A Study On The Effect Of Internal Audit Quality Upon Earnings Management And External Audit Fees

Modern internal audit has developed quickly since it began in railways department of America in early 20th century. Internal audit becomes the focus with the worldwide revolution of corporate governance because of Enron and WorldCom fraud. According to a model of corporate governance put forth by the Institute of Internal Auditors (IIA), the internal audit function (IAF) is one of four cornerstones of effective corporate governance, along with the board of directors, executive management, and the external auditor. The IAF has long been recognized in the academic literature as a key component of corporate governance with an important monitoring role and models, but regulators and the popular press have just recently begun to recognize the importance of the IAF. Association of Chartered Certified Accountants(ACCA) indicates that the root of credit crisis outbreaking in the United States in 2008 is failure of corporate governance in banks. So IAF as an important contributor to effective corporate governance has to play its governance role in the special period.IAF has developed since 1985 in China. The State Council of the People's Republic of China issues provisional regulations on the audit work that require medium-sized enterprises and nonprofit institutions to have an IAF. After that, there are series of rules of law published by China Securities Regulatory Commission (CSRC), stock exchange and so on. "The Basic Norms of Internal Control" published on June 28th 2008 supports IAF on the new height in enterprises. All of these suggest that IAF is receiving greater attention in China.CSRC published the notice that required listed companies to reinforce corporate governance on March 9th 2007, and one of the aims is to investigate whether listed companies have IAFs or not, and the effectiveness of internal control. However, whether IAF fulfills its responsibilities effectively, and whether IAF achieves its governance purpose, empirical evidences of these questions not only ease the department of supervision understanding the policy effect of setting up IAF and are helpful to perfect IAF, but also enrich the literature of IAF and provide experiences for other developing countries.This thesis investigates the role of internal audit function from perspectives of earnings management and external audit fees focusing on internal audit quality (IAQ). The results are significant in both theoretical and practical aspects for some parties such as listed companies, CSRC, external auditors to understand the role of internal audit in corporate governance. This thesis is arranged as follows.Chapter 1:Introduction. This chapter outlines research background, the objectives, the thought of the issues, the methodology, and the framework and writing arrangements. This chapter is overall planning.Chapter 2:Literature review. It summaries the relevant literature home and abroad from three aspects that are measures of IAQ, the relation between IAQ and earnings management and the relation between IAQ and external audit fees. Then make comments on the literature. This chapter identifies, the opportunities of research based on the literature review, being prerequisite for the'research.Chapter 3:System background and theoretical analysis. First, this chapter summaries the responsibilities of IAF, the standards of external audit fees and the influences that internal auditors to external auditors in performing a financial statement audit in China. Then analyse internal audit controlling earnings management in the theories of accountability and corporate governance, and derivate IAQ affecting external audit fees by supply and demand model for external audit fees. Analysis of system background ensures the rationality of research methodology, and theoretical analysis supports empirical research, so this chapter is the basis of this thesis.Chapter 4:Internal audit quality and earnings management. It is a chapter of empirical research of IAQ and levels of earnings management. It derives measures for IAQ from internal audit mode, number of internal auditors, whether establish IAF before rectification or not and whether establish rules of internal audit or not. Meanwhile, it measures earnings management using the proxy that is the abnormal accruals as determined by the performance-adjusted cross-sectional variation of the modified Jones model. Finally, test the expectation that a composite measure for IAQ is associated with reduced levels of earnings management. Furthermore, this chapter describes two additional analyses, one is estimating the abnormal accruals by Jones model again, and the other is excluding the influences by extreme data.Chapter 5:Internal audit quality and external audit fees. It is a chapter of empirical research of IAQ and external audit fees, and examining whether each IAQ variable including number of internal auditors, internal audit model and whether establish rules of internal audit is related to external audit fees. The measure of IAQ is the same as Chapter 4. To test these relations, this chapter empolys an unexpected external audit fee dependent measure which is the residual of a regression that external audit fees model.Chapter 6:It is a concluding section. Main findings are summarized again. The implication of the findings to companies, to external auditors, to CSRC, to exchange stock and so on is then carefully discussed. Expected direction for further study comes with the discussion of the limitation of this thesis.Main findings in this thesis are as follows.(1)IAQ is negatively associated with earnings management. This result suggests that internal audit affects financial reporting effectively, that is the higher IAQ is associated with the lower the absolute abnormal accruals measure.Further examination of the results for abnormal accruals suggests that the moderating effect of IAQ is largely driven by the positive abnormal accrual firm-year responses and it is the lack of an association between IAQ and negative abnormal accrual.(2)IAQ is associated with lower unexpected external audit fees. New evidence is found that IAQ can affect external audit fees, and external auditors rely on the work of internal auditors in performing a financial statement audit to some extent. And it suggests that there is an alternative relationship between internal auditors and external auditors.Number of internal auditors is positively associated with unexpected external audit fees that suggest listed companies are willing to pay higher external audit fees to gain higher audit quality while they amplify the size of IAF to strengthen IAF. Internal audit mode is inversely related to unexpected external audit fees owing to the more objective the IAF, external auditors are more likely to rely on the work of internal auditors. The variable whether establish rules of internal audit or not is not significantly associated with unexpected external audit fees. Empirical results also provide evidence that significant factors affecting external audit fees contain size, inherent risk, complexity, profitability, financial risk, auditor quality, audit opinion and auditor tenure in China, and this result is the same home and abroad.These contributions of this thesis include:First, enrich the literature of empirical research about internal auditIt is a long history of research about internal audit in China, however, most of them are normative research. There is a little number of empirical researches about internal audit from 2004. This thesis examines the efficiency of internal audit from the aspects of earnings management and external audit fees, especially examines the relation between internal audit quality and external audit fees at the first time in China. It enriches the literature of empirical research about internal audit.Second, contribute to research methods based on the prior researchThis thesis measures IAQ using a composite measure comprising four individual characteristics, which are internal audit mode, number of internal auditors, and motivation of establishment and rules of internal audit, IAQualiy as a variable of IAQ is measured through assigning and weighting to the four. characteristics. This can provide some methods for future research on internal audit.On the other hand, this thesis employs an unexpected external audit fee dependent measure that is the residual of a regression of external audit fees in order to control for multiple possible determinants of external audit fees in the first step while retaining sufficient power to detect a relation between IAQ and external audit fees in the second step. This modifies the methodology of the factors affecting external audit fees in the previous research in China.Third, provide new evidence for strengthening internal audit function and perfecting corporate governanceThe results of this thesis suggest that internal audit can monitor earnings management better than audit committee because of implementing audit of financial statements, and it provides a new direction for corporate governance in future.IAQ can affect external audit fees. Companies, including board of directors, audit committees and executive management can explore ways of saving cost in light of these findings that higher IAQ can help external auditors control risk, improve efficiency and reduce cost.