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MAJ
28,9 Internal audit function, board
quality and financial reporting
quality: evidence from Malaysia
780
Shireenjit K. Johl
Accounting, Economics and Finance, Deakin University, Burwood, Australia
Satirenjit Kaur Johl
School of Management and Humanities, University Teknologi PETRONAS,
Tronoh, Malaysia, and
Nava Subramaniam and Barry Cooper
School of Accounting, Economics and Finance, Deakin University, Burwood,
Australia
Abstract
Purpose – The purpose of this paper is to test the impact of the internal audit function (IAF), an
increasingly common internal governance mechanism, on a firm’s financial reporting quality. Specifically,
this paper investigates the association between the quality of the IAF and abnormal accruals (as a proxy for
financial reporting quality) and whether the board of directors play a role in moderating the relationship.
Design/methodology/approach – This paper uses a unique dataset of survey responses and
archival data. Regression analysis was used to test their hypotheses.
Findings – Although their initial findings show an unexpected positive relationship between internal
audit quality and abnormal accruals, this relationship is contingent on whether firms outsource their
internal audit activities and/or whether they are politically linked. In estimations excluding
outsourcing and political connections observations, this paper shows that the association between
internal audit quality and abnormal accruals is negative and in particular internal audit organisational
independence, financial focus audit activities and investment are associated with lower
income-increasing (opportunistic) abnormal accruals. Next, when this paper interact board quality
with internal audit quality, this paper finds although the lower ordered variables board quality and
internal audit quality coefficients are negatively related to abnormal accruals, the interaction variable
between these two variables is positively associated with abnormal accruals, indicating the possibility
of a substitution relationship between board quality and internal audit quality.
Research limitations/implications – Their findings show that certain internal audit attributes
play an important role in the financial reporting process and thus these findings are expected to inform
the Institute of Internal Auditors and other regulatory bodies on the role of internal audit (being an
important internal governance mechanism) in financial reporting, which in turn can assist in
market/regulatory reforms/changes and inform the revised Malaysian Code of Corporate Governance.
Originality/value – This paper extends prior internal auditing literature by examining the
relationship between internal audit quality and financial reporting quality in the context of a developing
country, namely Malaysia, and whether the board of directors moderate the examined association.
Keywords Corporate governance, Board quality, Earnings management, Financial reporting quality,
Internal audit function, Internal audit quality
Paper type Research paper
Managerial Auditing Journal
Vol. 28 No. 9, 2013
pp. 780-814 JEL classification – M42, M41, G34
q Emerald Group Publishing Limited
0268-6902
The authors gratefully acknowledge the financial support from the Institute of Internal
DOI 10.1108/MAJ-06-2013-0886 Auditors Malaysia and the Institute of Chartered Accountants Australia.
Introduction IAF board quality
While empirical evidence to date predominantly suggests that the quality of external and financial
financial reporting is related to corporate governance mechanisms such as board
structure, including board independence, financial expertise and audit committee reporting quality
effectiveness (Beasley, 1996; Klein, 2002; Abbott et al., 2004; Krishnan, 2005; Vafeas,
2005; Farber, 2005), there has been little attention paid to another well-regarded
internal monitoring mechanism – the internal audit function (IAF). In recent years, the 781
IAF has received significant attention from policy makers where many governance
regulatory guidelines and stock exchange listing requirements specifically advocate
the establishment of an IAF[1]. For example, some of the IAF reforms undertaken in
the USA include:
.
Section 404 on disclosure of material weakness of the Sarbanes-Oxley Act 2002
(US Congress, 2002) expanded IAF activities.
.
The New York Exchange now requires all listed firms to maintain an IAF
(NYSE, 2009).
.
Auditing Standard 5 (PCAOB, 2007) allows external auditors to extend their
reliance on the work of the internal auditor.

Recently, with the recommendation of the Public Company Accounting Oversight

Body (PCAOB) in the USA, large and complex firms which do not have an effective
IAF should be regarded as having a significant deficiency in their internal controls
(and this may be regarded as a significant weakness). Nevertheless, there is growing
criticism arguing that the mere presence of an IAF alone is inadequate and that it is the
quality of the IAF that is more critical for achieving the desired outcomes (Abbott et al.,
2012; Carcello et al., 2011)[2]. Against this background, we document and provide
empirical evidence on the role of the IAF in an emerging economy, being an important
internal governance mechanism, which in the past has largely been ignored in the
assessment of the quality of a firm’s external financial reporting process.
To date, empirical studies examining the role of internal audit in external financial
reporting (and specifically on financial reporting quality – earnings management)
remains scant and is largely limited to the USA. Gramling et al. (2004), based on a
review of prior survey and experimental studies, contend that the IAF has the potential
to affect corporate governance quality, financial reporting quality and firm
performance. However, in terms of assessing the link between IAF quality and
financial reporting quality, there is little research, with the exception of Prawitt et al.
(2009) and Davidson et al. (2005). Prawitt et al.’s study utilises 218 publicly listed US
firms from the years 2000 to 2005 and finds that the IAF quality constrains earnings
management. However, Prawitt’s study is limited in at least two ways. First, the
measure of the IAF quality does not take into consideration certain aspects of the
internal audit environment and in particular those relating to internal audit activities
(e.g. fieldwork quality assurance, grading, follow-up and coordination). Second, the
evidence is limited to the USA and does not consider conditions in developing countries
where the quality of corporate governance variables may be limited, given the poorer
regulatory monitoring and sanctions on firm behaviour and the existence of political
rent-seeking behaviour. More specifically, our paper extends this line of research in the
following ways.
MAJ First, we aim to improve on Prawitt et al.’s (2009) conceptualisation of IAF quality
28,9 and draw upon measures used in studies such as Lin et al. (2011), where additional
measures relating to the internal audit environment are drawn from professional
guidance. We also extend the Prawitt et al.’s (2009) and Lin et al. (2011) papers, by
examining whether other corporate mechanisms such as board quality[3] moderate the
relationship between the IAF and financial reporting quality. Although Prawitt et al.
782 (2009) include proxies for corporate governance mechanism as control variables in
their estimation model, they did not test the moderation effects of these mechanisms.
As noted by Prawitt et al., these two variables (governance index and AC effectiveness)
were not statistically significant and thus they conclude that internal audit quality
plays a more significant role in moderating earnings management than the other
aspects of corporate governance. On one hand, it is possible that the favourable effects
of internal audit on enhancing financial reporting quality may be contingent on the
strength of other governance mechanisms such as the quality of the board of directors.
For instance, if firms already have other strong internal (or external) governance
mechanisms such as strong boards, then having equally strong internal audit may
probably not be so valuable. However, if firms lack strong boards, then having strong
IAF should be particularly valuable. On the other hand, it is equally possible that
strong boards may also demand a strong IAF. Therefore, we also examine how the
effect of the IAF on financial reporting quality can change if firms have strong boards.
Second, given the evidence so far on the link between IAF quality and financial
reporting has focused on US firm data where corporate governance quality is generally
much higher, we extend the investigation in this area using firm data from a
developing country context. We choose Malaysian firms for the following reasons.
In the first instance, while Malaysia is significantly different from the USA in terms of
economic development and capital market maturity, internal audit in recent times has
attracted the attention of Malaysian regulators and policy makers. In Malaysia, the
1997-1998 Asian Financial Crisis was the major impetus for the significant attention
given to the IAF[4]. The Malaysian Code of Corporate Governance (MCCG) in March
2000 (The High Level Finance Committee on Corporate Governance, 2000) required
firm boards to maintain a sound system of internal controls and recommends the
establishment of an IAF. In situations where no IAF exists, boards are required to
explain the manner in which sufficient and regular assurance/review is undertaken on
the internal controls of the firms[5]. Further, in 2001, the Malaysian Securities
Commission appointed the Institute of Internal Auditors Malaysia (IIAM, 2002) to
establish an industry task force to formulate guidelines on establishing an IAF. The
MCCG was revised in 2007 and 2012 in light of the rising trend in corporate
irregularities (post-Asian crisis) such as Transmile Group Bhd[6], Takaful Bhd,
Southern Bank Bhd[7], Megan Media Holdings[8] and NasionCom Holdings. The
revised MCCG and Bursa Malaysia listing requirements focused on a number of
internal audit reforms and in particular:
(1) mandating the IAF for all listed entities;
(2) identifying the head of internal audit;
(3) requiring the head of internal audit to report directly to the audit committee and
be responsible for regular review of risk management, internal control and
governance processes within the firm;
 (4) requiring audit committees to review the adequacy of and competence of the IAF; IAF board quality
(5) ensuring the board solicits formal feedback on the adequacy of risk management and financial
and internal control from the head of the IAF at least once annually; and
reporting quality
(6) mandating disclosure on information pertaining to the IAF in the annual
reports of listed entities[9].
These developments clearly signify the substantial interest and confidence placed on 783
the IAF in Malaysia to monitor and enhance financial reporting quality.
We conduct our analysis using a unique set data of 128 observations (64 firms)
listed on the Bursa Malaysia, which was obtained through a questionnaire survey of
chief audit executives (or equivalent) for 2009 and 2010. Our initial estimations show
results contrary to our prediction, in that internal audit quality is positively related to
abnormal accruals, indicating lower financial reporting quality. Further examination,
through the removal of outsource and political connected observations, we find a
negative association between internal audit quality and abnormal accruals.
More specifically, when we examine the different dimensions of IAF quality, we find
internal audit investment is negatively associated with abnormal accruals, consistent
with the notion that a well-funded IAF has greater ability to monitor firm activities and
thus is able to constrain bias or opportunistic behaviour. This finding is consistent in
all estimations. Contrary to our expectations, organisational independence and
experience is positive but weakly related to abnormal accruals. Once again, when we
remove both outsource and politically connected observations in our further analyses,
we find internal audit organisational independence, audit activities with greater
financial focus and investment have a constraining effect on abnormal accruals, and
this is particularly more evident for income-increasing abnormal accruals. Collectively,
our results suggest that:
.
certain aspects of IAF is negatively associated with earnings management and in
particular internal audit organisational independence, financial focus audit
activities and investment, associated with lower income-increasing
(opportunistic) abnormal accruals; and
.
the outcomes of an IAF are dependent on the nature of the IAF
(in-house/outsource) and the institutional feature, namely political connections.

