Internal Audit Quality and Financial Reporting, 39 Page

Internal Audit Quality and Financial Reporting Quality: The Joint Importance of
Independence and Competence

Author(s): LAWRENCE J. ABBOTT, BRIAN DAUGHERTY, SUSAN PARKER and GARY F.
PETERS
Source: Journal of Accounting Research, Vol. 54, No. 1 (MARCH 2016), pp. 3-40
Published by: Wiley on behalf of Accounting Research Center, Booth School of Business,
University of Chicago
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DOI: 10.1111/1475-679X. 12099 W0B80TH3
Journal of Accounting Research
Vol. 54 No. 1 March 2016
Printed in U.S.A.
Internal Audit Quality and Financial

Reporting Quality: The Joint
Importance of Independence
and Competence
LAWRENCE J. ABBOTT,* BRIAN DAUGHERTY,*
SUSAN PARKER,t AND GARY F. PETERS'
Received 5 November 2013; accepted 24 September 2015
ABSTRACT
Iii light of the growing importance of internal audit functions (IAF)

limited archival evidence on internal audit quality, we examine an int
model of IAF quality (comprised of competence and independence
ter understand the determinants of IAF effectiveness as a financial r
monitor. Our tests support the hypothesis that the joint presence of
tence and independence is a necessary antecedent to effective IAF
reporting monitoring. In sum, our results show that, the answer to "wh
effect of internal audit competence (independence) on financial r
quality?" is "it depends on the independence (competence) of the
auditor." Our study extends the understanding of IAF quality determ
in the realm of financial reporting as it relates to ongoing discussion
searchers, standard setters, regulators, and practitioners.
* University of Wisconsin-Milwaukee; t Santa Clara University; 'University of A

Accepted by Philip Berger. We are grateful for assistance from Tim Seidel
comments from Cory Cassell, Dana Hermanson, Chris Hines, Adi Masli, Bill M
Shepardson, David Wood, and workshop participants at Santa Clara University,
Arkansas, Texas Tech University, the 2013 AAA Annual Meeting, and the 2012
tion Midyear Conference.
3
Copyright ©, University of Chicago on behalf of the Accounting Research Center, 2015
4 L. J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
JEL codes: D83; G39; M12; M41; M42

Keywords: internal audit; financial reporting quality; auditor indepen
dence; auditor competence
1. Introduction
In 2013, the NASDAQ Stock Market LLC (NASDAQ) proposed a rule

change that would require all NASDAQ registrants to maintain an internal
audit function (IAF) (NASDAQ [2013]).! The New York Stock Exchange
(NYSE) has required registrants to maintain an IAF since 2006. The ra
tionale for these requirements is that an effective IAF provides the au
dit committee and other financial reporting stakeholders with critical in
formation pertaining to a company's risks (including financial reporting
risks) and internal controls (i.e., Harrington [2004], NASDAQ [2013]).
Similarly, corporate governance proponents consistently emphasize the
IAF's role in enhancing financial reporting quality (Coram, Ferguson, and
Moroney [2008], Prawitt, Smith, and Wood [2009], Cohen, Krishnamoor
thy, and Wright [2010]). Nonetheless, the IAF's role in the financial report
ing process is not yet fully understood and empirical evidence concerning
the impact of IAF quality is minimal.
We investigate the potential impact of IAF quality as a joint function
of the IAF's competence and independence. We base this view upon the
theoretical work of DeAngelo [1981], who notes that external audit quality
is a function of the external auditor's ability (i.e., competence) to detect
accounting misstatements and willingness (i.e., independence) to oblige
proper accounting treatments. Similar to DeAngelo [1981], we assume
that, within the internal audit function, competence and independence
are important and distinct constructs that must interact to result in quality
outcomes.
Despite the intuitive appeal of IAF quality positively imp

reporting quality, prior empirical evidence is not as strong
would suggest. For example, Prawitt, Smith, and Wood [2
from 2000 to 2005, document mixed evidence between an overall com
posite measure of IAF quality and financial reporting quality. Their single
composite IAF quality measure adds several, equally weighted individual
IAF characteristics of competence and independence. One potential ex
planation for prior mixed results revolves around how these IAF character
istics interact with each other in creating IAF quality. Rather than an addi
tive relation between competence and independence whereby an increase
in competence can compensate for decreased independence, IAF quality
1 The NASDAQ subsequently tabled the proposal as registrants expressed concerns over
the costs and benefits of the proposal. An objective of the current study is to provide evidence
concerning one aspect of the benefits.
INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY 5
may be more appropriately described as an interactive, two-factor function

of both competence and independence. Thus, IAF competence (indepen
dence) may be unlikely to impact financial reporting quality unless it is in
the presence of IAF independence (competence).
In this paper, we develop and test a two-factor model of IAF quality as
a function of the IAF's ability to prevent/detect financial misstatements
(i.e., competence) and its inclination to report the misstatements to the
audit committee and/or external auditor (i.e., independence). Our study
uses survey evidence from 189 Chief Internal Auditors (CIAs) from For
tune 1000 companies during fiscal 2009.2 From this uniquely detailed and
rich set of IAF data, we are able to create separate measures of IAF com
petence and independence. Our measure of IAF competence is based on
the average hourly rate of budgeted IAF resources (Abbott, Parker, and
Peters [2012]). We also identify three potential factors related to IAF inde
pendence. First, consistent with Abbott, Parker, and Peters [2010, 2012],
we measure the audit committee's IAF influence vis-a-vis management's
IAF influence across multiple oversight dimensions.3 If upper management
(rather than the audit committee) wields greater IAF influence, this may
cause the IAF to fear reprisal should the IAF question management's finan
cial reporting decisions, and thus diminish the IAF's objectivity or indepen
dence (e.g., Cohen, Krishnamoorthy, and Wright [2010], Norman, Rose,
and Rose [2010]).
In addition to audit committee IAF influence, a review of the IAF litera
ture reveals two other potential threats to IAF independence: whether the
IAF serves as a management training ground (MTG) and the sizeable pres
ence of an IAF outside service provider (OSP). In particular, when the IAF
is used as an MTG, internal auditors may be more reluctant to report finan
cial reporting issues in an effort to ingratiate themselves to upper manage
ment (Messier et al. [2011], Christ et al. [2015]). The presence of an OSP
may create job security concerns for the in-house IAF, as registrants may
find the variable cost nature of OSPs attractive as a means of achieving cost
savings and/or financial reporting flexibility (Abbott et al. [2007]).
We regress our IAF-related variables and a set of control variables
against common measures of financial reporting quality, abnormal accruals
2 As compared to other extant IAF research, our sample follows the implementation of the
Public Company Accounting Oversight Board's (PCAOB) Auditing Standard No. 5 on the
effectiveness of internal control over financial reporting (ICFR), a period when substantial
IAF resources were diverted to ICFR testing.
3 In contrast, prior research commonly utilizes a dichotomous influence variable based
upon whether the LAF's formal reporting line is to the audit committee (e.g., Prawitt, Smith,
and Wood [2009]). However, Abbott, Parker, and Peters [2010] note that 96% of Chief Inter
nal Auditors agreed with the statement "the Internal Auditor reports to the audit committee."
As such, the utilization of the formal reporting arrangement as the sole IAF independence
characteristic leads to the possibility that the dichotomous identification of the reporting line
could simply capture a ceremonial structure and may not be indicative of a significant degree
of IAF independence.
(Kothari, Leone, and Wasley [2005], Prawitt, Smith, and Wood [2009]),
and whether the firm just meets or beats analyst forecasts (Koh, Mat
sumoto, and Rajgopal [2008], Prawitt, Smith, and Wood [2009], Mande
and Son [2012]). Our abnormal accruals are further segregated into
income-increasing and income-decreasing abnormal accruals. Consistent
with IAF quality being a two-factor, interactive function of independence
and competence, we document several statistically significant relations be
tween financial reporting quality and our interacted competence and in
dependence variables. We find that interactions between the IAF compe
tence and (1) the relative degree of audit committee IAF oversight and (2)
the lack of a substantial OSP presence curtail both income-increasing and
income-decreasing abnormal accruals. We obtain similar results when we
examine the firm's proclivity to just meet/beat analysts' forecasts.
In contrast, when independence is proxied by whether the IAF is not
used as an MTG, the interaction between the IAF independence factor and
competence exhibits a statistically significant, mitigating impact on income
decreasing abnormal accruals. This finding is consistent with lower likeli
hoods of IAF reporting of inappropriate income-decreasing opportunistic
reserve behaviors when the IAF is used as an MTG. In this manner, internal
auditors hoping to move into a non-IAF position may endeavor to ingrati
ate themselves to management, or demonstrate their ability to be a team
player when they perceive a lower downside of doing so.4
Our paper contributes to the IAF literature in several ways. Our study is
the first to establish IAF characteristics as separate, distinct constructs that
act jointly in creating IAF quality. In doing so, this study contributes to our
understanding of IAF quality and the determinants of the IAF as an effec
tive internally based financial reporting monitor. Second, our results sug
gest that there are at least three factors that can impact IAF independence
and that these factors have differential interactive effects with IAF compe
tence in influencing financial reporting quality. In contrast, prior IAF liter
ature generally uses a dichotomous, single-variable independence measure
and implicitly ignores other potential independence determinants (e.g.,
Ahlawat and Lowe [2004]). Moreover, we find that our IAF independence
characteristics are either not correlated or only weakly related to each other
or to our IAF competence measure. This is consistent with (1) IAF indepen
dence being characterized as a multifaceted attribute with at least three de
terminants and (2) IAF independence and competence being separate and
distinct constructs. While there is a very rich literature on threats to external
auditor independence, there is a paucity of archival evidence on the poten
tial determinants of internal auditor independence. With respect to internal
4 In terms of income-increasing abnormal accruals, internal auditors whose IAF serves as

a management training ground may simply defer auditing more contentious, higher profile
income-increasing abnormal accruals to the external auditor. Internal auditors may do so with
the knowledge that external auditors are likely to expend greater audit effort on income
increasing accruals (Abbott, Parker, and Peters [2006]).
auditor competence, we also provide descriptive evidence of the qualifica

tions of the IAF staff and Chief Audit Executives (CAEs) in large firms, and
the types of functions those staff carry out. A more detailed understanding
of the factors that influence IAF independence and competence should be
of interest to researchers, standard setters, regulators, and practitioners in
their efforts to hone the IAF's role as a financial reporting monitor.
Our study also provides archival evidence on the impact of third-party
IAF outsourcing on in-house IAF independence. Prior research has treated
outsourcing as a threat to in-house IAF independence when the provider
of such services was the external auditor (prior to the Sarbanes-Oxley Act
of 2002 (SOX) when such service were allowed) (e.g., Ahlawat and Lowe
[2004], Abbott et al. [2007], Prawitt, Sharp, and Wood [2012]). The evi
dence provided herein indicates that job security concerns can also be cre
ated by a large outsourcing presence unrelated to the external auditor. Fur
thermore, we find that over 65% of our sample IAFs have an outsourcing
agreement in place and that close to 33% of our sample IAFs have a sizeable
portion (i.e., in excess of 20%) of their budget allocated to OSPs. Given
the pervasiveness of OSP-provided IAF services, we believe that future re
searchers should consider the nature and magnitude of OSPs in analyzing
IAF independence.
Finally, we provide evidence that our IAF competence proxy, the hourly
in-house IAF rate, effectively summarizes several key IAF traits used in prior
literature that individually or collectively represent IAF quality, such as
tenure and certification (e.g., Prawitt, Smith, and Wood [2009], Lin et al.
[2011]). Our competence variable has several attractive features for use in
future research as it (1) is continuous, (2) allows for comparison between
IAFs of varying size, (3) does not require researcher judgment regarding
the weighting of IAF traits, and (4) does not require subjective judgment
by IAF respondents when collected via survey instrument.
Our study has several potential limitations. We draw survey data from a
single year, and 2009 was a year of significant economic events that may
have affected the generalizability of our study in unknown ways.5 In addi
tion, discretionary accruals as a measure of management financial report
ing discretion, though widely used, are likely to measure the underlying
construct with error. Our test variables, similarly, are likely to contain mea
surement error. We have conducted a number of validity tests that are de
tailed in the sensitivity discussion, and support our IAF variables and results.
Last, common to examinations involving internal attributes of an organiza
tion's financial reporting environments, it is often difficult to disentangle
the potential endogeneity of the roles that reside within an organization
(such as the IAF, Audit Committee, and Executive Suite). Nonetheless, we
believe our study offers insights into the operations of an increasingly im
portant component of the internal control systems of large companies.
5 We address this issue by conducting our analysis over the years 2010-2011, assuming that
our test variables would remain consistent over a short horizon. We find that our results con
tinue to be significant over that time frame.
2. Background, and Prior Literature
Prior IAF research investigating audit outcomes generally focuses on the

