You are on page 1of 9

CHAPTER ONE

INTRODUCTION
1.1 BACKGROUND OF THE STUDY
internal Audit practice is an integral part of accountancy and auditing profession. Any discussion in an
auditing literature will not be complete without mentioning internal control, Internal control can be linked to
heart which regulates the business blood, meaning that no business can succeed without effective internal
control system. Internal audit's role in this, is essential both in providing assurance on the effectiveness of
controls over key systems and advising executive management and those responsible for governance on the
management of risk. hese are not easy tasks when resources are stretched and increasing demands are made of
internal audit by departmental boards enhanced by highly experienced non executive board members with
commercial backgrounds. !ut the profession can reach new levels of influence and recognition as it responds to
the challenges it faces.
According to a model of corporate governance put forth by the Institute of Internal
Auditors "IIA#, an effective internal audit function "IA$# is one of four cornerstones
of corporate governance, along with the audit committee of the board of
directors, executive management, and the external auditor "IIA %&&'a#.( Internal auditors
provide a variety of services within their host organi)ations, including audits of financial
records and processes. o date, however, little research has examined how internal auditing
might affect the *uality of a company+s external financial reporting. In this paper, we
examine whether a high,*uality IA$ is associated with lower levels of earnings management.
In so doing, we build on an important stream of research in accounting that examines
the impact of various components of corporate governance on financial reporting.
hough little rigorous evidence exists, there is good reason to believe that internal
auditing plays an important role in external financial reporting. $or example, previous research
has shown that management+s forecasts are more biased when misrepresentation is
relatively difficult to detect "-ogers and .tocken %&&'# and that management+s communications
are more likely to be biased when they are not verified by a third party ".chwart)
and /oung %&&%#. $urther, year,end financial audit work by external auditors appears to
play a role in moderating earnings management by minimi)ing managers+ opportunities
to manage earnings in the fourth *uarter "!rown and 0inello %&&1#. 2igh,*uality internal
auditors serve as an additional third,party monitor of management+s actions on a year,round
basis3 thus, we posit that as a company+s IA$ improves in *uality, it is more likely to serve
as a credible detection and deterrent mechanism that moderates earnings management.%
4xternal auditing standards explicitly recogni)e the potential relevance of internal auditing
to the financial reporting process "AI50A (6613 05A7! %&&1a#. In the audit risk
model, a high,*uality IA$ can reduce overall control risk, and the work of the IA$ can be
relied upon to reduce detection risk to the extent that specific indicators of IA$ *uality are
present "AI50A (6613 05A7! %&&1a#. -ecent audit regulation permits and even encourages
external auditors to 88use the work of others to a greater extent when the work is performed
by sufficiently competent and ob9ective persons++ "05A7! %&&1b, (:#. 5onsistent with these
arguments, $elix et al. "%&&(# and 0rawitt et al. "%&&6# find evidence that external audit
fees are lower for companies that employ higher,*uality IA$s, and Anderson et al. "(66:#
report an inverse relation between external audit fees and internal audit budgets.
;e build on the limited research that examines the role of internal auditing in external
financial reporting by providing new evidence about the ability of the IA$ to moderate
earnings management. ;e examine the relation between IA$ *uality and earnings management
by combining publicly available data with a uni*ue and previously unavailable
data set from the IIA. <sing data from %(= publicly traded companies for fiscal years %&&&
through %&&' "'%= firm,year responses#, we test our prediction that a composite measure
of IA$ *uality is negatively associated with two different proxies for earnings management.
;e are guided in the formulation of our composite IA$ *uality measure by external
auditing standards. hese standards provide detailed guidance to external auditors in evaluating
the individual components of IA$ *uality before relying on internal auditors+ work in the course of a financial
statement audit "AI50A (661#.: he specific components that
we use to create our internal audit *uality measure include the average experience of the
internal auditors, the percentage of internal auditors that are professionally certified "5IA
or 50A#, the amount of time spent training during the year, the relative focus of the IA$
on financial audit work, the reporting relation of the head of the IA$, and the si)e of the
IA$ relative to its industry. ;e measure earnings management using two different proxies>
"(# the absolute value of abnormal accruals as determined by the performance,ad9usted,
modified ?ones model,
"%# the propensity of companies to meet versus 9ust miss analysts+
consensus earnings forecasts.
;e find a significant negative relation between overall IA$ *uality and absolute abnormal
accruals. An examination of signed abnormal accruals suggests that this relation is
largely driven by a moderation of negative abnormal accruals. ;e also find that companies
that 9ust miss analysts+ expectations have IA$s that are of significantly higher *uality relative
to the rest of the sample. hese results are robust to the inclusion of proxies for
various factors that prior research identifies as being associated with abnormal accruals and
for various aspects of corporate governance *uality, including the *uality of the audit committee,
the *uality of the external auditor, and management+s relative power "as measured
by @ompers et al.+s A%&&:B corporate governance index#. A supplementary two,stage leasts*uares
analysis provides additional assurance that the results for the abnormal accruals
model are not attributable to potential endogeneity concerns. he results of a two,stage
least,s*uares analysis for the missCbeat analysts+ expectation model are not significant.
