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Firm
Can internal audit functions operational
improve firm operational efficiency

efficiency? Evidence from China

Ying Chen 1167
International Business College, South China Normal University, Guangzhou, China
Received 12 January 2019
Bin Lin and Lizhen Lu Revised 10 December 2019
1 May 2020
Sun Yat-sen Business School, Centers for Accounting, Finance and Institutions, 5 July 2020
Accepted 20 July 2020
Sun Yat-sen University, Guangzhou, China, and
Gaoguang Zhou
Department of Accountancy and Law, Hong Kong Baptist University,
Kowloon, Hong Kong

Abstract
Purpose – The purpose of this study is to examine the effects of internal audit function (IAF) quality on the
operational efficiency of Chinese firms.
Design/methodology/approach – The authors use regression models with a sample of Chinese listed
companies to test their research hypotheses.
Findings – The authors find that IAF quality is positively associated with firm operational
efficiency. The result is unchanged after correcting for endogeneity via the instrumental variable
method and using an alternative measure of firm operational efficiency. The authors show that IAF
competence improves firm operational efficiency, but the relationship between IAF independence and
firm operational efficiency is insignificant. Additionally, they find that IAF quality can only
significantly improve firm operational efficiency in the presence of effective corporate governance at
the firm level and strong institutions at the province level. Using path analysis, the authors find that
an IAF can improve firm operational efficiency directly or indirectly by promoting firm internal
control quality.
Practical implications – The findings of this study suggest the need for a balance between IAF
competence and independence to achieve the goals of IAF. Additionally, the authors study suggests that the
effectiveness of IAF is contingent on corporate governance and market-based institutions.
Originality/value – The study’s findings contribute to the burgeoning literature on the relationship
between IAF and firm operational performance and deepen the authors’ understanding of the role of IAF in an
emerging economy whose government plays a major role in promoting and enforcing internal audits. The
study also empirically support the Internal Audit Governance Maturity Model proposed by the Institute of
Internal Auditors.
Keywords Corporate governance, Internal audit function, Operational efficiency,
External institutions
Paper type Research paper

The authors acknowledge financial supports from The National Natural Science Foundation of China Managerial Auditing Journal
Vol. 35 No. 8, 2020
under Grant #71802199 and 71332004, The National Social Science Fund of China under Grant pp. 1167-1188
#18VSJ082 and The Famous Accounting Training Project under Grant # [2016] No.15, the Ministry © Emerald Publishing Limited
0268-6902
of Finance, China. DOI 10.1108/MAJ-01-2019-2136
MAJ 1. Introduction
35,8 The important role played by internal audit function (IAF) in financial reporting and
corporate governance is widely recognized by regulators around the world. In the UK, for
example, the Cadbury Committee recommended in early 1992 that firms establish IAF to
ensure effective governance (Cadbury Committee, 1992). In the USA, after the Enron
scandal, the New York Stock Exchange (NYSE) and the National Association of Securities
1168 Dealers Automated Quotations began requiring listed firms to establish IAF in 2003 and
2013, respectively (Securities and Exchange Commission (SEC), 2003, 2013). In China, our
study’s setting, listed firms have been required to establish IAF since 2006.
Given the importance of IAF, as evidenced by the above global regulations, several
studies have examined the effectiveness of IAF at the firm level. These studies show that a
high-quality IAF can constrain earnings management (Prawitt et al., 2009), improve
financial reporting quality (Christ et al., 2015; Abbott et al., 2016), enhance the effectiveness
of internal control of financial reporting (Lin et al., 2011), deter management misconduct
(Ege, 2015) and reduce fraud risk (Norman et al., 2010). In addition, IAF can assist external
auditors in evaluating financial report quality, leading to lower external audit fees (Felix
et al., 2001) and higher audit efficiency (Dezoort et al., 2001; Messier et al., 2011; Lee and
Park, 2016). In a study closely related to ours, Cho et al. (2015) find no evidence that statutory
internal auditors’ compensation and expertise are positively associated with firm
operational efficiency. However, Jiang et al. (2019) show, using global data, that IAF
operations related services play a role in improving firm operational efficiency [1].Our study
extends prior studies by examining the influence of IAF on firm operational efficiency in
China, the world’s largest emerging economy.
Unlike the governments of Western countries, China’s Government plays both a
supervisory and an advisory role in promoting internal audit practices. Internal auditing
was initially developed in the 1980s in China as a supplement to state audits, supervised by
governmental auditing authorities (Cooper et al., 2006). However, China has since converged
with international internal audit standards and gradually expanded the function of internal
audits from financial reporting assurance to managerial advice. Currently, all listed
companies in China are required to establish IAF, and the government can influence internal
audit practices by issuing internal audit standards and verifying the effectiveness of
internal audits. Using China as a setting, we can advance our understanding of the effect of
IAF on firm operational efficiency in an emerging economy whose government has a major
influence on internal auditing practices.
International internal auditing standards require IAF to play a consulting role and
improve firm operational efficiency (The Institute of Internal Auditors (IIA), 1999, 2016).
Consistent with these standards, several studies show that IAF improves firm operational
efficiency by providing strategic recommendations and evaluating the effectiveness of risk
management (Burton et al., 2012; Carcello et al., 2017; Jiang et al., 2019). China’s internal audit
standards also require internal auditors to improve firm operational efficiency (China
Institute of Internal Audit [CIIA], 2013), and this requirement is enforced by the government.
Accordingly, we hypothesize that IAF quality improves firm operational efficiency in China.
We further consider the effects of two aspects of IAF quality, namely, competence and
independence, on firm operational efficiency. While we predict that IAF competence
improves firm operational efficiency because more competent internal auditors can better
acquire and analyze the information necessary for operational decisions, We cannot predict
a directional relationship between IAF independence and firm operational efficiency, as IAF
independence may improve operational efficiency via its monitoring function, whereas on
the other hand, stressing monitoring function of IAF may deter managers from consulting
internal auditors, weakening the effect of IAF on firm operational efficiency. We also Firm
hypothesize that better corporate governance and institutions strengthen the relationship operational
between IAF quality and firm operational efficiency, primarily because they deter managers
from engaging in misconduct and ensure that IAF has enough time and resources to provide
efficiency
consulting services for managers.
We test our hypotheses using a sample of Chinese listed firms. We obtain IAF data from
the 2014 survey on corporate governance by the China Securities Regulatory Commission
(CSRC). The survey comprised multiple questions regarding listed companies’ corporate 1169
governance, including IAF characteristics, over the previous three years (i.e. 2011–2013). We
combine these IAF data with financial data from the China Stock Market and Accounting
Research (CSMAR) database and the Wind database. Based on a sample of 2,889 firm-year
observations over the 2011–2013 period, we find that IAF quality is positively associated
with firm operational efficiency, consistent with our hypothesis. The result is unchanged
after correcting for endogeneity via the instrumental variable method and using an
alternative measure of operational efficiency measure. Even more interestingly, we show
that IAF competence improves firm operational efficiency, whereas the relationship between
IAF independence and firm operational efficiency is insignificant. Additionally, we find that
the effect of IAF quality on firm operational efficiency can only be observed in firms with
effective corporate governance and those located in provinces with high-level market-based
institutions. Using path analysis, we find that IAF improves firm operational efficiency both
directly and indirectly by promoting firm internal control quality.
Our study makes several contributions to the literature. First, it contributes to the
burgeoning literature on the relationship between IAF and firm operational performance.
The prior IAF literature focuses primarily on the contribution of IAF to the financial
reporting (Prawitt et al., 2009; Norman et al., 2010; Lin et al., 2011; Christ et al., 2015; Ege,
2015; Abbott et al., 2016), paying less attention to the role of IAF in improving firm
operational efficiency. The two most notable exceptions are Cho et al. (2015) and Jiang et al.
(2019). However, we examine the influence of overall IAF quality on operational efficiency,
whereas Jiang et al. (2019) focus on IAF’s operations-related services and Cho et al. (2015)
focus on the compensation and expertise of statutory internal auditors. Our study
complements and extends theirs by using Chinese data to show how IAF improves firm
operational efficiency. Additionally, our findings suggest that a balance between IAF
competence and independence is necessary to achieve the goals of IAF.
Second, our study empirically verifies the Internal Audit Governance Maturity Model
proposed by the Institute of Internal Auditors (The Institute of Internal Auditors [IIA], 2006)
by showing that the effectiveness of IAF varies with an organization’s governance practices.
The IIA (The Institute of Internal Auditors (IIA), 2006) asserts that the effectiveness of an
IAF is primarily influenced by the maturity of organizational governance. It expects internal
auditors to place more emphasis on specific governance-related issues than compliance and
basic organizational risks when organizational governance is mature (The Institute of
Internal Auditors (IIA), 2006, p. 4) [2]. However, no prior studies have tested this hypothesis.
Our study suggests that IAF quality improves firm operational efficiency only when firms’
corporate governance is mature. It thus lends empirical support for the IIA’s (2006)
hypothesis, with important implications for IAF practitioners responsible for making
decisions on allocating effort.
Finally, our study deepens our understanding of the effectiveness of IAF in improving
firm operational efficiency in an emerging economy whose government plays a major role in
promoting and enforcing internal audits. We show that the effectiveness of IAF is affected
by the regional institutions of the country. Given that in many emerging economies,
MAJ institutions are under-developed and the degree of institutional development is uneven, our
35,8 findings provide policy implications for the emerging economies with institutional
backgrounds similar to China’s.
The remainder of this paper is organized as follows. Section 2 introduces the institutional
background of IAF in China. Section 3 reviews the literature and develops our hypotheses.
Section 4 outlines our research design. Section 5 reports the empirical results. Section 6
1170 concludes the study.

