress, and will be subject to similar productivity and quality variations. In addition, there is a chance that reworked items may flow through the same cycle. Indeed, poor quality contract documentation may cause more cycles of rework, and require additional resources to rectify. Design organisations that are not able to produce good quality documentation will not be able to maximise their return from fees. The rework cycle can also be applied to activities being undertaken on-site. Errors and omissions can affect contractor and subcontractors the same way in which they affect design organisations, especially if preliminary items such as supervision, scaffolding, and cranage are required for extended periods. Clearly, there is a need to implement effective strategies to prevent the occurrence of rework in projects as it can have an adverse impact on individual, organisational and project performance. Construction organisations, particularly design consultants, must realise that quality


improvement results in cost improvement. Simply paying higher fees to design consultants will not reduce rework per se, as designing and constructing a facility right first time will always cost less. Solving problems by identifying their causes and eliminating them can result in measurable savings and improved processes. Thus, if construction organisations are to capitalise upon these savings they must implement a quality management system, which is supported with a quality cost system. Only when organisations begin to measure (and hence appreciate) their rework costs, will they really understand the economics of quality.

Conclusion To date there has been limited research that has sought to determine the indirect consequences of rework events. While the research presented in this paper has been exploratory in nature, it has demonstrated that the indirect costs of rework are significant as they can have a cost multiplier effect of three to six times the costs of actual rectification and therefore should not be ignored. Such costs can lead to an organisation experiencing reduced profits and competitiveness in their respective marketplace. A taxonomy of indirect costs that were experienced in the two examples presented were identified. These costs, which could not be assigned any monetary value, occurred at the individual (e.g. stress, fatigue, de-motivation) organisational (e.g. inter-organisational conflict, loss of future work, reduced profit) and project levels (e.g. work inactivity, end-user dissatisfaction). The findings presented in this paper, however, do highlight the importance of ‘‘getting things right the first time’’, and that construction organisations, particularly design consultants, should use a quality management concept to audit the costs associated with having to undertake rework. Once an organisation knows how rework is influencing its ‘‘bottom line’’ it can then implement the appropriate process improvement strategies to eliminate these costs. Until construction organisations take responsibility for their own actions, and improve the quality of service they provide then rework will remain an endemic feature in construction projects.

References Abdul-Hamid, T.K. and Madnick, S.E. (1991), Software Project Dynamics. An Integrated Approach, Prentice-Hall, Englewood Cliffs, NJ.

Abdul-Rahman, H. (1995), ‘‘The cost of nonconformance during a highway project: a case study’’, Construction Management and Economics, Vol. 13, pp. 23-32. Ashford, J.L. (1992), The Management of Quality in Construction, E & F Spon, London. Barber, P., Graves, A., Hall, M., Sheath, D. and Tomkins, C. (2000), ‘‘Quality failure costs in civil engineering projects’’, International Journal of Quality and Reliability Management, Vol. 17 No. 4/5, pp. 479-92. Building Research Establishment (BRE) (1982), Quality in Traditional Housing – An Investigation into Faults and Their Avoidance, BRE, Garston. Burati, J.L, Farrington, J.J. and Ledbetter, W.B. (1992), ‘‘Causes of quality deviations in design and construction’’, ASCE Journal of Construction Engineering and Management, Vol. 118 No. 1, pp. 34-49. Campanella, J. (1990), Principles of Quality Costs: Principles, Implementation and Use, ASQC Quality Press, Milwaukee, WI. Chan, D.W.M. and Kumaraswamy, M.M. (1997), ‘‘A comparative study of causes of time overruns in Hong Kong construction projects’’, International Journal of Project Management, Vol. 15 No. 1, pp. 55-63. Chapman, R.J. (1999), ‘‘The likelihood and impact of changes of key project personnel on the design process’’, Construction Management and Economics, Vol. 17, pp. 99-106. Construction Industry Development Agency (CIDA) (1995), Measuring up or Muddling through: Best Practice in the Australian Nonresidential Construction Industry, CIDA and Masters Builders Australia, Sydney, pp. 59-63. Cooper, K.G. (1993), ‘‘The rework cycle: benchmarks for the project manager’’, Project Management Journal, Vol. 24 No. 1, pp. 17-21. Cox, I.D., Morris, J., Rogerson, J.H. and Jared, G.E. (1999), ‘‘A quantitative study of post contract award design changes in construction’’, Construction Management and Economics, Vol. 17 No. 4. Crawshaw, D.T. (1976), Co-ordinating Working Drawings, Building Research Establishment, Current Paper CP 60/76, Watford. Dalty, C.D. and Crawshaw, D.T. (1973), Working Drawings in Use, Building Research Establishment, Current Paper CP 18/73, Watford. Davis, K., Ledbetter, W.B. and Burati, J.L. (1989), ‘‘Measuring design and construction quality costs’’, ASCE Journal of Construction Engineering and Management, Vol. 115, pp. 389-400. Department of Industry, Science and Tourism (DIST) (1998), Building for Growth. A Draft Strategy for the Building and Construction Industry, DIST, Commonwealth of Australia Publication, Canberra, February. Edwards, D., Holt, G.D. and Harris, F.C. (1998), Maintenance Management of Heavy Duty

