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The Impact Of Internal Audit On Financial Reporting Quality

ABSTRACT

This study was carried out on the impact of internal audit on financial reporting quality. Internal auditing is a vital aspect of all organizations for the efficient and effective management of resources, addition of value and improvement of operations for them to realize their financial goals. The internal audit department is a neutral source of information for smooth management of resources; thus, stakeholders have a level of confidence in the financial reports of the firm which reflect the quality of the department. The study employed a descriptive research design. The population was made up of all the firms listed on the Manufacturers Association of Nigeria. Data used was both primary and secondary. Questionnaires were used to collect relevant information. The audited and published financial statements of firms listed at the Manufacturers Association of Nigeria provided data on the financial reporting quality. Quantitative and qualitative analyses were used to analyze the data obtained. The independent variables studied: Top management support, auditor’s independence, professional proficiency of auditors and auditor’s quality of work were found to have a significant relationship with financial reporting quality.

CHAPTER ONE

INTRODUCTION

1.1       Background of the study

The role of board of directors, audit committees, management and internal and external auditors in financial reporting are being emphasized by legislators and regulators in the last decade. Most of the new regulative and legislation emphasized that adequate risk management of financial reporting with an adequate system of internal control should ensure that the accounting flexibility is in frames of fair presentation (e.g. SOX Act in the US 2002; EU Directive 2006/46/EC). The initial assumption of decision-SOX Act is that a sound system of internal control and strong control environment provide the best foundation for risk management of fraudulent financial reporting. In this context, disclosure of the internal control effectiveness under SOX Act “has become a valid indicator of the quality of a firm’s financial reporting system” (Dechow, Ge and Schrand 2010, 345). Further, many authors agree that the quality of the information are the result of an adequate application of accounting standards as well as the efficiency and effectiveness of enforcement system (Rahman 2000; Chen, Sun and Wang 2002; Wulandari and Rahman 2004; Barth et al. 2007).

Internal auditing (IA) is recognized as a valuable monitoring and advising mechanism in ensuring the reliability of financial reporting (Prawitt, Smith and Wood 2009; Lin et al.2014; Johl et al. 2016). Continuous cooperation with the board of directors, executive directors and external auditors in the context of testing the effectiveness of internal control over financial reporting, IA is assigned an active role in ensuring the integrity, quality and reliability of the financial reporting process (Subramaniam and Stewart 2006; Prawitt et al. 2009; Sarence, De Beelde and Everaert 2009). It is expected that internal audit, through the process of discovery of defects, analyzing causes and proposing measures for removing the shortcomings, act as a “constructive critic” who constantly contributes to the improvement of business processes in the company (Cohen and Sayag 2010) and “uphold business ethics and corporate integrity” (Aghghaleh F. Sh. et al. 2017, 105). Johl et al. (2016) agree that the competences and responsibilities of IA in implementing effective management processes give to IA a critical role in ensuring the integrity of the financial reporting process.

The main objective of financial reporting is to provide high quality financial information about economic entities that is useful for economic decision making. According to International Accounting Standard Board (IASB), (2008), high quality financial reporting is critical to investors and other stakeholders in making investment, credit and similar decision. An important variable of financial reporting that is usually used as a yardstick of financial reporting quality is accounting earnings, as it is reported in the published financial report of firms is expected to provide a timely and reliable input to potential investors, shareholders, creditors, employees, management, financial analysts, regulators and other stakeholders for efficient economic decisions.

It is in view of the importance of quality financial reporting that the International Federation of Accountants (IFAC) and its audit arm International Auditing and Assurance Standards Board (IAASB), stated that audit services is an assurances service that the financial statements prepared by the managers is true and fair, and free from intentional and unintentional errors and misstatements, and conform to the relevant rules and regulations guiding the preparation and presentation of accounting information (IAASB, 2016). According to IAASB, global financial stability is supported through high quality reporting, which could be achieve through high quality audits that can help foster trust in the quality of reporting. It also highlights the importance of audit quality and its relevance to all stakeholders in the financial reporting supply chain.

One of the critical roles of auditors is that, they assure confidence to financial statements users about the reported information. Audit services have been critical to financial reporting quality since industrial revolution (that is, separation of ownership from management). However, the ability of auditors or audit firm to provide high audit quality capable of producing high financial reporting quality is attributed to some certain features of the audit firm, these features are auditor independence, audit compensation, audit firm type and size and joint audit services (DeAngelo, 1981 & Krishnan, 2003). For instance, Brown, Falaschetti and Orlando (2006) state that auditor independence improve the quality of financial disclosures based on the evidence from the recent governance scandals around the world. They further lament that a widely held belief emerged that letting auditors consult for audit-clients compromises auditors’ independence and thus diminishes the quality of earnings reports. This is also supported by most of the regulations; for instance it forms part of the provision of Sarbanes-Oxley (SOX) Act of 2002, which restricted auditors from providing non-audit services to their clients (Brown et al, 2006). On the other hand, auditor’s independence with regard non-audit services which lead to non-audit fees can improve the quality of financial reporting (Arrunada, 1999). According to him, if informational inputs for producing the audit services intersect those for producing the non-audit services, then the jointly producing audit and non-audit services can improve financial reporting quality by facilitating scope economies. However, managers are using their capacity to threaten auditors with the loss of non-audit business; in this regard, jointly producing audit and non-audit services increases the pressures the managers can place on auditors to endorse compromised financial statements (Arrunada, 1999).