external auditor's reliance on the IAF for financial statement audit assis
tance (e.g., Messier etal. [2011], Prawitt, Sharp, and Wood [2011], Abbott,
Parker, and Peters [2012], Bame-Aldred et al. [2012]). This stream of re
search focuses on the two most prevalent IAF characteristics that extant
audit standards guide external auditors to consider: competence and inde
pendence.6 Competence generally refers to the auditor's ability to perform
tasks diligently and in accordance with professional standards (e.g., IAASB
[2013]). The Institute of Internal Auditors (IIA) defines competence as
"the ability of an individual to perform a job or task properly, being a set
of defined knowledge, skills and behavior" (IIA [2013, p. 2]). Within an
IAF setting, independence is defined as "the freedom from conditions that
threaten the ability of the internal audit activity to carry out internal audit
responsibilities in an unbiased manner" (IAASB [2013]). In other words,
independence is often framed as objectivity or as the means to protect
against bias, conflict of interest, or undue influence of others that would
override professional judgments.
Prawitt, Smith, and Wood [2009] is the first archival study to link IAF
quality to financial reporting quality. The IAF quality measure used in
Prawitt, Smith, and Wood [2009] is a single, additive composite, comprised
of equally weighted metrics representing experience, certification, train
ing, IAF reporting structure, time spent on financial activities, and rela
tive IAF size. Using data from 2000 to 2005, the authors find that their
composite measure of IAF quality is associated with mitigation of income
decreasing accruals, but not income-increasing accruals. When they disag
gregate their IAF characteristics, they find positive relationships between
financial reporting quality and the IAF's professional certifications
(income-decreasing accruals) and IAF size relative to industry (income
increasing accruals).7 Prawitt, Smith, and Wood [2009] do not find signif
icant associations between the IAF independence characteristic (whether
the IAF reports to the audit committee) and financial reporting quality.8
While their composite measure of IAF quality includes facets of compe
tence and independence, it is unclear when both of these characteristics
are present for a given firm and whether their relationship is interactive or
additive.
6The AICPA's Statement of Auditing Standards 65 (SAS 65) discusses indicators of IAF
competence and independence; however, very little overlap exists among the factors that SAS
65 describes as competence-related versus independence-related (AICPA [1991]).
7 They explain the unexpected result on IAF size as the possibility that IAF size proxies for
the difficulty of monitoring the firm, and, when monitoring is more difficult, managers may
be able to find avenues to exercise more discretion to increase income.
8 During the sample period involved (2000-2005), Prawitt, Smith, and Wood [2009] find
significant variation in this measure: 69% of sample lAFs reported to the audit committee and,
as such, this was likely to be an appropriate and parsimonious proxy for IAF independence.
Recent research points to other potential determinants of IAF indepen

dence and measures of how audit committees influence IAF independence,
such as outsourcing presence, MTG usage, and perceived audit committee
influence. (Quarles [1994], Abbott et al. [2007], Messier et al. [2011], Ab
bott, Parker, and Peters [2012]). In sum, prior research has provided only
limited evidence on the impact of IAF quality. Furthermore, a number of
IAF competence and independence measures have yet to be linked on a
stand-alone (or interactive) basis to financial reporting quality. Finally, the
IAF profession has also identified other mechanisms that can influence IAF
independence that have yet to be investigated.
3. Hypothesis Development
3.1 IAF MECHANISMS FOR IMPACTING FINANCIAL REPORTING QUALITY
The focus of this paper is on the association between IAF quality and
financial reporting quality. Therefore, an important antecedent to our re
search question is a description of the specific mechanisms by which an
IAF can influence financial reporting quality. We posit that these opportu
nities arise within at least four activities: assisting with the financial state
ment audit, financial statement audit of subsidiaries, compliance auditing,
and special consulting projects.9 Within the areas of financial statement
audit assistance and audits of subsidiaries, the IAF performs specific audit
procedures that allow it to potentially influence accrual decisions. These in
clude review of the financial closing process, reviewing procedures for non
standard journal entries and postclosing adjustments, and specific reviews
of critical accruals such as accounts receivable valuation and inventory re
serves (IIA [2005]). Compliance auditing can involve testing transactions
or journal entries for compliance with the company's financial reporting
policy. Special consulting projects may also involve the IAF delving into ac
counting matters that require greater judgment on the part of the preparer,
such as asset impairments, warranty reserves, collectability reserves, and/or
inventory write-downs (PwC [2009]).
It should be noted that, in any of the prior tasks, the IAF may encounter
high-level accruals choices. More specifically, the IIA advises that, as a part
of the quarterly financial reporting process, the IAF should engage the IAF
should review the policies, procedures, and process for reporting and re
lated disclosures. In particular, the IIA advises that, as a part of the quarterly
financial reporting process, the IAF should engage "special or specifically
targeted reviews of high-risk, complex, and problem areas; including ma
terial accounting estimates, reserve valuations, off-balance sheet activities,
major subsidiaries, joint ventures, and special purpose entities" (IIA [2005,
p. 236]).
9 We developed this list from a review of the prior literature, examination of IAF profes
sional guidance, and discussion with CIAs. As discussed in our results section, respondents
indicate a nontrivial budget allocation to these four activities.
10 L.J. ABBOTT, B. DAUGHERTY, S. PARKER, AND G. F. PETERS
3.2 AUDIT COMMITTEE IAF OVERSIGHT IN THE INTERACTIVE IAF QUALITY

MODEL
This study's examination of IAF quality—and its potential imp

nancial reporting quality—asserts that competence and indepen
necessary, but not individually sufficient determinants of IAF qu
investigate the potential impact of IAF quality as a joint funct
IAF's competence and independence. While it is expected tha
tent auditor is more likely to discover a financial reporting miss
the reporting of the discovered misstatement is contingent upo
tor's independence or objectivity. Similar to DeAngelo [1981], w
that competence and independence are distinct constructs that m
act to ultimately impact financial reporting quality.
Our first hypothesis pertains to the interaction of IAF compet
IAF independence, measured by audit committee or C-Suite
Both external and internal auditing standards assert that intern
independence is a direct function of the reporting relationship be
audit committee and the IAF (IIA [2002], AICPA [2013]). However, even
though official reporting by the IAF to the audit committee is common,
the extent and effects of active oversight by the audit committee and unof
ficial oversight by management varies greatly (e.g., Ernst & Young [2008],
Mabry and Schwartz [2008], Hoffelder [2012]). Moreover, prior academi
cians highlight the inherent conflicts of IAFs serving both management
and the audit committee (Hermanson [2002], Anderson [2003], Herman
son and Rittenberg [2003]).
Prior research supports an association between greater audit committee
oversight and greater independence for the IAF. For example, greater audit
committee oversight of the IAF is associated with the greater shielding from
possible management pressure (Quarles [1994], Carcello, Hermanson, and
Raghunandan [2005]) .10 If the IAF is not sufficiently shielded from possible
management pressure, the CEO or CFO can reduce the likelihood that the
issue will be reported to the proper channel. When the departure from
reporting policy originates at the C-Suite level, the IAF's independence is
particularly important. A lack of independence of the IAF from the C-Suite
may preclude the IAF from initiating a review of financial reporting choices
made at the CFO/CEO level. This may prevent the discovery and reporting
of financial reporting policy departures.11
10 For example, the internal auditors may be charged with reviewing the proper application
of the firm's policy for recording an inventory reserve. Divisions within the firm with sepa
rate profit targets may have incentives to either under- or overstate the reserve in order to
maximize internal rewards.
11 This mechanism may operate in two ways. First, the CEO/CFO may effectively pressure
the IAF to "filter" any IAF-generated reports that are forwarded to either the audit committee
or external auditor. Second, to the extent that the CEO/CFO can influence IAF budgets or
activities, the CEO/CFO may direct the IAF toward other activities that have an immediate,
beneficial impact on current earnings such as the examination of vendor rebates or other
Following our expectations, we posit that, as audit committee IAF influ

ence (IAF independence) increases, the likelihood that a misstatement discov
ered by a competent IAF is either (1) properly reported to the audit commit
tee and external auditor or (2) corrected by the party responsible for the
original misstatement also increases. Both scenarios lead to greater finan
cial reporting quality. This leads to our first hypothesis (stated in alternative
form):
HI: The interaction between IAF competence and audit commit

tee IAF influence is positively associated with financial reporting
quality.
3.3 THE IAF AS AN MTG IN THE INTERACTIVE IAF QUALITY MODEL
The second IAF independence determinant interacted with IAF compe

tence is the organization's use of the IAF as an MTG. Prior research suggests
that the use of IAF as an MTG is prevalent among corporate entities (Stew
art and Subramaniam [2010], Messier et al. [2011], Christ et al. [2015]).
Many organizations see this as a means to attract and develop corporate tal
ent by instituting both formal and informal rotations within the IAF (Ernst
& Young [2008]). Despite these intended benefits, other IAF constituents
see this as a potential threat to the independence of the IAF (Good
win and Yeo [2001], Ahlawat and Lowe [2004], Christopher, Sarens, and
Leung [2009]). Although concerns about both the costs and benefits of
this practice remain, the use of the IAF as an MTG is common (Prawitt,
Smith, and Wood [2009]).
To date, few studies directly investigate the impact of MTGs on IAF inde
pendence (Stewart and Subramaniam [2010]). Messier et al. [2011] docu
ment a negative association between the use of the IAF as an MTG and the
external auditor's assessment of IAF independence. Despite the negative ef
fect on perceived independence, MTGs were not associated with perceived
differences in internal audit competence. This provides further evidence
suggesting that independence and competence are separate and distinct
constructs.
When the IAF is an MTG, the IAF may be less likely to report
cial misstatement to the appropriate channel. If the misstateme
negatively on the division's management, those managers may b
to offer that particular internal auditor a position within that d
itive internal references may be less likely for an internal audi
a position at a different division within the same company. In o
misstatement to be corrected prior to the consolidation of resu
parent level, both IAF competence and independence must
As with our prior hypothesis, we consider the financial report
operational concerns, etc. (Abbott, Parker, and Peters [2010]). In doing so,
fectively precluded from collecting evidence that might serve to repudiate oth
deviations involving financial reporting decisions.
consequences of the joint importance of IAF independence and compe

tency when independence is potentially conditioned by the explicit use of
IAF as an MTG. This leads to our second hypothesis (stated in alternative
form):
H2: The interaction between IAF competence and an IAF that is not
used as an MTG is positively associated with financial reporting
quality.
3.4 OUTSOURCED INTERNAL AUDIT ACTIVITIES IN THE INTERACTIVE IAF
QUALITY MODEL
The final IAF independence factor interacted with IAF competence is

the presence of a substantial OSP. Outsourced IAF activities represent on
going sourcing strategies for many internal audit departments (Stewart and
Subramaniam [2010]). Outsourcing all or a portion of the IAF provides
management with the flexibility of adjusting IAF costs during the course
of the year because outsourced IAF hours are essentially variable in na
ture. In contrast, in-house IAF hours are fixed in nature due to salary struc
tures. Moreover, outsourced IAF activities can allow management to defer
expense recognition into subsequent accounting periods by simply schedul
ing outsourced IAF activities into following years. This contracting flexibil
ity may be especially attractive to management when the firm is faced with
revenue shortfalls.
Despite potential benefits of IAF outsourcing, there may be a cost in the