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Construction Plant and Equipment, Chandos Publishing, Oxford. Hakim, C. (1987), Research Design: Strategies and Choice in the Design of Social Research, Allen and Unwin, London. Hammarlund, Y. and Josephson, P.E. (1991), ‘‘Sources of quality failures in building’’, Proceedings of the European Symposium on Management, Quality and Economics in Housing and other Building Sectors, Lisbon, 30 September-4 October, pp. 671-9. Holt, G.D., Love, P.E.D. and Li, H. (2000), ‘‘The learning organisation: a paradigm for mutually beneficial strategic construction alliances’’, International Journal of Project Management, Vol. 18 No. 6, pp. 415-23. Hoxley, M. (2000), ‘‘Are competitive fee tendering and construction professional service quality mutually exclusive?’’, Construction Management and Economics, Vol. 18, pp. 599-605. Jick, T.D. (1979), ‘‘Mixing qualitative and quantitative methods: triangulation in accumulation’’, Administrative Science Quarterly, Vol. 24, pp. 602-11. Josephson, P.-E. and Hammarlund, Y. (1999), ‘‘The causes and costs of defects in construction. A study of seven building projects’’, Automation in Construction, Vol. 8 No. 6, pp. 681-42. Knocke, J. (1993), Post Construction Liability and Insurance, E & F Spon, London. Love, P.E.D. (2001), ‘‘The influence of project type and procurement method on rework costs in construction projects’’, ASCE Journal of Construction Engineering and Management. Love, P.E.D. and Holt, G.D. (2000), ‘‘Construction business performance measurement: the SPM alternative’’, Business Process Management Journal, Vol. 6 No. 5, pp. 408-16. Love, P.E.D. and Li, H. (2000a), ‘‘Quantifying the causes and costs of rework in construction’’, Construction Management and Economics, Vol. 18 No. 4, pp. 479-90. Love, P.E.D. and Li, H. (2000b), ‘‘Overcoming the problems associated with quality

certification’’, Construction Management and Economics, Vol. 18 No. 2, pp. 139-49. Love, P.E.D., Mandal, P., Smith, J. and Li, H. (2000), ‘‘Modelling the dynamics of design error induced rework in construction’’, Construction Management and Economics, Vol. 18 No. 5, pp. 575-86. Moselhi, O., Leonard, C. and Fazio, P. (1991), ‘‘Impact of change orders on construction productivity’’, Canadian Journal of Civil Engineering, Vol. 18, pp. 484-92. National Economic Development Office (NEDO) (1987), Achieving Quality on Building Sites, NEDO, pp. 18-19. Nesan, L.J. and Holt, G.D. (1999), Empowerment in Construction Organisations: The Way Forward for Performance Improvement, Research Studies Press, Somerset. Nyleń, K.-O. (1996), ‘‘Cost of failure in a major civil engineering project’’, Licentiate thesis, Division of Construction Management and Economics, Department of Real Estate and Construction Management, Royal Institute of Technology, Stockholm. Yin, R.K. (1989), ‘‘Case study research – design and methods’’, Applied Social Research Method Series, Vol. 34, Sage Publications, Newbury Park, CA. Zeitoun, A.A. and Oberlander, G.D. (1993), Early Warning Signs of Project Changes, Source Document 91, Construction Industry Institute, The University of Texas at Austin, Austin, TX.

Further reading Building Research Establishment (BRE) (1981), Quality Control on Building Sites, Current Paper 7/81, HMSO, London. Hammarlund, Y., Jacobsson, S. and Josephson, P. (1990), ‘‘Quality failure costs in building construction’’, Proceedings of the CIB W55/ W65 Joint Symposium, International Council for Building Research Studies and Documentation, Sydney, pp. 77-89.

Corporate governance: communications from internal and external auditors Janet L. Colbert Department of Accounting, Gordon Ford College of Business, Bowling Green, Kentucky, USA

Keywords Corporate governance, Auditors, Communication, Finance

Abstract International Standards on Auditing (ISAs) require external auditors to communicate with the client’s governance body regarding significant matters which came to the auditors’ attention during the engagement. Similarly, the authoritative Practice Advisories (PAs), issued by the Institute of Internal Auditors (IIA), mandate that internal auditors discuss certain items with the board. Thus, the governance body/board should be receiving information from two groups of auditors. Compares and contrasts the requirements of the ISAs and PAs with regard to communications with the governance body/board. The differences in the communications to the governance body/board by the external and internal auditors derive mainly from the focus of each group. The external auditors serve those users external to the organization; in contrast, internal auditors serve the board, which is responsible for the internal aspects of the entity. Besides communication on financial issues, the board also desires information on operational and compliance matters. The comparison of the international external auditing and the internal auditing standards shows that some information received by the governance body/ board is similar. However, much is unique. Both groups of auditors aid the governance body/board in achieving its objective of guiding the entity to carry out its mission effectively and efficiently


Introduction Under International Standards on Auditing (ISAs), external auditors have a responsibility to communicate certain matters discovered during the financial statement audit with those persons charged with governance of the entity. Similarly, the authoritative Practice Advisories (PA), issued by the Institute of Internal Auditors (IIA), require internal auditors to share observations and recommendations with those charged with oversight responsibilities, typically, the board of directors. Thus, the governance body/board should be receiving information from two sets of auditors. Does the communication from one set of auditors complement or supplement the insights gleaned from the other? Or, is this reporting by the two groups a duplication of effort and information? After briefly reviewing significant publications regarding corporate governance and the supporting roles of internal and external auditors, this article summarizes the requirements of the international external auditing standards and the internal auditing standards related to auditor communications with the governance body/ board. The article then goes on to compare and contrast the standards.

Significant publications In recent years, corporate governance has received increased attention in the accounting and auditing literature. See, for example, the Panel on Audit Effectiveness Report and Recommendations (Panel on Audit Effectiveness of the Public Oversight Board, 2000) and the Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, 1999). Both Cadbury (1992) and The current issue and full text archive of this journal is available at http://www.emeraldinsight.com/0268-6902.htm

COSO (1992) published reports related to controls and corporate governance in 1992. Still earlier, the Treadway Commission (National Commission on Fraudulent Financial Reporting, 1987) and the Cohen Commission (AICPA, 1978) addressed governance issues. Also, various Web sites deal with such topics; some which are of interest are shown in Table I. While these reports and others address, in varying degrees, corporate governance and internal and external audit issues, very little, if anything, has been written which specifically focuses on requirements for both internal and external auditors to communicate with the governance body/ board and what the governance body/board can expect. This article helps to fill that gap.

