RETHINKING INTERNAL AUDIT: GOVERNANCE NEEDS GARDENING

Abstract

It is a fact that the world is not on track to meet the Sustainable Development Goals by 2030. The alarm bell is ringing. And yet, we do not seem to be hearing it loud and clear. Governance is more than the third letter of ESG, it is the overarching concept. The acronym ESG is misleading. New and Sustainable Corporate Governance, say Governance 2.0, is a promising path. Governance needs strengthening (gardening) to help prevent failure. Internal audit can do more. Internal audit can do better. The purpose of this article is to help promote the idea that internal audit needs to think and behave differently to play a fuller, rounder and more effective role in improved governance, supporting sustainability, and the vital drivers for enhanced ESG practices, whether we like that term or not. Some of our old mantras may be less applicable in the volatile and demanding world we are increasingly moving in to. Effective future internal auditors must break free from some of our traditional constraints and limitations. Thinking, behaving, and working differently, as well as rethinking internal audit, are needed to fully exploit the value proposition of the internal auditing profession. The positioning of internal auditors as Gardeners of Governance can help the profession to become more impactful as enablers of learning and change, and help prevent governance failures. Like a garden, governance is never “done”.

INTRODUCTION

“It’s time to sound the alarm”, that is the call to action at the mid-way point on the journey to 2030, aspiring to protect people and the planet. The Sustainable Development Goals (SDG) Summit,¹ in September 2023, shall, again, be the turning point.

It is a fact that the world is not on track to meet the Goals by 2030. To prevent a climate catastrophe, more effective and timely climate action, focusing here on SDG 13 (Goal 13 aims to combat climate change), is required now. The time is now. There is no more time to waste. We need to change course. At pace.

Legal and regulatory action (coercive force) will be instrumental, a crucial part of the solution. Politics will clearly have to play a significant role around the globe. More energy and drive are needed. Success is also unlikely without the leadership of major, global corporations considering the externalities as part of their key targets. We need New Corporate Governance: Sustainable Governance. New or Next Generation Governance.

On this journey to safeguard the planet, nurture its biodiversity and protect us, what is the future role of internal auditing? More effective internal auditing can only help address these challenges - and we have to step up. Now.

“When governance breaks down it is because of too much power concentration or not enough accountability or both” (Korine, 2020, p. 11). There is more internal audit can do to help preventing governance failure.

This article focuses on the role, the self-image, positioning, and contributions of internal auditing when thinking differently. Governance is viewed as the overarching concept. Shareholder Welfare Maximation is the suggested new paradigm of corporate governance. The positioning of internal auditors as Gardeners of Governance can help us to become more impactful as enablers of learning and change. Internal audit can do more. Internal audit can do better. Internal audit can strengthen the foundation of organizations and can function as a real catalyst for positive, real and energetic improvement. Rethinking internal audit is needed to fully exploit the value proposition of the internal auditing profession.

THINKING DIFFERENTLY IS “AUDIT”²

Humphrey (2019) suggests rethinking audit. He challenges the audit profession. He wonders whether auditors are asking the right questions. He views “being trusted” as the foundation. His plea, rethinking audit, suggests agonizing less about independence, reporting, and evidence collection, encouraging the profession to break free from the constraints and limitations of its conceptual past. In his view, audit can be more than just a form of assurance. He asks, “what if we allow audit to become more of a primary function”, and challenges, “why that something ‘else’ cannot count as audit”? In his vision, audit is a voice that listens and communicates in ways that transform and enables people to do better things: “Thinking differently is the very essence of audit!”

The Lenz-Jeppesen Gardener article (2022)³ suggests positioning internal auditing as Gardener of Governance as a promising metaphor to strengthen its value proposition, both on a micro and on a macro level. The Lenz-Hoos ABC article (2023)⁴ suggests widening the repertoire of internal auditing. We diagnose an “ESG helplessness syndrome.” We suggest an ABC-Model © of Internal Auditing, adding “Building” as a new third pillar of internal audit value creation which complements the traditional Assurance and Consulting services. We encourage internal auditors to become “builders”, also when tackling the ESG challenge in their respective organizations.

IS IT TIME FOR RIP THE ACRONYM ESG?

To answer the rhetorical question, we obviously acknowledge that the term ESG is widely used, though often misinterpreted, and so abandoning the acronym is not a realistic option. The term ESG is simply too well-established now. Substance wise, we believe that while it would be a good thing to RIP ESG, this is simply not practical today.

