Z.11 Ismael Internal Audit Quality and Earnings Management: Evidence From The UK

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Internal audit
Internal audit quality and quality
earnings management:
evidence from the UK
Hazem Ramadan Ismael and Hany Kamel 951
College of Business and Economics, Qatar University, Doha, Qatar
Received 13 September 2020
Revised 9 May 2021
Accepted 1 July 2021
Abstract
Purpose – This study aims to examine the association between internal audit quality and the involvement
of UK companies in earnings management practices.
Design/methodology/approach – To measure the internal audit quality, this study uses 115 responses
for a postal questionnaire that was addressed to the heads of internal audit departments in a sample of non-
financial listed companies in the UK context. The other financial and governance data for the respondent
companies were collected from the Datastream and the companies’ annual reports. The present study uses the
signed abnormal accruals as a proxy for earnings management and uses both logistic and ordinary least
squares regression models to test the research hypothesis.
Findings – This study finds a negative relationship between the internal audit quality and the abnormal
accruals, implying the prominent role of internal audit in reducing the upwards earnings management. The
study also finds a significant impact of the internal audit competence on reducing the engagement of UK
companies in income-increasing earnings management compared to the internal audit independence. This
remarkable result suggests the companies need to focus more on enhancing the internal audit competence to
reduce the opportunistic management’s behaviour.
Practical implications – This study has important implications for the internal audit’s practice,
regulation and research.
Originality/value – This is the first study that investigates the relationship between internal audit quality
and earnings management in the UK context. Furthermore, it uses a comprehensive measure for the internal
audit function (IAF) quality covering different aspects of IAF quality based on the global Institute of Internal
Auditor standards and prior internal audit literature.
Keywords Internal audit, Earnings management, Corporate governance, Audit committee,

Financial reporting quality
Paper type Research paper
1. Introduction
The string of accounting scandals, which rocked the stock markets worldwide in the late
1990s and early 2000s, severely undermined the confidence in the financial reporting process
and, consequently, the financial markets as a whole (Yoon et al., 2006). The accumulated
evidence in the UK is consistent with the widespread suspicions that reported earnings
could not be relied upon, and that they are managed in favour of managers’ short-term
interests at the expense of the quality of financial reporting (Atieh and Hussain, 2012; Gore
et al., 2007; Iatridis and Kadorinis, 2009; Zalata and Roberts, 2017). It has been well-
documented in the accounting literature that managers may be engaged in manipulative Managerial Auditing Journal
earnings management activities so as to, for example, meet the earnings forecasts of Vol. 36 No. 7, 2021
pp. 951-978
financial analysts (Iatridis and Kadorinis, 2009), avoid reporting losses and the violation of © Emerald Publishing Limited
0268-6902
debt covenants (Charoenwong and Jiraporn, 2009), reduce the cost of debt (Orazalin and DOI 10.1108/MAJ-09-2020-2830
MAJ Akhmetzhanov, 2019) and maximize the proceeds of initial public offerings (Armstrong
36,7 et al., 2016; Cecchini et al., 2012).
The conflict of interests and information asymmetry between owners and managers,
which are embedded in the agency relationship (Jensen and Meckling, 1976), provide
incentives for management to commit earnings management. Therefore, rigorous
monitoring mechanisms are required to reduce earnings management practices and restore
952 trust in the financial markets. Accordingly, several studies have emerged in the academic
literature to explore whether the initiatives of corporate governance have led to an
improvement in the quality of financial reporting and to what extent these initiatives have
been effective in mitigating the problem of earnings management (Al-Okaily et al., 2020;
Arun et al., 2015; Kent et al., 2010; Klein, 2002; Peasnell et al., 2005; Qamhan et al., 2018; Xie
et al., 2003). The results, in general, demonstrate that the engagement in earnings
management practices is negatively associated with the presence of sound governance
mechanisms (such as the existence of an effective audit committee (AC), the existence of
an independent and competent board of directors and the existence of women directors on
boards). Regarding a specific internal governance mechanism (i.e. internal audit function
[IAF]), there is a widespread belief that an effective IAF could perform many roles relevant
to the financial reporting process. These roles include evaluating the risk exposure,
performing financial statements audit, providing assurance and consulting services about
the effectiveness of the internal controls over the financial reporting process, and helping
prevent and detect fraudulent financial reporting (Abbott et al., 2016; Abbott et al., 2012;
Baatwah et al., 2021; Felix et al., 2001; IIA, 2017; Kabuye et al., 2017; Oussii and Boulila
Taktak, 2018; Park and Park, 2020; Prawitt et al., 2009). These roles provided by the IAF are
closely aligned with the financial reporting oversight responsibilities of the board of
directors and the AC, and, therefore, the IAF is considered an important corporate
governance mechanism to safeguard financial reporting quality (Asare et al., 2008; Eighme
and Cashell, 2002; Gebrayel et al., 2018; Goodwin, 2003; Goodwin and Yeo, 2001; Ismael and
Roberts, 2018). Rezaee (2002) argues that internal auditors can help the AC and management
through evaluating the company’s compliance with its internal and external reporting
requirements, reviewing the appropriateness of the accounting principles that the company
uses, evaluating the sufficiency and effectiveness of the company’s internal controls over the
financial reporting process and providing information and insight regarding the strength of
controls over the quarterly reporting process, as well as the credibility of the quarterly
financial reports. Therefore, the IAF has received greater attention, especially after the
spectacular accounting scandals that have taken place in recent years, such as Enron,
WorldCom and Parmalat (Gramling et al., 2004). It is notable to mention here that the
internal auditor “Cynthia Cooper” was the person who discovered and reported the
WorldCom fraud case in 2002 (Prawitt et al., 2009). Thus, the Institute of Internal Auditors
(IIA) emphasizes that the establishment of an IAF would enhance the quality of internal
corporate governance, as it provides firms with objective assurance and insight on the
effectiveness and efficiency of risk management, internal control and governance processes
(IIA, 2018a; IIA, 2018b). Furthermore, the IIA standards require the IAF to evaluate the
fraud and non-compliance risks and how the organization manages these risks and report
periodically about these issues to the board and senior management (IIA, 2017).
As a further testament to the importance of the IAF, the listing rules of the New York
Stock Exchange (NYSE) have required all listed companies to have an IAF to help both the
AC and board of directors in fulfilling their corporate governance responsibilities (NYSE
Listed Company Manual, Section 303 A.07). In the UK, the establishment of an IAF is still
voluntary. However, the UK corporate governance code requires the listed companies to
disclose in their annual reports whether they have an IAF or not and to disclose the reasons Internal audit
for not having an IAF. In addition, it requires the AC to evaluate the need for such a function quality
annually (Financial Reporting Council, 2016).
Some studies have examined the association between IAF existence (but not IAF quality)
and financial reporting quality. Beasley et al. (2000), Sierra García et al. (2012) and Gebrayel
et al. (2018) found a significant negative association between IAF existence and committing
fraud and earnings management in the US, Spain and Oman, respectively. In contrast,
Davidson et al. (2005) found an insignificant association between the voluntary 953
establishment of an IAF and earnings management in Australia.
Furthermore, few prior studies examined the relationship between IAF quality and
financial reporting quality. In the US context, Prawitt et al. (2009) found a moderate negative
association between IAF quality and earnings management, whilst Ege (2015) found a
negative association with the likelihood of management misconduct. In addition, Abbott
et al. (2016) found that the interaction between the IAF competence and the AC’s influence
restrain upward and downward earnings management. Outside the USA, K. Johl et al. (2013)
provided mixed and unexpected results concerning the relationship between the IAF quality
and abnormal accruals in Malaysia, compared to the US studies. Their initial results
indicated a positive relationship between IAF quality and abnormal accruals.
Nevertheless, the previous studies conducted in the UK context have mostly failed to
address the impact of a quality IAF on the financial reporting quality. These studies have
mainly examined the association between the board composition and the phenomenon of
earnings management. For instance, Katmon and Farooque (2017) have empirically
investigated the impact of disclosure quality and some board and AC-related variables (i.e.
independence, size, number of meetings and financial expertise) on the prevalence of
earnings management using a sample of 145 UK listed companies over the period 2005-2008.
The findings have consistently pointed out a significant negative association between
earnings management and disclosure quality, whilst the associations between earnings
management and corporate governance mechanisms are mostly insignificant.
In the same vein, Peasnell et al. (2005) have examined the effect of board composition on
the incidence of earnings management in the UK context and found that firms with a higher
proportion of non-executive directors on the board are less likely to engage in income-
increasing earnings management. On the contrary, they have found no evidence that
the presence of an AC has any impact on the extent of income-increasing manipulations. The
authors have explained the AC’s insignificant result by the fact that most of the firms
included in the study (i.e. 84%) had such a committee.
In light of the preceding discussion and given the scarcity of research that addresses the
impact of IAF on the integrity of financial statements, this study is motivated to investigate
the association between the IAF quality and the engagement in earnings management
activities by the UK non-financial companies that are listed on the London stock exchange
(LSE) main market. Accordingly, this study, we argue, contributes to the existing
knowledge in many areas. Firstly, it is the first study, to the best of our knowledge, that
examines the relationship between IAF quality and earnings management in the UK, whilst
the previous studies on the same topic are few and have exclusively used US data (Abbott
et al., 2016; Ege, 2015; Prawitt et al., 2009).
Secondly, unlike the previous studies, this study uses a comprehensive composite
measure to proxy for the IAF quality. This measure, consistent with Ismael (2019), is based
on the comprehensive IIA standards and prior internal audit literature covering different
aspects of IAF quality, namely, size, independence, methodology and skills and knowledge.
The previous studies that investigated the association between IAF quality and earnings
MAJ management have mainly relied upon IAF quality measures that are based on the external
36,7 auditing standards (Prawitt et al., 2009) or relatively limited quality characteristics (Abbott
et al., 2016) compared to the comprehensive IIA standards.
Thirdly, to collect the IAF data from UK companies, this study relies on a postal
questionnaire with a transparent and approved process to identify each respondent
company. This method provides the present study with the advantage of matching the
954 questionnaire responses and the archival data for the respondent companies and increases
our results’ power compared to the previous studies. For example, Prawitt et al. (2009) used
responses from the IIA’s global audit information network (GAIN) to collect IAF data, whilst
the IIA itself does not identify the respondent’s organization in its shared data. Therefore,
the authors then matched the self-reported fields in the IIA’s GAIN survey with data items
in the Compustat to identify the companies and measure their earnings management and
other control variables. This process of matching might be less accurate than the approved
identification process adopted in the present study. Finally, our study contributes
empirically to the agency theory by providing evidence for the role of internal audit, as an
internal monitoring mechanism, in reducing agency problems such as the occurrence of
earnings management in the UK context.
The findings of our analyses (both the univariate and multivariate tests) show a
significant negative association between IAF quality and committing income-increasing
earning management. Companies with higher IAF quality are less likely to have positive
abnormal accruals, suggesting the critical role of IAF in reducing the engagement of UK
companies in income-increasing earnings management practices. In addition, the principal
component analysis (PCA) for the IAF quality characteristics indicates a significant impact
of the IAF competence on reducing the income-increasing earnings management, whilst the
IAF independence has an insignificant impact.
The remainder of this study is organized as follows: Section 2 discusses the relevant
literature and hypothesis development. Section 3 introduces the sampling and data,
measurement of variables and the used models. Section 4 discusses the descriptive statistics
and the empirical findings and provides further analyses and robustness checks. And
finally, conclusions and suggested future research are provided in Section 5.
2. Literature review and hypothesis development