form of decreased, in-house IAF independence. In particular, Abbott et al.
[2007] and Quarles [1994] note that a substantial IAF outsourcing pres
ence may undercut the in-house IAF's willingness to confront management
on issues due to concerns over job status. If an internal auditor feels "re
placeable" as a consequence of outsourcing, he may be less willing to report
a misstatement to the appropriate outlet for fear of losing his job within
the firm (Quarles [1994], Abbott et al. [2007]). As before, increased inde
pendence, in this case the lack of a substantial IAF outsourcing presence,
increases the likelihood that a misstatement discovered by a competent IAF
is properly reported or corrected by the party responsible for the misstate
ment.12 As already stated, we consider the financial reporting quality con
sequences of the joint importance of independence and competency when
in-house IAF independence is potentially influenced by the presence of
outsourced IAF services. This leads to our third hypothesis (stated in the
alternative):
H3: The interaction between IAF competence and the lack of a

substantial IAF outsourcing presence (increased IAF indepen
dence) is positively associated with financial reporting quality.
12 Though we feel the preponderance of evidence points to a positive association between

reporting quality and the lack of an OSP, we acknowledge that it is possible that the use of an
OSP might instead serve to spur the IIA to greater effort and independence in order to prove
their worth to the organization.
4. Research Design
4.1 SAMPLE SELECTION
Our study utilizes a survey questionnaire (see appendix) sent to 909 non
bank members of the FORTUNE 1000 (in terms of total sales) ,13 Consistent
with most prior internal audit research (e.g., Pelfrey and Peacock [1995],
Scarbrough, Rama, and Raghunandan [1998], Raghunandan, Read, and
Rama [2001], Carcello, Hermanson, and Raghunandan [2005], Abbott,
Parker, and Peters [2010, 2012]), the survey targets Chief Internal Audi
tors (CIAs) or Chief Audit Executives (CAEs). The survey includes ques
tions about the types of IAF services provided (whether in-house or out
sourced) , assistance to the external auditors, presence and activities of any
OSPs, the reporting relationship between the IAF and the audit commit
tee, and whether the IAF serves as an MTG. We asked recipients to provide
responses based upon fiscal year 2009.
The first survey mailing (sent October 2009) resulted in a total of 118
usable responses. A follow-up mailing (December 2009) produced an ad
ditional 99 usable responses, for a total of 227.14 However, we were unable
to obtain complete Compustat data for 38 of these firms, bringing our to
tal sample to 189. Table 1 provides a distribution of observations by two
digit focus industry membership (Hogan and Jeter [1999]). To test for po
tential nonresponse bias, we compare the characteristics of the early and
late responders with each other and test for significant differences in size,
leverage, return on assets, presence of a loss, and cash flow from opera
tions. None of the differences are significant.15 We also compare our re
spondents to the industry makeup of the original population of nonbank
Fortune 1000 firms. We conduct a test of differences of proportions com
paring the industry sample representation to the population and find only
the underrepresentation of the energy and manufacturing sectors to be
significant.
4.2 CHARACTERISTICS OF THE IAF
Our survey responses provide information about the current nature of

the IAF function in terms of qualification and activities. We document that
the overwhelming majority (over 80%) of CAEs have a CPA certification
13 Banks are excluded since they do not possess inventory and have unique regulatory envi
ronments. We identified 909 nonbank firms within the Fortune 1000.
14 Our effective response rate of 20.7% (or 189 responses/909 total companies) compares
favorably with the 12.7% rate obtained by Felix, Gramling, and Maletta [2001] in their internal
audit study. However, the Felix et al. rate may have been depressed by the need for survey
responses from both the internal and external auditors to constitute a complete sample pair.
Our response rate is higher than that reported in previous studies of senior managers. For
example, Graham and Harvey [2001] report a 9% response rate.
15 As with all surveys, there is a possibility of unknown response bias and of incorrect re
sponses. While we tested our early and late respondents for differences on a number of di
mensions, as previously discussed, it is possible that undetected bias is present.
TABLE 1
Sample Selection Results
Related Two No, of %of No. of Fortune % of Fortune

Focus Industry Digit SIC CodesFirms Sample 1000 Firms* 1000 Firms*
Construction 15-17 9 4.8 17 1.9
Consumer product & 20-33 43 22.8 180 19.8

food
Energy 10-14, 46, 49 32 16.9 172 18.9

Financial services 60-64, 67 11 5.8 62 6.8
Information Be 48, 73, 78, 79, 84 20 10.6 126 13.9
Communication
Manufacturing 34-39 31 16.4 140 15.4

Personal services & 72, 80, 83 2 1.1 28 3.1
health care
Professional, 75, 76, 82, 87, 89 1 0.5 11 1.2
commercial services,
education
Real estate 65, 70 1 0.5 6 0.7
Retail & wholesale 50-59 35 18.5 149 16.4
Transportation 40-42, 44, 45, 47 3 1.6 11 1.2

All other 1,2,7, 8,99 1 0.5 6 0.7
Totals 189 100 908 100
* Banks are excluded from both the population and the sample as these firms face additional regula
tion unique to their industry and do not have significant inventory accounts (making the model unfit for
regression purposes). The remaining Fortune 1000 firms (in terms of total assets) serve as our sampling
population.
while, perhaps surprisingly, only 39% have a Certified Internal Auditor

(CIA) certification. Responses also indicate that the CISA certification is
relatively rare among CAEs (at approximately 10%). As a reflection of the
changing and increasing importance of systems-based auditing, we find that
the CISA certification is much more prevalent (16%) among staff. At the
staff level, the CPA certification dominates, though less than half of staff
(40%) have a CPA certification, while over a quarter of staff have a CIA
certification (28%). The CPA-CIA certification "gap" is lower for staff (40%
vs. 28%) than it is for CAEs (82% vs. 39%). The CPA-CIA certification gap
indicates that the current generation of CAEs was most likely hired from
external audit firms. Experience in financial statement auditing is strongly
correlated (0.88) with the possession of a CPA. We believe this provides in
formation about the composition of the IAF at both the staff and executive
level.
We also provide descriptive statistics about what activities IAFs are per
forming. We note that 100% of survey respondents allocated a portion of
their annual IAF budget to Section 404-related work. Second, the mean
percentage of in-house IAF budgets allocated to Section 404 assistance
was 27.5%—the highest budget allocation percentage among IAF activities.
Sample results indicate that over 65% of our sample IAFs have an outsourc
ing agreement in place and that, on average, close to 31.8% of outsourced
IAF budgets are dedicated to Section 404 assistance. Thus, if an outsourced
IAF is utilized, it is utilized heavily to provide Section 404 assistance. This re

sult is consistent with our contention that a significant OSP presence could
represent a threat to internal IAF independence since there is a large over
lap in the services that are provided by in-house IAFs vis-a-vis OSPs.
4.3 REGRESSION MODEL
To test the relationship between financial reporting quality and the inter
active nature of IAF competence and independence, we adapt the following
regression model from prior research:
ABNACC = b0 + bjtACOMP + b2ACIAFINF + b3NONMTG
+ b4NONOSP2() + b;IACOMP * ACIAFINF
+ IhJACOMP * NONMTG + b7IACOMP * NONOSP2O
+ bsASSETS + b9AGE + bI0LEVERAGE + bnSEGNUM
+ b u CEO + b! 3 SALESGROW + bI4MTB + b15 CFOVOL
+ bl6ROA + b, 7 LOSS + bi8MATWEAK
big~2&INDUSTR.Y + £. (1)
The variables used in the empirical models

discussed below.
4.4 DEPENDENT VARIABLE
Following prior audit literature, we utilize abnormal accruals (ABNACC)

as a proxy for financial reporting quality (Francis [2011]). To measure ab
normal accruals, we use the performance-adjusted cross-sectional variation
of the modified Jones model (Dechow, Sloan, and Sweeney [1996]) as re
ported by Kothari, Leone, and Wasley [2005].16 The Kothari et al. model
includes both an intercept term and a measure of performance. Consistent
with prior research, we first estimate the model for firms with information
available on Compustat for 2009 (excluding financial institutions), and ap
ply the results by two-digit SIC code to the calculation of abnormal accruals
for the firms in our sample.1' Our estimate of abnormal accruals is the
residual from the following regression:
[TAu! Au-.il = A) + ft [l/Aa-x] + ft [(A REVit - DAR,t)/Alt-1]
+fi$\PPEit/Au-i] + PilNIit/Ai,-1] + Sit.
16 Our sample size, though small compared to many discretionary accruals studies, is similar
to other survey-based work in the area (Prawitt, Smith, and Wood [2009], Prawitt, Sharp, and
Wood [2012]).
17 In separate untabulated tests, we also limited data for the estimation model to only For
tune 1000 firms. However, there were a total of 47 firms (almost a quarter of our sample)
for which we could not estimate a reliable accrual estimation model. Thus, our tabulated AB
NACC variable based upon the Compustat population represents a tradeoff between capturing
additional business norms that drive transactional accruals within a given industry (popula
tion based) versus transaction accruals that might be limited to only a large-firm environment
(large-firm subsample).
TABLE 2
Variable Definitions
Description
The Kothari, Leone, and Wasley (2005) version of the modified Jones
model measure of abnormal accruals. Abnormal accruals is the error
term of the equation below:

[7A„/A„_,] = p„ + p, [1/A„_,] + PA(DREV„ - DARiMA,-,] +
PAPPE,,/a,-,] + PANIJA^] + e„,
where total accruals for estimation portfolio firm i for year t. TA, or total
accruals, are defined as income before extraordinary items (Compustat
Data Item #18) minus operating cash flows (Data Item #308). A,,_i is
total assets (Data Item #6) at (—1 for firm i. A REV,, is the change in net
revenues (Data Item #12) for estimation portfolio firm i for year t. AAR,,
is the change in accounts receivable (Data Item #2) for estimation
portfolio firm i for year t. PPEjt is gross property, plant, and equipment
(Data Item #7) for estimation portfolio firm i for year t. NI;, is net
income (Data Item #172) for estimation portfolio firm / for year t.
Dichotomous dependent variable coded "1" in instances where firm met
the forecast or exceeded it by the consensus, annual EPS forecast scaled
by price at the beginning of the year by more than 0.0005; "0" else.
Dichotomous variable calculated using a two-step process. First, we
calculate unmanaged earnings by backing out discretionary abnormal
accruals from reported earnings. We then identify firms that would have
missed analysts' forecasts, without management's exercise of the
accounting discretion. For these firms,JM/BEAT„„ equals "1" and for all
other firms JM/BEAT„„ equals "0."
Average IAF resource expenditure per hour. Calculated by dividing total
in-house IAF budget per survey question #4 by total in-house IA hours
per question #1.
Relative audit committee IAF influence vis-a-vis management (CEO and
CFO). Measured as the ratio of the total agreement points for the audit
committee in the numerator divided by the total agreement points for
the CFO and CEO in the denominator. The numerator is the sum of
agreement points (per the 1-5 Likert-scale responses) on survey
questions #12a, 12d, and 12g. The denominator is the sum of agreement
points (per the 1-5 Likert-scale responses) on survey questions #
12a—12i. The 1-5 Likert-scale response values are recalibrated to 0—4 for
purposes of computing this variable.
Indicator variable coded "1" when the IAF does not serve as a
management training ground per survey question #13 and "0"

