Introduction of internal audit
This sample essay is published by a student on the topic of internal audit role in corporate governance. If you have concerned about its publication please let us know.
Financial ratio analysis is a management tool that pulls together information from a government’s budgets and financial reports. Presently, there are three major comprehensive sets of financial indicators commonly used for assessing a city’s financial condition: (i) Financial trend monitoring system (FTMS) as advanced by Groves and Valente (1994); (ii) Ten-point test as advanced by K. Brown (1993); and (iii) Comprehensive financial ratios as developed by Kloha, Weissert, and Kleine (2005a) and Wang, Dennis, and Tu (2007). All of these methods are in the same accounting vein in that they involve measuring financial positions, fund balances, liquidities, debt burdens, and budget solvency, and that they mainly use multiple financial ratios as a basis for analysis. The data are mainly derived from the city’s financial reports (balance sheets, statement of revenue/expenditures, and the like).
The uncertainty faced by the public regarding internal audit is costly to local governments because the public demand a premium to bear the risks associated with the uncertainty. Local governments often attempt to reduce this risk by providing informative disclosures.
Although the financial ratio analysis is very attractive to public managers due to its simplicity, it has some weaknesses. First, the use of financial ratios often ignores key socioeconomic variables that are fundamental to the determination of taxing capacity and spending need10. Furthermore, each of the distinct indicators is separately evaluated from the others and does not allow a meaningful comparison among them. Thus, the result is often inconclusive and does not provide a comprehensive picture of the financial condition (Hendrick et al. 2006; Kloha, Weissert, and Kleine 2005a). Additionally, Hendrick et al. (2006) argue that the ten-point test is not sensitive enough to meaningfully distinguish a city’s financial condition since its use of quartile rankings is too broad and the assigned scores of -1, 0, 1, and 2 to each of the quartile ranks are made arbitrarily. Moreover, the ten-point test is not readily available for use in all circumstances due to its restricted database (Honadle and Lloyd-Jones 1998).
One factor that affects the perceived credibility of management disclosures is the level of assurance associated with the disclosure (e.g., Kinney 2000; Mercer 2004). Kinney (2000) notes that assurance services are useful to decision makers because they help mitigate the effects of measurement error and bias in financial information. While the extant literature includes studies on the effects of external assurance on perceived disclosure credibility (e.g., Libby 1979; Leftwich 1983; Blackwell et al. 1998; Hodge 2001), one potentially valuable within-firm source of assurance comes from a firm’s internal audit function (e.g., Kinney 2000; Mercer 2004).
Despite internal audit’s role as a cornerstone of corporate governance (IIA 2007a; Gramling et al. 2004), external stakeholders typically have no information about the composition, responsibilities, or activities of the function (Mercer 2004). This information is important given the heterogeneity that is found across internal audit functions which makes it difficult for stakeholders to make informed decisions related to the role of this key component in a firm’s overall governance structure (Gramling et al. 2004).2 Mercer (2004, 190) notes that: Internal auditors often serve as the first line of defense against disclosure errors, ferreting out unintentional errors caused by weaknesses in a company’s internal controls and intentional errors due to fraud.
Recent literature (e.g., Lapides et al. 2007; Archambeault et al. 2008; Holt and DeZoort 2009; Mercer 2004) has begun to investigate the need for greater internal audit transparency. For example, Holt and DeZoort (2009) provide initial evidence that a Internal Audit Report describing the composition, activities, and responsibilities of internal audit positively affects investor judgment and decision-making. The current study extends the internal audit disclosure literature by examining the effects of two internal audit function characteristics (i.e., role and reporting relationship) on perceived disclosure credibility.
