Internal Audit Use, Earnings Quality and External Audit Fees

Pacific Accounting Review, Vol. 33 No. 4, pp. 474-504. https://doi.org/10.1108/PAR-04-2020-0050

The University of Auckland Business School Research Paper Series

Posted: 25 Jan 2022

See all articles by Nishaal Prasad

Nishaal Prasad

The University of Auckland

David Hay

University of Auckland Business School

Lily Chen

University of Auckland Business School

Date Written: 2021

Abstract

Purpose
The purpose of this study is to examine the effect of internal audit function (IAF) use on earnings quality and external audit fees using empirical data collected from the New Zealand (NZ) setting.

Design/methodology/approach
Applying institutional theory as the underlying framework, this study examines an IAF’s ability to demonstrate legitimacy, which will shed light to the functions long-term survival. Using a unique data set from the NZ setting, which combines information obtained from “The Institute of Internal Auditors of New Zealand” with empirical firm data collected from publicly available sources, multivariate analysis is performed to test the prediction that IAF use is associated with earnings quality, measured using discretionary accruals, and external audit fees.

Findings
There is strong positive association between IAF use and external audit fees, which supports the complementary controls view, where better internal controls increase audit fees by increasing the demand for scope of external audit work. The authors find no significant relationship between IAF use and earnings quality, which is not entirely surprising.

Research limitations/implications
The aim is to empirically test the IAF value proposition and to delve deeper into the black box of IAF value drivers. Given the size of the NZ economy and limitations of data availability, total sample size used in this study is relatively modest. However, the analysis does yield significant results. Apart from academic contribution to knowledge, this study offers a profound list of practical contributions. Practitioners will be interested to learn about the IAF value proposition from an empirical viewpoint. Senior management (SM) will obtain value from the outcomes when contemplating IAF investment and sourcing decisions. Regulators will be inherently interested in whether IAFs should be mandated.

Originality/value
The aim is to empirically test IAF value proposition and to delve deeper into the black box of IAF value drivers. To the best of the authors’ knowledge, this is the first NZ-based academic investigation which examines the relationship between IAF use and earnings quality. Apart from academic contribution to knowledge, this study offers a profound list of practical contributions. Practitioners will be interested to learn about the IAF value proposition from an empirical viewpoint. SM will obtain value from the outcomes when contemplating IAF investment and sourcing decisions. Regulators will be inherently interested in whether IAFs should be mandated.

Full paper available at https://doi.org/10.1108/PAR-04-2020-0050

Keywords: Internal audit, Earnings management, Assurance, New Zealand, External audit fee

Suggested Citation

Prasad, Nishaal and Hay, David and Chen, Lily, Internal Audit Use, Earnings Quality and External Audit Fees (2021). Pacific Accounting Review, Vol. 33 No. 4, pp. 474-504. https://doi.org/10.1108/PAR-04-2020-0050, The University of Auckland Business School Research Paper Series, Available at SSRN: https://ssrn.com/abstract=4015913

Nishaal Prasad (Contact Author)

The University of Auckland

12 Grafton Rd
Private Bag 92019
Auckland, 1010
New Zealand

David Hay

University of Auckland Business School ( email )

12 Grafton Rd
Private Bag 92019
Auckland, 1010
New Zealand

Lily Chen

University of Auckland Business School ( email )

12 Grafton Rd
Private Bag 92019
Auckland, 1010
New Zealand

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