Our second hypothesis investigates whether board quality affects the relationship
between internal audit quality and abnormal accruals. We find that although the lower
ordered variables of board quality and internal audit quality coefficients are negatively
related to abnormal accruals, the interaction variable between these two variables is
positively associated with abnormal accruals, indicating a substitution relationship
exists between board quality and internal audit quality. These results suggest the
possibility that internal audit quality and board quality can be substituted for one
another to maintain the level of financial reporting quality.
The remainder of the paper is as follows. First we provide a literature review on the
role of internal audit in internal monitoring and its potential impact on financial
reporting quality (earnings quality). Next, we develop two hypotheses for the study
and present the research method and the results of the data analysis. Finally, we derive
the conclusions of the study and discuss the limitations and opportunities for future
research.
MAJ Literature review
28,9 Earnings quality is assumed as being fundamental to capital markets, as such
information will determine efficient resource allocation. Individual investors,
employees, other companies and the economy in general, face losses when the
underlying performance of a firm is not reflected in the reported earnings (Pergola and
Verreault, 2009). According to Schipper and Vincent (2003), users of financial reports
784 are interested in earnings quality, because such information affects decision-making,
particularly that related to contracting and investments. No doubt, poor and low
quality earnings information are likely to lead to unintended wealth transfers[10]. One
of the most significant roles played by a firm’s corporate governance system is to
ensure the quality of financial reporting or earnings quality (Cohen et al., 2004).
However, prior research has consistently revealed significant associations between
various corporate governance mechanisms and poor financial reporting quality, such
as earnings management/manipulation, financial statement fraud and deficiencies in
internal controls (Dechow and Skinner, 2000; Beasley, 1996; Beasley et al., 2000;
Carcello and Neal, 2000; Krishnan, 2001; Klein, 2002). Corporate governance is overseen
by at least four major stakeholders, namely the governing board (including the audit
committee as a sub-committee), external auditors, management and internal audit.
While substantial research has been undertaken on the quality of the board/audit
committee, external auditors and management’s impact on financial reporting quality,
the role of internal auditors in this regard remains an empirical issue.
Under the most recent definition, the IIA (2010) describes the IAF as “[. . .] an
independent, objective assurance and consulting activity designed to add value and
improve an organization’s operations.” Given that the IAF plays an important role in
implementing effective governance and controls, it is inevitable that it has a crucial
influence in ensuring the credibility of external financial reporting. The role of internal
audit has evolved over time, from a role that was traditionally assurance-related, to a
function that is more value-added in nature (Bou-Raad, 2000; Krogstad et al., 1999).
From an external audit perspective and in particular International Standard on
Auditing 610 (revised 2013 – using the work of internal auditors), external auditors
can use the work of internal auditors only if certain conditions are met. The use of
internal audit work may have implications on the nature or timing, or the extent, of
audit procedures to be performed directly by the external auditor. Bame-Aldred et al.
(2013) in their synthesis on external auditor reliance on the IAF, state that there is lack
of research concerning the effects of external auditor’s reliance on IAF in terms of
external auditor quality.
Nevertheless, to date only two studies have examined the association between
internal audit and earnings management and the results from these two studies are
inconsistent. The first by Davidson et al. (2005), using a sample of Australian firms, did
not find evidence that the presence of an IAF is related to lower earnings management.
The second study by Prawitt et al. (2009), specifically considered a number of quality
dimensions of the IAF and using data from US firms, revealed that IAF quality is
negatively associated with abnormal accruals (a proxy for earnings
management/quality). They also found that firms that just miss analysts’
expectations have a significantly higher IAF quality. Using a different methodology,
Gras-Gil et al. (2012) in the context of Spanish banks find that banks with high quality
financial reporting have better cooperation between internal and external auditors in
the annual audit. Specifically they find that greater participation of internal audit in the IAF board quality
review of financial reporting process leads to improved quality financial reporting. and financial
Malaysian background
reporting quality
Within the Malaysian context, most of the studies on the IAF relate to survey (and
semi-structured interviews) type of research (Mathews et al., 1994; Cooper et al., 1996;
Ali et al., 2004; Ernst & Young, 2004; Fadzil et al., 2005; Cooper et al., 2006). Cooper et al. 785
(1996) undertook a comparative benchmarking internal audit study in Australia,
Malaysia and Hong Kong. They found CEOs in Malaysia were generally more positive
in their perceptions of internal audit being an independent reviewer of the effectiveness
and efficiency of firm’s operations. Ali et al. (2004) examined the position of internal
audit (in terms of existence, staffing, competencies and top management support) in the
state and local government agencies. They found only a few of the local government
agencies have an IAF. More importantly, they found that the IAF in many of the state
and local government agencies were under-staffed, lacked appropriate audit
competencies and did not receive adequate support from top management. Fadzil et al.
(2005) examined whether the IAF of listed firms complied with International Standards
for the Professional Practice of Internal Auditing and whether compliance with the
standards is associated with a better internal control system. In summary, they found
that internal audit quality (in terms of management of internal audit department,
professional proficiency and objectivity) affects the monitoring aspect of the internal
control system. It is important to note that their study is based on perceptions of the
firms’ Chief Audit Executive (CAE)/Head of Internal Audit Department and Audit
Committee, which does not necessarily imply firm practice.
Zulkifflee et al. (2012) examined two aspects of internal audit quality, namely
internal audit competency and internal audit contribution to financial statement audits
and their relationship to audit fees. They find the tenure of the existence of internal
audit in the organization, training, internal audit staff prior experience in auditing and
accounting and certifications, are associated with lower audit fees and thus provides
support for the substitution view for explaining the links between internal audit
quality and audit fees. None of the above studies examine the IAF from an earnings
quality perspective. Thus, this study bridges the gap in the internal audit literature in
developing countries and in this case, Malaysia.

Hypotheses development
IAF quality involves a collection of attributes such as internal auditors’ competence,
educational level and certification, their hiring, reporting and termination
relationships, as well as the quality of their work performance (e.g. adequacy of
audit programs and scope of work performance). Prior studies have investigated the
link between IAF quality dimensions and whether and how external auditors
incorporate the IAF quality characteristics in assessing their overall competence,
objectivity and quality of work performance. Several studies have also investigated the
relationship between the IAF and related corporate governance mechanisms, such as
the audit committee and executive management.
Prior internal audit literature provides very little empirical evidence (with the
exception of Prawitt et al. (2009) and Davidson et al. (2005)) about the association
between the IAF and earnings quality (earnings management). Schneider and Wilner
MAJ (1990), in an experimental setting, found that internal auditing has a constraining effect
28,9 on financial reporting irregularities. They also found that the constraining effects of
internal auditors were quite similar to external auditors. Asare et al. (2003) showed that
internal auditors are sensitive to management’s incentive to misreport financial
information and will increase budgeted hours worked when management incentives to
misreport is high. Also, they found that internal auditors are sensitive to differences in
786 audit committee quality and are reflected in their fraud risk assessments and audit
plans (budgeted audit hours). In a related vein, Lin et al. (2011) showed that the nature
and scope of IAF activities are more strongly associated with material weaknesses
disclosures than the IAF attributes of competence, objectivity and investment.
Specifically using a set of US data from 214 firms, they found amongst the IAF
attribute measures that only the education level of the IAF is significantly associated
with material weakness disclosures. In relation to IAF activities, they find the activities
relating to the extent to which the IAF uses quality assurance techniques in fieldwork,
audit activities related to financial reporting, and follow-up on previously identified
control problems, has a negative association with material weakness disclosure.
As discussed earlier, apart from internal auditors, other internal governance
mechanisms, in particular the board of directors, play an important role in ensuring the
quality of financial reporting. Prior studies have shown certain attributes (such as
composition, independence, knowledge and expertise, and effectiveness) of the board
can have an influence on the quality of financial reporting (e.g. earnings quality,
earnings manipulation and fraud) (Beasley, 1996; Klein, 2002; Abbott et al., 2004;
Krishnan, 2005; Vafeas, 2005; Farber, 2005). Beasley (1996) found boards of firms with
no fraud have a significantly higher proportion of outside directors compared to firms
where fraud has been committed. Klein (2002) examined whether audit committee and
board attributes are associated with abnormal accruals (a measure of earnings quality).
He found a significant negative association between the board and audit committee
independence and abnormal accruals. Krishnan (2005) found firms with independent
audit committees and audit committees with financial expertise are less likely to be
related to incidence of internal control problems. Likewise, Farber (2005) found that
firms experiencing fraud have poor governance in the year prior to fraud detection. His
results specifically show that fraud firms have fewer financial experts on the audit
committee, a smaller percentage of Big 4 auditing firms and a higher proportion of
CEOs/chairperson dual positions. Farber also investigated whether improved
governance influences market participants and results show that firms taking
measures to improve governance have better stock performance. In summary, the
results from these studies show that good governance attributes does affect financial
reporting quality and investors seem to value firms that take actions to improve their
governance mechanisms.
Following the above discussion on the role of internal auditors and other
governance mechanisms and in particular the board of directors on financial reporting
quality, the hypotheses for this study are as follows:
H1. There is a significant positive relationship between the IAF quality and
financial reporting quality (measured by abnormal accruals).
H2. The significant positive relationship between IAF and financial reporting
 quality is moderated by other internal corporate mechanism, namely the IAF board quality
quality of the board. and financial
Methodology and model specification reporting quality
Data and sample
In addressing the hypotheses in this study, we obtain data from multiple sources. First,
data on a firm’s internal audit environment, attributes, characteristics and activities 787
comes from an online and an e-mailed questionnaire survey, which was sent to a
population of 620 firms listed on the Main Market of Bursa Malaysia[11]. Where the
names of the chief internal auditor and the financial controller[12] were identified
through public records and/or telephone interview, the questionnaires were addressed
accordingly. Alternatively, the questionnaire was addressed to the financial controller
of the firm. Three follow-up reminders were sent every three weeks after the initial and
the subsequent follow-up mailing. The questionnaire design involved four sections: the
participants’ and organisation details; overall IAF; in-house IAF; and outsourced
internal audit services. Information was requested for the years 2010 and 2009. The
questionnaire was pretested on two academics, one chief internal auditor from an
organisation, one internal audit consultant and two IIA technical consultants. Next,
data pertaining to the estimation of abnormal accruals and control variables was
obtained from Datastream for all firms for financial years 2009 and 2010. Finally,
corporate governance related data (board, audit committee and auditor attributes) was
hand collected from the respective annual reports.
Our initial sample was drawn from a population of 844 publicly listed firms as
recorded in the Main Market of Bursa Malaysia as at 31 December 2010. From this
initial sample, 224 firms were deleted because the head office was located outside of
Malaysia, are subsidiaries of a listed parent firm, contact details were not obtainable, or
were requested to be excluded from the survey. The final sample frame comprised of
620 firms. A total of 108 responded to our survey[13], yielding a response rate of 17.4
per cent. Next, we deleted 44 firms which had missing necessary internal audit
components data, were in the finance industry and/or had negative equity or missing
abnormal data. The survey data was subsequently merged with the abnormal accruals,
corporate governance and financial data. Our final sample consists of 128 observations
(64 firms). Table I shows a breakdown of how we arrived at our final sample.
Responses from the survey were used to develop an index on internal audit quality
(IAQ). In testing our hypotheses, we utilise two regression models as shown below. The
model regresses financial reporting quality, proxied by abnormal accruals on IAQ (and
attributes), and other firm specific control variables that could affect abnormal
accruals:
FRQ ¼ IAQ þ BODQ þ POL þ BUMICEO þ OUTSOURCE þ LEV þ SGROWTH
þ INV þ CFO þ LASSET þ BIG4 þ LAGE þ YEAR þ e
ð1Þ
FRQ ¼ IAQ * BODQ þ POL þ BUMICEO þ OUTSOURCE þ LEV þ SGROWTH
þ INV þ CFO þ LASSET þ BIG4 þ LAGE þ YEAR þ e
ð2Þ
The variables used in the above models are defined in Table II.
MAJ
Panel A: survey sample description and response breakdown
28,9 Count Percent
Sample frame respondents 108 17.4
Non-usable respondents 1 0.01
Non-respondents 512 82.6
Total sample size 620 100.0
788 Usable responses 107 100
Firms in financial sector 19 17.75
Firms with negative equity 7 6.54
Firms with missing necessary internal audit quality/components information 17 15.88
Final responses used to merge with dependent and control data 64 59.81
Total firm observation (years 2009 and 2010) 128 100
Panel B: abnormal accruals data description
Firm-year observations in Datastream database (2009 and 2010) 1,872
Less observations with negative equity (9)
Less observations from financial sector (270)
Less observations with missing data items for model estimation (111)
Firm-year observations used for abnormal accruals estimation – m-Jones model 1,482
Less observations with missing return on assets for Kothari m-Jones model (18)
Table I. Firm-year observations used for abnormal accruals estimation – Kothari m-Jones 1,464
Sample derivation model