The focus of the IAF was traditionally on controls and operational risks and helping
management make decisions (Ramamoorti, 2003). After the repeated financial scandals in the
early 2000s, this focus extended to improving the corporate governance process and detecting
management fraud and inappropriate accounting practices (including earnings management)
(Gramling et al., 2004; Sarens et al., 2009). For example, Gramling et al. (2004) concluded that the
IAF is considered a fundamental cornerstone for effective corporate governance that provides
services for the AC, management and the external auditor. Paape et al. (2003) also revealed that
the IAF can provide different audit activities such as operational audits, compliance audits,
financial audits, risk assessment and management and electronic data processing or
information technology (IT) audits. In addition, many studies (Beasley et al., 2009; Prawitt et al.,
2009; Sarens et al., 2009) found that the IAF role in monitoring and improving the internal
control system and detecting the weaknesses in internal controls over the financial reporting
process provides a significant level of comfort to the AC.
Although there has been a growing emphasis on the IAF roles in corporate governance
(as discussed above), a limited number of studies have empirically examined the association
between the existence of an IAF and the quality of the financial reporting process due to the
unavailability of data. For example, Beasley et al. (2000) investigated a sample of fraud firms
in the US and found that these firms were less likely to have an IAF than a benchmark of Internal audit
non-fraud firms. In addition, Sierra García et al. (2012) found a negative association between quality
earnings management and both the existence of an IAF and some AC’s characteristics (i.e.
size and a number of meetings) in a sample of 108 non-financial Spanish companies traded
on Madrid Stock Exchange. In contrast, Davidson et al. (2005) found no support for the
association between the voluntary establishment of an IAF and earnings management using
a sample of 434 Australian listed companies for the fiscal year of 2000. In a recent paper,
Gebrayel et al. (2018) found that the IAF existence positively affects the financial reporting 955
quality, measured as accruals quality and absolute discretionary accruals, in a sample of 71
non-financial firms listed on the Muscat Securities Market. Remarkably, all the studies
above argued that the existence of an IAF might not be a guarantee for increasing the
quality of the financial reporting process. The IAF’s ability to deter fraud, earnings
management or irregularities will heavily depend on its quality characteristics rather than
its only existence (Abbott et al., 2016; Ege, 2015; Ismael, 2019; Prawitt et al., 2009).
The previous internal audit literature and the IIA standards highlight four main
categories of quality characteristics that can affect the IAF’s ability and effectiveness in
performing its governance-related roles and activities (Arena and Azzone, 2009; Hass et al.,
2006; Ismael, 2019; Sarens, 2009; IIA, 2017). These four characteristics are the IAF’s size,
independence, methodology and management and skills and knowledge. Firstly, the
external auditors heavily use the IAF size to evaluate the IAF’s quality and whether they
will rely on its work or not (Arena and Azzone, 2009; Ismael, 2019; Felix et al., 2001). Larg
IAF is assumed to spend more auditing time, have different backgrounds and perform
various audit activities. Secondly, the IAF should be organizationally independent of upper
management. To maintain the IAF’s independence, according to the IIA standards, the IAF
must report functionally (directly) to the board/AC and administratively (operationally) to
the management (IIA, 2017). This dual reporting line would enable the IAF to serve the
management’s needs and, at the same time, protect the IAF from fear of top management’s
retaliation for reporting inappropriate actions (Eighme and Cashell, 2002). Also, to maintain
its independence, the IAF should have unrestricted access to and private meetings with the
board/AC and that the board/AC should also have the authority to hire and fire the chief
audit executive (CAE) and to approve the IAF’s charter, budget and annual plan (Abbott
et al., 2010; Arena and Azzone, 2009; Sarens, 2009; Goodwin and Yeo, 2001; IIA, 2017).
Thirdly, Sarens (2009) and Ismael (2019) highlight that the IAF’s compliance with particular
IIA standards concerning the methodology and management of the IAF will increase its
perceived quality. These IIA standards include the requirement to maintain an internal
audit charter, establish risk-based internal audit (RBIA) plans, establish guiding policies
and procedures (manuals) and develop and maintain a quality assurance and improvement
programme (IIA, 2017). Finally, both the prior literature and the IIA standards state that the
IAF must have the required skills and knowledge to fulfil its objectives. These skills and
Knowledge typically include several factors such as the internal audit experience, the IIA
membership and certification, an audit team with various backgrounds and the provision of
continuous training programmes for the IAF team (Myers and Gramling, 1997; Sarens, 2009;
Ismael, 2019).
Concerning the prior studies that investigate the relationship between IAF quality and
financial reporting quality, Prawitt et al. (2009) found a moderate negative association
between earnings management and the quality of an IAF. This study used responses of
internal auditors to the IIA GAIN survey and collected data for 218 publicly traded US firms
over the period 2000–2005. To assess the IAF quality, Prawitt et al. (2009) used a measure
based on an external auditing standard (i.e. statement on auditing standards No. 65) that
MAJ guides external auditors in evaluating the quality of IAF. This measure ranges from 0 to 6
36,7 and evaluates the IAF based on six components, namely, average experience, professional
certification, training, focus on financial audit work, the reporting line of the CAE and the
size of the IAF (the dollar amount spent on internal auditing).
Also, Ege (2015) explored the relationship between IAF quality and the likelihood of
management misconduct (illegal acts by executive managers, such as fraud bribery cases).
956 Similar to Prawitt et al. (2009), Ege (2015) used the IIA GAIN survey data and created a
composite measure of six points to measure the IAF quality. Using a final sample of 1,398
firm-year observations from 2000 to 2009, Ege (2015) found a negative association between
IAF quality and the likelihood of management misconduct in the US context. IAF
competence was also negatively associated with the likelihood of management misconduct,
implying the vital role of IAF competence in preventing management misconduct.
Furthermore, Abbott et al. (2016) investigated the impact of IAF competence and IAF
independence on financial reporting quality. The authors used survey responses from 189
chief internal auditors, were working at the US fortune 1,000 companies during the fiscal
year of 2009, to create separate measures for both the IAF competence and independence.
They used the “average hourly rate of budgeted IAF resources” to measure IAF competence
and used three factors as proxies for IAF independence. These three factors are the AC’s
influence vis-à-vis management’s influence, whether the IAF serves as a management
training ground, and the presence of substantial IAF outsourcing. Abbott et al. (2016) found
that the interaction between the IAF competence and the AC’s IAF influence and the lack of
substantial IAF outsourcing restrain both upward and downward earnings management.
