Should the Internal Audit director opt f

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DV450- 66902

November 27th_{, 2017}

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Subject: Principal-Agent framework applied to the Internal Audit of Mexico’s State-owned Electricity Company.

Specific Question:

Should the Internal Audit director opt for a top-down or bottom up approach in order for the Audit Plan to fight corruption and increase accountability?

Executive Summary: Corruption is a complex problem in Mexico. It happens in both the procurement process and in public works, where it is estimated that the government pays on average 20% more for procurement than private firms do (UNDOC, 2013; Garfias, 2015). According to Transparency International (2016), the perceived level of corruption in the public sector is 30 out of 100, with zero being highly corrupt. The Internal Audit (IA) director of the CFE (Federal Electricity Commission) needs to decide whether the new Audit Plan should have a top-down or bottom up approach. Specifically, given the issues of asymmetric information and moral hazard highlighted by the principal-agent, he should ask himself which approach can better tackle corruption and increase accountability, while also signaling that there is a trustworthy relation between the audits (agent) and the principals (stakeholders). This is a real question and there is no easy solution for this argument.

Background: In December 2013, the Mexican Congress approved the Energy Reform, which aimed to end the monopoly

in the Electricity Sector by transforming CFE from a state-owned company to a semi-public company. The Reform allowed the Internal Audit to be independent from the Federal Audit Ministry (ASF), and instead be accountable to the company’s stakeholders (board of public servants and prominent citizens). They appoint the Internal Audit director to perform the auditing and monitoring of the company.

Principal-Agent Framework and the role of the Internal Audit. IA’s play a central role in creating accountability by monitoring the board of directors and reporting to stakeholders. An IA “provides an independent check on the work of agents and of the information provided by an agent, which helps to maintain confidence and trust” (Maslen, 2005:7). In the CFE, the IA is created as an independent party to solve the asymmetric information problem between the principals (CFE’s stakeholders) and the agents (CFE’s board of directors). However, the IA is also an agent who reports to the stakeholders. On one hand, the IA must maintain independence from other agents (board of directors) to gain the stakeholders’ trust, while creating a cordial and trustworthy relation with the board of directors to reduce information asymmetries and successfully monitor the agents (Maslen, 2005).

Conflict of Interest, and Moral Hazard. Before the Energy Reform, the principal was the ASF while the agent was the IA director. There was a conflict of interest because the CEO of the company appointed the IA director. Therefore, the IA had an incentive to act against the will of the principal (ASF) by miss reporting information. This caused asymmetric information, in favor of the other agents (board of directors) and the incentives of the IA (agents) and the ASF (principals) were not aligned. Consequently, this lead to moral hazard where the IA had more information about the company but was not incentivized to respond to the principal’s interests since their paycheck and allegiance were with the CEO (Maslen, 2005; Denmbe,2000). There is empirical evidence from the Third-party audits (J-Pal 2013) study, which stated that when auditors are appointed and paid by the firm which they are auditing, the auditors have incentives to miss-report.

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Top-down vs. bottom-up approach. The IA director of the CFE needs to decide how to conduct the New Audit Plan,

which can either be a top-down or a bottom-up approach. The main aspects, advantages and disadvantages are outlined below:

•

Top

–

down

. The authoritative decisions are “centrally located” by the principals who seek to produce a “desired effects” (Matland, 1995:46). In this approach, the IA director decides to continue with the previous audit system where the planning and design of the audit was “centrally located” by the ASF. The traditional fields would be audited according to the National Audit Plan, and then adapted to the CFE. Advantage. Firstly, the stakeholders can ensure that the audits are independent and not schemed by the directors, making the recommendations more relevant than before the Reform. Secondly, the company is used to the top-down monitoring, so its implementation will not be a challenge. Disadvantage. The top-down approach continues to focus on auditing the procedures rather than the outcomes. For example, in procurement audits, the auditors revise if the procedure of buying complies with the regulation, rather than revising if the good was bought at a competitive price (Bromilow, 2011; UNDOC, 2013).

•

Bottom

–

up

. This approach focuses on the company’s own risks and necessities. The IA director would create the New Audit plan with three main inputs. Firstly, the risk map of the company, where the susceptible processes of corruption are mapped based on total budget expenditure. An example would be to audit the procurement process across the different administrative areas focusing in the total expenditure of buying the goods. Secondly, the stakeholder concerns and experiences could be highlighted through the risk map. Thirdly, a focus group with grassroots auditors, who are the actual implementers of the Audit Plan. They have experience and knowledge on the day to day activities of the company and could suggest susceptible areas and process where corruption takes place (Bromilow, 2011; Olken, 2007). Advantages. Firstly, the Audit Plan with be built according to the specific necessities and risks of the CFE. Secondly, evidence state that a best practice is when audits are based upon the knowledge of grassroots auditors (Matland, 1995; Olken, 2007). Thirdly, the increase in communication between the principal and the agent strengthen the trust and can reduce information asymmetries. Disadvantages. Firstly, evidence also states that enforcing a bottom-up approach is complicated since there are no clear and consistent goals (Elder, 2011). Secondly, since the opinion of different actors is considered there is a dilution of responsibility with no clear rules established. Thirdly, the implementation is challenging since it is complex and new for both auditors and the institution.

Policy recommendations and conclusions. Based on the previous arguments the policy recommendation is that the

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References:

Bromilow, C. and Keller, D. (2011), Comités de Auditoria: Mejores prácticas para aumentar su efectividad, Price Water House Coppers.

Dembe, Allard E. and Boden, Leslie I. (2000). "Moral Hazard: A Question of Morality?", New Solutions 2000 10(3), 257- 279.

Elder, C. et. Al. (2011) Top-down and Bottom-up Approaches within Implementation, political pipeline.

Ferraz, Claudio and Frederico Finan. 2008. “Exposing Corrupt Politicians: The Effects of Brazil’s Publicly Released Audits on Electoral Outcomes.” Quarterly Journal of Economics 123 (2): 703-745.

Garfias (2015) Corrupción en las compras gubernamentales, Nexos, https://www.nexos.com.mx/?p=26157

J-PAL Policy Briefcase. 2013. “Truth-Telling in Third Party Audits”. Abdul Latif Jameel Poverty Action Lab

Maslen, L. (2005) Agency Theory and the Role of the Audit, Audit Quality, UK.

OECD (2017), OECD Public Governance Reviews. Mexico's National Auditing, Mexico City.

Olken, Benjamin A. 2007. “Monitoring Corruption: Evidence from a Field Experiment in Indonesia.” Journal of Public Economics 115 (2): 200-249.

UNODC(2007), Transparencia, Objetividad y Competencia en las Contrataciones Públicas, Oficina de las Naciones Unidas contra la Droga y el Delito,

https://unodc.org/documents/mexicoandcentralamerica/publications/Transparencia_Publicas.pdf