2. Background of internal auditing in China

China’s IAF practices are strongly influenced by the government, which plays both a
supervisory and an advisory role in management of IAF. China’s IAF was initially
developed in the 1980s as a supplement to state audits. At that time, IAF fell under the
supervision of government auditing authorities and their goals was to protect state assets
and to ensure compliance with state laws and regulations (Cooper et al., 2006). In 1994, the
government enacted the Law of Auditing, which stipulates that governmental audit
institutions have the authority to supervise and provide professional guidance for state-
owned enterprises and non-governmental organizations. The National Audit Office of the
People’s Republic of China (CNAO) issued a regulation in 1995 that requires non-state-
owned enterprises to establish IAF in accordance with their needs. In 2006, the Shanghai
Stock Exchange and Shenzhen Stock Exchange issued a set of internal control guidelines
that require all Chinese listed firms to establish internal audit departments to oversee their
internal control systems. Since then, internal auditing in China has been viewed as an
important corporate governance mechanism for strengthening internal control and risk
management in listed companies.
In 2008, the CNAO issued the Audit Development Plan of the Audit Office from 2008 to
2012, which requires government audit institutions to conduct more performance audits. In
2011, the People’s Bank of China issued the Plan for Internal Audit Work Transformation
from 2011 to 2013, which identifies performance audits as one of the main elements of
internal audit transformation. Such audits were expected to improve the efficiency of firms’
resource utilization and help them to achieve operational objectives. In 2013, the China
Institute of Internal Audit (CIIA) issued internal audit standards in which improving
organizational performance is identified as the key objective of IAF (China Institute of
Internal Audit [CIIA], 2013). To further strengthen the internal audit operation and converge
with international internal audit standards, the CNAO issued Regulations of the Audit
Office on Internal Audit in 2018. These regulations further stressed the role of internal
auditing in improving corporate governance and firm operational efficiency.

