INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY: THE

JOINT IMPORTANCE OF INDEPENDENCE AND COMPETENCE

Lawrence J. Abbott
University of Wisconsin-Milwaukee

Brian Daugherty
University of Wisconsin-Milwaukee

Susan Parker
Santa Clara University

Gary F. Peters
University of Arkansas

October 2015

Accepted by Philip Berger. We are grateful for assistance from Tim Seidel and helpful
comments from Cory Cassell, Dana Hermanson, Chris Hines, Adi Masli, Bill Messier, Marcy
Shepardson, David Wood, and workshop participants at Santa Clara University, University of
Arkansas, Texas Tech University, 2013 AAA Annual Meeting, and 2012 Auditing Section
Midyear Conference.

Electronic copy available at: http://ssrn.com/abstract=2673280

 INTERNAL AUDIT QUALITY AND FINANCIAL REPORTING QUALITY: THE
JOINT IMPORTANCE OF INDEPENDENCE AND COMPETENCE

ABSTRACT

In light of the growing importance of internal audit functions (IAF) and the limited archival
evidence on internal audit quality, we examine an interactive model of IAF quality (comprised of
competence and independence) to better understand the determinants of IAF effectiveness as
financial reporting monitors. Our tests support the hypothesis that the joint presence of
competence and independence is a necessary antecedent to effective IAF financial reporting
monitoring. In sum our results show that the answer to “what is the effect of internal audit
competence (independence) on financial reporting quality?” is “it depends on the independence
(competence) of the internal auditor.” Our study extends the understanding of IAF quality
determinants in the realm of financial reporting as it relates to ongoing discussions by
researchers, standard setters, regulators, and practitioners.

Keywords: Internal Audit; Financial Reporting Quality; Auditor Independence; Auditor

Competence.

JEL CODES: M12 M42 M41 D83 G39

Electronic copy available at: http://ssrn.com/abstract=2673280

 I. INTRODUCTION

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

would require all NASDAQ registrants to maintain an internal audit function (IAF) (NASDAQ

[2013]).1 The New York Stock Exchange (NYSE) has required registrants to maintain an IAF

since 2006. The rationale for these requirements is that an effective IAF provides the audit

committee and other financial reporting stakeholders with critical information pertaining to a

company’s risks (including financial reporting risks) and internal controls (i.e. NASDAQ [2013],

Harrington [2004]). Similarly, corporate governance proponents consistently emphasize the

IAF’s role in enhancing financial reporting quality (Cohen et al. [2010], Prawitt et al. [2009],

Coram et al. [2008]). Nonetheless, the IAF’s role in the financial reporting process is not yet

fully understood and empirical evidence concerning the impact of IAF quality is minimal.

We investigate the potential impact of IAF quality as a joint function of the IAF’s

competence and independence. We base this view upon the theoretical work of DeAngelo

[1981], who notes that external audit quality is a function of the external auditor’s ability (i.e.

competence) to detect accounting misstatements and willingness (i.e. independence) to oblige

proper accounting treatments. Similar to DeAngelo [1981], we assume that within the internal

audit function, competence and independence are important and distinct constructs that must

interact to result in quality outcomes.

Despite the intuitive appeal of IAF quality positively impacting financial reporting

quality, prior empirical evidence is not as strong as the intuition would suggest. For example,

Prawitt et al. [2009], using data from 2000-2005, document mixed evidence between an overall

composite measure of IAF quality and financial reporting quality. Their single composite IAF

1
The NASDAQ subsequently tabled the proposal as registrants expressed concerns over the costs and benefits of the
proposal. An objective of the current study is to provide evidence concerning one aspect of the benefits.

1
quality measure adds several, equally-weighted individual IAF characteristics of competence and

independence. One potential explanation for prior mixed results revolves around how these IAF

characteristics interact with each other in creating IAF quality. Rather than an additive relation

between competence and independence whereby an increase in competence can compensate for

decreased independence, IAF quality may be more appropriately described as an interactive,

two-factor function of both competence and independence. Thus, IAF competence

(independence) may be unlikely to impact financial reporting quality unless it is in the presence

of IAF independence (competence).

In this paper, we develop and test a two-factor model of IAF quality as a function of the

IAF’s ability to prevent/detect financial misstatements (i.e. competence) and its inclination to

report the misstatements to the audit committee and/or external auditor (i.e. independence). Our

study uses survey evidence from 189 Chief Internal Auditors (CIAs) from Fortune 1000

companies during fiscal 2009.2 From this uniquely detailed and rich set of IAF data, we are able

to create separate measures of IAF competence and independence. Our measure of IAF

competence is based on the average hourly rate of budgeted IAF resources (Abbott et al. [2012]).

We also identify three potential factors related to IAF independence. First, consistent with

Abbott et al. [2012, 2010], we measure the audit committee’s IAF influence vis-à-vis

management’s IAF influence across multiple oversight dimensions.3 If upper management

2
As compared to other extant IAF research, our sample follows the implementation of the PCAOB’s Auditing
Standard No. 5 on the effectiveness of internal control over financial reporting (ICFR), a period when substantial
IAF resources were diverted to ICFR testing.
3
In contrast, prior research commonly utilizes a dichotomous influence variable based upon whether the IAF’s
formal reporting line is to the audit committee (e.g. Prawitt et al. [2009]). However, Abbott et al. [2010] note that 96
percent of Chief Internal Auditors agreed with the statement ‘the Internal Auditor reports to the audit committee.’
As such, the utilization of the formal reporting arrangement as the sole IAF independence characteristic leads to the
possibility that the dichotomous identification of the reporting line could simply capture a ceremonial structure and
may not be indicative of a significant degree of IAF independence.

2
(rather than the audit committee) wields greater IAF influence, this may cause the IAF to fear

reprisal should the IAF question management’s financial reporting decisions, and thus diminish

the IAF’s objectivity or independence (e.g. Cohen et al. [2010], Norman et al. [2010]).

In addition to audit committee IAF influence, a review of the IAF literature reveals two

other potential threats to IAF independence: whether the IAF serves as a management training

ground and the sizeable presence of an IAF outside service provider (OSP). In particular, when

the IAF is used as a management training ground, internal auditors may be more reluctant to

report financial reporting issues in an effort to ingratiate themselves to upper management

(Messier et al. [2011], Christ et al. [2015]). The presence of an OSP may create job security

concerns for the in-house IAF, as registrants may find the variable cost nature of OSPs attractive

as a means of achieving cost savings and/or financial reporting flexibility (Abbott et al. [2007]).

We regress our IAF-related variables and a set of control variables against common

measures of financial reporting quality, abnormal accruals (Prawitt et al. [2009], Kothari et al.

[2005]) and whether the firm just meets or beats analyst forecasts (Mande and Son [2012],

Prawitt et al. [2009], Koh et al. [2008]). Our abnormal accruals are further segregated into

income-increasing and income-decreasing abnormal accruals. Consistent with IAF quality being

a two-factor, interactive function of independence and competence, we document several

statistically significant relations between financial reporting quality and our interacted

competence and independence variables. We find that interactions between IAF competence and

(a) the relative degree of audit committee IAF oversight and (b) the lack of a substantial OSP

presence curtail both income-increasing and income-decreasing abnormal accruals. We obtain

similar results when we examine the firm’s proclivity to just meet/beat analysts’ forecasts.

3
 In contrast, when independence is proxied by whether the IAF is not used as a

management training ground, the interaction between IAF independence factor and competence

exhibits a statistically significant, mitigating impact on income-decreasing abnormal accruals.

This finding is consistent with lower likelihoods of IAF reporting of inappropriate income-

decreasing opportunistic reserve behaviors when the IAF is used as a management training

ground. In this manner, internal auditors hoping to move into a non-IAF position may endeavor

to ingratiate themselves to management, or demonstrate their ability to be a team player when

they perceive a lower downside of doing so.4

Our paper contributes to the IAF literature in several ways. Our study is the first to

establish IAF characteristics as separate, distinct constructs that act jointly in creating IAF

quality. In doing so, this study contributes to our understanding of IAF quality and the

determinants of the IAF as an effective internally-based financial reporting monitor. Second, our

results suggest that there are at least three factors that can impact IAF independence and that

these factors have differential interactive effects with IAF competence in influencing financial

reporting quality. In contrast, prior IAF literature generally uses a dichotomous, single-variable

independence measure and implicitly ignores other potential independence determinants (e.g.

Ahlawat and Lowe [2004]). Moreover, we find that our IAF independence characteristics are

either not correlated or only weakly related to each other or to our IAF competence measure.

This is consistent with (a) IAF independence being characterized as a multi-faceted attribute with

at least three determinants and (b) IAF independence and competence being separate and distinct

4
In terms of income-increasing abnormal accruals, internal auditors whose IAF serves as a management training
ground may simply defer auditing more contentious, higher-profile income-increasing abnormal accruals to the
external auditor. Internal auditors may do so with the knowledge that external auditors are likely to expend greater
audit effort on income-increasing accruals (Abbott et al. [2006]).

4
constructs. While there is a very rich literature on threats to external auditor independence, there

is a paucity of archival evidence on the potential determinants of internal auditor independence.

With respect to internal auditor competence, we also provide descriptive evidence of the

qualifications of the IAF staff and Chief Audit Executives (CAEs) in large firms, and the types

of functions those staff carry out. A more detailed understanding of the factors that influence IAF

independence and competence should be of interest to researchers, standard setters, regulators,

and practitioners in their efforts to hone the IAF’s role as a financial reporting monitor.

Our study also provides archival evidence on the impact of third-party IAF outsourcing

on in-house IAF independence. Prior research has treated outsourcing as a threat to in-house IAF

independence only when the provider of such services was the external auditor (in a pre-SOX

period when such service were allowed) (Abbott et al. [2007], Ahlawat and Lowe [2004]). The

evidence provided herein indicates that job security concerns can also be created by a large

outsourcing presence unrelated to the external auditor. Furthermore, we find that over 65% of

our sample IAFs have an outsourcing agreement in place and that close to 33% of our sample

IAFs have a sizeable portion (i.e. in excess of 20%) of their budget allocated to OSPs. Given the

pervasiveness of OSP-provided IAF services, we believe that future researchers should consider

the nature and magnitude of OSPs in analyzing IAF independence.

Finally, we provide evidence that our IAF competence proxy, the hourly in-house IAF

rate, effectively summarizes several key IAF traits used in prior literature that individually or

collectively represent IAF quality such as tenure and certification (e.g. Lin et al. [2011], Prawitt

et al. [2009]). Our competence variable has several attractive features for use in future research

as it (a) is continuous, (b) allows for comparison between IAFs of varying size, (c) does not

5
require researcher judgment regarding the weighting of IAF traits, and (d) does not require

subjective judgment by IAF respondents when collected via survey instrument.

Our study has several potential limitations. We draw survey data from a single year, and

2009 was a year of significant economic events which may have affected the generalizability of

our study in unknown ways.5 In addition, discretionary accruals as a measure of management

financial reporting discretion, though widely used, are likely to measure the underlying construct

with error. Our test variables, similarly, are likely to contain measurement error. We have

conducted a number of validity tests which are detailed in the sensitivity discussion, and support

our IAF variables and results. Lastly, common to examinations involving internal attributes of an

organization’s financial reporting environments, it is often difficult to disentangle the potential

endogeneity of the roles that reside within an organization (such as the IAF, Audit Committee,

and Executive Suite). Nonetheless, we believe our study offers insights into the operations of an

increasingly important component of the internal control systems of large companies.

