An international study of internal audit function quality

We investigate organisational and environmental factors that influence firms’ incentives to develop high-quality internal audit functions (IAFs) by using a unique international sample formed by matching proprietary data from a global internal auditor survey with public data obtained from Worldscope. Concerning organisational factors, we find that a positive relationship exists between IAF quality and firm complexity and confirm that complex firms have a higher demand for monitoring and advising and, therefore, a greater need for formal controls. In addition, IAF quality is positively related to board monitoring and audit committee diligence but negatively associated with CEO power, which suggests that IAF quality is influenced by other key players in corporate governance. Regarding environmental factors, we document that IAF quality is positively associated with industry competition, which implies that a firm’s incentive for a high-quality IAF is enhanced when confronted with greater environmental uncertainty. Furthermore, IAF quality has a significantly positive relationship with our self-constructed index of IAF requirements included in national corporate governance codes, which indicates that strong home-country corporate governance codes play a role in fostering IAF development.     

Earnings management and corporate governance: the role of the board and the audit committee

We examine the role of the board of directors, the audit committee, and the executive committee in preventing earnings management. Supporting an SEC Panel Report's conclusion that audit committee members need financial sophistication, we show that the composition of a board in general and of an audit committee more specifically, is related to the likelihood that a firm will engage in earnings management. Board and audit committee members with corporate or financial backgrounds are associated with firms that have smaller discretionary current accruals. Board and audit committee meeting frequency is also associated with reduced levels of discretionary current accruals. We conclude that board and audit committee activity and their members' financial sophistication may be important factors in constraining the propensity of managers to engage in earnings management.     

Internal audit: A comfort provider to the audit committee

This study, based upon four Belgian case studies, provides insights on (1) what drives the audit committee to look for the support of the internal audit function; and (2) what makes the internal audit function an expert at providing comfort to the audit committee [Pentland, B.T., 1993. Getting comfortable with the numbers: auditing and the micro-production of macro-order. Accounting, Organizations and Society 18 (7–8), 605–620; Carrington, T., Catasús, B., 2007. Auditing stories about discomfort: becoming comfortable with comfort theory. European Accounting Review 16 (1), 35–58]. We found that audit committees seek comfort, with respect to the control environment and internal controls, two areas in which they confront considerable discomfort. Besides the internal audit function's traditional assurance role, its involvement in improving internal controls provides a significant level of comfort to the audit committee. Internal auditors' unique knowledge about risk management and internal control, combined with appropriate inter-personal and behavioural skills, enables them to provide this comfort. Besides, their internal position, their familiarity with the company, and their position close to people across the company facilitate internal auditors being a major source of comfort for the audit committee. Formal audit reports and presentations, together with informal contacts, seem to be important symbols of comfort [Power, M., 1997. The Audit Society: Rituals of Verification. Oxford University Press, Oxford]. In addition, we found that the overall level of comfort to the audit committee can be enhanced via collaboration between internal and external auditing (the so-called ‘joint audit approach’).     

Factors associated with internal audit function involvement with XBRL implementation in public companies: An international study

We examine the relationships of national legal system, company size, and corporate governance quality with internal audit function (IAF) involvement with eXtensible Business Reporting Language (XBRL) implementation in public companies. Our data source is The Institute of Internal Auditors' Global Internal Audit Common Body of Knowledge (CBOK) database, from which we extract responses from 692 chief audit executives (CAEs) for our investigation. We find evidence of differential effects of company size on IAF involvement with XBRL implementation, depending on the national legal system. In civil law countries, IAFs of small companies have significantly higher levels of XBRL involvement than do IAFs of large companies, whereas, in common law countries, IAFs of large companies have higher levels of involvement than do those of small companies. Finally, we find evidence that corporate governance quality is positively associated with IAF involvement with XBRL implementation.     