2owever, on balance we conclude that the results provide evidence consistent with the idea
that higher,*uality IA$s are associated with lower levels of earnings management.

!oard of directors are responsible for accounting for the daily activities in organisations and rendering proper
stewardship on how the financial resources of the shareholders were managed. owards this end, shareholders, at
Annual @eneral Deetings, appoint an external auditor to provide assurance services that the financial statements
prepared by Danagement represent the underlying financial transactions of the organi)ation for the period
covered. he reality facing stakeholders of financial reporting is that corporate financial reporting failures have
been on the increase, especially in the past decade.
;indow dressed accounts raised concerns in the <.A with the collapse of the energy corporation 4E-7E in
%&&(. he company filed for bankruptcy after ad9usting its accounts. ;orld5om, @lobal 5rossing and -ank
Ferox are other companies in the <.A with similar problem. In Italy, 0armalat failed in %&&: when it engaged in
accounting scandals worth = billion 4uros "Gemaki, %&((3 Eorwani, et al., %&((##. In Eew Healand, Allied
Eationwide $inance failed in .eptember %&(& while EH$ Doney became bankrupt in ?anuary, %&(( "Iianne,
%&((#. Eigeria has had its own share of financial reporting failures with the problems in 5adbury Eigeria 0lc. in
%&&J3 Afribank Eigeria 0lc faced problem of financial reporting in %&&63 Intercontinental !ank 0lc. "%&&6#.
5ountries all around the world have set codes of best practice as guidelines to address governance and financial
reporting anomalies>
5adbury -eport was produced in <nited Kingdom, .arbanes 7xley in <nited .tates, he Gey -eport in
5anada, the Lienot -eport in $rance, the 7livencia -eport in .pain, the King+s -eport in .outh Africa,
0rinciples and @uidelines on 5orporate @overnance in Eew Healand and the 5romme 5ode in @ermany. he
goal of these regulations was to improve firms+ corporate governance environments "!hagat and !olton, %&&6#.
In Eigeria, the -egulatory authorities have responded by compelling companies to comply with stringent
corporate governance codes. Idornigie "%&(&# reports that Eigeria have multiplicity of codes of corporate
governance with distinctive dissimilarities namely>
i. .ecurity and 4xchange 5ommission ".45# code of corporate governance "%&&:# addressed to public
companies listed in the Eigeria .tock 4xchange "E.4#. he code was reviewed in %&((3
ii. 5entral !ank of Eigeria "5!E# 5ode "%&&J# for banks established under the provision of the !ank and 7ther
$inancial Institutions Act "!7$IA#3
iii. Eational Insurance 5ommission "EAI57D# 5ode "%&&6#, directed at all insurance, reinsurance, broking and
loss ad9usting companies in Eigeria3 and
iv. 0ension 5ommission "04E57D# 5ode "%&&=#, for all licensed pension fund operators.
Gespite the interventions of the regulatory authorities, the challenges of ensuring credibility in financial
reporting and auditing are still prevalent. It therefore becomes pertinent to investigate the factors affecting audit
*uality in order to enhance the relevance of audit and assurance functions.
1.2 Problem Analy!
heoretically, the auditor is expected to be independent of the management staff of the company being audited.
2owever, a number of factors like familiarity, threat of replacement of an auditor and the provision of
management advisory services appear to impair auditor+s independence. 5oncerns have been expressed about the
conflict of interest between the statutory role of the auditor and the other services it may undertake for a client
"<K 2ouse of 5ommon reasury 5ommittee, %&&=#. he spate of audit failures in the world has brought a great
deal of disappointment to investors and other corporate financial reporting stakeholders. Iongevity of audit firm
tenure has also been linked with fraudulent financial reporting. If empirical studies are not carried out with
respect to specific environmental factors the problem of poor audit *uality may be exacerbated with likely grave
conse*uences for the nascent Eigerian 5apital Darket.
$inally, no internal control system elaborated, can by it self guarantee efficient and effective administration
completeness and accuracy of the records in a private sector. his assertion could be attributed to the following
factors>,
Iack of proper procedures for record keeping
Iack of competent and trustworthy personnel
Inade*uate segregation of duties
Inade*uate document and record proper
no physical control over assets and records
Inade*uate checks on performance
hese factors seems to be the hall mark in most of our private sectors firms where the menaces of incessant
fraud perpetrated by persons working in the companies. It is against this background and considering the huge
amount of money being made available for the establishment of private firms that becomes absolutely a
necessity for installing and maintaining effective control system in these companies. "e.g .kye !ank 0lc where
such control is highly in place#, and the internal auditors are fre*uently sent for training on audit course, to
efficiently perform the function.
he ma9or causes of the problems to which solutions are sought for by this study are>,
he problem of incompetence of the internal control staff in the companies
2uman errors
Iack of Integrity
Abuse of Authority
$raudulent collusion and alteration of system.
All the above become the sub9ect matters for investigation.