II. BACKGROUND AND PRIOR LITERATURE

Prior IAF research investigating audit outcomes generally focuses on the external

auditor’s reliance on the IAF for financial statement audit assistance (e.g. Bame-Aldred et al.

[2012], Abbott et al. [2012], Messier et al. [2011], Prawitt et al. [2011]). This stream of research

focuses on the two most prevalent IAF characteristics which extant audit standards guide

external auditors to consider: competence and independence.6 Competence generally refers to the

auditor’s ability to perform tasks diligently and in accordance with professional standards (e.g.

5
We address this issue by conducting our analysis over the years 2010-2011, assuming that our test variables would
remain consistent over a short horizon. We found that our results continued to be significant over that timeframe.
6
The AICPA’s Statement of Auditing Standards 65 (SAS 65) discusses indicators of IAF competence and
independence; however very little overlap exists among the factors that SAS 65 describes as competence-related vis-
à-vis independence-related (AICPA [1991]).

6
IAASB [2013]). The IIA defines competence as “the ability of an individual to perform a job or

task properly, being a set of defined knowledge, skills and behavior” (IIA 2013). Within an IAF

setting, independence is defined as “the freedom from conditions that threaten the ability of the

internal audit activity to carry out internal audit responsibilities in an unbiased manner” (IAASB

[2013]). In other words, independence is often framed as objectivity or as the means to protect

against bias, conflict of interest, or undue influence of others that would override professional

judgments.

Prawitt et al. [2009] is the first archival study to link IAF quality to financial reporting

quality. The IAF quality measure used in Prawitt et al. [2009] is a single, additive composite,

comprised of equally-weighted metrics representing experience, certification, training, IAF

reporting structure, time spent on financial activities, and relative IAF size. Using data from

2000-2005, the authors find their composite measure of IAF quality is associated with mitigation

of income-decreasing accruals, but not income-increasing accruals. When they disaggregate their

IAF characteristics, they find positive relationships between financial reporting quality and the

IAF’s professional certifications (income-decreasing accruals) and IAF size relative to industry

(income-increasing accruals).7 Prawitt et al. [2009] do not find significant associations between

IAF independence characteristic (whether the IAF reports to the audit committee) and financial

reporting quality.8 While their composite measure of IAF quality includes facets of competence

and independence, it is unclear when both of these characteristics are present for a given firm

and whether their relationship is interactive or additive.

7
They explain the unexpected result on IAF size as the possibility that IAF size proxies for the difficulty of
monitoring the firm, and when monitoring is more difficult, managers may be able to find avenues to exercise more
discretion to increase income.
8
During the sample period involved (2000-2005), Prawitt et al. [2009] find significant variation in this measure: 69
percent of sample IAFs reported to the audit committee and, as such, this was likely to be an appropriate and
parsimonious proxy for IAF independence.

7
 Recent research points to other potential determinants of IAF independence and measures

of how audit committees influence IAF independence, such as outsourcing presence,

management training ground usage, and perceived audit committee influence. (Abbott et al.

[2007], Quarles [1994], Messier et al. [2011], Abbott et al. [2012]). In sum, prior research has

provided only limited evidence on the impact of IAF quality. Furthermore, a number of IAF

competence and independence measures have yet to be linked on a stand-alone (or interactive)

basis to financial reporting quality. Finally, the IAF profession has also identified other

mechanisms that can influence IAF independence that have yet to be investigated.

III. HYPOTHESIS DEVELOPMENT

IAF Mechanisms for Impacting Financial Reporting Quality

The focus of this paper is on the association between IAF quality and financial reporting

quality. Therefore, an important antecedent to our research question is a description of the

specific mechanisms by which an IAF can influence financial reporting quality. We posit that

these opportunities arise within at least four activities: assisting with the financial statement

audit, financial statement audit of subsidiaries, compliance auditing, and special consulting

projects.9 Within the areas of financial statement audit assistance and audits of subsidiaries, the

IAF performs specific audit procedures that allow them to potentially influence accrual

decisions. These include review of the financial closing process, reviewing procedures for non-

standard journal entries and post-closing adjustments and specific reviews of critical accruals

such as accounts receivable valuation and inventory reserves (IIA [2011]). Compliance auditing

can involve testing transactions or journal entries for compliance with the company’s financial

9
We developed this list from review of the prior literature, examination of IAF professional guidance, and
discussion with CIAs. As discussed in our results section, respondents indicate a non-trivial budget allocation to
these four activities.

8
reporting policy. Special consulting projects may also involve the IAF delving into accounting

matters that require greater judgment on the part of the preparer, such as asset impairments,

warranty reserves, collectability reserves and/or inventory write-downs (PwC 2009).

It should be noted that in any of the prior tasks, the IAF may encounter high-level

accruals choices. More specifically, the IIA notes that the IAF should review the policies,

procedures, and process for reporting and related disclosures. In particular, the IIA notes that

‘special or specifically targeted reviews of high-risk, complex, and problem areas; including

material accounting estimates, reserve valuations, off-balance sheet activities, major subsidiaries,

joint ventures, and special purpose entities’ are recommended activities for the IAF (IIA 2011).

Audit Committee IAF Oversight in the Interactive IAF Quality Model

This study’s examination of IAF quality – and its potential impact on financial reporting

quality – asserts that competence and independence are necessary, but not individually sufficient

determinants of IAF quality. We investigate the potential impact of IAF quality as a joint

function of the IAF’s competence and independence. While it is expected that a competent

auditor is more likely to discover a financial reporting misstatement, the reporting of the

discovered misstatement is contingent upon the auditor’s independence or objectivity. Similar to

DeAngelo [1981], we assume that competence and independence are distinct constructs that

must interact to ultimately impact financial reporting quality.

Our first hypothesis pertains to the interaction of IAF competence and IAF independence,

measured by audit committee or C-Suite influence. Both external and internal auditing standards

assert that internal auditor independence is a direct function of the reporting relationship between

the audit committee and the IAF (IIA [2002], AICPA [2013]). However, even though official

reporting by the IAF to the audit committee is common, the extent and effects of active oversight

9
by the audit committee and unofficial oversight by management varies greatly (e.g. Hoffelder

[2012], Ernst & Young [2008], Mabry and Schwartz [2008]). Moreover, prior academicians

highlight the inherent conflicts of IAFs serving both management and the audit committee

(Anderson [2003], Hermanson and Rittenberg [2003], Hermanson [2002]).

Prior research supports an association between greater audit committee oversight and

greater independence for the IAF. For example, greater audit committee oversight of the IAF is

associated with the greater shielding from possible management pressure (Carcello et al. [2005],

Quarles [1994]).10 If the IAF is not sufficiently shielded from possible management pressure, the

CEO or CFO can reduce the likelihood that the issue will be reported to the proper channel.

When the departure from reporting policy originates at the C-Suite level, the IAF’s independence

is particularly important. A lack of independence of the IAF from the C-Suite may preclude the

IAF from initiating a review of financial reporting choices made at the CFO/CEO level. This

may prevent the discovery and reporting of financial reporting policy departures. 11

Following our expectations, we posit that as audit committee IAF influence (IAF

independence) increases, the likelihood that a misstatement discovered by a competent IAF is

either (a) properly reported to the audit committee and external auditor or (b) corrected by the

party responsible for the original misstatement also increases. Both scenarios lead to greater

financial reporting quality. This leads to our first hypothesis (stated in alternative form):

H1: The interaction between IAF competence and audit committee IAF influence is
positively associated with financial reporting quality.

10
For example, the internal auditors may be charged with reviewing the proper application of the firm’s policy for
recording an inventory reserve. Divisions within the firm with separate profit targets may have incentives to either
under- or overstate the reserve in order to maximize internal rewards.
11
This mechanism may operate in two ways. First, the CEO/CFO may effectively pressure the IAF to ‘filter’ any
IAF-generated reports that are forwarded to either the audit committee or external auditor. 11 Second, to the extent
that the CEO/CFO can influence IAF budgets or activities, the CEO/CFO may direct the IAF towards other
activities that have an immediate, beneficial impact on current earnings such as the examination of vendor rebates or
other operational concerns, etc. (Abbott et al. [2010]). In doing so, the IAF is effectively precluded from collecting
evidence that might serve to repudiate other compliance deviations involving financial reporting decisions.

10
The IAF as a Management Training Ground in the Interactive IAF Quality Model

The second IAF independence determinant interacted with IAF competence is the

organization’s use of the IAF as a management training ground (MTG). Prior research suggests

that the use of IAF as an MTG is prevalent among corporate entities (Messier et al. [2011],

Christ et al. [2015], Stewart and Subramaniam [2010]). Many organizations see this as a means

to attract and develop corporate talent by instituting both formal and informal rotations within

the IAF (Ernst & Young [2008]). Despite these intended benefits, other IAF constituents see this

as a potential threat to the independence of the IAF (Christopher et al. [2009] Ahlawat and Lowe

[2004], Goodwin and Yeo [2001]). Although concerns about both the costs and benefits of this

practice remain, the use of the IAF as an MTG is common (Prawitt et al. [2009]).

To date, few studies directly investigate the impact of MTGs on IAF independence

(Stewart and Subramaniam [2010]). Messier et al. [2011] document a negative association

between the use of the IAF as an MTG and the external auditor’s assessment of IAF

independence. Despite the negative effect on perceived independence, MTG’s were not

associated with perceived differences in internal audit competence. This provides further

evidence suggesting that independence and competence are separate and distinct constructs.

When the IAF is an MTG, the IAF may be less likely to report the financial misstatement

to the appropriate channel. If the misstatement reflects negatively on the division’s management,

those managers may be less likely to offer that particular internal auditor a position within that

division. Positive internal references may be less likely for an internal auditor seeking a position

at a different division within the same company. In order for a misstatement to be corrected prior

to the consolidation of results at the parent level, both IAF competence and independence must

be present. As with our prior hypothesis, we consider the financial reporting quality

11
consequences of the joint importance of IAF independence and competency when independence

is potentially conditioned by the explicit use of IAF as a management training ground. This leads

to our second hypothesis (stated in alternative form):

H2: The interaction between IAF competence and an IAF that is not used as a
management training ground is positively associated with financial reporting quality.

Outsourced Internal Audit Activities in the Interactive IAF Quality Model

The final IAF independence factor interacted with IAF competence is the presence of a

substantial outside service provider (OSP). Outsourced IAF activities represent ongoing sourcing

strategies for many internal audit departments (Stewart and Subramaniam [2010]). Outsourcing

all or a portion of the IAF provides management with the flexibility of adjusting IAF costs

during the course of the year because outsourced IAF hours are essentially variable in nature. In

contrast, in-house IAF hours are fixed in nature due to salary structure. Moreover, outsourced

IAF can allow management to defer expense recognition into subsequent accounting periods by

simply scheduling outsourced IAF activities into following years. This contracting flexibility

may be especially attractive to management when the firm is faced with revenue shortfalls.