The dependent variable, FRQ, is financial reporting quality. We use abnormal accruals
(AA) as a proxy for financial reporting quality and is obtained using the cross-sectional
m-Jones model[14]. Abnormal accruals are the regression residual, which is estimated
by year and industry (GICS code) for all listed firms (Bursa Malaysia) in Datastream
from 2009 and 2010. Similar to prior studies, we excluded all financial institutions
because the empirical models utilised in this study are based on non-financial firms
and typically the financial reporting requirements and disclosures of these firms are
substantially different from firms in other industries. A minimum of ten firm year
observations per industry year is required to estimate the abnormal accrual measure.
In addition to the absolute value of the abnormal accruals, we also estimate the main
model using the signed, income-increasing and income-decreasing accruals.
The variable internal audit quality (IAQ) is our test variable, which is a composite
measure of five broad internal audit characteristics/constructs, being internal audit
experience, internal audit organisational independence, internal audit quality control
assurance, internal audit financial focus activities and internal audit investment.
In developing these constructs, we referred to measures and the approach outlined in
prior studies (Prawitt et al., 2009; Lin et al., 2011) and professional guidance (ISA 610
(revised) using the work of internal audit; International Standards for the Professional
Practice of Internal Auditing).
Our broad IAF attributes construct is made up of organisational independence,
competence and investment. Our organisational independence (IAFORGIND) differs
from prior studies in that the dimension is measured using five variables, CAE
functional reporting (CAEREPORT), CAE appointment and termination approval
(CAEAPTERM), internal audit budget approval (IABUDGET), CAE remuneration
approval (CAEREM) and CAE performance evaluation (CAEVALUATE). For each of
these variables, a score of 1 is given, respectively, if the CAE reports functionally to the
 IAF board quality
Variable Definition and measurement
and financial
Dependent variable
FRQ (jAAj) ¼ Financial reporting quality, measured using absolute value of abnormal accruals,
reporting quality
and is measured using Kothari et al. (2005) version of the modified Jones model
controlling for current year’s firm performance (ROA)
Test variables 789
IAQ ¼ Internal audit quality, a composite score measuring the quality of IAF ranging
between 0 and 5 with 0 indicating lowest quality and 5 highest quality. The score is
formed by aggregating the composite scores obtained from fiver broad constructs,
IAFORGIND, EXP, FINFOCUS, IAINVEST, IAFQC. A value of 1 is given for
each of the five constructs if the variables value is above median and 0 otherwise
IAFORGIND ¼ Internal audit function organisation independence is a composite score of five
variables; CAEREPORT; CAEAPTERM; IABUDGET; CAEREM; and
CAEVALUATE
CAEREPORT ¼ CAE functional reporting, a dummy variable indicating whether the CAE
functionally reports to the audit committee. A value of 1 is given if the CAE reports
to the audit committee, and 0 if the CAE reports to a lower-level entity within the
organisation
CAEAPTERM ¼ CAE appointment and termination, a dummy variable indicating whether the
appointment and termination of the CAE is approved by the audit committee. A
value of 1 is given if the CAE’s appointment and termination is approved by the
audit committee, and 0 if the approval is undertaken by lower-level entity within
the organisation
IABUDGET ¼ Internal audit budget, a dummy variable indicating whether the audit committee
approves the IAF annual budget. A value of 1 is given if the internal audit annual
budget is approved by the audit committee, and 0 if the approval is undertaken by
lower-level entity within the organisation
CAEREM ¼ CAE remuneration, a dummy variable indicating whether the remuneration and
bonus of the CAE is determined and approved by the audit committee. A value of 1 is
given if the CAE’s remuneration is determined and approved by the audit committee,
and 0 if the approval is undertaken by lower-level entity within the organisation
CAEVALUATE ¼ CAE performance evaluation, a dummy variable indicating whether the
performance of the CAE is evaluated by the audit committee. A value of 1 is given
if the CAE’s performance evaluation is undertaken by the audit committee, and 0 if
the evaluation is undertaken by lower-level entity within the organisation
EXP ¼ Experience, is the age of the firm’s IAF and is number of years since the year of
IAF establishment. A value of 1 is given if the variables value is above median and
0 otherwise
IAINVEST ¼ Internal audit investment, total IAF operating costs divided by the firm’s total
assets. A value of 1 is given if the variables value is above median and 0 otherwise
FINFOCUS ¼ Financial focus, measures the extent the internal audit activities relate to financial
reporting. The variable is measured by taking the proportion of time spent on
adequacy of internal controls; accuracy, reliability and completeness of financial
records (relating to published financial statements and internal monthly records),
impact of changes in accounting rules or regulations including IFRS compliance;
and assisting external auditors in financial statement audit. A value of 1 is given if
the variables value is above median and 0 otherwise
IAFQC ¼ Internal audit quality control assurance, is a composite score measuring the
internal audit quality control assurance level and ranges between 0 and 3 with 0
indicating lowest quality and 3 highest quality. The IAFQC score consist of three
variables, QCPROG; INTASSESS; and EXTASSESS, for which each of the
measures are aggregated. A value of 1 is given if the variables value is above Table II.
median and 0 otherwise Definition and
(continued) measurement of variables
MAJ Variable Definition and measurement
28,9 QCPROG ¼ Existence of an ongoing formal quality control assurance and improvement
program, a dummy variable, takes a value of 1 if the firm’s IAF has a formal
quality assurance and improvement program and 0 otherwise
INTASSESS ¼ Internal quality assessment, an average of two survey items that measure the extent
of ongoing monitoring (day-to-day supervision/review) and period reviews of the
790 performance of the internal audit activity. A value of 0 is given if no such assessments
are carried out and 4 if such assessments are carried out always (all the time)
EXTASSESS ¼ External quality assessment, an average of three survey items that measure the
level of external quality assessment. A value of 1 is given for each of the three
items (is there an external quality assessment; a full external quality assessment
was carried out and the last quality assessment was carried out not more than
three years ago); 0 otherwise
BODQ ¼ Board of directors’ quality, a composite measure of the firm’s board effectiveness and
ranges between 0 and 4 with 0 indicating lowest effectiveness and 4 highest
effectiveness. The BODQ score consist of four variables, BODIND; BODSIZE;
BODEXPERT; and BODMEET, for which each of the measures are aggregated
BODIND ¼ Board independence, a value of 1 is given if all board members are independent
non-executive directors, 0 otherwise
BODEXPERT ¼ Board financial expertise, a value of 1 is given if at least one of the board members
is a financial expert. Or alternatively a value of 1 is given if the proportion of
members with financial expertise is above median and 0 otherwise
BODSIZE ¼ Board size, a value of 1 is given if the number of members in the board is greater
than the median value, 0 otherwise
BODMEET ¼ Board meeting, a value of 1 is given if the number of board meetings is greater
than the median value, 0 otherwise
IAQ*BODQ ¼ Interaction term between IAQ and BODQ
Control variables
OUTSOURCE ¼ Outsourced IAF, dummy variable takes a value of 1 if the firm fully outsourced
their IAF to a third party, 0 otherwise
POL ¼ Politically connected firm, dummy variable takes a value of 1 if the firm is
politically connected to Barisan National, ruling party, 0 otherwisea
BUMICEO ¼ Bumiputera CEO, dummy variable takes a value of 1 if the firm’s CEO is a
Bumiputra, and 0 otherwise
BIG4 ¼ Big 4 audit firm dummy, equalling one if the firm hires a Big 4 auditor, zero otherwise
LASSET ¼ Natural logarithm of total assets
INV ¼ Total inventories over total assets
LEV ¼ Financial leverage, measured as total liabilities divided by total assets
CFO ¼ Cash flow from operations scaled by total assets
LAGE ¼ Firm age, natural log of the number of years since year of incorporation
SGROWTH ¼ Sales growth, annual sales growth (current year sales – prior year’s sales)/prior
year’s sales

Notes: aOur variable political connection (POL) is obtained from Gul (2006) and Mitchell and Joseph
(2010) papers; both these papers used Johnson and Mitton (2003) classification of politically connected
firms which was done by search of the entire text by Gomez and Jomo (1997), who provide a detailed
analysis of Malaysian corporations and their political connections prior to the Asian financial crisis;
Table II. Mitchell and Joseph (2010) updated the initial list provided by Johnson and Mitton (2003)

audit committee; CAE’s appointment and termination is approved by the audit

committee; internal audit budget is approved by the audit committee; CAE’s
remuneration is approved by the audit committee; and if the CAE evaluation is
approved by the audit committee. Otherwise a 0 is used as the score. In order to
maximize the use of our responses, the competence variable varies from Prawitt et al. IAF board quality
(2009) and Lin et al. (2011), in that we only used the experience (EXP) and it is measured and financial
by taking the number of years since the year of IAF establishment. The variable
Investment (IAINVEST) measures the investment put in by the entity in its IAF. It is reporting quality
acknowledged that the larger the internal audit investment cost relative to the size of
the entity, the greater the ability of the IAF to monitor the firm’s activities and thus
have greater capacity to detect and deter possible mismanagement, misstatement, and 791
fraud and management opportunism. IAINVEST is measured using the total cost
spent of internal audit activities over the firm’s total assets.
Moving to the nature and scope of internal audit activities, our fourth and fifth
internal audit component are the extent that internal audit activities relate to financial
reporting processes (FINFOCUS) and IAF quality control (IAFQC). Although in
Malaysia listed firms are required to have an IAF, it is to a large extent still at an early
stage and thus the extent, focus and relevance (to the external auditor) of internal audit
activities carried out, varies across firms. As outlined in ISA 610, in deciding the areas
and extent to which reliance can be placed on the work of the internal auditor, the
external auditor is required to consider the nature, scope and relevance of the work that
has been undertaken by the internal auditor. Thus, FINFOCUS is the proportion of
internal audit work spent on areas/activities relating to financial reporting.
ISA 610 also requires the external auditor, in assessing the work of the internal
auditor, to consider and evaluate the extent IAF applies quality control. Thus, the fifth
construct is IAF quality control (IAFQC) and consists of three variables, namely,
existence of a quality assurance program (QCPROG), internal assessment
(INTASSESS) and external assessment (EXTASSESS). IAFQC is a dummy variable,
which takes a value of 1 if there is an ongoing formal quality assurance and
improvement program and 0 otherwise. INTASSESS is measured as an average of two
items, being use of internal ongoing monitoring and periodic reviews. Each of these
items is categorical and ranges between 1 (none at all) and 5 (always). The variable
EXTASSESS consists of three items, which are use of an external quality assessment,
nature of the external assessment and whether the assessment was carried out in the
last three years. A value of 1 is given to each of the items – 1 if an external quality
assessment exists or 0 if otherwise; 1 if the assessment was a full external quality
assessment and 0 otherwise; and 1 if the assessment was carried out in the last three
years, or 0 otherwise. We construct a composite score on the internal audit function
quality control (IAFQC) in that each of the three variables (and items) (QCPROG,
INTASSESS and EXTASSESS) are dichotomised by giving a value of 1 if it is above
the sample’s median, and 0 otherwise (i.e. if it is below the sample’s median). Next we
take the sum of scores given to create the individual component quality score which is
then aggregated to obtain the IAFQC score.
Each of the five components is dichotomised by giving a value of 1 if it is above the
sample’s median and 0 otherwise (i.e. if it is below the sample’s median). Finally, to
obtain the overall internal audit function quality (IAQ) score, the scores for each of the
five components (IAFORGIND, EXP, IAINVEST, FINFOCUS, IAFQC) are summed up.
The values range from 0 to 5.
Our second test variable is board of directors’ quality (BODQ), which is argued to
moderate the relationship between internal audit quality and financial reporting quality.
This variable is a composite score of four variables relating to board independence
MAJ (proportion of board members who are independent), financial expertise (proportion of
28,9 members who are accounting experts), size (number of board members) and meetings
(number of board meetings). For each of the variables, a value of 1 is given if it is above
the sample’s median, and 0 otherwise (i.e. if it is below the sample’s median). Next we
aggregate these scores to obtain the BODQ score. A similar approach was taken by prior
studies such as Prawitt et al., 2009). Figure 1 shows our hypothesised associations
792 between IAF, audit committee and financial reporting quality.
Similar to prior studies, we control for a number of firm-specific factors which has
been argued and shown to affect financial reporting quality. The control variables used
in the model are:
.
total assets (LASSET) controls for firm size;
. inventory (INV) which captures internal control risk associated with inventory
and product obsolescence;
.
leverage (LEV) controls for debt effects;
.
cash flows from operations (CFO) and sales growth (SGROWTH) controls for
firm growth;

Board Quality
Independence
Size
Expertise
Meetings

Internal Audit Function Quality

IAF Attributes

Organisational Independence
- CAE reporting
- Appointment / Termination CAE
- Approving Annual budget
- Approving CAE Remuneration H2
- CAE Performance Evaluation

Competence
- Experience Financial Reporting Quality

Investment/Resources Abnormal Accruals

- IA cost
H1
IAF Activities
Financial Focus

IAF Quality Control

Quality Assurance Program
Figure 1. Internal Assessment
The relationship between External Assessment
IAF, board of directors
and financial reporting
quality
 .
big 4 auditor (BIG4); IAF board quality
. firm age (LAGE); and and financial
.
outsource (OUTSOURCE) controls for firms that fully outsource their IAF reporting quality
function to a third party.