The first characteristic tested is internal auditor role (i.e., primarily assurance-related vs. primarily consulting-related). With the passage of SOX, many internal audit functions shifted their focus away from traditional assurance services (e.g., compliance and financial audits) towards consulting services (e.g., Krell 2005; Proviti 2007). However, this shift creates a conflict between the collaborative consulting work supplied by internal auditors to management and the need for objectivity in providing assurance work (e.g., Galloway 1995; Pickett 1997; DeZoort et al. 2001; Krell 2005; Reding et al. 2007). Additionally, an internal audit department whose work is primarily consulting-related may be perceived as having less capability to detect errors and fraud than a department whose work is primarily assurance-related given a relative lack of evidence gathering. Furthermore, the study predicts that the relation between internal audit role and perceived financial reporting credibility is attributable to the mediating effect of the perceived level of assurance offered by internal audit.
The second characteristic tested is internal auditor reporting relationships (i.e., report strategically to the audit committee and administratively to the Chief Executive Officer vs. strategically and administratively to the Chief Financial Officer). Objectivity is an essential component of assurance services (e.g., Mautz and Sharaf 1961; Kinney 2000). Assurance services are of little value to public if public can place little trust in the auditor’s willingness to report material departures from measurement criteria. The IIA’s Organizational Independence standard states that a company’s Chief Audit Executive should report to a level that ensures the function can complete its duties (IIA 2007a). An appropriate reporting relationship is essential to ensuring that internal audit activities are not unduly influenced by management. Kinney (2000) notes that objectivity impairments due to inappropriate reporting relationships may undermine the monitoring benefits that internal auditors provide to stockholders.
Internal Audit’s Role in Corporate Governance
The four primary cornerstones of corporate governance include the audit committee, management, external audit, and internal audit (Bailey et al. 2003; Gramling et al. 2004). Over the past several years, the role of the internal audit function as a major component of corporate governance has become increasingly important as a result of corporate scandals and increased legislation (Carcello et al. 2005; Jackson 2007). Deloitte (2006) notes that there would likely have been a significantly higher number of material weaknesses during SOX implementation if not for the work of internal auditors.
Various regulatory bodies have highlighted the importance of internal audit to corporate governance. The Public Company Accounting Oversight Board (2004) stated that the absence of a properly functioning internal audit function might be grounds for a material weakness in internal controls over financial reporting for mature or complex companies. Additionally, SEC officials (e.g., Herdman 2002; Richards 2002; Gadziala 2005) have repeatedly highlighted the critical role that internal audit plays in maintaining an effective control structure within an organization. For example, SEC Associate Director of the Office of Compliance Inspections and Examinations Gadziala (2005) stated that she considers internal audit departments to be critical governance components in the prevention of abuses within a company. Furthermore, the major stock exchanges have begun to recognize the importance of a company’s internal audit function. Accounting research also has reflected on the importance of internal audit to corporate governance. Collectively, the existing accounting literature emphasizes that an effective internal audit function plays a critical role in governance through its effect on corporate risk management and control processes.
Richard A. Musgrave was the first to note the independent relationship between provision and production: “provision for public wants … does not require public production management (1959, p. 15). ” Ostrom, Tiebout and Warren’s 1961 work was one of the first specifications of the relationship between the modes of provision, production and the attributes of collective and individual goods and services. Ronald Oakerson (1987) advocates the distinction of provision side from production side, anticipating that each side will engage in distinctive activities. Oakerson’s idea on the public provision refers to “decisions that determine what public goods and services will be made available to a community.” And production refers to “how those goods and services will be made available (1987, p. 1).”
The provision decision by local government consists of wide range of institutional arrangement for delivering service. Local government can serve as a direct producer or supervisor of service production. A government service does not have to be produced by public employees or use public equipments. Although municipal governments use many types of provision of services and goods, contracting is the most popular privatization mode in purchasing public services from either other government units or private and nonprofit organizations (Warner and Hedbon, 2001, Savas, 2005).
