Professional Documents
Culture Documents
12099
Journal of Accounting Research
Vol. 54 No. 1 March 2016
Printed in U.S.A.
ABSTRACT
In light of the growing importance of internal audit functions (IAF) and the
limited archival evidence on internal audit quality, we examine an interactive
model of IAF quality (comprised of competence and independence) to bet-
ter understand the determinants of IAF effectiveness as a financial reporting
monitor. Our tests support the hypothesis that the joint presence of compe-
tence and independence is a necessary antecedent to effective IAF financial
reporting monitoring. In sum, our results show that, the answer to “what is the
effect of internal audit competence (independence) on financial reporting
quality?” is “it depends on the independence (competence) of the internal
auditor.” Our study extends the understanding of IAF quality determinants
in the realm of financial reporting as it relates to ongoing discussions by re-
searchers, standard setters, regulators, and practitioners.
3
Copyright
C , University of Chicago on behalf of the Accounting Research Center, 2015
4 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
1. Introduction
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) (NASDAQ [2013]).1 The New York Stock Exchange
(NYSE) has required registrants to maintain an IAF since 2006. The ra-
tionale for these requirements is that an effective IAF provides the au-
dit committee and other financial reporting stakeholders with critical in-
formation pertaining to a company’s risks (including financial reporting
risks) and internal controls (i.e., Harrington [2004], NASDAQ [2013]).
Similarly, corporate governance proponents consistently emphasize the
IAF’s role in enhancing financial reporting quality (Coram, Ferguson, and
Moroney [2008], Prawitt, Smith, and Wood [2009], Cohen, Krishnamoor-
thy, and Wright [2010]). Nonetheless, the IAF’s role in the financial report-
ing process is not yet fully understood and empirical evidence concerning
the impact of IAF quality is minimal.
We investigate the potential impact of IAF quality as a joint function
of the IAF’s competence and independence. We base this view upon the
theoretical work of DeAngelo [1981], who notes that external audit quality
is a function of the external auditor’s ability (i.e., competence) to detect
accounting misstatements and willingness (i.e., independence) to oblige
proper accounting treatments. Similar to DeAngelo [1981], we assume
that, within the internal audit function, competence and independence
are important and distinct constructs that must interact to result in quality
outcomes.
Despite the intuitive appeal of IAF quality positively impacting financial
reporting quality, prior empirical evidence is not as strong as the intuition
would suggest. For example, Prawitt, Smith, and Wood [2009], using data
from 2000 to 2005, document mixed evidence between an overall com-
posite measure of IAF quality and financial reporting quality. Their single
composite IAF quality measure adds several, equally weighted individual
IAF characteristics of competence and independence. One potential ex-
planation for prior mixed results revolves around how these IAF character-
istics interact with each other in creating IAF quality. Rather than an addi-
tive relation between competence and independence whereby an increase
in competence can compensate for decreased independence, IAF quality
1 The NASDAQ subsequently tabled the proposal as registrants expressed concerns over
the costs and benefits of the proposal. An objective of the current study is to provide evidence
concerning one aspect of the benefits.
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 5
2 As compared to other extant IAF research, our sample follows the implementation of the
Public Company Accounting Oversight Board’s (PCAOB) Auditing Standard No. 5 on the
effectiveness of internal control over financial reporting (ICFR), a period when substantial
IAF resources were diverted to ICFR testing.
3 In contrast, prior research commonly utilizes a dichotomous influence variable based
upon whether the IAF’s formal reporting line is to the audit committee (e.g., Prawitt, Smith,
and Wood [2009]). However, Abbott, Parker, and Peters [2010] note that 96% of Chief Inter-
nal Auditors agreed with the statement “the Internal Auditor reports to the audit committee.”
As such, the utilization of the formal reporting arrangement as the sole IAF independence
characteristic leads to the possibility that the dichotomous identification of the reporting line
could simply capture a ceremonial structure and may not be indicative of a significant degree
of IAF independence.
6 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
(Kothari, Leone, and Wasley [2005], Prawitt, Smith, and Wood [2009]),
and whether the firm just meets or beats analyst forecasts (Koh, Mat-
sumoto, and Rajgopal [2008], Prawitt, Smith, and Wood [2009], Mande
and Son [2012]). Our abnormal accruals are further segregated into
income-increasing and income-decreasing abnormal accruals. Consistent
with IAF quality being a two-factor, interactive function of independence
and competence, we document several statistically significant relations be-
tween financial reporting quality and our interacted competence and in-
dependence variables. We find that interactions between the IAF compe-
tence and (1) the relative degree of audit committee IAF oversight and (2)
the lack of a substantial OSP presence curtail both income-increasing and
income-decreasing abnormal accruals. We obtain similar results when we
examine the firm’s proclivity to just meet/beat analysts’ forecasts.
In contrast, when independence is proxied by whether the IAF is not
used as an MTG, the interaction between the IAF independence factor and
competence exhibits a statistically significant, mitigating impact on income-
decreasing abnormal accruals. This finding is consistent with lower likeli-
hoods of IAF reporting of inappropriate income-decreasing opportunistic
reserve behaviors when the IAF is used as an MTG. In this manner, internal
auditors hoping to move into a non-IAF position may endeavor to ingrati-
ate themselves to management, or demonstrate their ability to be a team
player when they perceive a lower downside of doing so.4
Our paper contributes to the IAF literature in several ways. Our study is
the first to establish IAF characteristics as separate, distinct constructs that
act jointly in creating IAF quality. In doing so, this study contributes to our
understanding of IAF quality and the determinants of the IAF as an effec-
tive internally based financial reporting monitor. Second, our results sug-
gest that there are at least three factors that can impact IAF independence
and that these factors have differential interactive effects with IAF compe-
tence in influencing financial reporting quality. In contrast, prior IAF liter-
ature generally uses a dichotomous, single-variable independence measure
and implicitly ignores other potential independence determinants (e.g.,
Ahlawat and Lowe [2004]). Moreover, we find that our IAF independence
characteristics are either not correlated or only weakly related to each other
or to our IAF competence measure. This is consistent with (1) IAF indepen-
dence being characterized as a multifaceted attribute with at least three de-
terminants and (2) IAF independence and competence being separate and
distinct constructs. While there is a very rich literature on threats to external
auditor independence, there is a paucity of archival evidence on the poten-
tial determinants of internal auditor independence. With respect to internal
a management training ground may simply defer auditing more contentious, higher profile
income-increasing abnormal accruals to the external auditor. Internal auditors may do so with
the knowledge that external auditors are likely to expend greater audit effort on income-
increasing accruals (Abbott, Parker, and Peters [2006]).
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 7
5 We address this issue by conducting our analysis over the years 2010–2011, assuming that
our test variables would remain consistent over a short horizon. We find that our results con-
tinue to be significant over that time frame.
8 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
6 The AICPA’s Statement of Auditing Standards 65 (SAS 65) discusses indicators of IAF
competence and independence; however, very little overlap exists among the factors that SAS
65 describes as competence-related versus independence-related (AICPA [1991]).
7 They explain the unexpected result on IAF size as the possibility that IAF size proxies for
the difficulty of monitoring the firm, and, when monitoring is more difficult, managers may
be able to find avenues to exercise more discretion to increase income.
8 During the sample period involved (2000–2005), Prawitt, Smith, and Wood [2009] find
significant variation in this measure: 69% of sample IAFs reported to the audit committee and,
as such, this was likely to be an appropriate and parsimonious proxy for IAF independence.
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 9
3. Hypothesis Development
3.1 IAF MECHANISMS FOR IMPACTING FINANCIAL REPORTING QUALITY
The focus of this paper is on the association between IAF quality and
financial reporting quality. Therefore, an important antecedent to our re-
search question is a description of the specific mechanisms by which an
IAF can influence financial reporting quality. We posit that these opportu-
nities arise within at least four activities: assisting with the financial state-
ment audit, financial statement audit of subsidiaries, compliance auditing,
and special consulting projects.9 Within the areas of financial statement
audit assistance and audits of subsidiaries, the IAF performs specific audit
procedures that allow it to potentially influence accrual decisions. These in-
clude review of the financial closing process, reviewing procedures for non-
standard journal entries and postclosing adjustments, and specific reviews
of critical accruals such as accounts receivable valuation and inventory re-
serves (IIA [2005]). Compliance auditing can involve testing transactions
or journal entries for compliance with the company’s financial reporting
policy. Special consulting projects may also involve the IAF delving into ac-
counting matters that require greater judgment on the part of the preparer,
such as asset impairments, warranty reserves, collectability reserves, and/or
inventory write-downs (PwC [2009]).
