The Effect of Internal Audit Reports to Stakeholders on Audit Quality and Earnings Performance - Essay Example

The Effect of Internal Audit Reports to Stakeholders on Audit Quality and Earnings Performance: An Empirical Study of the Companies Listed on the London Stock Exchange (LCE) Introduction An internal audit is an independent and objective consulting and assurance activity in which the idea of adding value to enhance the operations of a company is the guiding principle. It helps the company to accomplish its objective by bringing a systematic and disciplined approach to evaluating and improving the efficiency of the company’s governance, internal controls, and risk management (Institute of international Auditors, 2010, p. 1). The quality of the audit plays a vital role in maintaining an efficient market environment. However, an independent quality audit underpins the confidence in the credibility and the integrity of the financial statements, which is essential for the proper functioning of the markets and the enhancement of financial operations (Farouk and Hassan, 2014, p. 2). The internal audit department provides an objective, reliable, and neutral service to the management, the board of directors, and the audit committee (Ljubisavljević and Jovanovi, 2011, p. 124). However, the stakeholders are interested in a return on investments, sustainable growth, reliable reporting on financial performance, strong leadership, and business practices (Al-Matari, Al-Swidi and Fadzil, 2014, p. 35). Recently, the issue of the globalization of auditing has gained more attention, and so the need for ensuring the quality of audit functions at different locations is essential. Similarly, the growth of investments across borders has increased, and thus the importance of evaluating the quality of financial statements attested to by audit firms has increased (Kleinman, Lin and Palmon, 2014, p. 62). The responsibility of the auditor is not exclusively to satisfy the needs of individual customers or employees. The auditor is responsible to the decision makers, either internally or externally, since they use the information with the belief that there are no material misstatements in the financial statements (Hoa et al., 2014, p. 73). The responsibility of the auditor is, therefore, to act in the interest of the public, since the perception of audit quality is necessary to ensure public confidence in public accounting. Scope of Internal Auditing The Institute of Internal Auditors (2015, p.1) defines the essential purpose, nature, and extent of internal auditing. It identifies an internal audit as an independent and purposeful assurance and consulting undertaking that intends to improve the value and functions of a firm. It assists the organization in achieving outlined goals by establishing a systematic, disciplined methodology of assessing and enhancing the effectiveness of risk management and governance practices (Büsselberg, 2011, p. 19). Internal auditors deal with important issues that can ensure the survival and prosperity of an organization. Unlike external auditors, their examinations go beyond the financial statements and risks to consider wider issues. These broader issues include the company’s reputation, growth, environmental impact, and the manner in which it relates to its employees. The overall aim of the internal auditor is to help an enterprise succeed. The auditor does this by combining assurance and consultation practices. In assurance, the internal auditors inform the managers whether the processes and systems of the company inquiries and concerns are working appropriately and then consult on how to improve these systems (Chartered Institute of Internal Auditors, 2015, p. 1). Roles of the Internal Audit Function The internal audit function (IAF) plays a significant role in a company. It helps the management in assessing risk and offers advice to the management on how to design and implement controls throughout the reporting process. The traditional monitoring role of the IAF is reviewing and testing the effectiveness of controls. Following the identification of control problems, internal auditing should come up with plans for collecting the issues and conducting follow-up reviews. In addition, the IAF is responsible for communicating the ongoing audit activities to the appropriate parties (Pizzini, Lin and Ziegenfuss, 2015, p. 29). Factors Affecting Audit Quality Audit quality comprises major features that seek to ensure that an organization carries out quality audits consistently. The chief factors that influence audit quality are the auditor’s competence level, the scope and the clarity of the audit objectives, and the degree of auditor independence. A firm can achieve a quality audit if it allocates the task to an auditor or audit team that has the right attitudes, ethics, and values with regard to the task. The team must have sufficient knowledge, experience, and skills, and the organization must allocate enough time for the team or the individual auditor to perform the duties (Wright and Capps III, 2012, p. 70). Furthermore, an organization can help to ensure a quality audit if the auditor or the team applies quality control procedures and processes that comply with the standards, laws, and regulations of the state. The team must interact appropriately with relevant stakeholders and provide the audit report on time. Therefore, the