Understanding the Restatement Process

Much research examines investors' reactions to restatements and the effects of restatements on chief executive officer (CEO), chief financial officer (CFO), and auditor turnover; however, little research explores the process of restating financial reports. In this study, we investigate the process of issuing a restatement. We specifically focus on the interactions among the parties involved (e.g., CFO, board, audit committee, audit partner, and regulators) in determining and ultimately resolving a restatement, as well as the impact of the restatement on the relationships among these parties. We investigate the restatement process via semi‐structured interviews. We immersed ourselves in the restatement process by interviewing all parties typically involved, such as CFOs, auditors, and regulators. Given the findings in the auditor–client management negotiation area, which suggest that negotiation of accounting treatment and disclosure is frequent, our findings indicate that negotiations and/or difficult discussions take place among the parties involved when determining whether a restatement is necessary as well as in achieving the ultimate restatement outcome. Our findings (based on a small sample) suggest that the restatement process may influence or be influenced by such factors as the nature of the misstatement, the party that identified the misstatement, the reaction of the various parties to the misstatement, disagreement among the parties on whether to restate, communication with the regulator, the press release, client size, the personality of the CFO, audit committee strength, and the relationships among the parties subsequent to the restatement.     

Overlapping membership between risk management committee and audit committee and bank risk-taking: Evidence from China

Although overlapping membership between risk management committee and audit committee is prevalent in banks' boards, the existing literature focuses on the impact of a single board committee on bank risk-taking. Using a sample of Chinese listed banks from 2007 to 2020, we examine whether and how overlapping membership between risk management committee and audit committee influences bank risk-taking. The results show that overlapping membership between risk management committee and audit committee reduces bank risk-taking. Furthermore, the risk-averse role of overlapping membership between risk management committee and audit committee is stronger in banks with weaker monitoring intensity and higher information acquisition costs. When exploring the potential channels of monitoring and information, we find that overlapping membership between risk management committee and audit committee helps reduce executive earnings management and make conservative interbank liability decisions. Finally, compared with other overlapping member characteristics, the role of overlapping risk management committee chair and financial experts in reducing bank risk-taking is more evident.     

A Study of the Informal Interactions between Audit Committees and Internal Auditors in Australia

This paper finds evidence for the growing importance of informal interactions between the internal audit function and the audit committee (AC) in Australia – a relatively unexplored topic in the literature – using a survey of Chief Audit Executives (CAEs). It also describes the nature of these informal interactions. The most innovative elements of this paper are the findings that certain personal characteristics of CAEs, the specific knowledge and expertise of the AC chair, as well as some of the AC chair's personal characteristics are associated with the existence (and increase) of informal interactions.     

Former auditors on the audit committee and earnings management: Evidence from African banks

This paper investigates whether former auditors on the audit committee constrain earnings management through loan loss provisions. Based on an analysis of the annual reports of 82 African listed banks over the period 2011–2016, findings show that the presence of former auditors on an audit committee is associated with lower earnings management. This result suggests that audit committee members with auditing expertise and background contribute to effective monitoring of management’s accounting practices. Furthermore, results reveal that the reducing effect on earnings management of former auditors is strongest for directors who are unaffiliated with the bank’s current external auditor.     

Relation between external audit fees, audit committee characteristics and internal audit

This study examines whether the existence of an audit committee, audit committee characteristics and the use of internal audit are associated with higher external audit fees. Higher audit fees imply increased audit testing and higher audit quality. We find that the existence of an audit committee, more frequent committee meetings and increased use of internal audit are related to higher audit fees. The expertise of audit committee members is associated with higher audit fees when meeting frequency and independence are low. These findings are consistent with an increased demand for higher quality auditing by audit committees, and by firms that make greater use of internal audit.     

Internal governance structures and earnings management

This paper investigates the role of a firm's internal governance structure in constraining earnings management. It is hypothesized that the practice of earnings management is systematically related to the strength of internal corporate governance mechanisms, including the board of directors, the audit committee, the internal audit function and the choice of external auditor. Based on a broad cross‐sectional sample of 434 listed Australian firms, for the financial year ending in 2000, a majority of non‐executive directors on the board and on the audit committee are found to be significantly associated with a lower likelihood of earnings management, as measured by the absolute level of discretionary accruals. The voluntary establishment of an internal audit function and the choice of auditor are not significantly related to a reduction in the level of discretionary accruals. Our additional analysis, using small increases in earnings as a measure of earnings management, also found a negative association between this measure and the existence of an audit committee.     

