Does Internal Audit Function Quality Deter Management Misconduct?

Abstract

Standard-setters believe high-quality internal audit functions (IAFs) serve as a key resource to audit committees for monitoring senior management. However, regulators do not enforce IAF quality or require disclosures relating to IAF quality, which is in stark contrast to regulatory requirements placed on boards, audit committees, and external auditors. Using proprietary data, I find that a composite measure of IAF quality is negatively associated with the likelihood of management misconduct even after controlling for board, audit committee, and external auditor quality. This result is robust to a variety of other specifications, including controlling for internal control quality and separate estimation during the pre- and post-SOX time periods. A difference-in-differences analysis indicates that misconduct firms have low IAF quality and competence during misconduct years and improve IAF quality and competence in the post-misconduct years. These findings suggest that regulators, audit committees, and other stakeholders should consider ways to improve IAF quality.

Performance Effects of Internal Audit Characteristics and Relationships in Nigerian Local Governments

“…The findings agree with the resource-based theory that competencies, skills and capabilities of human resource within an organization are critical for organizational performance (Barney, 2001). Also, the study supports Ege (2015) that the quality of internal audit can deter management excesses and contribute to the health of the organization. Thus, the higher the internal audit characteristics, the more the contribution to improved performance of an organization.…”

“…These characteristics enable the internal audit function to add value to an organization through their unique part in governance, risk, and control. Also, these characteristics determine the extent and perception of the quality of an internal audit function (Ege, 2015;Hutchinson & Zain, 2009). A number of studies have found significant relationships between these characteristics and effectiveness of internal audit (Arena & Azzone, 2009;Cohen & Sayag, 2010).…”

Rotational internal audit programs and financial reporting quality: Do compensating controls help?

“…By the IIA's definition, internal audit should bring a ''systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes'' (IIA, 2011a). Standards for the internal auditing profession affirm the IAF's responsibility to monitor financial reporting (e.g., IPPF, 2012) and help detect and deter fraud (e.g., IIA, 2009b;IPPF, 2012), as well as reduce related losses (Coram, Ferguson, & Moroney, 2008;Ege, 2015;KPMG, 2003;Norman et al, 2010).…”

“…While this spectrum of rotational programs exists in practice, prior academic literature has focused on the first two types of programs and examined how internal auditors' ultimate goal of obtaining a management position outside of internal audit likely impacts his/her effectiveness as an internal auditor. Both academics and practitioners refer to these types of rotational programs as ''management training grounds'' (i.e., MTGs) because one of their main purposes is developing future managers' skills by working in internal audit (e.g., Burton, Starliper, Summers, & Wood, 2015;Ege, 2015;IIA, 2013;Messier et al, 2011;Rose et al, 2013).…”

“…In addition, internal audit is expected to help prevent and detect fraudulent financial reporting (IIA, 2009b;IPPF, 2012) and otherwise constrain aggressive financial reporting (KPMG, 2003;Prawitt, Sharp, & Wood, 2012;Prawitt, Smith, & Wood, 2009;Ege, 2015;Norman, Rose, & Rose, 2010). 1 However, internal audit functions use a variety of staffing models to fulfill their responsibilities, including a range of systematic rotational programs.…”