3. Literature review and hypothesis development

International internal audit standards define an IAF as an independent, objective assurance
and consulting function designed to add value to an organization and improve its
operational efficiency [IIA, 1999; IIA, 2016). Several experimental studies show that
consistent with their stated objective, IAF directly improves firms’ operational efficiency by
providing strategic recommendations and evaluating the effectiveness of the firms’ risk
management (Burton et al., 2012; Carcello et al., 2017). Regarding the advisory role of IAF,
Jiang et al. (2019) provide archival evidence that internal audit operations related services
are significantly and positively associated with operating performance. In China, the idea of
using IAF to improve organizational objectives had been developed and put into practice
many years before 2013, as discussed in the previous section. Additionally, China’s internal
auditing standards formally require internal auditors to improve firm operational efficiency
(China Institute of Internal Audit [CIIA], 2013) and the government enforces these standards Firm
in several ways. Accordingly, it is plausible to expect high-quality IAF to improve firm operational
operational efficiency in China. Our first hypothesis is therefore as follows: efficiency
H1a. There is a positive association between IAF quality and firm operational
efficiency.
In contrast to prior studies (Cho et al., 2015; Jiang et al., 2019), we examine the effects of the 1171
two key aspects of IAF quality on firm operational efficiency. Auditing standards and
empirical studies show that competence and independence are important elements of the
quality of IAF (AICPA, 1991; IIA, 2016) and that both factors influence financial reporting
quality (Abbott et al., 2016). However, we argue that these two components have different
effects on firm operational efficiency.
An IAF is competent when its internal auditors have sufficient expertise, knowledge and
skills to carry out internal audits effectively (Prawitt et al., 2009; Lin et al., 2011; Abbott et al.,
2016). We argue that IAF competence can improve firm operational efficiency in the
following ways. First, more competent internal auditors (i.e. those with a higher educational
level) are better able to acquire and analyze relevant information (Lai and Liu, 2018). Hence,
they are more likely to identify opportunities to improve firms’ operational efficiency by
assessing potential risks, enhancing cost savings or increasing firm operational
effectiveness (Anderson, 2003). Second, more competent internal auditors can better respond
to the needs of managers and provide constructive recommendations to support their
decision-making. In summary, we expect IAF competence to be positively related to firm
operational efficiency. We formally state this hypothesis as follows:

H1b. There is a positive association between IAF competence and firm operational
efficiency.
However, the relationship between IAF independence and firm operational efficiency is ex
ante unclear. On the one hand, IAF independence can improve financial reporting quality
(Dezoort et al., 2002; Ege, 2015) and the efficiency of internal control (Fadzil et al., 2005), both
of which can increase firm operational efficiency (Biddle et al., 2009; Cheng et al., 2018). On
the other hand, high IAF independence may adversely affect firm operational efficiency for
the following reasons. First, independent internal auditors may lack firm-specific knowledge
related to operations and therefore may be unable to provide managers with useful advice
on improving firm operational efficiency. Additionally, stressing the monitoring function of
IAF by upholding IAF independence may deter managers from consulting internal auditors,
similar to the paradox described by Adams and Ferreira (2007) in the board setting.
Managers are reluctant to share information with a board that has more independent
directors, because doing so will invite monitoring from the board (Adams and Ferreira,
2007). As such, a firm that demands more advice from its board is likely to engage fewer
independent board directors (Duchin et al., 2010; Faleye et al., 2011). These arguments can
also be applied to the IAF setting, because IAF, like a board of directors, plays the dual role
of monitor and consultant. To the extent that consulting internal auditors may invite more
intense monitoring from these auditors, increasing IAF independence may discourage
managers from sharing information with the IAF, adversely affecting its consulting
function and weakening its role in improving firm operational efficiency [3].Therefore,
whether IAF independence affects firm operational efficiency becomes an empirical research
question.
MAJ We go on to examine the moderating influence of corporate governance on the
35,8 relationship between IAF quality and firm operational efficiency. The IIA (2006)
expects internal auditors to place more emphasis on specific governance-related
processes than compliance and basic organizational risks when an organization’s
governance is more mature (IIA, 2006, p. 4). We provide additional arguments to
explain why the presence of effective corporate governance may influence the
1172 effectiveness of IAF. First, firms with effective corporate governance set the tone at the
top and establish mechanisms to support IAF in performing its advisory role (Arena
and Azzone, 2009; Cohen and Sayag, 2010; Jiang et al., 2018). For example, firms with
effective governance may be able to devote more of their budget to supporting the IAF
(Barua et al., 2010; Anderson et al., 2012) and encouraging it to provide advice for
managers. Second, effective corporate governance can mitigate financial reporting
risks and give IAF more time to advise managers. IAF is required both to ensure the
compliance of financial reporting and to provide consulting services for managers. As a
result, the time spent ensuring compliance may crowd out the time providing
consulting services. To the extent that effective corporate governance is associated
with improved financial reporting quality, as evidenced by a lower incidence of fraud
(McMullen, 1996; Abbott et al., 2000; Beasley et al., 2000; Farber, 2005), fewer
restatements (Abbott et al., 2004) and lower levels of earnings management (Klein,
2002; Xie et al., 2003; Bédard et al., 2004), we expect that, all else being equal, IAF can
focus more on providing consulting services and therefore improving firm operational
efficiency when effective corporate governance is in place. We formally state this
hypothesis as follows:

H2. The association between IAF quality and firm operational efficiency is stronger for
firms with more effective corporate governance.
The institutional environment is likely to affect IAF practices (IIA, 2016). In China, the
institutional environment varies across regions (Fan et al., 2007; Kusnadi et al., 2015),
which allows us to test the moderating effect of institutions on the relationship between
IAF quality and firm operational efficiency. We use the market development index (Fan
et al., 2011) to capture institutional factors. In a weak institutional environment, IAF
must allocate a large amount of time to compliance activities because of the prevalence
of misconduct (Wang and Yan, 2010). Conversely, strong institutions can improve
audited financial reporting quality (Francis and Wang, 2008; Gul et al., 2013) and
therefore give IAF sufficient time to provide consulting services for managers.
Additionally, strong institutions deter managers from pursuing private benefits at the
expense of shareholders (La Porta et al., 2000), and may encourage them instead to work
closely with internal auditors to improve firm performance, seeking to obtain higher
pay and promotion opportunities. Similar to H2, we argue that corporate leaders in
regions with stronger institutions are more likely to support IAF to improve
operational efficiency. Hence, our final hypothesis is as follows:

H3. The association between IAF quality and firm operational efficiency is more
prominent for firms located in provinces with stronger institutions.
In summary, our hypotheses focus on the relationship between IAF quality and operational
efficiency and the factors that moderate this relationship. To better illustrate our
hypotheses, we summarize them in Figure 1.
 Firm
IAF Quality operational
Competence Independence
efficiency

Corporate H2 H3 Institutional
H1b H1a 1173
Governance Environment

Firm Operational Efficiency Figure 1.

