Surat Izin Balai Desa

Journal of Finance, Accounting and Management, 7(2), 1-30, July 2016 1
The Effects of Internal Audit on Performance of Ethiopian Financial Institutions
Abraham Gebregiorgis Berhe, Asmamaw Getie Mihret, Mohammed Seid Ali

College of Business and Economics
Mekelle University, Ethiopia
acc_abi2000@yahoo.com, asmamawgetie@yahoo.com, seidmehommed64@yahoo.com
Abstract
A company’s accounting control practices is widely believed to be crucial to the success of an
enterprise as it acts as a powerful brake on the possible deviations from the predetermined
objectives and policies (Kiabel, 2012). A strong relationship exists between internal audit quality
and firm performance with opportunities of high growth (Hermanson and Rittenberg, 2003;
Hutchinson and Zain, 2009). However, (Mihret, James and Mula, 2010; Kiabel, 2012; Ejoh and
Ejom, 2014) found that where internal auditing exists, does not significantly impact these
enterprises’ financial performance. Due to the inconsistencies in the extant research,
recommendation from different researchers, and because of its contribution to the Ethiopia
Growth and Transformation Plan (GTP) where creating efficient, effective, transparent and
accountable financial system is among the strategic direction being pursued during the plan period
through enhancing the capacity of internal auditing (MoFED, 2014), this study proposed to
investigate the effects of internal auditing on financial performance of Ethiopian financial
institutions. This research has adopted quantitative research approach, and questionnaires were
collected from the head offices of financial institutions. Spearman’s zero order correlation and
spearman’s partial correlation was run to test the hypotheses. The findings of the study reveal that
there is no association between the internal audit effectiveness and ROA. Moreover, no correlation
exists between the internal audit effectiveness and ROE.
Key words: Internal audit, internal audit effectiveness, management action, financial institutions,
performance
Background and Justification