International auditing standards International Standards Auditing section 260 (ISA 260), ‘‘Communications of audit matters with those charged with governance’’ (International Federation of Accountants, 2000)[1], provides guidance in communicating matters which may be of interest to the governance body of an entity. The Standard applies to external auditors. The persons and body which should receive the communication as well as the matters to be included are addressed in the Standard. Also, the timing and form of the communication is covered. Finally, the Standard’s discussion encompasses confidentiality issues as well as matters related to applicable laws and regulations.

Relevant persons and governance body The external auditor must determine the persons or body entrusted with the governance of the entity. The relevant persons, and the body they make up, should be those responsible for supervising, controlling, and directing the entity, as well as for achieving its objectives. The governance body is also accountable for appropriate financial reporting and for reporting other matters to interested parties. The title and structure of the governance

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Janet L. Colbert Corporate governance: communications from internal and external auditors Managerial Auditing Journal 17/3 [2002] 147–152

Table I Relevant Web sites URL

Organization

www.cbc.to/

CBC (Commonwealth Business Encourages best practices in Council) corporate governance ECGN (European Corporate Research into corporate governance Governance Network) issues IIA (Institution of Internal Auditors) ‘‘Tone at the Top’’ newsletter for audit committees, boards and executive management OECD (Organization for Economic Principles of corporate governance Co-operation and Development)

www.ecgn.ulb.ac.be/ecgn/ www.theiia.org/ecm/newsletters. cfm?doc_id=739 www.oecd.org/daf/governance/ principles.htm

body may vary across countries, according to legal and cultural norms. Regardless of the composition and name of the governance body, the external auditors should identify it and establish a working relationship with the members.

Brief description

documentation should be included in the working papers. The documentation might consist of minutes of the governance body’s meeting or a confirmation sent to that group by the external auditor.

Confidentiality, laws and regulations Matters to be communicated The matters which the external auditor must communicate to the governance body are those which are discovered during the financial statement audit and which the external auditor believe are significant and relevant to that group. The external auditor is under no obligation to specifically search for matters of governance interest, but may locate such items in the normal course of the engagement. ISA 260 notes some of the matters which might come to the attention of the external auditor and which may be of interest to the governance body in fulfilling its oversight role. These are: . the scope of the audit; . management’s selection of, or changes in, significant accounting policies; . significant risks and exposures with a potential financial statement effect; . proposed and booked audit adjustments; . material uncertainties which may impact the going concern assumption; . disagreements with management; . expected modifications to the standard audit report; . material weaknesses in internal control; . management integrity; . fraud.

Timing and form of communication The communication of matters to the governance body should be done in a timely fashion. Prompt reporting enables the body to take appropriate action. The form of the communication to the governance body is not regulated by the ISA; either oral or written communication is allowed. If the external auditor chooses to relay matters orally, appropriate

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ISA 260 notes that the confidentiality rules of accounting licensing bodies or legal requirements may restrict the external auditor’s communication with the governance body. Thus, the external auditor’s ethical responsibilities to communicate with the group may differ from its legal ones. Conversely, the Standard observes that accounting licensing bodies or legal requirements may mandate specific communication with governance bodies. To sort out these differing perspectives, the external auditor may wish to consult with an attorney. The ISA does not address the requirements of these licensing bodies or legal authorities.

Internal auditing standards Like ISA 260, guidance in the IIA’s Practice Advisories[2], discusses the auditor’s responsibilities in communicating with the governing body of an organization. However, the PAs apply to internal auditors rather than their external colleagues. The guidance in the PAs addresses the appropriate body which internal auditors are to communicate with and the communications to be made to that group. Also, a charter, internal audit plans, and activity reports are discussed in the advisories. Finally, the PAs cover coordination of the work of the internal auditors with that of their external colleagues.

Governing body and direct communication The PAs note that the chief audit executive (CAE) should report to the audit committee, the board of directors, or other governing authority. Regardless of its name, the


appropriate body for internal auditors to report to is the one with oversight responsibility for auditing, financial reporting, organizational governance, and control. The CAE should have direct and regular contact with the board. Such contact helps to ensure that the board and the CAE communicate regarding matters which are relevant to both.

Charter, plans and activity reports The PAs specify that every internal audit department should have a charter. The document validates the unit’s position in the entity, authorizes internal audit access to records, and defines the scope of its work. The charter should be approved by senior management and accepted by the board. Periodically, the CAE should assess whether the charter is still adequate and communicate the assessment to senior management and the board. The CAE should also submit to senior management and the board a summary of plans for work for the upcoming year. The summary should be approved by senior management and tendered to the board for informational purposes. Such information helps the board ascertain if the work of internal auditing supports the objectives and plans of the entity. After completing the work, the internal audit department should present reports of its activities to senior management and the board. Significant engagement observations and recommendations are included in the report. The reporting should be undertaken at least annually. Below are those items which the PAs suggest might constitute significant engagement observations and therefore, should be communicated to the board: . irregularities; . illegal acts; . errors; . waste; . inefficiency; . ineffectiveness; . conflicts of interest; . control weaknesses. While it is the internal auditor’s responsibility to report significant engagement observations, it is management’s duty to resolve those issues. Management may decide to act by implementing recommendations made by the internal auditors or by making other changes. Alternatively, management may decide not to take action, thereby accepting whatever risk the internal auditors have identified in the current situation. Regardless of which

course management chooses, the internal auditor is then responsible for informing the board as to management’s actions or decisions.

External auditors The PAs note that, to ensure appropriate audit coverage and to minimize duplication of work, internal and external audit coverage should be coordinated. The CAE should periodically evaluate the coordination of the work of the two sets of auditors and communicate the results of the evaluation to the board. The PAs recognize that external auditors are required to communicate directly with the board regarding certain issues. The CAE should be prepared for questions from the board and have an understanding of those matters which the external professionals will discuss. Thus, in advance of the external auditors’ meeting with the board, the internal group should request information from their external colleagues regarding the issues to be presented.

