The Relationship between Internal Audit Quality and Reporting Quality: A Study of Quoted Banks in Nigeria

CHAPTER ONE

INTRODUCTION

1.1         Background of the Study

Corporate scandals around the world, such as that reported in respect of Enron, WorldCom, Global Crossing, and Rank Xerox, in the USA, Parmalat in Italy (Demaki, 2011; Norwani, Zam, & Chek, 2011), Allied Nationwide Finance in New Zealand (Lianne, 2011), and, Cadbury, Afribank, Intercontinental, Wema Bank, NAMPAK, Finbank, Springbank, in Nigeria, among others (Farouk & Hassan, 2014; Adeyemi & Fagbemi, 2010) have captured the attention of the public, and increased attention to internal audit as regard to its ability to contribute towards corporate governance processes, including promoting effective controls, risk management and mitigating fraud risk (Hermanson, Ivancevich, & Ivancevich, 2008). Internal audit is defined ‘as an independent, objective assurance and consulting activity designed to add and improve an organization’s operations’ (The Institute of Internal Auditors (IIA), 2001). It is considered an independent, objective assurance and consulting activity designed to add value (Komeleh & Garkaz, 2014), by measuring and evaluating the effectiveness of organizational controls (Carmichael, Willingham, & Schaller, 1996).

Internal auditing is an important managerial control device (Pinto, Pereira, Imoniana, & Peters, 2014) to improve firms’ operations, which is directly linked to the organizational structure and the general rules of the business (Cai, 1997). Internal audit aims to protect the company’s assets against frauds or intentional misstatements. Classified by Moyes, Young and Din (2013) as i) misstatements resulting from fraudulent financial reporting and ii) misstatement resulting from misappropriation of assets. It assists firms to accomplish their objectives by bringing a systematic, disciplined method to assess and to improve the effectiveness of risk management, control, and governance processes (Raghunandan, Rama, & Read, 2001; Fama & French, 1993).

The scope of internal auditing within firms is extensive and may include topics such as an organization’s governance, risk management and management controls (Krishnan, 2005). Internal auditing may also include conducting proactive fraud audits to determine potentially fraudulent acts; participating in fraud investigations under the direction of fraud investigation professionals, and conducting post investigation fraud audits to detect control breakdowns and to establish financial loss (Komeleh & Garkaz, 2014). The objective of internal auditing is to assist the organization, in particular managers and members of the board of directors, to discharge of their responsibilities effectively.  In today’s business environment internal auditors provides management with a far broader range of information concerning the organization’s financial, operational and compliance activities to improve effectiveness, efficiency, and economy of management performance and activities (Rezaee, 1996).

In reality, the function of an internal auditor is practically the same as that of an external auditor. Both act as watchdogs in the organisation. The role of the internal audit can include a varied set of responsibilities: supporting the management in establishing auditable anti-fraud mechanisms; facilitating the assessment of fraud and reputational risks at the level of an organization and its business process; assessing the connections between fraud risks and internal controls; auditing frauds; supporting the specialists in fraud investigation; supporting the efforts to rectify deficiencies; and reporting to the audit committee the problems regarding anti-fraud mechanisms, fraud and reputational risks assessment, or fraud cases and suspicions (Petraşcu, 2012).

Financial reporting quality has remained an issue of major concern among professional accountants, regulators and other users of financial information (Mbobo & Ekpo, 2016), following notorious corporate scandals (Lin, Liu, & Wang, 2007) that occurred in both the international and local scene. This is due to the fact that financial reporting has been a principal means of communicating the results of transactions and events which transpired within the organisation to the outsiders; who may use such information in assessing the economic performance and condition of a business as well as a guide in making economic decisions (Mbobo & Ekpo, 2016). This study therefore explores the relationship between internal audit quality and reporting quality of quoted banks in Nigeria.

1.2         Statement of the Problem

Despite the growing importance of internal audit functions (Abbott, Daugherty, Parker, & Peters, 2016), there is limited archival evidence on internal audit quality (Abbott, Daugherty, Parker, & Peters, 2016; Johl, Kaur Johl, Subramaniam, & Cooper, 2013). The IIA (2010) describes internal audit function as “[. . .] an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations.” Given that the internal audit function plays an important role in implementing effective governance and controls, it is inevitable that it has a crucial influence in ensuring the credibility of external financial reporting (Johl, Kaur Johl, Subramaniam, & Cooper, 2013).

The role of internal audit has evolved over time, from a role that was traditionally assurance-related, to a function that is more value-added in nature (Bou-Raad, 2000; Krogstad, Ridley, & Rittenberg, 1999). Organisations therefore are increasingly relying on internal audit functions to strengthen their internal control mechanisms. According to a study carried out by PricewaterhouseCoopers [PWC] (2008b) on the perceived status of internal audit in 2012, noted that it will have to adapt to a changing environment in which it operates:

“The rapid growth of the profession and the many changes in the business environment makes it essential for the internal audit profession to adopt new mindsets if it wants to remain a role-player in the future.”

