INTERNAL AUDIT AND MERGERS AND ACQUISITIONS

Transcription

1 INTERNAL AUDIT AND MERGERS AND ACQUISITIONS Dr. Theofanis Karagiorgos 1, Dr. George Drogalas 2 Dr. Panagiotis Pantelidis 3 Abstract: Rapid changes in information technology and managerial practices in many organizations were forcing efficient internal audit as a tool for the exact management of any business economic resources. Simultaneously, recently numerous mergers have been realized. However there is no such a research which describes the interaction between M&As and internal audit. For this reason the purpose of our study is to highlight via theoretical and empirical data the interaction between M&As and internal audit. The results point out that internal audit can contribute significantly to acquisitions activity. Finally, further work is suggested in extending the geographical area of the research for a longer period. Keywords: Internal auditing, Auditing, Mergers, Acquisitions, M&As, Accounting, Management JEL Classification: M40, M41, M10. 1 Dr. Theofanis Karagiorgos: Associate Professor and Head of the Department of Business Administration, University of Macedonia, Greece. Mailing Address: 156, Egnatia Str., Thessaloniki, Greece Zip Code: GR , Tel.: karaght@uom.gr 2 Dr. George Drogalas: Adjunct Lecturer, Department of International Economic Relations and Development, Democritus University of Thrace, Greece. Mailing Address: 26 Raidestou Str., Serres, Greece Zip Code: GR , Tel.: , georgedrogalas@yahoo.gr Corresponding author 3 Dr. Panagiotis Pantelidis: Associate Professor, Department of Business Administration, Greece. Mailing Address: Magnisias Str., Serres, Greece Zip Code: GR-62124, pan@teiser.gr

2 1. INTRODUCTION The technological advancements, globalization of economy, allegations of fraudulent financial reporting and increased competition have recently sharpened the everincreasing attention on internal controls and internal audit functions (Karagiorgos et al., 2010). Simultaneously, many companies are pursuing mergers and acquisitions (M&A) as a primary growth strategy (Lin et al., 2006). In this context, there is a wide literature about the possible effects of a merger: in particular, operating and financial synergies are considered (Cigota and Modesti, 2008) as mergers and acquisitions are becoming an increasingly popular strategic option for organizations (McEntire and Bentley, 1996; Appelbaum et al., 2007a; Nogeste 2010). The fundamental question which this research, on mergers and acquisitions, has endeavoured to answer is the following: Does the relationship between M&As and internal audit create economic value? That is, does this interaction lead to greater aggregate wealth for the combined shareholders of the acquiring and acquired firms? This is an extremely important issue because both M&As and internal audit are considered to add value to businesses (Bou-Raad, 2000; Schraeder and Self, 2003; Walker et al., 2003; Jeffrey, 2008; Karagiorgos et al., 2009). Despite the aforementioned perceptions, until now a limited research has been conducted on the relationship between M&As and internal audit. For this reason, the object of this paper is not only to review briefly the current theories pertaining to the conceptual framework of M&As and internal auditing but also to describe the relationship between M&As and internal auditing in Greek businesses, in particular. Consistent with our predictions, our results indicate that internal audit is already playing a very positive and constructive role in mergers and acquisitions To best describe its aim, the structure of this paper is as follows: the next section on the one hand describes the theoretical background of M&As and internal auditing, on the other hand presents the recent literature review. The third section presents the research design by providing information on the development of the survey, the methodology for data analysis and the methodology for the questionnaire. The results of the study are reported and discussed in the fourth section. Finally, the last section contains conclusions, remarks, limitations of the study and recommendations for future research concerning internal auditing and M&As.

3 2. LITERATURE REVIEW 2.1 Conceptual Framework of Internal Auditing and M&As On the one hand, there has been much confusion and a lack of consensus as to what internal control means (Drogalas et al., 2005). According to the Institute of Internal Auditors, (Taylor and Glezen, 1991; IIA, 1995; Fadzil et al., 2005) internal auditing is an independent appraisal function, established within an organization to examine and evaluate its activities as a service to the organization. More recently, one of the most comprehensive definition is given by Sawyer (2003) who stated that internal auditing is a systematic, objective appraisal by internal auditors of the diverse operations and controls within an organization to determine whether (1) financial and operating information is accurate and reliable, (2) risks to the enterprise are identified and minimized, (3) external regulations and acceptable internal policies and procedures are followed, (4) satisfactory operating criteria are met, (5) resources are used efficiently and economically and (6) the organization s objectives are effectively achieved all for the purpose of consulting with management and for assisting members of the organization in the effective discharge of their governance responsibilities (Karagiorgos et al., 2010). From the above, it is important to stress that a sound system of internal control provides reasonable, but not absolute, assurance that a company will not be hindered in achieving its business objectives by circumstances which may reasonably be foreseen (Dittenhofer, 2001; Sarens and Beelde, 2006; Savcuk, 2007). On the other hand, mergers and acquisitions are arguably the most popular strategy among firms who seek to establish a competitive advantage over their rivals (Kumar and Bansal, 2008). In other words, M&As may be considered to occur everywhere, in various types of industry sectors and variously sized organisations (Balle, 2008). In this context, M&As are considered as one of the mechanisms by which firms gain access to new resources and, via resource redeployment, increase revenues and reduce cost (Wolf, 2003). This major proposition for the M&As increased activity is mainly imposed by intense competition, evolving technology, low interest rates, changing regulations in the financial markets, and many other factors (Antila and Kakkonen, 2008).