It should be noted that, in any of the prior tasks, the IAF may encounter
high-level accruals choices. More specifically, the IIA advises that, as a part
of the quarterly financial reporting process, the IAF should engage the IAF
should review the policies, procedures, and process for reporting and re-
lated disclosures. In particular, the IIA advises that, as a part of the quarterly
financial reporting process, the IAF should engage “special or specifically
targeted reviews of high-risk, complex, and problem areas; including ma-
terial accounting estimates, reserve valuations, off-balance sheet activities,
major subsidiaries, joint ventures, and special purpose entities” (IIA [2005,
p. 236]).
9 We developed this list from a review of the prior literature, examination of IAF profes-
sional guidance, and discussion with CIAs. As discussed in our results section, respondents
indicate a nontrivial budget allocation to these four activities.
10 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
10 For example, the internal auditors may be charged with reviewing the proper application
of the firm’s policy for recording an inventory reserve. Divisions within the firm with sepa-
rate profit targets may have incentives to either under- or overstate the reserve in order to
maximize internal rewards.
11 This mechanism may operate in two ways. First, the CEO/CFO may effectively pressure
the IAF to “filter” any IAF-generated reports that are forwarded to either the audit committee
or external auditor. Second, to the extent that the CEO/CFO can influence IAF budgets or
activities, the CEO/CFO may direct the IAF toward other activities that have an immediate,
beneficial impact on current earnings such as the examination of vendor rebates or other
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 11
operational concerns, etc. (Abbott, Parker, and Peters [2010]). In doing so, the IAF is ef-
fectively precluded from collecting evidence that might serve to repudiate other compliance
deviations involving financial reporting decisions.
12 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
reporting quality and the lack of an OSP, we acknowledge that it is possible that the use of an
OSP might instead serve to spur the IIA to greater effort and independence in order to prove
their worth to the organization.
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 13
4. Research Design
4.1 SAMPLE SELECTION
Our study utilizes a survey questionnaire (see appendix) sent to 909 non-
bank members of the FORTUNE 1000 (in terms of total sales).13 Consistent
with most prior internal audit research (e.g., Pelfrey and Peacock [1995],
Scarbrough, Rama, and Raghunandan [1998], Raghunandan, Read, and
Rama [2001], Carcello, Hermanson, and Raghunandan [2005], Abbott,
Parker, and Peters [2010, 2012]), the survey targets Chief Internal Audi-
tors (CIAs) or Chief Audit Executives (CAEs). The survey includes ques-
tions about the types of IAF services provided (whether in-house or out-
sourced), assistance to the external auditors, presence and activities of any
OSPs, the reporting relationship between the IAF and the audit commit-
tee, and whether the IAF serves as an MTG. We asked recipients to provide
responses based upon fiscal year 2009.
The first survey mailing (sent October 2009) resulted in a total of 118
usable responses. A follow-up mailing (December 2009) produced an ad-
ditional 99 usable responses, for a total of 227.14 However, we were unable
to obtain complete Compustat data for 38 of these firms, bringing our to-
tal sample to 189. Table 1 provides a distribution of observations by two-
digit focus industry membership (Hogan and Jeter [1999]). To test for po-
tential nonresponse bias, we compare the characteristics of the early and
late responders with each other and test for significant differences in size,
leverage, return on assets, presence of a loss, and cash flow from opera-
tions. None of the differences are significant.15 We also compare our re-
spondents to the industry makeup of the original population of nonbank
Fortune 1000 firms. We conduct a test of differences of proportions com-
paring the industry sample representation to the population and find only
the underrepresentation of the energy and manufacturing sectors to be
significant.
4.2 CHARACTERISTICS OF THE IAF
Our survey responses provide information about the current nature of
the IAF function in terms of qualification and activities. We document that
the overwhelming majority (over 80%) of CAEs have a CPA certification
13 Banks are excluded since they do not possess inventory and have unique regulatory envi-
favorably with the 12.7% rate obtained by Felix, Gramling, and Maletta [2001] in their internal
audit study. However, the Felix et al. rate may have been depressed by the need for survey
responses from both the internal and external auditors to constitute a complete sample pair.
Our response rate is higher than that reported in previous studies of senior managers. For
example, Graham and Harvey [2001] report a 9% response rate.
15 As with all surveys, there is a possibility of unknown response bias and of incorrect re-
sponses. While we tested our early and late respondents for differences on a number of di-
mensions, as previously discussed, it is possible that undetected bias is present.
14 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
TABLE 1
Sample Selection Results
Related Two- No. of % of No. of Fortune % of Fortune
Focus Industry Digit SIC Codes Firms Sample 1000 Firms∗ 1000 Firms∗
Construction 15–17 9 4.8 17 1.9
Consumer product & 20–33 43 22.8 180 19.8
food
Energy 10–14, 46, 49 32 16.9 172 18.9
Financial services 60–64, 67 11 5.8 62 6.8
Information & 48, 73, 78, 79, 84 20 10.6 126 13.9
Communication
Manufacturing 34–39 31 16.4 140 15.4
Personal services & 72, 80, 83 2 1.1 28 3.1
health care
Professional, 75, 76, 82, 87, 89 1 0.5 11 1.2
commercial services,
education
Real estate 65, 70 1 0.5 6 0.7
Retail & wholesale 50–59 35 18.5 149 16.4
Transportation 40–42, 44, 45, 47 3 1.6 11 1.2
All other 1, 2,7, 8, 99 1 0.5 6 0.7
Totals 189 100 908 100
∗
Banks are excluded from both the population and the sample as these firms face additional regula-
tion unique to their industry and do not have significant inventory accounts (making the model unfit for
regression purposes). The remaining Fortune 1000 firms (in terms of total assets) serve as our sampling
population.
IAF is utilized, it is utilized heavily to provide Section 404 assistance. This re-
sult is consistent with our contention that a significant OSP presence could
represent a threat to internal IAF independence since there is a large over-
lap in the services that are provided by in-house IAFs vis-à-vis OSPs.
4.3 REGRESSION MODEL
To test the relationship between financial reporting quality and the inter-
active nature of IAF competence and independence, we adapt the following
regression model from prior research:
ABNACC = b 0 + b1 IACOMP + b2 ACIAFINF + b3 NONMTG
+ b 4 NONOSP20 + b5 IACOMP ∗ ACIAFINF
+ b 6 IACOMP ∗ NONMTG + b7 IACOMP ∗ NONOSP20
+ b 8 ASSETS + b9 AGE + b10 LEVERAGE + b11 SEGNUM
+ b 12 CFO + b13 SALESGROW + b14 MTB + b15 CFOVOL
+ b 16 ROA + b17 LOSS + b18 MATWEAK
+ b 19−28 INDUSTRY + ε. (1)
The variables used in the empirical models are summarized in table 2 and
discussed below.
4.4 DEPENDENT VARIABLE
Following prior audit literature, we utilize abnormal accruals (ABNACC)
as a proxy for financial reporting quality (Francis [2011]). To measure ab-
normal accruals, we use the performance-adjusted cross-sectional variation
of the modified Jones model (Dechow, Sloan, and Sweeney [1996]) as re-
ported by Kothari, Leone, and Wasley [2005].16 The Kothari et al. model
includes both an intercept term and a measure of performance. Consistent
with prior research, we first estimate the model for firms with information
available on Compustat for 2009 (excluding financial institutions), and ap-
ply the results by two-digit SIC code to the calculation of abnormal accruals
for the firms in our sample.17 Our estimate of abnormal accruals is the
residual from the following regression:
[TAit /Ait−1 ] = β0 + β1 [1/Ait−1 ] + β2 [(REVit − DARit )/Ait−1 ]
+β3 [PPEit /Ait−1 ] + β4 [NIit /Ait−1 ] + εit .
16 Our sample size, though small compared to many discretionary accruals studies, is similar
to other survey-based work in the area (Prawitt, Smith, and Wood [2009], Prawitt, Sharp, and
Wood [2012]).
