CEO involvement in selecting CAE, internal audit competency and independence, and financial reporting quality
Abstract
The purpose of this study is to explore the argument that Chief Executive Officer (CEO) involvement in the appointment of the Chief Auditing Executive (CAE) is detrimental to efforts to achieve good financial reporting quality (FRQ). The study is original in that to date, this precise link has not been investigated. Data are obtained via survey and annual reports relating to 307 UK companies listed on the London Stock Exchange, and the working capital and discretionary accruals are used as proxies for financial reporting quality. The findings support the contention that the benefits to FRQ of an independent and competent internal audit function are not realized when there is CEO involvement in the appointment of the CAE, since management is able to override IA controls. Indeed, high FRQ is only evident when the CEO is not involved in the appointment. The results are found to be robust after using two different methods of estimation, and carry the implication regulators concerned with FRQ and quality of internal audit function that the CEO should not be party to the appointment of the CAE since this will depress FRQ.
Keyword : internal audit, financial reporting quality, CEO, internal audit competency, internal audit independence, chief audit executive, audit committee
How to Cite
Alzeban, A. (2018). CEO involvement in selecting CAE, internal audit competency and independence, and financial reporting quality. Journal of Business Economics and Management, 19(3), 456-473. https://doi.org/10.3846/jbem.2018.6264
This work is licensed under a Creative Commons Attribution 4.0 International License.
References
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Alzeban, A. (2015). The impact of culture on the quality of internal audit: an empirical study. Journal of Accounting, Auditing, & Finance, 30(1), 57-77. https://doi.org/10.1177/0148558X14549460
Alzeban, A., & Gwilliam, D. (2014). Factors affecting the internal audit effectiveness: a survey of the Saudi public sector. Journal of International Accounting, Auditing and Taxation, 23(2), 74-86. https://doi.org/10.1016/j.intaccaudtax.2014.06.001
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Bailey, J. (2007). Best practices for internal auditor independence. Internal Auditing, 22(2), 34-37.
Barua, A., Rama, D., & Sharma, V. (2010). Audit committee characteristics and investment in internal auditing. Journal of Accounting and Public Policy, 29(5), 503-513. https://doi.org/10.1016/j.jaccpubpol.2010.09.001
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Castro, I., Galán, J., & Casanueva, C. (2016). Management of alliance portfolios and the role of the board of directors. Journal of Business Economics and Management, 17(2), 215-233. https://doi.org/10.3846/16111699.2014.958093
Christ, M., Masli, A., Sharp, N., & Wood, D. (2015). Rotational internal audit programs and financial reporting quality: Do compensating controls help? Accounting, Organizations and Society, 44, 37-59. https://doi.org/10.1016/j.aos.2015.05.004
Christopher, J., Sarens, G., & Leung, P. (2009). A critical analysis of the independence of the internal audit function: evidence from Australia. Accounting, Auditing & Accountability Journal, 22(2), 200-220. https://doi.org/10.1108/09513570910933942
Dechow, P., & Dichev, I. (2002). The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77(4), 35-59. https://doi.org/10.2308/accr.2002.77.s-1.35
Dechow, P., Sloan, R., & Sweeney, A. (1996). Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research, 13(1), 1-36. https://doi.org/10.1111/j.1911-3846.1996.tb00489.x
Deli, D., & Gillan, S. (2000). On the demand for independent and active audit committees. Journal of Corporate Finance, 6(4), 427-445. https://doi.org/10.1016/S0929-1199(00)00016-X
Dhaliwal, D., Naiker, V., & Navissi, F. (2010). The association between accruals quality and the characteristics of accounting experts and mix of expertise on audit committees. Contemporary Accounting Research, 27(3), 787-827. https://doi.org/10.1111/j.1911-3846.2010.01027.x