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

decreased, in-house IAF independence. In particular, Abbott et al. [2007] and Quarles [1994]

note that a substantial IAF outsourcing presence may undercut the in-house IAF’s willingness to

confront management on issues due to concerns over job status. If an internal auditor feels

‘replaceable’ as a consequence of outsourcing, they may be less willing to report a misstatement

to the appropriate outlet for fear of losing their job within the firm (Abbott et al. [2007], Quarles

[1994]). As before, increased independence, in this case the lack of a substantial IAF outsourcing

presence, increases the likelihood that a misstatement discovered by a competent IAF is properly

12
reported or corrected by the party responsible for the misstatement.12 As prior stated, we consider

the financial reporting quality consequences of the joint importance of independence and

competency when in-house IAF independence is potentially influenced by the presence of

outsourced IAF services. This leads to our third hypothesis (stated in the alternative):

H3: The interaction between IAF competence and the lack of a substantial IAF
outsourcing presence (increased IAF independence) is positively associated
with financial reporting quality.

IV. RESEARCH DESIGN

Sample selection

We mailed the survey questionnaire provided in the Appendix to 909 non-bank members

of the FORTUNE 1000 (in terms of total sales).13 Consistent with most prior internal audit

research (e.g. Abbott et al. [2012, 2010], Carcello et al. [2005], Raghunandan et al. [2001],

Scarbrough et al. [1998], Pelfrey and Peacock [1995]), we directed our survey to the Chief

Internal Auditors (CIAs). We requested information about the types of IAF services provided

(whether in-house or outsourced), assistance to the external auditors, presence and activities of

any OSPs, the reporting relationship between the IAF and the audit committee, and whether the

IAF serves as a management training ground. We asked recipients to provide responses based

upon fiscal year 2009.

The first survey (sent October 2009) resulted in a total of 118 usable responses. A follow-

up mailing (December 2009) produced an additional 99 usable responses, for a total of 227.14

12
Though we feel the preponderance of evidence points to a positive association between reporting quality and the
lack of an OSP, we acknowledge that it is possible that the use of an OSP might instead serve to spur the IIA to
greater effort and independence in order to prove their worth to the organization.
13
Banks are excluded since they do not possess inventory and have unique regulatory environments. We identified
909 non-bank firms within the Fortune 1000.
14
Our effective response rate of 20.7 percent (or 189 responses/909 total companies) compares favorably with the
12.7 percent rate obtained by Felix et al. [2001] in their internal audit study. However, the Felix et al. rate may have
been depressed by the need for survey responses from both the internal and external auditors to constitute a

13
However, we were unable to obtain complete Compustat data for 38 of these firms, bringing our

total sample to 189. Table 1 provides a distribution of observations by two-digit focus industry

membership (Hogan and Jeter [1999]). To test for potential non-response bias, we compared the

characteristics of the early and late responders with each other and tested for significant

differences in size, leverage, return on assets, presence of a loss and cash flow from operations.

None of the differences were significant.15 We also compared our respondents to the industry

makeup of the original population of non-bank Fortune 1000 firms. We conducted a test of

differences of proportions comparing the industry sample representation to the population and

found only the under-representation of the energy and manufacturing sectors to be significant.

[Insert Table 1 Here]

Characteristics of the IAF

Our survey responses provide information about the current nature of the IAF function in

terms of qualification and activities. We document that the overwhelming majority (over 80%) of

CAEs have a CPA certification while, perhaps surprisingly, only 39% have a Certified Internal

Auditor (CIA) certification. Responses also indicate that the CISA certification is relatively rare

amongst CAEs (at approximately 10%). As a reflection of the changing and increasing

importance of systems-based auditing, we find that the CISA certification is much more

prevalent (16%) amongst staff. At the staff level, the CPA certification dominates, though less

than half of staff (40%) have a CPA certification, while over a quarter of staff have a CIA

certification (28%). The CPA-CIA certification 'gap' is lower for staff (40% versus 28%) than it

is for CAEs (82% versus 39%). The CPA-CIA certification gap indicates that the current

complete sample pair. Our response rate is higher than that reported in previous studies of senior managers. For
example, Graham and Harvey [2001] report a nine percent response rate.
15
As with all surveys, there is a possibility of unknown response bias and of incorrect responses. While we tested our
early and late respondents for differences on a number of dimensions, as previously discussed, it is possible that
undetected bias is present.

14
generation of CAEs was most likely hired from external audit firms. Experience in financial

statement auditing is strongly correlated (0.88) with the possession of a CPA. We believe this

provides information about the composition of the IAF at both the staff and executive level.

We also provide descriptive statistics about what activities IAFs are performing. We note

that 100% of survey respondents allocated a portion of their annual IAF budget to Section 404-

related work. Second, the mean percentage of in-house IAF budgets allocated to Section 404

assistance was 27.5% - the highest budget allocation percentage amongst IAF activities. Sample

results indicate that over 65% of our sample IAFs have an outsourcing agreement in place and

that on average, close to 31.8% of outsourced IAF budgets are dedicated to Section 404

assistance. Thus, if an outsourced IAF is utilized, it is utilized heavily to provide Section 404

assistance. This result is consistent with our contention that a significant outsource provider

(OSP) presence could represent a threat to internal IAF independence since there is a large

overlap in the services that are provided by in-house IAFs vis-à-vis OSPs.

Regression Model

To test the relationship between financial reporting quality and the interactive nature of

IAF competence and independence we adapt the following regression model from prior research:

ABNACC = b0 + b1IACOMP + b2ACIAFINF + b3NONMTG + b4NONOSP20 +

b5IACOMP*ACIAFINF + b6IACOMP*NONMTG + b7IACOMP*NONOSP20 +
b8ASSETS + b9AGE+ b10LEVERAGE + b11SEGNUM+ b12CFO +
b13SALESGROW+ b14MTB+ b15CFOVOL + b16ROA + b17LOSS +
b18MATWEAK + b19-28INDUSTRY +      

The variables used in the empirical models are summarized in table 2 and discussed below.

[Insert Table 2 Here]

Dependent Variable

Following prior audit literature we utilize abnormal accruals (ABNACC) as a proxy for

15
financial reporting quality (Francis [2011]). To measure abnormal accruals, we use the

performance-adjusted cross-sectional variation of the modified Jones model (Dechow et al.

[1996]) as reported by Kothari et al. [2005].16 The Kothari et al. model includes both an intercept

term and a measure of performance. Consistent with prior research, we first estimate the model

for firms with information available on Compustat for 2009 (excluding financial institutions),

and apply the results by two-digit SIC code to the calculation of abnormal accruals for the firms

in our sample.17 Our estimate of abnormal accruals is the residual from the following regression:

[TAit/Ait-1] = 0 + 1[1/Ait-1] + 2[(REVit - ARit)/ Ait-1] + 3[PPEit/Ait-1] + 4[NIit/ Ait-1] + it

We then segregate our abnormal accruals as positive (income-increasing) and negative (income-

decreasing) abnormal accruals. Our predicted relations are symmetrical for negative and positive

accruals. We argue that if the information used for internal decision-making is incorrectly biased

in either direction, there may be career penalties for the internal auditor.

Test variables

Our test variables are IACOMP, ACIAFINF, NONMTG, and NONOSP20, and their

respective interactive terms. Consistent with Abbott et al. [2012], IACOMP is a proxy for IAF’s

competence. IACOMP is defined as the average in-house IAF resource expenditure per budget

hour. We divided total in-house IAF budget per survey question #4 by total in-house IA hours

per question #1. On average, the resource commitment per hour of budgeted audit staff should

capture and summarize several disparate dimensions of IAF competence such as educational

16
Our sample size, though small compared to many discretionary accruals studies, is similar to other survey-based
work in the area (Prawitt et al. [2012, 2009]).
17
In separate untabulated tests we also limited data for the estimation model to only Fortune 1000 firms. However,
there were a total of 47 firms (almost a quarter of our sample) for which we could not estimate a reliable accrual
estimation model followed the Fortune 1000 restriction and produced inconclusive results. Thus, our tabulated
ABNACC variable based upon the Compustat population represents a trade-off between capturing additional
business norms that drive transactional accruals within a given Industry (population based) vs transaction accruals
that might be limited to only a large-firm environment (large-firm subsample).

16
level, professional experience, and certification of the IAF staff. When we compare IACOMP to

the Prawitt et al. [2009] IAF quality measure, we find that most of the elements of the Prawitt et

al. [2009] measure are related to competence (experience, certifications, training, IAF size [a

measure of unexpected spending on the IAF]). We suggest these individual IAF traits are

captured by an hourly, in-house IAF compensation rate.18

Following Abbott et al. [2012], we incorporate a separate continuous measure of audit

committee influence into our tests of IAF independence. Prior internal audit research suggests

that oversight roles or influence, though potentially prescribed by a charter, do not necessarily

manifest themselves in practice as dichotomous characteristics (Ernst and Young [2008], Rose

and Norman [2008], Kaplan and Schultz [2006]).19 Therefore, ACIAFINF is defined as the

relative level of influence exerted over the IAF by the audit committee vis-à-vis management. To

measure ACIAFINF we asked (survey question #12) CIAs to state their level of agreement

concerning the amount of influence exhibited by the audit committee versus management (CEO

and CFO) on reporting lines, termination rights, and budget determination.20 The level of

agreement can range from strongly disagree (‘1’) to strongly agree (‘5’). We then construct a

ratio of the total agreement points for the audit committee in the numerator (i.e. the sum of

agreement points for survey questions #12a., #12d. and #12g.) divided by the total agreement

18
We believe our composite IACOMP measure offers other certain advantages, as it incorporates many different
IAF elements (i.e. experience, certification, training) into one summary measure, is continuous in nature (allowing
for easier comparison between different-sized IAFs), and does not require an implicit equal weighting of inputs. Due
in part to the underlying relationship between budgets and hours, we include additional subsequent tests to ascertain
whether our proxy is correlated with various dimensions of competence. See additional analysis discussions.
Utilizing per hour amounts strengthens our ability to capture individual auditor traits that might otherwise be lost
when utilizing a measure of competence based upon IAF budgets deflated by firm size. Defining IACOMP as
Budgets / Firm size yields inconclusive results, likely due in part to its lack of correlation with individual auditor
competence traits that drive per hour costs. We thank the anonymous reviewer for bringing this to our attention.
19
Ernst & Young [2008] notes that audit committees take different approaches to the level of active oversight of the
internal audit department, in which the internal auditor may perceive different levels of actual influence or authority
exhibited by the corresponding overseer.
20
Similar to Abbott et al. [2008] we do not utilize answers to survey question 12j.-12l. (reviewing/approving the
IAF’s annual risk assessment plan) when calculating the ACIAFINF variable.

17
points for the audit committee, CFO, and CEO in the denominator (i.e. the sum of agreement

points for survey questions #12a. - #12i.).21

To further illustrate ACIAFINF, if the CIA answers ‘5’ (i.e. strongly agrees) to all survey

questions #12a.-12i., then the audit committee is seen as an equal tri-partner with management.