otherwise.
Coded "1" ("0") when the following ratio constructed from survey
question #4 is less than (greater than) 0.20: (Budgeted OSP$)/(Budgeted
OSP$ + Budgeted in-house IAF%).
Total assets in millions (Compustat Data Item #6).
Number of years the firm was listed on Compustat, truncated at 25 years
The sum of long-term debt (Compustat Data Item #9) and current
liabilities (Data Item #5) of a company divided by total assets (Data Item
#6).
Number of disclosed segments in which the company operates.
Cash flows from operations (Compustat Data Item #308).
TABLE 2—Continued
Variable Description
SALESGROW One year sales growth (Compustat Data Item #12fy2o<» - Item #12 mim/
Item #12 fhoos)
MTB A company's market-to-book ratio (Compustat Data Item #24 * Item #25
/Item #216).
CFOVOL Standard deviation of operating cash flows for 2005-2009.
ROA Return on assets (Compustat Data Item #172 / Data Item # 6).
LOSS Coded "1" if the firm experienced a loss in fiscal year 2008, "0" else.
MATWEAK Indicator variable coded "1" for client firm disclosing a material
weakness in internal controls over financial reporting during the prior
two years and "0" otherwise.
INDUSTRY Coded "1" if firm's two-digit SIC code is included in specific focus
industry per table 1, "0" otherwise. Focus industry groupings per Hogan
and Jeter (1999).
*Variable used only in additional analysis section.
We then segregate our abnormal accruals as positive (income-increas

and negative (income-decreasing) abnormal accruals. Our predicted r
tions are symmetrical for negative and positive accruals. We argue tha
the information used for internal decision-making is incorrectly biase
either direction, there may be career penalties for the internal auditor
4.5 TEST VARIABLES
Our test variables are IACOMP, ACIAFINF, NONMTG, and NONOSP2O,

and their respective interaction terms. Consistent with Abbott, Parker, and
Peters [2012], IACOMP'is a proxy for IAF's competence. IACOMP is defined
as the average in-house IAF resource expenditure per budget hour. We di
vided total in-house IAF budget per survey question #4 by total in-house
IA hours per question #1. On average, the resource commitment per hour
of budgeted audit staff should capture and summarize several disparate di
mensions of IAF competence such as educational level, professional expe
rience, and certification of the IAF staff. When we compare IACOA1P to the
Prawitt, Smith, and Wood [2009] IAF quality measure, we find that most of
the elements of the Prawitt, Smith, and Wood [2009] measure are related
to competence (experience, certifications, training, IAF size (a measure of
unexpected spending on the IAF)). We suggest these individual IAF traits
are captured by an hourly, in-house IAF compensation rate.18
18 We believe our composite IACOMP measure offers other certain advantages, as it incor
porates many different IAF elements (i.e., experience, certification, training) into one sum
mary measure, is continuous in nature (allowing for easier comparison between different-sized
IAFs), and does not require an implicit equal weighting of inputs. Due in part to the underly
ing relationship between budgets and hours, we include additional subsequent tests to ascer
tain whether our proxy is correlated with various dimensions of competence. See additional
analysis discussions. Utilizing per hour amounts strengthens our ability to capture individual
auditor traits that might otherwise be lost when utilizing a measure of competence based upon
Following Abbott, Parker, and Peters [2012], we incorporate a separate

continuous measure of audit committee influence into our tests of IAF in
dependence. Prior internal audit research suggests that oversight roles or

influence, though potentially prescribed by a charter, do not necessaril
manifest themselves in practice as dichotomous characteristics (Kaplan an
Schultz [2006], Ernst and Young [2008], Rose and Norman [2008]).1
Therefore, ACIAFINF is defined as the relative level of influence exerted
over the IAF by the audit committee vis-a-vis management. To measure ACI
AFINF, we asked (survey question #12) CIAs to state their level of agree
ment concerning the amount of influence exhibited by the audit commit
tee versus management (CEO and CFO) on reporting lines, termination
rights, and budget determination.20 The level of agreement can range from
strongly disagree ("1") to strongly agree ("5"). We then construct a ratio
of the total agreement points for the audit committee in the numerator
(i.e., the sum of agreement points for survey questions #12a, 12d, and 12g)
divided by the total agreement points for the audit committee, CFO, and
CEO in the denominator (i.e., the sum of agreement points for survey ques
tions #12a-12i).21
To further illustrate ACIAFINF, if the CIA answers "5" (i.e., strongly
agrees) to all survey questions #12a-12i, then the audit committee is seen
as an equal IAF oversight partner with management. Our ACIAFINF vari
able would receive a value of 0.33, denoting 33% relative oversight of the
IAF, vis-a-vis management. If, however, the CIA strongly disagrees with any
CEO/CFO relationship, while strongly agreeing with all audit committee
relationships, our A CIAFINFvariable equals 1, denoting full IAF control by
the audit committee.22
IAF budgets deflated by firm size. Defining IACOMPas Budgets / Firm size yields inconclusive
results, likely due in part to its lack of correlation with individual auditor competence traits
that drive per hour costs. We thank the anonymous reviewer for bringing this to our attention.
19 Ernst and Young [2008] notes that audit committees take different approaches to the
level of active oversight of the internal audit department, in which the internal auditor may
perceive different levels of actual influence or authority exhibited by the corresponding over
seer.
20 Similar to Abbott, Parker, and Peters [2010], we do not utilize answ

#12j—121 (reviewing/approving the IAF's annual risk assessment plan
ACIAFINF variable.
21 Within upper management, the IAF can report to either or both the CEO and CFO. We
combine the CEO and CFO responses since both share common risk preferences (compared
to the Audit Committee) and are required by SOX Section 302 to certify the financial state
ments (SOX [2002]).
22 Survey responses to questions #12a-12i can range from 1 to 5, but are recalibrated
to a scale of 0-4. By doing so, our ACIAFINF variable captures the intuition behind the
relative IAF influence. For example, assume that the CIA respondent strongly agrees with
the audit committee's influence over IAF reporting, termination, and budgeting (i.e., re
sponds with a "5" for survey questions 12a, 12d, and 12g). Also assume the CIA respon
dent also strongly disagrees with the CEO and CFO's influence over IAF reporting, termi
nation, and budgeting (i.e., responds with a "1" for survey questions 12b/12c, 12e/12f, and
NONMTG represents our second facet of the IAF's independence,

namely, whether IAF is formally used as an MTG. NONMTG is coded "1"
when the IAF is not part of a management training rotation, but instead is
considered a separate career position within the company (survey question
#13). The results of viewing the IAF as a distinct career position potentially
induces greater attachment by the staff to the role of professional inter
nal auditor, and thus a greater commitment to independence. In addition,
those professionally attached to the IAF are less likely to feel pressure from
audited managers in order to protect future placement opportunities.
NONOSP20 represents the extent of the threat to the in-house IAF pre
sented by the extent of outsourcing. Limited outsourcing may be related to
the need for specialized expertise not possessed by the IAF, but larger levels
of outsourcing may indicate a willingness on the part of a company to con
sider outsourcing core IAF functions. We identify outsourcing of more than
20% of the total budget as an appropriate level to indicate a possible threat
to the IAF. The initial 20% threshold is based upon informal conversations
with internal auditors concerning the level at which outsourcing would ap
pear to threaten job security. We expect that, as the level of outsourcing
increases, the in-house IAF may view itself as vulnerable to replacement,
thus reducing the internal IAF's independence. NONOSP2O is coded "1" if
the level of outsourcing does not reach 20%, reflecting little or no threat to
IAF independence. The extent of outsourcing is constructed from survey
question #4:
(Budgeted OSP $) / (Budgeted OSP $ + Budgeted in-house IAF $).
Each of our stated hypotheses addresses the interactive nature of IAF

competence and separate measures of independence. We test HI by inter
acting IACOMP and ACIAFINF. We test H2 by the interacting IACOMP and
NONMTG. We test H3 by interacting IACOMP and NONOSP2O. In all three
interactions, we expect a negative (positive) association with abnormal ac
cruals (financial reporting quality).
4.6 CONTROL VARIABLES
We include control variables that may impact the level of abnormal ac

cruals. We expect that ASSETS (log of company size) will magnify the size
12h/12i). Without recalibration to a 0-4 scale, the ACIAFINF value would equal 0.833 (e.g.,
(5+5+5)/(5+l+l+5+l+l+5+l+l)). With recalibration, the ACIAFINF value becomes 1 or
((4+4+4)/(4+0+0+4+0+0+4+0+0)). A second example further illustrates. In this case,
assume that the CIA strongly disagrees with the audit committee's IAF reporting, termina
tion, and budgeting influence (i.e., responds with a "1" for survey questions 12a, 12d, and
12g) and also strongly agrees with the CFO's reporting, termination, and budgeting influence
(i.e., responds with a "5" for survey questions 12b. 12e, and 12h). Also assume that the CIA
strongly disagreed with the CEO's IAF reporting, termination, and budgeting influence (i.e.,
responds with a "1" for survey questions 12c, 12f, and 12i). In this case, ACIAFINF equals 0
(e.g., (0+0+0) / (0+4+0+0+4+0+0+4+0)).
of accruals (Dechow and Dichev [2002]). For this reason, we predict a pos
itive association between company size and positive accruals and a negative
association between company size and negative accruals. AGE (number of
years the company has been listed on Compustat, truncated at 25 years) is
included because firms may experience different accrual patterns as they
age (Prawitt, Smith, and Wood [2009]). We expect that LEVERAGE (to
tal debt/total assets) will be associated with more income-increasing ac
cruals to allow for nonviolation of debt covenants (Press and Weintrop
[1990]) and income-decreasing accruals (DeAngelo, DeAngelo, and Skin
ner [1994]) to reduce earnings for contractual renegotiations. We include
a variable that proxies for firm complexity using the number of operating
segments a firm discloses in its 10K (SEGNUM). Firms with greater complex
ity may have greater financial reporting latitude due to the inherent com
plexity of their operations. We therefore expect that SEGNUM will be pos
itively (negatively) associated with income-increasing (income-decreasing)
abnormal accruals. CFO (operating cash flows), SALESGROW(sales growth
from the prior year), and MTB (market to book) are included to control for
growth, and CFOVOL (operating cash flow volatility) is included because it
may impact the accrual calculation (Dechow, Sloan, and Sweeney [1996],
Matsumoto [2002], Menon and Williams [2004]).
Low performance provides an incentive for accruals management, so we
include ROA (net income/assets) and LOSS (coded "1" if the firm experi
enced a loss in the preceding year, "0" else). In terms of income-increasing
abnormal accruals, increases in ROA may impact the calculation of ab
normal accruals and we expect a positive relation. In terms of income
decreasing accruals, positive ROA provides incentives to "smooth" earnings
and we expect a negative association between ROA and income-decreasing
abnormal accruals. Firms with a net loss may have an incentive to magnify
income-increasing abnormal accruals to avoid debt covenant violations and
magnify income-decreasing abnormal accruals to "take a bath." We there
fore expect a positive (negative) association between LOSS and income
increasing (decreasing) abnormal accruals. We also include an indicator
variable for the presence of material internal control weaknesses. Mate
rial weaknesses have been shown to be associated with an increase in ab
normal accruals (Doyle, Ge, and McVay [2007]). Finally, consistent

prior accruals-based research, we include dummy variables for foc
try membership.
5. Results
5.1 DESCRIPTIVE STATISTICS
Table 3 presents descriptive statistics for the 189 respondents. Panel

A provides information related to the IAF budget. The mean number
of in-house (outsourced) IAF hours is 34,873 (4,195) and the mean in
house (outsourced) budget is $2,056,256 ($484,312). The mean (median)
TABLE 3
Descriptive
Descriptive Statistics
Statistics
Panel A: Internal audit budget descriptive statistics

Variable Name Mean Median 25th % 75th %
Total outsourced internal 4,195 1,800 0 5,000

audit hours (n= 133)*
Total outsourced internal $484,312 $450,000 $0 $900,000
audit budget
Total in-house internal audit 34,873 20,000 8,000 37,750
hours (n = 189)
Total in-house internal audit $2,056,236 $1,500,000 $900,000 $2,500,000
budget ($)
Hourly OSP IA resource $178.73/hr $150/hr $100/hr $250/hr
expenditures"
Hourly in-house IA (IACOMP) $102.42/hr $87.72/hr $75/hr $115/hr
resource expenditures"
Total combined IAF hours 40,983 24,000 8,460 46,000
Total combined IAF budgets $3,580,450 $2,225,000 $1,250,000 $5,250,000
(mP)
% of OSP $ budget to total IAF 0.177 0.072 0.00 0.332
$ budget
IAFs with OSP budget > 20% 0.338 0.00 0.00 1.00
of overall IAF budget (0,1)

