Research On The Role Of Internal Audit Function’s Status In Firm Operation

An effective internal audit function(IAF)is one of four cornerstones of corporate governance,along with the board of directors,executive management,and the external auditor.With the continuous development of corporate governance,the role of IAF has gradually expanded from the financial audit to the management audit,which is an independent,objective assurance and consulting activity of the governance process,designed to add value and improve an organization’s operations.While prior studies have documented the benefits of IAF on better financial reporting quality.To date,little research has examined how the IAF might affect the process of firm operation.With the unique advantage of embedding within the organization,IAF can evaluate and improve the effectiveness of the firm’s risk management,internal control,and governance processes using a systematic and disciplined approach to track and supervise its production and operation activities.However,the IAF’s objective may be in conflict with the managers’ interests.If upper management wields the IAF influence,rather than the board of directors,this might cause the IAF to fear reprisal should the IAF question management’s operation decisions,and thus diminish the IAF’s objectivity and independence.Therefore,it is essential to enhance the organizational status of IAF.Compared with the IAF subordinate to the management,the IAF under the board of directors’ leadership represents a higher organizational status and will be viewed as more independent and authoritative.This paper focuses on the organizational status of IAF and divides the firm operation process into two stages,ex ante decision and ex post implementation.Through theoretical analysis and empirical tests,it examines the dynamic relationship between the organizational status of IAF and the firm operation process at different stages.Furthermore,based on the trade-off between the ex ante efficiency of decision-making and the ex post efficiency of implementation,this study also investigates the organizational status of IAF and the firm operational efficiency.According to the incomplete contract theory,this paper constructs a theoretical analysis framework of the relationship between the organizational status of IAF and organization operations from two stages of decision-making and implementation.The internal audit is a part of the contract on corporate governance.Due to bounded rationality and opportunistic behavior,the contract is doomed to be incomplete.The higher organizational status of IAF can increase the degree of completeness of the contract,which results in a lower cost of implementation ex post and a higher cost of making decisions ex ante.The IAF with higher status is more likely to be independent and authoritative,which can effectively reduce the opportunistic behavior of managers and the firm’s operational risk,thus improving the implementation efficiency ex post.However,strict supervision and restraint from the IAF might weaken the risk incentives of managers,lead to conservative operational decisions,and damage the decision-making efficiency ex ante.Therefore,the organizational status of IAF has different effects at different stages of the firm operation.Under the setting of cost management and budget management,this study empirically tests the relationship between the organizational status of IAF and the process of organization operations using the sample of Chinese A-share listed firms that went public over the period from 2001 to 2019.The results indicate that,as to cost management,the organizational status of IAF decreases the extent of cost asymmetry and increases the cost elasticity.As to budget management,the organizational status of IAF reduces the budget implementation deviation but increases the budget slack.The empirical findings are consistent with the theoretical analysis that the status of IAF can increase implementation efficiency but decrease decision-making efficiency.Thus,the effect of IAF status on the firm operation is a double-edged sword.This study further explores how the IAF status influences overall operation efficiency.The results show that the organizational status of IAF has a positive effect on the operation efficiency generally.This study has both theoretical contributions and practical implications.In terms of theoretical contributions,firstly,this paper expands extant research on the internal audit by documenting the association between the internal audit and firm operation.Secondly,this study contributes to the literature by examining a new measure of IAF: the organizational status of IAF from the organization structure chart,which improves the availability of internal audit data and increases future research opportunities.Thirdly,this paper constructs a theoretical analysis framework of the relationship between the organizational status of IAF and organizational operations,which provides a theoretical basis for explaining and predicting the specific effect of IAF on the firm operation.In terms of practical implications,the research findings provide important insights for governments and firms to further strengthen IAF and improve corporate governance.Firms can benefit from the effectiveness of IAF by improving the organizational status of IAF.However,they should pay attention to the conservative tendency in the decision-making stage,and encourage managers by other motivation methods.Additionally,this paper provides policy support and practical guidance for the transformation of internal auditing from financial audit to management audit.Internal auditors should not only prevent irregularities but also put forward solutions and pay attention to the application of audit results.