Doyle, J., Ge, W., & McVay, S. (2007). Accruals quality and internal control over financial reporting. The Accounting Review, 82(5), 1141-1170. https://doi.org/10.2308/accr.2007.82.5.1141
Financial Reporting Council. (2016). The UK corporate governance code. London: FRC. Retrieved from www.frc.org.uk
Francis, J., & Yu, M. (2009). Big 4 office size and audit quality. The Accounting Review, 84(5), 1521-1552. https://doi.org/10.2308/accr.2009.84.5.1521
Gomariz, F., & Ballesta, J. (2014). Financial reporting quality, debt maturity and investment efficiency. Journal of Banking and Finance, 40, 494-506. https://doi.org/10.1016/j.jbankfin.2013.07.013
Goodwin, J. (2003). The relationship between the audit committee and the internal audit function: evidence from Australia and New Zealand. International Journal of Auditing, 7(3), 263-278. https://doi.org/10.1046/j.1099-1123.2003.00074.x
Haniffa, R., & Hudaib, M. (2007). Locating audit expectations gap within a cultural context: the case of Saudi Arabia. Journal of International Accounting, Auditing and Taxation, 16(2), 179-206. https://doi.org/10.1016/j.intaccaudtax.2007.06.003
Institute of Internal Auditors. (2017). International standards for the professional practice of internal auditing. Retrieved from http://www.theiia.org
Jones, J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29(2), 193-228. http://doi.org/10.2307/2491047
Kang, S., & Kim, Y. (2012). Effect of corporate governance on real activity-based earnings management: evidence from Korea. Journal of Business Economics and Management, 13(1), 29-52. https://doi.org/10.3846/16111699.2011.620164
Kasznik, R. (1999). On the association between voluntary disclosure and earnings management. Journal of Accounting Research, 37(1), 57-81. http://doi.org/10.2307/2491396
Kent, P., Kent, R., Routledge, J., & Stewart, J. (2016). Choice of governance structure and earnings quality. Accounting Research Journal, 29(4), 372-390. https://doi.org/10.1108/ARJ-06-2014-0056
Klein, A. (2002). Audit committee, board of director characteristics, and earnings management. Journal of Accounting and Economics, 33(3), 375-400. https://doi.org/10.1016/S0165-4101(02)00059-9
Lin, S., Pizzini, M., Vargus, M., & Bardhan, I. (2011). The Role of the internal audit function in the disclosure of material weaknesses. The Accounting Review, 86(1), 287-323. https://doi.org/10.2308/accr.00000016
Maijoor, S., & Vanstraelen, A. (2006). Earnings management within Europe: the effects of member state audit environment, audit firm quality and international capital markets. Accounting and Business Research, 36(1), 33-52. https://doi.org/10.1080/00014788.2006.9730005
Mazza, T., & Azzali, S. (2015). Effects of internal audit quality on the severity and persistence of controls deficiencies. International Journal of Auditing, 19(3), 148-165. https://doi.org/10.1111/ijau.12044
McNichols, M. (2002). Discussion of the quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77(S1), 61-69. https://doi.org/10.2308/accr.2002.77.s-1.61
Peasnell, K., Pope, P., & Young, S. (2005). Board monitoring and earnings management: do outside directors influence abnormal accruals? Journal of Business Finance and Accounting, 32(7/8), 1311-1346. https://doi.org/10.1111/j.0306-686X.2005.00630.x
Pizzini, M., Lin, S., & Ziegenfuss, D. (2015). The impact of internal audit function quality and contribution on audit Delay. Auditing: A Journal of Practice & Theory, 34(1), 25-58. https://doi.org/10.2308/ajpt-50848
Prawitt, D., Smith, J., & Wood, D. (2009). Internal audit quality and earnings management. The Accounting Review, 84(4), 1255-1280. https://doi.org/10.2308/accr.2009.84.4.1255
Raghunandan, K., Read, W., & Rama, V. (2001). Audit committee composition, “Gray director”, and interaction with internal auditing. Accounting Horizons, 15(2), 105-118. https://doi.org/10.2308/acch.2001.15.2.105
Stewart, J., & Kent, P. (2006). Relation between external audit fees, audit committee characteristics and internal audit. Accounting and Finance, 46(3), 387-404. https://doi.org/10.1111/j.1467-629X.2006.00174.x