IAFs with OSP budget < 20% 0.662 1.00 0.00 1.00
of overall budget
(NON08P20)
IAF used as a management 0.8465 1.00 1.00 1.00
training ground (0,1)

IAF not used as a management 0.1535 0.00 0.00 0.00
training ground (NONMTG)

*Only 133 of our 189 responding firms outsourced internal audit tasks and therefore our sample size for
outsourced IAF data is 133.
**To obtain this figure, we calculated individual per hour IAF resource expenditures rates for each
sample firm. We then averaged these 133 (189) rates to arrive at a mean (median) and percentiles figures
for the OSP (in-house) IAF departments, respectively.
IACOMP is $102.42 (87.72). Approximately 85% of the respondents re

ported that IAF was an MTG. The mean ratio of OSP budget dollars to in
house dollars is 17.7%, with a median of 7.2% and a range of 0 at the 25th
percentile to 33.2% at the 75th percentile. Almost 34% of the 133 firms that
outsourced had an OSP budget higher than 20%, indicating the pervasive
nature of outsourcing portions of the IAF.
Panel B of table 3 provides details concerning ACIAFINF. The mean
(median) overall ACIAFINF measure is 0.41 (0.42), suggesting that on
average the organizational oversight of the IAF is almost evenly split
between management and the audit committee. As in Abbott, Parker, and
Peters [2012], there is substantial, interfirm variation among the oversight
roles. We find that, for the lower 25% of sample firms, the audit committee
has relatively little influence over the IAF with a value of 0.26. The upper
25% of sample firms suggest that the IAF's potential objectivity is relatively
TABLE 3—Continued
Panel B: Audit committee and management oversight of internal audit function
Degree of Agreement with

survey statements #12a-12i Mean Median 25th % 75th %
IAF reports to the audit 4.73 5.00 4.00 5.00

committee
IAF reports to the CFO 3.65 4.00 3.00 4.00
IAF reports to the CEO 2.50 2.00 2.00 3.00

Audit committee authorized to 4.52 5.00 3.00 5.00
terminate Chief Internal
Auditor
The CFO authorized to 3.65 4.00 3.00 4.00
Auditor
The CEO authorized to 3.05 3.00 3.00 4.00
Auditor
The audit committee 3.22 3.00 3.00 4.00
determines Internal Audit's
annual budget
The CFO determines Internal 3.75 4.00 3.00 4.00
Audit's annual budget

The CEO determines Internal 3.02 3.00 3.00 4.00
Audit's annual budget

ACIAFINF" 0.41 0.42 0.26 0.61
*** ACIAFINF = The ratio of the total agreement points for the audit committee in the numer
vided by the total agreement points for the CFO and CEO in the denominator. The numerator is t
of agreement points (per the 1-5 Likert-scale responses) on survey questions #12a, 12d, and 12g.
nominator is the sum of agreement points (per the 1-5 Likert-scale responses) on survey question
12i. The 1-5 Likert-scale responses are recalibrated to 0-4 for purposes of computing this variable.
more protected from management influence, with the 75th percent

value of A CIAFINFeq ua I ing 0.61.
The audit committee's oversight is strongly manifested in reporting
and termination authority. The respondents agree strongly with the
ment that the IAF reports to the audit committee (mean of 4.75 and
dian of 5.00), and only slightly less strongly with the statement that the
committee has termination authority over the CIA (mean of 4.52 an
dian of 5.00). However, in terms of reporting relationships, internal
appears to be reporting to both the audit committee and the CFO or
This could be indicative of a "solid line" or functional relationship wit
audit committee and a "dotted line" or administrative relationship wit
CFO or CEO. We observe lower agreement with the statement that th
dit committee determines the IAF's budget (mean of 3.22 and media
3.00). Budgetary authority is greater for the CFO than the audit com
tee (mean of 3.75 and median of 4.00). The budgetary authority resp
represents the primary difference from results reported by Abbott, Park
and Peters [2012] in a similar survey from an earlier time period (20
We believe that the economic situation in our sample year, 2009, is a l
TABLE 3—Continued
Panel C: Control variables descriptive statistics

Variable name Mean Median 25th % 75th %
ABNACC 0.0289 -0.0139 -0.0788 0.0269
JM/BEAV" 0.1957 0.0000 0.0000 1.000
ASSETS (mil) $19,602 $5,318 $2,613 $12,828
AGE 20.49 25.00 15.00 25.00
LEVERAGE 0.4729 0.4531 0.3598 0.5644
SEGNUM 4.3280 4.000 2.0000 6.0000
CEO (mil) $1,780 $566.9 $258.4 $1,126
SALESGROW -0.1177 -0.0947 -0.2129 -0.0105
MTB 2.5294 1.6393 1.0786 2.7566
CFOVOL 496.9 132.9 66.85 340.2
ROA 0.0321 0.0365 0.0038 0.0698
LOSS 0.2698 0.0 1.0 0.0
MATWEAK 0.0423 0.0 0.0 0.0
All variable definitions can be found in table 2.
****Variable used in additional analysis section only.

ABNACC is Kothari, Leone, and Wasley's (2005) version of the modified Jones model measure of ab
normal accruals. JM/BEATis a dichotomous dependent variable coded "1" in instances where the firm met
the consensus annual EPS forecast scaled by price at the beginning of the year or exceeded the forecast
by more than 0.0005; "0" elses. ASSETS equals total assets in millions. AGE is the number of years the firm
was listed on Compustat, truncated at 25 years. LEVERAGE equals the sum of long-term debt and current
liabilities of a company divided by total assets. SEGNUM equals the number of disclosed segments in which
the company operates. CFO equals cash flows from operations. SALESGROW equals one-year sales growth
percentage. MTB equals market-to-book ratio. CFOVOL is the standard deviation of operating cash flows for
2005-2009. ROA equals return on assets. LOSS is coded "1" if the firm experienced a loss in fiscal year 2008,
"0" else. MATWEAK is coded "1" for a client firm disclosing a material weakness in internal controls over
financial reporting during the prior two years and "0" otherwise.
explanation for the difference. In tight economic conditions, it seems prob

able that all areas of the firm, including the IAF, would be scrutinized by
the CFO for possible cost savings.
Table 3, panel C, shows the control variable descriptive statistics. Our
companies are quite large and "old," as might be expected, with a mean
(median) asset size of $19.6 billion ($5.3 billion) and a mean (median)
age of 20.49 (25) years. Their leverage is fairly high (mean of 47%, median
of 45%), and most have been public companies for at least 25 years, and
many for much longer. Our sample firms have on average 4.32 operating
segments. Operating cash flow is $1.78 billion (mean), $567 million
(median). Notably, mean sales growth from 2008 to 2009 was —11.8%,
and mean ROA was 3.2%, reflecting the 2009 economic environment.
The mean market-to-book ratio is 2.6, while mean cash flow volatility is
496.9. Reflecting the economic downturn during our sample period, the
incidence of a prior year loss (LOSS) is almost 27%. All these measures
(except loss incidence) are lower than those reported in Prawitt, Smith,
and Wood [2009], again likely reflective of the updated economic environ
ment in our study. We also note a very low incidence of reported material
weaknesses, with the mean of MATWEAK of 0.0405. This is consistent with
a dramatic decrease in Section 404 weaknesses after the issuance of Audit
Standard No. 5 (PCAOB [2007]). Table 3, panel C, also shows that the
mean ABNACC is 0.0289, and the median is —0.0139.
5.2 UNIVARIATE RESULTS
Table 4 provides the results of examining the sample, based upon

whether the respondent firms do not use the IAF as an MTG (NONMTG)
or do not have substantial OSP (NONOSP20). In panel A, firms not utiliz
ing the IAF as an MTG (n = 28) are larger and have higher cash flows than
firms that use the IAF as an MTG (n — 161). This is generally consistent
with larger IAFs being able to provide an internal audit "career" (Messier
et al. [2011]). Panel B of table 4 provides univariate differences based upon
firms with less than 20% of their budgets attributed to outsourcing (n —
125) and those with more than 20% (n = 64). We note that firms without
a substantial OSP presence have a greater audit committee IAF influence
and a less severe deceleration in sales. The former result suggests that audit
committees may exert a preference for in-house IAF. The latter result indi
cates that outsourcing may be an attractive means of cutting costs. We find
no difference in the lack of an MTG between the two subsamples.
Table 4, panel C, provides univariate comparisons based upon whether
firms just meet or beat their analyst's EPS forecast (n = 37) and those that
do not (n = 152). We find a low level of just meeting or beating analyst
forecasts (less than 20%), consistent with the Sarbanes-Oxley Act curtail
ing (but not eliminating) earnings management (Koh, Matsumoto, and
Rajgopal [2008]). Consistent with prior literature, firms that just meet or
beat analysts' forecasts have more leverage, are more complex, have more
operating cash flow, and have a greater market-to-book ratio. We find a
marginally smaller IACOMP value for firms that just meet or beat analysts'
forecasts. Consistent with panels A and B, there are no univariate differ
ences in IACOMP, NONMTG, or NONOSP2O. Overall, the univariate results
are consistent with (1) our three IAF independence measures capturing
different independence mechanisms and (2) the inability of competence
and independence to significantly influence financial reporting quality on
a stand-alone basis.
5.3 MULTIVARIATE RESULTS
Tables 5 and 6 present our main results.23 Table 5 summarizes the re

sults from regressing positive (income-increasing) accruals on our IAF
related variables and controls variables. In table 5, our predicted signs
for our interaction variables are all negative, as we predict lower income
increasing accruals when the IAF exhibits both greater competence and in
dependence.24 With respect to the interactive term between IACOMP and
ACIAFINF (coefficient = —0.00017, £-stat. = —2.302), our results suggest
that the effect of competence depends on the amount of oversight pro
vided by the audit committee and vice versa (in support of HI). In other
23 In the interest of brevity, we do not report the coefficient estimates on our INDUSTRY
dummy variables.
24 We are careful to not overinterpret our stand-alone variables, as they are not necessarily
reflective of main effects due to the continuous nature of some of our test variables (Jaccard
andTurrisi [2003]).
TABLE 4
Univariate Comparisons
Panel A: Univariate comparison of IAF's management training grou

Firms with Firms with Mann-Whitney
Variable Name NONMTG = 1 NONMTG= 0 Difference Statistic
IACOMP $107.59/hr $101.52/hr $6.07/hr 1.0051

ACIAFINF 0.439 0.405 0.034 1.2323
NONOSP2O 0.6786 0.6584 0.0202 0.9974
ASSETS (mil) $24,145 $18,812 $5,333 1.6736*
AGE 19.97 20.62 -0.65 0.9929
LEVERAGE 0.4907 0.4698 0.0209 0.6788
SEGNUM 4.4643 4.2919 0.1724 0.7505
CFO (mil) $1,929 $1,754 $175 1.5029*
SALESGROW -0.1332 -0.1150 0.0182 0.7471
MTB 2.41 2.54 -0.1300 0.8515
CFOVOL 448.2 505.4 -57.2 0.4793
ROA 0.0298 0.0325 -0.0027 0.5555
LOSS 0.2500 0.2733 -0.0233 0.6099
MATWEAK 0.0357 0.0435 -0.0078 0.3311
Observations 28 161
Panel B: Univariate comparison of IAFs lacking/with a significant (>20%) OSP presence

Firms with Firms with Mann-Whitney
Variable Name NONOSP2O = 1 NONOSP2O = 0 Difference Statistic
IACOMP $104.89/hr $97.59/hr $7.30/hr 1.1011