Studies have shown that internal audit function has a significant impact on financial reporting quality in terms of fraud detection and prevention (Church, McMillan, & Schneider, 2001; Coram, Ferguson, & Moroney, 2008), reducing the level of earnings management (Prawitt, Smith, & Wood, 2009). Also, investors who have access to internal audit reports are more confident of financial statements reliability than those who do not have access to the reports (Holt & DeZoort, 2009; Archambeault, DeZoort, & Holt, 2008; James, 2003). Other studies show that internal audit function plays an important role in completing the financial statements audit (Zain, Subramaniam, & Stewart, 2006; Felix & Gramling, 2001; Abdel-Khalik, Snowball, & Wragge, 1983; Ward & Robertson, 1980). Komeleh and Garkaz (2014) show a positive and significant relationship between firms with internal auditing in their activities and quality of financial statements.

These studies investigate the relationship between internal audit function quality and reporting quality, using several proxies, for instance Abbott, Daugherty, Parker, and Peters (2016) used an interactive model of internal audit function quality (comprised of competence and independence), Johl, Kaur Johl, Subramaniam, and Cooper (2013) investigate the association between the quality of the internal audit function and abnormal accruals (as a proxy for financial reporting quality), Prawitt, Smith, and Wood (2009) measure internal audit function quality using a composite measure comprising six individual components of internal audit function quality based on SAS No. 65, which guides external auditors in assessing the quality of an internal audit function with respect to its role in financial reporting.

However, Al-Shetwi, Ramadili, Chowdury, and Sori (2011) note that despite empirical evidence on the importance of internal audit function quality in influencing financial reporting quality, there has been little research on the link between the two, more especially in developing countries. This study therefore examines the relationship between internal audit quality and reporting quality of quoted banks in Nigeria. The role of internal audit function in improving financial reporting quality is premised on the assumption that developments in legal and accounting systems are important factors that help enhance the quality of governance process and financial reporting quality (Al-Shetwi, Ramadili, Chowdury, & Sori, 2011).

1.3         Objective of the Study

The general objective of the study is to examine the relationship between internal audit quality and reporting quality of quoted banks in Nigeria. The specific objectives are as follows:

1. To ascertain the relationship between internal audit size and reporting quality of quoted banks in Nigeria.
2. To determine the relationship between experience and certification of internal audit staff and reporting quality of quoted banks in Nigeria.
3. To ascertain the extent independence and objectivity of internal auditors affect reporting quality of quoted banks in Nigeria.

1.4         Research Questions

The following questions were raised to address the objectives stated above:

1. What is the relationship between internal audit size and reporting quality of quoted banks in Nigeria?
2. What is the relationship between experience and certification of internal audit staff and reporting quality of quoted banks in Nigeria?
3. To what extent does independence and objectivity of internal auditors affect reporting quality of quoted banks in Nigeria?

1.5         Research Hypotheses

The following hypotheses were formulated to guide the study. The hypotheses are stated in their null forms as follows:

1. There is no significant relationship between internal audit size and reporting quality of quoted banks in Nigeria
2. There is no significant relationship between experience and certification of internal audit staff and reporting quality of quoted banks in Nigeria
3. Independence and objectivity of internal auditors do not affect reporting quality of quoted banks in Nigeria

1.6         Significance of the Study

Internal auditors bring enormous value to organizations and the stakeholders they serve; therefore this study is expected to benefit the following:

1. Internal Auditors: This work would be beneficial to internal auditors by highlighting the role they need to play to ensure quality financial reporting with the organization. As one of the cornerstones of corporate governance, internal auditors are expected to work with audit committees, boards and senior management to help set the right “tone at the top” and to help ensure that ethical behaviour flows down through the ranks to lower level employees (IIA, 2003; Brown, Mendenhall, & Kramer, 2003; Bailey, Gramling, & Ramamoorti, 2003). An interview conducted by Coetzee and Fourie (2009) on the role of the internal audit function in respect of risk in South Africa found that though the internal audit function’s role is perceived as positive, the views of senior management and those of the chairpersons of the audit committees show an expectancy of increase in internal auditing’s involvement in risk-related issues.
2. Corporate board: The board of organisations relies on internal auditing for objective assurance and insight on the effectiveness and efficiency of governance, risk management, and internal control processes (Institute of Internal Auditors, 2010). This study will highlight the contribution of internal audit in financial reporting quality in organisation, thereby enabling the management understand how the internal audit function could affect reliability of financial reports of the organization.
3. Scholars/Researchers: This study will contribute to the academic and business literature on the subject of internal audit. The findings will serve as pedestal for further studies on the subject.

1.7         Scope of the Study

The geographical scope of the study is Awka, the capital of Anambra State. Private organisations in Awka, were selected for the study, while participants for the study were drawn from their accounting and audit departments.

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