Information Asymmetry and Governance Transparency
Jensen and Meckling (1976) model an agency relationship between the managers of local government and the shareholders of the local government. There are inherent problems (e.g., moral hazard and information asymmetry) in this contractual relationship because the managers of the local government have inside information and may not always make decisions that are most advantageous for the local government shareholders. As a result, shareholders and rule-making bodies implement corporate governance mechanisms to monitor firm activities to ensure that the managers of a firm are acting as proper stewards of firm assets. These accounting and auditing governance mechanisms are a critical part of the capital market system (Imhoff 2003).
The extant accounting literature documents the benefits of decreased information uncertainty that results from such disclosures. For example, several studies (e.g., Botosan 1997; Lang and Lundholm 2000; Botosan and Plumlee 2002) find that increased disclosure is associated with lowered cost of equity. Additionally, decreased levels of information uncertainty are associated with lowered cost of debt (e.g., Sengupta 1998), improved market liquidity (e.g., Heflin et al. 2005; Lambert et al. 2006), lowered IPO underpricing (e.g., Schrand and Verrecchia 2005), and increased stock prices (e.g., Bloomfield and Wilks 2000). Furthermore, Field et al. (2005) find that increased disclosure may even decrease litigation risk.
Governance transparency refers to the availability and extent of disclosures related to corporate governance (Bushman et al. 2004). Given the critical role that corporate governance plays in meeting local governments’ organizational objectives, disclosures about companies’ governance mechanisms are likely to be useful to shareholders. Accounting research has begun to provide evidence on the benefits of increased governance transparency. Farber (2005) finds that improved governance transparency increased analysts’ following. He also finds that these governance improvements were associated with better stock performance after controlling for earnings effects. Furthermore, Bhat et al. (2006) find a positive relation between the accuracy of analysts’ forecasts and the level of governance transparency even after controlling for financial transparency.
Mercer (2004) provides a framework for assessing investor perceptions of disclosure credibility. She notes that one key factor that affects perceptions of disclosure credibility is the degree of external and internal assurance. While much of the extant literature (e.g., Libby 1979; Leftwich 1983; Blackwell et al. 1998; Hodge 2001) focuses on assurance added by the external auditor, the internal audit function is a potential source of information that may lend disclosure credibility. Internal auditors often serve as the first-line of defense in preventing errors and detecting fraud (Mercer 2004). An adequately structured internal audit function has the capacity to discover and correct problems before they grow large. However, there is little empirical evidence linking internal audit strength and disclosure credibility due to lack of information available about local governments’ internal audit functions.
Internal Audit Reports
While there are mandatory corporate disclosures about the audit committee, the external auditor, and management, there are currently no mandated disclosures about a company’s internal audit function. The audit committee report may be an indirect source of voluntary disclosures about internal audit. However, Carcello et al. (2002) find that the vast majority of a sample of these disclosures contains no mention of the internal audit function. Former Securities and Exchange Commission chairman Harvey Pitt noted that it is in a company’s best interest to provide governance disclosures beyond those currently mandated (Marshall 2005). Given the critical role of internal audit in corporate governance and benefits of reduced information asymmetry as a result of governance transparency, researchers have begun to explore the benefits of increased internal audit transparency (e.g., Archambeault et al. 2008; Holt and DeZoort 2009; Lapides et al. 2007). For example, Lapides et al. (2007) encourages company consideration of providing an IAR detailing the composition, responsibilities, and activities of the internal audit function to external shareholders.
Internal Audit Role
The role of internal audit has changed over time (Bailey et al. 2003). While the role was traditionally assurance-related in nature, the IIA officially adopted a new definition of internal audit in 1999 in an attempt to focus on a more value-added approach of the function (e.g., Bou-Raad 2000; Krogstad et al. 1999). Under the new definition, the IIA (2007b) describes the internal audit function as “an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations.”
Although the work performed by internal audit can encompass a wide variety of activities, those activities can generally be classified as either assurance or consulting services (Bailey et al. 2003). Assurance services provide objective examinations and assessments of risk management, control, or governance processes within a company. Examples of assurance services include financial audits, compliance audits, or system security audits. Consulting services are services that are advisory in nature in which the customer requesting the service agrees upon the scope and nature of the service. Examples of consulting services include training programs, operational advice, or providing counsel (Reding et al. 2007).