4 2.2 The Contribution of Internal Auditing to M&As As markets develop, the aim of achieving rapid growth through the purchase of existing companies has become increasingly popular. Therefore, mergers and acquisitions are considered to be an important aspect of strategic financial management (Vinten, 1993; Ramakrishnan, 2010). However, the results of acquisition activity have been generally disappointing. In line with the above internal audit function is considered as an important tool in attaining corporate objectives and in specialized projects such as M&As. The role of internal audit varies at different times in the cycle and is divided into: the pre-acquisition Stage and the post-acquisition Stage. More specifically, at the pre-acquisition stage, the research on potential candidates is of major importance. In this respect internal audit function ought to examine business position, current and forecast results and the potential fit between companies. Hence, at the pre-acquisition stage, internal audit ought to confirm the readiness of the company for acquisition. To accomplish the aforementioned scope, internal audit ought to ascertain how to add value, ensure financial discipline and develop an effective organizational structure (Cook, 1993). The role and responsibilities of internal audit increase as the process develops (Lees, 1992). For this reason, at the post-acquisition stage, internal audit ought to alert company directors to the risks to which they may be exposed if the company is not diligent in its post-acquisition management. More precisely, firstly, internal audit should check the efficiency of the reporting systems, structures and people. Then internal audit ought to examine the usage of assets, compare outcomes with original strategy and identify opportunities to integrate facilities. 2.3 Recent Empirical Literature Numerous studies investigate the importance of M&As. Similarly, the growing importance of internal auditing as an economic factor has led to systematic research into the factors that improve the performance of internal auditing. Despite the aforementioned perceptions, a limited amount of research has been conducted on the interaction between M&As and internal audit.

5 In this respect, Lees (1992) examined the role of internal auditing in M&As. The researcher stressed the importance of post acquisition stage. The results pointed out that the possibilities are considerable for internal audit to make a significant strategic informational input into the acquisition-planning process. Finally, the researcher emphasize that internal audit ought to shift its emphasis from the more mechanistic policing role to one which had a greater strategic emphasis. At the same time, Cook (1993) examined the role of internal audit in acquisitions before a purchase is made. Specifically, the article looks at the type of review which can be undertaken at the pre-acquisition stage, while a company is gearing up towards diversification. The results point out that internal auditing at the pre-acquisition stage is vital in the effectiveness of M&As. The results also reveal that internal audit should seek to become involved as early as possible. However, once the purchase is completed, the internal audit function has an important part in ensuring that effective internal controls are implemented for the group as a whole. For this reason, Cook (1993) analyzes the role of internal audit after acquisition. The main output is the fact that internal audit function after an acquisition is very considerable, but in facing the challenge, audit can give much assistance to help the organization achieve its goals. Similar to the aforementioned studies, Selim et al. (2003) examined the role of internal auditors in M&As. The survey indicates a low level of involvement of internal auditors at the various stages of mergers and acquisitions (M&AS). Hence, the research reveals a desire by internal auditors to become more involved with M&A projects and to become associated with these activities at an earlier stage. In other words the study sets out the pre-requisites for internal auditors expanded role and discusses the means of achieving this. Finally, Dounis (2006) also describes the involvement of internal auditors in M&As. The study examined the present level of involvement of the internal audit function during M&A activity' and compared it with internal auditing's preferred levels. The research used a questionnaire which was mailed to 120 chief audit executives in leading edge organizations that participated as bidder companies in M&As between

