Internal Audit Quality and Financial Reporting Quality: The Joint Importance of Independence and Competence

• Author: LAWRENCE J. ABBOTT,GARY F. PETERS,BRIAN DAUGHERTY,SUSAN PARKER
• Published date: 01 March 2016
• DOI: http://doi.org/10.1111/1475-679X.12099
• Date: 01 March 2016

DOI: 10.1111/1475-679X.12099

Journal of Accounting Research

Vol. 54 No. 1 March 2016

Printed in U.S.A.

Internal Audit Quality and Financial

Reporting Quality: The Joint

Importance of Independence

and Competence

LAWRENCE J. ABBOTT,

∗BRIAN DAUGHERTY,

∗

SUSAN PARKER,

†AND GARY F. PETERS

‡

Received 5 November 2013; accepted 24 September 2015

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.

∗University of Wisconsin–Milwaukee; †Santa Clara University; ‡University of Arkansas.

Accepted by Philip Berger. We are grateful for assistance from Tim Seidel and helpful

comments from Cory Cassell, Dana Hermanson, Chris Hines, Adi Masli, Bill Messier, Marcy

Shepardson, David Wood, and workshop participants at Santa Clara University, University of

Arkansas, Texas Tech University, the 2013 AAA Annual Meeting, and the 2012 Auditing Sec-

tion Midyear Conference.

3

Copyright C, University of Chicago on behalf of the Accounting Research Center,2015

4L.J.ABBOTT,B.DAUGHERTY,S.PARKER,AND G.F.PETERS

JEL codes: D83; G39; M12; M41; M42

Keywords: internal audit; financial reporting quality; auditor indepen-

dence; auditor competence

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]).1The 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

1The 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

may be more appropriately described as an interactive, two-factor function

of both competence and independence. Thus, IAF competence (indepen-

dence) may be unlikely to impact financial reporting quality unless it is in

the presence of IAF independence (competence).

In this paper, we develop and test a two-factor model of IAF quality as

a function of the IAF’s ability to prevent/detect financial misstatements

(i.e., competence) and its inclination to report the misstatements to the

audit committee and/or external auditor (i.e., independence). Our study

uses survey evidence from 189 Chief Internal Auditors (CIAs) from For-

tune 1000 companies during fiscal 2009.2From this uniquely detailed and

rich set of IAF data, we are able to create separate measures of IAF com-

petence and independence. Our measure of IAF competence is based on

the average hourly rate of budgeted IAF resources (Abbott, Parker, and

Peters [2012]). We also identify three potential factors related to IAF inde-

pendence. First, consistent with Abbott, Parker, and Peters [2010, 2012],

we measure the audit committee’s IAF influence vis-`

a-vis management’s

IAF influence across multiple oversight dimensions.3If upper management

(rather than the audit committee) wields greater IAF influence, this may

cause the IAF to fear reprisal should the IAF question management’s finan-

cial reporting decisions, and thus diminish the IAF’s objectivity or indepen-

dence (e.g., Cohen, Krishnamoorthy, and Wright [2010], Norman, Rose,

and Rose [2010]).

In addition to audit committee IAF influence, a review of the IAF litera-

ture reveals two other potential threats to IAF independence: whether the

IAF serves as a management training ground (MTG) and the sizeable pres-

ence of an IAF outside service provider (OSP). In particular, when the IAF

is used as an MTG, internal auditors may be more reluctant to report finan-

cial reporting issues in an effort to ingratiate themselves to upper manage-

ment (Messier et al. [2011], Christ et al. [2015]). The presence of an OSP

may create job security concerns for the in-house IAF, as registrants may

find the variable cost nature of OSPs attractive as a means of achieving cost

savings and/or financial reporting flexibility (Abbott et al. [2007]).

We regress our IAF-related variables and a set of control variables

against common measures of financial reporting quality, abnormal accruals

2As 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.

3In 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.