Our ACIAFINF variable would receive a value of .33, denoting 33 percent relative oversight of

the internal audit function, vis-à-vis management. If, however, the CIA strongly disagrees with

any CEO/CFO relationship, while strongly agreeing with all audit committee relationships, our

ACIAFINF variable equals 1, denoting full IAF control by the audit committee.22

NONMTG represents our second facet of the IAF’s independence; namely, whether IAF

is formally used as an MTG. NONMTG is coded ‘1’ when the IAF is not part of a management

training rotation, but instead is considered a separate career position within the company (survey

question #13). The results of viewing the IAF as a distinct career position potentially induces

greater attachment by the staff to the role of professional internal auditor, and thus a greater

commitment to independence. In addition, those professionally attached to the IAF are less likely

to feel pressure from audited managers in order to protect future placement opportunities.

21
Within upper management, the IAF can report to either or both the CEO and CFO. We combine the CEO and
CFO responses since both share common risk preferences (compared to the Audit Committee) and are required by
SOX Section 302 to certify the financial statements (SOX [2002]).
22
Survey responses to questions #12a-12i can range from 1-5, but are recalibrated to a scale of 0-4. By doing so, our
ACIAFINF variable captures the intuition behind the relative IAF influence. For example, assume the CIA
respondent strongly agrees with the audit committee’s influence over IAF reporting, termination and budgeting (i.e.
responds with a ‘5’ for survey questions 12a, 12d and 12g). Also assume the CIA respondent also strongly disagrees
with the CEO and CFO’s influence over IAF reporting, termination and budgeting (i.e. responds with a ‘1’ for
survey questions 12b/12c, 12e/12f and 12h/12i). Without recalibration to a 0-4 scale, the ACIAFINF value would
equal 0.833 [e.g. (5+5+5)/(5+1+1+5+1+1+5+1+1)]. With recalibration, the ACIAFINF value becomes 1 or
[(4+4+4)/(4+0+0+4+0+0+4+0+0)]. A second example further illustrates. In this case, assume the CIA strongly
disagrees with the audit committee’s IAF reporting, termination and budgeting influence (i.e. responds with a ‘1’ for
survey questions 12a., 12d. and 12g.) and also strongly agreed with the CFO’s reporting, termination and budgeting
influence (i.e. responds with a ‘5’ for survey questions 12b., 12e. and 12h.). Also assume the CIA strongly disagreed
with the CEO’s IAF reporting, termination and budgeting influence (i.e. responds with a ‘1’ for survey questions
12c, 12f and 12i). In the case, ACIAFINF equals 0 [e.g. (0+0+0)/(0+4+0+0+4+0+0+4+0)].

18
 NONOSP20 represents the extent of the threat to the in-house IAF presented by the extent

of outsourcing. Limited outsourcing may be related to the need for specialized expertise not

possessed by the IAF, but larger levels of outsourcing may indicate a willingness on the part of

company to consider outsourcing core IAF functions. We identify outsourcing of more than 20%

of the total budget as an appropriate level to indicate a possible threat to the IAF. The initial 20%

threshold is based upon informal conversations with internal auditors concerning the level at

which outsourcing would appear to threaten job security. We expect that, as the level of

outsourcing increases, the in-house IAF may view itself as vulnerable to replacement, thus

reducing the internal IAF’s independence. NONOSP20 is coded ‘1’ if the level of outsourcing

does not reach 20%, reflecting little or no threat to IAF independence. The extent of outsourcing

is constructed from survey question #4:

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

Each of our stated hypotheses addresses the interactive nature of IAF competence and

separate measures of independence. We test H1 by interacting IACOMP and ACIAFINF. We test

H2 by the interacting IACOMP and NONMTG. We test H3 by interacting IACOMP and

NONOSP20. In all three interactions we expect a negative (positive) association with abnormal

accruals (financial reporting quality).

Control variables

We include control variables that may impact the level of abnormal accruals. We expect

that ASSETS (log of company size) will magnify the size of accruals (Dechow and Dichev

[2002]). For this reason, we predict a positive association between company size and positive

accruals and a negative association between company size and negative accruals. AGE (number

of years the company has been listed on Compustat, truncated at 25 years) is included because

19
firms may experience different accrual patterns as they age (Prawitt et al. [2009]). We expect

that LEVERAGE (total debt/total assets) will be associated with more income-increasing accruals

to allow for non-violation of debt covenants (Press and Weintrop [1990]) and income-decreasing

accruals (DeAngelo et al. [1994]) to reduce earnings for contractual renegotiations. We include a

variable that proxies for firm complexity using the number of operating segments a firm

discloses in its 10K (SEGNUM). Firms with greater complexity may have greater financial

reporting latitude due to the inherent complexity of their operations. We therefore expect that

SEGNUM will be positively (negatively) associated with income-increasing (income-decreasing)

abnormal accruals. CFO (operating cash flows), SALESGROW (sales growth from the prior

year), MTB (market to book) are included to control for growth, and CFOVOL (operating cash

flow volatility) is included because it may impact the accrual calculation (Menon and Williams

[2004], Matsumoto [2002], Dechow et al. [1996]).

Low performance provides an incentive for accruals management, so we include ROA (net

income/assets) and LOSS (coded ‘1’ if the firm experienced a loss in the preceding year, ‘0’

else). In terms of income-increasing abnormal accruals, increases in ROA may impact the

calculation of abnormal accruals and we expect a positive relation. In terms of income-

decreasing accruals, positive ROA provides incentives to ‘smooth’ earnings and we expect a

negative association between ROA and income-decreasing abnormal accruals. Firms with a net

loss may have incentive to magnify income-increasing abnormal accruals to avoid debt covenant

violations and magnify income-decreasing abnormal accruals to ‘take a bath.’ We therefore

expect a positive (negative) association between LOSS and income-increasing (decreasing)

abnormal accruals. We also include an indicator variable for the presence of material internal

control weaknesses. Material weaknesses have been shown to be associated with an increase in

20
abnormal accruals (Doyle et al. [2007]). Finally, consistent with prior accruals-based research,

we include dummy variables for focus industry membership.

[Insert Table 2 here]

V. RESULTS

Descriptive statistics

Table 3 presents descriptive statistics for the 189 respondents. Panel A provides

information related to the IAF budget. The mean number of in-house (outsourced) IAF hours is

34,873 (4,195) and the mean in-house (outsourced) budget is $2,056,236 ($484,312). The mean

(median) IACOMP is $102.42 (87.72). Approximately 85 percent of the respondents reported

that IAF was a management training ground. The mean ratio of OSP budget dollars to in-house

dollars is 17.7 percent, with a median of 7.2 percent and a range of 0 at the 25th percentile to 33.2

percent at the 75th percentile. Almost 34 percent of the 133 firms that outsourced had an OSP

budget higher than 20%, indicating the pervasive nature of outsourcing portions of the IAF.

[Insert Table 3 Here]

Panel B of Table 3 provides details concerning ACIAFINF. The mean (median) overall

ACIAFINF measure is 0.41 (0.42), suggesting that on average the organizational oversight of the

IAF is almost evenly split between management and the audit committee. As in Abbott et al.

(2012), there is substantial, inter-firm variation among the oversight roles. We find that for the

lower 25 percent of sample firms, the audit committee has relatively little influence over the IAF

with a value of 0.26. The upper 25 percent of sample firms suggest that the IAF’s potential

objectivity is relatively more protected from management influence, with the 75th percentile

value of ACIAFINF equaling 0.61.

21
 The audit committee’s oversight is strongly manifested in reporting lines and termination

authority. The respondents agree strongly with the statement that the IAF reports to the audit

committee (mean of 4.73 and median of 5.00), and only slightly less strongly with the statement

that the audit committee has termination authority over the CIA (mean of 4.52 and median of

5.00). However, in terms of reporting relationships, internal audit appears to be reporting to both

the audit committee and the CFO or CEO. This could be indicative of a ‘solid line’ or functional

relationship with the audit committee and a ‘dotted line’ or administrative relationship with the

CFO or CEO. We observe lower agreement with the statement that the audit committee

determines the IAF’s budget (mean of 3.22 and median of 3.00). Budgetary authority is greater

for the CFO than the audit committee (mean of 3.75 and median of 4.00). The budgetary

authority response represents the primary difference from results reported by Abbott et al. [2012]

in a similar survey from an earlier time period (2005). We believe that the economic situation in

our sample year, 2009, is a likely explanation for the difference. In tight economic conditions, it

seems probable that all areas of the firm, including the IAF would be scrutinized by the CFO for

possible cost savings.

Table 3, panel C shows the control variable descriptive statistics. Our companies are quite

large and ‘old’, as might be expected, with a mean (median) asset size of $19.6 billion ($5.3

billion) and a mean (median) age of 20.49 (25) years. Their leverage is fairly high (mean of 47

percent, median of 45 percent), and most have been public companies for at least 25 years, and

many for much longer. Our sample firms have on average 4.32 operating segments. Operating

cash flow is $1.78 billion (mean), $567 million (median). Notably, mean sales growth from

2008-2009 was -11.8 percent, and mean ROA was 3.2 percent, reflecting the 2009 economic

environment. The mean market-to-book ratio is 2.6, while mean cash flow volatility is 496.9.

22
Reflecting the economic downturn during our sample period, the incidence of a prior year loss

(LOSS) is almost 27 percent. All these measures (except loss incidence) are lower than those

reported in Prawitt et al. [2009], again likely reflective of the updated economic environment in

our study. We also note a very low incidence of reported material weaknesses, with the mean of

MATWEAK of 0.0405. This is consistent with a dramatic decrease in Section 404 weaknesses

after the issuance of AS5 (PCAOB [2007]). Table 3, panel C also shows that the mean ABNACC

is 0.0289, and the median is -0.0139.

Univariate results

Table 4 provides the results of examining the sample, based upon whether the respondent

firms do not use the IAF as a management training ground (NONMTG) or do not have substantial

OSP (NONOSP20). In panel A, firms not utilizing the IAF as a management training ground

(n=28) are larger and have higher cash flows than firms that use the IAF as a management

training ground (n=161). This is generally consistent with larger IAFs being able to provide an

internal audit ‘career’ (Messier et al. [2011]). Panel B of Table 4 provides univariate differences

based upon firms with less than 20% of their budgets attributed to outsourcing (n=125) and those

with more than 20% (n=64). We note that firms without a substantial OSP presence have a

greater audit committee IAF influence and a less severe deceleration in sales. The former result

suggests that audit committees may exert a preference for in-house IAF. The latter result

indicates that outsourcing may be an attractive means of cutting costs. We find no difference in

the lack of a management training ground between the two sub-samples.

Table 4 Panel C provides univariate comparisons based upon whether firms just meet or

beat their analyst’s EPS forecast (n=37) and those that do not (n=152). We find a low level of

just meeting or beating analyst forecasts (less than 20%), consistent with the Sarbanes-Oxley Act

23
curtailing (but not eliminating) earnings management (Koh et al. [2008]). Consistent with prior

literature, firms that just meet or beat analysts’ forecasts have more leverage, are more complex,

have more operating cash flow and have a greater market-to-book ratio. We find a marginally

smaller IACOMP value for firms that just meet or beat analysts’ forecasts. Consistent with

Panels A and B, there are no univariate differences in IACOMP, NONMTG or NONOSP20.

Overall, the univariate results are consistent with (a) our three IAF independence measures

capturing different independence mechanisms and (b) the inability of competence and

independence to significantly influence financial reporting quality on a stand-alone basis.