6 2000 and Thirty-four of the questionnaires were completed and returned. This comparison led to the identification of possible reasons for the low level of involvement and means and prerequisites for internal auditing participating more actively. To be more comprehensive, Table 1 depicts a short review of the literature by presenting the authors, the scopes and the basic outputs of the aforementioned studies. Table 1: Short Review of the Literature Authors Scope Basic Output Lees (1992) The role of internal auditors The post acquisition stage is of major in M&As. importance. Cook The role of internal auditors Internal auditing at the pre-acquisition (1993) at the pre-acquisition stage. stage is vital in the effectiveness of M&As. Cook (1993) The role of internal auditors at the post-acquisition stage. Internal audit after an acquisition is very considerable. Selim et al. The role of internal auditors Internal auditor s involvement in (2003) in M&As. M&As can only be described as moderate. Dounis (2006) The role of internal auditors in M&As. Internal auditors are seeking more proactive involvement in mergers and acquisitions. 3. RESEARCH DESIGN The researchers carried out the fieldwork during the second half of 2009 and the first half of To describe more realistically the association between internal audit and M&As, the sample of research was companies listed on the Athens Stock Exchange. To achieve its goal the study uses the exploratory research methods of questionnaires. Cover letters and surveys, along with postage paid return envelopes, were mailed directly to each of the business executives. However it should be mentioned that even the organizations, which finally completed the questionnaire, initially were not willing to complete it, because they believed that data about the M&As should not be

7 disclosed outside their organizations. They finally agreed to complete the questionnaire after we signed a non-disclosure agreement. Respondents were asked to indicate their degree of agreement or disagreement with each of the statements on a five-point Likert response scale (Likert, 1932) that ranged from strongly agree (scored as 5) to strongly disagree (scored as - 1). This methodology was employed because it is relatively easy for respondents to use, and responses from such a scale are likely to be reliable (Nunnally, 1978; Anderson et al., 1983; Myers and Gramling; 1997; Balzan and Baldacchino, 2007; Lam and Kolic, 2008). Hence, the questionnaire is designed in such a way that enables its rapid completion. For this reason, it is separated into two main parts: part A refers to Preacquisition stage and part B refers to Post-acquisition stage. 4. RESULTS The aim of this section is not to make a critical analysis over the related literature, but to provide evidence of how some terms were perceived in this study. About 275 questionnaires were distributed to different organizations. After excluding incomplete and invalid questionnaires, the research ended with 43 valid and usable questionnaires representing a 15.6 percent response rate. Part A of the questionnaire refers to the Pre-acquisition stage. In this context the screening of potential candidates is depicted via 1-3 questions. Question 1 examines whether internal audit identifies the political, economic, social, technical environments. The majority of the respondents answered, strongly agree or agree (82 percent). The next two questions examine to which degree internal audit check the forecast results and the potential fit between the companies. In both questions the vast majority (75% and 90%, respectively) of the respondents claim that both themes are of major importance for the internal auditors. The last three questions of part 1 refer to the readiness of the company for acquisition. Question 4 examines the degree that internal audit ascertain how to add value. The results are also positive. However, it is worth to mention that only 13 percent of the employees totally agree with the above statement. In line with the above question 5 analyze the financial discipline. 85 percent of the respondents claim that internal audit ensure the financial discipline. Finally the quality of organizational structure is examined. Again most of

8 the respondents believe that internal auditors develop an effective organizational structure. To be more accurate Table 2 shows descriptive statistics of questions 1-6. Table 2: Descriptive Statistics (Questions 1 6) N Mean Std. Deviation Valid Missing VAR ,29 0,800 VAR ,03 0,738 VAR ,32 0,803 VAR ,97 1,014 VAR ,15 0,893 VAR ,05 0,863 Part B of the questionnaire refers to the Post-acquisition stage. Specifically Question 7, examines the impact of internal audit on the authorization of payment.. From the responses, the vast majority of the respondents believe that internal audit checks the authorization of payments. The next question examines whether internal audit create separate accountable units. In contrast with the above findings, only 65 percent of the respondents strongly agree or agree with the above statement. Then the motivation of personnel through targets is examined. Most of the respondents, (62 percent) claim that internal audit motivate people through targets, while another 40 percent answered, agree. The last three questions are also very interesting. Question 10 examined the degree that internal audit finds mechanism to safeguard the assets. It is worth mentioning that 85% of the respondents believe that internal audit checks the usage of assets. Then question 11 considers the degree that internal audit identifies opportunities to integrate facilities. The results are encouraging, although further improvement can be achieved since 31 percent of the employees are opposed to the above statement. The last question considers whether the internal auditors compare outcomes with original goals. It is worth noting that none of the employees strongly disagree with the above statement, whereas 71 percent agree or strongly agree. To be more accurate Table 3 shows descriptive statistics of questions 7-12