After the passage of SOX, many internal audit departments were called upon to shift their role from focusing on traditional assurance services to providing consulting services related to the new compliance regulations (e.g., Krell 2005; Redmond et al. 2008). For example, the internal audit at Chevron refocused its efforts to supply controls documentation and training(Redmond et al. 2008). Six years after the passage of SOX, many internal audit functions are still burdened with the compliance consulting activities related to SOX, and many CAEs are anxious to return to traditional assurance activities (Redmond et al 2008). PricewaterhouseCoopers (Krell 2005, 20) notes:
Simply put, the legislation is diverting internal audit resources from risk-based auditing, creating the potential for dire consequences. That’s because a failure to address key strategic and operational risks as well as compliance risk in an internal audit program undermines the effectiveness of internal audit, diminishes its strategic value to key stakeholders, and exposes the enterprise to greater operational and financial risks in the future.
According to assurance theory (e.g., Mautz and Sharaf 1961; Libby 1979; Libby et al. 2004) individuals perceive audited information to be more credible than unaudited information. This increase in perceived credibility results from a perception that more evidence gathering is required in order to provide the assurance. By its very nature, the shift away from assurance services to consulting services reduces the amount of evidence gathered by internal audit resulting in a lowered level of assurance offered by the function. Additionally, an internal audit function whose activities are primarily consulting-related may be perceived as lacking objectivity. During consulting projects, internal auditors often work closely with management (Breakspear 1998). These working relationships may lead to perceptions of objectivity impairments for the internal auditor as the internal auditors may be hesitant to report adverse findings (Greenspan et al. 1994). Furthermore, internal auditors are often called upon to test their own work performed during SOX compliance implementation.
This situation represents an inherent objectivity impairment (Krell 2005). Source credibility theory (Birnbaum and Stegner 1979) highlights source bias as a critical component ininformation credibility evaluations. Accordingly, individuals perceive information as more credible to the extent that they believe the source is more objective.
Internal Audit Reporting Relationships
The IIA’s Organizational Independence standard states that a company’s CAE should report to a level that ensures the function can complete its duties (IIA 2007a). An appropriate reporting relationship is essential to ensuring that internal audit activities are not unduly influenced by management. However, there has been considerable debate (e.g., SEC 2003c; James 2003; Johnson 2006) about what reporting relationship best achieves the appropriate level of internal audit independence. The SEC (2003b) asked for comments regarding whether the responsibility for personnel decisions and oversight of the internal audit function should be placed directly with or under the supervision of the audit committee. The SEC chose not to act on the matter after receiving mixed comments from a variety of groups.4 The New York State Bar Association’s response to the proposal noted that prior to the passage of the rule, the SEC should conduct research to determine potential problems associated with various reporting relationships (SEC 2003c).
Strategic reporting of the internal audit function involves the governance activities of the internal audit function such as charter approval, hiring or terminating the CAE, and receiving periodic results of internal audit activities. Administrative reporting involves the day-to-day activities of the internal audit function including human resource administration, budgeting, and administration of internal policies and procedures (IIA 2002). The IIA (2007b) and Moody’s Investor Services (Johnson 2006) recommend that the best practice to ensure internal audit independence is a dual reporting relationship where the CAE reports strategically to the audit committee and administratively to the CEO. In a survey of 379 CAEs in the IIA Global Audit Information Network (GAIN) database, 55% of internal audit respondents note that they report strategically to the audit committee. Furthermore, for administrative reporting, only 10% report to the CEO while 51% report to either the CFO or Controller (IIARF 2003).