[Insert Table 4 Here]

Multivariate results

Tables 5 and 6 present our main results.23 Table 5 summarizes the results from regressing

positive (income-increasing) accruals on our IAF-related variables and controls variables. In

Table 5, our predicted signs for our interaction variables are all negative, as we predict lower

income-increasing accruals when the IAF exhibits both greater competence and independence.24

With respect to the interactive term between IACOMP and ACIAFINF (coefficient = -0.00017,

t-stat = -2.302), our results suggest that the effect of competence depends on the amount of

oversight provided by the Audit Committee and vise versa (in support of H1). In other words, the

impact of the IAF on financial reporting quality is jointly dependent on the level of competence

and independence of the IAF. The reduction in the size of positive abnormal accruals for a

certain level of IAF competence (audit committee oversight of IAF) is conditional upon audit

committee oversight of IAF (IAF competence). Economically, this suggests that firm’s

23
In the interest of brevity, we do not report the coefficient estimates on our INDUSTRY dummy variables.
24
We are careful to not over-interpret our stand-alone variables, as they are not necessarily reflective of main effects
due to the continuous nature of some of our test variables (Jaccard and Turrisi, [2003]).

24
overinvesting in competence (independence), but not in independence (competence), are in

danger of establishing an IAF that is not effective in strengthening the firm’s financial reporting

process. In other words, the presence of both competence and independence is a necessary

antecedent for effective financial reporting monitoring by the IAF.

The significantly negative coefficient (coefficient -0.00013, t-stat -3.248) for the

interaction term between IACOMP and NONOSP20 suggests that the abnormal accrual

reduction effect of IACOMP is greater for firms that do not have a substantial OSP presence (in

support of H3). In other words, greater amounts of investment in the in-house IAF activities

(both in terms of budgets and hours provided by the in-house IAF) yield greater reductions in

positive abnormal accruals (i.e. increase in financial reporting quality). We do not find a

significant interaction effect between IACOMP and NONMTG. Several of the control variables

are significant. ASSETS, LEVERAGE, CFO, MTB, CFOVOL, ROA and LOSS are all significant

and in the predicted direction.

[Insert Table 5 Here]

Table 6 summarizes the results from regressing negative (income-decreasing) accruals on

our IAF-related variables and controls variables. Table 6 indicates that our results for income-

decreasing accruals are also generally consistent with our hypotheses. In support of H1, H2, and

H3, the coefficient estimates for all three interactive competence and independence terms

(IACOMP*ACIAFINF; IACOMP*NONOSP20; IACOMP*NONMGT) are significantly positive,

(indicating associations with smaller negative accruals; i.e. negative accruals that are closer to

zero). The same control variables are significant as in Table 5, except that the cash flow variables

lose significance and SALESGROW gains significance. We interpret this as suggesting that

income-decreasing (negative) abnormal accruals are less likely to be associated with cash flow

25
considerations, and also that they are less (closer to zero) when sales are growing. This is

consistent with fewer incentives for ‘big bath’ behavior when growth is present.

We note that in order for IAF quality to impact financial reporting quality, it is necessary

for the IAF to be involved in the monitoring of the financial reporting process. Per survey

question #3 in the appendix, such opportunities include financial statement audits of subsidiaries

and/or assisting external auditor with the financial statement audit. We observed that all

respondents had non-zero budget allocations to these activities, indicating that all sample IAF

departments had the opportunity to monitor the financial reporting process.25 In summary, the

evidence of Tables 5 and 6 is consistent with the characterization of a two-factor IAF quality

function, whereby competence and independence must combine with each other to promote the

IAF as an effective, internally-based financial reporting monitor.26

[Insert Table 6 Here]

Additional Analysis – Other financial reporting quality proxies

While accruals-based measures of earnings management are the most pervasive proxy for

financial reporting quality, extant research also uses the ability to just meet/beat analysts’

forecasts and the use of positive accruals to just meet/beat analysts’ forecasts as proxies for

financial reporting quality (Mande and Son [2012], Prawitt et al. [2009], Koh et al. [2008]). We

also incorporate these additional financial reporting quality proxies into our analysis by utilizing

logistic regression where our dependent variable is a dichotomous variable as to whether the firm

just meets or beats analyst’s expectations (JM/BEAT) or uses positive abnormal accruals to just

meet or beat analyst’s expectations (JM/BEATaccr)

25
Our survey respondents reported spending 15.4 percent of in-house audit hours on assisting with the financial
audit, 10.3 percent on audits of subsidiaries, 6.8 percent on compliance auditing and 9.8 percent on special projects.
For comparison, the highest single percentage of time was devoted to SOX related controls work (27.15 percent).
26
Breusch-Pagan tests failed to detect the presence of heteroskedasticity.

26
 To compute which firms just meet/beat analyst’s expectations, we divide how close the

firm was to consensus forecast by price at the beginning of the year and then examine a bin that

is within 0.0005 (Prawitt et al. [2009]). This results in 37 firms that meet or just beat analysts’

forecasts (JM/BEAT=1) and 152 other firms (JM/BEAT=0). Our set of independent variables is

consistent with those found in the prior section. Table 7 Column A provides the results for

JM/BEAT as the dependent variable. The logistic regressions were conducted in a manner

consistent with Norton et al. [2004] and Ai and Norton [2003].

Consistent with the main results, coefficient estimates for our interactive terms of

IACOMP*ACIAFINF and IACOMP*NONOSP20 are statistically significant. Our coefficient

estimate for IACOMP*NONMTG is in the predicted direction, but is not statistically significant.

This provides additional evidence in support of H1 and H3. In general, the joint presence of audit

committee IAF oversight and IAF competence appears to reduce the risk of firms artificially just

meeting or beating the consensus EPS forecast. Similarly, when competence increases when

there is not a substantial outsourcing presence, there is a reduction in the likelihood of a firm just

meeting or beating the consensus EPS forecast.27

Table 7 Column B provides the results for JM/BEATaccr as the dependent variable.

Following Koh et al. [2008], we calculate unmanaged earnings by backing out discretionary

abnormal accruals from reported earnings. We then identify firms that would have missed

analysts’ forecasts, without management’s exercise of the accounting discretion and code these

firms as JM/BEATaccr=1. We find 25 firms that belong to this category (JM/BEATaccr=1) and the

remaining 164 (JM/BEATaccr=0) firms do not. We obtain evidence similar to that provided in

Column A. The coefficient estimates for the interactive terms of IACOMP*ACIAFINF and

27
In untabulated results, we isolate those firms who appear to have utilized abnormal accruals to just meet.beat
forecasts, and find similar results, though at lower levels of significance.

27
IACOMP*NONOSP20 suggests that the disciplining interactive impact of competence and

independence are acute for this form of financial reporting quality.

[Insert Table 7 Here]

Additional Analysis – Determinants of IAF Competence

We assert that IACOMP is a parsimonious measure that aggregates many individual, IAF

competence-related characteristics. To test this assertion, we regress IACOMP against several

IAF characteristics that may be associated with competence. Individual IAF characteristics

include measures of IAF certification, CIA certification, and tenure, which relate to survey

questions #6-8. We further augment our model to include other non-competence variables that

have been shown to impact overall IAF budgets (Anderson et al. [2012] and Carcello et al.

[2005]). These additional variables include firm size, leverage, percentage of inventory to total

assets, and operating cash flows. Finally, as a means of discerning if any of our independence-

related measures are potentially determinants of IACOMP, we include ACIAFINF, NONOSP20

and NONMTG as regressors.28 The untabulated results show that professional certification,

experience, percentage of assets in inventory and firm size are positively related to IACOMP.

The significant, positive association between IACOMP and the percentage of total assets

comprised of inventory is likely attributable to the more complex accounting systems needed to

accumulate and analyze product costs. Similarly, firm size may proxy for both the relative

amount of firm resources available to devote to IAF, as well as firm complexity. Only one of the

independence measures, ACIAFINF, is marginally associated with IACOMP. As the relative

degree of audit committee-IAF oversight increases, per –hour IAF compensation increases as

28
Carcello et al. [2005] also find that the presence of an OSP negatively impacts overall IAF budget. Instead of
using a dichotomous OSP ‘presence’ variable per Carcello et al. [2005], we use NONOSP20, which is substantively
similar to the variable used in Carcello et al. [2005]. We note that neither NONOSP20 nor a dichotomous OSP
presence variable are significantly associated with IACOMP.

28
well. This result is consistent, although at a much lower economic and statistical significance,

with Anderson et al. [2012] and Carcello et al. [2005]). These results provide evidence that our

measures of competence and independence capture separate and distinct constructs.

Sensitivity Analysis

To address potential endogeneity, we execute a two-stage least squares analysis using an

instrumental variable approach (Prawitt et al. [2009]). Given that our IAF independence

variables are not highly correlated with each other and do not appear to significantly influence

IAF competence, our primary focus is predicting IACOMP in a first-stage regression. Similar to

Prawitt et al. [2009], our objective is to utilize instrumental variables that are correlated with

IACOMP, but not correlated with our measures of financial reporting quality. Our two

instrumental variables include an average IACOMP score by industry and the amount of

inventory relative to assets.29 We then use the predicted IACOMP value in a second stage

regression using the same set of dependent variables found in Tables 5-7. We obtain virtually

identical results to those reported in Tables 5-7.

We also considered numerous categories of potentially omitted correlated variables. With

respect to auditor-related variables, prior research has indicated that auditor tenure (Davis et al.

[2009]), auditor industry specialization (Reichelt and Wang [2010]) and the magnitude of non-

audit fees (Frankel et al. [2002]) may impact financial reporting quality. Our results remain

unchanged, when we included: (a) a continuous variable defined as total auditor tenure (capped

at n=25); (b) a dichotomous variable coded ‘1’ when the external auditor audited the largest

29
The industry-wide average of IACOMP is likely to be associated with an individual firm’s IACOMP because
internal auditors have the opportunity to transfer their skills from one company to the other and would do so as a
means of increasing or maintaining their current salary. Similar to Prawitt et al. [2009], the industry-wide IACOMP
value is unlikely to be correlated with our dependent variables since we do not find that financial reporting quality is
highly concentrated in a few industries.

29
percentage of client assets per the two-digit focus industry per Table 1 and ‘0’ otherwise, and (c)

a continuous variable defined as the ratio of non-audit service fees to audit fees.

We utilized various alternative control variables for corporate governance and/or audit

committee effectiveness, including the Gompers et al. [2003] corporate governance index, and

the type and percentage of financial experts present on the audit committee (Dhaliwal et al.

[2010]).30 We also examined certain CFO characteristics (age, tenure, board membership,

stockholdings, and gender) given their potential impact on financial reporting decisions (Ge et al.

[2011]). Inclusion of the above variables did not substantively alter the results of Tables 5-7.

We examined whether IACOMP might be capturing the effect of high cost of living areas

by including “high-cost” dummy variables.31 We included a variable for the percentage of IAF

budget allocated to financial statement auditing per Lin et al. [2011]. We examined the potential

effects of litigious industries and labor intensiveness (Frankel et al. [2002]; Matsumoto [2002]).

We included a dichotomous variable coded ‘1’ in instances where the primary SIC code

indicated a litigious industry per Frankel et al. [2002].32 We also included a continuous variable

calculated as 1 minus the ratio of gross property, plant, and equipment (PPE) to total assets. The

results of Tables 5-7 remained qualitatively similar.