Zain, M., Subramaniam, N., & Stewart, J. (2006). Internal auditors’ assessment of their contribution to financial statement audits: the relationship with audit committee and internal audit function characteristics. International Journal of Auditing, 18(1), 1-18. https://doi.org/10.1111/j.1099-1123.2006.00306.x
Abbott, L., Parker, S., & Peters, G. (2010). Serving two masters: the association between audit committee internal audit oversight and internal audit activities. Accounting Horizons, 24(1), 1-24. https://doi.org/10.2308/acch.2010.24.1.1
Abbott, L., Parker, S., Peters, G., & Raghunandan, K. (2003). The association between audit committee characteristics and audit fees. Auditing: A Journal of Practice & Theory, 22(2), 17-32. https://doi.org/10.2308/aud.2003.22.2.17
Alzeban, A. (2015). The impact of culture on the quality of internal audit: an empirical study. Journal of Accounting, Auditing, & Finance, 30(1), 57-77. https://doi.org/10.1177/0148558X14549460
Alzeban, A., & Gwilliam, D. (2014). Factors affecting the internal audit effectiveness: a survey of the Saudi public sector. Journal of International Accounting, Auditing and Taxation, 23(2), 74-86. https://doi.org/10.1016/j.intaccaudtax.2014.06.001
Alzeban, A., & Sawan, N. (2015). The impact of audit committee characteristics on the implementation of internal audit recommendations. Journal of International Accounting, Auditing and Taxation, 24(1), 61-71. https://doi.org/10.1016/j.intaccaudtax.2015.02.005
Al-Twaijry, A., Brierley, J., & Gwilliam, D. (2002). An examination of the role of audit committees in the Saudi Arabian corporate sector. Corporate Governance, 10(4), 288-297. https://doi.org/10.1111/1467-8683.00293
Bailey, J. (2007). Best practices for internal auditor independence. Internal Auditing, 22(2), 34-37.
Barua, A., Rama, D., & Sharma, V. (2010). Audit committee characteristics and investment in internal auditing. Journal of Accounting and Public Policy, 29(5), 503-513. https://doi.org/10.1016/j.jaccpubpol.2010.09.001
Carcello, J., & Neal, T. (2000). Audit committee composition and auditor reporting. The Accounting Review, 75(4), 453-467. https://doi.org/10.2308/accr.2000.75.4.453
Castro, I., Galán, J., & Casanueva, C. (2016). Management of alliance portfolios and the role of the board of directors. Journal of Business Economics and Management, 17(2), 215-233. https://doi.org/10.3846/16111699.2014.958093
Christ, M., Masli, A., Sharp, N., & Wood, D. (2015). Rotational internal audit programs and financial reporting quality: Do compensating controls help? Accounting, Organizations and Society, 44, 37-59. https://doi.org/10.1016/j.aos.2015.05.004
Christopher, J., Sarens, G., & Leung, P. (2009). A critical analysis of the independence of the internal audit function: evidence from Australia. Accounting, Auditing & Accountability Journal, 22(2), 200-220. https://doi.org/10.1108/09513570910933942
Dechow, P., & Dichev, I. (2002). The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77(4), 35-59. https://doi.org/10.2308/accr.2002.77.s-1.35
Dechow, P., Sloan, R., & Sweeney, A. (1996). Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC. Contemporary Accounting Research, 13(1), 1-36. https://doi.org/10.1111/j.1911-3846.1996.tb00489.x
Deli, D., & Gillan, S. (2000). On the demand for independent and active audit committees. Journal of Corporate Finance, 6(4), 427-445. https://doi.org/10.1016/S0929-1199(00)00016-X
Dhaliwal, D., Naiker, V., & Navissi, F. (2010). The association between accruals quality and the characteristics of accounting experts and mix of expertise on audit committees. Contemporary Accounting Research, 27(3), 787-827. https://doi.org/10.1111/j.1911-3846.2010.01027.x
Doyle, J., Ge, W., & McVay, S. (2007). Accruals quality and internal control over financial reporting. The Accounting Review, 82(5), 1141-1170. https://doi.org/10.2308/accr.2007.82.5.1141
Financial Reporting Council. (2016). The UK corporate governance code. London: FRC. Retrieved from www.frc.org.uk