In addition, we also control for firms with political connections (POL) and CEOs who
are Bumiputras[15] (BUMICEO), being two other variables which are unique to the 793
Malaysian environment and are expected to affect financial reporting quality. Prior
studies (Ball et al., 2003; Bushman et al., 2004; Gul, 2006), show that firms that are
politically connected are negatively associated with good corporate governance
practice, signalling the higher agency costs inherent in such firms. Similarly prior
studies in the context of Malaysia argue that Bumiputra CEOs tend to have higher
levels of reputational risk for poor business management and tend to be more open to
cronyism and rent-seeking behaviours (Johl et al., 2012). Collectively these two
variables have implications for the financial reporting process.

Findings
Descriptive statistics
Table III presents the descriptive statistics for our 128 observations. The average
experience in terms of number of years the sample firms have undertaken internal audit is
12 years and ranges between two and 32 years. Some 36 per cent of our sample firms have

Variable Mean Median SD Min. Max.

jAAj 0.05 0.03 0.04 0.00 0.22

AA 0.01 0.01 0.06 2 0.14 0.22
IAQ 2.59 3.00 1.31 0.00 5.00
EXP 0.55 1.00 0.50 0.00 1.00
IAFQC 0.36 0.00 0.48 0.00 1.00
IAFORGIND 0.39 0.00 0.49 0.00 1.00
FINFOCUS 0.43 0.00 0.50 0.00 1.00
IAFINVEST 0.50 0.50 0.50 0.00 1.00
IAFCOST (RM) 946,291 221,500 3,490,000 6,000 28,700,000
POL 0.17 0.00 0.38 0.00 1.00
BUMICEO 0.22 0.00 0.42 0.00 1.00
OUTSOURCE 0.24 0.00 0.43 0.00 1.00
BODQ 1.89 2.00 0.87 0.00 4.00
LEV 0.20 0.20 0.16 0.00 0.71
SGROWTH 0.04 2 0.01 0.29 2 0.88 1.68
INV 0.10 0.08 0.10 0.00 0.46
CFO 0.07 0.07 0.10 2 0.76 0.24
LASSET 20.33 20.24 1.54 17.90 24.33
TASSET (RM’000) 2,520,000 617,000 5,720,000 59,200 37,000,000
BIG4 0.74 1.00 0.44 0.00 1.00
LAGE 3.18 3.33 0.71 0.69 4.62
AGE (in years) 29.63 28.00 18.00 2.00 101.00
Notes: n ¼ 128; IAFCOST is the amount spent by the firm on their IAF; TASSET is dollar value of Table III.
total assets; AGE is the number of years since incorporation; all other variables are defined in Table II Descriptive statistics
MAJ an internal audit quality assurance program, whilst 43 per cent of the sample firms have a
28,9 financial focus in their internal audit activities. In terms of internal audit organisational
independence, 39 per cent of the sample firms have a composite score above the sample
median (3), with a mean of 3 and ranges between 0 and 5. In terms of internal audit
investment cost, the sample firms spent an average of RM 946,000 (median – RM 221,500)
and range between RM 6,000 and RM 28.7 million. Our internal audit quality composite
794 score is the sum of the five internal audit attributes (each having a score of 1 if above
median) and as shown in the table, the sample firms have an average of 2.23, median of
2.00 and ranges between 0 and 4. We find that 24 per cent of our sample outsource their
IAF to an outside provider and 65 per cent have a full in-house function.
The variable board quality (a composite score based on four board characteristics),
have an average score of 1.89, a median of 2 and ranges between 0 and 4. Our sample
firms’ age (number of years from date of incorporation) mean is 29 years (median – 28
years) and ranges between 2 and 101 years. Some 17 per cent of our sample firms are
politically/government connected firms and 22 per cent are managed by a Bumiputra
CEO. We note that 74 per cent of the sample firms were audited by the Big 4.
Table IV provides the spearman correlation coefficients (and p-values) for all the
variables used in our model. The correlations results show that abnormal accruals is
positively associated with internal audit quality and three of its components
(independence, quality assurance and experience), which is rather disturbing and is
against our expectations. The only significant correlation is between absolute abnormal
accruals and internal audit organisational independence. Only two of the internal audit
components (financial focus and internal audit investment) have a negative correlation,
indicating that these components have a constraining effect on earnings management. In
terms of correlations between our independent variables, none of the variables had a
correlation of more than 0.70, suggesting multicollinearity is not of an issue. In addition,
VIF was calculated for each independent variable after each estimation. Prior literature
(Myers, 1990) suggests that a VIF value of 10 and above is a cause for concern. With the
exception of estimations using interactions, the results (not shown in paper) indicate that
all the independent variables used in each of the estimations had VIF values of less than 3.

Multivariate results
Internal audit quality and abnormal accruals
Table V reports our OLS regression of absolute, signed, positive and negative
measures of abnormal accruals on internal audit quality (estimations 1-4, respectively).
From estimations 1 to 3, we find IAQ is positive and significantly associated with
abnormal accruals ( p , 0.05). This finding is contrary to our expectations and also to
the findings of Prawitt et al. (2009) in the USA, which suggest higher internal audit
quality is related to more earnings management. Further analyses by positive
(income-increasing) and negative (income-decreasing) abnormal accruals, suggest that
our findings are mainly driven by positive abnormal accruals, which is rather
disturbing. Our results imply that firms with higher internal audit quality are
ineffective, or probably allow for more income-increasing earnings management.
Board quality (BODQ) being a proxy for another internal aspect of corporate
governance is not significant in all regressions, suggesting that boards may be ineffective
in constraining earnings management. Surprisingly we find that firms which are
government and politically linked have significantly lower absolute abnormal accruals.
 1 jAAj 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

2 IAQ 0.075 1
2 0.398
3 EXP 0.046 0.505 1
2 0.604 0
4 IAFQC 0.054 0.477 0.114 1
2 0.548 0 2 0.199
5 IAFORGIND 0.164 0.63 0.073 0.201 1
2 0.064 0 2 0.413 2 0.023
6 FINFOCUS 20.12 0.231 20.143 20.19 0.081 1
2 0.178 2 0.009 2 0.107 2 0.032 2 0.361
7 IAINVEST 20.021 0.237 20.066 20.105 0.174 0.031 1
2 0.811 2 0.007 2 0.459 2 0.239 2 0.05 2 0.73
8 BODQ 20.084 0.174 20.167 0.076 0.156 0.037 0.187 1
2 0.348 2 0.049 2 0.059 2 0.396 2 0.078 2 0.681 2 0.034
9 POL 20.049 0.336 0.158 0.177 0.06 0.023 0.174 0.415 1
2 0.582 0 2 0.075 2 0.046 2 0.503 2 0.798 2 0.049 0
10 BUMICEO 0.129 20.096 20.096 0.037 20.153 20.192 0.074 0.11 0.36 1
2 0.148 2 0.283 2 0.28 2 0.679 2 0.086 2 0.03 2 0.409 2 0.216 0
11 OUTSOURCE 0.011 20.369 20.301 20.309 20.041 20.012 20.109 2 0.097 20.209 20.167 1
2 0.903 0 2 0.001 0 2 0.642 2 0.895 2 0.223 2 0.277 2 0.018 2 0.06
12 LEV 20.088 20.126 20.133 20.022 0.021 0.21 20.254 0.165 0.024 0.19 0.067 1
2 0.321 2 0.155 2 0.133 2 0.804 2 0.811 2 0.017 2 0.004 2 0.063 2 0.789 2 0.032 2 0.456
13 SGROWTH 20.021 20.005 20.065 0.066 20.049 0.014 20.134 0.094 20.016 0.11 20.011 0.054 1
2 0.813 2 0.959 2 0.464 2 0.462 2 0.581 2 0.872 2 0.132 2 0.291 2 0.858 2 0.215 2 0.905 2 0.547
14 INV 0.109 20.092 20.053 20.076 20.239 0.038 20.062 2 0.008 20.084 20.204 0.208 20.164 0.037 1
2 0.219 2 0.299 2 0.553 2 0.392 2 0.007 2 0.668 2 0.486 2 0.933 2 0.343 2 0.021 2 0.018 2 0.064 2 0.679
15 CFO 20.371 0.011 0.135 0.1 20.198 0.014 20.142 0.032 20.013 20.174 0.067 20.102 0.265 0.118 1
0 2 0.902 2 0.128 2 0.26 2 0.025 2 0.875 2 0.111 2 0.723 2 0.888 2 0.049 2 0.456 2 0.25 2 0.003 2 0.185
16 LASSET 20.094 0.262 0.254 0.368 0.025 0.111 20.279 0.224 0.287 0.12 20.533 0.294 0.088 20.158 0.166 1
2 0.291 2 0.003 2 0.004 0 2 0.781 2 0.21 2 0.001 2 0.011 2 0.001 2 0.176 0 2 0.001 2 0.325 2 0.076 2 0.061
17 BIG4 20.013 0.239 20.025 0.106 0.142 0.115 0.139 0.193 0.269 20.12 20.125 20.137 0.004 0.013 0.181 0.185 1
2 0.88 2 0.007 2 0.78 2 0.232 2 0.109 2 0.197 2 0.116 2 0.029 2 0.002 2 0.177 2 0.158 2 0.122 2 0.962 2 0.888 2 0.041 2 0.037
18 LAGE 20.069 0.189 0.303 20.061 20.022 0.043 0.064 0.106 0.071 0.023 20.431 20.233 0.048 20.002 0.116 0.225 0.298 1
2 0.437 2 0.033 2 0.001 2 0.49 2 0.807 2 0.628 2 0.476 2 0.235 2 0.429 2 0.8 0 2 0.008 2 0.591 2 0.979 2 0.193 2 0.011 2 0.001

Notes: Coefficient and p-value; variables are defined in Table II

Correlations matrix
reporting quality

795
IAF board quality

Table IV.
and financial
 28,9

796
MAJ

Table V.

abnormal accruals
Multivariate results of
internal audit quality and
1 2 3 4
Variable Prediction Absolute abnormal accruals Signed abnormal accruals Positive abnormal accruals Negative abnormal accruals