Hypothetical model

4. Research design
4.1 Sample selection
To examine our hypotheses, we construct our sample by merging various datasets. First, the
data used to measure IAF quality are collected from the CSRC’s 2014 survey on corporate
governance. The survey consisted of several questions regarding listed companies’
corporate governance (including IAF) over the previous three years (2011–2013). The CSRC
distributed the questionnaires to all 2,526 Chinese listed companies in 2014 and required the
firms to complete the survey [4]. The CSRC received valid responses from 2,154 firms,
yielding a high response rate of 84.95%. The questions regarding IAF are listed in
Appendix 2.
The institutional environment data are obtained from the National Economic Research
Institute (NERI) market development index. The corporate governance variables and control
variables are from the CSMAR and Wind databases. Our initial sample consists of all
Chinese A-share listed firms in the 2011–2013 period. After eliminating firm-year
observations from the financial and utilities industries and observations with missing
information for some of the variables, our final sample consists of 2,889 firm-year
observations. Finally, all of the continuous variables are winsorized at the top and bottom
1% to control for outliers.

4.2 Regression model

To test the relationship between high-quality IAF and firm operational efficiency, we
estimate the following model:
X
OEFFit ¼ a0 þ a1 IAFit þ CONTROL þ « (1)

X
OEFFit ¼ a0 þ a1 COMPit ðINDEPit Þ þ CONTROL þ « (2)

where OEFFit refers to the operational efficiency of firm i in year t. Following Cheng et al.
(2018), we use data envelopment analysis (DEA) to construct a measure of firm operational
efficiency based on seven input indicators and one output indicator [5]. This measure
captures the relative operational efficiency of a firm compared with other firms that lie in the
efficient frontier determined by the optimization program. DEA has advantages over a
conventional efficiency approach, as it is non-parametric and does not require a functional
MAJ relationship between inputs and outputs or a prior weighting of inputs (Demerjian et al.,
35,8 2012; Cheng et al., 2018). Specifically, we use REVENUEit (sales revenue) as the output
indicator because it is a primary source of the earnings and cash flows generated from firms’
operating activities (Demerjian et al., 2012; Cheng et al., 2018). The seven inputs used are as
follows:

1174 (1) PPEit (net fixed assets);

(2) INVit (net inventory);
(3) COGSit (costs of goods);
(4) SG&Ait (selling and administrative expenses);
(5) R&Dit (research and development expenditures);
(6) GOODWILLit (net goodwill); and
(7) INTANGIBLE it (net intangible assets).

Using DEA, we calculate the overall operating efficiency for each firm-year observation
based on the above inputs and output.
Five individual indicators measure different aspects of IAF quality. To capture the
commonalities of these indicators under the umbrella of a single construct (Bushman et al.,
2004), we conduct principal component analysis (using the first principal component) to
construct a composite IAF quality measure, IAFit. Following Kolenikov and Angeles (2004),
we construct IAFit based on the following five indicators:
(1) INDEPit (IAF independence, an indicator variable equal to 1 if the Chief Audit
Executive (CAE) functionally reports to the board of directors or audit committee
(Prawitt et al., 2009) in year t, and 0 otherwise);
(2) CAE_EDUit (the CAE’s educational background, an indicator variable equal to 1 if
the CAE holds a bachelor’s degree or above, and 0 otherwise);
(3) DEP_EDUit (the percentage of internal auditors with a bachelor’s degree or above
in the internal audit department);
(4) SALARY it (the average compensation of internal auditors from the internal audit
department); and
(5) CAE_CERTit (an indicator variable equal to 1 if the CAE is professionally certified,
and 0 otherwise).

We also construct a measure of IAF competence (COMPit) from the last four indicators
discussed above, using principal component analysis (with the first principal
component).
CONTROL refers to the determinants of firm operational efficiency identified in previous
studies (Demerjian et al., 2012; Cheng et al., 2018). We control for 11 variables, which are
defined in detail in Appendix 1. We expect the coefficient on IAFit (COMPit) to be
significantly positive, consistent with H1a (H1b). Because of competing arguments
regarding the relationship between IAF independence and firm operational efficiency, we
cannot predict the signs of the coefficient on INDEPit.
To test H2, we partition our sample into two sub-samples based on the median of the
corporate governance measure (G_Indexit) and estimate Model (1) based on these two sub-
samples, respectively. G_Indexit is constructed through principal component analysis (using
the first principal component) based on the following eight indicators (Fang and Jin, 2013):
 (1) BLOCKHOLDER1it (percentage of shares held by the largest shareholder); Firm
(2) BLOCKHOLDER2 it (equity concentration of the second largest to the tenth largest operational
shareholder); efficiency
(3) DUALit (an indicator variable equal to 1 if the chairman of the board also serves as
the firm’s CEO, and 0 otherwise);
(4) INDDIRit (the percentage of independent directors on the board);
(5) ACSIZEit (audit committee size, calculated as the number of audit committee
1175
members);
(6) MANAGEROWNit (percentage of shares held by managers);
(7) BHSHAREit (an indicator variable equal to 1 if the firm issues both B and H
shares, and 0 otherwise); and
(8) SOEit (an indicator variable equal to 1 if the firm is state-owned, and 0 otherwise).

A higher value of G_Indexit indicates more mature corporate governance. H2 predicts that
the coefficient on IAFit will be significantly positive only in the group with more effective
corporate governance.
Similarly, we partition our sample into two sub-samples based on the median of the
market development index (MARKET it) and estimate Model (1) based on these two sub-
samples. The market index is an index compiled by NERI (Fan et al., 2011) to measure
regional market development in China; it is frequently used by researchers (Wang et al.,
2008; Kusnadi et al., 2015; Wang et al., 2016). This index captures the following aspects of
regional market development: the relationship between the government and the market; the
development of non-state business; the development of product markets; the development of
factor markets; and the development of market intermediaries and the legal environment. A
higher value of MARKETit means that a province’s institutions are more developed. H3
predicts that the coefficient on IAFit will be significantly positive in the group with a higher
market development index.