Why do we dislike the concept of ESG? Clearly the acronym ESG is misleading and simplistic. It might be easy labeling, but like much that is easy, it is also lazy. Governance (G) is much, much more than the third letter of ESG, in our opinion, it is the critical overarching and underpinning concept that enables both the E and the S elements. Without a strong G, the E and the S will fail.

Cadbury put it well over 30 years ago: “Corporate governance is the system by which companies are directed and controlled” (Cadbury Committee, 1992).⁵“At its core, corporate governance, like political governance, is about limiting power and holding power accountable” (Korine, 2020, p. 15).

We posit, with New or Next Generation Governance (Sustainable Governance) as the overarching concept, the environmental and societal challenges can be addressed more effectively. Effective Governance is the overarching enabler for preventing organizational failure and for successfully addressing the E and the S (Diagram 1):

Diagram 1. Governance (G) is the overarching concept.

When coining the term ESG⁶: “Sound corporate governance and risk management systems are crucial pre-requisites to successfully implementing policies and measures to address environmental and social challenges …” (Pollman, 2022, p. 12, with own highlighting). There is more. There is more than E and S. All 17 Sustainable Development Goals (SDGs) deserve due attention, but we believe that there is value and potential in viewing G (Governance) as the overarching concept.

THE NEW - OR NEXT GENERATION - CORPORATE GOVERNANCE⁷

The legacy paradigm “Shareholder Value Maximation (SVM)“ ignores the increasing importance of externalities and social considerations. While capitalism⁸ per se is the best system known - admittedly, some will argue that given the present challenges to save people and the planet - the mechanisms of (new/sustainable) capitalism need to also include the (non-capital, non-financial) externalities, that is, the E (Environment), the S (Social), and there is more. That is THE challenge: how to successfully embed non-financial ambitions into the set of targets corporations are pursuing?

Hart and Zingales (2022) offer practical solutions about how to consider environmental and social responsibilities in the equation. In their landmark article, “Shareholder Welfare Maximation (SWM)” is the suggested new paradigm of corporate governance: “The New Corporate Governance.” The preferences of investors have changed and are likely to change further. Investors are increasingly far more sensitive to externalities, environmental and social issues.

SWM = Financial Impact + ʎ x Externalities, with ʎ ranging from 0 to 1, with ʎ representing the social preferences of the shareholders when assessing options, and when taking decisions.

There is no plan(et) B, “sustainability is here to stay, and corporate governance will have to deal with it.” (Thomsen, 2023).⁹ Thomsen (2023) suggests starting with company purpose and to adjust corporate governance, thereby discussing key elements of “sustainable corporate governance 2.0”.¹⁰ In his roadmap for sustainable governance he concludes (Thomsen, 2023, p. 31): ”the most promising avenue for future progress at this point is to start with a corporate purpose that states how a company creates value for society through its core business. While the company should aim to be net positive toward all its stakeholders including nature, its core value proposition is defined by the purpose.” In other words, keep working on regulation, heightening demands, and strengthening coercive force is part of the success formula, but efforts should not be limited to that. Firm inducements can direct the corporate world to heighten the importance of externalities in their interpretation and equation of Shareholder Welfare.

Present C-level executives and supervisory board members need to ask themselves challenging questions, including: are we doing enough to safeguard the planet, the environment and people? Is there more we can do? Do we have to adjust our company or organization’s purpose, vision and mission? How best do we adjust our corporate governance to enable this, and turn intent into positive action? What does effective and sustainable corporate governance 2.0 look like? We may not have all the answers now. However, asking (these and more) questions would be a good start. We need to change course. We need to do it now.

With The New Corporate Governance emerging, how will that impact the future of internal auditing? “Corporate governance failures do not emerge full-blown; rather, they develop over time, often over a number of years” (Korine, 2020, p. 99). Building on the Gardener article (Lenz & Jeppesen, 2022) and the ABC article (Lenz & Hoos, 2023) we see value in The House of Governance with the right mind-set as foundation: a garden is never finished.¹¹ “Corporate governance is never ‘done’” (Korine, 2020, p. 99). Governance needs constant strengthening. Governance needs gardening.

GOVERNANCE NEEDS GARDENING

It is scientific consensus that our planet is at risk. In the Global Risks Report 2023¹² environmental challenges account for six out of the top 10 risks over a 10-year period (World Economic Forum 2023). How best can internal auditing contribute and support the mitigation of these global challenges?

Lenz and Hoos (2023, pp. 44 and 49) suggest “Internal auditors must widen their repertoire to deal with the changing context from complicated to complex.” The ABC article advocates a pragmatic way of better serving the purpose of the organization we work for by possibly adding “Build” to our repertoire, in addition to “Assure” and “Consult”, so “doing stuff”, becoming project-team members, becoming (co-) architects may be value adding, especially when considering what is at stake. ESG is the subject of this article, an example. There is more.