IAQ 2 Coefficient 0.006 0.007 0.008 2 0.001

t-stat. 1.720 * * 1.790 * * 1.490 * 2 0.149
POL 2 Coefficient 2 0.019 0.001 2 0.002 2 0.007
t-stat. 2 1.820 * * 2 0.033 2 0.138 2 0.567
BUMICEO þ Coefficient 0.021 2 0.012 0.006 2 0.004
t-stat. 2.430 * ** 2 1.010 0.402 2 0.469
OUTSOURCE 2 Coefficient 0.009 0.044 0.030 2 0.027
t-stat. 0.853 3.860 * ** 2.230 ** 2 1.820 *
BODQ þ Coefficient 2 0.003 0.004 2 0.002 2 0.004
t-stat. 2 0.599 1.040 2 0.409 2 0.808
LEV þ Coefficient 2 0.039 0.009 2 0.021 0.040
t-stat. 2 1.770 * * 0.297 2 0.768 1.080
SGROWTH þ Coefficient 0.013 0.065 0.042 2 0.040
t-stat. 0.836 3.610 * ** 1.890 ** 2 3.560 ** *
INV þ Coefficient 0.073 2 0.026 0.059 2 0.051
t-stat. 1.490 * 2 0.488 0.805 2 1.260
CFO 2 Coefficient 2 0.175 2 0.499 2 0.327 0.479
t-stat. 2 3.360 * ** 2 5.950 * ** 2 4.610 *** 5.030 ** *
LASSETS þ Coefficient 0.002 0.003 0.002 2 0.003
t-stat. 0.649 0.859 0.529 2 0.832
BIG4 2 Coefficient 0.010 0.006 0.012 0.010
t-stat. 1.100 0.656 0.950 1.130
LAGE 2 Coefficient 2 0.005 0.019 0.009 2 0.015
t-stat. 2 0.819 3.140 * ** 1.090 2 2.400 ** *
YEAR ? Coefficient 2 0.006 2 0.016 2 0.017 0.009
t-stat. 2 0.852 2 2.210 * 2 2.010 * 1.130
_cons Coefficient 0.008 2 0.115 2 0.043 0.107
t-stat. 0.115 2 1.540 2 0.476 1.450
R2 0.240 0.620 0.504 0.513
R 2_a 0.154 0.576 0.395 0.359
F 3.34 11.3 2.98 6.7
n 128 128 73 55
Notes: Statistical significance at: *0.10, * *0.05, and * * *0.01 levels for a one-tailed test; variables are defined in Table II
Internal audit quality, board quality and abnormal accruals IAF board quality
Table VI presents the findings of whether board quality moderates/has an impact on and financial
the relationship between internal audit quality and abnormal accruals. As shown in the
table, the interaction term between IAQ and BODQ is positive and significantly reporting quality
associated with abnormal accruals ( p , 0.5) in estimations 1 and 3. The result is
contrary to our expectations for a complementary effect, in that high internal audit
quality in conjunction with high board quality may seem to be ineffective or are 797
allowing for greater earnings management. However, looking at the lower ordered
variables, IAQ and BODQ, as expected the coefficient signs are all negative and
significant. Further, in reviewing the size of the coefficient estimates in the absolute
abnormal accruals model (Panel C, Table IX), it appears that the added benefit from
increasing board quality variable (BODQ) is outweighed by the reduction in the benefit
attributed to the interactive variable, suggesting a possible substitution relationship
between board quality and internal audit quality.

Components of internal audit quality and abnormal accruals

Next, we analysed the effects of the individual components of internal audit quality
(IAQ). We essentially re-estimated our results for Tables V and VI by using the five
individual components (experience (EXP), independence (IAFORGIND), financial focus
(FINFOCUS), quality control assurance (IAFQCA), and investment (IAINVEST)) in
place of our composite IAQ variable. As shown in Table VII, we find EXP and
IAINVEST and IAFORGIND are the only three significant variables in our sample
firms. Contrary to our expectations, the variable experience (EXP) is positive and
significant at 0.05 level in the absolute, signed and positive abnormal accruals
estimations. The finding indicates that firms having an IAF for a longer period are
associated with greater earnings management and more so for income-increasing
accruals, which is contrary to the insignificant findings of Prawitt et al. (2009) and
Lin et al. (2011). Similar positive association (though weak in significance – p ¼ 0.10
level) is found for the internal audit organisational independence, which once again
differs from the insignificant findings of this variable in Prawitt et al. (2009) and
Lin et al. (2011). The only variable showing an expected association with abnormal
accruals is the internal audit investment. With the exception of the estimation using
negative abnormal accruals, for all other estimations (absolute, signed and positive
abnormal accruals), we find IAINVEST is negative and significant at 0.05 level of
significance. These findings are consistent with our prediction that more investment in
IAF implies greater monitoring ability via extent of internal auditing activities, and
thus are more able to detect and deter management biasness or opportunistic
behaviour[16].
From Table VIII, the variable board quality (BODQ) being another proxy for internal
governance mechanism is insignificant in all estimations. Similar to the estimations in
Table VII, we interacted BODQ with each of the internal audit quality components. As
shown in Table IX, our results are quite similar to the earlier findings using the
composite IAQ variable. Specifically, IAFORGIND*BODQ is positive and significant at
0.10 and 0.05 for the absolute, signed and positive abnormal accruals estimation,
respectively. The finding is once again puzzling and contrary to our expectations that
firms which that have a more independent IAF and have better quality boards are
associated with more earnings management. Although insignificant, both the related
 28,9

798
MAJ

Table VI.

board quality and

abnormal accruals
internal audit quality,
Multivariate results of
1 2 3 4
Variable Absolute abnormal accruals Signed abnormal accruals Positive abnormal accruals Negative abnormal accruals

IAQ Coefficient 2 0.005 0.001 2 0.007 2 0.005

t-stat. 2 0.524 0.126 2 0.764 2 0.297
BODQ Coefficient 2 0.016 2 0.003 2 0.020 2 0.009
t-stat. 2 1.600 ** 2 0.272 2 1.750 ** 2 0.471
IAQ *BODQ Coefficient 0.005 0.003 0.007 0.002
t-stat. 1.490 ** 0.727 1.960 ** 0.283
POL Coefficient 2 0.020 2 0.001 2 0.004 2 0.007
t-stat. 2 2.080 ** 2 0.074 2 0.265 2 0.559
BUMICEO Coefficient 0.022 2 0.012 0.008 2 0.003
t-stat. 2.530 *** 2 0.989 0.508 2 0.383
OUTSOURCE Coefficient 0.010 0.044 0.030 2 0.027
t-stat. 0.867 3.910 *** 2.290 ** 2 1.800 *
LEV Coefficient 2 0.043 0.007 2 0.026 0.038
t-stat. 2 1.920 ** 0.226 2 0.988 0.947
SGROWTH Coefficient 0.015 0.066 0.044 2 0.039
t-stat. 0.940 3.580 *** 1.880 ** 2 3.420 ***
INV Coefficient 0.074 2 0.026 0.068 2 0.052
t-stat. 1.590 * 2 0.475 0.950 2 1.280 *
CFO Coefficient 2 0.173 2 0.499 2 0.321 0.483
t-stat. 2 3.320 *** 2 5.930 *** 2 4.570 *** 5.210 ***
LASSET Coefficient 0.002 0.003 0.002 2 0.003
t-stat. 0.602 0.858 0.410 2 0.787
BIG4 Coefficient 0.009 0.006 0.012 0.009
t-stat. 1.030 0.625 0.965 1.020
LAGE Coefficient 2 0.004 0.020 0.010 2 0.014
t-stat. 2 0.606 3.210 *** 1.140 2 2.380 ***
YEAR Coefficient 2 0.007 2 0.017 2 0.019 0.008
t-stat. 2 1.010 2 2.240 ** 2 2.170 ** 0.983
_cons Coefficient 0.035 2 0.100 0.007 0.114
t-stat. 0.490 2 1.400 0.077 1.630
R2 0.251 0.621 0.522 0.514
R 2_a 0.158 0.574 0.407 0.344
F 3.63 11.1 4.08 6.27
n 128 128 73 55
Notes: Statistical significance at: *0.10, * *0.05, and * * *0.01 levels for a one-tailed test; variables are defined in Table II
 1 2 3 4
Variable Absolute abnormal accruals Signed abnormal accruals Positive abnormal accruals Negative abnormal accruals

IAQ Coefficient 0.003 0.004 0.004 0.001

t-stat. 0.825 1.010 0.715 2 0.099
POL Coefficient 2 0.115 2 0.087 2 0.110 0.001
t-stat. 2 3.850 *** 2 2.680 *** 2 3.290 *** 0.003
IAQ*POL Coefficient 0.033 0.030 0.034 2 0.003
t-stat. 3.250 *** 2.410 *** 3.090 *** 2 0.145
BUMICEO Coefficient 0.023 2 0.010 0.007 2 0.004
t-stat. 2.830 *** 2 0.951 0.530 2 0.485
OUTSOURCE Coefficient 0.000 0.035 0.019 2 0.027
t-stat. 0.032 2.920 *** 1.340 * 2 1.750 **
BODQ Coefficient 2 0.002 0.004 2 0.001 2 0.004
t-stat. 2 0.520 1.140 2 0.101 2 0.800
LEV Coefficient 2 0.027 0.020 2 0.012 0.039
t-stat. 2 1.240 0.690 2 0.467 0.993
SGROWTH Coefficient 0.013 0.065 0.039 2 0.040
t-stat. 0.818 3.560 *** 1.830 * 2 3.350 ***
INV Coefficient 0.085 2 0.015 0.072 2 0.052
t-stat. 1.880 ** 2 0.289 1.010 2 1.310 *
CFO Coefficient 2 0.162 2 0.488 2 0.310 0.479
t-stat. 2 3.380 *** 2 6.180 *** 2 4.740 *** 5.030 ***
LASSETS Coefficient 2 0.001 0.000 2 0.002 2 0.003
t-stat. 2 0.319 2 0.010 2 0.393 2 0.723
BIG4 Coefficient 0.011 0.007 0.013 0.010
t-stat. 1.170 0.782 1.010 1.110
LAGE Coefficient 2 0.002 0.022 0.011 2 0.015
t-stat. 2 0.301 3.360 *** 1.290 * 2 2.090 ***
YEAR Coefficient 2 0.005 2 0.016 2 0.016 0.009
t-stat. 2 0.820 2 2.170 ** 2 1.930 ** 1.130
_cons Coefficient 0.074 2 0.056 0.033 0.103
t-stat. 0.949 2 0.773 0.389 1.370
R2 0.284 0.636 0.545 0.513
R 2_a 0.195 0.591 0.435 0.343
F 4.9 10.8 5.03 7.94
n 128 128 73 55
Notes: Statistical significance at: *0.10, * *0.05, and * * *0.01 levels for a one-tailed test; variables are defined in Table II

abnormal accruals
political connections and
internal audit quality,
Multivariate results of
reporting quality
IAF board quality

Table VII.
799
and financial
MAJ
1 2 3 4
28,9 Absolute Signed Positive Negative
abnormal abnormal abnormal abnormal
Variable accruals accruals accruals accruals