The time period of our study was a recession year, and thus our results may not be

generalizable to other years. We assumed that our test variables would remain relatively constant

over a short horizon, and tested our model for 2010 and 2011. We also included abnormal returns

and a dummy variable for negative abnormal return to our regression as a control for accelerated

30
Experts are current or former certified public accountants, CFOs, vice presidents of finance, controllers and those
with other major accounting positions.
31
The high cost cities included New York, Boston, Los Angeles, Chicago and San Francisco.
32
High-litigation industries are industries with SICs of 2833–2836, 3570–3577, 3600–3674, 5200–5961, and
7370–7374 (Frankel et al. 2002).

30
recognition of losses in a recession year (Ball and Shivakumar [2006]). Our results remained

qualitatively similar in both these tests.

Lastly, we attempted to separate the relative influence of the CEO and CFO over the IAF.

In our first test, we created a dichotomous variable (CFODOMAIN) coded ‘1’ in instances where

the survey respondent indicated a strong level of agreement with survey questions 12b/12e/12h,

while simultaneously indicating strong disagreement with survey questions 12c/12f/12i. We then

interacted IACOMP*ACIAINF*CFODOMAIN. Inclusion of these variables in our regression did

not substantively alter the results of Tables 5-7. In a second set of analyses, we re-defined

CFODOMAIN as ‘1’ in instances where the sum of survey responses to 12b/12e/12h was greater

than survey responses to 12c/12f/12i (that is in observations where the CIA noted that the CFO

had relatively greater IAF influence). CFODOMAIN occurred in slightly more than 80 percent of

our observations – indicating that the CFO has relatively greater influence over the IAF vis-à-vis

the CEO in the overwhelming majority of instances. Inclusion of this re-defined CFODOMAIN

variable in our regressions did not impact our overall results and the coefficient estimates on

CFODOMAIN on a stand-alone or interactive basis were statistically insignificant.33

VI. CONCLUSION

We examine whether IAF quality – and its ability to foster higher quality financial

reporting – can be reasonably characterized as a joint function of both competence and

independence. Our tests rely on the argument that the effectiveness of the IAF rests upon the

33
There were zero observations where the CIA indicated a strong level of disagreement with the following survey
questions 12a/12d/12g. That is, survey respondents all stated that the audit committee had some sort of influence
over the IAF. In slightly less than 3 percent of our observations, the CIA indicated that the Audit Committee had
sole province over the IAF (that is strongly agree with survey questions 12a/12d/12g, while simultaneously strongly
disagreeing with survey questions 12b/12c/12e/12f/12h/12i). These results indicate that it is extremely rare for the
audit committee to have sole control over the IAF and that there are virtually no instances where the audit committee
has no influence over the IAF.

31
complementary roles of competence and independence. For example even though a competent

IAF may be more likely to identify a misstatement, an IAF that lacks independence may be less

likely to report it to the appropriate channel or demand that the party originally responsible for

the misstatement to correct it. Despite a large amount of practitioner guidance on the importance

of independence, little is known about how independence interacts with competence in fostering

the IAF’s role as an effective financial reporting monitor. In sum our results show that if one

wishes to ask “what is the effect of IAF competence (independence) on financial reporting

quality?”, the answer is “it depends on the independence (competence) of the internal auditor.”

Our study is also motivated by the relative scarcity of archival evidence on factors that

potentially impact IAF competence, IAF independence, and their joint influence on the IAF

quality. Our proxy for competence is captured by the organization’s investment in average

hourly rates of budgeted IAF resources. We consider three specific artifacts of independence: the

relative degree of audit committee oversight vis-à-vis management oversight, the preponderance

of internal audit outsourcing, and the use of internal audit as a management training ground. We

regress several financial reporting quality proxies on our set of competence and independence

variables, as well as the interaction of the competence and independence variables. We find that,

consistent with a two-factor IAF quality function, we document statistically significant

associations between our interaction terms and financial reporting quality. The overall results

provide evidence consistent with the hypothesis that the combined presence of both competence

and independence is a necessary antecedent to effective IAF financial reporting monitoring.

With respect to the IAF characteristics, we find results consistent with independence

being enhanced by relatively greater degrees of audit committee oversight of the IAF, versus

management oversight. We utilize a measure of oversight influence that extends beyond formal

32
reporting lines. This enhanced independence interacts with IAF competence as a means of

curtailing financial reporting discretions in both income-increasing and income-decreasing

environments. We also document a similar set of relationships when we interact IAF competence

and the relative lack of IAF outsourcing. Finally, we find lower occurrences of income

decreasing abnormal accruals as IAFs jointly reflect both greater competence and are not used as

a management training ground. Our findings extend prior research and deepen our understanding

of the determinants of IAF quality. We believe more research is needed in this area to enrich our

understanding of how and why IAFs impact financial reporting quality. Our study points to the

need to better understand how an IAF can benefit a firm, but also how researchers can potentially

demonstrate and quantify the value of a competent and independent IAF.

33
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 TABLE 1
Sample Selection Results
Related # of % of # of Fortune % of Fortune
Focus Industry Two-Digit SIC Codes firms sample 1000 firms* 1000 firms*
Construction 15 – 17 9 4.8 17 1.9
Consumer product & food 20 – 33 43 22.8 180 19.8
Energy 10 – 14, 46, 49 32 16.9 172 18.9
Financial Services 60 – 64, 67 11 5.8 62 6.8
Information & Communication 48, 73, 78, 79, 84 20 10.6 126 13.9
Manufacturing 34 – 39 31 16.4 140 15.4
Personal services & healthcare 72, 80, 83 2 1.1 28 3.1
Professional, commercial services, education 75, 76, 82, 87, 89 1 0.5 11 1.2
Real Estate 65, 70 1 0.5 6 0.7
Retail & Wholesale 50 – 59 35 18.5 149 16.4
Transportation 40- 42, 44, 45, 47 3 1.6 11 1.2
All other 1, 2,7, 8, 99 1 0.5 6 0.7
Totals 189 100 908 100

* Banks are excluded from both the population and the sample as these firms face additional regulation unique to their industry and do not have significant
inventory accounts (making the model unfit for regression purposes). The remaining Fortune 1000 firms (in terms of total assets) serve as our sampling
population.

40
 Table 2
Variable Definitions
Variable Description
ABNACCR The Kothari et al. (2005) version of the modified Jones model measure of abnormal
accruals. Abnormal accruals is the error term of the equation below:
[TAit/Ait-1] = 0 + 1[1/Ait-1] + 2[(REVit - ARit)/ Ait-1] + 3[PPEit/Ait-1] + 4[NIit/ Ait-1] + it
Where total accruals for estimation portfolio firm i for year t. TA, or total accruals, are
defined as income before extraordinary items (Compustat Data Item #18) minus operating
cash flows (Data Item #308). Ait-1 is total assets (Data Item #6) at t-1 for firm i. REVit is
the change in net revenues (Data Item #12) for estimation portfolio firm i for year t. ARit
is the change in accounts receivable (Data Item #2) for estimation portfolio firm i for year t.
PPEit is gross property plant and equipment (Data Item #7) for estimation portfolio firm i
for year t. NIit is net income (Data Item #172) for estimation portfolio firm i for year t.
JM/BEAT* Dichotomous dependent variable coded ‘1’ in instances where firm met the forecast or
exceeded it by the consensus, annual EPS forecast scaled by price at the beginning of the
year by more than 0.0005; ‘0’ else.
JM/BEATaccr* Dichotomous variable calculated using a two-step process. First, we calculate unmanaged
earnings by backing out discretionary abnormal accruals from reported earnings. We then
identify firms that would have missed analysts’ forecasts, without management’s exercise
of the accounting discretion. For these firms, JM/BEATaccr equals ‘1’ and for all other firms
JM/BEATaccr equals ‘0’.
IACOMP Average IAF resource expenditure per hour. Calculated by dividing total in-house IAF
budget per survey question #4 by total in-house IA hours per question #1.
ACIAFINF Relative audit committee IAF influence vis-à-vis management (CEO and CFO). Measured
as the ratio of the total agreement points for the audit committee in the numerator divided
by the total agreement points for the CFO and CEO in the denominator. The numerator is
the sum of agreement points (per the 1-5 Likert-scale responses) on survey questions #12a.,
12d. and 12g. The denominator is the sum of agreement points (per the 1-5 Likert-scale
responses) on survey questions # 12a.- i. The 1-5 Likert-scale response values are
recalibrated to 0-4 for purposes of computing this variable.
NONMTG Indicator variable coded ‘1’ when the IAF does not serve as a management training ground
per survey question #13 and 0 otherwise.
NONOSP20 Coded ‘1’ (‘0’) when the following ratio constructed from survey question #4 is less than
(greater than) 0.20: (Budgeted OSP $)/(Budgeted OSP $ + Budgeted in-house IAF $).
ASSETS Total assets in millions (Compustat Data Item #6).
AGE Number of years the firm was listed on Compustat, truncated at 25 years
LEVERAGE The sum of long term debt (Compustat Data Item #9) and current liabilities (Data Item #5)
of a company divided by total assets (Data Item #6).
SEGNUM Number of disclosed segments company operates in.
CFO Cash flows from operations (Compustat Data Item #308).
SALESGROW One year sales growth (Compustat Data Item #12FY2009 – Item #12 FY2008/ Item #12 FY2008).
MTB A company’s market-to-book ratio (Compustat Data Item #24 * Item #25 / Item #216).
CFOVOL Standard deviation of operating cash flows for 2005-2009
ROA Return on assets (Compustat Data Item #172 / Data Item # 6).
LOSS Coded ‘1’ if the firm experienced a loss in fiscal year 2008, ‘0’ else.
MATWEAK Indicator variable coded ‘1’ for client firm disclosing a material weakness in internal
controls over financial reporting during the prior 2 years and ‘0’ otherwise.
INDUSTRY Coded ‘1’ if firm’s 2-digit SIC code is included in specific focus industry per Table 1, ‘0’
otherwise. Focus industry groupings per Hogan and Jeter (1999).
*variable used only in additional analysis section.

41
 TABLE 3
Descriptive Statistics
Panel A: Internal Audit Budget Descriptive Statistics
Variable Name Mean Median 25th % 75th %
Total Outsourced Internal Audit hours (n=133)* 4,195 1,800 0 5,000
Total Outsourced Internal Audit budget $484,312 $450,000 $0 $900,000
Total In-house Internal Audit hours (n=189) 34,873 20,000 8,000 37,750
Total In-house Internal Audit budget ($) $2,056,236 $1,500,000 $900,000 $2,500,000
Hourly OSP IA resource expenditures** $178.73/hr $150/hr $100/hr $250/hr
Hourly In-house IA (IACOMP) resource expenditures** $102.42/hr $87.72/hr $75/hr $115/hr
Total Combined IAF hours 40,983 24,000 8,460 46,000
Total Combined IAF budgets ($) $3,580,450 $2,225,000 $1,250,000 $5,250,000
% of OSP $ budget to total IAF $ budget 0.177 0.072 0.00 0.332
IAFs with OSP budget > 20% of overall IAF budget (0,1) 0.338 0.00 0.00 1.00
IAFs with OSP budget < 20% of overall budget (NONOSP20) 0.662 1.00 0.00 1.00
IAF used as a management training ground (0,1) 0.8465 1.00 1.00 1.00
IAF not used as a management training ground (NONMTG) 0.1535 0.00 0.00 0.00
* Only 133 of our 189 responding firms outsourced internal audit tasks and therefore our sample size for outsourced IAF data is 133.
** To obtain this figure, we calculated individual per hour IAF resource expenditures rates for each sample firm. We then averaged these 133 (189) rates to
arrive at a mean (median) and percentiles figures for the OSP (In-house) IAF departments respectively.