The internal audit department is very important inside a firm that the internal audit is regarded as
the key element in the application of accounting systems (or it is a backbone of the business
accounting). The efficiency of internal audit helps develop the work of the company because the
financial reports reflect the internal audit department’s quality. The financial and corporate
strategy of a company is underpinned by effective internal systems in which the internal audit has
an important role in raising the reliability of the internal control system, improving the process of
risk management (Al-Matari, Al-Swidi, & Fadzil, 2014). Thus, internal auditing is widely believed
to be crucial to the success of an enterprise as it acts as a powerful brake on the possible deviations
from the predetermined objectives and policies (Kiabel, 2012).
Hutchinson and Zain (2009) explored the relationship between internal audit quality (audit
experience and accounting qualification) and firm performance in Malaysia. They found a strong
relationship between internal audit quality and firm performance with opportunities of high
growth. This finding was consistent with Hermanson and Rittenberg (2003) argument that the
existence of an effective internal audit function is associated with superior organizational
performance.
Kiabel (2012) revealed that where internal auditing exists, in a government owned companies does
not significantly influence financial performance consistent with the findings of Mihret et al.
(2010) that internal audit effectiveness does not significantly impact the enterprises’ financial
performance. Ejoh and Ejom (2014) also found that internal audit function has no significant effect
on the financial performance. The absence of a relationship might arise from possible under-
emphasis on internal auditing by these enterprises. Where the internal audit function is de-
emphasized, clearly, it cannot impact positively on financial performance consistent (Ejoh &
Ejom, 2014). These findings contradicts to the results of Hutchinson and Zain (2009) study of 60
Malaysian companies found that a strong association between internal audit quality and firm
performance.
Previous study dedicated to examining the relationship between internal audit and firm
performance is so limited in both developed countries and developing countries. There are some
studies that have concentrated on problems concerning internal auditing in developed countries
including the U.S. and the U.K. but little evidence is found in developing counties.
In addition, Al-Matari, Al-Swidi, Faudziah, & Al-Matari (2012) investigated the relationship
between board characteristics and firm performance in Kuwait. They recommend future
researchers to examine the association between internal audit and firm performance whether
directly or through a moderator. The inconsistencies in the extant research, recommendation from
different researchers, and because of its contribution to the Ethiopia Growth and Transformation
Plan (GTP) where creating efficient, effective, transparent and accountable financial system is
among the strategic direction being pursued during the plan period through enhancing the capacity
of internal auditing (MoFED, 2014), this study intend to investigate the effects of internal auditing
on performance of Ethiopian financial institutions. This research has adopted quantitative research
approach, and Spearman’s zero order correlation and spearman’s partial correlation will run to test
the hypotheses.
Purpose Statement
The intent of this study is to examine the effects of internal audit on performance of Ethiopian
financial institutions through adopting the quantitative research approach. Further, this study
attempts to assess the internal audit effectiveness of the financial institutions.
Hypothesis
From the extant literature (Al-Matari et al., 2014; Al-Matari et al., 2012; Badara & Saidin, 2013;
Hermanson & Rittenberg, 2003; Kiabel, 2012; Mihret et al., 2010) the researcher proposed the
following tentative explanations.
H1a. Internal audit effectiveness is positively associated with Return on Assets (ROA).
H1b. Internal audit effectiveness is positively associated with Return on Equity (ROE).
H2a. Management’s action on internal audit recommendations positively moderates the
association between Internal Audit effectiveness and Return on Asset (ROA).
H2b. Management’s action on internal audit recommendations positively moderates the
association between Internal Audit effectiveness and Return on Equity (ROE).
Review of literature
Internal Audit
Internal audit is a long standing function and an effective tool of management in many
organizations. It has been a recognized component of organizations in both the public and private
sectors and in most industries for many years. Internal auditing is often seen as an overall
monitoring activity with responsibility to management for assessing the effectiveness of control
procedures which are the responsibility of other functional managers. The internal audit function
is not limited to the operation of any particular function within an organization. Rather, it is all-
embracing and structured in the organization as a separate entity responsible only to a high level
of management (Kiabel, 2012).
Internal auditing is an independent, objective, assurance and consulting activity designed to add
value and improve an organization’s operations. The literature suggests that internal audit is
expected to add value in contemporary organizations (Mihret et al., 2010; Yee, Sujan, James, &
Leung, 2008) and assist organizations to accomplish their objectives.
Internal audit is considered as a value adding activity in contemporary organizations and when
internal audit adds value to organizations, it is effective (Yee et al., 2008). Therefore, identifying
dynamics that influence internal audit effectiveness arguably enhances understanding of internal
audit‘s value adding demeanor in respect of the context in which the function is practiced. The
following section provides a review of the literature on internal audit effectiveness and its possible
association with company’s performance.
Internal Audit Effectiveness

Internal audit effectiveness is the ability of the internal auditors to achieve established objective
within the organization (Badara & Saidin, 2013). The value adding role of internal audit presumes
that internal audit is effective. Nevertheless, the literature implies that internal audit effectiveness
tends to be influenced by the contextual dynamics within which internal audit is practiced. Al-
Twaijry, Brierley, and Gwilliam (2004) and Mihret et al. (2010) consider compliance with the
Standards for Professional Practice of Internal Auditors (SPPIA) as indicator of value adding
internal audit and internal audit effectiveness. This approach has adopted for the present study,
possibly offers a more comprehensive set of internal audit effectiveness indicators. Internal auditor
objectivity, internal auditor proficiency, quality of internal audit planning and execution, and
quality of internal audit reporting and follow-up are the indicators of internal audit effectiveness
(Mihret et al., 2010).
Internal Audits Objectivity