Similarly, to Humphrey (2019), Lenz and Hoos (2023, p. 49) suggest less navel-gazing about independence and objectivity, and breaking free from the constraints and limitations of the conceptual past of internal auditing, by proposing their credo for the future Internal Audit functions’ contribution to the ESG agenda: “Let Internal Auditors Go Surfing!”. Thinking differently, and rethinking internal audit is needed to fully exploit the value proposition of the internal auditing profession. Let us see where the project “Vision 2035”¹³ will take the profession. The jury is out. For now.

Lenz and Jeppesen (2022, p. 12) suggest “Gardener of Governance not Guardian of Governance for the metaphor Gardener displays a healthy level of modesty being exposed to reality and unexpected weather conditions in the real world. The metaphor Gardener underpins humility. Gardeners are very respectful toward nature, the environment they live in. Similarly, internal auditors are well advised to be respectful toward the rest of the organization in which they operate. With the soft/er metaphor of Gardener we deliberately position internal auditing as a constant learner, a learn-it-all, rather than a know-it-all.”

Internal auditing may become even more relevant, more impactful, more effective when seeking to strengthen the foundations of organization, enhancing the mind-set, the culture, contributing to a psychologically safe environment, so that everybody can best engage in the joint success of the enterprise.

In doing so, internal auditors must increasingly inspire, infuse energy, not drain it, or seek to crush it through excessive bureaucracy, dressed up as control. We need more from internal auditing than assurance. Some sectors may be more progressive, more innovative than others. That is how evolution works. Some internal audit functions will be the innovators, some will be (fast) followers, and some will not or hardly evolve and change. Those who do not adjust at all are likely to become irrelevant over time.

OUR HOUSE OF GOVERNANCE

Mario Andretti, the Italian car-racer used to say: “If everything seems under control, you’re not going fast enough.” These days, and for too long, things are no longer under control.

We need to think performance, risks, and controls as intertwined. Governance is more than the third letter of the acronym ESG, it is the overarching concept. Thus, the term ESG is misleading.

We picture the House of Governance with Performance Management on the top floor. Risk Management in the middle, the hinge. There are rooms, so to speak, for Compliance, and for E (Environment), and S (Social) and for more, Legal, Tax, IT, for example, and most importantly for strategic and operational risks (Diagram 2):

Diagram 2. House of Governance (Lenz and Chesshire 2023).

We view internal auditors as enablers of learning and change - and builders. Internal Audit can be instrumental in strengthening the foundation, enhancing the ABC of organizational change, Attitude – Behavior – Culture. Without a solid foundation, the House of Governance would simply be built on sand.

CONCLUSION

It is a fact that the world is not on track to meet the Sustainable Development Goals by 2030. The alarm bell is ringing. And yet, we do not seem to be hearing it loud and clear. We as a global society are presently on a path to disaster. We must change course. We must do it now. We need to limit climate change by tackling greenhouse gas emissions. We must find ways to give due consideration to the Sustainable Development Goals (SDG). Politics and organizations/corporations must do more and better. To do this will not be easy, quick, or straightforward. As Trent Reznor, of Nine Inch Nails fame, said, “I really try to put myself in uncomfortable situations. Complacency is my enemy.”¹⁴ We are in an uncomfortable situation. There is no room for complacency, however temporarily comforting that may feel.

Governance is more than the third letter of ESG, it is the overarching concept. The acronym ESG is misleading. New and Sustainable Corporate Governance, say Governance 2.0, is a promising path. Shareholder Welfare Maximation (SWM) is the suggested new paradigm of corporate governance, thereby including externalities in the set of targets.

The positioning of internal auditors as Gardeners of Governance can help the profession to become more impactful as enablers of learning and change, and help preventing governance failures. Like a garden, governance is never “done”. Governance needs gardening.

When seeking to do more, building is suggested as the third pillar of the portfolio, widening the repertoire, to become – framed and safeguarded as necessary - project managers, “doers”, co-creators, and co-architects in the House of Governance - wherever appropriate. Internal audit can do more. Internal audit can enhance the foundation of organizations, thereby helping mutual understanding, strengthening the ABC of organizational change: Attitude, Behavior, and Culture. Without such a solid foundation, the House of Governance would be built on sand. Future effective internal auditors will increasingly inspire, infuse energy, and become impactful co-creators, enabling people to do better things. Effective future internal auditors will be less focused on independence, reporting, and evidence collection. Effective future internal auditors will break free from the constraints and limitations of the conceptual past.