Audit committee composition and the use of an industry specialist audit firm

Independent, competent boards of directors and audit committees are said to be important mechanisms of corporate governance. The purpose of the present study is to empirically examine the association between audit committee composition and audit quality. Specifically, the link between the proportion of non‐executive directors on an audit committee, financial qualifications of directors and the number of audit committee meetings held in a year are investigated and expected to have a positive association with the quality of the audit firm used. Audit quality is proxied by industry specialization. The results support the link between a higher proportion of non‐executive directors on an audit committee and use of an industry specialist audit firm. Other measures of audit committee quality (those with a higher proportion of directors with financial qualifications and those that meet more frequently) are not significantly associated with the use of an industry specialist audit firm. Sensitivity analysis shows that the presence of an audit committee is linked to use of an industry specialist audit firm.     

Changes in audit effort and changes in auditors’ disclosures of risks of material misstatement

This paper investigates whether auditors' year-to-year modification to risks of material misstatements (RMMs) in extended auditors' reports (EARs) are associated with changes in underlying audit effort, as proxied by changes in audit fees. We examine the dynamics of RMMs over time in terms of adding or dropping specific RMMs. Our main results show that, on average, audit fees increase more from the previous year's fees when more RMMs are added to the current year's EAR. This increase is partially offset by dropping RMMs that were disclosed in the previous year, but changes in audit fees are not significantly affected by dropping RMMs without adding new RMMs. Further analysis suggests the effect of added RMMs is attributable to “new” RMMs originating with the auditor and that added RMMs that were previously known, based on related disclosures in the prior year's audit committee report, do not significantly impact on changes in audit fees. Overall, our results suggest that changes in the choice of RMMs included in EARs reflect changes in underlying audit effort.     

The relationship between internal audit and information security: An exploratory investigation

The internal audit and information security functions should work together synergistically: the information security staff designs, implements, and operates various procedures and technologies to protect the organization's information resources, and internal audit provides periodic feedback concerning effectiveness of those activities along with suggestions for improvement. Anecdotal reports in the professional literature, however, suggest that the two functions do not always have a harmonious relationship. This paper presents the first stage of a research program designed to investigate the nature of the relationship between the information security and internal audit functions. It reports the results of a series of semi-structured interviews with both internal auditors and information systems professionals. We develop an exploratory model of the factors that influence the nature of the relationship between the internal audit and information security functions, describe the potential benefits organizations can derive from that relationship, and present propositions to guide future research.     

Is the objectivity of internal audit compromised when the internal audit function is a management training ground?

We conduct an experiment with 74 internal auditors to examine the effects of using the internal audit function as a training ground for future senior managers. Specifically, we investigate internal auditors' willingness to resist current management's aggressive revenue recognition policies, assuming that internal auditors expect to move into senior management positions in the future. We also examine whether increasing the power of the board of directors can reduce threats to internal auditors' objectivity. This is the first study to empirically examine whether training grounds influence internal auditors objectivity. Results of our study indicate that internal auditors are less objective (i.e. they are more likely to side with management's aggressive revenue recognition policies) when they expect to move into senior management positions, relative to when internal auditing is not used as a training ground. We also find that empowering the audit committee further decreases the objectivity of internal auditors. These results suggest that board power can have unintended consequences on the behaviour of internal auditors and that board empowerment does not guarantee improved governance or improved oversight of financial reporting.     

Effects of audit committee chair characteristics on auditor choice,audit fee and audit quality

We investigate whether the characteristics of audit committee (AC) chairs are associated with decisions about auditor choice, audit fees and audit quality. Using hand-collected Australian data, firms with AC chairs who have longer tenure and multiple AC memberships across several boards are found to be more likely to choose Big 4 and/or industry specialist auditors, pay higher audit fees and have lower discretionary accruals. Those AC chairs with higher business qualifications are more likely to hire a Big 4 auditor, pay higher audit fees and have lower discretionary accruals, while AC chairs with professional qualifications are more likely to hire a Big 4 and/or industry specialist auditor. In contrast, firms with AC chairs who are executive directors are less likely to hire a Big 4 auditor and have higher discretionary accruals. Our findings contribute to the literature by documenting that various characteristics of AC chairs are important for enhancement of auditor selection and audit quality.     