Objectivity is essential for any professional who provides professional judgment either by himself
or through others, and without it this judgment loses its value and becomes meaningless in others’
opinion. The need for objectivity is clearly evident in the business environment in general, and
especially for auditors where the users of audit services depend in part on their opinions when they
take their decisions (Endaya & Hanefah, 2013).
The independence and objectivity of internal auditing is with respect to both assurance services
and consulting for the organization. The audit activity should have sufficient independence from
those it is required to audit so that it can both conduct its work without interference and be seen to
be able to do so. This will make the auditors provide the objective report and reliable professional
judgment on the auditing work to achieve the mandate given to them with integrity. Thus, there
exist significant positive relationships among auditors’ independence and objectivity to the
effectiveness of internal audit (Baharud-din, Shokiyah, & Ibrahim, 2014).
Internal Audits Proficiency

In today’s dynamic business environment, it is imperative that internal auditors are qualified as
they should be thorough in their knowledge of business, systems, developments and other business
topics. In addition, the high quality profession of a chief audit executive is to improve the quality
of audit. A certified auditor is able to make a good decision in the fastest time without having to
wait or to consult with another team (Al-Matari et al., 2014).
Internal auditors must possess the knowledge, skills, and other competencies that are needed to
achieve their individual responsibilities and the only way for internal auditors to continue this
professional conduct is by undergoing proper training and development programs (Endaya &
Hanefah, 2013). Technical competence and continuous training are considered essential for
effective internal audit. Mihret and Yismaw (2007) revealed that internal audit office constantly
face the problem of low technical staff proficiency and high staff turnover, which would limit its
capacity to provide effective service to management. Competency of auditors determines the
quality of the audit work performed in an organization. Badara and Saidin (2013); Baharud-din et
al. (2014) argued that competency can be relate to the ability of an individual to perform a job or
task properly base on the educational level, professional experience (Al-Matari et al., 2014) and
the effort of the staffs for continuing professional development.
According to Baharud-din et al. (2014), Mihret and Yismaw (2007), auditors’ competency
determines the effective auditing in the organization. Thus, the ability of the auditors to perform
the systematic and disciplined audit approaches improve the effectiveness of internal audit.
Scope of Audit Work

The scope and quality of work is another important factor that reflects internal audit effectiveness.
Specifically, the sufficiency of internal audit‘s scope of work and the standard with which the
audits are planned and executed, and reported and follow-up are important illustrations of effective
internal audit (Al-Twaijry et al., 2004; Mihret et al., 2010; Mihret & Woldeyohannes, 2008).
Internal Audit association with Firm Performance

Effective internal audit is considered to add value to organizations (Mihret et al., 2010). Yee et al.
(2008) revealed that internal audit can assist management to meet its accountability to investors in
Marx‘s framework. The management is accountable for increasing return on capital employed
(ROCE) and internal audit not only assists management through enhancing timely and accurate
reporting of this rate but also it helps increase this rate.
internal audit‘s contribution to achievement of organizational objectives could be viewed from the
perspective of improving return on asset (ROA henceforth). Internal audit possibly contributes to
organizational performance by assisting management to protect or improve ROA (Bryer, 2006b as
cited in Mihret et al., 2010). This could be achieved by internal audit‘s consulting role on efficient
and effective use of resources as well as its assistance in the management of risk. It also assists the
management in the mitigation of wastage and devaluation of capital from fraud (Coram, Ferguson
& Moroney, 2008; Yee et al., 2008).
Management Action on Internal Audit Recommendations

A sufficient degree of acceptance and appreciation of the internal audit function is crucial to allow
for internal audit findings and recommendations to have an impact (Christopher, Sarens, & Leung,
2009). Mihret and Yismaw (2007); and Sarens (2009) revealed that the offices ability to
communicate the results of audits is a proxy for audit quality. Further, internal auditing findings
and recommendations will not serve much purpose unless management is committed to implement
those recommendations (Mihret & Yismaw, 2007). Mihret and Woldeyohannis (2008) were used
non-repeated findings to the total audit findings of an earlier audit period as measure of
implementation of internal audit findings, and this implementation as an indicator of internal audit
effectiveness. Mihret et al. (2010) had used the rate of implementation as moderating variable for
internal audit effectiveness contribution on company’s performance.
Conceptual model and measures