task of conducting quality audits on financial records and statements rests with the auditors. However, achieving quality audits depends on the environment, the support the auditor receives from the firm, and the level of participation and interaction with the financial reporting chain (International Auditing and Assurance Standards Board, 2011, p. 8). The manner in which stakeholders perceive audit quality varies depending on how directly involved they are with the audits and their assessment of audit quality (International Auditing and Assurance Standards Board, 2011. p. 3). Study of the Problem There has recently been unprecedented activity and change in auditing standards and the regulatory oversight of audits. However, the effectiveness of these developments in securing confidence in auditing over the long-term is still in question. In addition, it is questionable whether these new developments will ensure the capability of capturing all the conditions necessary for an audit, nor is it clear whether they will ensure adaptability to economic situations and new experience or lead to changes in perceptions of audit quality (Farouk and Hassan, 2014, p. 2375). This study will determine the effect of the internal audit reports issued to stakeholders on the quality of the external audit and the earnings performance of the companies listed on the London Stock Exchange. It will attempt to identify the extent of the relationship and the factors that affect it. Most researchers find some evidence that there is an inverse relationship between the quality of the audit report and the practices of earnings management. If a firm performs high-quality internal audit activities, this leads to a reduction in management earnings practices. As a result, there is an rise in the quality and transparency of the financial reporting. A firm can improve the independence and objectivity of the auditor by publicly linking the reputation of the partner to the audits that he oversees (Tepalagul and Ling, 2015, p. 102). The following questions helped in formulating the research problem. Research Questions 1. Is there a relationship between the management practices for earnings performance and the quality of the internal audit report? 2. Are there expected relationships between the quality of the external audit report and the practices of earnings performance? 3. Does the internal audit function affect the decisions of the external auditors when assessing fraud and risks? 4. Does the internal audit-reporting channel affect the external auditor’s fraud and control risks assessments? 5. What determinants for the quality of external audit activities are associated with a reduction in earnings performance? 6. Does the quality of the external audit have an impact on the earnings performance of companies listed on the London Stock Exchange? 7. What is the quality of earnings of the companies listed on the London Stock Exchange? 8. Are London auditing firms characterized by quality audit reports? Study Goal The fundamental endeavor of this research is to examine the relationship between the internal audit report to stakeholders (the dependent variable) and the external audit quality and earning performance of the companies listed on the London Stock Exchange (the independent variables). This will aid in determining the efficiency of the external audit in reducing earnings performance of companies listed on the London Stock Exchange. Other goals are as follows: • To recognize the factors influencing the quality of external audits for companies on the London Stock Exchange based on the relevant professional standards • To determine the relationship between aspects that affects the quality of the external audit and earnings performance • To investigate the factors that affects the quality of the external audit in connection with a reduction in earnings performance • To identify the effect of the internal audit reports to external stakeholders on the fraud risk and control risk assessments of external auditors • To investigate the extent to which internal audit-reporting channels affect external audit quality and earnings performance Importance of the Study Some companies engage in a number of fraud activities, such as manipulation of the accounting numbers and fraud financial reporting. The aim of this study is to examine the role of internal controls in helping to detect and reduce malpractices to help ensure the transparency of financial records. Having an independent and unbiased auditor confirms the financial transparency of an organization relating to the processes behind the transactions that are true and fair. The study will provide investors and shareholders with a trusted opinion regarding a company’s financial statements and provide insights into how the company is run. The study will help company accountants or finance directors to ensure that financial figures are accurate. Finally, the study will assist financial analysts in analyzing and commenting on the company’s financial position and help them to make predictions about the company’s future success. According to theories, a manager can boost investor confidence by investing in internal controls over financial reporting, ICFR (Wu and Tuttle, 2014, p. 445). ICFR refers to the controls that address risk regarding financial reporting. The controls help in providing an assurance that the organization’s