5. Empirical results
5.1 Descriptive statistics
Table 1 presents the descriptive statistics for the key variables used in our regression
analysis. OEFFit is calculated using DEA and ranges from 0 to 1. Its mean value is 0.506,
suggesting that the operational efficiency of Chinese listed firms is high overall. The
average, minimum and maximum values of IAFit are –0.002, –2.601 and 2.604, respectively,
suggesting a relatively high degree of variation with respect to IAF quality.

5.2 Multivariate regression analyses

5.2.1 Results of testing H1. Table 2 presents the regression results for the association
between IAF quality and firm operational efficiency. As shown in Table 2, the coefficient on
IAFit is positive and significant (0.008 with a t-statistic of 4.16). This result indicates that
firm operational efficiency is higher for firm-years with an effective IAF, which is consistent
with H1a.
Table 3 shows the results of Model (2). We find that the coefficient on COMPit is
significantly positive (0.009 with a t-statistic of 4.20), supporting H1b. As shown in Column
3, the coefficient on INDEPit is insignificant, whereas COMPit remains significantly positive
after controlling for INDEPit, supporting H1b. The results for INDEPit may suggest that
IAF independence cannot significantly improve operational efficiency because of competing
MAJ Variable N Mean Median Min. Max. Std.
35,8
OEFF 2,889 0.506 0.487 0.213 1.000 0.151
IAF 2,889 –0.002 0.267 –2.601 2.604 1.213
COMP 2,889 –0.002 0.273 –2.607 2.493 1.216
INDEP 2,889 0.886 1.000 0.000 1.000 0.317
SIZE 2,889 21.660 21.540 19.500 24.810 1.032
1176 CFO 2,889 0.035 0.036 –0.199 0.236 0.074
AGE 2,889 1.639 1.792 0.000 2.996 0.994
FOREIGN 2,889 0.608 1.000 0.000 1.000 0.488
SEC_NUM 2,889 2.269 2.000 1.000 8.000 1.620
LOSS 2,889 0.076 0.000 0.000 1.000 0.266
BIG10 2,889 0.575 1.000 0.000 1.000 0.494
M&A 2,889 0.711 1.000 0.000 1.000 0.453
HH 2,889 0.261 0.223 0.200 0.608 0.091
Table 1. INDDIR 2,889 0.369 0.333 0.333 0.556 0.049
Descriptive statistics BLOCKHOLDER1 2,889 0.355 0.339 0.088 0.758 0.150

(1)
Variable OEFF

IAF 0.008*** (4.16)

SIZE 0.018*** (5.82)
CFO 0.212*** (4.95)
AGE –0.006* (–1.77)
FOREIGN –0.007 (–1.23)
SEC_NUM –0.006*** (–3.62)
LOSS –0.077*** (–7.96)
BIG10 –0.005 (–1.06)
M&A –0.007 (–1.28)
HH –0.007 (–0.07)
INDDEP 0.056 (1.13)
BLOCKHOLDER1 0.066*** (3.74)
Industry fixed effect YES
Year fixed effect YES
Table 2. N 2,889
Internal audit Adj. R2 0.288
functions quality and Notes: This table shows the results for the relationship between IAF quality and firm operational
firm operational efficiency. All of the variables are defined in Appendix 1. The t-statistics are in parentheses. *, **, and
efficiency ***indicate significance at the 10%, 5%, and 1% levels, respectively

forces, as discussed earlier. However, we find a significant association between IAF

competence and operational efficiency only in a sub-sample with a high level of
independence, suggesting that IAF quality is a joint function of competence and
independence (Abbott et al., 2016) [6].
5.2.2 Results of testing H2. We report the results of testing H2 in Table 4. We find that
the coefficient on IAFit is positive and significant (0.011 with a t-statistic of 3.75) in the
effective corporate governance group. However, the coefficient on IAFit is positive but not
significant in the ineffective corporate governance group. These results are consistent with
 (1) (2) (3)
Firm
Variable OEFF OEFF OEFF operational
efficiency
COMP 0.009*** (4.20) 0.009*** (4.21)
INDEP 0.009 (1.17) 0.009 (1.205)
SIZE 0.018*** (5.83) 0.020*** (6.38) 0.018*** (5.86)
CFO 0.212*** (4.94) 0.208*** (4.83) 0.211*** (4.91)
AGE –0.005* (–1.75) –0.004 (–1.30) –0.005 (–1.57) 1177
FOREIGN –0.007 (–1.23) –0.007 (–1.20) –0.007 (–1.22)
SEC_NUM –0.006*** (–3.62) –0.006*** (–3.48) –0.006*** (–3.63)
LOSS –0.077*** (–7.96) –0.078*** (–8.13) –0.077*** (–7.95)
BIG10 –0.005 (–1.07) –0.005 (–1.06) –0.005 (–1.09)
M&A –0.007 (–1.28) –0.007 (–1.31) –0.007 (–1.30)
HH –0.007 (–0.07) –0.008 (–0.07) –0.006 (–0.06)
INDDEP 0.055 (1.12) 0.040 (0.82) 0.051 (1.04)
BLOCKHOLDER1 0.066*** (3.74) 0.067*** (3.79) 0.066*** (3.74)
Industry fixed effect YES YES YES Table 3.
Year fixed effect YES YES YES Internal audit
N 2,889 2889 2,889 functions quality and
Adj. R2 0.288 0.270 0.288 firm operational
Notes: This table shows the results for the effects of IAF competence and independence on firm efficiency:
operational efficiency. All of the variables are defined in Appendix 1. The t-statistics are in parentheses. *, competence and
**, and ***indicate significance at the 10, 5, and 1% levels, respectively independence

the second hypothesis that the positive effect of IAF quality on firm operational efficiency is
stronger for firms with more effective corporate governance.
5.2.3 Results of testing H3. In Table 5, the coefficient on IAFit is positive and significant
(0.016 with a t-statistic of 5.48) in the strong institutional environment group. However, the
coefficient on IAFit is positive but not significant in the weak institutional environment
group. This result indicates that the association between high-quality IAF and firm
operational efficiency is more pronounced for firms in provinces with stronger institutions,
consistent with H3.