The extant literature shows that the effective internal audit can enhance firm performance (Al-
Matari et al., 2014; Hitchinson & Zain, 2009; Yee et al., 2008). Thus, this study aims to examine
the association between internal audit effectiveness and financial performance. This sub section
outlines the research design in terms of the conceptual model of the study, measures to be
employed, and research hypotheses.
Conceptual model
The study is designed in a flexible manner to enable using multiple approaches, data types and
sources, and theories. Based on the research of Mihret et al. (2010) done on the same area, Marx‘s
theory of the circuit of industrial capital was employed in the present research.
Marx‘s theory of the circuit of industrial capital was used to explain the contribution that effective
internal audit could make to organizational goal achievement, taking ROA and ROE as a proxy.
This theory indicates that value is created in the production process. Thus, the notion of value
adding internal audit is considered to fit in this framework (Yee et al., 2008; Mihret et al., 2010).
Management action
on Internal Audit
Recommendations
Internal audit effectiveness

 Internal auditor objectivity
 Internal auditor proficiency Firm
Performance
 Quality of internal audit
 ROA
planning and execution
 ROE
 Quality of internal audit
reporting and follow-up
Figure 1. Conceptual Model of the Study adopted from Mihret et al. (2010)
Definition of Measures
The conceptual model pools together the major concepts discussed in the literature and portrays
their possible relationships. Internal audit effectiveness is represented by four indicators: internal
auditor objectivity, internal auditor proficiency, quality of internal audit planning and execution,
and quality of internal audit reporting and follow-up (Al-Twaijry et al., 2004; Mihret et al., 2010).
Firm Performance
Firm performance refers to the extent to which an organization achieves its goals. The firm
performance will be measured using ROA and ROE, i.e., income after tax divided by total assets
and total equity, will be employed as a proxy to measure financial institutions performance. ROA
and ROE will be computed using financial statement figures. ROA as measurement of firm
performance was used by Mihret et al. (2010). Kiabel (2012), Hitchinson and Zain (2009) were
adopted both ROA and ROE as proxies to measure firm performance. Further, Bryer (2006) as
cited in Mihret et al. (2010) suggest ROE as a measure of companies ‘value added.
Management Action on Internal Audit Recommendations

Management action on internal audit recommendations stands for the extent to which internal audit
recommendations are implemented. An approximate measure considered is the number of internal
audit recommendations in the past few years divided by total audit findings in the period. An
alternative approach will be employed internal audit directors‘and staff‘s perceptions of the extent
to which management implements internal audit recommendations.
Research Hypothesis
Internal audit is expected to contribute positively to accomplishment of organizational goals
(Hermanson & Rittenberg, 2003). In this study, a positive association between internal audit
effectiveness and performance of financial institutions is predicted. ROA and ROE will be used as
a proxy for performance. Thus, the following hypotheses are driven from the literature;
H1a. Internal audit effectiveness is positively associated with ROA.
H1b. Internal audit effectiveness is positively associated with ROE.
The contribution of internal audit to performance of financial institutions is expected to be

moderated by the extent to which management takes action based on recommendation of internal
auditors. This relationship will be tested using Hypothesis 2 as shown below:
association between Internal Audit effectiveness and ROA.
association between Internal Audit effectiveness and ROE.
Methodology
This section outlines the methodology employed to deal with the research objective and test the
research hypotheses formulated in the literature. It starts by explaining the use of quantitative
approach that was used in the study. Measurement and instrumentation procedures as well as the
related issues are then outlined. This is followed by a discussion of data collection procedures.
Data analysis techniques and procedures are then discussed.
Quantitative Research Methods