Outside the US, K. Johl et al. (2013) examined the relationship between the quality of IAF
and abnormal accruals (as a proxy for financial reporting quality) in a sample of 64 listed
firms in Malaysia. However, this study provided mixed and unexpected results compared to
the previously mentioned studies conducted in the US, and the authors explained these
unexpected results in terms of contextual and political links in Malaysia. Their initial
estimations indicated that the internal audit quality is positively related to abnormal
accruals, indicating lower financial reporting quality. Further examination, through the
removal of outsourced and politically connected observations, found a negative association
between internal audit quality and abnormal accruals. Baatwah et al. (2021) examined the
association between the industry and firm expertise of the outsourced IAF and real earnings
management (REM). They found that the firm-specific expertise of the outsourced IAF,
which results from continuous engagement with a specific client over a long period, is
significantly associated with lower REM.
Other recent studies have focused on aspects other than earnings management. For
example, Park and Park (2020) used 1,798 firm-year observations from 2009 to 2013 for
Korean listed firms and found that higher quality of statutory internal auditors – measured
through the compensation and financial expertise – is associated with lower possibilities of
future stock price crash risk. They argued that high-quality internal auditors are more likely
to ensure timely disclosure of bad news and suppress managers’ bad news hoarding
activities to lower litigation risk and preserve their reputation. In the public sector, Asiedu
and Deffor (2017) analysed the link between corruption and IAF quality in Ghana through a
survey of directors and managers of selected public sector organizations. They concluded
that the size and independence of the IAF significantly affect its effectiveness, which will
help fight administrative corruption.
In light of the preceding discussion, it is apparent that this new trend of research that
investigates the association between IAF quality and earnings management is still scant
and mainly limited to the US context. In addition, the measures/dimensions used by the
previous studies to proxy for the IAF quality are still limited compared to the global IIA Internal audit
standards. Thus, the present study is much motivated to examine the following main quality
hypothesis empirically in the UK context:
H1. Ceteris paribus, firms with higher quality IAF are less likely to commit income-
increasing earnings management.
Similar to the previous literature that addresses the impact of external audit quality on 957
earnings management (Becker et al., 1998; Caramanis and Lennox, 2008), we argue in this
hypothesis that a higher quality IAF is less likely to be associated with income-increasing
earnings management, as earnings overstatement is generally known by its higher litigation
risk for auditors compared to the practices of earnings management that understate
earnings (DeFond and Jiambalvo, 1993; Kinney and Martin, 1994; St. Pierre and Anderson,
1984). Our hypothesis is also consistent with Basu (1997), who argued that the tendency
towards conservatism has increased over time because of the increase in auditors’ legal
liability exposure. Basu (1997) stated that conservatism denotes the tendency to require a
higher degree of verification to recognize gains than to recognize losses. Therefore, the
concept of accounting conservatism implies the preference to report the lowest values of
assets and revenues and the highest values of liabilities and expenses (Cameran et al., 2016;
Shroff et al., 2013). Consequently, we empirically examine our hypothesis using a signed
measure of abnormal accruals that allows us to observe the internal auditors’ preferences for
earnings understatement. The implementation of this signed measurement would also help
us mitigating the correlated omitted variable problems and the potential bias (in favour of
rejecting the null hypothesis of no earnings management) that might arise from the use of
unsigned measures of earnings management (Hribar and Nichols, 2007).
In addition to testing the main hypothesis (H1), this study also investigates (in additional
analyses) the individual impact of both IAF independence and IAF competence on
committing earnings managements. External auditors use these two main categories of IAF
quality to evaluate the IAF and the extent of relying on its work (Breger et al., 2020; Park
and Park, 2020). However, recent studies presented mixed results regarding their impact on
financial reporting quality. For example, Kabuye et al. (2017) found that both the IAF
independence and competence are associated with fraud management practices in Uganda’s
financial sector. Also, Asiedu and Deffor (2017) concluded that the size (as a proxy of
competence) and independence significantly affect the effectiveness of the IAF in fighting
administrative corruption in Ghana. On the other hand, some studies provide evidence that
supports the positive association between IAF competence and firm operational efficiency
(Chen et al., 2020), internal control quality (Oussii and Boulila Taktak, 2018) and financial
reporting quality in financial institutions (Kaawaase et al., 2021), whilst they found no
evidence that supports such association with IAF independence. In addition, Morais and
Franco (2019) surveyed external auditors in Portugal and found that competence is most
important for external auditors to trust and cooperate with internal auditors.
Accordingly, we also expect a negative association between these two components and
the engagement of UK companies in upwards earnings management activities as stated in
the following two sub-hypotheses:
H1a. Ceteris paribus, firms with more independent IAF are less likely to commit
income-increasing earnings management.
H1b. Ceteris paribus, firms with more competent IAF are less likely to commit income-
increasing earnings management.
MAJ 3. Research methodology
36,7 3.1 Sample and data collection
This study used a postal questionnaire survey to collect actual data about the quality
characteristics of the internal audit departments in UK listed companies. Therefore, the survey
targeted the head of internal audit in these companies because they are suitable persons who
can provide such factual information about the IAF to measure the IAF quality. The survey
958 was sent in early 2012 to 2013 non-financial companies listed on LSE main market. These
companies have in-house IAF as they had disclosed in their 2011 annual reports. In total, 132
responses were received from the heads of the internal audit department in these companies,
with a response rate of 62%. However, as shown in Table 1, the final sample of the present
study comprises 115 companies (54% of the distributed questionnaires) after excluding 17
companies with insufficient data (either internal audit or financial data). Table 2 shows the
distribution of this final sample among sectors and Financial Times stock exchange (FTSE)
indices. As shown in Panel A of Table 2, only 3 sectors have more than 10 companies, namely,
i.e. industrials (47 companies), consumer goods (17 companies) and consumer services (25
companies). The remaining sectors of the final sample have less than 10 companies. Panel B of
Table 2 also shows that 41% of the final sample are FTSE 250 companies followed by both
FTSE 100 and FTSE Smallcaps (28% each), suggesting that the sample is representative of
large, medium and small companies.
Questionnaire survey sent to listed non-financial companies on 213

