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Internal auditors can add substantial value to their organisation by periodically assessing whether the design and implementation of the executive compensation and benefits (ECB) program supports the achievement of strategic business objectives established by the board. However, only a small minority is seizing this important opportunity, according to a recent member survey conducted by The Institute of Internal Auditors (IIA).

The global survey reveals that only 45.3% of respondent organidations conduct even limited reviews of the appropriateness of ECB and that only about one-third of such reviews are spearheaded by internal auditing. Moreover, the survey indicates that when conducting such reviews, internal auditors are most likely to focus on program compliance rather than on overall program design.

“Lawmakers and regulators around the world have begun holding boards accountable for ensuring that executive compensation packages appropriately align with business objectives and do not incentivize excessive risk-taking,” notes Günther Meggeneder, CIA, chief audit executive (CAE) of ista International, a global energy cost- and data- management company based in Essen, Germany. Meggeneder specifically cites a proposal recently approved by Members of the European Parliament to restructure bankers’ bonuses. If European Union governments agree to the proposal, the new rules would be the strictest in the world.

“Internal auditors can and should be seated at the table when the board is discussing how best to balance this critical fiduciary responsibility to shareholders with its responsibility to compensate executives adequately for a job well done,” says Meggeneder, who also is 2010-2011 chairman of the board of The IIA, which sets global standards for the professional practice of internal auditing.

Executive compensation is a sensitive and emotional topic, observes Steven E. Jameson, CAE of Community Trust Bancorp Inc. in Pikeville, Ky. “I sense that although many internal auditors are comfortable looking at components of executive compensation packages as part of broader audits of payroll practices or benefits administration, very few are willing to fulfill the larger and more valuable role of providing the board with an opinion of the appropriateness of the overall plan,” he says.

Lynn C. Morley, CIA, CGA, an internal-auditing consultant and former CAE of Suncor Energy Inc. in Calgary, Alberta, agrees that limited internal audit review of executive compensation can add only limited value to the organisation. “Internal auditors won’t be able to fully understand all the risks unless they examine the system of compensation and benefits holistically,” she says. This is a legitimate and, in fact necessary role for today’s internal auditors, says Morley, principle author of the IIA Practice Guide, Auditing Executive Compensation and Benefits, issued in April 2010. “Poorly designed compensation programs can have unintended consequences ranging from financial reporting fraud to rewarding poor leadership. Such consequences often lead to poor morale, and public exposure could lead to long-term reputation damage,” she says.

Among the minority of respondents who report that their organisation formally reviews the appropriateness of ECB, the top five focus areas are overall plan design (56%), cash compensation (56%), stock-based compensation (37.4%), deferred compensation (31.9%) and pension and other retirement contributions (25.3%). Reputation risk is cited most often (41.9%) as the reason for conducting such a review, which is most commonly conducted by the human resources function (46.2%), followed by internal auditing (33%) and the legal function (20.9%). The results are shared most often with the board’s compensation committee (59.3%) or audit committee (38.8%).

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