17 In separate untabulated tests, we also limited data for the estimation model to only For-
tune 1000 firms. However, there were a total of 47 firms (almost a quarter of our sample)
for which we could not estimate a reliable accrual estimation model. Thus, our tabulated AB-
NACC variable based upon the Compustat population represents a tradeoff between capturing
additional business norms that drive transactional accruals within a given industry (popula-
tion based) versus transaction accruals that might be limited to only a large-firm environment
(large-firm subsample).
16 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
TABLE 2
Variable Definitions
Variable Description
ABNACC The Kothari, Leone, and Wasley (2005) version of the modified Jones
model measure of abnormal accruals. Abnormal accruals is the error
term of the equation below:
[T Ait /Ait−1 ] = β0 + β1 [1/Ait−1 ] + β2 [(DR E Vit − DARit )/Ait−1 ] +
β3 [P P E it /Ait−1 ] + β4 [N Iit /Ait−1 ] + εit ,
where total accruals for estimation portfolio firm i for year t. TA, or total
accruals, are defined as income before extraordinary items (Compustat
Data Item #18) minus operating cash flows (Data Item #308). Ait −1 is
total assets (Data Item #6) at t−1 for firm i. REVit is the change in net
revenues (Data Item #12) for estimation portfolio firm i for year t. ARit
is the change in accounts receivable (Data Item #2) for estimation
portfolio firm i for year t. PPEit is gross property, plant, and equipment
(Data Item #7) for estimation portfolio firm i for year t. NIit is net
income (Data Item #172) for estimation portfolio firm i for year t.
JM/BEAT∗ Dichotomous dependent variable coded “1” in instances where firm met
the forecast or exceeded it by the consensus, annual EPS forecast scaled
by price at the beginning of the year by more than 0.0005; “0” else.
∗
JM/BEATaccr Dichotomous variable calculated using a two-step process. First, we
calculate unmanaged earnings by backing out discretionary abnormal
accruals from reported earnings. We then identify firms that would have
missed analysts’ forecasts, without management’s exercise of the
accounting discretion. For these firms, JM/BEATaccr equals “1” and for all
other firms JM/BEATaccr equals “0.”
IACOMP Average IAF resource expenditure per hour. Calculated by dividing total
in-house IAF budget per survey question #4 by total in-house IA hours
per question #1.
ACIAFINF Relative audit committee IAF influence vis-à-vis management (CEO and
CFO). Measured as the ratio of the total agreement points for the audit
committee in the numerator divided by the total agreement points for
the CFO and CEO in the denominator. The numerator is the sum of
agreement points (per the 1–5 Likert-scale responses) on survey
questions #12a, 12d, and 12g. The denominator is the sum of agreement
points (per the 1–5 Likert-scale responses) on survey questions #
12a–12i. The 1–5 Likert-scale response values are recalibrated to 0–4 for
purposes of computing this variable.
NONMTG Indicator variable coded “1” when the IAF does not serve as a
management training ground per survey question #13 and “0”
otherwise.
NONOSP20 Coded “1” (“0”) when the following ratio constructed from survey
question #4 is less than (greater than) 0.20: (Budgeted OSP $)/(Budgeted
OSP $ + Budgeted in-house IAF $).
ASSETS Total assets in millions (Compustat Data Item #6).
AGE Number of years the firm was listed on Compustat, truncated at 25 years
LEVERAGE The sum of long-term debt (Compustat Data Item #9) and current
liabilities (Data Item #5) of a company divided by total assets (Data Item
#6).
SEGNUM Number of disclosed segments in which the company operates.
CFO Cash flows from operations (Compustat Data Item #308).
(Continued)
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 17
T A B L E 2—Continued
Variable Description
SALESGROW One year sales growth (Compustat Data Item #12FY2009 – Item #12 FY2008 /
Item #12 FY2008 ).
MTB A company’s market-to-book ratio (Compustat Data Item #24 ∗ Item #25
/ Item #216).
CFOVOL Standard deviation of operating cash flows for 2005–2009.
ROA Return on assets (Compustat Data Item #172 / Data Item # 6).
LOSS Coded “1” if the firm experienced a loss in fiscal year 2008, “0” else.
MATWEAK Indicator variable coded “1” for client firm disclosing a material
weakness in internal controls over financial reporting during the prior
two years and “0” otherwise.
INDUSTRY Coded “1” if firm’s two-digit SIC code is included in specific focus
industry per table 1, “0” otherwise. Focus industry groupings per Hogan
and Jeter (1999).
∗
Variable used only in additional analysis section.
18 We believe our composite IACOMP measure offers other certain advantages, as it incor-
porates many different IAF elements (i.e., experience, certification, training) into one sum-
mary measure, is continuous in nature (allowing for easier comparison between different-sized
IAFs), and does not require an implicit equal weighting of inputs. Due in part to the underly-
ing relationship between budgets and hours, we include additional subsequent tests to ascer-
tain whether our proxy is correlated with various dimensions of competence. See additional
analysis discussions. Utilizing per hour amounts strengthens our ability to capture individual
auditor traits that might otherwise be lost when utilizing a measure of competence based upon
18 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
IAF budgets deflated by firm size. Defining IACOMP as Budgets / Firm size yields inconclusive
results, likely due in part to its lack of correlation with individual auditor competence traits
that drive per hour costs. We thank the anonymous reviewer for bringing this to our attention.
19 Ernst and Young [2008] notes that audit committees take different approaches to the
level of active oversight of the internal audit department, in which the internal auditor may
perceive different levels of actual influence or authority exhibited by the corresponding over-
seer.
20 Similar to Abbott, Parker, and Peters [2010], we do not utilize answers to survey question
#12j–12l (reviewing/approving the IAF’s annual risk assessment plan) when calculating the
ACIAFINF variable.
21 Within upper management, the IAF can report to either or both the CEO and CFO. We
combine the CEO and CFO responses since both share common risk preferences (compared
to the Audit Committee) and are required by SOX Section 302 to certify the financial state-
ments (SOX [2002]).
22 Survey responses to questions #12a–12i can range from 1 to 5, but are recalibrated
to a scale of 0–4. By doing so, our ACIAFINF variable captures the intuition behind the
relative IAF influence. For example, assume that the CIA respondent strongly agrees with
the audit committee’s influence over IAF reporting, termination, and budgeting (i.e., re-
sponds with a “5” for survey questions 12a, 12d, and 12g). Also assume the CIA respon-
dent also strongly disagrees with the CEO and CFO’s influence over IAF reporting, termi-
nation, and budgeting (i.e., responds with a “1” for survey questions 12b/12c, 12e/12f, and
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 19
12h/12i). Without recalibration to a 0–4 scale, the ACIAFINF value would equal 0.833 (e.g.,
(5+5+5)/(5+1+1+5+1+1+5+1+1)). With recalibration, the ACIAFINF value becomes 1 or
((4+4+4)/(4+0+0+4+0+0+4+0+0)). A second example further illustrates. In this case,
assume that the CIA strongly disagrees with the audit committee’s IAF reporting, termina-
tion, and budgeting influence (i.e., responds with a “1” for survey questions 12a, 12d, and
12g) and also strongly agrees with the CFO’s reporting, termination, and budgeting influence
(i.e., responds with a “5” for survey questions 12b, 12e, and 12h). Also assume that the CIA
strongly disagreed with the CEO’s IAF reporting, termination, and budgeting influence (i.e.,
responds with a “1” for survey questions 12c, 12f, and 12i). In this case, ACIAFINF equals 0
(e.g., (0+0+0)/(0+4+0+0+4+0+0+4+0)).
20 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
of accruals (Dechow and Dichev [2002]). For this reason, we predict a pos-
itive association between company size and positive accruals and a negative
association between company size and negative accruals. AGE (number of
years the company has been listed on Compustat, truncated at 25 years) is
included because firms may experience different accrual patterns as they
age (Prawitt, Smith, and Wood [2009]). We expect that LEVERAGE (to-
tal debt/total assets) will be associated with more income-increasing ac-
cruals to allow for nonviolation of debt covenants (Press and Weintrop
[1990]) and income-decreasing accruals (DeAngelo, DeAngelo, and Skin-
ner [1994]) to reduce earnings for contractual renegotiations. We include
a variable that proxies for firm complexity using the number of operating
segments a firm discloses in its 10K (SEGNUM). Firms with greater complex-
ity may have greater financial reporting latitude due to the inherent com-
plexity of their operations. We therefore expect that SEGNUM will be pos-
itively (negatively) associated with income-increasing (income-decreasing)
abnormal accruals. CFO (operating cash flows), SALESGROW (sales growth
from the prior year), and MTB (market to book) are included to control for
growth, and CFOVOL (operating cash flow volatility) is included because it
may impact the accrual calculation (Dechow, Sloan, and Sweeney [1996],
Matsumoto [2002], Menon and Williams [2004]).