financial statements are reliable and that they are in line with the generally accepted accounting standards (GAAP). Financial statements may be inaccurate because of issues such as mathematical errors, intentional misstatements (fraud) or misapplication of GAAP. Therefore, a good ICFR system should address such possibilities. The risk of fraudulent reporting is a major consideration in the design and operations of a company’s internal controls. For instance, market expectations for revenues, earning and other targets may pressure the management to meet these thresholds. Thus, effective ICFR helps assure that there are no misstatements in corporate records in response to those pressures. The company should therefore design and implement controls having the risk of fraud in mind and design them to the specific circumstances of the company. The motive behind regulators requiring audit firms to issue public transparency reports is that the transparency of an audit firm helps in ensuring audit quality. In addition, it makes it easy to differentiate between audit firms (Deumes et al., 2012, p. 194). Limitations of the Study Providing access to information involving its finances can be uncomfortable for a company. This made the process quite challenging due to resistance from the accounting and finance departments. In addition, most staff members within varied stock exchange firms had limited control over earnings and financial management imperative files or information. Study Sample The study will examine companies listed in the London Stock Exchange. As of 31 January 2015, there were 2429 companies listed in the London Stock Exchange. However, this study will focus on a few major companies listed on the London Stock Exchange. The study will sample the working staff members of these companies who have a relationship with the internal control and management of earnings. Research Methodology Data collection methods The survey makes use of data from secondary sources from the sampled firms annual accounts and report. The study will also use other secondary sources, such as journals, books, web pages, and statistics. In addition, a questionnaire distributed to the sample population will help to gather opinions about internal audits and controls in companies listed on the London Stock Exchange. Data analysis methodology The study examines the effect of the internal audit report to stakeholders on the external audit quality and earnings performance of companies listed on the London Stock Exchange. The study will adopt a descriptive design methodology, which involves conducting a survey while searching for facts about the companies’ scenario through observation (Kanire, 2012, p. 9). The method will help to measure and analyze the aforementioned scenario through the identification of variables and hypothetical constructs. Variables The study will use internal audit reports to stakeholders as the dependent variable while the independent variables will be external audit quality and earning performance, and it will provide a theoretical analysis of each variable. The analyses will show the importance of the variables with regard to the relationship between the quality of the external audit and earnings management. The study will measure these variables. Other independent variables selected for this study are as follows: 1. The size of the internal audit department 2. Internal auditors’ knowledge of company operations 3. Experience 4. Training 5. Independence of the internal audit 6. Availability of a quality control system in the performance of the audit function Hypotheses To achieve the objectives of this study, we test the following two hypotheses: Alternative hypothesis H1—There is an inverse correlation between earnings performance and the quality of the external audit activities Null hypothesis H2—There is no inverse correlation between earnings performance and the quality of the external audit activities. Conclusion The key target of the study is to examine the relationship between the internal audit reports to stakeholders (the dependent variable) and the quality of the external audit activities of the companies listed on the London Stock Exchange (the independent variable). To achieve the Objectives of this survey, we test the null hypothesis, which argues that there is no inverse relationship between earnings management and the quality of the internal audit activities. In addition, we test the alternative hypothesis, which states that there is an inverse relationship between earnings management and the quality of the internal audit activities. To establish another hypothesis, we will test other independent variables such as the size of the internal audit department and the staff members’ knowledge of company operations within the stock exchange firm. Additional variables include experience, training, and the independence of the internal audit, as well as the availability of a quality control system in the performance of the audit function. The study will use Primary and secondary sources of data and it will utilize descriptive design to analyze the data. Works Cited Al-Matari, E.M., Al-Swidi, A.K. and Fadzil, B.H.M. (2014). ‘The effect of the internal audit and firm performance: A proposed research framework’, International Review of Management and Marketing, 4(1), pp. 34-41, [Online]. 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