5.3 Path analysis: the effect of internal control

Cheng et al. (2018) show that effective internal control is associated with high firm
operational efficiency. One of the key objectives of IAF is to ensure that internal control is
effectively implemented (Sawyer and Vinten, 1996). Fadzil et al. (2005) show that high-
quality IAF can result in effective internal control. Therefore, we conjecture that high-
quality IAF improves firm operational efficiency by affecting internal control. That is,
internal control may be an intermediary mechanism through which IAF influences
operational efficiency.
To verify the hypothesized mediating effect of internal controls, we follow prior studies
(Baron and Kenny, 1986) in estimating the following empirical model:
X
OEFFit ¼ a0 þ a1 IAFit þ CONTROL þ « ðPath aÞ (3)
X
IC_Indexit ¼ a0 þ a1 IAFit þ CONTROL þ « ðPath bÞ (4)
MAJ (1) (2)
35,8 Variable High corporate governance Low corporate governance

IAF 0.011*** (3.75) 0.004 (1.45)

SIZE 0.018*** (4.19) 0.023*** (4.80)
CFO 0.222*** (3.62) 0.243*** (4.02)
AGE –0.008* (–1.70) –0.011** (–2.17)
1178 FOREIGN –0.011 (–1.25) –0.005 (–0.61)
SEC_NUM –0.009*** (–3.66) –0.002 (–0.95)
LOSS –0.069*** (–5.52) –0.088*** (–5.94)
BIG10 –0.008 (–1.08) –0.004 (–0.61)
M&A –0.000 (–0.04) –0.012 (–1.63)
HH 0.108 (0.67) –0.096 (–0.72)
Industry fixed effect YES YES
Year fixed effect YES YES
Table 4. N 1,445 1,444
Internal audit Adj. R2 0.267 0.281
functions quality and
Notes: This table shows the effects of IAF quality on firm operational efficiency for the sub-samples with
firm operational different levels of corporate governance (partitioned by the median value of the corporate governance
efficiency: corporate measure). All of the variables are defined in Appendix 1. The t-statistics are in parentheses. *, **, and
governance ***indicate significance at the 10, 5, and 1% levels, respectively

(1) (2)
Variable High market index Low market index

IAF 0.016*** (5.48) 0.001 (0.27)

SIZE 0.012*** (2.64) 0.030*** (6.63)
CFO 0.194*** (3.30) 0.172*** (2.72)
AGE –0.003 (–0.59) –0.007 (–1.62)
FOREIGN –0.010 (–1.15) –0.002 (–0.25)
SEC_NUM –0.005** (–2.03) –0.007*** (–2.84)
LOSS –0.094*** (–6.59) –0.062*** (–4.90)
BIG10 –0.012* (–1.74) –0.000 (–0.05)
M&A –0.006 (–0.82) –0.005 (–0.71)
HH –0.126 (–0.94) 0.067 (0.43)
INDDEP 0.112* (1.73) 0.004 (0.06)
BLOCKHOLDER1 0.066** (2.49) 0.063*** (2.60)
Industry fixed effect YES YES
Table 5. Year fixed effect YES YES
Internal audit N 1,549 1,340
2
functions quality and Adj. R 0.280 0.312
firm operational
Notes: This table shows the effects of IAF quality on firm operational efficiency in the sub-samples with
efficiency: external high and low marketization levels (partitioned by the median value of the marketization measure). All of the
institutional variables are defined in Appendix 1. The t-statistics are in parentheses. *, **, and ***indicate significance
environment at the 10, 5, and 1% levels, respectively
 X
OEFFit ¼ a0 þ a1 IC_Indexit þ þ a2 IAFit þ CONTROL þ « ðPath cÞ (5) Firm
operational
where IC_Indexit is an internal control quality index developed by Shenzhen DIB Risk efficiency
Management Technology Co., Ltd. (the DIB index) and widely used in prior studies (Wang
et al., 2018; Chen et al., 2019; Li et al., 2019) [7]. According to the Basic Standards for
Enterprise Internal Control, known as the Chinese version of SOX (C-SOX), a firm’s internal
control system has five elements: the internal environment, risk assessment, control activity, 1179
information and communication and internal monitoring. These five elements can be further
divided into 65 indicators. The DIB index assigns each indicator a value of 1 if a firm meets
the requirement for the indicator, and 0 otherwise. IC_Indexit is the sum of the 65 indicators.
A higher value of IC_Indexit means that a firm has better internal control.
Panels A and B of Table 6 report the regression results for the mediating effect of internal
control on the association between IAF quality and firm operational efficiency. As shown in
Panel A, we find that the coefficient on IAFit is significantly positive for Path a (0.007 with a
t-statistic of 3.59), the coefficient on IAFit is significantly positive for Path b (0.004 with a t-
statistic of 2.45) and the coefficients on IC_Indexit and IAFit are significantly positive for
Path c (coefficient on IC_Indexit = 0.11 with a t-statistic of 3.34; coefficient on IAFit = 0.007
with a t-statistic of 3.39). In Panel B, we present the bootstrap test results. We calculate the

(1) (2) (3)

Path a (not including Path b (intermediary Path c (including
intermediary factor) factor test) intermediary factor)

Panel A: Path test

IC_Index 0.110*** (3.34)
IAF 0.007*** (3.59) 0.004** (2.45) 0.007*** (3.39)
SIZE 0.019*** (5.99) 0.031*** (12.11) 0.015*** (4.69)
CFO 0.234*** (5.71) 0.088*** (3.21) 0.224*** (5.49)
AGE –0.007** (–2.36) –0.013*** (–5.50) –0.006* (–1.90)
FOREIGN –0.007 (–1.11) 0.006 (1.19) –0.007 (–1.21)
SEC_NUM –0.006*** (–3.20) –0.002 (–0.94) –0.006*** (–3.10)
LOSS –0.063*** (–6.01) –0.183*** (–17.87) –0.043*** (–3.48)
BIG10 –0.005 (–1.10) 0.001 (0.15) –0.005 (–1.12)
M&A –0.008 (–1.46) 0.000 (0.02) –0.008 (–1.47)
HH –0.032 (–0.32) –0.006 (–0.10) –0.031 (–0.32)
INDDEP 0.046 (0.94) 0.008 (0.15) 0.046 (0.92)
BLOCKHOLDER1 0.063*** (3.52) 0.004 (0.28) 0.062*** (3.51)
Industry fixed YES YES YES
effect
Year fixed effect YES YES YES
N 2,805 2,805 2,805
Adj. R2 0.278 0.280 0.283

Panel B: Bootstrap test Table 6.