LSE main market, which have an IAF
Total responses received from companies (initial sample) 132
Companies removed from the sample:
Companies with insufficient IAF quality data (6)
Table 1. Companies with missing financial data (11) (17)
Sample selection Final sample 115
Sector/FTSE index No. (%) Cumulative percent
Panel A: Analysis of sample by sectors

Oil and gas 4 3 3
Basic materials 4 3 7
Industrials 47 41 48
Consumer goods 17 15 63
Health care 2 2 65
Consumer services 25 22 87
Telecommunications 4 3 90
Utilities 5 4 94
Technology 7 6 100
Total 115 100
Panel B: Analysis of sample by FTSE indices
FTSE 100 32 28 28
Table 2. FTSE 250 47 41 69
Analysis of sample FTSE smallcaps 32 28 97
by sectors and FTSE FTSE fledgling 4 3 100
indices Total 115 100
This study also used the 2012 annual reports and Thomson Reuters Datastream to obtain Internal audit
the required financial and governance data for the respondent companies. These data were quality
used by the present study in conjunction with the data collected by the questionnaire survey
about the quality characteristics of the IAF.
3.2 Variables measurement and research models

3.2.1 Measurement of internal audit quality. Similar to Ismael (2019), this study uses a 959
comprehensive measure for IAF quality. This composite measure (of 20 points) captures
four different IAF’s quality characteristics (5 points each), namely, size, independence,
methodology and management and skills and knowledge.
As explained in Appendix, the score of IAF size (that ranges from 1 to 5) is based on the
number of internal auditors employed by the IAF; one point if the size is 1 to 5 auditors, two points
if the size is 6 to 10 auditors, three points if the size is 11 to 15 auditors, four points if the size is 16
to 25 auditors and five points if the size is over 25 auditors. To measure the IAF independence, this
study uses six dimensions to obtain an initial score of six points. These dimensions are the CAE
attends all the AC’s meetings, the CAE has direct and unrestricted access to the AC, the CAE
reports directly to the AC, the CAE is appointed or dismissed by the AC, the AC approves the
internal audit budget and the AC approves the IAF’s audit plan. Then, the obtained score is
multiplied by 5/6 (i.e. 83.3%) to get the weighted 5 points IAF independence score.
Likewise, to measure the IAF methodology and management, an initial score of 4 points
is obtained based on four dimensions: adopting an RBIA methodology, using an operating
manual, having an internal audit charter and having a quality assurance and improvement
programme. Then, this initial score is multiplied by 5/4 (i.e. 125%) to obtain the weighted 5
points methodology and management score.
Finally, an initial score of 10 points is obtained to measure the IAF skills and knowledge.
This initial score is based on the IAF has experienced internal auditors (with more than 10
years experience), the IAF has members with IIA membership, the IAF has members with
IIA certificate, the IAF has members with different backgrounds (e.g. accounting, finance,
computing/IT, law and legislative, engineering and any other background) and the internal
auditors receive regular training. Then, the initial score is multiplied by 5/10 (i.e. 50%) to get
the weighted 5 points skills and knowledge score. To calculate the final total IAF quality
score, the weighted 5 points score of the four quality characteristics were added together to
get a composite score of 20 points that captures all these characteristics.
Furthermore, as it will be shown in the additional analyses of Section 4.3.2, the PCA is
used to produce an alternative measure for IAF quality that constitutes the regression scores
for only one factor (component) generated from the four quality characteristics. In addition,
the PCA produces two key components (factors) of IAF quality, which explain 72% of the
variance in this composite measure. These two components are referred to as IAF
competency and IAF independence.
3.2.2 Measurement of earnings management. Our proxy for earnings management is
based on a measure of the abnormal accruals that is commonly used in the previous literature
(Huang et al., 2014; Jones et al., 2008; Kothari et al., 2005; Lo et al., 2017). This proxy aggregates
into a single measure the net effect of numerous recognition and measurement decisions,
thereby capturing the portfolio nature of reported earnings determination (Watts and
Zimmerman, 1990). The use of this proxy can be justified in light of the theoretical contention
that management can incorporate bias in financial statements. Hence, we can measure this
degree of bias by calculating the abnormal component of the reported total accruals.
Empirically, the abnormal accruals (AbAci,t) are calculated by the difference between
actual and normal accruals. The normal accruals are measured in each sector by using the
MAJ following cross-sectional regression model with at least 10 observations. Nevertheless, as
36,7 this requirement was only attainable in three sectors (i.e. industrials, consumer goods and
consumer services), we adopted a similar strategy to that of Elshandidy et al. (2013), who
merged a number of UK sectors based on their comparable activities. Accordingly, we
reclassified our investigated sectors under the following four groups, namely, basic
materials, industrials and oil and gas (55 observations), health care, consumer services and
960 utilities (32 observations), telecommunications and technology (11 observations) and
consumer goods as a stand-alone group (17 observations):
TACi;t 1 DREVi;t DRECi;t PPEi;t DOCFi;t

¼ ai;t þ b i;t þ g i;t þ d i;t þ « i;t
TAi;t1 TAi;t1 TAi;t1 TAi;t1 TAi;t1
(1)
where
TACi,t total accruals for firm i in year t calculated as the difference between net
income before extraordinary items and cash flows from operating activities;
DREVi,t change in revenues for firm i from year t–1 to year t;
DRECi,t change in receivables for firm i from year t–1 to year t;
PPEi,t gross property, plant and equipment for firm i in year t;
DOCFi,t change in cash flows from operating activities for firm i from year t–1
total assets for firm i in year t–1;
« i,t error term for firm i in year t, which is our proxy for abnormal accruals
in the present study.
In the above model, the purpose of subtracting the change in receivables from the change in
revenues was to mitigate the possibility that managers might manipulate the reported
revenues through, for example, delaying or accelerating the recognition of credit sales. This
approach was previously proposed by Dechow et al. (1995) to remove any managerial
discretion over the recognition of revenue that, if it existed, would remove part of the
managed earnings from the measurement of the earnings management proxy. Moreover,
following the recommendation of Kothari et al. (2005), the change in cash flows from
operating activities was incorporated in the above regression model to control for the effect
of firm performance, and, therefore, alleviate the misspecification problems that might be
associated with the abnormal accruals models.
3.2.3 Research models. This study uses two multivariate regression analyses, i.e.
the binary logistic regression and the ordinary least squares (OLS) regression, to test
the association between the IAF quality and the signed measure of abnormal accruals
(our proxy for the involvement of UK companies in earnings management activities).
The present study considers the binary logistic regression as the main statistical model
as it is consistent with our research hypothesis in which we argue that the IAF quality
is negatively associated with the likelihood of committing positive (income-increasing)
accruals. The dependent variable in this logistic regression model is a dummy variable
that equals 1 if the company has positive abnormal accruals and equals 0 if the
company has negative abnormal accruals. It is also believed that the binary logistic
regression would be more appropriate for the present study to overcome the problem of
using a relatively small sample (115 companies) and the related difficulty of classifying
the overall sample under two separate subsamples, positive and negative abnormal Internal audit
accruals and conducting the regression for each subsample. quality
3.2.3.1 Logistic regression model
AbAc_Dummy ¼ b0 þ b1 IA Fquality þ b2 AC effectiveness þ b3 L everage þ b4 MB

þ b5 ROA þ b6 CFO þ b7 Sales Growth þ b8 Segments þ b9 Audit Fees þ «
(2) 961
However, as a robustness test, the present study also uses the OLS regression to test the
association between the IAF quality and the signed value of the abnormal accruals. In this
model, we argue that the IAF quality is negatively associated with the signed value of
abnormal accruals (the dependent variable) in each company.
3.2.3.2 OLS regression model
AbAc ¼ b0 þ b1 IAF quality þ b2 AC effectiveness þ b3 L everage þ b4 MB þ b5 ROA

þ b6 CFO þ b7 Sales Growth þ b8 Segments þ b9 Audit Fees þ «
(3)
The measurement of IAF quality and abnormal accruals was previously discussed in the
above sections. Besides, and consistent with the prior studies that have investigated the
potential factors that might be associated with earnings management (Abbott et al., 2016;
Davidson et al., 2005; Prawitt et al., 2009; Sierra García et al., 2012), this study uses some
controls variables that are expected to affect the value of abnormal accruals in our sample.
These control variables include AC effectiveness, leverage, market-to-book ratio, return on
assets ratio, cash flows from operations ratio, sales growth ratio, number of operating
segments and the percentage of external audit fees as a proxy for external audit quality. In
this regard, it should be noted that the “BIG4” auditor is not included in the above regression
models because 114 companies (of the final sample) were audited by a BIG4 auditor, whilst
only one company was audited by a non Big4 auditor. Therefore, it is not appropriate to
incorporate this variable (that lacks variability) in the logistic regression model that requires
a sufficient number of observations in each category. The entire variables used in the
previous two regression models are described in detail in Appendix.
4. Results
4.1 Descriptive statistics
Table 3 presents the descriptive statistics for all variables used in our analysis. Panel A of
Table 3 shows the descriptive statistics for the abnormal accruals in the whole sample (i.e. the
dependent variable used in the OLS regression model) and for the two sub-groups used in the
logistic regression model; companies with income-decreasing earnings management and
companies with income-increasing earnings management. In total, 50 companies (43%) of the
sample have negative abnormal accruals, whilst 65 companies (57%) have positive abnormal
accruals. In addition, Panel B of Table 3 provides the descriptive statistics for the IAF’s
quality characteristics and the IAF quality composite measure used in the analysis. As shown
in Panel B of Table 3, the mean and median for IAF quality are 11.82 and 11.92 (out of 20
points), respectively. It also shows that both independence and methodology and management
characteristics have the highest mean and median scores (above 3 out of 5 points), suggesting
that the majority of the sample have relatively independent and well-managed IAF. This
MAJ Percentiles
36,7 Variables N Mean Median SD Minimum Maximum 25 75
Panel A: Earnings management (dependent variable)