ACIAFINF 0.441 0.349 0.092 1.6993*
NONMTG 0.168 0.157 0.011 0.0694
ASSETS (mil) $20,038 $18,750 $1,288 0.8828

AGE 20.53 20.41 0.12 0.3324
LEVERAGE 0.4780 0.4629 0.0151 0.7247
SEGNUM 4.2480 4.4844 -0.2364 0.8791
CFO (mil) $1,775 $1,789 -$14 1.0801
SALESGROW -0.0988 -0.1546 -0.0558 3.4804"
MTB 2.47 2.61 -0.14 0.3779
CFOVOL 515.1 487.6 27.5 0.1155
ROA 0.0293 0.0335 -0.0042 0.9013
LOSS 0.2720 0.2656 0.0640 0.6528
MATWEAK 0.0400 0.0468 -0.0680 0.4999
Observations 125 64
Panel C: Univariate comparison of firms that just meet/beat analyst forecast to other firms
Firms that Just
Meet/Beat All Other Mann-Whitney
Variable Name Analysts' Forecasts Firms Difference Statistic
IACOMP $99.87/hr $103.04/hr —$3.17/hr 1.4011

ACIAFINF 0.3606 0.4220 -0.0614 1.7804'
NONMTG 0.1622 0.1513 0.0109 1.0501
NONOSP2O 0.6486 0.6652 -0.0166 0.7822
ASSETS (mil) $18,087 $19,971 -$1,904 1.8736*
AGE 19.57 20.65 -1.0800 0.4424
LEVERAGE 0.4994 0.4664 0.0330 1.9942*
TABLE 4—Continued
Panel C: Univariate comparison of firms that just meet/beat analyst forecast to o
Firms that Just

Meet/Beat All Other Mann-Whitney
Variable Name Analysts' Forecasts Firms Difference Statistic
SEGNUM 4.8214 4.2422 0.5792 1.7305*

CFO (mil) $2,010 $1,724 $286 1.8544*
SAIJLSGROW -0.1103 -0.1195 -0.0092 1.1008
MTB 2.82 2.46 0.36 2.0011**
CFOVOL 481.4 500.3 -18.9 0.3021
ROA 0.0339 0.0317 0.0022 0.4933
LOSS 0.2432 0.2763 -0.0233 0.6224
MATWEAK 0.0541 0.0395 0.0146 0.7754
Observations 37 152
Significance levels (one-tailed if in predicted direction): *•**• *** = Rvalue < 0.10, 0.05, 0.01, respectively.
IACOMP equals average IAF resource expenditure per hour. ACIAFINFis the relative audit committee
IAF influence vis-a-vis management (CEO and CFO). NONMTG is an indicator variable coded "1" when the
IAF does not serve as a management training ground per survey question #13 and 0 otherwise. NONOSP2O
coded "1" ("0") when the budgeted outsourced IAF services are less than 20% of IAF total budget. ASSETS
equals total assets in millions. AGE is the number of years the firm was listed on Compustat, truncated at
25 years. LEVERAGE equals sum of long-term debt and current liabilities of a company divided by total
assets. SEGNUM equals number of disclosed segments in which a company operates. CEO equals cash flows
from operations. SALESGROWequals one-year sales growth percentage. MTB equals market-to-book ratio.
CFOVOL'is the standard deviation of operating cash flows for 2005-2009. ROA equals return on assets. LOSS
is coded "1" if the firm experienced a loss in fiscal year 2008, "0" else. MAll/VEAKis coded "1" for client firm
disclosing a material weakness in internal controls over financial reporting during the prior two years and
"0" otherwise.
words, the impact of the IAF on financial reporting quality is jointly de

pendent on the level of competence and independence of the IAF. The
reduction in the size of positive abnormal accruals for a certain level of IAF
competence (audit committee oversight of the IAF) is conditional upon au
dit committee oversight of the IAF (IAF competence). Economically, this
suggests that firms overinvesting in competence (independence), but not
in independence (competence), are in danger of establishing an IAF that
is not effective in strengthening the firms' financial reporting process. In
other words, the presence of both competence and independence is a nec
essary antecedent for effective financial reporting monitoring by the IAF.
The significantly negative coefficient (coefficient —0.00013, £-stat
—3.248) for the interaction term between IACOMP and NONOSP2O sug
gests that the abnormal accrual reduction effect of IACOMP is greater for
firms that do not have a substantial OSP presence (in support of H3). In
other words, greater amounts of investment in the in-house IAF activities
(both in terms of budgets and hours provided by the in-house IAF) yield
greater reductions in positive abnormal accruals (i.e., increase in financial
reporting quality). We do not find a significant interaction effect between
IACOMP and NONMTG. Several of the control variables are significant. AS
SETS, IjEVERAGE, CFO, MTB, CFOVOL, ROA, and LOSS are all significant
and in the predicted direction.
Table 6 summarizes the results from regressing negative (income
decreasing) accruals on our IAF-related variables and controls variables.
TABLE 5
OLS Regression Results:

Results: Positive
Positive Abnormal
Abnormal Accruals
Accruals
Positive ABNACC = b„ + bJACOMP + b2ACIAFINF + b,NONMTG + b4NONOSP20

+ bJACOMP * ACIAFINF + bJACOMP * NONMTG
+ bJACOMP * NONOSP2O + bsASSETS + b9AGE + b,.LEVERAGE
+ bnSEGNUM + b,2CFO + b„SALESGROW + buMTB + b,,CFOVOL
+ bKROA + bnLOSS + b,sMATWEAK + b, ^INDUSTRY + e.
Independent Variable Expected Sign Coefficient Estimate ^Statistic
Intercept 0.0467 1.1099

I AGO MP ? -0.00004 -1.1921
ACIAFINF ? -0.0369 -1.4201*
NONMTG ? -0.0187 -0.8645
NONOSP2O 5 -0.0101 -0.6779
IACOMP' ACIAFINF -
-0.00017 -2.3022"
IACOMP" NONMTG -
-0.00005 -1.2199
IACOMP "NONOSP2O -
-0.00013 -3.2481***
ASSETS + 0.0003 2.5778***
AGE -
-0.0004 -0.3101
LEVERAGE + 0.0412 1.7844*
SEGNUM + 0.0052 2.9941***
CFO -
-0.0001 -1.4245*
SALESGROW + 0.0069 0.7274
MTB + 0.0048 2.9998***
CFOVOL + 0.0001 2.2217**
ROA -
-0.0101 0.3741
LOSS + 0.0108 0.9577
MATWEAK + 0.0128 0.5299
INDUSTRY Included
Observations 81
Adjusted If 0.2399
Significance levels (one-tailed if in predicted direction): *•**• *** = Rvalue < 0.10, 0.05,0.01, respectively.
ABNACC is the Kothari, Leone, and Wasley (2005) version of the modified Jones model measure of
abnormal accruals. IACOMP equals average LAP resource expenditure per hour. ACIAFINF is the relative
audit committee IAF influence vis-a-vis management (CEO and CFO). NONMTG is an indicator variable
coded "1" when the IAF does not serve as a management training ground per survey question #13, and 0
otherwise. NONOSP20 is coded "1" ("0") when the budgeted outsourced IAF services are less than 20% of
the IAF total budget. ASSETS equals total assets in millions. AGE is the number of years the firm was listed on
Compustat, truncated at 25 years. LEVERAGE equals the sum of long-term debt and current liabilities of a
company divided by total assets. SEGNUM equals the number of disclosed segments a company operates in.
CFO equals cash flows from operations. SALESGROWequals one-year sales growth percentage. MTB equals
the market-to-book ratio. CFOVOL is the standard deviation of operating cash flows for 2005-2009. ROA
equals return on assets. LOSS is coded "1" if the firm experienced a loss in fiscal year 2008, "0" otherwise.
MATWEAK is coded "1" for a client firm disclosing a material weakness in internal controls over financial
reporting during the prior two years and "0" otherwise.
Table 6 indicates that our results for income-decreasing accruals are

also generally consistent with our hypotheses. In support of HI, H2,
and H3, the coefficient estimates for all three interactive competence
and independence terms (IACOMP*ACIAFINF, IACC>MP*NONOSP20,
IACOMP*NONMGT) are significantly positive (indicating associations with
smaller negative accruals, that is, negative accruals that are closer to zero).
The same control variables are significant as in table 5, except that the cash
flow variables lose significance and SALESGROW gains significance. We
interpret this as suggesting that income-decreasing (negative) abnormal
TABLE 6
OLS Regression Results:

Results: Negative
Negative Abnormal
Abnormal Accruals
Accruals
Negative ABNACC = b„ + b,IACOMP + b2ACIAFINF + b,NONMTG +

+ bJACOMP * ACIAFINF + bJACOMP * NONMTG
+ bJACOMP * NONOSP2O + b„ASSETS + b,AGE + b,„LEVERAGE
+ buSEGNUM + b,2CFO + b,,SALESGROW + b,,MTB + b„CFOVOL
+ b„,ROA + bl7LOSS + b,„MATWEAK + b„_2SINDUSTRY + e.
Independent Variable Expected Sign Coefficient Estimate (-Statistic
Intercept -0.3110 -1.0772

IACOMP ? 0.00054 1.6005*
ACIAFINF J 0.0104 1.2002
NONMTG ? 0.0171 0.8895
NONOSP2O p 0.0027 0.8874
IACOMP'ACIAFINF + 0.00018 2.9444***
IACOMP'NONMTG + 0.00013 2.6222**
IACOMP "NONOSP20 + 0.00006 2.9004***
ASSETS -
-0.0034 -0.4747
AGE + 0.0012 0.1111
LEVERAGE -
-0.0877 -1.4123*
SEGNUM -
0.0029 0.3133
CFO -
0.0001 0.5998
SALESGROW + 0.0549 1.2987*
MTB + 0.0008 2.8956***
CFOVOL -
-0.0002 -0.0765
ROA -
-0.4176 -3.1767***
LOSS -
-0.0728 -2.5649***
MATWEAK -
-0.0504 -0.2772
INDUSTRY Included
Observations 108
Adjusted R2 0.201
Significance levels (one-tailed if in predicted direction): *,**, *** = Rvalue < 0.10, 0.05, 0.01, respectively.
All variable definitions can be found in table 2.
ABNACC is the Kothari, Leone, and Wasley (2005) version of the modified Jones model measure of
abnormal accruals. IACOMP equals average IAF resource expenditure per hour. ACIAFINF is the relative
audit committee IAF influence vis-a-vis management (CEO and CFO). NONMTG is an indicator variable
coded "1" when the IAF does not serve as a management training ground per survey question #13, and 0
otherwise. NONOSP20 is coded "1" ("0") when the budgeted outsourced IAF services are less than 20% of
the IAF total budget. ASSETS equals total assets in millions. AGE is the number of years the firm was listed
on Compustat, truncated at 25 years. LEVERAGE equals the sum of long-term debt and current liabilities of
a company divided by total assets. SEGNUM equals the number of disclosed segments in which the company
operates. CEO equals cash flows from operations. SAIJESGROW equals one-year sales growth percentage.
MTB equals market-to-book ratio. CFOVOL is the standard deviation of operating cash flows for 2005-2009.
ROA equals return on assets. LOSS is coded "1" if the firm experienced a loss in fiscal year 2008, "0" oth
erwise. MATWEAK is coded "1" for a client firm disclosing a material weakness in internal controls over
financial reporting during the prior two years and "0" otherwise.
accruals are less likely to be associated with cash flow considerations, and
also that they are less (closer to zero) when sales are growing. This is consis
tent with fewer incentives for "big bath" behavior when growth is present.
We note that, in order for IAF quality to impact financial reporting qual
ity, it is necessary for the IAF to be involved in the monitoring of the fi
nancial reporting process. Per survey question #3 in the appendix, such
opportunities include financial statement audits of subsidiaries and/or as
sisting the external auditor with the financial statement audit. We observed
that all respondents had nonzero budget allocations to these activities, indi
cating that all sample IAF departments had the opportunity to monitor the
financial reporting process.25 In summary, the evidence of tables 5 and 6
is consistent with the characterization of a two-factor IAF quality function,
whereby competence and independence must combine with each other
to promote the IAF as an effective, internally based financial reporting
monitor.26
5.4 ADDITIONAL ANALYSIS: OTHER FINANCIAL REPORTING QUALITY