Compare and contrast Some of the information provided to the governance body/board by the international external and the internal auditors will be similar, while much may be unique to one or the other sets of auditors. The comparison of the international external and internal audit guidance regarding communications with the governance body/board is summarized in Table II. To comprehend the similarities and differences in the information the two groups proffer, it is helpful to begin by understanding the sources of both the demand for the external audit and the authority for the internal audit function.

Authority/demand The demand for the external audit derives from the users of financial statements and their representatives and advisors. These parties are aided in their decision making regarding financial matters by the added credibility which an independent audit provides. Another factor which impacts on the demand for external audits is the legal and regulatory climate. Specific laws or regulations in various countries may require entities to submit audited financial statements. Whether the demand for an engagement emanates from added credibility and/or laws and regulations, the external auditor’s focus is to protect third party or public interests.

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Table II Comparison of ISAs and PAs regarding communication with governance body/board Topic

ISAs

PAs

Authority/demand

External focus Aid users by adding credibility Mandated by laws/regulations Protect the public interest Gather evidence to support opinion on financial statements Not required to plan procedures to locate matters to communicate Report matters which may have come to attention of external auditor; no requirement to search for matters Matters are generally limited to those financial in nature No obligation to follow up on findings Generally report at or near end of engagement Allows coordination with internal auditors Requires external auditors to consider work of internal auditor; does not require communication regarding that consideration

Internal focus Derived from definition/charter Serves the board

Planning, scope

Reporting responsibilities

Coordination with other auditors

Because of this perspective, that auditor’s communication with the governance body centers on information garnered during the work performed in this role. In contrast to that of the external auditor, the internal auditor’s focus derives from the definition of internal auditing and from language in the department’s charter. The definition of internal auditing is: Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of management, control, and governance processes[3].

This definition emphasizes internal audit’s role in aiding the entity to achieve its objectives. The internal audit function’s charter should reinforce this view. Because the board is ultimately responsible for the entity’s accomplishment of its objectives, the internal auditor’s focus is on providing information to that group. Both external and internal auditors communicate with the governance body/ board. However, the external auditors are ultimately attempting to protect the public interest – an external focus – while the internal auditors serve the board – an internal focus.

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Plans approved by senior management, summary presented to board Restrictions on scope reported to board Submit plans for coming period Present activity report of work performed Matters may be operational, compliance, or financial in nature Mandate to follow up on significant engagement observations and recommendations

Allows coordination with external auditors Requires communication to the board regarding coordination of the two sets of auditors

Planning and scope In planning the engagement and determining its scope, the external auditor’s main objective is to gather evidence to support giving an opinion on the financial statements. Secondarily, and as a product of the audit, the composition of the governance body and what matters are to be communicated to it are considered. ISA 260 notes that the form of the governance body may vary across jurisdictions. In some countries, two boards exist; one is typically a supervisory, nonexecutive body and the other is a management, or executive, board. Other countries may embrace the single board model. Regardless of which structure the country and entity utilize, the external auditor should plan to report to the body which supervises, controls, and directs the entity. This group is accountable for ensuring that the entity’s objectives are achieved and that financial results and other information are reported to interested parties. When planning the engagement, the external auditor is not required to design procedures specifically to gather information to report to the governance body. Rather, matters to be communicated are those which come to the auditor’s attention in the course of the engagement and which the auditor deems to be significant and relevant to the governance body. To make clear the scope of


the work and their responsibilities regarding communication, the external auditors may elect to include this information in an engagement letter. Because the demand for, and objectives of, internal audit are distinct from those of external audit, the planning and scope of the two types of engagements also vary. Internal auditors typically plan engagements which are different in nature and much broader in scope than those of their external colleagues. While external engagements focus on the financial statement audit, internal audit work typically encompasses compliance and operational engagements, as well as financial work. The PAs indicate that the CAE should annually prepare a summary of the planned work and staffing requirements, as well as a budget. Senior management should give approval to this overall plan. For informational purposes, the board should be presented with a summary of the plan. The summary should be detailed enough to allow the board to ascertain if the work of internal audit bolsters the objectives of the entity and the board. As the internal auditors perform engagements during the year, they may encounter scope limitations. Such restrictions arise when the internal audit activity is prevented from carrying out its plans and meeting its objectives. For example, a scope limitation may arise when access to locations, records, or employees is limited, the internal auditors are not able to perform necessary procedures, or the planned work is restricted. The board should be informed, preferably in writing, of these challenges and their possible impact.

Reporting responsibilities In communicating with the governance body, the external auditor covers those matters already listed. When discussing the items noted, the external auditors should make clear that the financial statement audit is not designed to locate all matters which may be relevant to the governing body. Rather, only those which came to the external auditor’s attention when performing the engagement are included. Unless requested by the governing body, no special work is performed to search for such matters. The external audit’s communication with the governing body should be completed in a timely fashion. Generally, at or near the completion of the audit is sufficient. However, if critical items are found, meeting with the governing body before the end of the engagement may be warranted. In comparison to that of the external auditors, the internal auditor’s communications with the board are generally more detailed. Also, internal

auditors are likely to communicate more frequently than their external colleagues. Besides submitting plans for the coming year’s work, internal auditors also prepare activity reports covering those items already listed. The activity reports, emphasizing significant observations and recommendations, may be prepared as the work is being performed or after it has been completed. The CAE presents these activity reports to senior management and the board at least annually. However, the CAE is likely to communicate with the board much more often, perhaps several times a year. In studying the list of matters to be communicated, it is apparent that the external auditor relays matters with either a direct financial statement impact or which were unearthed during the financial statement audit. In contrast, the list of engagement observations shows that the significant audit observations found by the internal auditor are much broader in scope than the external audit findings. The internal audit observations follow from the activity’s coverage of operational and compliance, as well as financial statement, issues. Besides the breadth of the observations, recommendations, and findings, the auditor’s treatment of the entity’s responses to them differs between the external and internal groups. The external auditors have no obligation to follow up with the governing body or management to ascertain if action has been taken. (Of course, during the next year’s audit, the issues may surface again.) In contrast to their external colleagues, internal auditors are under a mandate to follow up on significant engagement observations and recommendations. The internal group is to ascertain if appropriate action has been taken, or if not, if management has accepted the related risks. Management is not required to implement the recommendations of the internal audit activity or to make any changes at all. However, the changes implemented, or management’s acceptance of the risks, should be reported back to the board.