AbAc 115 0.0001 0.0057 0.0598 0.2492 0.1618 0.0214 0.0278
AbAc- Negative (0) 50 (43%) 0.0473 0.0267 0.0516 0.2492 0.0021 0.0619 0.0179
AbAc- Positive (1) 65 (57%) 0.0362 0.0256 0.0353 0.0002 0.1618 0.0102 0.0512
962
Panel B: Internal audit function (IAF) quality characteristics
Size 115 1.85 1.00 1.265 1.00 5.00 1.00 2.00

Independence 115 3.99 4.17 1.038 0.00 5.00 3.33 5.00
Methodology 115 3.72 3.75 1.266 1.25 5.00 2.50 5.00
Skills and knowledge 115 2.27 2.00 0.859 1.00 4.00 1.50 3.00
IAF quality 115 11.82 11.92 2.947 5.00 19.00 9.58 13.33
Panel C: Other variables included in the models
AC effectiveness 115 1.57 2.00 1.319 0.00 4.00 0.00 3.00

Leverage 115 0.61 0.57 0.294 0.15 2.80 0.44 0.72
MB 115 1.07 2.06 19.066 198.86 23.99 1.20 3.47
ROA 115 0.06 0.07 0.120 0.95 0.27 0.04 0.10
CFO 115 0.09 0.09 0.068 0.09 0.32 0.05 0.14
Sales growth 115 0.03 0.03 0.131 0.45 0.40 0.03 0.11
Table 3. Segments 115 3.30 3.00 1.778 1.00 11.00 2.00 4.00
Descriptive statistics Audit fees 115 0.15 0.11 0.132 0.01 0.78 0.07 0.20
result is consistent with the IIA’s standards, which states the importance of a well-developed
IAF that reports directly to the AC and has direct and unrestricted access to the board.
Furthermore, companies must comply with the corporate governance code in the UK that
requires the AC to receive reports from the IAF and review its effectiveness. In contrast, the
majority of the sample have relatively small IAF (with up to 10 auditors); both the mean and
median of the IAF size are below 2 (out of 5 points). However, this is consistent with Selim
et al. (2009) and Goodwin-Stewart and Kent (2006), who found that most IAFs in UK/Ireland,
Italy and Australia have up to 10 internal auditors. Furthermore, Panel C of Table 3 presents
the descriptive statistics for the other control variables used in the analysis.
Table 4 compares the two sub-groups of companies (positive vs negative abnormal accruals)
in terms of their IAF quality. This table shows a significant difference between the two sub-
groups of companies in terms of their IAF Quality, supported by both t-test and Mann-Whitney
test (p-value < 0.01). Companies with positive abnormal accruals (income-increasing earnings
management) have lower quality IAFs than companies with negative abnormal accruals.
Table 4 also shows that companies with positive abnormal accruals have lower scores for the
individual quality characteristics than companies with negative abnormal accruals. However,
the differences between the two sub-groups are only statistically significant with regard to the
IAF size and IAF methodology and management. To sum up, Table 4 provides preliminary
support for the negative association between IAF quality and the signed value of abnormal
accruals, and, therefore, the engagement in income-increasing earnings management.
Table 5 presents the correlation coefficients (both Pearson and Spearman’s rho) among
the continuous variables used in the analysis. It indicates no multicollinearity problem
between the independent variables, as no correlation coefficient above 0.8 exists between the
variables (Field, 2009; Pallant, 2007). The absence of multicollinearity problem is also
Mann-
Internal audit
t-test* Whitney** quality
AbAc p-value p-value
IAF quality characteristics groups N Mean Median (two-tailed) (two-tailed)
IAF quality 0 Negative 50 12.67 12.92 0.006 0.005

1 Positive 65 11.16 11.00
IAF size 0 Negative 50 2.22 2.00 0.009 0.008 963
1 Positive 65 1.57 1.00
IAF independence 0 Negative 50 4.13 4.17 0.199 0.113
1 Positive 65 3.88 4.17
IAF methodology and 0 Negative 50 4.00 3.75 0.032 0.045
management 1 Positive 65 3.50 3.75
IAF skills and knowledge 0 Negative 50 2.36 2.00 0.330 0.386
1 Positive 65 2.20 2.00
Table 4.
Notes: *The parametric t-test for differences in Means; **The non-parametric Mann-Whitney test for IAF quality of the
differences in Medians AbAc groups
supported by the variance inflation factor (VIF) and tolerance values presented in the
multivariate regression results where the VIF values are always less than 10 and the
Tolerance values are consistently above 0.1.
4.2 Multivariate regression results

Table 6 presents the regression results for both the logistic and OLS models. In the logistic
regression model (Panel A), the dependent variable (AbAc-Dummy) is a dummy variable
equals 1 if the company has positive abnormal accruals and 0 if the company has negative
abnormal accruals. Consistent with our main H1, the results in Panel A show a significant
negative relationship (p-value < 0.01) between IAF quality and AbAc-Dummy, suggesting
that companies with higher IAF quality are less likely to have positive abnormal accruals.
This result might indicate that higher-quality IAF is more likely to prevent management
from committing income-increasing earnings management. This result, consistent with the
agency theory, can provide evidence for the role of IAF in reducing agency problems such as
the occurrence of earnings management. It is also in alignment with prior internal audit
literature (Adams, 1994; Goodwin-Stewart and Kent, 2006; Ismael, 2019; Ismael and Roberts,
2018; Prawitt et al., 2009) that considers internal audit as a monitoring or bonding cost to
reduce the agency problem and the opportunistic behaviour by management. This result is
also in harmony with the findings of Caramanis and Lennox (2008), who have found that
companies are less likely to manage earnings upwards when the audit hours (i.e. their proxy
for external audit quality) are higher.
Concerning the control variables, the results in Panel A of Table 6 show a significant
positive association between AbAc-Dummy and Leverage, implying that highly leveraged
companies have stronger incentives to report positive abnormal accruals to avoid debt
covenant violations (Abbott et al., 2016; Jiang et al., 2008). Moreover, the ROA is significantly
positive, indicating that more profitable companies have greater financial reporting latitude
to report positive abnormal accruals (Kothari et al., 2005; Prawitt et al., 2009). Also,
Segments is significantly positive; a finding that is in line with the notion that companies
with more complex operations (as reflected by the number of operating segments) would
36,7
964
MAJ
Table 5.
Pearson and
respectively)
spearman’s rho
below the diagonal,