EXP Coefficient 0.015 0.018 0.022 0.005

800 t-stat. 1.880 * * 2.410 * * 2.350 * * 0.377
IAFQC Coefficient 0.004 0.006 0.009 2 0.005
t-stat. 0.430 0.783 0.844 2 0.527
IAFORGIND Coefficient 0.013 0.014 0.011 0.006
t-stat. 1.280 * 1.780 1.130 0.608
FINFOCUS Coefficient 20.002 0.002 20.001 2 0.016
t-stat. 20.233 0.268 20.141 2 1.820
IAINVEST Coefficient 26.670 2 11.500 214.800 3.660
t-stat. 21.520 * * 2 2.920 * * * 23.400 * * * 0.932
POL Coefficient 20.019 2 0.001 20.005 2 0.011
t-stat. 21.770 * * 2 0.060 20.330 2 0.641
BUMICEO Coefficient 0.025 2 0.006 0.006 2 0.003
t-stat. 2.620 * * * 2 0.530 0.375 2 0.250
OUTSOURCE Coefficient 0.004 0.037 0.025 2 0.030
t-stat. 0.342 3.350 * * * 1.790 * * 2 1.900 * *
BODQ Coefficient 0.000 0.008 0.006 2 0.004
t-stat. 0.040 1.910 1.250 2 0.731
LEV Coefficient 20.040 0.002 20.020 0.053
t-stat. 21.740 * * 0.087 20.749 1.420 *
SGROWTH Coefficient 0.012 0.063 0.043 2 0.041
t-stat. 0.853 3.880 2.160 2 3.650
INV Coefficient 0.086 2 0.015 0.051 2 0.041
t-stat. 1.650 * * 2 0.258 0.627 2 1.140
CFO Coefficient 20.172 2 0.499 20.352 0.475
t-stat. 23.080 * * * 2 6.170 * * * 24.740 * * * 5.410 * * *
LASSET Coefficient 0.000 2 0.001 20.001 2 0.004
t-stat. 20.032 2 0.181 20.349 2 0.750
BIG4 Coefficient 0.014 0.012 0.015 0.016
t-stat. 1.470 * * 1.250 1.210 1.070
LAGE Coefficient 20.007 0.017 0.009 2 0.016
t-stat. 21.090 2.570 * * * 0.962 2 2.600 * * *
YEAR Coefficient 20.004 2 0.015 20.014 0.010
t-stat. 20.678 2 2.04 * * 21.64 * * 1.33 *
_cons Coefficient 0.057 2 0.037 0.019 0.11
t-stat. 0.747 2 0.486 0.214 1.2
R2 0.28 0.648 0.577 0.578
R 2_a 0.169 0.594 0.446 0.384
Table VIII. F 3.18 15.2 10.1 7.04
Multivariate results of n 128 128 73 55
internal audit
components, and Notes: Statistical significance at: *0.10, * *0.05, and * * *0.01 levels for a one-tailed test; variables are
abnormal accruals defined in Table II

lower order variables (IAFORGIND and BODQ) coefficients are negative, indicating a
constraining effect on abnormal accruals which is as expected. A substitution effect may
be in part being the explanation to this finding. It is possible that internal governance
mechanisms do not work well when firms have multiple internal governance
 1 2 3 4
Variable Absolute abnormal accruals Signed abnormal accruals Positive abnormal accruals Negative abnormal accruals

EXP Coefficient 0.003 0.017 0.017 0.022

t-stat. 0.174 0.827 0.525 0.822
IAFQC Coefficient 2 0.007 0.005 20.010 0.003
t-stat. 2 0.284 0.211 2 0.395 0.140
IAFORGIND Coefficient 2 0.009 2 0.006 20.019 0.013
t-stat. 2 0.383 2 0.356 2 0.810 0.455
FINFOCUS Coefficient 2 0.007 0.019 0.009 20.009
t-stat. 2 0.334 0.900 0.329 2 0.400
IAINVEST Coefficient 2 9.110 2 10.000 28.450 285.000
t-stat. 2 0.593 2 0.528 2 0.460 2 3.930 * *
EXP*BODQ Coefficient 0.005 0.000 0.003 20.007
t-stat. 0.588 0.034 0.216 2 0.622
IAFQC*BODQ Coefficient 0.005 0.000 0.008 20.010
t-stat. 0.428 2 0.031 0.622 2 0.762
IAFORGIND*BODQ Coefficient 0.012 0.011 0.016 20.004
t-stat. 1.260 1.380 1.670 2 0.310
FINFOCUS*BODQ Coefficient 0.002 2 0.010 20.006 20.002
t-stat. 0.234 2 0.890 2 0.526 2 0.152
IAINVEST*BODQ Coefficient 0.678 2 1.560 24.250 46.900
t-stat. 0.093 2 0.163 2 0.462 4.260 * * *
BODQ Coefficient 2 0.012 0.009 20.003 20.011
t-stat. 2 0.812 0.608 2 0.185 2 0.617
POL Coefficient 2 0.017 0.000 20.003 20.021
t-stat. 2 1.680 * * 0.032 2 0.199 2 1.680 * *
BUMICEO Coefficient 0.024 2 0.008 0.004 0.001
t-stat. 2.400 * * * 2 0.702 0.267 0.133
(continued)

quality and abnormal

accruals
components, board
Multivariate results of
internal audit
Table IX.
reporting quality

801
IAF board quality
and financial
 28,9

802
MAJ

Table IX.
1 2 3 4
Variable Absolute abnormal accruals Signed abnormal accruals Positive abnormal accruals Negative abnormal accruals

OUTSOURCE Coefficient 0.004 0.034 0.018 20.028

t-stat. 0.329 3.020 * * * 1.220 2 1.660 * *
LEV Coefficient 2 0.044 0.004 20.022 0.040
t-stat. 2 1.810 * * 0.137 2 0.751 0.996
SGROWTH Coefficient 0.015 0.065 0.045 20.024
t-stat. 0.981 3.800 * * * 2.030 * * 2 1.650 * *
INV Coefficient 0.088 2 0.015 0.069 20.049
t-stat. 1.600 * 2 0.240 0.796 2 1.400
CFO Coefficient 2 0.175 2 0.505 20.346 0.582
t-stat. 2 3.010 * * * 2 6.440 * * * 2 4.800 * * * 6.160 * * *
LASSET Coefficient 2 0.001 2 0.001 20.003 0.000
t-stat. 2 0.158 2 0.369 2 0.841 0.094
BIG4 Coefficient 0.013 0.013 0.015 0.004
t-stat. 1.290 * 1.290 * 1.140 0.234
LAGE Coefficient 2 0.005 0.018 0.009 20.017
t-stat. 2 0.695 2.550 0.831 2 2.300
YEAR Coefficient 2 0.006 2 0.015 20.014 0.006
t-stat. 2 0.814 2 2.000 2 1.480 0.741
_cons Coefficient 0.088 2 0.025 0.081 0.041
t-stat. 0.984 2 0.365 0.945 0.369
R2 0.298 0.658 0.611 0.719
R 2_a 0.151 0.587 0.439 0.525
F 3.88 16 30.8 12.1
n 128 128 73 55
Notes: Statistical significance at: *0.10, * *0.05, and * * *0.01 levels for a one-tailed test; variables are defined in Table II
mechanisms and therefore is detrimental to the firm. Other control variables that are IAF board quality
significant in most of the estimations are politically connected firms, namely (POL), and financial
Bumiputra CEO (BUMICEO), outsource (OUTSOURCE), leverage (LEV), growth
(SGROWTH) and cash flows from operation (CFO). reporting quality

Further analyses
Two additional analyses are performed to test for sensitivity and to provide further 803
explanations to our findings.

Analyses excluding outsource observations

A total of 26 per cent of our sample consists of firms that outsource more than 50 per cent
of the internal audit activities (note: 24 per cent outsource the function in full) and hence
may be driving part of our results. Outsource parties are arguably more independent and
hence may be able to fulfil the monitoring role better. For example, Desai et al. (2011)
using an experimental design in the USA find that external auditors assess the quality of
outsourced IAF to be higher than the quality of an in-house IAF and thus are more
willing to rely (to a larger extent) on outsourced IAF than in-house IAF.
From our findings as shown in Tables V – IX, the variable OUTSOURCE is positive
and significant in the signed and positive abnormal accruals estimations, and negative
in the negative abnormal accruals estimation. Specifically, these findings show that
firms that outsource a significant amount of their internal audit activity are associated
with more opportunistic behaviour via income-increasing earnings management and
less conservative via decrease in income-decreasing earnings management.
Collectively, the findings imply that firms that outsource all or a significant amount
of their internal audit activities are less able to detect management biasness and
opportunism.
Given the results, we re-ran the models by excluding firms that outsource all of their
IAF to a third party. From Table X Panel A, we find that although the IAQ coefficients
are positive for the absolute, signed and positive abnormal accruals, they are not
significant. Panel B of Table X, shows the results when the IAQ variable is substituted
with its five components. Of the five internal audit components, we find that the
variable internal audit investment (IAINVEST) is the most significant. Specifically the
variable is negative and significant in the absolute ( p-value ¼ 0.10), signed
( p-value ¼ 0.05) and positive ( p-value ¼ 0.05) abnormal accruals estimations. These
results indicate that when firms put in more investment in their internal audit activities
this results to lower abnormal accruals. This result implies that as more internal audit
monitoring is carried out (more internal audit activity results in more cost),
management becomes less biased and thus results lead to better financial reporting
quality (lower abnormal accruals).
The second internal audit component variable which is significant is the financial
focus variable and from Panel B, Table X; the variable is negative and significant in the
absolute ( p-value ¼ 10), positive ( p-value ¼ 10) and negative ( p-value) estimations.
The results show that when the IAF has a high financial focus in their audit activity,
management is deterred from bias and opportunistic behaviour, which in turn results
to higher financial reporting quality (lower abnormal accruals). Finally the third
internal audit component variable which showed some significance is the experience
(EXP) variable. Contrary to our expectations, the EXP coefficient is positive in the
 observations
excluding outsource
Further analyses –
Table X.

804

28,9
MAJ
1 2 3 4 1 2 3 4
Absolute Signed Positive Negative Absolute Signed Positive Negative
abnormal abnormal abnormal abnormal abnormal abnormal abnormal abnormal
Variable accruals accruals accruals accruals accruals accruals accruals accruals

Panel A Panel B
IAQ Coefficient 0.005 0.008 0.010 2 0.001
t-stat. 0.995 1.380 * 1.410 * 2 0.178
EXP Coefficient 0.014 0.017 0.013 0.006
t-stat. 1.490 * 1.700 ** 0.884 0.384
IAFQC Coefficient 0.000 0.008 0.008 2 0.011
t-stat. 2 0.028 1.290 * 1.100 2 1.910 * *
IAFORGIND Coefficient 0.001 0.001 2 0.001 0.001
t-stat. 0.381 0.302 2 0.126 0.166
FINFOCUS Coefficient 2 0.014 0.006 2 0.022 2 0.030
t-stat. 2 1.320 * 0.563 2 1.360 * 2 3.040 * *
IAINVEST Coefficient 2 5.750 2 9.220 2 10.600 2.080
t-stat. 2 1.440 * 2 2.120 ** 2 2.200 * * 0.645
BODQ Coefficient 2 0.003 0.004 0.001 2 0.007 0.002 0.009 0.011 2 0.004
t-stat. 2 0.588 0.776 0.089 2 1.090 * * * 0.321 1.550 * 2.200 * * 2 0.572
IAQ*BODQ Coefficient
t-stat.
POL Coefficient 2 0.018 0.004 2 0.002 2 0.005 2 0.022 0.001 2 0.006 2 0.019
t-stat. 2 1.500 * 0.230 2 0.107 2 0.310 2 1.570 * * 0.005 2 0.333 2 0.767
IAQ*POL Coefficient
t-stat.
BUMICEO Coefficient 0.022 2 0.016 2 0.002 2 0.007 0.023 2 0.012 2 0.019 0.004
t-stat. 2.000 * * 2 1.200 * 2 0.088 2 0.636 1.770 * * 2 0.842 2 0.824 0.240
LEV Coefficient 2 0.034 0.020 2 0.023 0.064 2 0.037 0.014 2 0.017 0.033
t-stat. 2 1.060 0.575 2 0.648 1.250 2 1.070 0.370 2 0.530 0.669
SGROWTH Coefficient 0.012 0.066 0.043 2 0.043 0.012 0.063 0.053 2 0.048
t-stat. 0.627 3.430 * * * 1.860 * * 2 3.040 * * * 0.692 3.670 * * * 2.510 * * 2 3.150 * * *
INV Coefficient 0.096 2 0.020 0.080 2 0.052 0.113 2 0.019 0.059 2 0.010
t-stat. 1.780 * * 2 0.286 0.977 2 0.916 1.920 2 0.277 0.778 2 0.203
CFO Coefficient 2 0.174 2 0.503 2 0.367 0.466 2 0.177 2 0.518 2 0.421 0.438
t-stat. 2 2.970 * * * 2 6.240 * * * 2 5.480 * * * 4.090 2 2.720 * * * 2 6.360 * * * 2 6.420 * * * 3.460 * * *
LASSETS Coefficient 0.003 0.004 0.005 2 0.004 0.001 2 0.002 0.002 2 0.001
t-stat. 0.664 0.934 1.000 2 0.820 * 0.146 2 0.403 0.571 2 0.258
BIG4 Coefficient 0.014 0.011 0.022 0.012 0.025 0.017 0.030 0.030
(continued)
 1 2 3 4 1 2 3 4
Absolute Signed Positive Negative Absolute Signed Positive Negative
abnormal abnormal abnormal abnormal abnormal abnormal abnormal abnormal
Variable accruals accruals accruals accruals accruals accruals accruals accruals