Coordination with other auditors Because members of the governance body/ board will be hearing from both the external and internal auditors, they may naturally have queries regarding the two groups working together. The internal audit literature addresses the coordination of work with the external auditors in PA 2050-1, ‘‘Coordination.’’ ISA 610, ‘‘Considering the Work of Internal Auditing,’’ focuses on this issue in the international external audit standards (International Federation of Accountants, 2000)

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Both the ISA 610 and PA 2050-1 allow coordination of the work of the external and internal audit groups. However, neither standard goes so far as to require coordination. The international external audit standard directs the auditor to consider the activities of the internal audit function and to determine if that function’s activities might impact on the external engagement. However, the ISA does not require the external auditor to communicate the results of the consideration with the governance body. In contrast, the PA mandates that the director of internal audit evaluate the coordination of the two sets of auditors and then communicate the assessment to senior management and the board. Also, the director of internal audit may choose to communicate regarding the performance of the external auditor. The internal audit standard goes on to indicate that the internal auditor should anticipate that the external auditor will communicate with the board regarding various issues. The internal auditor is advised to be prepared by having an understanding of the topics. Similar advice is not present in the international external auditing standard.

Conclusion Both the ISAs and the PAs address the communication of the respective auditors with the governance body/board. Significantly, both sets of standards require such communication. Also, both the ISAs and the PAs allow, but do not require, coordination with the other group of auditors. The differences in the communications of the external and internal auditors with the governance body/board derive from the focus of each group. While the demand for the external audit arises from external users’ desire for credible financial statements, the need for the internal audit function arises from the board’s wish for information useful in fulfilling its duty to aid in achieving the entity’s objectives. Thus, the scope of the external audit is limited to matters related to the financial statements while the work of internal audit encompasses operational and compliance, as well as financial issues. Other differences between the external and internal audit communications relate to follow-up on the auditor’s observations, recommendations, and findings and notification regarding coordination with the other set of auditors. From the comparison of the international external auditing and the internal auditing standards regarding communications with the governance body/board, it can be seen

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that some information received by the body from the two sets of auditors is similar. However, the objectives of an external audit and an internal audit differ. Therefore, the information and perspective the two sets of auditors offer to the governance body/board are distinct. Both groups of auditors aid the governance body/board in its role of guiding the entity in effectively and efficiently carrying out its mission.

Notes 1 Effective for audits of financial statements for periods ending on or after 31 December 2000. 2 The IIA Practice Advisories referenced in this article are: . 1000-1: Internal audit charter; . 1110-1: Organizational independence; . 1130-1: Impairments to independence or objectivity; . 2020-1: Communication and approval; . 2050-1: Coordination; . 2060-1: Reporting to board and senior management; . 2410-1: Communication criteria. 3 www.theiia.org, Professional Practices Framework, approved June 1999, effective 1 January 2002.

References AICPA (1978), The Commission on Auditors’ Responsibilities: Report, Conclusions, and Recommendation, The Cohen Commission Report, AICPA, New York, NY. Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (1999), Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, National Association of Securities Dealers (NASB) and New York Stock Exchange (NYSE), February. Cadbury, Sir A. (1992), Financial Report of the Committee on the Financial Aspects of Corporate Governance, Financial Reporting Council, London Stock Exchange, London (Cadbury Report), December. Committee on Sponsoring Organizations (COSO) of the Treadway Commission (1992), Internal Control – Integrated Framework, AICPA, New York, NY. International Federation of Accountants (IFAC) (2000), IFAC 2000 Technical Pronouncements, IFAC, New York, NY. National Commission on Fraudulent Financial Reporting (Treadway Commission) (1987), Report of the National Commission on Fraudulent Financial Reporting, National Commission on Fraudulent Financial Reporting. Panel on Audit Effectiveness of the Public Oversight Board (2000), The Panel on Audit Effectiveness Report and Recommendations August 31, 2000, Public Oversight Board, Stamford, CT, available at www.pobauditpanel.org

Slack in public administration: conceptual and methodological issues

Tor Busch Sør Trøndelag College, Trondheim Business School, Trondheim, Norway

Keywords Costs, Management, Efficiency, Public administration

Abstract Ever since its introduction, the concept of organisational slack has constituted the basis for a considerable body of research within behavioural science. A great deal of this research has concentrated on budgetary slack, and within the field of public administration the focus has been on the slack- or budgetmaximising bureaucrat. As the reduction of slack is the purpose of many of the techniques which are part of the new public management, there is a need to focus on how to measure changes in the level of slack. The objective of this paper is to discuss the relationship between three central concepts within the research on slack: organizational slack, budgetary slack, and the discretionary budget; to assess whether these concepts are suitable for public organizations; and to discuss problems of measurement.


Over the past few decades a wide range of reforms and management techniques have been introduced in public administration to improve productivity and efficiency – management by objectives, total quality management, performance measurement, zero-base budgeting, etc. This movement is described as the ‘‘new public management’’, which, according to Jackson (1994, p. 121), puts the emphasis on ‘‘the importance of financial devolution; explicit standards of measuring performance; clear relationship between inputs and outputs; increased accountability; the superiority of private sector management practises and styles; the efficiency of competition and contracting out; and efficiency of parsimony’’. Critics have seen the new public management as a marked-based ideology invading the public sector, while others regard it as a management hybrid with a strong emphasis on core public values. In connection with this development there is a need to assess whether new techniques, management information systems, and organizational forms lead to increased productivity, efficiency, and quality. Because of the complexity of public administration, this may be difficult. In this context the concept of slack may be useful. Ever since Cyert and March (1963) introduced organizational slack as a significant concept in their theory of the firm, the level of slack has been used as an indicator of productivity. Even if a certain level of slack is necessary in order for an organization to be able to carry out its tasks in a satisfactory manner, a high level of slack may be an indication of poor utilisation of resources. The objective of this paper is to discuss the relationship between three central concepts within the research on slack: organizational slack, budgetary slack, and the discretionary budget; to assess whether these concepts are The current issue and full text archive of this journal is available at http://www.emeraldinsight.com/0268-6902.htm

suitable for public organizations; and to discuss problems of measurement.