James (2003) finds that lenders perceive internal auditors that reported both strategically and administratively to the audit committee are more likely to prevent financial statement fraud than internal auditors that report both strategically and administratively to management. This study examines the effect of reporting relationship on investor perceptions of disclosure credibility. The two reporting relationships examined in this study are an internal audit function that reports strategically to the audit committee and administratively to the CEO and an internal audit function that reports both strategically and administratively to the CFO.
Source credibility theory (e.g. Walster et al. 1966; Birnbaum and Stegner 1979; Eagly and Chaiken 1993) provides a basis for predicting that the level of internal audit independence as proxied by reporting relationships will affect investor perceptions of disclosure credibility.
According to this theory, individuals should place more reliance on information that they perceive as more credible. As previously mentioned, Birnbaum and Stegner (1979) highlight source bias as a critical component in information credibility evaluation, and individuals perceive information as more credible to the extent that they believe the source has more objectivity. Gramling et al. (2004) find that in evaluating an internal auditor’s objectivity, independence is generally the most important criterion.5 Thus, investor perceptions of disclosure credibility should increase as perceptions of the level of internal audit independence increases.
Need A Professionally Written Essay on Similar Topic? We Have Hired PhD Level Writers to Help You in Writing Essays on Any Topic and For Any Deadline. Just Fill the Order Form and Get Your Essay at the Most Affordable Price
Akerloff, G. A. 1970. The market for “lemons”: Quality uncertainty and the market mechanism. Quarterly Journal of Economics 84(3): 488-500.
Archambeault, D., F. T. DeZoort, and T. P. Holt. 2008. Governance transparency and the need for an internal audit report to external stakeholders. Accounting Horizons (December): 375-388.
Blackwell, D., T. Noland, and D. Winters. 1998. The value of auditor assurance: Evidence from loan pricing. Journal of Accounting Research 36 (1): 57-70.
Easley, D and M. O’Hara. 2004. Information and the cost of capital. Journal of Finance 59(4): 1553-1583.
Elliott, R. K. and P. D. Jacobson. 1994. Costs and benefits of business information disclosure. Accounting Horizons 8 (4): 80-96.
Gramling, A., Maletta, M., A. Schneider, and B. Church. 2004. Role of the Internal Audit Function in Corporate Governance: A Synthesis of the Extant Internal Auditing Literature and Directions for Future Research. Journal of Accounting Literature 23: 194- 244.
Hodge, F. D. 2001. Hyperlinking unaudited information to audited financial statements: Effects on investor judgments. The Accounting Review (October): 675-691.
Holt, T. and T. DeZoort. 2009. The effects of internal audit report disclosure on investor confidence and decisions. International Journal of Auditing (March): 61-77.
Institute of Internal Auditors (IIA). 2007a. International Standards for the Professional Practice of Internal Auditing. Altamonte Springs, FL. http://www.theiia.org/guidance/standards-andpractices/ professional-practices-framework/standards/standards-for-the-professionalpractice- of-internal-auditing/.
Kinney, W. 2000. Information Quality Assurance and Internal Control. Boston, MA: Irwin McGraw-Hill.
Krell, E. 2005. Is Sarbanes-Oxley compromising internal audit? Business Finance (August): 18-24.
Lapides, P. D., M. S. Beasley, J. V. Carcello, F. T. DeZoort, D. R. Hermanson, and T. L. Neal. 2007. 21st Century Governance and Audit Committee Principles. Corporate Governance Center, Kennesaw State University.
Leftwich, R. 1983. Accounting information in private markets: Evidence from private lending agreements. The Accounting Review 58 (1): 23-42.
Libby, R. 1979. Bankers’ and auditors’ perceptions of the message communicated by the audit report. Journal of Accounting Research 17 (Spring): 99-122.
Mercer, M. 2004. How do investors assess the credibility of management disclosures? Accounting Horizons (September): 185-196.
Proviti. 2007. Moving Internal Audit Back into Balance. Available at http://www.protiviti.com.
Watts, R., and J. Zimmerman. 1986. Positive Accounting Theory. Upper Saddle River, NJ: Prentice-Hall.