Independent audit committee members’ board tenure and audit fees

An independent audit committee is an audit committee on which all members are independent directors. This study examines whether independent audit committee members’ board tenure affects audit fees. On the basis of the prior literature, we formulate an unsigned hypothesis. This is because on the one hand, long board tenure audit committee members (defined as members with board tenure of 10 or more years) have greater incentives to protect their reputational capitals by purchasing increased audit effort, which positively affects audit fees. On the other hand, audit pricing reflects audit committee quality. Long board tenure audit committee members may have less need for increased audit effort because they can effectively oversee the financial reporting process themselves, which negatively affects audit fees. We find that audit fees are negatively associated with the proportion of long board tenure directors on the independent audit committee, consistent with the notion that audit committee members’ long board tenure results in lower audit effort.     

The existence and independence of audit committees in France

This paper uses an agency theory framework to investigate the determinants of audit committees in France. Empirical tests address a cross-sectional sample of 285 listed companies for the fiscal year 1997, which is two years after the first Viénot report recommending the creation of audit committees among listed companies. Multivariate analyses show that the existence of an audit committee, and the committee's independence, are both negatively correlated with insider ownership, consistent with the owner-manager agency theory that considers audit committees as devices aimed at strengthening the monitoring system, the quality of financial reporting and the whole corporate governance environment. The existence of an audit committee that complies with corporate governance recommendations (i.e., a minimum of three directors, all of whom are non-executive directors) also positively depends on leverage if the firm has a high-IOS (Investment Opportunity Set). The quality of accounting numbers thus seems important in shareholder-debtholder relationships if lenders are potentially more exposed to default risk and expropriation mechanisms. However, this result might be sensitive to the IOS measurement and classification of high- and low-IOS companies. Finally, the presence of an audit committee is found to be positively correlated with board size, firm size, auditor reputation, and with the diversity of the company's operations.     

Reputation concerns and herd behavior of audit committees - A corporate governance problem

This paper offers an explanation for audit committee failures within a corporate governance context. The management of a firm sets up financial statements that are possibly biased. These statements are audited/reviewed by an external auditor and by an audit committee. Both agents report the result of their work, the auditor acting first. Both use an imperfect technology that results in a privately observed signal regarding the quality of financial statements. The audit committee as well as the auditor are anxious to build up reputation in the labor market. Given this predominant goal they report on the signal in order to maximize the market’s assessment of their ability. At the end of the game the true character of the financial statements is revealed to the public with some positive probability. The market uses this information along with the agents’ reports to update beliefs about the agents’ abilities. We show that a herding equilibrium exists in which the audit committee “herds” and follows the auditor’s judgement no matter what its own insights suggest. This result holds even if the audit committee members are held liable for detected failure. However, performance based bonus payments induce truthful reporting at least in some cases.     

Internal audit reporting lines,fraud risk decomposition,and assessments of fraud risk

The main purpose of this research is to examine the effects of internal audit reporting lines on fraud risk assessments made by internal auditors when the level of fraud risk varies. Significant emphasis has been placed on the importance of reporting lines in maintaining the autonomy of internal auditors, but the perceived benefits of requiring internal audit to report directly to the audit committee have not been validated or systematically investigated. Results of an experiment involving 172 experienced internal auditors and additional survey findings indicate that internal auditors perceive more personal threats when they report high levels of risk directly to the audit committee, relative to management. Perceived threats lead internal auditors to reduce assessed levels of fraud risk when reporting to the audit committee relative to when reporting to management. This finding runs counter to the anticipated benefits of requirements that the internal audit function report directly to the audit committee, and it reveals potential conflicts of interest and independence threats created by the audit committee itself. We also investigate the effects of fraud risk decomposition on risk assessments made by internal auditors. We find that fraud risk assessment decomposition does not have the same effects on internal auditors as it has on external auditors, and the effects of decomposition do not align with the expected benefits of decomposition.