The study was employed quantitative research approach. Quantitative data were collected on
internal audit effectiveness, and institutions performance. The researcher tests a theory by
specifying narrow hypotheses and the collection of data are used to support or refute the
hypotheses. The data were collected on an instrument that measures attitudes, and the information
collected will be analyzed using statistical procedures and hypothesis testing (Creswell, 2009).
The uses of quantitative methods help to make statistical inferences about the relationships
between variables. Quantitative data can be productive for descriptive, reconnoitering,
exploratory, inductive, and opening purposes. And can be productive for explanatory,
confirmatory, hypothesis testing purposes (Creswell, 2009).
Measurement and Instrumentation

This section describes in a greater detail measurement of each variable and indicates the data
collection instruments will be employed.
Internal audit effectiveness was measured on a 5-point Likert-type scale that ranges from ‘Strongly
Agree‘(coded as 5) to ‘Strongly Disagree‘(coded as 1). Internal audit directors and staff were asked
to indicate their opinions about internal audit in their financial institutions. As indicated in the
literature, internal audit effectiveness is measured by the extent of internal audit objectivity,
internal audit proficiency, quality of audit planning and execution and quality of reporting and
follow-up in the firms using internal audit practitioners’ views through specific items.
Although internal audit practitioners’ views are also a proxy rather than direct measure, this is
considered as the best practical measure. This is because practitioners are expected to have intimate
knowledge of the concepts of interest to the study. The validity of the measures is considered to
be acceptable for the following reasons. First, most items relate to statements of fact, as compared
to mere opinion. This is because auditors possess firsthand experience of the concepts of interest.
Second, the literature indicates that constructs (i.e., variables measured using respondents
opinions) could be used to measure research phenomena about individuals and organizations so
long as appropriate steps are taken to ensure validity and reliability (Kwok & Sharp, 1998 as cited
in Mihret et al., 2010). As a step to ensuring validity, the items in the questionnaire in this study
were basically derived from prior research instruments and/or the literature.
As internal audit objectivity, proficiency, planning, and reporting are abstract concepts, further
operationalisation was made to make them measurable. This operationalisation is undertaken by
identifying specific constructs on which internal audit practitioners were asked to express their
views. These constructs are specific aspects of internal audit department‘s organization, staffing,
and work performance.
Furthermore, appropriate items were identified for internal audit scope, audit planning and
execution, and internal audit reporting, follow-up and quality review. Most phenomena of interest
are latent variables that cannot be measured directly. As a result, participants’ views were
considered as a proxy for the latent variables.
Financial institutions performance were measured using ROA and ROE, i.e., income after tax
divided by total assets and income after tax divided by total equity, were used as a proxy to measure
financial institutions performance. ROA and ROE were computed using financial statement
figures. ROA as measurement of firm performance was used by Mihret et al. (2010). Kiabel
(2012), Hitchinson and Zain (2009) were adopted both ROA and ROE as proxies to measure firm
performance. Further, Bryer (2006) as cited in Mihret et al. (2010) suggest ROE as a measure of
companies‘value-added.
Data Collection Instruments

Two sets of data collection instruments were employed. The first Instrument was a questionnaire
for internal audit directors and staff; while second instrument was annual report of financial
institutions responding to the survey, i.e. financial statements.
The first Instrument was a questionnaire for internal audit practitioners (i.e., internal audit directors
and staff). Items were grouped under sub-headings to help respondents gain easy grasp of the
questions asked (Zikmund, 2003). In this questionnaire, respondents were asked about internal
audit organization and operation under five sections, i.e., internal audit proficiency, independence
and objectivity, scope of work, planning and execution, and reporting, follow-up and quality
review.
In the questionnaire, a 5-point Likert-type scale with response options ranging from ‘Strongly
Agree‘ (codes as 5) to ‘Strongly Disagree‘ (coded as 1) were employed. This type of scale was
used in similar areas (see Kiabel, 2012; Mihret & Woldeyohannes, 2008; Mihret et al., 2010;
Mihret & Admassu, 2010). The descriptors ‘Strongly Agree‘ (5), ‘Agree‘ (4), ‘Neutral‘ (3),
‘Disagree‘ (2), and ‘Strongly Disagree‘ (1) were provided.
In such type of scales, it is necessary to clearly indicate the attitude object about which opinions
are sought (Bradburn, Sudman & Wansink, 2004 as cited in Mihret et al., 2010). Thus, instructions
were given that clearly state that respondents are expected to provide opinions on statements as
applied to their organization.
A total of 134 questionnaires were distributed to 26 financial institutions, out of which, 97