t-stat. 1.180 0.767 1.210 0.938 2.020 * * 1.090 1.880 * * 1.810 * *

LAGE Coefficient 2 0.002 0.023 0.023 2 0.014 2 0.006 0.023 0.026 2 0.023
t-stat. 2 0.237 2.780 * * 2.040 * * 2 1.610 2 0.538 2.440 2.190 2 2.950
YEAR Coefficient 2 0.005 2 0.026 2 0.030 0.015 2 0.003 2 0.025 2 0.026 0.015
t-stat. 2 0.626 2 3.370 2 3.180 1.600 2 0.418 2 3.170 2 2.960 1.610
_cons Coefficient 2 0.008 2 0.139 2 0.147 0.113 0.034 2 0.047 2 0.112 0.097
t-stat. 2 0.096 2 1.590 2 1.310 1.350 0.416 2 0.532 2 1.130 0.996
R2 0.267 0.640 0.581 0.527 0.323 0.662 0.680 0.653
R 2_a 0.159 0.587 0.455 0.325 0.182 0.592 0.538 0.421
F 3.05 11.9 4.05 8.2 3.13 10 9.05 21.6
n 94 94 53 41 94 94 53 41
Panel C Panel D
IAQ Coefficient 2 0.021 0.001 2 0.018 2 0.036 2 0.001 0.003 0.001 2 0.001
t-stat. 2 1.930 * * 0.009 2 1.880 * * 2 1.820 * * 2 0.167 0.478 0.204 2 0.099
EXP Coefficient
t-stat.
IAFQC Coefficient
t-stat.
IAFORGIND Coefficient
t-stat.
FINFOCUS Coefficient
t-stat.
IAINVEST Coefficient
t-stat.
BODQ Coefficient 2 0.041 2 0.008 2 0.044 2 0.050 2 0.002 0.005 0.004 2 0.007
t-stat. 2 2.860 * * * 2 0.458 2 2.460 * * * 2 2.070 * * 2 0.394 1.000 0.565 2 1.190
IAQ*BODQ Coefficient 0.013 0.004 0.014 0.017
t-stat. 3.060 * * * 0.734 3.020 * * * 1.920 * *
(continued)

Table X.
reporting quality

805
IAF board quality
and financial
 28,9

806
MAJ

Table X.
1 2 3 4 1 2 3 4
Absolute Signed Positive Negative Absolute Signed Positive Negative
abnormal abnormal abnormal abnormal abnormal abnormal abnormal abnormal
Variable accruals accruals accruals accruals accruals accruals accruals accruals

POL Coefficient 2 0.016 0.004 0.002 0.002 2 0.138 2 0.105 2 0.134 0.014
t-stat. 2 1.450 * 0.283 0.145 0.138 2 4.320 *** 2 3.100 *** 2 3.170 *** 0.230
IAQ*POL Coefficient 0.040 0.037 0.042 2 0.007
t-stat. 3.860 *** 3.210 *** 3.510 *** 2 0.328
BUMICEO Coefficient 0.026 2 0.015 0.007 2 0.005 0.026 2 0.013 0.001 2 0.008
t-stat. 2.430 * * 2 1.130 0.378 2 0.393 2.560 *** 2 1.030 0.036 2 0.704
LEV Coefficient 2 0.034 0.020 2 0.015 0.049 2 0.022 0.031 2 0.019 0.061
t-stat. 2 1.110 0.580 2 0.498 0.856 2 0.728 0.939 2 0.539 1.080
SGROWTH Coefficient 0.015 0.067 0.042 2 0.047 0.012 0.066 0.039 2 0.045
t-stat. 0.767 3.380 * * * 1.580 * 2 3.300 * * * 0.603 3.240 *** 1.740 ** 2 2.900
INV Coefficient 0.103 2 0.017 0.111 2 0.059 0.121 0.003 0.104 2 0.056
t-stat. 1.990 * * 2 0.251 1.310 * 2 1.130 2.880 *** 0.055 1.420 * 2 1.040
CFO Coefficient 2 0.161 2 0.499 2 0.334 0.544 2 0.159 2 0.489 2 0.342 0.472
t-stat. 2 2.700 * * * 2 6.080 * * * 2 4.870 * * * 4.850 * * * 2 3.140 *** 2 6.790 *** 2 5.980 *** 4.210
LASSETS Coefficient 0.001 0.003 0.002 2 0.004 2 0.002 2 0.001 2 0.001 2 0.003
t-stat. 0.272 0.871 0.507 2 0.962 2 0.473 2 0.161 2 0.174 2 0.602
BIG4 Coefficient 0.009 0.009 0.016 0.001 0.018 0.015 0.026 0.012
t-stat. 0.763 0.670 0.946 0.109 1.470 * 1.080 1.490 0.921
LAGE Coefficient 0.000 0.024 0.023 2 0.009 0.001 0.026 0.021 2 0.016
t-stat. 0.008 2.850 * * * 2.280 2 1.190 0.082 3.090 *** 2.040 ** 2 1.400
YEAR Coefficient 2 0.006 2 0.027 2 0.030 0.013 2 0.004 2 0.025 2 0.027 0.015
t-stat. 2 0.817 2 3.330 2 3.250 1.330 2 0.533 2 3.300 3.080 1.610
_cons Coefficient 0.088 2 0.110 2 0.011 0.198 0.078 2 0.061 2 0.029 0.103
t-stat. 0.950 2 1.260 2 0.120 2.550 0.880 2 0.796 2 0.300 1.240
R2 0.310 0.642 0.624 0.577 0.344 0.671 0.649 0.529
R 2_a 0.198 0.584 0.499 0.373 0.237 0.617 0.532 0.302
F 5.58 13.4 5.18 12.8 6.32 13.1 9.01 7.92
n 94 94 53 41 94 94 53 41
Notes: Statistical significance at: *0.10, * *0.05, and * * *0.01 levels for a one-tailed test; variables are defined in Table II
absolute and signed abnormal estimations but not in the positive or the negative IAF board quality
abnormal estimations. The findings seem to indicate that a firm with a longer-term IAF and financial
tenure is associated with more earnings management. Compared to our earlier results
using both in-house and outsource sample, it is evident that the IAF carried out by reporting quality
in-house is quite different from outsourced activity. We did not estimate the outsource
function separately as the sample is quite small (34 observations).
In terms of our H2 on whether board quality has a moderating effect on the 807
relationship between internal audit quality and abnormal accruals, we find the
following:
.
The board quality (BODQ) variable coefficient is negative but not significant in
the absolute abnormal estimation and is negative and significant in the negative
abnormal accruals estimation (see Panel A).
.
When BODQ is interacted with the IAQ variable (BODQ*IAQ), the interaction
term coefficient is positive and strongly significant in the absolute ( p ¼ 0.01),
positive ( p ¼ 0.01) and negative ( p ¼ 0.05) abnormal accruals estimations.

As expected, the lower order variables, IAQ and BODQ, coefficient signs are all
negative and significant. Further, in reviewing the size of the coefficient estimates in
the absolute abnormal accruals model (Panel C, Table X), it appears that the added
benefit from increasing board quality variable (BODQ) is outweighed by the reduction
in the benefit attributed to the interactive variable, suggesting a possible substitution
relationship between board quality and internal audit quality.

Analyses relating to political connections

The Malaysia environment is unique in that the corporate landscape is influenced by
the existence of connections with political parties and government. Prior studies have
shown a link between political connections, corporate governance and audit fees (Gul,
2006; Johnson and Mitton, 2003). From our main analyses, as shown in Tables V and
VI, the variable political connections (POL) coefficient is negative and significant
indicating that political connected firms are associated with lower absolute abnormal
accruals. The findings imply that the management of these firms are less biased and
opportunistic, as there is no reason for such behaviour given these firms are usually
bailed out during difficult times. In addition, we interacted the internal audit quality
variable with political connections to explore whether politically connected firms with
increasing internal audit quality are associated with lower abnormal accruals.
As shown in Table VII, we find the interacted variable (IAQ*POL) coefficient is
positive, indicating that political firms with increasing internal audit quality are
associated with more abnormal accruals suggesting lower financial reporting quality.
The lower order variable POL coefficient remains negative and significant at
p-value ¼ 0.01, whilst IAQ although has a positive coefficient, it is insignificant.
About 17 per cent of our sample consists of politically connected firms, which on
average have higher internal audit quality compared to non-politically connected firms
(politically connected firms IAQ mean is 3 whilst non-politically connected firms IAQ
mean is 2) and may be driving out results. Thus, we re-ran our estimations by
excluding politically connected and outsource observations from our sample. From
Table XI – Panel A, although the IAQ variable is insignificant, its coefficient is now
negative indicating that internal audit quality may be inefficient in constraining
 28,9

808
MAJ

Table XI.

observations
political connected
Further analyses –
excluding outsource and
1 2 3 4 1 2 3 4 1 2 3 4
Absolute Signed Positive Negative Absolute Signed Positive Negative Absolute Signed Positive Negative
abnormal abnormal abnormal abnormal abnormal abnormal abnormal abnormal abnormal abnormal abnormal abnormal
Variable accruals accruals accruals accruals accruals accruals accruals accruals accruals accruals accruals accruals