correlations (above/
Variables 1 2 3 4 5 6 7 8 9 10
1- AbAc 0.052 0.102 0.149 0.016 0.480** 0.205* 0.056 0.045 0.082
2- IAF Quality 0.132 0.446** 0.067 0.003 0.028 0.001 0.174 0.301** 0.175
3- AC Effectiveness 0.011 0.418** 0.009 0.132 0.155 0.069 0.191* 0.207* 0.258**
4- Leverage 0.161 0.194* 0.123 0.099 0.215* 0.248** 0.246** 0.037 0.059
5- MB 0.027 0.115 0.201* 0.307** 0.051 0.075 0.005 0.010 0.214*
6- ROA 0.177 0.008 0.087 0.030 0.598** 0.373** 0.314** 0.081 0.045
7- CFO 0.267** 0.010 0.089 0.111 0.537** 0.602** 0.022 0.094 0.013
8- Sales Growth 0.038 0.183 0.201* 0.178 0.179 0.260** 0.009 0.055 0.061
9- Segments 0.031 0.223* 0.171 0.085 0.126 0.018 0.101 0.013 0.052
10- Audit Fees 0.095 0.293** 0.226* 0.012 0.035 0.074 0.067 0.038 0.147
Notes: ** Correlation is significant at the 0.01 level (two-tailed); *Correlation is significant at the 0.05 level (two-tailed)
Panel A: Logistic regressiona Panel B: OLS regressionb
c
Variables in the equation B Wald p-value B t p-value Tolerance VIF
IAF Quality 0.593 14.199 0.000 0.211 2.600 0.011 0.728 1.374
AC Effectiveness 0.631 0.853 0.356 0.003 0.042 0.967 0.716 1.397
Leverage 5.219 5.040 0.025 0.163 2.149 0.034 0.832 1.202
MB 0.288 4.788 0.029 0.005 0.067 0.946 0.920 1.086
ROA 59.394 17.475 0.000 0.634 8.012 0.000 0.767 1.304
CFO 46.094 22.888 0.000 0.637 8.235 0.000 0.801 1.248
Sales Growth 12.159 9.673 0.002 0.173 2.173 0.032 0.755 1.325
Segments 0.452 4.807 0.028 0.118 1.576 0.118 0.862 1.160
Audit Fees 2.048 0.440 0.507 0.120 1.604 0.112 0.864 1.158
Constant 5.072 5.114 0.024 0.032 1.510 0.134
Model chi-square 74.871 Model F statistic 11.930
Df 9 df 9
Model p-value 0.000 Model p-value 0.000
Cox and Snell R2 0.491 R2 0.515
Nagelkerke R2 0.658 Adjusted R2 0.472
Overall percentage correct 80.2
Notes: a. Logistic regression model: AbAc_Dummy ¼ b0 þ b1 IAF quality þ b2 AC effectiveness þ b3 Leverage þ b4 MB þ b5 ROA þ b6 CFO
þb7 Sales Growth þ b8 Segments þ b9 Audit Fees þ « ; b. OLS regression model: AbAc ¼ b0 þ b1 IAF quality þ b2 AC effectiveness þ b3 Leverage
þb4 MB þ b5 ROA þ b6 CFO þ b7 Sales Growth þ b8 Segments þ b9 Audit Fees þ « ; c. Variables in the equation: AbAc: The abnormal component of total
accruals measured by the difference between actual and normal accruals. AbAc_Dummy: Equals 1 if the value of the abnormal accruals is positive and 0 if the
value is negative. IAF Quality: A composite aggregate score of 20 points to measure the quality of the IAF. IAF Effectiveness: A composite four points score to
measure the effectiveness of the audit committee. Leverage: Total liabilities divided by total assets. MB: The market-to-book ratio. ROA: Return on assets ratio.
CFO: Cash flows from operations divided by total assets. Sales Growth: Equals [(current year sales or revenue – prior year sales or revenue)/prior year sales or
revenue]. Segments: The number of operating segments. Audit Fees: Total audit fees divided by total assets
Internal audit
Regression results
Table 6.
965
quality
MAJ have a greater ability to opportunistically manage their earnings upwards (Abbott et al.,
36,7 2016).
As for the control variables of growth opportunities (i.e. market-to-book ratio (MB) and
sales growth), we unexpectedly find that companies with rapid growth are negatively
associated with manipulating earnings upwards (Jaggi et al., 2009). In addition, we find that
companies with high cash flows from operations (CFO) are less likely to be involved in
966 income-increasing earnings management, arguably because they do not have poor
performance to hide (Gul et al., 2009).
Finally, in line with previous studies that highlight the role of the AC and external audit
quality (efforts) in constraining the engagement in earnings management practices
(Klein, 2002; Sharma et al., 2011), the results in Panel A of Table 6 show negative
associations between AbAc-Dummy and both “AC Effectiveness” and the proportion of
“Audit Fees”. Nevertheless, these negative associations are statistically insignificant, as
previously documented by Davidson et al. (2005) and Prawitt et al. (2009).
The results of the OLS regression model, presented in Panel B of Table 6, support the
previously discussed results of the logistic regression regarding the impact of IAF quality
on abnormal accruals. In this OLS regression model, the dependent variable is the signed
value of abnormal accruals. The results show a significant negative association (p-value <
0.05) between IAF quality and abnormal accruals, suggesting that IAF quality is more likely
to reduce income-increasing earnings management. Again, these results support our main
H1, and they are consistent with those of Caramanis and Lennox (2008), who have found a
negative association between the number of audit hours (i.e. the measure of external audit
quality) and the signed abnormal accruals (i.e. their proxy for the magnitude of income-
increasing earnings management).
The OLS regression model also provides consistent positive significant results for
Leverage and ROA and significant negative results for CFO and Sales Growth.
4.3 Additional analyses