questionnaires were completed and returned, and 94 were usable. Thus, this gives usable response
rate of 70.15 percent. The usable sample of questionnaire is considered as sufficient because a
response rate of 70 percent or above is usually taken as adequate (Roberts, 2004 as cited in Mihret
et al., 2010).
The second Instrument is a secondary data that was used to guide the gathering of documentary
sources (financial statements report).
Pre-testing of Instruments
The data collection instruments of this study was subjected to pre-test at several stages before the
actual data collection begin by the research teams in the research to refine questions, instruments,
or procedures (Cooper & Schindler, 2014). Based on the comments and suggestions from the pre-
testing, the data collection instruments were revised before data collection commenced. These
procedures are considered to have enhanced the reliability of measurement, which in turn possibly
helped enhance statistical power (DeVellis, 2003 as cited in Mihret et al., 2010).
Sampling Methods and Strategy

Stratified purposive sampling was adopted for the study. This is because the purpose of the study
is to generate inferences about the relationships among the variables rather than attempt to derive
statistical generalizations about a population (Oppenheim, 1992 as cited in Mihret et al., 2010).
Moreover, Cooper and Schindler (2014) noted that if the differences in sampling costs or variances
among strata are large, then disproportionate sampling (stratified purposive sampling) is desirable.
The limitation of this sampling approach, i.e., not enabling statistical generalizations on a
population remains. However, the technique is considered the most appropriate in view of the
purpose of the present study. Studies that employed a similar research design (Mihret et al., 2010)
to the quantitative component of this study have employed purposive sampling.
Mainly, financial institutions are the units of analyses in the study; thus, sample financial
institutions were selected in the first stage. Financial institutions, i.e. banks, insurances and micro
finances were included. Institutions in the study were limited to banking, insurance, and micro
finances sub-sectors. This is because most other private companies in Ethiopia have not adopted
internal audit (Mihret et al., 2010).
Number of financial institutions obtained from the register of financial institutions that the
National Bank of Ethiopia maintains. All internal audit directors and staff in the financial
institutions include in the sample will be considered as potential participants. There were 18 private
and 3 government-owned banks, 14 private and 1 government-owned insurance companies, and
31 Micro Finance Institutions as of May, 2012.
This study was undertaken on financial institutions of Ethiopia which have 2013 fiscal year
financial statements. Questionnaires were collected from the head offices of the financial
institutions. Further, due to the budget constraint the researchers were collected data from micro
finances located in Addis Ababa, Mekelle, and Hawassa.
Data Analysis
This section outlines the detailed data analysis techniques and procedures were employed for the
quantitative data.
Before hypothesis testing was conducted, quantitative data were explored for missing values,
outliers, and distributional characteristics. The reliability of the measures were assessed using
Cronbach‘s alpha for Likert-type data.
Procedures for testing hypothesis 1

H1a. Internal Audit effectiveness is positively associated with ROA.
H1b. Internal Audit effectiveness is positively associated with ROE.
Spearman‘s zero order correlation was employed to test H1. This test is chosen because internal
audit effectiveness is generated as ordinal data. This test has been employed in internal auditing
area having similar design (Mihret et al., 2010). Because independence and objectivity,
proficiency, and work performance are interrelated (Krishnamoorthy 2002 as cited in Mihret et al.,
2010), the data for each construct could be correlated. Thus, to arrive at valid results, it is necessary
to take a single value representing the variables (Field, 2005 as cited in Mihret et al., 2010).
Therefore, a single value is derived by taking median values.
Procedures for testing hypothesis 2