9 Table 3: Descriptive statistics (Questions 7 12) N Mean Std. Deviation Valid Missing VAR ,27 0,790 VAR ,79 0,798 VAR ,42 0,903 VAR ,17 0,864 VAR ,89 0,833 VAR ,45 0, CONCLUSIONS The last few decades have been characterized by unparalleled change. In the light of this unique business environment, we have seen a large number of mergers and acquisitions among companies as corporate acquisitions have widespread effects on the wealth of various groups of agents involved in the market for corporate control (Mathur and De, 1989; Schweiger and Goulet, 2000; Wood, 2005; Aduloju et al., 2008). Undoubtedly, acquisitions provide a path for rapid growth, but it is also essential to emphasize that mistakes can be costly and even fatal. Simultaneously internal audit becomes an important managerial control device (Carmichael et al., 1996; Maijoor, 2000), which is directly linked to the organizational structure and the general rules of the business (Cai, 1997; Brody and Lowe, 2000; Candreva, 2006). However until now, a limited amount of research has been conducted examining the relationship between internal audit and M&As. Overall, from the results, it is important to mention that internal audit is already playing a very positive and constructive role in mergers and acquisitions. More specifically, the results revealed that at the Pre-acquisition stage, the measurement of the financial fit between companies is of major importance for internal audit. Hence, regarding the readiness of the company for acquisition, the results pointed out that internal audit pays attention to the efficiency of treasury function to a large degree. However, it is worth mentioning that further improvement can be achieved on how internal audit adds value. Likewise, at the Post-acquisition stage, the results indicate that internal audit motivate the personnel through targets effectively. In line

10 with the above, the respondents claimed that internal audit compares outcomes with original goals to a large degree. On the contrary, further improvement can be achieved regarding the creation of separate accountable units. Overall, the results reveal that internal audit function is potentially in a strong position to improve the quality of management throughout the acquisition process, and provide a service which can significantly affect the organization's profitability. However, the results of this study should be interpreted with caution. Besides the usual caveats of survey research, there are several limitations to this research. First, the sampling area was limited to the Greek business sector. A further limitation in carrying out this research is the small number of respondents on which the study was necessarily based. Hence, this study provides useful insights on the interaction between internal auditing and M&As, although only the perceptions of internal auditors were obtained. According to the above, this research did not have the intention of concluding the discussions over this matter; however, it is expected to be one more element to help the formation of opinions and to diffuse other discussions on the subject. There is a need for further research to expand the geographical areas of study. Moreover, survey data for this research needs to be confirmed with detailed interviews with a variety of practitioners in all countries. In line with the above, perhaps, a future study could be conducted to explore the perception of other parties such as employees or external auditors on the interaction between internal auditing and M&As in business units. Finally, another promising research initiative would be to further explore how internal audit function might be best operationalised to a M&As procedure. Undoubtedly, the relationship between internal audit and M&As will attract much attention among academics in the future. As the saying goes, the future is bright, but the road ahead is tortuous.

11 REFERENCES Aduloju, S., Awoponle, A. and Oke, S. (2008) Recapitalization, mergers, and acquisitions of the Nigerian insurance industry, The Journal of Risk Finance, Vol. 9 No. 5, pp Anderson, A.B., Basilevshy, A. and Hum, D.P.J. (1983) Measurement: theory and techniques, in Rossi, P.H., Wright, J.D. and Anderson, A.B. (Eds) Handbook of Survey Research, Academic Press, San Diego, CA. Antila, E. and Kakkonen, A. (2008) Factors affecting the role of HR managers in international mergers and acquisitions A multiple case study, Personnel Review, Vol. 37, No. 3, pp Appelbaum, S.H., Lefrancois, F., Tonna, R. and Shapiro, B.T. (2007a) Mergers 101 (part one): training managers for communications and leadership challenges, Industrial & Commercial Training, Vol. 39, No. 3, pp Balle, N. (2008) Hearts at stake a theoretical and practical look at communication in connection with mergers and acquisitions, Corporate Communications: An International Journal, Vol. 13 No. 1, pp Balzan, L. and Baldacchino, P.J. (2007) Benchmarking in Maltese internal audit units, Benchmarking: An International Journal, Vol. 14, No. (6), pp Bou-Raad, G. (2000) Internal auditors and a value-added approach: the new business regime, Managerial Auditing Journal, Vol. 15, No. 4, pp Brody, G. R. and Lowe, D J. (2000) The new role of the internal auditor. Implications for Internal Auditor Objectivity, International Journal of Auditing, ISSN , Management Audit Ltd, 4, pp Cai, C. (1997) On the functions and objectives of internal audit and their underlying conditions, Managerial Auditing Journal, Vol. 12, No. 4, pp

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16 Appendix Table 4: Questionnaire Evaluate the following proposals marking X Pre-acquisition stage The internal audit function: Strongly disagree Disagree Neither agree nor disagree Agree Strongly agree 1. checks the political, economic, social, technical environments 2. estimates the current and forecast financial results 3. measures the financial fit between companies 4. ascertains how to add value 5. estimates the efficiency of treasury function 6. measures the quality of organization structure Post-acquisition stage The internal audit function: 7. checks the authorization of payment 8. creates separate accountable units 9. motivate the personnel through targets 10. finds mechanism to safeguard the assets 11. identifies opportunities to integrate facilities 12. compares outcomes with original goals