1." PURPOSE OF THE STUDY
According to 2orngan and $oster "(66&>6(:#, irrespective of the organi)ational si)e or nature or whether it is
private or public sector, must have one form of internal control or another which cuts across its operations,
inform of accounting systems and controls.
he main purpose of these study is outlined as follows>,
"(# o help management operate their organi)ations more efficiently and effectively in the private firms.
"%# o make recommendations based on the findings on how to install and maintain effective internal
control as a means of achieving financial accountability in private firms.
":# o find out whether there exist effective internal control system that may bring about financial
accountability in private firms
"M# o ascertain the factors affecting the effectiveness of internal control system in the private sectors.
1.# RESEARCH $UESTIONS
"i# o what extent has auditors+ engagement in management advisory services "non,audit services# influenced
the *uality of financial reporting in EigeriaN
"ii# Goes the length of auditors+ tenure enhance audit *uality in EigeriaN
"iii# o what extent does multiple directorship of audit committee members influence the *uality of financial
reportingN
"iv# Goes financial literacy of audit committee members influence the *uality of corporate reportingN
"v# Is there any relationship between independence of audit committee and *uality of audit observed in EigeriaN
"vi# ;hich factor is the most significant in encouraging audit *uality in EigeriaN
1.% HYPOTHESIS
"i# 2&(> Eon,audit services will not have a significant effect on the *uality of financial reporting in Eigeria.
"ii# 2&%> here is a significant negative relationship between the length of audit tenure and audit *uality in
Eigeria.
"iii# 2&:> here is no significant relationship between multiple directorships of audit committee members and
the *uality of corporate financial reporting in Eigeria.
"iv# 2&M> here is no significant relationship between the financial literacy of audit committee members and the
audit *uality in Eigeria.
"v# 2&'> he *uality of audit does not depend on the independence of the audit committee.
1.& SIGNIFICANT OF THE STUDY
his study informs the management of private firms the causes of their failure to maintain an effective control
system. 5ontrol in privateCpublic companies is concerned wit the achievement of certain standard of
performance related to the idea of satisfaction performance, are the concept of organi)ational efficiency and
effectiveness.
It would suggest steps re*uired to establish and maintain a sound internal control system. $irms in private
sectors would benefit from this study as it would suggest measures of at least minimi)ing limiting factors if not
combating them wholly.
his study will be useful to managers, internal auditors and board of directors of private firms, the area on the
factors affecting the effectiveness of their internal control system, which will enable them identify and take care
of those factors in order to maintain effective system and not 9eopardi)e the attainment of financial report.
1.' SCOPE OF THE STUDY
his study is limited in scope to internal control system of private sector companies selected within the country
".kye !ank 0lc#.
1.( )I*ITATIONS
Eo internal control system however elaborated can it self guarantee efficient administration, completeness and
accuracy of the records nor can it be proved against fraudulent collusion especially on the part of those holding
the positions of authority or trust. Internal controls which depends on segregation can be avoided by collusion.
Internal control can be limited by the following factors>,
"(# Incompetence
"%# $atigue in human errors
":# Iack of integrity
"M# he alteration of systems for their considered improvement.
1.+ DEFINITION OF TER*S
he following definition of terms used in this study are "(6JM>(&:# best regarded as indicating the whole system
of controls, financial and otherwise established by the management in the conduct of a business include>,
,1- INTERNA) CHECKS
Internal check is regarded as the checks on day, to, day transaction which operate continuously as part
of the routine system whereby the work of one person is proved independently or is complementary to
the work of another, the ob9ective being the prevention or early detection of errors and fraud. Internal
check therefore include such matters as the allocation of authorities, division of work and paper method
of recording transaction.
,2- EFFECTI.ENESS OF INTERNA) CONTRO)
he effectiveness of internal control is the degree to which an organi)ation is successful in ac*uiring and
utili)ing scarce and valued resources "!edeian (6=&>(:M#. 7rgani)ation take,in resources from their
environment and return them as valued output, the more effective organi)ations survive, the more they
can maintain a greater intake of resources than is re*uired to produce their output.
,"- INTERNA) CONTRO)
According to 2oward"(61:>%'# defined internal control as a control not only checks and internal audit,
but the whole system of control, financial and other wise, established by management in order to carry
on the business of the company in an orderly manner, safeguard its assets and secure as far as possible
the accuracy and reliability of its records.
,%- INTERNA) AUDIT
Internal Audit is an element of internal control system set up by the management. herefore internal
audit is an independent appraisal activity within an organi)ation for the review of accounts, financial and
other operations as a basis for service to management. Its ob9ectivity is to investigate and appraise the
system of internal control and the efficiency with which the various units of the organi)ation are
carrying out their assigned functions.
,&- FINANCIA) REPORTING
his is simply the representation of financial data of a company's operating performance position and
funds flow for an accounting period. $inancial statements alongside related informationCdocuments may
be contained in various forms for external party use such as in annual reports. It is basically financial
information that companies gives about their activities including how they prepare and show it.

You might also like