Low performance provides an incentive for accruals management, so we
include ROA (net income/assets) and LOSS (coded “1” if the firm experi-
enced a loss in the preceding year, “0” else). In terms of income-increasing
abnormal accruals, increases in ROA may impact the calculation of ab-
normal accruals and we expect a positive relation. In terms of income-
decreasing accruals, positive ROA provides incentives to “smooth” earnings
and we expect a negative association between ROA and income-decreasing
abnormal accruals. Firms with a net loss may have an incentive to magnify
income-increasing abnormal accruals to avoid debt covenant violations and
magnify income-decreasing abnormal accruals to “take a bath.” We there-
fore expect a positive (negative) association between LOSS and income-
increasing (decreasing) abnormal accruals. We also include an indicator
variable for the presence of material internal control weaknesses. Mate-
rial weaknesses have been shown to be associated with an increase in ab-
normal accruals (Doyle, Ge, and McVay [2007]). Finally, consistent with
prior accruals-based research, we include dummy variables for focus indus-
try membership.
5. Results
5.1 DESCRIPTIVE STATISTICS
Table 3 presents descriptive statistics for the 189 respondents. Panel
A provides information related to the IAF budget. The mean number
of in-house (outsourced) IAF hours is 34,873 (4,195) and the mean in-
house (outsourced) budget is $2,056,236 ($484,312). The mean (median)
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 21
TABLE 3
Descriptive Statistics
Panel A: Internal audit budget descriptive statistics
Variable Name Mean Median 25th % 75th %
Total outsourced internal 4,195 1,800 0 5,000
audit hours (n = 133)∗
Total outsourced internal $484,312 $450,000 $0 $900,000
audit budget
Total in-house internal audit 34,873 20,000 8,000 37,750
hours (n = 189)
Total in-house internal audit $2,056,236 $1,500,000 $900,000 $2,500,000
budget ($)
Hourly OSP IA resource $178.73/hr $150/hr $100/hr $250/hr
expenditures∗∗
Hourly in-house IA (IACOMP) $102.42/hr $87.72/hr $75/hr $115/hr
resource expenditures∗∗
Total combined IAF hours 40,983 24,000 8,460 46,000
Total combined IAF budgets $3,580,450 $2,225,000 $1,250,000 $5,250,000
($)
% of OSP $ budget to total IAF 0.177 0.072 0.00 0.332
$ budget
IAFs with OSP budget > 20% 0.338 0.00 0.00 1.00
of overall IAF budget (0,1)
IAFs with OSP budget < 20% 0.662 1.00 0.00 1.00
of overall budget
(NONOSP20)
IAF used as a management 0.8465 1.00 1.00 1.00
training ground (0,1)
IAF not used as a management 0.1535 0.00 0.00 0.00
training ground (NONMTG)
∗
Only 133 of our 189 responding firms outsourced internal audit tasks and therefore our sample size for
outsourced IAF data is 133.
∗∗
To obtain this figure, we calculated individual per hour IAF resource expenditures rates for each
sample firm. We then averaged these 133 (189) rates to arrive at a mean (median) and percentiles figures
for the OSP (in-house) IAF departments, respectively.
T A B L E 3—Continued
Panel B: Audit committee and management oversight of internal audit function
Degree of Agreement with
survey statements #12a–12i Mean Median 25th % 75th %
IAF reports to the audit 4.73 5.00 4.00 5.00
committee
IAF reports to the CFO 3.65 4.00 3.00 4.00
IAF reports to the CEO 2.50 2.00 2.00 3.00
Audit committee authorized to 4.52 5.00 3.00 5.00
terminate Chief Internal
Auditor
The CFO authorized to 3.65 4.00 3.00 4.00
terminate Chief Internal
Auditor
The CEO authorized to 3.05 3.00 3.00 4.00
terminate Chief Internal
Auditor
The audit committee 3.22 3.00 3.00 4.00
determines Internal Audit’s
annual budget
The CFO determines Internal 3.75 4.00 3.00 4.00
Audit’s annual budget
The CEO determines Internal 3.02 3.00 3.00 4.00
Audit’s annual budget
ACIAFINF∗∗∗ 0.41 0.42 0.26 0.61
∗∗∗
ACIAFINF = The ratio of the total agreement points for the audit committee in the numerator di-
vided by the total agreement points for the CFO and CEO in the denominator. The numerator is the sum
of agreement points (per the 1–5 Likert-scale responses) on survey questions #12a, 12d, and 12g. The de-
nominator is the sum of agreement points (per the 1–5 Likert-scale responses) on survey questions #12a–
12i. The 1–5 Likert-scale responses are recalibrated to 0–4 for purposes of computing this variable.
23 In the interest of brevity, we do not report the coefficient estimates on our INDUSTRY
dummy variables.
24 We are careful to not overinterpret our stand-alone variables, as they are not necessarily
reflective of main effects due to the continuous nature of some of our test variables (Jaccard
and Turrisi [2003]).
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 25
TABLE 4
Univariate Comparisons
Panel A: Univariate comparison of IAF’s management training grounds
Firms with Firms with Mann-Whitney
Variable Name NONMTG = 1 NONMTG = 0 Difference Statistic
IACOMP $107.59/hr $101.52/hr $6.07/hr 1.0051
ACIAFINF 0.439 0.405 0.034 1.2323
NONOSP20 0.6786 0.6584 0.0202 0.9974
ASSETS (mil) $24,145 $18,812 $5,333 1.6736∗
AGE 19.97 20.62 −0.65 0.9929
LEVERAGE 0.4907 0.4698 0.0209 0.6788
SEGNUM 4.4643 4.2919 0.1724 0.7505
CFO (mil) $1,929 $1,754 $175 1.5029∗
SALESGROW −0.1332 −0.1150 0.0182 0.7471
MTB 2.41 2.54 −0.1300 0.8515
CFOVOL 448.2 505.4 −57.2 0.4793
ROA 0.0298 0.0325 −0.0027 0.5555
LOSS 0.2500 0.2733 −0.0233 0.6099
MATWEAK 0.0357 0.0435 −0.0078 0.3311
Observations 28 161
Panel C: Univariate comparison of firms that just meet/beat analyst forecast to other firms
Firms that Just
Meet/Beat All Other Mann-Whitney
Variable Name Analysts’ Forecasts Firms Difference Statistic
IACOMP $99.87/hr $103.04/hr −$3.17/hr 1.4011
ACIAFINF 0.3606 0.4220 −0.0614 1.7804∗
NONMTG 0.1622 0.1513 0.0109 1.0501
NONOSP20 0.6486 0.6652 −0.0166 0.7822
ASSETS (mil) $18,087 $19,971 −$1,904 1.8736∗
AGE 19.57 20.65 −1.0800 0.4424
LEVERAGE 0.4994 0.4664 0.0330 1.9942∗
(Continued)
26 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
T A B L E 4—Continued
Panel C: Univariate comparison of firms that just meet/beat analyst forecast to other firms
Firms that Just
Meet/Beat All Other Mann-Whitney
Variable Name Analysts’ Forecasts Firms Difference Statistic
SEGNUM 4.8214 4.2422 0.5792 1.7305∗
CFO (mil) $2,010 $1,724 $286 1.8544∗
SALESGROW −0.1103 −0.1195 −0.0092 1.1008
MTB 2.82 2.46 0.36 2.0011∗∗
CFOVOL 481.4 500.3 −18.9 0.3021
ROA 0.0339 0.0317 0.0022 0.4933
LOSS 0.2432 0.2763 −0.0233 0.6224
MATWEAK 0.0541 0.0395 0.0146 0.7754
Observations 37 152
Significance levels (one-tailed if in predicted direction): ∗ ,∗∗ , ∗∗∗ = p-value < 0.10, 0.05, 0.01, respectively.