4.3.1 Alternative measure for internal audit function quality. As a sensitivity analysis, we
used another measure for IAF quality in the present study. This measure (IAF Quality2) is a
composite aggregate score of four points and equals the sum of four dummy variables:
(1) IAF Size (= 1 if the score is above the median, 0 otherwise).
(2) IAF Independence (= 1 if the score is above the median, 0 otherwise).
(3) IAF Methodology and Management (= 1 if the score is above the median, 0
otherwise).
(4) IAF Skills and Knowledge (= 1 if the score is above the median, 0 otherwise).
Table 7 presents the regression results after using this alternative measure for IAF quality.
As it appears in Table 7, the results are qualitatively similar to those presented in Table 6
except for the insignificant association with “segments” under the logistic model. Panel A of
Table 7 shows a significant negative association between AbAc-Dummy and IAF Quality2
and, likewise, Panel B of Table 7 shows a significant negative association between AbAc
and IAF Quality2. These results confirm that companies with higher IAF quality are less
likely to have positive abnormal accruals and to conduct income-increasing earnings
management.
4.3.2 The principal component analysis. The PCA can produce factor(s) from continuous
measures (variables) in a way that captures the variability in these measures (variables)
(Field, 2009; Pallant, 2007). Therefore, this study used the PCA to generate and use an
Variables in the equationc B Wald p-value B t p-value Tolerance VIF
IAF Quality2 0.828 9.119 0.003 0.181 2.287 0.024 0.776 1.289
Leverage 4.463 4.747 0.029 0.164 2.142 0.035 0.829 1.207
MB 0.269 4.699 0.030 0.005 0.075 0.941 0.920 1.087
ROA 47.863 16.977 0.000 0.630 7.907 0.000 0.767 1.304
CFO 36.790 20.877 0.000 0.620 7.940 0.000 0.799 1.251
Sales Growth 8.581 6.257 0.012 0.165 2.058 0.042 0.759 1.318
Segments 0.215 1.622 0.203 0.093 1.265 0.209 0.903 1.107
Audit Fees 0.356 0.019 0.889 0.110 1.475 0.143 0.871 1.149
Constant 0.006 0.000 0.997 0.001 0.037 0.971
Df 9 df 9
Notes: a. Logistic regression model: AbAc_Dummy ¼ b0 þ b1 IAF quality2 þ b2 AC effectiveness þ b3 Leverage þ b4 MB þ b5 ROA þ b6 CFO
þb7 Sales Growth þ b8 Segments þ b9 Audit Fees þ « ; b. OLS regression model: AbAc ¼ b0 þ b1 IAF quality2 þ b2 AC effectiveness þ b3 Leverage
value is negative. IAF Quality 2: A composite aggregate score of 4 points to measure the quality of the IAF. IAF Effectiveness: A composite 4-points score to
(using another
Internal audit
Regression results
Table 7.
quality)
967
quality
measure of IAF
MAJ alternative measure for IAF quality named “IAF Quality- PCA FAC”. This alternative
36,7 measure constitutes the regression scores for only one factor (component) generated by PCA
from the four quality characteristics (size, independence, methodology and management and
skills and knowledge). Table 8 displays the results after using this alternative measure and
shows similar results to those presented in Table 6. As shown in Panels A and B of Table 8,
“IAF Quality- PCA FAC” again has significant negative associations with “AbAc-Dummy”
968 and “AbAc”.
The PCA analysis for the four IAF quality characteristics also indicated the presence of
two components (factors) with eigenvalues exceeding 1, explaining a total of 72% of the
variance in IAF quality. Three measures related to competence (skills and knowledge, size
and methodology and management) had strong loading (above 0.4) with the first component
(factor), and therefore, this factor is named IAF Competency- FAC1. Only IAF Independence
had strong loading (above 0.4) with the second component (factor), and therefore, this factor
is named “IAF Independence- FAC2”. The regression scores for the previous two
components (factors) were used in both the logistic and OLS regression models as two
individual measures for IAF quality. As shown in Table 9, both “IAF competency- FAC1”
and “IAF independence- FAC2” have negative associations with “AbAc-Dummy” and
“AbAc”. However, Table 9 demonstrates that only “IAF competency- FAC1” has significant
negative associations with “AbAc-Dummy” and “AbAc”, suggesting that the competence of
the IAF has a superior role than its independence in reducing the engagement of UK
companies in income-increasing earnings management activities. Consequently, the results
of Table 9 support our predictions in H1a but reject those of H1b. This remarkable finding is
consistent with Ege (2015), who has found that IAF competence, but not objectivity, is
negatively associated with the likelihood of management misconduct, suggesting that IAF
competence is vital in preventing management misconduct. It is also consistent with Chen
et al. (2020), Kaawaase et al. (2021) and Oussii and Boulila Taktak (2018), who indicated a
significant result for IAF competence but not for IAF independence. Competent IAF is more
able to deter fraud, earnings management or irregularities. Furthermore, the UK regulatory
context can also provide a valid justification for this result. The UK corporate governance
code stresses the importance of direct communication between the IAF and the AC
(Financial Reporting Council, 2016). It requires the AC to meet privately with the head of
internal audit, discuss and approve the annual internal audit plan and receive reports about
the effectiveness of internal controls, risk management and the integrity of the financial
reporting process. Therefore, most UK listed companies have an independent IAF with
direct and unrestricted access to the board and the AC to comply with the governance code.
Thus, the variability is low between companies in terms of IAF independence. In contrast,
the UK governance code does not have any specific requirements regarding the other
characteristics of the IAF (such as size, skills and knowledge). Therefore, there is significant
variability between the listed companies in term of competency that justify its significant
result compared to independence.
Table 9 also shows that the results for the remaining variables are still qualitatively
similar to those presented and discussed in Table 6.
4.3.3 The individual measures scores. As a further robustness check on the results
presented in Table 9, Table 10 shows the regression results after using two individual
measures (scores) for both IAF Competency and IAF Independence based on the original
scores discussed in the main analysis (Section 3.2.1 and Appendix). IAF Competency
constitutes a composite aggregate score of 15 points (the sum score of IAF Size,
Methodology and Management and Skills and Knowledge), whilst IAF Independence
represents the five-points weighted score to measure the IAF Independence. Consistent with
IAF Quality- PCA FAC 1.462 12.364 0.000 0.191 2.357 0.020 0.738 1.356
Leverage 4.661 4.768 0.029 0.166 2.170 0.032 0.827 1.209
MB 0.251 3.984 0.046 0.006 0.086 0.932 0.921 1.086
ROA 53.000 17.333 0.000 0.634 7.965 0.000 0.767 1.304
CFO 41.458 22.216 0.000 0.631 8.113 0.000 0.802 1.247
Sales Growth 10.749 7.956 0.005 0.164 2.046 0.043 0.760 1.317
Segments 0.354 3.416 0.065 0.111 1.484 0.141 0.867 1.153
Audit Fees 1.422 0.237 0.626 0.120 1.599 0.113 0.860 1.163
Constant 1.550 0.898 0.343 0.013 0.762 0.448
Df 9 df 9
value is negative. IAF Quality- PCA FAC: The regression score for one factor generated by the Principal Components Analysis (PCA) from the four quality
characteristics (Size, Independence, Methodology and Management and Skills and Knowledge). The regression score of that PCA factor is used as an alternative
measure for IAF Quality. IAF Effectiveness: A composite 4-points score to measure the effectiveness of the audit committee. Leverage: Total liabilities divided by
total assets. MB: The market-to-book ratio. ROA: Return on assets ratio. CFO: Cash flows from operations divided by total assets. Sales Growth: Equals [(current
year sales or revenue – prior year sales or revenue)/prior year sales or revenue]. Segments: The number of operating segments. Audit Fees: Total audit fees
divided by total assets
regression scores)
(using PCA
Internal audit
Regression results
Table 8.
969
quality
36,7
970
MAJ
Table 9.
Regression results
(using PCA factors)
c
Variables in the equation B Wald p-value B t p-value Tolerance VIF
IAF Competency- FAC1 1.308 10.645 0.001 0.184 2.229 0.028 0.717 1.396
IAF Independence- FAC2 0.636 2.554 0.110 0.029 0.389 0.698 0.892 1.122
Leverage 4.760 4.668 0.031 0.168 2.165 0.033 0.818 1.223
MB 0.260 4.119 0.042 0.006 0.084 0.933 0.921 1.086
ROA 54.861 17.278 0.000 0.633 7.918 0.000 0.766 1.305
CFO 42.963 22.309 0.000 0.630 8.015 0.000 0.794 1.260
Sales Growth 11.088 8.277 0.004 0.163 2.019 0.046 0.756 1.323
Segments 0.366 3.595 0.058 0.112 1.484 0.141 0.863 1.159
Audit Fees 1.015 0.114 0.735 0.123 1.586 0.116 0.814 1.228
Constant 1.620 0.914 0.339 0.013 0.766 0.446
Model Chi-square 70.597 Model F statistic 10.405
Df 10 df 10
Notes: a. Logistic regression model: AbAc_Dummy ¼ b0 þ b1 IAF competency þ b2 IAF independency þ b3 AC effectiveness þ b4 Leverage
þb5 MB þ b6 ROA þ b7 CFO þ b8 Sales Growth þ b9 Segments þ b10 Audit Fees þ « ; b. OLS regression model: AbAc ¼ b0 þ b1 IAF competency
þb2 IAF independency þ b3 AC effectiveness þ b4 Leverage þ b5 MB þ b6 ROA þ b7 CFO þ b8 Sales Growth þ b9 Segments þ b10 Audit Fees þ « ; c. Variables
in the equation: AbAc: The abnormal component of total accruals measured by the difference between actual and normal accruals. AbAc_Dummy: Equals 1 if the
value of the abnormal accruals is positive and 0 if the value is negative. IAF Competency- FAC1: The regression score for the first factor generated by the
Principal Components Analysis (PCA) from the IAF quality characteristics. The regression score of that PCA factor is used as a measure for IAF Competency.
IAF Independence- FAC2: The regression score for the second factor generated by the Principal Components Analysis (PCA) from the IAF quality characteristics.
The regression score of that PCA factor is used as a measure for IAF Independence. IAF Effectiveness: A composite 4-points score to measure the effectiveness of
the audit committee. Leverage: Total liabilities divided by total assets. MB: The market-to-book ratio. ROA: Return on assets ratio. CFO: Cash flows from
operations divided by total assets. Sales Growth: Equals [(current year sales or revenue – prior year sales or revenue)/prior year sales or revenue]. Segments: The
number of operating segments. Audit Fees: Total audit fees divided by total assets
IAF Competency 0.566 13.060 0.000 0.202 2.422 0.017 0.702 1.425
IAF Independence 0.461 1.430 0.232 0.026 0.347 0.729 0.880 1.137
Leverage 5.139 5.200 0.023 0.172 2.220 0.029 0.810 1.235
MB 0.265 4.179 0.041 0.005 0.072 0.943 0.920 1.087
ROA 55.945 17.287 0.000 0.632 7.927 0.000 0.766 1.306
