Research On Substitution And Agency Costs Effects Of Internal Audit Function Of Listed Companies

The important role of internal audit function(IAF) in corporate governance has been attracted more and more attention as the outbreak of the United States enron and worldcom events in 2001. In 2002,according to a model of corporate governance put forth by the Institute of Internal Auditors(IIA), an effective IAF is one of four cornerstones of corporate governance, along with the audit committee of the board of directors, executive management, and the external auditor(IIA,2002). So, the New York Stock Exchange(NYSE) has required that all listed companies maintain an IAF from 2004(NYSE, 2004). The NASDAQ stock exchange does not require listed companies to have an IAF, but does encourage it as a best practice. Then, the Shenzhen Stock Exchange also required listed companies to set up an IAF in 2006.However, the questions which include whether the IAF gives a full play in corporate governance level,how the IAF plays a role in corporate governance,what the IAF plays in corporate governance and so forth, especially under the China’s current corporate governance mechanism, are lack of enough theoretical foundation and empirical research at the present literature. In particular, little research attention has focused on the effects of internal auditing.Using a larger available data set from the listed companies of main board market in China, we investigate the governance effects of the IAF from the perspective of substitution effect and the agency costs effect. The author measures the internal audit quality by its independence,scope of authority,scale and competence.Then, this paper analyzes the current situation of the IAF in our country and examines the internal audit quality and characteristics’ influence on external audit fees, earnings management, agency costs, and firm performance.Based on the principal-agent theory, the accountability theory, and transaction cost theory, this paper has built the theoretical basis of internal audit. The principal-agent theory is the internal auditing’s basic theory, which illustrates the emergence and development of the internal auditing; the accountability theory is very important, which explains the development of the internal auditing; the transaction cost theory is essential, which emphasizes the reason of the internal audit must be within the organization configuration. The organic combination of the principal-agent theory, the accountability theory, and transaction cost theory build the theoretical system of internal audit, and promote the continuous development of internal audit. On this basis, an analysis framework of the IAF role is built in this paper. That is the interactions between the IAF and the board of directors, audit committee, senior management, external auditing and analyses the pathway to bring about governance effects. On the one hand, the IAF can improve its organization status and reputation, and win the advanced technology experience to improve professional competence; On the other hand, the IAF can help the other three governance body efficiently fulfill its accountability, eventually to improve the overall level of corporate governance, reduce agency cost, and increase the purpose of the enterprise value.Then, based on 2007-2013 annual data from the listed companies of Shenzhen main board market A shares in China, this research firstly analyzes he present situation of IAF in China. Through the analysis we find that internal audit in our country is still in the stage of development, the overall level is not high. Although, most of the listed companies are gradually set up the IAF in the organization, but the quality of the IAF is not optimistic. Specifically: From the point of information disclosure of internal audit, the ratio of listed companies with more comprehensive IAF information accounts for only 47.8%, less than 50%.From the perspective of the IAF’s quality, the IAF’s overall level is needed be further promoted, which reflect on the characteristics of the factors: There is need to strengthen the organization status, further expand the scope of responsibilities, increase the scale and competence. From the industry distribution, the IAF’s quality is the highest in manufacturing industry; followed by construction; third is extractive industries; the IAF’s quality is the lowest in communication and cultural industries.Secondly, this paper investigates IAF’s effects of substitution and the agency costs, specifically in the aspect of external audit fees, earnings management, agency costs, and firm performance. The results show that: 1. IAF has substitution effect to external audit.the higher quality of IAF is associated with lower external audit fees significantly. Yet, different internal audit quality characteristics’ influences on external audit fees are inconsistent: Scope of responsibility and scale of IAF are inversely related to external audit fees significantly. IAF’s competence is inversely related to external audit fees, but not significantly. While,IAF’s independence is positively related to external audit fees significantly; 2. IAF has agency costs effect.(1)IAF quality is associated with a moderation in the level of earnings management,especially for positive earnings management. This also proves the internal audit has substitution effect to external audit from another aspect. However,we only find IAF’s competence is inversely related to earnings management,especially for positive earnings management;(2) The higher quality of IAF is associated with lower agency costs. However, we find IAF’s independence and scope of authority is inversely related to the level of agency costs;(3) IAF quality is significantly positively associated with firm performance. This also proves IAF quality is associated with a moderation in the level of agency costs.However, we only find IAF’s scope of authority is positively associated with firm performance significantly.Based on these results, this paper argues that the higher quality of IAF is associated with higher effects.We should improve IAF from two aspects:(1) more attention from government’s regulators, Institute of Internal Auditors and enterprise.That is:Government’s regulators should strengthen the supervision and improve the internal audit information disclosure, highlighting the importance of the internal audit activity; the institute of internal auditors of China should further strengthen norms and guidance, constantly promoting the development of IAF; Enterprises should pay more attention to IAF, improving the mechanism of IAF;(2) IAF’s more efforts to become a valuable resources. Particular attention should be paid to the following: Firstly, supervision function is still the most basic functions of IAF. Although the advisory function of internal audit is won more and more recognition and attention, but the supervision function is basic functions of internal audit, whenever the IAF can’t give up the supervision function of internal audit department; Secondly, the IAF should positively interact with the other three governance body so as to win recognition and support.By this way, the IAF can not only improve its organization status and reputation, and win the advanced technology experience to improve professional competence; But also,the IAF can help the other three governance body efficiently fulfill its accountability,and become a valuable resources. Only in this way, the quality of IAF can be better improved effectively.This paper builts the theoretical framework of effects of the IAF.Then, this paper has investigated the effects of the IAF from the perspective of substitution effect and the agency costs. Empirical studies results show that the IAF can play a role of improving in the corporate governance. At the same time, this paper measures the internal audit quality by its organization position, scope of responsibilities, scale and regulations, and examines the internal audit quality and characteristics’ influence on external audit fees, earnings management, agency costs, and firm performance. This will make people have better understanding about the IAF, and promote the further development of the internal auditing’s theory and practice. Obviously, as the beneficial supplement for IAF’s theoretical and empirical studies, this paper has theoretical and realistic significance to further development of the China’s IAF.