IACOMP equals average IAF resource expenditure per hour. ACIAFINF is the relative audit committee
IAF influence vis-à-vis management (CEO and CFO). NONMTG is an indicator variable coded “1” when the
IAF does not serve as a management training ground per survey question #13 and 0 otherwise. NONOSP20
coded “1” (“0”) when the budgeted outsourced IAF services are less than 20% of IAF total budget. ASSETS
equals total assets in millions. AGE is the number of years the firm was listed on Compustat, truncated at
25 years. LEVERAGE equals sum of long-term debt and current liabilities of a company divided by total
assets. SEGNUM equals number of disclosed segments in which a company operates. CFO equals cash flows
from operations. SALESGROW equals one-year sales growth percentage. MTB equals market-to-book ratio.
CFOVOL is the standard deviation of operating cash flows for 2005–2009. ROA equals return on assets. LOSS
is coded “1” if the firm experienced a loss in fiscal year 2008, “0” else. MATWEAK is coded “1” for client firm
disclosing a material weakness in internal controls over financial reporting during the prior two years and
“0” otherwise.
words, the impact of the IAF on financial reporting quality is jointly de-
pendent on the level of competence and independence of the IAF. The
reduction in the size of positive abnormal accruals for a certain level of IAF
competence (audit committee oversight of the IAF) is conditional upon au-
dit committee oversight of the IAF (IAF competence). Economically, this
suggests that firms overinvesting in competence (independence), but not
in independence (competence), are in danger of establishing an IAF that
is not effective in strengthening the firms’ financial reporting process. In
other words, the presence of both competence and independence is a nec-
essary antecedent for effective financial reporting monitoring by the IAF.
The significantly negative coefficient (coefficient −0.00013, t-stat
−3.248) for the interaction term between IACOMP and NONOSP20 sug-
gests that the abnormal accrual reduction effect of IACOMP is greater for
firms that do not have a substantial OSP presence (in support of H3). In
other words, greater amounts of investment in the in-house IAF activities
(both in terms of budgets and hours provided by the in-house IAF) yield
greater reductions in positive abnormal accruals (i.e., increase in financial
reporting quality). We do not find a significant interaction effect between
IACOMP and NONMTG. Several of the control variables are significant. AS-
SETS, LEVERAGE, CFO, MTB, CFOVOL, ROA, and LOSS are all significant
and in the predicted direction.
Table 6 summarizes the results from regressing negative (income-
decreasing) accruals on our IAF-related variables and controls variables.
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 27
TABLE 5
OLS Regression Results: Positive Abnormal Accruals
Positive ABNACC = b0 + b1 IACOMP + b2 ACIAFINF + b3 NONMTG + b4 NONOSP20
+ b 5 IACOMP ∗ ACIAFINF + b6 IACOMP ∗ NONMTG
+ b 7 IACOMP ∗ NONOSP20 + b8 ASSETS + b9 AGE + b10 LEVERAGE
+ b 11 SEGNUM + b12 CFO + b13 SALESGROW + b14 MTB + b15 CFOVOL
+ b 16 ROA + b17 LOSS + b18 MATWEAK + b19−28 INDUSTRY + ε.
Independent Variable Expected Sign Coefficient Estimate t-Statistic
Intercept 0.0467 1.1099
IACOMP ? −0.00004 −1.1921
ACIAFINF ? −0.0369 −1.4201∗
NONMTG ? −0.0187 −0.8645
NONOSP20 ? −0.0101 −0.6779
IACOMP ∗ ACIAFINF − −0.00017 −2.3022∗∗
IACOMP ∗ NONMTG − −0.00005 −1.2199
IACOMP ∗ NONOSP20 − −0.00013 −3.2481∗∗∗
ASSETS + 0.0003 2.5778∗∗∗
AGE − −0.0004 −0.3101
LEVERAGE + 0.0412 1.7844∗
SEGNUM + 0.0052 2.9941∗∗∗
CFO − −0.0001 −1.4245∗
SALESGROW + 0.0069 0.7274
MTB + 0.0048 2.9998∗∗∗
CFOVOL + 0.0001 2.2217∗∗
ROA − −0.0101 0.3741
LOSS + 0.0108 0.9577
MATWEAK + 0.0128 0.5299
INDUSTRY Included
Observations 81
Adjusted R2 0.2399
Significance levels (one-tailed if in predicted direction): ∗ ,∗∗ , ∗∗∗ = p-value < 0.10, 0.05, 0.01, respectively.
ABNACC is the Kothari, Leone, and Wasley (2005) version of the modified Jones model measure of
abnormal accruals. IACOMP equals average IAF resource expenditure per hour. ACIAFINF is the relative
audit committee IAF influence vis-à-vis management (CEO and CFO). NONMTG is an indicator variable
coded “1” when the IAF does not serve as a management training ground per survey question #13, and 0
otherwise. NONOSP20 is coded “1” (“0”) when the budgeted outsourced IAF services are less than 20% of
the IAF total budget. ASSETS equals total assets in millions. AGE is the number of years the firm was listed on
Compustat, truncated at 25 years. LEVERAGE equals the sum of long-term debt and current liabilities of a
company divided by total assets. SEGNUM equals the number of disclosed segments a company operates in.
CFO equals cash flows from operations. SALESGROW equals one-year sales growth percentage. MTB equals
the market-to-book ratio. CFOVOL is the standard deviation of operating cash flows for 2005–2009. ROA
equals return on assets. LOSS is coded “1” if the firm experienced a loss in fiscal year 2008, “0” otherwise.
MATWEAK is coded “1” for a client firm disclosing a material weakness in internal controls over financial
reporting during the prior two years and “0” otherwise.
TABLE 6
OLS Regression Results: Negative Abnormal Accruals
Negative ABNACC = b0 + b1 IACOMP + b2 ACIAFINF + b3 NONMTG + b4 NONOSP20
+ b5 IACOMP ∗ ACIAFINF + b6 IACOMP ∗ NONMTG
+ b 7 IACOMP ∗ NONOSP20 + b8 ASSETS + b9 AGE + b10 LEVERAGE
+ b 11 SEGNUM + b12 CFO + b13 SALESGROW + b14 MTB + b15 CFOVOL
+ b 16 ROA + b17 LOSS + b18 MATWEAK + b19−28 INDUSTRY + ε.
Independent Variable Expected Sign Coefficient Estimate t-Statistic
Intercept −0.3110 −1.0772
IACOMP ? 0.00054 1.6005∗
ACIAFINF ? 0.0104 1.2002
NONMTG ? 0.0171 0.8895
NONOSP20 ? 0.0027 0.8874
IACOMP ∗ ACIAFINF + 0.00018 2.9444∗∗∗
IACOMP ∗ NONMTG + 0.00013 2.6222∗∗
IACOMP ∗ NONOSP20 + 0.00006 2.9004∗∗∗
ASSETS − −0.0034 −0.4747
AGE + 0.0012 0.1111
LEVERAGE − −0.0877 −1.4123∗
SEGNUM − 0.0029 0.3133
CFO − 0.0001 0.5998
SALESGROW + 0.0549 1.2987∗
MTB + 0.0008 2.8956∗∗∗
CFOVOL − −0.0002 −0.0765
ROA − −0.4176 −3.1767∗∗∗
LOSS − −0.0728 −2.5649∗∗∗
MATWEAK − −0.0504 −0.2772
INDUSTRY Included
Observations 108
Adjusted R 2 0.201
Significance levels (one-tailed if in predicted direction): ∗ ,∗∗ , ∗∗∗ = p-value < 0.10, 0.05, 0.01, respectively.
All variable definitions can be found in table 2.
ABNACC is the Kothari, Leone, and Wasley (2005) version of the modified Jones model measure of
abnormal accruals. IACOMP equals average IAF resource expenditure per hour. ACIAFINF is the relative
audit committee IAF influence vis-à-vis management (CEO and CFO). NONMTG is an indicator variable
coded “1” when the IAF does not serve as a management training ground per survey question #13, and 0
otherwise. NONOSP20 is coded “1” (“0”) when the budgeted outsourced IAF services are less than 20% of
the IAF total budget. ASSETS equals total assets in millions. AGE is the number of years the firm was listed
on Compustat, truncated at 25 years. LEVERAGE equals the sum of long-term debt and current liabilities of
a company divided by total assets. SEGNUM equals the number of disclosed segments in which the company
operates. CFO equals cash flows from operations. SALESGROW equals one-year sales growth percentage.