Thinking differently, and rethinking internal audit is needed to fully exploit the value proposition of the internal auditing profession. Let us see where the project “Vision 2035”¹⁵ will take the profession. The jury is out. For now.

”Ein GARTEN ist niemals fertig” (Lucenz & Bender 2018). A garden is never finished.

Like a garden, governance is never ”done”. Governance needs gardening.

Internal audit can do more. Internal audit can do better.

The positioning of internal auditors as Gardeners of Governance can help the profession to become more impactful as enablers of learning and change, and help prevent governance failures.

Acknowledgments

Rainer and John thank the reviewers of our paper, and we thank Dan Swanson, the Managing Editor of EDPACS, for the opportunity. We thank David Hill, CEO at SWAP Internal Audit Services, and Alexander Ruehle, CEO at zapliance, for co-funding OPEN ACCESS.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Additional information

Notes on contributors

Rainer Lenz

Rainer Lenz is a financial and corporate audit executive with 30+ years of international experience in global organizations. He has a PhD in Economics and Management Science from the Louvain School of Management in Belgium. Dr Lenz has published a series of articles about internal auditing in peer-reviewed journals. He has earned several awards for his thought leadership, including the 2023 Bradford Cadmus Memorial Award from the Global Institute of Internal.

John Chesshire

John Chesshire is an internal audit, risk management and governance expert with 24+ years’ experience in these fields. Mr. Chesshire holds several senior internal audit positions. He chairs and speaks at internal audit conferences, mentors chief audit executives, delivers training and conducts external quality assessments. He received the Chartered Institute of Internal Auditor’s J.J. Morris Distinguished Conduct Award in 2019 for outstanding service to the internal audit profession in the UK.

Notes

1. Accessed on 14 July 2023, https://www.un.org/en/conferences/SDGSummit2023.

2. Accessed on 14 July 2023, https://auditfutures.net/blogs/thinking-differently-is-audit.

3. Lenz, R. and Jeppesen K.K. (2022), The Future of Internal Auditing: Gardener of Governance, EDPACS, 66:5, 1–21 https://www.tandfonline.com/doi/full/10.1080/07366981.2022.2036314.

4. Lenz, R. and Hoos, F. (2023), The Future Role of the Internal Audit Function: Assure. Build. Consult. EDPACS, 67:3, 39–52 https://doi.org/10.1080/07366981.2023.2165361.

5. Accessed on 02 September 2023, https://en.wikipedia.org/wiki/Cadbury_Report

6. Pollman, Elizabeth, The Making and Meaning of ESG (October 31, 2022). U of Penn, Inst for Law & Econ Research Paper No. 22–23, European Corporate Governance Institute – Law Working Paper No. 659/2022, Available at SSRN: https://ssrn.com/abstract=4219857.

7. Hart, Oliver D. and Zingales, Luigi, The New Corporate Governance (April 25, 2022). University of Chicago Business Law Review, Summer 2022, Vol.1, Issue 1, University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2022–55, Available at SSRN: https://ssrn.com/abstract=4094175 or http://dx.doi.org/10.2139/ssrn.409.

8. Accessed on 14 July 2023, https://en.wikipedia.org/wiki/Capitalism.

9. Thomsen, Steen, Sustainable Corporate Governance. An Overview and an Assessment. (May 25, 2023). Available at SSRN: https://ssrn.com/abstract=4459225 or http://dx.doi.org/10.2139/ssrn.4459225.

10. Including company law (director liability), long-term ownership, ESG investment, company purpose, sustainability committees, sustainability competencies, ESG incentives, climate plans, climate risk management, sustainability reporting, and internal carbon pricing.

11. Book title in German: “Ein Garten ist niemals fertig“(Lucenz & Bender 2018). Translated into English.

12. Accessed on 14 July 2023, https://www.weforum.org/reports/global-risks-report-2023.

13. Accessed on 14 July 2023, https://www.theiia.org/en/internal-audit-foundation/latest-research-and-products/ia-2035-project/.

14. Accessed on 27 August 2023, https://www.brainyquote.com/lists/topics/top-10-complacency-quotes.

15. Accessed on 31 August 2023: https://www.theiia.org/en/internal-audit-foundation/latest-research-and-products/ia-2035-project/: “The Internal Audit Foundation is undertaking a groundbreaking initiative: “Internal Audit: Vision 2035 - Creating Our Future Together.” This project is designed to identify what the internal audit profession will look like in 2035, how we can elevate the value of internal audit during that time, and what steps we must take to make that future a reality.”