Auditing Section Research Summaries Space

A Database of Auditing Research - Building Bridges with Practice

This is a public Custom Hive  public

research summary

    Internal Audit Quality and Earnings Management
    research summary posted May 7, 2012 by The Auditing Section, last edited May 25, 2012, 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 
    1191 Views
    Title:
    Internal Audit Quality and Earnings Management
    Practical Implications:

    This study develops an empirical measure of internal audit quality, and provides evidence supporting companies’ use and  development of an IAF as part of improvements to its overall governance environment.  Regulators and other parties interested in corporate governance may find it helpful to more explicitly consider the role of internal auditor in the evaluation of the firm. 

    Citation:

    Prawitt, D., J. Smith, D. A. Wood 2009. Internal Audit Quality and Earnings Management. The Accounting Review 84 (4): 1255-1280.

    Keywords:
    corporate governance; internal audit function; internal audit quality; earnings management; abnormal accruals; analyst forecasts
    Purpose of the Study:

    Standards promulgated by the AICPA and PCAOB recognize the impact that a high-quality internal audit function (IAF) can have on reducing control risk, and by extension, audit risk.  As such, regulators permit and encourage external auditors to rely on the work of others if that work is deemed to be performed by “competent and objective persons” (PCAOB 2007).  Similarly, the Institute of Internal Auditors (IIA) recognizes the IAF as one of the four cornerstones of corporate governance, along with the audit committee, executive management, and the external auditor.  However, while several prior studies establish a negative association between the quality of firm’s corporate governance mechanisms and management’s tendency and ability to manipulate reported financial results, there is little evidence that relies on archival data concerning the impact of a quality IAF on firms’ earnings manipulation activities.

    The purpose of this study is to examine archival data to determine whether differences in the quality of firms’ IAF impact firms’ earnings management activities.

    Design/Method/ Approach:

    The authors rely on the IIA maintained GAIN database (a proprietary database), that is composed of survey responses from chief audit executives associated with IIA member organizations.  Member organizations responding to the survey include publicly traded and private companies, educational and governmental institutions, as well as individual divisions within companies.  The study covers the fiscal years of 2000-2005. 

    The authors create an index based on six factors that SAS No. 65 suggests external auditors should consider when evaluating whether to rely on the work of the internal auditors, and therefore differentiate IAF quality.  Those factors include the IAF’s professional experience, professional certifications, training, objectivity, relevance of their work to the financial reporting function, and the IAF’s relevance to the organization based on how much resources the corporation invests in the IAF group.  To capture management’s earnings management activities, the authors rely on measures of abnormal accruals and whether the firm just misses or beats analysts’ forecasts.

    Findings:
    • Overall, the results suggest that higher quality IAFs reduce management’s ability to manipulate earnings.
    • Specifically, higher quality IAFs appear to be associated with smaller negative abnormal accruals.
    • Companies with higher quality IAFs appear more likely to just miss analysts’ earnings forecasts, a measure of less earnings management.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Governance
    Sub-category:
    Reliance on Internal Auditors, Internal auditor role and involvement in controls and reporting
    Home:
    home button