MTB equals market-to-book ratio. CFOVOL is the standard deviation of operating cash flows for 2005–2009.
ROA equals return on assets. LOSS is coded “1” if the firm experienced a loss in fiscal year 2008, “0” oth-
erwise. MATWEAK is coded “1” for a client firm disclosing a material weakness in internal controls over
financial reporting during the prior two years and “0” otherwise.
accruals are less likely to be associated with cash flow considerations, and
also that they are less (closer to zero) when sales are growing. This is consis-
tent with fewer incentives for “big bath” behavior when growth is present.
We note that, in order for IAF quality to impact financial reporting qual-
ity, it is necessary for the IAF to be involved in the monitoring of the fi-
nancial reporting process. Per survey question #3 in the appendix, such
opportunities include financial statement audits of subsidiaries and/or as-
sisting the external auditor with the financial statement audit. We observed
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 29
that all respondents had nonzero budget allocations to these activities, indi-
cating that all sample IAF departments had the opportunity to monitor the
financial reporting process.25 In summary, the evidence of tables 5 and 6
is consistent with the characterization of a two-factor IAF quality function,
whereby competence and independence must combine with each other
to promote the IAF as an effective, internally based financial reporting
monitor.26
25 Our survey respondents reported spending 15.4% of in-house audit hours on assisting
with the financial audit, 10.3% on audits of subsidiaries, 6.8% on compliance auditing, and
9.8% on special projects. For comparison, the highest single percentage of time was devoted
to SOX-related controls work (27.15%).
26 Breusch-Pagan tests failed to detect the presence of heteroskedasticity.
30 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
TABLE 7
Logistic Regression Results: Just Meet/Beat Analysts’ Forecasts
JM /BEAT = b0 + b1 IACOMP + b2 ACIAFINF + b3 NONMTG + b4 NONOSP20
+ b 5 IACOMP ∗ ACIAFINF + b6 IACOMP ∗ NONMTG
+ b 7 IACOMP ∗ NONOSP20 + b8 ASSETS + b9 AGE + b10 LEVERAGE
+ b 11 SEGNUM + b12 CFO + b13 SALESGROW + b14 MTB + b15 CFOVOL
+ b 16 ROA + b17 LOSS + b18 MATWEAK + b19−28 INDUSTRY + ε.
Column A Column B
Independent Expected Coefficient Chi-Square Coefficient Chi-Square
Variable Sign Estimate Statistic Estimate Statistic
Intercept −0.3110 1.0772 −0.4971 1.0772
IACOMP ? 0.0054 1.0504 0.0054 1.6603
ACIAFINF ? 0.0104 2.4691 0.0089 1.8550
NONMTG ? 0.0171 0.6738 0.0124 1.7776
NONOSP20 ? −0.0027 0.8874 0.0022 0.6911
IACOMP ∗ ACIAFINF − −0.0098 4.4823∗∗ −0.0117 4.4187∗∗
IACOMP ∗ NONMTG − −0.0013 1.6788 −0.0005 2.5558
IACOMP ∗ NONOSP20 − −0.0048 5.9004∗∗ −0.0054 5.1234∗∗
ASSETS + −0.0034 1.2626 −0.0301 1.7231
AGE − 0.0049 0.9203 0.0012 0.1111
LEVERAGE + 1.3944 3.9487∗∗ 1.6553 3.7349∗
SEGNUM + 0.3249 2.8777∗ 0.0829 2.7792∗
CFO − 0.0001 0.0075 −0.0002 0.0978
SALESGROW + 0.3551 1.0013 0.2817 1.1113
MTB + 0.0498 4.7145∗∗ 0.0502 2.8277∗
CFOVOL − −0.0002 0.0765 −0.0002 0.0765
ROA + 2.8783 5.1055∗∗ 2.6533 3.6783∗
LOSS − −0.4445 1.3011 −0.6235 0.9645
MATWEAK − −0.0513 0.7381 −0.0719 0.5334
INDUSTRY Included Included
Observations 189 189
Pseudo-R 2 0.201 0.137
Significance levels (one-tailed if in predicted direction): ∗ ,∗∗ , ∗∗∗ = p-value < .10, .05, .01, respectively.
Column A present results when the dependent variable is defined as JM/BEAT is a dichotomous depen-
dent variable coded “1” in instances where the firm met the consensus annual EPS forecast scaled by price
at the beginning of the year or exceeded the forecast by more than 0.0005; “0” else. Column B presents
results when the dependent variable is defined as JM/BEATaccr , coded “1” if the firm would have missed
analysts’ forecasts, without abnormal positive accruals, “0” else. All other variables are defined as previously
described.
27 In untabulated results, we isolate those firms that appear to have utilized abnormal accru-
als to just meet/beat forecasts, and find similar results, though at lower levels of significance.
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 31
28 Carcello, Hermanson, and Raghunandan [2005] also find that the presence of an OSP
negatively impacts overall the IAF budget. Instead of using a dichotomous OSP “presence”
variable per Carcello, Hermanson, and Raghunandan [2005], we use NONOSP20, which is
substantively similar to the variable used in Carcello, Hermanson, and Raghunandan [2005].
We note that neither NONOSP20 nor a dichotomous OSP presence variable is significantly
associated with IACOMP.
32 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
correlated with each other and do not appear to significantly influence IAF
competence, our primary focus is predicting IACOMP in a first-stage regres-
sion. Similar to Prawitt, Smith, and Wood [2009], our objective is to utilize
instrumental variables that are correlated with IACOMP, but not correlated
with our measures of financial reporting quality. Our two instrumental vari-
ables include an average IACOMP score by industry and the amount of in-
ventory relative to assets.29 We then use the predicted IACOMP value in a
second-stage regression using the same set of dependent variables found in
tables 5–7. We obtain virtually identical results to those reported in tables
5–7.
We also considered numerous categories of potentially omitted corre-
lated variables. With respect to auditor-related variables, prior research has
indicated that auditor tenure (Davis, Soo, and Trompeter [2009]), auditor
industry specialization (Reichelt and Wang [2010]) and the magnitude of
non-audit fees (Frankel, Johnson, and Nelson [2002]) may impact financial
reporting quality. Our results remained unchanged when we included: (1)
a continuous variable defined as total auditor tenure (capped at 25); (2)
a dichotomous variable coded “1” when the external auditor audited the
largest percentage of client assets per the two-digit focus industry per table
1, and “0” otherwise and (3) a continuous variable defined as the ratio of
non-audit service fees to audit fees.
We utilized various alternative control variables for corporate governance
and/or audit committee effectiveness, including the Gompers, Ishii, and
Metrick [2003] corporate governance index, and the type and percent-
age of financial experts present on the audit committee (Dhaliwal, Naiker,
and Navissi [2010]).30 We also examined certain CFO characteristics (age,
tenure, board membership, stockholdings, and gender) given their poten-
tial impact on financial reporting decisions (Ge, Matsumoto, and Zhang
[2011]). Inclusion of the above variables did not substantively alter the re-
sults of tables 5–7.
We examined whether IACOMP might be capturing the effect of high
cost of living areas by including “high-cost” dummy variables.31 We included
a variable for the percentage of IAF budget allocated to financial state-
ment auditing per Lin et al. [2011]. We examined the potential effects of
litigious industries and labor intensiveness (Frankel, Johnson, and Nelson
[2002], Matsumoto [2002]). We included a dichotomous variable coded
“1” in instances where the primary SIC code indicated a litigious industry
IACOMP because internal auditors have the opportunity to transfer their skills from one com-
pany to the other and would do so as a means of increasing or maintaining their current salary.
Similar to Prawitt, Smith, and Wood [2009], the industry-wide IACOMP value is unlikely to be
correlated with our dependent variables since we do not find that financial reporting quality
is highly concentrated in a few industries.
30 Experts are current or former certified public accountants, CFOs, vice presidents of fi-
6. Conclusion
We examine whether IAF quality—and its ability to foster higher quality
financial reporting—can be reasonably characterized as a joint function of
both competence and independence. Our tests rely on the argument that
the effectiveness of the IAF rests upon the complementary roles of compe-
tence and independence. For example, even though a competent IAF may
the following survey questions: 12a/12d/12g. That is, survey respondents all stated that the
audit committee had some sort of influence over the IAF. In slightly less than 3% of our ob-
servations, the CIA indicated that the audit committee had sole province over the IAF (that is,
strongly agreed with survey questions 12a/12d/12g, while simultaneously strongly disagreeing
with survey questions 12b/12c/12e/12f/12h/12i). These results indicate that it is extremely
rare for the audit committee to have sole control over the IAF and that there are virtually no
instances where the audit committee has no influence over the IAF.
