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    The Role of the Internal Audit Function in the Disclosure of...
    research summary posted March 4, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of Weaknesses 
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    Title:
    The Role of the Internal Audit Function in the Disclosure of Material Weaknesses
    Practical Implications:

    Results indicate that the education level of IAF staff and the extent to which the IAF incorporates quality assurance techniques into fieldwork, audits activities related to financial reporting, and monitors the remediation of previously identified control problems are negatively associated with MW disclosures.

    The timing of Section 404 work and the nature of follow-up monitoring suggest that these aspects of IAF quality help prevent the existence of MWs. The IAF practices of grading audit engagements and coordinating with external auditors are both positively associated with MW disclosures. The positive relations suggest that these activities increase the effectiveness of Section 404 compliance processes and thereby increase the likelihood that extant MWs will be detected and disclosed. Together, this study’s results have important implications for managers responsible for determining IAF staffing and the structure of IAF activities, external auditors who perform Section 404 work, and standard-setters who provide Section 404 guidance. Moreover, the evidence that the IAF affects the financial reporting process lends support to the requirement that NYSE-listed companies maintain an internal audit function

    For more information on this study, please contact Shu Lin.

    Citation:

    Lin, S., M. Pizzini, M. Vargus, and I. R. Bardhan. 2011. The Role of the Internal Audit Function in the Disclosure of Material Weaknesses. The Accounting Review 86 (1): 287-323. 

    Keywords:
    internal audit function; material weakness; corporate governance; internal control over financial reporting
    Purpose of the Study:

    This study investigates the role that a firm’s internal audit function (IAF) plays in the disclosure of material weaknesses reported under Section 404 of the Sarbanes-Oxley Act of 2002. Despite the IAF’s duties surrounding internal control over financial reporting (ICFR), few researchers have empirically investigated the IAF’s role in the financial reporting process. A notable exception is a recent study by Prawitt et al. (2009), which provides evidence that the IAF can improve reporting quality by mitigating potential weaknesses in incentive system design. This study complements theirs, in that the authors examine the association between the IAF and ICFR through prevention and detection of material weaknesses. Accordingly, it helps fill an important gap in the literature regarding the influence of the IAF on the quality of the financial reporting process.

    Design/Method/ Approach:

    To examine the relation between material weakness (MW) disclosures and various IAF attributes and activities, the authors conduct the tests using data on 214 firms that provided detailed responses to the IIA’s Global Auditing Information Network (GAIN) survey for 2003–2004. 45 firms that disclosed at least one MW under SOX Section 404 are identified.

    The researchers draw on Prawitt et al. (2009) and professional guidance to develop measures of IAF quality (AICPA 1991; IIA 2008). These suggest that IAF quality measures encompass (1) competence, (2) objectivity, (3) relative investment in the IAF, and (4) the nature and scope of IAF activities. The authors group the first three measures together as IAF attributes because these three address the characteristics of organizations performing internal audit activities. The last construct, the nature and scope of IAF activities, captures IAF practices that are guided by Performance Standards.

    Findings:

    The sample contains a high concentration of firms in regulated industries, and the sample firms are significantly larger, older, and more profitable than those in the Compustat universe. Approximately 21 percent of our sample firms disclosed at least one material weakness during the period November 2004 through December 2006.

    Univariate tests of differences between the partitions indicate that material weakness firms are more likely to have internal auditors that issue grades in their audit reports, and have fewer financial reporting activities audited by their internal auditors. Consistent with prior research, material weakness firms have significantly higher incidences of restructuring activities and losses, lower cash flows from operations, and higher bankruptcy risk.

    There is significant correlation between IAF attributes and activities, and little support for associations between MW disclosures and the IAF quality attributes of competence, objectivity, and IAF investment. However, there is a strong support for associations between MW disclosures and the following IAF activities. Firms with IAFs that follow-up on extant control problems are significantly less likely to report a material weakness. It is also found that firms are significantly more likely to report a material weakness when the IAF coordinates audit activities with the external auditors.

    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses, Impact of 404 on Fees and Financial Reporting Quality, Reporting Material Weaknesses