CFO 44.092 22.571 0.000 0.633 8.116 0.000 0.798 1.254
Sales Growth 11.602 8.524 0.004 0.163 2.033 0.045 0.756 1.324
Segments 0.413 4.157 0.041 0.118 1.566 0.120 0.858 1.166
Audit Fees 1.959 0.374 0.541 0.129 1.659 0.100 0.803 1.245
Constant 4.522 3.675 0.055 0.024 1.034 0.304
Model Chi-square 73.580 Model F statistic 10.580
Df 10 df 10
value is negative. IAF Competency: A composite aggregate score of 15 points to measure the IAF competency (the sum of Size, Methodology and Management
and Skills and Knowledge). IAF Independence: A five-points weighted score to measure the IAF Independence. IAF Effectiveness: A composite 4-points score to
scores)
characteristics
Internal audit
Regression results
971
quality
(using individual
Table 10.
MAJ the findings of Table 9, Table 10 indicates that both “IAF Competency” and “IAF
36,7 Independence” have negative associations with AbAc-Dummy and AbAc, only “IAF
Competency” has significant negative associations with “AbAc-Dummy” and “AbAc” and
the results for the remaining variable are similar to those presented and discussed in
Table 6.
972 5. Conclusions
This study investigates the relationship between the IAF quality and the involvement in
earnings management activities using a sample of the UK listed non-financial companies.
The primary motive for this study is that this relationship has not been investigated before
in the UK and that the IAF quality measures used by the previous studies are solely based
on limited dimensions of the IIA standards. The present study uses responses for a postal
questionnaire survey addressed to the CAEs and the related archived data (from the
Datastream and the annual reports) for the respondent companies to investigate this
relationship.
The univariate tests provide initial evidence that the companies with positive abnormal
accruals (income-increasing earnings management) have significantly lower quality IAFs
than companies with negative abnormal accruals (income-decreasing earnings
management). This result suggests that the IAF quality is more likely to reduce income-
increasing earnings management. Consistent with this initial result, both the logistic and
OLS regression models support the negative association between the IAF quality and the
signed abnormal accruals and, accordingly, the management’s intent to commit upwards
earnings management. This finding also supports prior internal audit studies that consider
internal audit as a monitoring or bonding cost to reduce the agency problem and the
opportunistic behaviour by management. In contrast, this study finds negative but
insignificant associations between the likelihood of committing income-increasing earnings
management and both the AC Effectiveness and the proportion of external audit Fees.
Concerning the other financial variables, the study provided additional evidence that the
income-increasing earnings management is positively associated with the level of debt, ROA
and the number of operating segments and negatively related to the percentages of MB, CFO
and sales growth.
Moreover, the PCA analysis for the four IAF quality characteristics resulted in two
components (factors) with eigenvalues exceeding 1; IAF Competency and IAF
Independence. Consistent with Ege (2015), only IAF competency is found to have a
significant negative association with income-increasing earnings management. This result
indicates the importance of having a competent IAF to reduce the magnitude of earnings
management in the UK context.
This study has practical, regulatory and academic implications. Given the internal audit
role in reducing the upwards earnings management, the board of directors should consider
the importance of having a quality IAF. The board needs to build a strong relationship with
the IAF and to maintain competent internal auditors. The regulatory bodies should also
update their requirements regarding the use of IAF and its quality. In the UK, the use of an
IAF by the listed companies is still voluntary, and no requirements are mentioned in the
regulations (such as the corporate governance code and the LSE listing rules) regarding the
IAF’s organizational structure or its required skills and knowledge. Therefore, the UK
regulations might consider mandating the IAF, at least in the large companies, and focusing
more on requirements to enhance its competence and independence. In academia, the area of
research that focuses on the role of internal audit in improving the financial reporting
quality is still very limited, and the existing few studies in this area are mainly based on the
US context. Future research should consider this area of research in different settings and Internal audit
with larger samples. quality
This study has some limitations. Firstly, the use of a questionnaire survey to collect the IAF
data might affect the reliability of the results. However, the survey is the only appropriate way
to collect internal audit data because no data are publicly available about the IAF in the UK.
Besides, both the pilot test and the Cronbach’s alpha test revealed no concerns over the validity
and reliability of the data used in this study. Secondly, the present study relies on a relatively
small sample (115 companies) as a result of using the questionnaire survey to collect the IAF 973
data. However, the response rate in this study (54% of the distributed questionnaires to the
non-financial listed companies) is considered high compared to the other previous studies that
collected internal audit data from companies through a questionnaire survey. Thirdly, the
results of this study are based on UK data, and this might affect its generalizability to other
contexts. However, this limitation allows future research to confirm these results in different
settings. Finally, this study examined the quality of in-sourced (in-house) IAF and its
association with earnings management. Therefore, other future studies can examine the quality
characteristics of the outsourced IAF (provided by an external auditing firm) and its impact on
the financial reporting quality.
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Sections/
Corresponding author
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MAJ Appendix
36,7
Variable Description
AbAc The abnormal component of total accruals measured by the difference between
actual and normal accruals, which are estimated based on the following cross-
sectional regression model:
978 TACi;t 1 DREVi;t DRECi;t PPEi;t DOCFi;t
¼ ai;t þ b i;t þ g i;t þ d i;t þ « i;t
TAi;t1 TAi;t1 TAi;t1 TAi;t1 TAi;t1
AbAc_Dummy Equals 1 if the value of the abnormal accruals is positive and 0 if the value is
negative
IAF Quality A composite aggregate score of 20 points to measure the quality of the IAF. This
composite score consists of the weighted scores of four components, namely, IAF
size, IAF independence, IAF methodology and management and IAF skills and
knowledge. Each component constitutes 25% (i.e. 5 points) of the composite
aggregate score
IAF Size It is a five points score to measure the IAF size based on the number of internal
auditors used by the IAF: one point if the size is 1 to 5 auditors, two points if the
size is 6 to 10 auditors, three points if the size is 11 to 15 auditors, four points if the
size is 16 to 25 auditors and five points if the size is over 25 auditors
IAF Independence It is a five-points weighted score to measure the IAF independence. Firstly, a score
that ranges from 0 to 6 is obtained based on whether or not the chief audit executive
(CAE) attends all audit committee’s (AC) meetings, has direct and unrestricted
access to the AC, reports directly to the AC, is appointed or dismissed by the AC,
and whether or not the AC approves the internal audit budget and the internal audit
plan. Secondly, the obtained score is multiplied by 5/6 (i.e. 83.3%) to get the
weighted 5 points independence score
Methodology and It is a five points weighted score to measure the IAF methodology and
Management management. Firstly, a score that ranges from 0 to 4 is obtained based on whether
or not the IAF adopts a risk-based internal audit (RBIA) methodology, uses an
operating manual, has a charter and has a quality assurance and improvement
programme. Secondly, the obtained score is multiplied by 5/4 (i.e. 125%) to get the
weighted 5 points methodology and management score
IAF Skills and It is a five points weighted score to measure the IAF skills and knowledge. Firstly, a
Knowledge score that ranges from 0 to 10 is obtained based on whether or not the IAF has a
member(s) with more than 10 years experience with IIA membership, with IIA
certificate, who receives regular training, with different backgrounds such as
accounting, finance, computing/IT, law and legislative, engineering and any other
background. Secondly, the obtained score is multiplied by 5/10 (i.e. 50%) to get the
weighted 5 points skills and knowledge score
AC Effectiveness A composite four points score to measure the effectiveness of the audit committee.
This aggregate score is the sum of AC Size (= 1 if the audit committee size is above
the median, 0 otherwise), AC Independence (= 1 if the independent members of the
AC are above the median, 0 otherwise), AC Financial Expertise (= 1 if the AC has
more than one member with accounting and financial expertise, 0 otherwise) and
AC Meetings (= 1 if the number of the audit committee’s meetings are above the
median, 0 otherwise)
Leverage Total liabilities divided by total assets
MB The market-to-book ratio
ROA Return on assets ratio
CFO Cash flows from operations divided by total assets
Sales Growth A company’s one year- sales growth = [(current year sales or revenue – prior year
sales or revenue)/prior year sales or revenue]
Table A1. Segments The number of operating segments
Variables description Audit Fees Total audit fees divided by total assets
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Keywords Internal audit, Earnings management, Corporate governance, Audit committee,

2. Literature review and hypothesis development

Questionnaire survey sent to listed non-ﬁnancial companies on 213

Sector/FTSE index No. (%) Cumulative percent

Panel A: Analysis of sample by sectors

3.2 Variables measurement and research models

TACi;t 1 DREVi;t DRECi;t PPEi;t DOCFi;t

AbAc_Dummy ¼ b0 þ b1 IA Fquality þ b2 AC effectiveness þ b3 L everage þ b4 MB

AbAc ¼ b0 þ b1 IAF quality þ b2 AC effectiveness þ b3 L everage þ b4 MB þ b5 ROA

Panel A: Earnings management (dependent variable)

Size 115 1.85 1.00 1.265 1.00 5.00 1.00 2.00

Panel C: Other variables included in the models

AC effectiveness 115 1.57 2.00 1.319 0.00 4.00 0.00 3.00

IAF quality 0 Negative 50 12.67 12.92 0.006 0.005

4.2 Multivariate regression results

below the diagonal,

4.3 Additional analyses

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