PROXIES
While accruals-based measures of earnings management are the mo

pervasive proxy for financial reporting quality, extant research also uses
ability to just meet/beat analysts' forecasts and the use of positive
als to just meet/beat analysts' forecasts as proxies for financial repor
quality (Koh, Matsumoto, and Rajgopal [2008], Prawitt, Smith, and W
[2009], Mande and Son [2012]). We also incorporate these addition
nancial reporting quality proxies into our analysis by utilizing logisti
gression where our dependent variable is a dichotomous variable
whether the firm just meets or beats analysts' expectations (JM/BEA
uses positive abnormal accruals to just meet or beat analysts' expectat
(JM/BEATaccr).
To compute which firms just meet/beat analysts' expectations, we d
how close the firm was to consensus forecast by price at the beginn
of the year and then examine a bin that is within 0.0005 (Prawitt, Sm
and Wood [2009]). This results in 37 firms that meet or just beat anal
forecasts (JM/BEAT — 1) and 152 other firms (JM/BEAT = 0). Our se
independent variables is consistent with those found in the prior sec
Table 7, column A, provides the results for JM/BEAT as the dependent
able. The logistic regressions were conducted in a manner consistent
Norton, Wang, and Ai [2004] and Ai and Norton [2003].
Consistent with the main results, coefficient estimates for our inter
tive terms of I A COMP* /l CIAFINF an d IA COMP* NONOSP2C) are statisti
significant. Our coefficient estimate for IACOMP*NONMTG is in the
dicted direction, but is not statistically significant. This provides addit
evidence in support of HI and H3. In general, the joint presence
dit committee IAF oversight and IAF competence appears to reduce
risk of firms artificially just meeting or beating the consensus EPS f
cast. Similarly, when competence increases when there is not a substa
25 Our survey respondents reported spending 15.4% of in-house audit hours on assi
with the financial audit, 10.3% on audits of subsidiaries, 6.8% on compliance auditing
9.8% on special projects. For comparison, the highest single percentage of time was de
to SOX-related controls work (27.15%).
26 Breusch-Pagan tests failed to detect the presence of heteroskedasticity.
TABLE 7
Logistic
Logistic Regression
RegressionResults:
Results:Just
JustMeet/Beat
Meet/BeatAnalysts'
Analysts'
Forecasts
Forecasts
JM/BEAT = b„ + bJACOMP + b2ACIAFINF + b,NONMTG + b4NONO

+ bJACOMP * ACIAHNF + bJACOMP * NONMTG
+ bJACOMP * NONOSP2O + bsASSETS + b„AGE + bwLEVERAGE
+ buSEGNUM + b,2CFO + b,,SALESGROW + buMTB + b„CFOVOL
+ bKROA + b,7LOSS + b,sMATWEAK + b ^INDUSTRY + s.
Column A Column B
Independent
Expected Coefficient Chi-Square Coefficient Chi-Square
Variable Sign Estimate Statistic Estimate Statistic
Intercept -0.3110 1.0772 -0.4971 1.0772

IACOMP } 0.0054 1.0504 0.0054 1.6603
ACIAFINF ? 0.0104 2.4691 0.0089 1.8550
NONMTG ? 0.0171 0.6738 0.0124 1.7776
NONOSP2O p -0.0027 0.8874 0.0022 0.6911
IACOMP'ACIAFINF -
-0.0098 4.4823" -0.0117 4.4187"
IACOMP'NONMTG -
-0.0013 1.6788 -0.0005 2.5558
I A CO MP * NONOSP2O -
-0.0048 5.9004** -0.0054 5.1234"
ASSETS + -0.0034 1.2626 -0.0301 1.7231
AGE -
0.0049 0.9203 0.0012 0.1111
LEVERAGE + 1.3944 3.9487" 1.6553 3.7349*
SEGNUM + 0.3249 2.8777* 0.0829 2.7792*
CFO -
0.0001 0.0075 -0.0002 0.0978
SALESGROW + 0.3551 1.0013 0.2817 1.1113
MTB + 0.0498 4.7145" 0.0502 2.8277*
CFOVOL -
-0.0002 0.0765 -0.0002 0.0765

ROA + 2.8783 5.1055" 2.6533 3.6783*
LOSS -
-0.4445 1.3011 -0.6235 0.9645
MATWEAK -
-0.0513 0.7381 -0.0719 0.5334
INDUSTRY Included Included
Observations 189 189
Pseudo-R2 0.201 0.137
Significance levels (one-tailed if in predicted direction): *•**• *** = Rvalue < .10, .0
Column A present results when the dependent variable is defined as JM/BEAT
dent variable coded "1" in instances where the firm met the consensus annual EPS f
at the beginning of the year or exceeded the forecast by more than 0.0005; "0"
results when the dependent variable is defined as JM/BEAT,lirr, coded "1" if the fi
analysts' forecasts, without abnormal positive accruals, "0" else. All other variables a
described.
outsourcing presence, there is a reduction in the likelihood of a firm just

meeting or beating the consensus EPS forecast.27
Table 7, column B, provides the results for JM/BEATaccr as the depen
dent variable. Following Koh, Matsumoto, and Rajgopal [2008], we calcu
late unmanaged earnings by backing out discretionary abnormal accruals
from reported earnings. We then identify firms that would have missed ana
lysts' forecasts, without management's exercise of the accounting discretion
and code these firms as JM/BEATaccr — 1. We find 25 firms that belong to
27 In untabulated results, we isolate those firms that appear to have utilized abnormal accru
als to just meet/beat forecasts, and find similar results, though at lower levels of significance.
this category (JM/BEATaccr = 1) and the remaining 164 (JM/BEATaccr = 0)

firms do not. We obtain evidence similar to that provided in column A.
The coefficient estimates for the interactive terms of IACOMP*ACIAFINF
and IACOMP*NONC)SP20 suggests that the disciplining interactive imp

of competence and independence are acute for this form of financia
porting quality.
5.5 ADDITIONAL ANALYSIS: DETERMINANTS OF LAF COMPETENCE
We assert that IACOMP is a parsimonious measure that aggregates many

individual, IAF competence-related characteristics. To test this assertion, we
regress IACOMP against several IAF characteristics that may be associated
with competence. Individual IAF characteristics include measures of IAF
certification, CIA certification, and tenure, which relate to survey questions
#6-8. We further augment our model to include other noncompetence
variables that have been shown to impact overall IAF budgets (Carcello,
Hermanson, and Raghunandan [2005] and Anderson etal. [2012]). These
additional variables include firm size, leverage, percentage of inventory to
total assets, and operating cash flows. Finally, as a means of discerning if
any of our independence-related measures are potentially determinants of
IACOMP, we include ACIAFINF, NONOSP20, and NONM'fG as regressors.28
The untabulated results show that professional certification, experience,
percentage of assets in inventory, and firm size are positively related to
IACOMP. The significant, positive association between IACOMP and the
percentage of total assets comprised of inventory is likely attributable to the
more complex accounting systems needed to accumulate and analyze prod
uct costs. Similarly, firm size may proxy for both the relative amount of firm
resources available to devote to the IAF, as well as firm complexity. Only
one of the independence measures, ACIAFINF, is marginally associated with
IACOMP. As the relative degree of audit committee-IAF oversight increases,
per-hour IAF compensation increases as well. This result is consistent, al
though at a much lower economic and statistical significance, with Carcello,
Hermanson, and Raghunandan [2005] and Anderson etal. [2012]). These
results provide evidence that our measures of competence and indepen
dence capture separate and distinct constructs.
5.6 SENSITIVITY ANALYSIS
To address potential endogeneity, we execute a two-stage least squares

analysis using an instrumental variable approach (Prawitt, Smith, and
Wood [2009]). Given that our IAF independence variables are not highly
28 Carcello, Hermanson, and Raghunandan [2005] also find that the presence of an OSP
negatively impacts overall the IAF budget. Instead of using a dichotomous OSP "presence"
variable per Carcello, Hermanson, and Raghunandan [2005], we use NONOSP2O, which is
substantively similar to the variable used in Carcello, Hermanson, and Raghunandan [2005].
We note that neither NONOSP2O nor a dichotomous OSP presence variable is significantly
associated with IACOMP.
correlated with each other and do not appear to significantly influence IAF
competence, our primary focus is predicting IACOMPin a first-stage regres
sion. Similar to Prawitt, Smith, and Wood [2009], our objective is to utilize
instrumental variables that are correlated with IACOMP, but not correlated
with our measures of financial reporting quality. Our two instrumental vari
ables include an average IACOMP score by industry and the amount of in
ventory relative to assets.29 We then use the predicted IACOMP value in a
second-stage regression using the same set of dependent variables found in
tables 5-7. We obtain virtually identical results to those reported in tables
5-7.
We also considered numerous categories of potentially omitted corre
lated variables. With respect to auditor-related variables, prior research has
indicated that auditor tenure (Davis, Soo, and Trompeter [2009]), auditor
industry specialization (Reichelt and Wang [2010]) and the magnitude of
non-audit fees (Frankel, Johnson, and Nelson [2002]) may impact financial
reporting quality. Our results remained unchanged when we included: (1)
a continuous variable defined as total auditor tenure (capped at 25); (2)
a dichotomous variable coded "1" when the external auditor audited the
largest percentage of client assets per the two-digit focus industry per t
1, and "0" otherwise and (3) a continuous variable defined as the ratio
non-audit service fees to audit fees.
We utilized various alternative control variables for corporate governance

and/or audit committee effectiveness, including the Gompers, Ishii, and
Metrick [2003] corporate governance index, and the type and percent
age of financial experts present on the audit committee (Dhaliwal, Naiker,
and Navissi [2010] ).so We also examined certain CFO characteristics (age,
tenure, board membership, stockholdings, and gender) given their poten
tial impact on financial reporting decisions (Ge, Matsumoto, and Zhang
[2011]). Inclusion of the above variables did not substantively alter the re
sults of tables 5-7.
We examined whether IACOMP might be capturing the effect of high
cost of living areas by including "high-cost" dummy variables.31 We included
a variable for the percentage of IAF budget allocated to financial state
ment auditing per Lin et al. [2011], We examined the potential effects of
litigious industries and labor intensiveness (Frankel, Johnson, and Nelson
[2002], Matsumoto [2002]). We included a dichotomous variable coded
"1" in instances where the primary SIC code indicated a litigious industry
29 The industry-wide average of IACOMP is likely to be associated with an individual firm's

IACOMPbecause internal auditors have the opportunity to transfer their skills from one com
pany to the other and would do so as a means of increasing or maintaining their current salary.
Similar to Prawitt, Smith, and Wood [2009], the industry-wide IACOMPvalue is unlikely to be
correlated with our dependent variables since we do not find that financial reporting quality
is highly concentrated in a few industries.
!fl Experts are current or former certified public accountants, CFOs, vice presidents of fi
nance, controllers, and those with other major accounting positions.
31 The high-cost cities include New York, Boston, Los Angeles, Chicago, and San Francisco.
per Frankel, Johnson, and Nelson [2002].32 We also included a continuous

variable calculated as 1 minus the ratio of gross property, plant, and equip
ment (PPE) to total assets. The results of tables 5-7 remained qualitatively
similar.
The time period of our study was a recession year, and, thus, our results
may not be generalizable to other years. We assumed that our test vari
ables would remain relatively constant over a short horizon, and tested our
model for 2010 and 2011. We also included abnormal returns and a dummy
variable for negative abnormal return to our regression as a control for ac
celerated recognition of losses in a recession year (Ball and Shivakumar
[2006]). Our results remained qualitatively similar in both these tests.
Last, we attempted to separate the relative influence of the CEO and
CFO over the IAF. In our first test, we created a dichotomous variable
(CFODOMAIN) coded "1" in instances where the survey respondent in
dicated a strong level of agreement with survey questions 12b/12e/12h,
while simultaneously indicating strong disagreement with survey questions
12c/12f/12i. We then interacted IACOMP*ACIAINF* CFODOMAIN Inclu
sion of these variables in our regression did not substantively alter the re
sults of tables 5-7. In a second set of analyses, we redefined CFODOMAIN
as "1" in instances where the sum of survey responses to 12b/12e/12h
was greater than survey responses to 12c/12f/12i (that is, in observations
where the CIA noted that the CFO had relatively greater IAF influence).
CFODOMAIN occurred in slightly more than 80% of our observations—
indicating that the CFO has relatively greater influence over the IAF vis-a-vis
the CEO in the overwhelming majority of instances. Inclusion of this rede
fined CFODOMAIN variable in our regressions did not impact our overall
results and the coefficient estimates on CFODOMAIN on a stand-alone or
interactive basis were statistically insignificant.33
6. Conclusion
We examine whether IAF quality—and its ability to foster higher quality

financial reporting—can be reasonably characterized as a joint function of
both competence and independence. Our tests rely on the argument that
the effectiveness of the IAF rests upon the complementary roles of compe
tence and independence. For example, even though a competent IAF may
32 High-litigation industries are industries with SICs of 2833-2836, 3570-3577, 3600-3674,