Organizational slack Cyert and March (1963, p. 36) associate organizational slack with an understanding of the firm as a coalition of stakeholders. They define organizational slack as ‘‘[the] disparity between the resources available to the organization and the payments required to maintain the coalition’’. Using their contribution as a starting point, the research on organizational slack has taken several directions. Bourgeois (1981), Bourgeois and Singh (1983), and Sharfman et al. (1988) have analysed organizational slack from a behavioural perspective, discussing both theoretical models and problems of measurement in empirical research. Bourgeois (1981) emphasises that organizational slack forms a basis of resources which enables the organization to adapt to internal and external pressures, as well as to initiate any strategic changes required. He thus indicates that organizational slack is needed in all organizations. Wayne and Rubinstein (1992) apply the concept in a game-theory analysis of decision-making situations with particular emphasis on relations of co-operation and conflict. Leibenstein (1966, 1978, 1980), in particular, has discussed the concept from a micro-economic perspective. Through his concept of X-efficiency he analyses the degree to which an organization possesses an unutilised potential for improving its efficiency. Williamson (1963, 1964) discusses the concept based on the manager’s possibility for using organizational slack to his own advantage. Within public administration, this research has been further developed, particularly by Mique´ and Belange´r (1974); Niskanen (1975), Breton and Wintrobe (1982), Wyckoff (1990), and Duizendstraal and Nentjes (1994). According to Cyert and March (1963), organizational slack exists in two shapes –

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Tor Busch Slack in public administration: conceptual and methodological issues Managerial Auditing Journal 17/3 [2002] 153–159

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either as additional inducements for the stakeholders, or as a reserve accumulated by the management to which they can resort for resources during difficult times. In order to accumulate a reserve the management can regulate the amount of input/output which is transferred between the stakeholders and the organization. By supplying the organization with greater amounts of input than necessary to maintain a certain level of production, i.e. by keeping the productivity at a lower level than that which is ultimately possible to achieve, the level of organizational slack will increase. Likewise, the management may reduce the amount of output which is transferred to the customers, i.e. keep the volume of sales at a lower level than that which is actually possible, and thus create another form of potential slack. An interesting question in this context is whether it makes sense to apply the concept of organizational slack, given its definition, to the public sector and non-profit organizations as opposed to private enterprises: the stakeholders have a different composition; they are connected to the organization through different forms of contracts; and the management has fewer possibilities for influencing the basis of income. The relationship to the customers or the users of public services is of particular importance. In private businesses a normal market contract exists between the firm and the customer, and the overall demand governs the supply – at least in the long run. Provided that the firm does not have problems supplying the goods, the amount purchased by a customer is not in itself part of the inducements. For the public services, which are usually not financed through direct payment from the users, the level of production needs to be regulated through budgetary restrictions. This implies that the output of public services may in itself constitute an important part of the users’ inducements. Besides, the users of some public services have no alternative suppliers at hand. As Cyert and March’s definition of organizational slack presupposes that the stakeholders may leave the coalition, it is difficult to define what proportion of the slack is at the disposal of the users in these organizations. Another difference between private and public organizations is that public sector managers cannot establish a slack reserve by keeping the sales volume at a lower level than that which is realistically achievable in the market. In reality, therefore, the picture is very complex. As a conclusion we may say that it should be possible to apply the concept of

organizational slack to public agencies. However, Cyert and March’s definition is unsuitable as a way of grasping all the forms of slack which may exist within the public sector.

Budgetary slack Most researchers who have concerned themselves with budgetary slack position themselves in relation to Cyert and March (1963), but the relationship between organizational slack and budgetary slack has not been addressed or clarified to any significant degree. Although the basis for the concept of budgetary slack lies in the theory of organizational slack, budgetary slack is normally defined as the difference between the stated budget and an honest budgetary prediction (Kirby et al., 1991; Lukka, 1988; Ueno and Sekaran, 1992; Waller, 1988). Lowe and Shaw (1968) and Lukka (1988) use the concept ‘‘budgetary bias’’ in order to distinguish between, on the one hand, slack as an overestimate of the costs and underestimate of the income, and on the other hand, what is termed ‘‘upward bias’’, i.e. a conscious bias of the budget in the opposite direction. A distinction is also made between budgetary slack based on a conscious action by the budget manager; and an unintended misjudgement or an actual change in productivity or efficiency (Anderson, 1974; Demski, 1967; Lukka, 1988; Otley, 1985). According to these views, budgetary slack in public administration can be defined as a conscious overestimate of the costs ex ante. A large proportion of the research on budgetary slack has been conducted with the aim of identifying the factors which influence the development of this type of slack. There are strong indications that participation is a necessary, although not sufficient, precondition for the establishment of budgetary slack (Dunk, 1990, 1993; Govindarajan, 1986; Leavins et al., 1995; Young, 1985). Research also shows that budgetary slack co-varies with budgetary emphasis (Dunk, 1993; Leavin et al., 1995); with asymmetrical information (Ueno and Sekaran, 1992); technology (Merchant, 1985); commitment and job involvement (Nouri, 1994); as well as with linkages between the budget and reward systems (Chow et al., 1991; Dunk, 1990; Kirby et al., 1991; Leavins et al., 1995; Waller, 1988). Within this research, budgetary slack is measured partly by means of composite variables taking as their starting point management attitudes toward budgetary slack; partly by means of financial


key figures; and in experiments on the difference between an honest budgetary prediction and the stated budget proposal. The difference between organizational slack and budgetary slack is, first, that budgetary slack is defined ex ante, while organizational slack is defined ex post. Second, budgetary slack is tied to the assessment of the budget manager as to what represents the minimum cost at which a specified amount of goods/services can be produced. Any budget manager acts as a principal towards her or his subordinates, and if we presuppose asymmetrical information and the existence of opportunistic behaviour, the honest assessments of this manager will be flawed in various ways. The concept of organizational slack is defined and applied on the assumption that full information is available. Third, the time scope is limited in the context of the budget. This means that organizational slack which has accumulated within the organization and which cannot be dissolved within the budget period in question, is unlikely to be considered as slack by the budget manager. The conclusion must be, therefore, that according to the dominating definitions, organizational slack and budgetary slack are indeed two independent concepts, each with its separate content.