Nigeria like other countries of the world witnessed corporate scandals and failures, such as Oceanic Bank, Societe Generale Bank, Savannah Bank and Cadbury Plc, which are not pointed by the financial reports in spite of the auditor’s endorsement. That financial reports are true and fair, and conform to the relevant rules and regulations; and the actual transactions. Building material firms are critical to the economic development of any country; this sector is not being given adequate attention in terms of researches on financial reporting quality particularly in relation to auditors’ characteristics. Specially, building material firms are characterized with heavy machineries, large volume of transactions and large volume of accruals. These features are potentials for hiding accounting irregularities, misstatements and earnings management, which affect financial reporting quality adversely. Therefore, the need for quality financial reports in the recent times and the negative consequences of poor quality reporting prompted the study of financial reporting quality of building material firms in Nigeria.

 

1.2       Statement of the problem

In recent years, corporate accounting scandals coupled by an outcry for transparency and integrity in financial reporting have given rise to two logical outcomes. Internal audit skills are now critical in resolving the complicated accounting manipulations which have muddled financial statements. In addition, public outcry for change and regulatory action has modified the face of corporate governance. As a result, the bar of ethical and legal scrutiny has been raised for agents of companies working for the principals. These outcomes are jointly responsible for addressing investors’ anxieties about the financial reporting system. However, laxity still exists in implementing these internal audit findings and recommendations. (Kinyua et al., 2018).

Financial reports are supposed to provide relevant information to the external parties of an organization. It is thus important that financial reports provide truthful and accurate financial information to enable shareholders and other interested parties to make decision wisely. Lack of accuracy in financial reporting will lead shareholders and prospective investors to make wrong judgment about the organization. Incidentally, the heavy reliance placed on accounting numbers (as it measures the direction of business entity as well as decision base by different users of accounting information, Kothari, et al., 2000; and Bello, 2010) has provided an incentive for managers to manipulate earnings to their own advantage. This manipulation that is not supposed to go unchecked by auditors has often led to the eventual collapse of firms of various sizes and even called to questions the integrity of auditors and characteristics of audit firms.

Few of the studies such as Semiu and Kehinde (2014), Semiu and Johnson (2015) and Umar (2015) used data from emerging economies such as like Nigeria. Little is known about the relationship between internal audit and firms reporting quality in developing markets such as those in Nigeria particularly, using data on building materials firms. It is therefore pertinent to conduct a study that will fill this literature gap. Moreover, this study used four audit firm chrematistics variables to investigate their impacts on the financial reporting quality of manufacturing firms in Nigeria. Hence gap to be filled in the literature because most of the studies in this area focused on usually one aspect of internal audit firm characteristics.

 

1.3       Objectives of the study

The main objective of the study is to examine the impact of internal audit on financial reporting quality.

Specifically, the study sought to:

  1. Examine the impact of Internal Audit Standards on financial reporting quality.
  2. Examine the impact of Internal Audit Independence on financial reporting quality.
  3. Examine the impact of Professional Competence on financial reporting quality.
  4. Examine the impact of Top Management Support on financial reporting quality.

 

1.4       Research questions

  1. What is the impact of Internal Audit Standards on financial reporting quality?
  2. What is the impact of Internal Audit Independence on financial reporting quality?
  3. What is the impact of Professional Competence on financial reporting quality?
  4. What is the impact of Top Management Support on financial reporting quality?

 

1.5       Significance of the study

This study is significant in light of the recent search by regulators for measures that could protect and improve the financial reporting quality in the corporate world. It is also a response to the current call by the IAASB’s Framework for Audit Quality which, include raising awareness of the key elements of audit quality; encouraging key stakeholders to explore ways to improve audit quality; and facilitating greater dialogue between key stakeholders on the topic (IAASB, 2016). Moreover, the IAASB framework for audit quality attributed the primary responsibility for performing quality audits to auditors, and emphasized that audit quality is best achieved in an environment where there is support from other participants in the financial reporting supply chain. Hence, this study is an effort towards such direction.

The study is also significant as it focused on issues related to internal audit characteristics that are threatening the survival of audit firms of all sizes, on one hand and the going concern of corporate entities on the other hand. Therefore, the study is of importance in ensuring the credibility of financial information not only for the purpose of pointing the tendencies of corporate scandals, but most importantly the survival of their accounting and audit profession and the development of healthy financial and capital market. The study is therefore of immense value to auditors, regulators, managers, professional accounting bodies, existing and potential shareholders and researchers.

The findings from this study could assists auditors in their duties and responsibilities with regards financial reporting, as to the factors that are of eminent importance in achieving high audit quality and high financial reporting quality. The study will also offer important input to serve as a strong base for the regulators and professional accounting bodies to establish policies relating to type of audit firm characteristics, audit fees, non-audit services and joint audit. This is important because most of the issues in this area are based on anecdotal evidence, particularly in Nigerian context since evidence regarding these issues has been relatively limited. The study therefore hopes not only to help enrich the literature, but also provides important quantitative information for policy formulation.

The findings from the study could educate both existing and potential shareholders of building material firms in Nigeria on the audit firm characteristics that improve the quality of financial reporting (with respect to audit firm characteristics). The study is also of great importance to researchers, as it provides empirical evidence on the relationships between audit firm characteristics and the quality of financial reporting from listed building material firms in Nigeria.

 

1.6       Scope of the study

This study focuses on internal audit and the quality of financial reporting, within the context of listed manufacturing companies in Nigeria. The study covers the period of six years, from 2017-2019. Financial reporting quality is represented by earnings quality which is proxied by absolute discretionary accruals of the quoted manufacturing firms during the period covered by the study.

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