Francis, J., & Yu, M. (2009). Big 4 office size and audit quality. The Accounting Review, 84(5), 1521-1552. https://doi.org/10.2308/accr.2009.84.5.1521
Gomariz, F., & Ballesta, J. (2014). Financial reporting quality, debt maturity and investment efficiency. Journal of Banking and Finance, 40, 494-506. https://doi.org/10.1016/j.jbankfin.2013.07.013
Goodwin, J. (2003). The relationship between the audit committee and the internal audit function: evidence from Australia and New Zealand. International Journal of Auditing, 7(3), 263-278. https://doi.org/10.1046/j.1099-1123.2003.00074.x
Haniffa, R., & Hudaib, M. (2007). Locating audit expectations gap within a cultural context: the case of Saudi Arabia. Journal of International Accounting, Auditing and Taxation, 16(2), 179-206. https://doi.org/10.1016/j.intaccaudtax.2007.06.003
Institute of Internal Auditors. (2017). International standards for the professional practice of internal auditing. Retrieved from http://www.theiia.org
Jones, J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29(2), 193-228. http://doi.org/10.2307/2491047
Kang, S., & Kim, Y. (2012). Effect of corporate governance on real activity-based earnings management: evidence from Korea. Journal of Business Economics and Management, 13(1), 29-52. https://doi.org/10.3846/16111699.2011.620164
Kasznik, R. (1999). On the association between voluntary disclosure and earnings management. Journal of Accounting Research, 37(1), 57-81. http://doi.org/10.2307/2491396
Kent, P., Kent, R., Routledge, J., & Stewart, J. (2016). Choice of governance structure and earnings quality. Accounting Research Journal, 29(4), 372-390. https://doi.org/10.1108/ARJ-06-2014-0056
Klein, A. (2002). Audit committee, board of director characteristics, and earnings management. Journal of Accounting and Economics, 33(3), 375-400. https://doi.org/10.1016/S0165-4101(02)00059-9
Lin, S., Pizzini, M., Vargus, M., & Bardhan, I. (2011). The Role of the internal audit function in the disclosure of material weaknesses. The Accounting Review, 86(1), 287-323. https://doi.org/10.2308/accr.00000016
Maijoor, S., & Vanstraelen, A. (2006). Earnings management within Europe: the effects of member state audit environment, audit firm quality and international capital markets. Accounting and Business Research, 36(1), 33-52. https://doi.org/10.1080/00014788.2006.9730005
Mazza, T., & Azzali, S. (2015). Effects of internal audit quality on the severity and persistence of controls deficiencies. International Journal of Auditing, 19(3), 148-165. https://doi.org/10.1111/ijau.12044
McNichols, M. (2002). Discussion of the quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review, 77(S1), 61-69. https://doi.org/10.2308/accr.2002.77.s-1.61
Peasnell, K., Pope, P., & Young, S. (2005). Board monitoring and earnings management: do outside directors influence abnormal accruals? Journal of Business Finance and Accounting, 32(7/8), 1311-1346. https://doi.org/10.1111/j.0306-686X.2005.00630.x
Pizzini, M., Lin, S., & Ziegenfuss, D. (2015). The impact of internal audit function quality and contribution on audit Delay. Auditing: A Journal of Practice & Theory, 34(1), 25-58. https://doi.org/10.2308/ajpt-50848
Prawitt, D., Smith, J., & Wood, D. (2009). Internal audit quality and earnings management. The Accounting Review, 84(4), 1255-1280. https://doi.org/10.2308/accr.2009.84.4.1255
Raghunandan, K., Read, W., & Rama, V. (2001). Audit committee composition, “Gray director”, and interaction with internal auditing. Accounting Horizons, 15(2), 105-118. https://doi.org/10.2308/acch.2001.15.2.105
Stewart, J., & Kent, P. (2006). Relation between external audit fees, audit committee characteristics and internal audit. Accounting and Finance, 46(3), 387-404. https://doi.org/10.1111/j.1467-629X.2006.00174.x
Zain, M., Subramaniam, N., & Stewart, J. (2006). Internal auditors’ assessment of their contribution to financial statement audits: the relationship with audit committee and internal audit function characteristics. International Journal of Auditing, 18(1), 1-18. https://doi.org/10.1111/j.1099-1123.2006.00306.x