Discretionary budget In terms of slack in public administration, the most fundamental contribution was made by Niskanen (1971). He works within the public choice tradition, and his main thesis from 1971 is that bureaucrats will seek to maximise the budget of their bureau. This is based on the supposition that there exists a positive co-variation between the size of the budget and the utility that can be obtained by the bureaucrat. Niskanen claims that a range of variables will be included in the bureaucrat’s utility function: pay, fringe benefits, power, reputation, security, production volume, and the amount of energy needed in order to manage and change one’s own department. Mique´ and Belange´r (1974) suggested an extension of the model and argue that bureaucrats act to maximise their discretionary budget, defined as the difference between the total budget and the minimum cost of producing the output expected by the political authorities. This modification implies that the model will predict low productivity rather than ‘‘budget maximisation’’ in public administration. Niskanen (1991) accepts this as the general model and claims that his original model,

predicting budget maximisation, constitutes a special case. Many critical voices have been raised against the model of the slack-maximising bureaucrat, and empirical investigations designed to test out the validity of the model have proven difficult. Several studies have been conducted in order to examine whether public organizations are less productive than private ones – with ambiguous results (Borcherding et al., 1982; Downs and Larkey, 1986; Mueller, 1989; Savas, 1982). After going through the relevant research, Blais and Dion (1991), however, claim that the hypotheses of the bureaucrat’s tendency to maximise his or her own budget or the discretionary budget should still constitute a central basis in any theory on bureaucratic behaviour. The discretionary budget has not been theoretically defined either in relation to organizational or budgetary slack. According to the definition, political authorities will have certain expectations in terms of the volume that should be produced by a public organization. In the model is embedded an assumption that there exists a minimum cost which is necessary in order for the production to remain at this level. The difference between this minimum cost and the stated budget is defined as the discretionary budget. The concept is thus very similar to budgetary slack, but there is a significant difference in the sense that the discretionary budget is not based on the perception of the budget manager as to what minimum cost is achievable in real terms within the budget period in question. Furthermore, there is no indication in Mique´ and Belange´r’s model (1974) that additional inducements to the stakeholders are drawn in as a variable in the definition of minimum cost. However, Niskanen (1991) indicates that the discretionary budget may, among other things, be used for additional inducements in the shape of perquisites to the management and/or the employees. Another portion of it will be spent in ways that serve the interests of the political review authorities. According to Niskanen, negotiations will take place with the purpose of distributing the discretionary budget among uses which serve the interests of the bureau and the interests of the political review authorities respectively. As the discretionary budget may be used to meet the interests of the political review authorities, this may also, directly or indirectly, benefit the population. The corresponding condition applies in the special case of the management of a bureau having preferences in relation to the

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maximisation of output. The additional inducements for the users of public services are thus better defined than was the case when the concept of organizational slack was applied. The relation between the discretionary budget and organizational slack is therefore somewhat unclear. Both concepts include the reserve which the management may establish in order to keep the productivity at a lower level than that which is realistically speaking achievable, both are defined ex post, and both are applied on the condition of full information. The difference is primarily found in the fact that while organizational slack is defined in terms of what inducements are necessary in order to keep the stakeholders within the coalition, the discretionary budget does not have a clear definition of what inducements should be included in the model. On the basis of this, the relationship between the three concepts of slack may be described as in Table I.

Measuring slack Even though organizational slack has proved to be an important concept in analyses, great problems are associated with measuring the phenomenon empirically. Bourgeois (1981) suggests a method in which each group of stakeholders is asked how big a reduction in the inducements they are willing to accept in the event of the organization being plunged into a crisis. This method has also been described by Barnard (1938), March and Simon (1958), and Cyert and March (1963), and is used by Nohria and Gulati (1996) in studying the correlation between innovation and organizational slack. In the public agencies where important stakeholders have no real alternatives, this method cannot easily be applied. For reasons of validity and reliability, Bourgeois (1981) and Bourgeois and Singh

(1983) suggest as an alternative that relative changes in the slack level can be measured by using data from the accounts as a basis. They recommend that an indicator variable be developed, building on retained earnings; dividend pay-outs; general and administrative expenses; working capital as a percentage of sales; debt as a percentage of equity; credit rating; short-term loan interest compared to prime rate; and price/earnings ratio. Furthermore, they introduce the dimension ‘‘ease-of-recovery’’ – using the three categories available slack, recoverable slack, and potential slack. Cheng and Kesner (1997) used this method when they analysed organizational slack and responses to environmental change. Sharfman et al. (1988) operate according to the same guidelines, although their operationalisation is somewhat simpler: they regard slack as the physical resources available in an organization. Williamson (1964) and Schiff and Lewin (1968) found that when pressure arose to reduce organizational slack, the focus was primarily directed toward selling, general, and administrative expenses. According to Wolf (1971, cited in Leavins et al., 1995), these costs are non-repetitive, which means that they can function as a barometer for changes in slack. Miller et al. (1996) used selling, general and administrative expenses as a percentage of total costs as a measure of the slack absorbed within the organization. Using figures from the accounts to measure organizational slack is generally a problematic approach, and it is particularly problematic in relation to public administration. First, the accounts do not offer any impression of what inducement the stakeholders would have accepted in a crisis situation, and second, it is extremely difficult to uncover what, in real terms, would be the highest achievable productivity. Thus, it is not possible to uncover the level of slack by