Panel A Panel B Panel C

IAQ Coefficient 20.001 2 0.001 20.002 0.001 2 0.019 0.003 20.019 2 0.043
t-stat. 2 0.023 2 0.012 2 0.315 0.089 2 1.610 * 0.198 2 2.320 * * * 2 1.430 *
EXP Coefficient 0.004 0.010 2 0.017 0.014
t-stat. 0.366 0.796 2 0.861 0.991
IAFQC Coefficient 0.003 0.005 0.014 20.011
* *
t-stat. 0.409 0.655 1.860 2 1.150
IAFORGIND Coefficient 2 0.002 20.003 2 0.008 0.002
* *
t-stat. 2 0.505 2 0.692 2 1.820 0.496
FINFOCUS Coefficient 2 0.028 0.002 2 0.042 20.032
* * *
t-stat. 2 2.470 * * * 0.131 2 2.240 2 2.290 * * *
IAINVEST Coefficient 2 0.897 2 12.100 2 9.330 4.860
* *
t-stat. 2 0.174 2 2.320 * * * 2 1.730 1.120
BODQ Coefficient 20.005 0.008 0.005 20.015 2 0.003 0.013 0.010 20.010 2 0.033 0.012 20.024 2 0.067
* *
t-stat. 2 0.679 1.410 * 0.650 2 2.000 * * 2 0.384 1.890 * * 1.740 2 1.340 2 2.130 * * 0.639 2 1.130 2 2.060 * *
IAQ*BODQ Coefficient 0.010 20.001 0.009 0.021
t-stat. 1.990 * * 20.222 1.600 * 1.590 *
BUMICEO Coefficient 0.029 2 0.025 20.008 0.005 0.032 20.021 2 0.011 0.026 0.031 20.026 20.002 0.001
* * * * * * *
t-stat. 2.130 2 1.490 2 0.322 0.440 2.250 2 1.270 2 0.580 1.530 2.260 * * 2 1.450 2 0.066 0.008
LEV Coefficient 20.011 0.026 20.021 0.086 2 0.002 0.034 2 0.008 0.028 2 0.013 0.026 20.016 0.057
t-stat. 2 0.272 0.644 2 0.466 1.550 * 2 0.047 0.606 2 0.253 0.369 2 0.314 0.634 2 0.383 0.766
SGROWTH Coefficient 0.007 0.063 0.037 20.039 0.012 0.062 0.046 20.044 0.009 0.063 0.037 2 0.052
* * * * * * * * * * * * *
t-stat. 0.298 2.910 1.650 2 2.180 * * * 0.517 3.280 2.300 2 2.660 * * * 0.388 2.910 1.440 * 2 3.050 * * *
INV Coefficient 0.134 0.012 0.125 20.066 0.159 20.014 0.099 0.006 0.133 0.012 0.140 2 0.097
* * * * * * * *
t-stat. 2.950 0.207 1.480 2 0.949 2.970 2 0.205 1.510 0.085 2.930 * * * 0.210 1.560 * 2 1.660 *
CFO Coefficient 20.149 2 0.488 20.331 0.538 2 0.164 20.518 2 0.393 0.478 2 0.140 20.490 20.312 0.653
* * * * * * * * * * * * * * * * * * * * *
t-stat. 2 2.710 2 6.110 2 5.020 3.950 * * * 2 2.700 2 6.140 2 6.990 3.280 * * * 2 2.470 * * * 2 5.960 2 4.380 * * * 4.820 * * *
LASSETS Coefficient 20.001 2 0.001 20.002 20.005 2 0.001 20.007 2 0.001 0.001 2 0.001 20.001 20.003 2 0.005
t-stat. 2 0.195 2 0.179 2 0.375 2 0.949 2 0.120 2 1.020 2 0.087 0.083 2 0.206 2 0.173 2 0.523 2 0.760
BIG4 Coefficient 0.018 0.016 0.025 0.004 0.027 0.022 0.040 0.028 0.014 0.017 0.021 2 0.008
* * * * * * * * *
t-stat. 1.410 1.210 1.380 0.306 2.180 1.500 3.830 1.400 * 1.050 1.220 1.120 2 0.577
LAGE Coefficient 20.001 0.018 0.011 20.004 2 0.001 0.022 0.032 20.018 0.001 0.017 0.012 2 0.003
* * * * * *
t-stat. 2 0.058 1.600 0.721 2 0.269 2 0.007 1.510 1.890 2 1.230 0.040 1.600 0.808 2 0.188
YEAR Coefficient 0.001 2 0.020 20.023 0.010 0.002 20.021 2 0.019 0.012 2 0.001 20.020 20.023 0.008
* * * *
t-stat. 0.160 2 2.190 2 2.370 1.020 0.221 2 2.190 2 2.590 1.250 2 0.015 2 2.080 2 2.420 0.889
_cons Coefficient 0.064 2 0.025 0.040 0.109 0.051 0.069 2 0.049 0.031 0.116 20.032 0.101 0.207
t-stat. 0.594 2 0.265 0.361 1.270 0.467 0.647 2 0.565 0.247 1.010 2 0.347 1.070 2.550
R2 0.301 0.661 0.639 0.604 0.410 0.690 0.816 0.748 0.326 0.661 0.658 0.664
R 2_a 0.173 0.599 0.502 0.374 0.252 0.607 0.706 0.496 0.190 0.592 0.512 0.440
F 4.97 10.5 4.14 9.41 6.14 13 11.3 58.5 4.32 17.70 4.96 11.10
n 72 72 41 31 72 72 41 31 72 72 41 31

Notes: Statistical significance at: *0.10, * *0.05, and * * *0.01 levels for a one-tailed test; variables are defined in Table II
earnings management behaviour. Moving to the estimations using the five internal IAF board quality
audit components (Panel B), with the exception of experience (EXP) all the other and financial
variables have a negative coefficient suggesting a constraining effect on abnormal
accruals. Specifically, IAF quality control assurance (IAFQC) coefficient is negative reporting quality
and significant at p-value ¼ 0.05 in the positive abnormal accruals estimation
suggesting it is associated with lower opportunistic earnings management. The
internal audit organisational independence (IAQORGIND) is now negative and 809
significant ( p-value ¼ 0.05) in the positive abnormal accruals estimation, indicating
firms that have greater internal audit independence are able to monitor management
activities which results to less management biasness and opportunistic behaviour
which in turn results in better financial reporting quality. We find similar results with
the FINFOCUS and IAINVEST variable. Next, in the estimations using the interaction
between board quality and internal audit quality (see Panel C, Table XI) estimations we
once again find substitution relation between board quality and internal audit quality.

Conclusion
In this paper, we examine the association between internal audit quality (and its
components) and abnormal accruals, being a proxy for financial reporting quality. We also
examine the moderating role of the board on this relationship. Using a unique dataset of
survey responses and archival data from a developing nation where certain corporations are
politically influenced, we test our prediction that internal audit quality (and its components)
is related to increased financial reporting quality and that this relationship is affected by the
quality of the board. We extend Prawitt et al.’s (2009) study by testing the relationship in an
emerging country, which has significant institutional differences compared to the USA;
including firms that outsource their IAF either in full or in part, improving the measure of
two of the internal audit quality characteristics such as quality control assurance and
internal audit organisational independence; and testing the moderation effect of board
quality being an important overall internal governance mechanism.
Our findings are interesting in that, although our initial findings show an
unexpected positive relationship between internal audit quality and abnormal
accruals, this relationship is contingent on whether firms outsource their internal audit
activities and whether they are politically linked. In other words, outsource and
politically linked firms with increasing internal audit quality have higher earnings
management/lower financial quality.
Next, when we substitute internal audit quality with its components (organisational
independence, experience, investment, financial focus and quality control assurance),
we find investment is negatively associated with abnormal accruals, consistent with
the notion that a well-funded IAF has a greater ability to monitor firm activities and
thus is able to constrain bias or opportunistic behaviour. This finding is consistent in
all estimations. Contrary to our expectations, organisational independence and
experience is positive but weakly related to abnormal accruals. Once again, when we
remove both outsource and politically connected observations in our further analyses,
we find internal audit organisational independence, audit activities with greater
financial focus, and investment have a constraining effect on abnormal accruals. This
is particularly more evident for income-increasing abnormal accruals. Collectively, our
results suggest that the outcomes of an IAF are dependent on the nature of the IAF
(in-house/outsource) and the institutional feature, namely political connections.
MAJ Our H2 investigates whether board quality affects the relationship between internal
28,9 audit quality and abnormal accruals. We find that although the lower ordered
variables board quality and internal audit quality coefficients are negatively related to
abnormal accruals, the interaction variable between these two variables is positively
associated with abnormal accruals, indicating substitution relationship exists between
board quality and internal audit quality. These results suggest that internal audit
810 quality and board quality can be substituted for one another to maintain the level of
financial reporting quality.
Our findings show that certain internal audit attributes play an important governance
role in the financial reporting process and synergies can be formed between the board of
directors and the IAF. Collectively, these findings are expected to inform the Institute of
Internal Auditors and other regulatory bodies on the role of internal audit (being an
important internal governance mechanism) in financial reporting, which in turn can assist in
market/regulatory reforms/changes and inform the revised MCCG.
Our study is subject to several limitations. First is the small sample size and with a
large number of control variables and this has a tendency to lower the power of our
statistical tests. Also given our small sample, especially for our sub-sample, we are
unable to be completely confident that the lack in significance for internal audit
attributes (namely experience) is due to sample size or other competing explanations.
Finally, the measure used to capture financial reporting quality may be inadequate to
capture the construct.

Notes
1. Some examples include Enron, Worldcom in the USA, HIH and OneTel in Australia and
Parmalat in Italy.
2. Gramling et al. (2004) provide an extensive review of how the internal audit monitoring role
has evolved over time.
3. We selected the board of directors over audit committee because there is a lack of variation in
the audit committee variable. For instance, all firms in Malaysia are required to have an
audit committee which consist of majority independent directors, most firms have at least
three members sitting on the committee and all firms must have at least one financial
accounting expertise (SC, 2012). In addition it is acknowledged in the literature that the
board plays a major role in the financial reporting process.
4. The major corporate scandals prior/(during) to the 1997-1998 crisis were Bank Bumiputra,
Technology Resources Industries Bhd (TRI), Pewaja Steel and Bank Islam due to lack of
internal controls. In the case of TRI, Telekom Malaysia who took control of the entity
discovered fictitious invoices amounting to RM260 million were issued between 1998 and
1999 and if the accounts were restated it would have resulted to a decrease of RM 198 million
in the net book value of the firm (The Financial Times, 2002). As for the misconduct in
Pewaja Steel it involved inaccurate accounting records and transactions and claims without
proper supporting documents and authorization which resulted to debts amounting to RM7
billion (Abdul Rahman, 2006).
5. Other initiatives include the setting up of the Minority Shareholders Watchdog Group
(MSWG) in 2001, amendments to the Companies Act 1965, the Securities Industry Act 1983,
the Securities Commission Act 1993, the Banking and Financial Institutions Act 1989 and
the Bursa Malaysia Securities Listing Rules (Subramaniam et al., 2009).
6. The sales figure in Transmile Bhd for the years 2006 and 2005 were inflated by RM530
million through the use of fictitious invoices.
 7. In the case of Southern Bank Bhd, the profit for the year was overstated by RM160 million IAF board quality
due to the use of inappropriate accounting treatment in valuing certain financial
instruments. Also, a number of items were capitalised instead of expensing out. and financial
8. Megan Media Holdings Bhd suffered a shortfall of RM456 million in the firm’s net realisable reporting quality
value due to various fraudulent transactions such as fictitious invoices, trading, payments
and trade creditors and false deposit payments.
9. Bursa Malaysia main listing rules (annual report disclosures) requires a statement in the 811
annual reports relating to the IAF – , i.e. whether the function is performed in-house or is
out-sourced and the costs incurred for the IAF in respect of the financial year.
10. An example provided by Schipper and Vincent (2003) is that managers will be
overcompensated if earnings that are overstated are used as a basis for their performance.
Likewise, earnings that are overstated may also disguise solvency that is declining which
may lead to lenders being misguided by continuing to lend or to delay foreclosure.
11. As at 31 December 2010, there were 844 firms listed on the Main Market of Bursa Malaysia.
Out of this, 224 firms were deleted (as discussed in the later part of this section) leaving a
total of 620 firms.
12. We chose chief internal auditors as our main respondents so as to be in line with prior
literature (Carcello et al., 2005; Raghunandan et al., 2001) and more importantly because they
are in the best position to provide the necessary information about their firm’s IAF. In
instances where the function is outsourced to external parties, we then sent the survey to
next most appropriate person in the organisation which is the financial controller.
13. The survey was first conducted in April 2012, with three follow-up reminders sent every
three weeks. Information was requested for financial years 2010 and 2009. Note: we did not
request 2011 data as most firms had a December financial year end and annual reports for
2011 will not be available till much later in the year.
14. Abnormal accruals is the error term as measured using the Kothari modified Jones
(Dechow et al., 1995) model (absolute value is used in testing):

TACit/TAt2 1 ¼ b0 1/TAt2 1 þ b1 (DREVit 2 DRECit)/TAt2 1 þ b2 PPEit/TAt2 1 b3

ROAit þ eit

where: TACit – total accruals scaled by TAt2 1; TAt2 1 – beginning balance of total assets
(total assets in the previous year); DREVit – the change in revenue of firm i scaled by TAt2 1
(Operating Revenuet 2 Operating Revenuet2 1); DRECit – the change in receivables of firm i
scaled by TAt2 1 (Receivablest 2 Receivablest2 1); PPEit – gross property, plant and
equipment of firm i scaled by TAt2 1.
15. Bumiputra are also referred to Malays. They form the dominant ethnic group in Malaysia,
followed by Chinese and Indians and a variety of indigenous groups in East Malaysia. Typically
the Malays form the controlling group in the Malaysian political administration (Johl et al., 2012).
16. The internal audit investment variable was not significant in both Prawitt et al. (2009) and
Lin et al. (2011) studies.

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Corresponding author
Shireenjit K. Johl can be contacted at: [email protected]

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