42
 TABLE 3 - Continued
Descriptive Statistics
Panel B: Audit Committee and Management Oversight of Internal Audit Function
Degree of Agreement with survey statements #12a. - 12i. Mean Median 25th % 75th %
IAF reports to the Audit Committee 4.73 5.00 4.00 5.00
IAF reports to the CFO 3.65 4.00 3.00 4.00
IAF reports to the CEO 2.50 2.00 2.00 3.00
Audit Committee authorized to terminate Chief Internal Auditor 4.52 5.00 3.00 5.00
The CFO authorized to terminate Chief Internal Auditor 3.65 4.00 3.00 4.00
The CEO authorized to terminate Chief Internal Auditor 3.05 3.00 3.00 4.00
The Audit Committee determines Internal Audit’s annual budget 3.22 3.00 3.00 4.00
The CFO determines Internal Audit’s annual budget 3.75 4.00 3.00 4.00
The CEO determines Internal Audit’s annual budget 3.02 3.00 3.00 4.00
ACIAFINF* 0.41 0.42 0.26 0.61

*ACIAFINF = The ratio of the total agreement points for the audit committee in the numerator divided by the total agreement points for the CFO and CEO in the
denominator. The numerator is the sum of agreement points (per the 1-5 Likert-scale responses) on survey questions #12a., 12d. and 12g. The denominator is the
sum of agreement points (per the 1-5 Likert-scale responses) on survey questions #12a. - i. The 1-5 Likert-scale responses are recalibrated to 0-4 for purposes of
computing this variable.

43
 TABLE 3 - Continued
Descriptive Statistics
Panel C: Control Variables Descriptive Statistics
Variable Name Mean Median 25th % 75th %
ABNACCR 0.0289 -0.0139 -0.0788 0.0269
JUSTMEET/BEAT* 0.1957 0.0000 0.0000 1.000
ASSETS (mil) $19,602 $5,318 $2,613 $12,828
AGE 20.49 25.00 15.00 25.00
LEVERAGE 0.4729 0.4531 0.3598 0.5644
SEGNUM 4.3280 4.000 2.0000 6.0000
CFO (mil) $1,780 $566.9 $258.4 $1,126
SALESGROW -0.1177 -0.0947 -0.2129 -0.0105
MTB 2.5294 1.6393 1.0786 2.7566
CFOVOL 496.9 132.9 66.85 340.2
ROA 0.0321 0.0365 0.0038 0.0698
LOSS 0.2698 0.0 1.0 0.0
MATWEAK 0.0423 0.0 0.0 0.0
All variable definitions can be found in Table 2.
*Variable used in additional analysis section only.

ABNACCR is Kothari et al. (2005) version of the modified Jones model measure of abnormal accruals. JM/BEAT is a dichotomous dependent variable coded ‘1’
in instances where firm met the forecast or exceeded it by the consensus, annual EPS forecast scaled by price at the beginning of the year by more than 0.0005;
‘0’ else. ASSETS equal total assets in millions. AGE is the number of years the firm was listed on Compustat, truncated at 25 years. LEVERAGE equals sum of
long-term debt and current liabilities of a company divided by total assets. SEGNUM equals number of disclosed segments company operates in. CFO equals
cash flows from operations. SALESGROW equals one-year sales growth percentage. MTB equals market-to-book ratio. CFOVOL is the standard deviation of
operating cash flows for 2005-2009. ROA equals return on assets. LOSS is coded ‘1’ if the firm experienced a loss in fiscal year 2008, ‘0’ else. MATWEAK is
coded ‘1’ for client firm disclosing a material weakness in internal controls over financial reporting during the prior 2 years and ‘0’ otherwise.

44
 TABLE 4
Univariate Comparisons
Panel A: Univariate Comparison of IAFs Management Training Grounds
Firms with Firms with Mann- Whitney
Variable Name NONMTG = 1 NONMTG = 0 Difference statistic
IACOMP $107.59/hr $101.52/hr $6.07/hr 1.0051
ACIAFINF 0.439 0.405 0.034 1.2323
NONOSP20 0.6786 0.6584 0.0202 0.9974
ASSETS (mil) $24,145 $18,812 $5,333 1.6736*
AGE 19.97 20.62 (0.65) 0.9929
LEVERAGE 0.4907 0.4698 0.0209 0.6788
SEGNUM 4.4643 4.2919 0.1724 0.7505
CFO (mil) $1,929 $1,754 $175 1.5029*
SALESGROW -0.1332 -0.1150 0.0182 0.7471
MTB 2.41 2.54 (0.1300) 0.8515
CFOVOL 448.2 505.4 (57.2) 0.4793
ROA 0.0298 0.0325 (0.0027) 0.5555
LOSS 0.2500 0.2733 (0.0233) 0.6099
MATWEAK 0.0357 0.0435 (0.0078) 0.3311
Observations 28 161

Panel B: Univariate Comparison of IAFs lacking/with a significant (>20%) OSP presence

Firms with Firms with Mann-Whitney
Variable Name NONOSP20=1 NONOSP20=0 Difference statistic
IACOMP $104.89/hr $97.59/hr $7.30/hr 1.1011
ACIAFINF 0.441 0.349 0.092 1.6993*
NONMTG 0.168 0.157 0.011 0.0694
ASSETS (mil) $20,038 $18,750 $1,288 0.8828
AGE 20.53 20.41 0.12 0.3324
LEVERAGE 0.4780 0.4629 0.0151 0.7247
SEGNUM 4.2480 4.4844 (0.2364) 0.8791
CFO (mil) $1,775 $1,789 ($14) 1.0801
SALESGROW -0.0988 -0.1546 (0.0558) 3.4804**
MTB 2.47 2.61 (0.14) 0.3779
CFOVOL 515.1 487.6 27.5 0.1155
ROA 0.0293 0.0335 (0.0042) 0.9013
LOSS 0.2720 0.2656 0.0640 0.6528
MATWEAK 0.0400 0.0468 (0.0680) 0.4999
Observations 125 64
Significance levels (one-tailed if in predicted direction): *,**, *** = p-value < .10, .05, .01, respectively.

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 TABLE 4 (continued)
Univariate Comparisons
Panel C: Univariate Comparison of Firms that just meet/beat analyst forecast to other firms
Firms that just
Meet/beat analysts’ Mann-Whitney
Variable Name forecasts All other firms Difference statistic
IACOMP $99.87/hr $103.04/hr ($3.17/hr) 1.4011
ACIAFINF 0.3606 0.4220 (0.0614) 1.7804*
NONMTG 0.1622 0.1513 0.0109 1.0501
NONOSP20 0.6486 0.6652 (0.0166) 0.7822
ASSETS (mil) $18,087 $19,971 ($1,904) 1.8736*
AGE 19.57 20.65 (1.0800) 0.4424
LEVERAGE 0.4994 0.4664 0.0330 1.9942*
SEGNUM 4.8214 4.2422 0.5792 1.7305*
CFO (mil) $2,010 $1,724 $286 1.8544*
SALESGROW -0.1103 -0.1195 (0.0092) 1.1008
MTB 2.82 2.46 0.36 2.0011**
CFOVOL 481.4 500.3 (18.9) 0.3021
ROA 0.0339 0.0317 0.0022 0.4933
LOSS 0.2432 0.2763 (0.0233) 0.6224
MATWEAK 0.0541 0.0395 0.0146 0.7754
Observations 37 152
Significance levels (one-tailed if in predicted direction): *,**, *** = p-value < .10, .05, .01, respectively.

IACOMP equals average IAF resource expenditure per hour. ACIAFINF is the relative audit committee IAF
influence vis-à-vis management (CEO and CFO). NONMTG is an indicator variable coded ‘1’ when the IAF does
not serve as a management training ground per survey question #13 and 0 otherwise. NONOSP20 coded ‘1’ (‘0’)
when the budgeted outsourced IAF services are less than 20 percent of IAF total budget. ASSETS equal total assets
in millions. AGE is the number of years the firm was listed on Compustat, truncated at 25 years. LEVERAGE equals
sum of long-term debt and current liabilities of a company divided by total assets. SEGNUM equals number of
disclosed segments company operates in. CFO equals cash flows from operations. SALESGROW equals one-year
sales growth percentage. MTB equals market-to-book ratio. CFOVOL is the standard deviation of operating cash
flows for 2005-2009. ROA equals return on assets. LOSS is coded ‘1’ if the firm experienced a loss in fiscal year
2008, ‘0’ else. MATWEAK is coded ‘1’ for client firm disclosing a material weakness in internal controls over
financial reporting during the prior 2 years and ‘0’ otherwise.

46
 TABLE 5
OLS Regression Results – Positive Abnormal accruals
Positive ABNACC = b0 + b1IACOMP + b2ACIAFINF + b3NONMTG + b4NONOSP20 +
b5IACOMP*ACIAFINF + b6IACOMP*NONMTG + b7IACOMP*NONOSP20 +
b8ASSETS + b9AGE+ b10LEVERAGE + b11SEGNUM+ b12CFO +
b13SALESGROW+ b14MTB+ b15CFOVOL + b16ROA + b17LOSS +
b18MATWEAK + b19-28INDUSTRY + 
Expected Coefficient T-
Independent Variable Sign Estimate Statistic
Intercept 0.0467 1.1099
IACOMP ? -0.00004 -1.1921
ACIAFINF ? -0.0369 -1.4201*
NONMTG ? -0.0187 -0.8645
NONOSP20 ? -0.0101 -0.6779
IACOMP*ACIAFINF - -0.00017 -2.3022**
IACOMP*NONMTG - -0.00005 -1.2199
IACOMP*NONOSP20 - -0.00013 -3.2481***
ASSETS + 0.0003 2.5778***
AGE - -0.0004 -0.3101
LEVERAGE + 0.0412 1.7844*
SEGNUM + 0.0052 2.9941***
CFO - -0.0001 -1.4245*
SALESGROW + 0.0069 0.7274
MTB + 0.0048 2.9998***
CFOVOL + 0.0001 2.2217**
ROA - -0.0101 0.3741
LOSS + 0.0108 0.9577
MATWEAK + 0.0128 0.5299
INDUSTRY Included
Observations 81
Adjusted R-squared 0.2399
Significance levels (one-tailed if in predicted direction): *,**, *** = p-value < .10, .05, .01, respectively.