34 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
APPENDIX
4. Please indicate the total fiscal year 2009 internal audit-related expen-
ditures for:
6. Please indicate the percentage of your staff who have the following
certifications:
CPA CIA CISA % of staff with at least 1 certification
7. With respect to you personally, please indicate how many years of work
experience you have as: an internal auditor
a financial statement auditor
8. With respect to you personally, which certification(s) do you possess?
(check all that apply):
CPA CIA CISA Other
9. Which of the following best describes how controls over financial re-
porting are monitored at your entity?
a. Separate Evaluations b. Controls self-assessments c. Other (explain)
10. Which of the following best describes how your entity conducts its
assessments of the effectiveness of controls over financial reporting?
a. Ongoing testing throughout the year b. Point-in-time near year-end
c. Other (explain).
11. What are the key components of your organization’s internal audit
risk assessment and weighting of each (not considered, low, medium,
high).
12. Please indicate your level of agreement with the following statements:
Level of agreement
Statement (circle one number)
a. Internal audit reports to the Audit Committee 12345
b. Internal audit reports to the Chief Financial Officer 12345
(CFO)
c. Internal audit reports to the Chief Executive Officer 12345
(CEO)
d. The Audit Committee has authorization to 12345
terminate the Chief Internal Auditor
e. The CFO has authorization to terminate the Chief 12345
Internal Auditor
f. The CEO has authorization to terminate the Chief 12345
Internal Auditor
g. The Audit Committee determines Internal Audit’s 12345
annual budget
h. The CFO determines Internal Audit’s annual budget 12345
i. The CEO determines Internal Audit’s annual budget 12345
j. The Audit Committee reviews and approves Internal 12345
Audit’s annual risk assessment plan
k. The CFO reviews and approves Internal Audit’s 12345
annual risk assessment plan
l. The CEO reviews and approves Internal Audit’s 12345
annual risk assessment plan
13. Does internal audit serve as a training ground for future management
positions? Yes No
REFERENCES
ABBOTT, L. J.; S. PARKER; AND G. F. PETERS. “Earnings Management, Litigation Risk, and Asym-
metric Audit Fee Responses.” Auditing: A Journal of Practice and Theory 25 (2006): 85–98.
ABBOTT, L. J.; S. PARKER; AND G. F. PETERS. “Serving Two Masters: The Association Between Au-
dit Committee Internal Audit Oversight and Internal Audit Activities.” Accounting Horizons
24 (2010): 1–24.
ABBOTT, L. J.; S. PARKER; AND G. F. PETERS. “Audit Fee Reductions from Internal Audit-
Provided Assistance: The Incremental Impact of Internal Audit Characteristics.” Contempo-
rary Accounting Research 29 (2012): 94–118.
38 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
ABBOTT, L. J.; S. PARKER; G. F. PETERS; AND D. V. RAMA. “Corporate Governance, Audit Quality,
and the Sarbanes-Oxley Act: Evidence from Internal Audit Outsourcing.” The Accounting
Review 82 (2007): 803–35.
AHLAWAT, S. S., AND D. J. LOWE. “An Examination of Internal Auditor Independence: In-
House Versus Outsourcing.” Auditing: A Journal of Practice and Theory 23 (2004): 147–58.
AI, C., AND E. NORTON. “Interaction Terms in Logit and Probit Models.” Economic Letters 80
(2003): 123–29.
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS (AICPA). AU Section 322: SAS No. 65 -
The Auditor’s Consideration of the Internal Audit Function in an Audit of Financial Statements. New
York, NY: AICPA, 1991.
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS (AICPA). Proposed Statement on Audit-
ing Standards: Using the Work of Internal Auditors. New York, NY: AICPA, 2013.
ANDERSON, U. “Assurance and Consulting Services” in Research Opportunities in Internal Au-
diting, edited by A.D. Bailey, A. A. Gramling, and S. Ramamoorti. Altamonte Springs, FL:
Institute of Internal Auditors Research Foundation, 2003.
ANDERSON, U.; M. CHRIST; K. JOHNSTONE; AND L. RITTENBERG. “A Post-SOX Examination of
Factors Associated with the Size of the Internal Audit Functions.” Accounting Horizons 26
(2012): 167–91.
BALL, R., AND L. SHIVAKUMAR. “The Role of Accruals in Asymmetric Timely Gain and Loss
Recognition.” Journal of Accounting Research 44 (2006): 207–42.
BAME-ALDRED, C.; D. BRANDON; B. MESSIER; L. RITTENBERG; AND C. M. STEFANIAK. “A Sum-
mary of Research on External Auditor Reliance on the Internal Audit Function.” Auditing:
A Journal of Practice and Theory 32 (2012): 251–86.
CARCELLO, J.; D. HERMANSON; AND K. RAGHUNANDAN. “Factors Associated with U.S. Public
Companies’ Investment in Internal Auditing.” Accounting Horizons 19 (2005): 69–84.
CHRIST, M. H.; A. MASLI; N. Y. SHARP; AND D. A. WOOD. “Rotational Internal Audit Programs
and Financial Reporting Quality: Do Compensating Controls Help?” Accounting, Organiza-
tions and Society 44 (2015): 37–59.
CHRISTOPHER, J.; G. SARENS; AND P. LEUNG. “A Critical Analysis of the Independence of the
Internal Audit Function: Evidence from Australia.” Accounting, Auditing, & Accountability
Journal 22 (2009): 200–20.
COHEN, J.; G. KRISHNAMOORTHY; AND A. WRIGHT. “Corporate Governance in the Post-Sarbanes
Oxley Era: Auditors’ Experiences.” Contemporary Accounting Research 27 (2010): 751–86.
CORAM, P.; C. FERGUSON; AND R. MORONEY. “The Internal Audit, Alternative Internal Audit
Structures, and the Level of Misappropriation of Assets Fraud.” Accounting and Finance 48
(2008): 543–59.
DAVIS, L.; B. SOO; AND G. TROMPETER. “Auditor Tenure and the Ability to Meet or Beat Earn-
ings Forecasts.” Contemporary Accounting Research 26 (2009): 517–48.
DEANGELO, H.; L. DEANGELO; AND D. J. SKINNER. “Accounting Choice in Troubled Compa-
nies.” Journal of Accounting and Economics 17 (1994): 113–43.
DEANGELO, L. “Auditor Size and Audit Quality.” Journal of Accounting and Economics 3 (1981):
189–99.
DECHOW, P. M., AND I. D. DICHEV. “The Quality of Accruals and Earnings: The Role of Accrual
Estimation Errors.” The Accounting Review 77 (2002): 35–59.
DECHOW, P. M.; R. SLOAN; AND A. SWEENEY. “Causes and Consequences of Earnings Manip-
ulation: An Analysis of Firms Subject to Enforcement Actions by the SEC.” Contemporary
Accounting Research 13 (1996): 1–36.
DHALIWAL, D. S.; V. NAIKER; AND F. NAVISSI. “The Association Between Accruals Quality and
the Characteristics of Accounting Experts and Mix of Expertise on Audit Committees.” Con-
temporary Accounting Research 27 (2010): 787–827.
DOYLE, J. T.; W. GE; AND S. MCVAY. “Accruals Quality and Internal Control over Financial
Reporting.” The Accounting Review 82 (2007): 1141–70.
ERNST & YOUNG (EY). Global Internal Audit Survey, 2008. Available at www.ey.com.
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 39
FELIX, W.; A. GRAMLING; AND M. MALETTA. “The Contribution of Internal Audit as a Determi-
nant of External Audit Fees and Factors Influencing this Contribution.” Journal of Accounting
Research 39 (2001): 513–34.
FRANCIS, J. “A Framework for Understanding and Researching Audit Quality.” Auditing: A Jour-
nal of Practice and Theory 30 (2011): 125–52.
FRANKEL, R.; M. JOHNSON; AND K. NELSON. “The Relation Between Auditors’ Fees for Nonaudit
Services and Earnings Management.” The Accounting Review 77 (2002): 71–105.
