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    Internal Audit Quality and Financial Reporting Quality: The...
    research summary posted October 12, 2016 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
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    Title:
    Internal Audit Quality and Financial Reporting Quality: The Joint Importance of Independence and Competence
    Practical Implications:

     This study is the first to establish IAF characteristics as separate, distinct constructs that act jointly in creating IAF quality; therefore, it contributes to the overall understanding of IAF quality and the determinants of the IAF as an effective internally based financial reporting monitor.

    Citation:

     Abbott, L. J., B. Daugherty, S. Parker and G. F. Peters. 2016. Internal Audit Quality and Financial Reporting Quality: The Joint Importance of Independence and Competence. Journal of Accounting Research 54 (1): 3-40.

    Purpose of the Study:

     In 2013, the NASDAQ Stock Market LLC (NASDAQ) proposed a rule change that would require all NASDAQ registrants to maintain an internal audit function (IAF). The New York Stock Exchange (NYSE) has required all registrants to maintain an IAF since 2006. The thinking behind these requirements is that an effective IAF provides the audit committee and other financial reporting stakeholders with critical information pertaining to a company’s risks and internal controls. Corporate governance proponents also emphasize the IAF’s role in enhancing financial reporting quality; however, despite having many proponents the IAF’s role in the financial reporting process is not yet fully understood and empirical evidence concerning the impact of IAF quality is minimal. As a result of this lack of evidence, the authors investigate the potential impact of IAF quality as a joint function of the IAF’s competence and independence. They base this view upon theoretical work stating that external audit quality is a function of the external auditor’s ability (competence) to detect accounting misstatements and willingness (independence) to oblige proper accounting treatments.

    Design/Method/ Approach:

    In this paper, the authors develop and test a two-factor model of IAF quality as a function of the IAF’s ability to prevent/detect financial misstatements (competence) and its inclination to report the misstatements to the audit committee and/or external auditor (independence). The study uses survey evidence from 189 Chief Internal Auditors from Fortune 1000 companies during fiscal 2009.

    Findings:
    • The authors’ overall results provide evidence consistent with the hypothesis that the combined presence of both competence and independence is a necessary antecedent to effective IAF financial reporting.
    • The authors find results consistent with independence being enhanced by relatively greater degrees of audit committee oversight of the IAF, as opposed to management oversight.
    • The authors find that enhanced independence interacts with IAF competence as a means of curtailing financial reporting discretion in both income-increasing and income-decreasing environments. A similar set of relationships were documented when the authors interact IAF competence and the relative lack of IAF outsourcing.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Governance
    Sub-category:
    Internal auditor role and involvement in controls and reporting, Reliance on Internal Auditors