Coef Boot SE Z P>Z Bias-corrected 95% CI Percentile 95% CI Internal audit
Indirect effect 0.001 0.000 1.66 0.096 0.000 0.001 0.000 0.001 functions quality and
Direct effect 0.006 0.000 3.25 0.001 0.002 0.105 0.003 0.106 firm operational
Notes: This table shows the results of the path analysis. Panel A reports the path test results, and Panel B efficiency: Mediating
presents the bootstrap test results. All of the variables are defined in Appendix 1. The t-statistics are in effect of internal
parentheses. *, **, and ***indicate significance at the 10, 5, and 1% levels, respectively control
MAJ estimated value and confidence interval (CI) for both the direct and indirect effects. The
35,8 coefficient of the indirect effect (by improving internal control) is 0.001, with P < 10% (CI
[0.000, 0.001] and percentile 95% CI [0.000, 0.001]). For the direct effect, the coefficient is
0.006, with P < 1% (CI [0.002, 0.105] and percentile 95% CI [0.003, 0.106]). We summarize the
results of the path analysis in Figure 2. Taken together, these results show that IAF can
improve firm operational efficiency directly or indirectly by improving internal control
1180 effectiveness.

5.4 Robustness tests

5.4.1 Endogeneity test. Our results so far may be subject to an endogeneity problem,
because some omitted-correlated variables may affect IAFit and OEFFit simultaneously. To
mitigate this problem, we apply the instrumental variable method. Following the literature,
we choose IAF_Indjt (the year-industry average of IAF quality) as an instrumental variable,
as it affects firms’ IAF quality but is unlikely to influence OEFFit.
In the first stage of the regression, the coefficient on IAF_Indjt is positive and significant
at the less than 1% level. We use the estimated IAF derived from the first stage regression
results to replace IAFit in Model (1). As shown in Table 7, the coefficient on the estimated
IAF is positive and significant at the 1% level, suggesting that our results are robust to the
two-stage ordinary least squares test.
5.4.2 Alternative measurement of firm operational efficiency. Following Jiang et al.
(2019), we replace the dependent variable in Model (1) with TATit (total asset turnover) as an
alternative firm efficiency measure. With this alternative specification, the coefficients on
IAFit are still significantly positive, suggesting that our results are not sensitive to the
measure of the dependent variable. The results for the alternative measure are not tabulated
for reasons of space.

6. Conclusion
In this study, we examine whether and how IAF quality affects firm operational efficiency in
China. We find that IAF quality is positively associated with firm operational efficiency.
The result is unchanged after correcting for endogeneity via the instrumental variable
method and using an alternative firm operational efficiency measure. Furthermore, we show

IC_Index
0.110***
0.004**

IAF OEFF
0.007***

Notes: This figure illustrates the path analysis results. IAF denotes
IAF quality. IC_Index is our internal control measure. OEFF is firm
operational efficiency. The figure illustrates how IAF affects OEFF
directly and indirectly by improving internal control effectiveness.
Figure 2. The arrows represent the directions in which IAF affects OEFF.
IAF and firm The arrows are labeled with the coefficients from the results in
operational efficiency: Panel A of Table 6. *, ** and *** indicate significance at the 10%,
path analysis results
5% and 1% levels, respectively
 (1) (2)
Firm
First stage Second stage operational
IAF OEFF efficiency
IAF_Ind 0.923*** (13.32)
IAF (Est.) 0.048*** (4.52)
SIZE 0.143*** (4.58) 0.026*** (5.40)
CFO –0.186 (–0.45) 0.189*** (3.00) 1181
AGE 0.102*** (2.63) –0.001 (–0.11)
FOREIGN 0.117* (1.87) –0.024*** (–2.82)
SEC_NUM 0.026 (1.46) –0.001 (–0.52)
LOSS –0.187* (–1.71) –0.045*** (–2.72)
BIG10 –0.023 (–0.41) 0.003 (0.46)
M&A 0.042 (0.68) –0.018** (–2.15)
HH 0.623* (1.92) –0.010 (–0.19)
INDDEP –1.545*** (–2.69) 0.038 (0.50)
BLOCKHOLDER1 0.001 (0.01) 0.089*** (3.43)
Year fixed effect YES YES
Industry fixed effect YES YES
N 1,555 1,555 Table 7.
Adj. R2 0.168 0.029 Internal audit
function quality and
Notes: We estimate IAF using year-industry average IAF quality as an instrumental variable and report
the results in Column (1). We report the second-stage regression results for the effect of the estimated IAF firm operational
on operational efficiency. All of the variables are defined in Appendix 1. The t-statistics are in parentheses. efficiency:
*, **, and ***indicate significance at the 10, 5, and 1% levels, respectively endogeneity test