GE, W.; D. MATSUMOTO; AND J. ZHANG. “Do CFOs Have Style? An Empirical Investigation of
the Effect of Individual CFOs on Accounting Practices.” Contemporary Accounting Research 28
(2011): 1141–79.
GOMPERS, P.; J. ISHII; AND A. METRICK. “Corporate Governance and Equity Prices.” The Quarterly
Journal of Economics 118 (2003): 107–156.
GOODWIN, J., AND T. Y. YEO. “Two Factors Affecting Internal Audit Independence and Inde-
pendence: Evidence from Singapore.” International Journal of Auditing 5 (2001): 107–25.
GRAHAM, J. R., AND C. R. HARVEY. “The Theory and Practice of Corporate Finance: Evidence
from the Field.” Journal of Financial Economics 60 (2001): 187–243.
HARRINGTON, C. “Internal Audit’s New Role.” Journal of Accountancy (September) (2004): 25–40.
HERMANSON, D. “The Growing Stature of Internal Auditing.” Internal Auditing 17 (2002): 43–
44.
HERMANSON, D., AND L. RITTENBERG. “Internal Audit and Organizational Governance.” In Re-
search Opportunities in Internal Auditing. Altamonte Springs, FL: Institute of Internal Auditors
Research Foundation, 2003.
HOFFELDER, K. “New Guidance Could Add Teeth to Internal Audit.” CFO.com, 2012. Avail-
able at http://www3.cfo.com/article/2012/10/auditing˙eisneramper-institute-of-internal-
auditors-chief-audit-executive-standards/.
HOGAN, C., AND D. JETER. “Industry Specialization by Auditors.” Auditing: A Journal of Practice
and Theory 18 (1999): 1–17.
INSTITUTE OF INTERNAL AUDITORS (IIA). The IIA’s Recommendations to the Conference Committee on
H.R. 3703. Altamonte Springs, FL: IIA, 2002.
INSTITUTE OF INTERNAL AUDITORS (IIA). Professional Practices Framework.” Altamonte Springs,
FL: IIA, 2005.
INSTITUTE OF INTERNAL AUDITORS (IIA). Global Internal Audit Competency Framework. Altamonte
Springs, FL: IIA, 2013.
INTERNATIONAL AUDITING AND ASSURANCE STANDARDS BOARD (IAASB). ISA 610 (Revised
March 2013), Using the Work of Internal Auditors. International Federation of Accountants
(IFAC), New York. Available at http://www.ifac.org/sites/default/files/publications/files/
ISA-610-(Revised-2013).pdf.
JACCARD, J. J., AND R. TURRISI. Interaction Effects in Multiple Regression, Second edition, Sage
Publications, Newbury Park, CA: 2003.
KAPLAN, S. E., AND J. J. SCHULTZ JR. The Role of Internal Audit in Sensitive Communications. The
Institute of Internal Audit Research Foundation. Altamonte Springs, FL: IIA, 2006.
KOH, K.; D. A. MATSUMOTO; AND S. RAJGOPAL. “Meeting or Beating Analyst Expectations in
the Post-Scandals World: Changes in Stock Market Rewards and Managerial Actions.” Con-
temporary Accounting Research 25 (2008): 1067–98.
KOTHARI, S. P.; A. J. LEONE; AND C. E. WASLEY. “Performance Matched Discretionary Accrual
Measures.” Journal of Accounting and Economics 39 (2005): 163–97.
LIN, S.; M. PIZZINI; M. VARGUS; AND I. R. BARDHEN. “The Role of the Internal Audit Function
in the Disclosure of Material Weakness.” The Accounting Review 86 (2011): 287–323.
MABRY, B., AND L. SCHWARTZ. Working with Auditors and Management. Ernst & Young LLP, 2008.
MANDE, V., AND M. SON. “CEO Centrality and Meeting or Beating Analysts’ Earnings Fore-
casts.” Journal of Business Finance and Accounting 39 (2012): 82–112.
MATSUMOTO, D. “Management’s Incentives to Avoid Negative Earnings Surprises.” The Account-
ing Review 77 (2002): 483–514.
MENON, K., AND D. WILLIAMS. “Former Audit Partners and Abnormal Accruals.” The Accounting
Review 79 (2004): 1095–118.
40 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
MESSIER, W. F.; J. K. REYNOLDS; C. A. SIMON; AND D. A. WOOD. “The Effect of Using the Inter-
nal Audit Function as a Management Training Ground on the External Auditor’s Reliance
Decision.” The Accounting Review 86 (2011): 2131–154.
NASDAQ STOCK MARKET LLC (NASDAQ). “Notice of Filing of Proposed Rule Change to
Require that Listed Companies Have an Internal Audit Function.” Release No. 34-69030;
File No. SR-NASDAQ-2013-032, 2013. Available at http://www.sec.gov/rules/sro/nasdaq/
2013/34-69030.pdf.
NORMAN, C. S.; A. M. ROSE; AND J. M. ROSE. “Internal Audit Reporting Lines, Fraud Risk
Decomposition, and Assessments of Fraud Risk.” Accounting, Organizations, and Society 35
(2010): 546–57.
NORTON, E.; H. WANG; AND C. AI. “Computing Interaction Effects and Standard Errors in
Logit and Probit Models.” The Stata Journal 4 (2004): 154–67.
PELFREY, S., AND E. PEACOCK. “A Current Status Report on Outsourcing.” Internal Auditing Fall
(1995): 26–32.
PRAWITT, D. F.; N. Y. SHARP; AND D. A. WOOD. “Reconciling Archival and Experimental Re-
search: Does Internal Audit Contribution Affect the External Audit Fee?” Behavioral Research
in Accounting 23 (2011): 187–206.
PRAWITT, D. F.; N. Y. SHARP; AND D. A. WOOD. “Internal Audit Outsourcing and the risk of Mis-
leading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get It Wrong?” Contemporary
Accounting Research 29 (2012): 1109–36.
PRAWITT, D. F.; J. L. SMITH; AND D. A. WOOD. “Internal Audit Characteristics and Earnings
Management.” The Accounting Review 84 (2009): 1255–80.
PRESS, E. G., AND J. B. WEINTROP. “Accounting-Based Constraints in Public and Private Debt
Agreements.” Journal of Accounting and Economics 12 (1990): 65–95.
PRICEWATERHOUSECOOPERS LLP (PWC). Business Upheaval: Internal Audit Weighs Its Role Amid
the Recession and Evolving Enterprise Risks. New York, NY: PWC, 2009.
PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD (PCAOB). Auditing Standard 5: An Audit of
Internal Control over Financial Reporting that Is Integrated with an Audit of Financial Statements.
Washington, D.C.: PCAOB, 2007.
QUARLES, N. R. “An Examination of Promotion Opportunities and Evaluation Criteria as
Mechanisms for Affecting Internal Auditor Commitment, Job Satisfaction and Turnover
Intentions.” Journal of Managerial Issues 6 (1994): 176–94.
RAGHUNANDAN, K.; W. READ; AND D. V. RAMA. “Audit Committee Composition, ‘Grey Direc-
tors,’ and Interaction with Internal Auditing.” Accounting Horizons 15 (2001): 105–18.
REICHELT, K., AND D. WANG. “National and Office-Specific Measures of Auditor Industry Ex-
pertise and Effects on Audit Quality.” Journal of Accounting Research 48 (2010): 647–86.
ROSE, J., AND C. S. NORMAN. Internal Audit Reporting Lines: Fraud Risk Decomposition, and As-
sessments of Fraud Risk. Altamonte Springs, FL: The Institute of Internal Auditors Research
Foundation, 2008.
SARBANES-OXLEY ACT OF 2002 (SOX). “Corporate and Auditing and Accountability, Respon-
sibility, and Transparency Act of 2002.” U.S. Public Law 107-204. 107th Cong., 2d sess., 30
July 2002.
SCARBROUGH, D.; D. V. RAMA; AND K. RAGHUNANDAN. “Audit Committee Composition and
Interaction with Internal Auditing: Canadian Evidence.” Accounting Horizons 12 (1998): 51–
62.
STEWART, J., AND N. SUBRAMANIAM. “Internal Audit Independence and Independence: Emerg-
ing Research Opportunities.” Managerial Auditing Journal 25 (2010): 328–60.