5200-5961, and 7370-7374 (Frankel, Johnson, and Nelson [2002]).
33 There were zero observations where the CIA indicated a strong level of disagreement with
the following survey questions: 12a/12d/12g. That is, survey respondents all stated that the
audit committee had some sort of influence over the IAF. In slightly less than 3% of our ob
servations, the CIA indicated that the audit committee had sole province over the IAF (that is,
strongly agreed with survey questions 12a/12d/12g, while simultaneously strongly disagreeing
with survey questions 12b/12c/12e/12f/12h/12i). These results indicate that it is extremely
rare for the audit committee to have sole control over the IAF and that there are virtually no
instances where the audit committee has no influence over the IAF.
be more likely to identify a misstatement, an IAF that lacks independence

may be less likely to report it to the appropriate channel or demand that
the party originally responsible for the misstatement to correct it. Despite
a large amount of practitioner guidance on the importance of indepen
dence, little is known about how independence interacts with competence
in fostering the IAF's role as an effective financial reporting monitor. In
sum, our results show that, if one wishes to ask "what is the effect of IAF
competence (independence) on financial reporting quality?," the answer
is "it depends on the independence (competence) of the internal auditor."
Our study is also motivated by the relative scarcity of archival evidence
on factors that potentially impact IAF competence, IAF independence, and
their joint influence on the IAF quality. Our proxy for competence is cap
tured by the organization's investment in average hourly rates of budgeted
IAF resources. We consider three specific artifacts of independence: the rel
ative degree of audit committee oversight vis-a-vis management oversight,
the preponderance of internal audit outsourcing, and the use of internal
audit as an MTG. We regress several financial reporting quality proxies on
our set of competence and independence variables, as well as the interac
tion of the competence and independence variables. We find that, consis
tent with a two-factor IAF quality function, we document statistically sig
nificant associations between our interaction terms and financial reporting
quality. The overall results provide evidence consistent with the hypothesis
that the combined presence of both competence and independence is a
necessary antecedent to effective IAF financial reporting monitoring.
With respect to the IAF characteristics, we find results consistent with in
dependence being enhanced by relatively greater degrees of audit commit
tee oversight of the IAF, versus management oversight. We utilize a measure
of oversight influence that extends beyond formal reporting lines. This en
hanced independence interacts with IAF competence as a means of curtail
ing financial reporting discretions in both income-increasing and income
decreasing environments. We also document a similar set of relationships
when we interact IAF competence and the relative lack of IAF outsourcing.
Finally, we find lower occurrences of income-decreasing abnormal accruals
as IAFs jointly reflect both greater competence and are not used as an MTG.
Our findings extend prior research and deepen our understanding of the
determinants of IAF quality. We believe that more research is needed in
this area to enrich our understanding of how and why IAFs impact finan
cial reporting quality. Our study points to the need to better understand
how an IAF can benefit a firm, but also how researchers can potentially
demonstrate and quantify the value of a competent and independent IAF.
APPENDIX
Dear Sir or Madam:
We are conducting a brief survey to obtain data about internal audit f

tions, audit risk factors, and the relationship between internal audit
the audit committee. Your insight is vital to this project, so please take a fe
minutes to complete the survey and return it in the self-addressed enve

lope enclosed. Please be assured that all responses will be strictly confidential, and
no company or individual will be specifically identified. If you would like a copy of
our findings, please include an e-mail and/or mailing address. Thank you for your
time and cooperation on this survey.
1. During fiscal 2009, approximately how many hours were devoted to

internal audit services by:
OUTSIDE SERVICE PROVIDERS (OSPs) hours

INTERNAL PROVIDERS hours
2. Of the total internal audit hours provided by outs

provider(s) per question 1, please give the approximate p
distribution of activities (note the percentages should add
Activity Description % of hours Activity Description % of hours

Financial statement audits EDP auditing
of subsidiaries
Special consulting projects Internal control evaluation

Compliance auditing Section 404-related work
Risk management activities Fraud audits
Assisting external auditor Other (explain)

in financial statement
audit
3. Of the total internal audit hours provided by the in-house internal

audit department per question 1, give the approximate percentage
distribution of activities (note the percentages should add to 100%):
Activity Description % of hours Activity Description % of hours

Financial statement audits EDP Auditing
of subsidiaries
Special consulting projects Internal control evaluation
Compliance auditing Section 404-related work
Risk Management Activities Fraud audits

Assisting external auditor Self-assessment programs/
in financial statement Other (explain)
audit
4. Please indicate the total fiscal year 2009 internal audit-related expen
ditures for:
OUTSIDE SERVICE PROVIDERS $_

IN-HOUSE INTERNAL AUDIT $
5. Please indicate the total Section 404-related fees paid to your external
auditor in 2009. $
6. Please indicate the percentage of your staff who have the following
certifications:
CPA CIA CISA % of staff with at least 1 certification _

7. With respect to you personally, please indicate how many years of work
experience you have as: an internal auditor _
a financial statement auditor _
8. With respect to you personally, which certification (s) do you possess?
(check all that apply):
CPA CIA CISA Other
9. Which of the following best describes how

porting are monitored at your entity?
a. Separate Evaluations b. Controls self-asses
10. Which of the following best describes ho

assessments of the effectiveness of controls o
a. Ongoing testing throughout the year b. Po

c. Other (explain).
11. What are the key components of your o

risk assessment and weighting of each (not
high).
Factor Not applicable Low Medium High

Extent of routine versus nonroutine transactions
Dollar materiality
Ethical tone set by management
Changes in upper management
Complexity of the operation
Quality of application-level controls
Physical controls over assets
Quality of manual controls
Complexity of accounting guidance
Financial condition of the entity
Program level changes since last audit
Asset liquidity
Controls over period-end reporting
Complexity of controls
Budget variances of auditable entities
Changes in nonmanagement personnel
Downsizing
Foreign Corrupt Practices Act compliance
Currency fluctuation exposure
Political risk
Environmental regulation
Exposure to financially distressed
third parties (i.e., customers, vendors)
Factor Not applicable Low Medium High

Quality of management forecasts
Revenue fluctuation
Other (please explain)

12. Please indicate your level of agreement with the following statements
(1= strongly disagree; 2 = disagree; 3 = neutral; 4 = agree; 5 = strongly

agree)
Level of agreement
Statement (circle one number)
a. Internal audit reports to the Audit Committee 1 2345

b. Internal audit reports to the Chief Financial Officer1 2345
(CFO)
1 2345
c. Internal audit reports to the Chief Executive Officer
(CEO)
d. The Audit Committee has authorization to 1 2345
terminate the Chief Internal Auditor
e. The CFO has authorization to terminate the Chief 1 2345
Internal Auditor
f. The CEO has authorization to terminate the Chief 1 2345
Internal Auditor
g. The Audit Committee determines Internal Audit's 1 2345

annual budget
h. The CFO determines Internal Audit's annual budget1 2 3 45
i. The CEO determines Internal Audit's annual budget 1 2345
j. The Audit Committee reviews and approves Internal 1 2345
Audit's annual risk assessment plan
k. The CFO reviews and approves Internal Audit's 1 2345
annual risk assessment plan

1. The CEO reviews and approves Internal Audit's 1 2345
annual risk assessment plan
13. Does internal audit serve as a training ground for future ma

positions? Yes No
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Internal Audit Quality and Financial Reporting Quality: The Joint Importance of

Independence and Competence

Internal Audit Quality and Financial

Received 5 November 2013; accepted 24 September 2015

Iii light of the growing importance of internal audit functions (IAF)

* University of Wisconsin-Milwaukee; t Santa Clara University; 'University of A

Copyright ©, University of Chicago on behalf of the Accounting Research Center, 2015

JEL codes: D83; G39; M12; M41; M42

In 2013, the NASDAQ Stock Market LLC (NASDAQ) proposed a rule

Despite the intuitive appeal of IAF quality positively imp

may be more appropriately described as an interactive, two-factor function

4 In terms of income-increasing abnormal accruals, internal auditors whose IAF serves as

auditor competence, we also provide descriptive evidence of the qualifica

tinue to be significant over that time frame.

2. Background, and Prior Literature

Prior IAF research investigating audit outcomes generally focuses on the

Recent research points to other potential determinants of IAF indepen

3.2 AUDIT COMMITTEE IAF OVERSIGHT IN THE INTERACTIVE IAF QUALITY

This study's examination of IAF quality—and its potential imp

Following our expectations, we posit that, as audit committee IAF influ

HI: The interaction between IAF competence and audit commit

3.3 THE IAF AS AN MTG IN THE INTERACTIVE IAF QUALITY MODEL

The second IAF independence determinant interacted with IAF compe

consequences of the joint importance of IAF independence and compe

The final IAF independence factor interacted with IAF competence is

Despite potential benefits of IAF outsourcing, there may be a cost in the

H3: The interaction between IAF competence and the lack of a

12 Though we feel the preponderance of evidence points to a positive association between

4.2 CHARACTERISTICS OF THE IAF

Our survey responses provide information about the current nature of

Sample Selection Results

Related Two No, of %of No. of Fortune % of Fortune

Construction 15-17 9 4.8 17 1.9

Consumer product & 20-33 43 22.8 180 19.8

Energy 10-14, 46, 49 32 16.9 172 18.9

Manufacturing 34-39 31 16.4 140 15.4

Transportation 40-42, 44, 45, 47 3 1.6 11 1.2

while, perhaps surprisingly, only 39% have a Certified Internal Auditor

IAF is utilized, it is utilized heavily to provide Section 404 assistance. This re

+ b4NONOSP2() + b;IACOMP * ACIAFINF

+ IhJACOMP * NONMTG + b7IACOMP * NONOSP2O

+ bsASSETS + b9AGE + bI0LEVERAGE + bnSEGNUM

+ b u CEO + b! 3 SALESGROW + bI4MTB + b15 CFOVOL

+ bl6ROA + b, 7 LOSS + bi8MATWEAK

The variables used in the empirical models

4.4 DEPENDENT VARIABLE

Following prior audit literature, we utilize abnormal accruals (ABNACC)

[TAu! Au-.il = A) + ft [l/Aa-x] + ft [(A REVit - DAR,t)/Alt-1]

+fi$\PPEit/Au-i] + PilNIit/Ai,-1] + Sit.

term of the equation below:

management training ground per survey question #13 and "0"

We then segregate our abnormal accruals as positive (income-increas

4.5 TEST VARIABLES

Our test variables are IACOMP, ACIAFINF, NONMTG, and NONOSP2O,

Following Abbott, Parker, and Peters [2012], we incorporate a separate

dependence. Prior internal audit research suggests that oversight roles or

20 Similar to Abbott, Parker, and Peters [2010], we do not utilize answ

NONMTG represents our second facet of the IAF's independence,

(Budgeted OSP $) / (Budgeted OSP $ + Budgeted in-house IAF $).

Each of our stated hypotheses addresses the interactive nature of IAF

4.6 CONTROL VARIABLES

We include control variables that may impact the level of abnormal ac

normal accruals (Doyle, Ge, and McVay [2007]). Finally, consistent

5.1 DESCRIPTIVE STATISTICS