that IAF competence improves firm operational efficiency, whereas the relationship between
IAF independence and firm operational efficiency is insignificant. Additionally, we find that
IAF quality can only significantly improve firm operational efficiency in the presence of
effective corporate governance at the firm level and strong institutions at the province level.
Using path analysis, we find that IAF can improve firm operational efficiency both directly
and indirectly by improving internal control effectiveness.
We acknowledge some limitations of our study. Because of survey limitations, we
use only a single measure of IAF independence, which may reduce the rigorousness of
our inference. Another limitation, which is common in this type of study, is that our
findings may not be generalizable from China to other countries with different
institutions. Despite these limitations, our study complements Cho et al. (2015) and
Jiang et al. (2019) by using Chinese data to demonstrate the important role played by
IAF in increasing firm operational efficiency. Our study also extends theirs by showing
that IAF competence plays a more important role in improving operational efficiency
than IAF independence. In the domain of corporate governance, while many scholars
claim that independence can improve directors’ monitoring capacity, others argue that
it may negatively affect directors’ advisory role (Adams and Ferreira, 2007). Similar to
a corporate board, an IAF faces a trade-off in its dual role as a monitor and consultant.
To the extent that IAF competence and independence make unequal contributions to
improve operational efficiency, as shown in our study, top managers need to strike a
proper balance between IAF competence and independence. Our study also contributes
to the literature by showing that the effectiveness of IAF in improving operational
efficiency is contingent on corporate governance and external institutions. The findings
reveal institutional complementarity among IAF-related institutions. One implication
MAJ is that IAF-related institutions such as firm-level corporate governance and external
35,8 institutions should be well developed to ensure that IAF is effective. Regulators and
practitioners from other emerging economies may benefit from our study by improving
IAF-related institutions to reap more benefits from IAF.
Our study also has several implications for future research. Prior studies of IAF
mainly focus on the influence of IAF quality on the process and outcomes of financial
1182 reporting; few examine the real consequences of IAF quality. As a result, we know little
about its economic benefits. Ours is one of the first studies to examine the consequences
of IAF quality for operational efficiency. To the extent that IAF quality affects the
quality of financial reporting and business decision-making, it should affect a wide
range of stakeholders, including creditors, shareholders, customers, and the public.
Accordingly, future studies could examine other real consequences of IAF quality, such
as corporate finance, corporate investment, and stock market performance, to shed
more light on the economic consequences of IAF quality. For example, future studies
could examine lenders’ perceptions of IAF quality by examining debt contracting
terms. As high-quality IAF results in informed decisions, another worthwhile task is to
examine whether IAF quality improves investment efficiency, an important measure of
firm activity that has recently attracted research attention (Roychowdhury et al., 2019).
Finally, future studies could investigate whether and how IAF can improve operational
efficiency in emerging economies with different institutional environments, and
thereby deepen our understanding of how the interaction between IAF and other
institutions affects firm operational efficiency.

Notes
1. Developed economies account for two-thirds of the countries covered in the survey. Specifically,
US firms make up the largest proportion of the sample (35%), followed by Japanese firms (15%)
and Taiwanese firms (10%).
2. Mature corporate governance, according to the IIA (The Institute of Internal Auditors (IIA),
2006), means that a firm already has an effective corporate governance system. Therefore, we use
the terms “mature corporate governance” and “effective corporate governance” interchangeably
in this paper.
3. While we argue that increasing IAF independence is likely to impair IAF’ consulting function, we
do not suggest that IAF independence is definitely detrimental to IAF consulting function.
Indeed, our empirical results show a positive association between IAF independence and
operational efficiency.
4. The CSRC sent the questionnaires to the chairmen of the board, CEOs, secretaries of the board,
Chief Financial Officers (CFOs), CAEs, Chief Information Officers and internal control managers.
5. DEA is based on a set of homogeneous decision-making units (DMUs) (such as all listed firms).
Using an optimization programming method, DEA projects each DMU onto the efficient frontier
surface to establish an efficient production frontier and evaluates the relative efficiency of each
DMU based on its deviations from the efficient frontier.
6. For brevity, we do not report the results in the paper. We will provide them upon request. We
thank an anonymous reviewer for pointing this out.
7. The index was developed by Shenzhen DIB Risk Management Co., Ltd., the first professional
institution to publish an annual white paper on the internal control of China’s listed firms. The IC
index provided by DIB has been published in China Securities Daily every year since 2008 and is
widely used in academic studies. For details, visit www.dibcn.com/
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Appendix 1 Firm
operational
efficiency
Variable Definition

AGEit The natural logarithm of the number of years that the firm has been listed
BIG10it An indicator variable that equals 1 if a firm hires a top 10 accounting firm in year
t, and 0 otherwise 1187
BLOCKHOLDER1it Percentage of shares held by the biggest shareholder in year t
CFOit Operating cash flow/total assets in year t
COMPit Composite indicator of IAF competence, constructed through principal
component analysis (using the first principal component)
FOREIGNit An indicator variable that equals 1 if a firm has foreign business in year t, and 0
otherwise
HHjt Industry-level competition, measured by the Herfindahl index based on the top
five firms’ sales in each year-industry (j)
IAF_Indjt The year-industry (j) average of IAF quality
IAFit Composite indicator of IAF quality, constructed through principal component
analysis (using the first principal component)
IC_Indexit An index of internal control quality developed by DIB
INDDIRit The percentage of independent directors on the board in year t
INDEPit IAF independence, an indicator variable that equals 1 if the CAE functionally
reports to the board of directors or audit committee in year t, and 0 otherwise
LOSSit An indicator variable that equals 1 if the firm reports a net loss in year t, and 0
otherwise
M&Ait An indicator variable that equals 1 if the firm is involved in mergers and
acquisitions or restructuring in year t, and 0 otherwise
OEFFit Firm operational efficiency measured by DEA, ranging from 0 to 1. A higher
value means higher firm operational efficiency Table A1.
SEC_NUMit The number of business segments in year t Key variable
SIZEit The natural logarithm of total assets in year t definitions
MAJ Appendix 2
35,8

Aspects of IAF Questions in CSRC survey Variable definition

1188
Independence of IAF To whom does the CAE functionally An indicator equal to 1 if the CAE
report in your organization? functionally reports to the board of
A. Board of directors directors (A) or the audit committee (B) in
B. Audit committee year t, and 0 otherwise
C. CEO
D. CFO
E. Other
Competence of IAF What is the educational background of An indicator equal to 1 if the CAE chooses
the CAE? option (A), (B), or (C), and 0 if CAE chooses
A. Doctoral degree (D)
B. Master’s degree
C. Bachelor’s degree
D. Below Bachelor’s degree
Does the CAE have professional senior An indicator equal to 1 if the CAE is
accountant certification? professionally certified, and 0 otherwise
A. Yes
B. No
The number of employees in the The percentage of internal auditors with a
Table A2.
internal audit department with a bachelor’s degree or above in the internal
Questions about bachelor’s degree or above audit department
internal audit The total annual compensation paid to The average salary of the internal auditors
functions quality in the employees of the internal audit
the CSRC survey department

Corresponding author
Lizhen Lu can be contacted at: lulzh_0203@163.com

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