ABNACCR is Kothari et al. (2005) version of the modified Jones model measure of abnormal accruals. IACOMP
equals average IAF resource expenditure per hour. ACIAFINF is the relative audit committee IAF influence vis-à-
vis management (CEO and CFO). NONMTG is an indicator variable coded ‘1’ when the IAF does not serve as a
management training ground per survey question #13 and 0 otherwise. NONOSP20 coded ‘1’ (‘0’) when the
budgeted outsourced IAF services are less than 20 percent of IAF total budget. ASSETS equals total assets in
millions. AGE is the number of years the firm was listed on Compustat, truncated at 25 years. LEVERAGE equals
sum of long-term debt and current liabilities of a company divided by total assets. SEGNUM equals number of
disclosed segments company operates in. CFO equals cash flows from operations. SALESGROW equals one-year
sales growth percentage. MTB equals market-to-book ratio. CFOVOL is the standard deviation of operating cash
flows for 2005-2009. ROA equals return on assets. LOSS is coded ‘1’ if the firm experienced a loss in fiscal year
2008, ‘0’ else. MATWEAK is coded ‘1’ for client firm disclosing a material weakness in internal controls over
financial reporting during the prior 2 years and ‘0’ otherwise.

47
 TABLE 6
OLS Regression Results – Negative Abnormal accruals
Negative ABNACC = b0 + b1IACOMP + b2ACIAFINF + b3NONMTG + b4NONOSP20 +
b5IACOMP*ACIAFINF + b6IACOMP*NONMTG + b7IACOMP*NONOSP20 +
b8ASSETS + b9AGE+ b10LEVERAGE + b11SEGNUM+ b12CFO +
b13SALESGROW+ b14MTB+ b15CFOVOL + b16ROA + b17LOSS +
b18MATWEAK + b19-28INDUSTRY + 
Expected Coefficient T-
Independent Variable Sign Estimate Statistic
Intercept -0.3110 -1.0772
IACOMP ? 0.00054 1.6005*
ACIAFINF ? 0.0104 1.2002
NONMTG ? 0.0171 0.8895
NONOSP20 ? 0.0027 0.8874
IACOMP*ACIAFINF + 0.00018 2.9444***
IACOMP*NONMTG + 0.00013 2.6222**
IACOMP*NONOSP20 + 0.00006 2.9004***
ASSETS - -0.0034 -0.4747
AGE + 0.0012 0.1111
LEVERAGE - -0.0877 -1.4123*
SEGNUM - 0.0029 0.3133
CFO - 0.0001 0.5998
SALESGROW + 0.0549 1.2987*
MTB + 0.0008 2.8956***
CFOVOL - -0.0002 -0.0765
ROA - -0.4176 -3.1767***
LOSS - -0.0728 -2.5649***
MATWEAK - -0.0504 -0.2772
INDUSTRY Included
Observations 108
Adjusted R-squared 0.201
Significance levels (one-tailed if in predicted direction): *,**, *** = p-value < .10, .05, .01, respectively.
All variable definitions can be found in Table 2

ABNACCR is Kothari et al. (2005) version of the modified Jones model measure of abnormal accruals. IACOMP
equals average IAF resource expenditure per hour. ACIAFINF is the relative audit committee IAF influence vis-à-
vis management (CEO and CFO). NONMTG is an indicator variable coded ‘1’ when the IAF does not serve as a
management training ground per survey question #13 and 0 otherwise. NONOSP20 coded ‘1’ (‘0’) when the
budgeted outsourced IAF services are less than 20 percent of IAF total budget. ASSETS equal total assets in
millions. AGE is the number of years the firm was listed on Compustat, truncated at 25 years. LEVERAGE equals
sum of long-term debt and current liabilities of a company divided by total assets. SEGNUM equals number of
disclosed segments company operates in. CFO equals cash flows from operations. SALESGROW equals one-year
sales growth percentage. MTB equals market-to-book ratio. CFOVOL is the standard deviation of operating cash
flows for 2005-2009. ROA equals return on assets. LOSS is coded ‘1’ if the firm experienced a loss in fiscal year
2008, ‘0’ else. MATWEAK is coded ‘1’ for client firm disclosing a material weakness in internal controls over
financial reporting during the prior 2 years and ‘0’ otherwise.

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 TABLE 7
Logistic Regression Results – Just Meet/Beat Analysts’ Forecasts
JM/Beat = b0 + b1IACOMP + b2ACIAFINF + b3NONMTG + b4NONOSP20 + b5IACOMP*ACIAFINF
+ b6IACOMP*NONMTG + b7IACOMP*NONOSP20 + b8ASSETS + b9AGE+
b10LEVERAGE + b11SEGNUM+ b12CFO + b13SALESGROW+ b14MTB+ b15CFOVOL +
b16ROA + b17LOSS + b18MATWEAK + b19-28INDUSTRY + 

Column A Column B
Expected Coefficient Chi-Square Coefficient Chi-Square
Independent Variable Sign Estimate Statistic Estimate Statistic
Intercept -0.3110 1.0772 -0.4971 1.0772
IACOMP ? 0.0054 1.0504 0.0054 1.6603
ACIAFINF ? 0.0104 2.4691 0.0089 1.8550
NONMTG ? 0.0171 0.6738 0.0124 1.7776
NONOSP20 ? -0.0027 0.8874 0.0022 0.6911
IACOMP*ACIAFINF - -0.0098 4.4823** -0.0117 4.4187**
IACOMP*NONMTG - -0.0013 1.6788 -0.0005 2.5558
IACOMP*NONOSP20 - -0.0048 5.9004** -0.0054 5.1234**
ASSETS + -0.0034 1.2626 -0.0301 1.7231
AGE - 0.0049 0.9203 0.0012 0.1111
LEVERAGE + 1.3944 3.9487** 1.6553 3.7349*
SEGNUM + 0.3249 2.8777* 0.0829 2.7792*
CFO - 0.0001 0.0075 -0.0002 0.0978
SALESGROW + 0.3551 1.0013 0.2817 1.1113
MTB + 0.0498 4.7145** 0.0502 2.8277*
CFOVOL - -0.0002 0.0765 -0.0002 0.0765
ROA + 2.8783 5.1055** 2.6533 3.6783*
LOSS - -0.4445 1.3011 -0.6235 0.9645
MATWEAK - -0.0513 0.7381 -0.0719 0.5334
INDUSTRY Included Included
Observations 189 189
Psuedo-R2 0.201 0.137
Significance levels (one-tailed if in predicted direction): *,**, *** = p-value < .10, .05, .01, respectively.

Column A present results when the dependent variable is defined as JM/BEAT, coded ‘1’ in instances where firm
met the forecast or exceeded it by the consensus, annual EPS forecast scaled by price at the beginning of the year by
more than 0.0005; ‘0’ else. Column B presents results when the dependent variable is defined as JM/BEATaccr, coded
‘1” if the firm would have missed analysts’ forecasts, without abnormal positive accruals, ‘0’ else. All other
variables are defined as previously described.

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APPENDIX
Dear Sir or Madam:

We are conducting a brief survey to obtain data about internal audit functions, audit risk factors, and the relationship between
internal audit and the audit committee. Your insight is vital to this project, so please take a few minutes to complete the survey
and return it in the self-addressed envelope enclosed. Please be assured that all responses will be strictly confidential, and no
company or individual will be specifically identified. If you would like a copy of our findings, please include an e-mail and/or
mailing address. Thank you for your time and cooperation on this survey.

1. During fiscal 2009, approximately how many hours were devoted to internal audit services by:
OUTSIDE SERVICE PROVIDERS (OSPs) _____ hours INTERNAL PROVIDERS ________ hours

2. Of the total internal audit hours provided by outside service provider(s) per question 1, please give the
approximate percentage distribution of activities (note the percentages should add to 100%):

% of % of
Activity Description hours Activity Description hours
Financial statement audits of subsidiaries EDP auditing
Special consulting projects Internal control evaluation
Compliance auditing Section 404-related work
Risk management activities Fraud audits
Assisting external auditor in financial Other (explain)
statement audit

3. Of the total internal audit hours provided by the in-house internal audit department per question 1, give the
approximate percentage distribution of activities (note the percentages should add to 100%):

% of % of
Activity Description hours Activity Description hours
Financial statement audits of subsidiaries EDP Auditing
Special consulting projects Internal control evaluation
Compliance auditing Section 404-related work
Risk Management Activities Fraud Audits
Assisting external auditor in financial Self-assessment programs/
statement audit Other (explain)
4. Please indicate the total fiscal year 2009 internal audit-related expenditures for:
OUTSIDE SERVICE PROVIDERS $_______ IN-HOUSE INTERNAL AUDIT $ ________

5. Please indicate the total Section 404-related fees paid to your external auditor in 2009. $_______

6. Please indicate the percentage of your staff who have the following certifications:
CPA _____ CIA _____ CISA _____ % of staff with at least 1 certification _____

7. With respect to you personally, please indicate how many years of work experience you have
as: an internal auditor _______ as a financial statement auditor _______

8. With respect to you personally, which certification(s) do you possess? (check all that apply):
CPA_____ CIA _____ CISA _____ Other________

9. Which of the following best describes how controls over financial reporting are monitored at your entity?
a. Separate Evaluations b. Controls self-assessments c. Other (explain)

10. Which of the following best describes how your entity conducts its assessments of the effectiveness of controls
over financial reporting?
a. On-going testing throughout the year b. Point-in-time near year-end c. Other (explain).

50
11. What are the key components of your organization’s internal audit risk assessment and weighting of each (not
considered, low, medium, high).

Factor Not applicable Low Medium High

Extent of routine vs. non-routine transactions
Dollar materiality
Ethical tone set by management
Changes in upper management
Complexity of the operation
Quality of application-level controls
Physical controls over assets
Quality of manual controls
Complexity of accounting guidance
Financial condition of the entity
Program level changes since last audit
Asset liquidity
Controls over period-end reporting
Complexity of controls
Budget variances of auditable entities
Changes in non-management personnel
Downsizing
Foreign Corrupt Practices Act compliance
Currency fluctuation exposure
Political risk
Environmental regulation
Exposure to financially-distressed
third parties (i.e. customers, vendors)
Quality of management forecasts
Revenue fluctuation
Other (please explain)
Other (please explain)
Other (please explain)

12. Please indicate your level of agreement with the following statements:
(1= strongly disagree; 2 = disagree; 3 = neutral; 4 = agree; 5 = strongly agree)
Level of agreement
Statement (circle one number)
Internal audit reports to the Audit Committee 1 2 3 4 5
Internal audit reports to the Chief Financial Officer (CFO) 1 2 3 4 5
Internal audit reports to the Chief Executive Officer (CEO) 1 2 3 4 5
The Audit Committee has authorization to terminate the Chief Internal Auditor 1 2 3 4 5
The CFO has authorization to terminate the Chief Internal Auditor 1 2 3 4 5
The CEO has authorization to terminate the Chief Internal Auditor 1 2 3 4 5
The Audit Committee determines Internal Audit’s annual budget 1 2 3 4 5
The CFO determines Internal Audit’s annual budget 1 2 3 4 5
The CEO determines Internal Audit’s annual budget 1 2 3 4 5
The Audit Committee reviews and approves Internal Audit’s annual risk assessment plan 1 2 3 4 5
The CFO reviews and approves Internal Audit’s annual risk assessment plan 1 2 3 4 5
The CEO reviews and approves Internal Audit’s annual risk assessment plan 1 2 3 4 5

13. Does internal audit serve as a training ground for future management positions? Yes No

51