Table I The relationship between organizational slack, budgetary slack and discretionary budget

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Organizational slack

Discretionary budget

Budgetary slack

1 Defined ex post 2 Inducements to the stakeholders beyond what is necessary to secure their participation in the coalition

1 Defined ex post 2 Additional inducements to the management, employees or the customers

3 Reserve built up by the management by keeping productivity and sales volume at lower levels than those which are actually obtainable

3 Reserve built up by the management by keeping productivity at a lower level than what is actually obtainable

1 Defined ex ante 2 The share of the inducements which the manager assumes can be freed through negotiations with the stakeholders during the budget period 3 The share of the reserves of which the management has conscious knowledge, and which it assumes can be dissolved in the course of the budget period


studying the accounts of a public bureau. Is it, then, feasible to develop an indicator variable which depicts relative changes in the level of slack? The greatest problem is probably one of distinguishing between changes in the level of slack and a redistribution of slack between the stakeholders. The distribution of slack is not random, but tied to decisions made by the dominating coalition (Cyert and March, 1963). In some organizations, the employees may, through a strong bargaining position, have attracted slack in the form of high pay; in others, dominating customers may have secured particularly good conditions for themselves. This means that the distribution of slack is influenced by the relations of power and the composition of the dominating coalition. If we accept without reservation the accounts as our starting point, it is difficult, not to say impossible, to know whether registered changes are associated with a change in the level of slack, or with a redistribution of it. Stable contracts, especially with regard to the dominating coalition, are therefore a prerequisite for measuring relative changes in slack by means of figures from the accounts. This means that it may be difficult to find a single indicator with sufficient validity for all situations. In order to solve this dilemma, indicators measuring relative changes with respect to the most important stakeholders may be developed. In terms of the employees, indicators may be constructed which build on inducements which are by nature shortterm, and can easily be changed; in terms of the users of the public goods/services, the indicator may build on the level of quality; and in terms of the management, the indicator may build on the productivity development. The slack at each stakeholder’s disposal is determined by the contracts entered into with the coalition. The type of contract, the contract costs, relations of power, and the time-span of the contracts, as well as the degree of transaction-specific investments, are important factors which influence both the distribution of slack between the stakeholders, and the slack’s degree of solubility. As many public agencies have the same purpose, task structure, and organization, the analyses may be extended to a comparison between the bureaus. This may give an indication both of level of slack as well as of changes over a period of time. In the existing research on the slackmaximising bureaucrat, very little attention has been paid to methods for measuring the level of slack. The aim of this research has primarily been directed towards verifying

the model, and/or towards developing the model with respect to the number of variables and relations. In terms of measuring the discretionary budget, we encounter a new problem in that the model contains a special case in assuming that some bureaucrats have a special preference for maximising the output of the bureau. In this case it is very difficult to measure the total amount of slack. In terms of low productivity and extra inducements for the stakeholders, we come up against the same problems of measurement as the ones associated with measuring organizational slack. The accounts are not likely to provide a basis for measuring the total level of slack, but by studying selected entries and comparing these with those of corresponding bureaus, it may be possible to obtain indications of relative changes. The great volume of empirical research shows that it is easier to find operational measures for budgetary slack than for organizational slack. Particularly in experiments, budgetary slack has often been directly measured (Chow et al., 1991; Waller, 1988; Wayne and Rubinstein, 1992). This research has provided us with valuable insight into the connections between budgetary slack and other behavioural concepts. Such measurements are more difficult to conduct in field studies. The respondents have reservations about giving information on budgetary slack within their own fields of authority, and unless they are very conscious of their own behaviour, their assessments may be flawed in numerous ways. The method which is most frequently applied, according to their reports, was developed by Onsi (1973). However, methods of measurement have also been developed by Daley et al. (1985), and by Dunk (1993). Onsi’s instrument consists of four items and emerges as consistent with regard to measuring attitudes to budgetary slack. Onsi (1973) does not report any reliability analyses, but Merchant (1985) estimated the Cronbach’s alpha to be 0.70 for this instrument. Two of the items have an affective basis, while the remaining two have a cognitive foundation. Those who have applied Onsi’s method in their research have treated it as an indicator of behaviour directed towards establishing slack (Ueno and Sekaran, 1992), or of propensity towards establishing slack (Merchant, 1985; Nouri, 1994; Govindarajan, 1986). Dunk’s method also consists of four items, and Dunk (1993) reports an Alpha-coefficient of 0.68. The distinction between Dunk’s method and Onsi’s method is that the former only has a cognitive foundation, and that it focuses on

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the degree of difficulty in attaining the budgetary goals. It is implicitly presupposed that if the respondents perceive the budget goals as easily attainable, they will have established a large degree of slack in the budget, and conversely, if they perceive them as difficult, there is little budgetary slack. Attitudes to slack are so far only measured in connection with budgetary slack. The reason for this is that budgetary slack builds on the budget manager’s estimate as to which resources are required in order to produce the volume budgeted for. Based on the problems of measuring organizational slack and the discretionary budget, the possibility of measuring the attitudes to accumulating this type of slack should also be considered. The processes of change which the public sector is currently undergoing have made it particularly important to find good instruments with a broad application and the capacity to register indications of changes in the level of slack.

Summary Many of the changes which are now being effected in the public sector seek to improve productivity, and efficiency, as well as quality, and in many contexts the intermediary variable is constituted by different forms of slack. Often, a change in the level of slack or the distribution of slack is therefore necessary in order to meet the goals of developing a public sector which runs more smoothly. In future research, it is, therefore, necessary to develop new methods of measurement which are adapted to the public sector and suitable for a comprehensive assessment of new initiatives. This applies both to methods which build on quantitative data from the accounts/production as well as to instruments which measure attitudes to slack. The latter have a broad area of application, and would make it easier to compare the development in different sectors and to conduct comparative analyses of the public sector in several countries.

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