Hypotheses 2 aims at testing the moderating impact of management action on internal audit
findings on the relationship claimed in H1. Thus, spearman’s partial correlation was run controlling
for management’s action on internal audit recommendations.
Discussion and Analysis

This chapter presents the results of the data collected through using questionnaire and from
financial statements. It begins with analysis of effectiveness of financial institutions internal audit
practices and followed by tests of the correlation of internal audit with the financial institutions
performance.
Financial Institutions Background

The ratio of institutions participated in the study and profile of the surveying institutions internal
auditors are discussed under this section.
General information of Internal Audit

Table 4.1.1. Background of Internal Audit
Frequency Percent Valid Percent

Valid Bank 56 59.6 75.7
Insurance 10 10.6 13.5
Microfinanc 8 8.5 10.8
Total 74 78.7 100.0
Missing System 20 21.3
Total 94 100.0
Sources: Questionnaire Results, 2015
The survey result shows that 75.7% questionnaires were collected from banks and 13.5% and
10.8% were collected from Insurance and Microfinance respectively from the valid percentage.
Thus, more than two-third of questionnaire were collected from banks.
Table 4.1.2. Distribution of Internal Auditors service
Ranges Frequency Percent Valid Percent

Valid 1 to 5 5 5.3 7.5
6 to 10 19 20.2 28.4
11 to 15 7 7.4 10.4
more than 15 36 38.3 53.7
Total 67 71.3 100.0
Missing System 27 28.7
Total 94 100.0
The number of employees employed by the institutions shows that 53.7% financial institutions
have more than 15 internal auditors, and 35.9% have less than 10 internal auditors. National bank
of Ethiopia issued new directives that attempts to strengthen the financial institutions
accountability and transparency through structuring their internal audit, but they are struggling to
do so, especially the microfinance institutions.

Internal audit effectiveness represented by four indicators: internal auditor objectivity, internal
auditor proficiency, quality of internal audit planning and execution, and quality of internal audit
reporting and follow-up (Al-Twaijry et al., 2004; Mihret et al., 2010). Hence, the indicators of
internal audit effectiveness are assessed in this part of the chapter.
Internal Audit Independence and Objectivity

There exists a significant positive relationship among auditors’ independence and objectivity to
the effectiveness of internal audit (Baharud-din, Shokiyah, & Ibrahim, 2014).
Table 4.2.1 Internal Audit Independence and Objectivity
Questions N Minimum Maximum Mean Std. Dev.
IA free from intervention 92 1.00 5.00 3.9674 1.14307

IA free to include any findings 92 1.00 5.00 3.8913 1.16219
IA provide reports to BOD or AC 94 1.00 5.00 3.8191 1.24402
BOD or AC always oversee IA 87 1.00 5.00 2.9080 1.09579
IA not assigned to areas they participated 89 1.00 5.00 3.1461 1.25726
IA not participated in areas they responsible 92 1.00 5.00 3.1413 1.50151
IA assignments are rotated periodically 90 1.00 5.00 3.3444 1.20076
Mgt take action on IA report & recommendation 94 1.00 5.00 3.6809 1.05965
Valid N (listwise) 78

The independence and objectivity of internal auditing is with respect to both assurance services
and consulting for the organization. Independence and objectivity are closely related where the
freedom from conditions that may threaten objectivity and no significant quality compromises are
made during rendering the audit service. There exists significant and positive relationship between
auditors’ independence and objectivity to the effectiveness of internal audit (Baharud-din,
Shokiyah, & Ibrahim, 2014). The results of the questionnaire shows that the independency and
objectivity of the internal auditors are good except in the areas of overseeing of board of directors
internal auditors, assignments of internal auditors in the area where they are responsible and
participated, and rotation of internal auditors periodically. This indicates that there are limitations
in internal auditors’ independency and objectivity that influences internal auditors to achieve the
institutions established objectives where internal audit effectiveness is the ability of the internal
auditors to achieve established objective within the organization (Badara and Saidin, 2013).
Proficiency of Internal Audits

Table 4.3.1 Proficiency of Internal Audit
IA department is large to carry out its duties 93 1.00 5.00 3.6237 1.16015
IA obtains sufficient budget 94 1.00 5.00 3.5106 1.10468

IA possess sufficient experience 94 1.00 5.00 3.6064 1.11893
IA possess knowledge & skills 94 1.00 5.00 3.6915 1.02681

IA has policies for hiring IA staff 91 1.00 5.00 3.0659 1.20924
IA has policies for training IA staff 92 1.00 5.00 3.4891 1.10438
IA undertake continuous professional

92 1.00 5.00 3.2065 1.10482
development
Adequate short-term training arranged for IA 94 1.00 5.00 3.4574 1.06423
Competent IA manual exists to guide IA work 93 1.00 5.00 3.9140 .85537
Proficiency relates to the ability of an individual and setting of the department to perform a job or
task properly based on the educational level, professional experience, budget of the department,
training and hiring policies, capacity of the department, internal audit manual and the effort of the
staffs for continuing professional development that improves the effectiveness of internal audit.
The results of the questionnaire regarding proficiency of internal audit function in the financial
institutions demonstrates strong proficiencies in relation to having of complete internal audit
manual, capacity of internal audit, budget, experience, and skills and knowledge of the internal
auditor. However, it shows weak proficiencies regarding to the policies on hiring and training of
internal auditors, and the continuous professional development that affects the effectiveness of
internal audit negatively since technical competence and continuous training are considered
essential for effective internal audit (Mihret and Yismaw, 2007; Badara and Saidin, 2013; Al-
Matari et al., 2014; Baharud-din et al., 2014).
Scope of Audit Work

The capability of internal audit‘s scope of work and the standard with which the audits are planned
and executed, and reported and follow-up are important illustrations of effective internal audit (Al-
Twaijry et al., 2004; Mihret and Woldeyohannes, 2008; Mihret et al., 2010).
Internal Audit Planning and Execution

Table 4.4.1.1 Internal Audit Planning and Execution
Annual IA plan is prepared constantly 89 1.00 5.00 4.3820 .85951

Risk Assessment done as part of audit planning 91 1.00 5.00 3.4945 1.14866
Fraud risk considered in setting audit priorities 89 1.00 5.00 3.7528 .96861
Senior mgt input is well planned in setting IA 88 1.00 5.00 3.6932 .96321
Preliminary survey is performed before an audit 91 1.00 5.00 3.3626 1.02758
Analytical audit procedures used in examination 89 1.00 5.00 3.4944 .93083
Audit work documented and maintained in a file 93 1.00 5.00 4.4409 .78660
Objectives of activities to be audited reviewed 94 1.00 5.00 3.9681 .92110
Potential risks relevant to audit are identified 94 1.00 5.00 3.8511 .99415
Prior audit reports are reviewed constantly 93 1.00 5.00 4.1398 .85455
Prior audit working paper are reviewed 93 1.00 5.00 3.9032 .97874
Preliminary communication made with auditees 91 1.00 5.00 3.6703 1.17431
Resources necessary to perform audit reviewed 92 1.00 5.00 3.8261 .93302
Audit objectives are always established 92 1.00 5.00 4.1522 .78355
Written audit programs are always established 91 1.00 5.00 4.1209 1.03102

The mean results indicate that the internal audit planning and execution practices of financial
institutions is above 3.6 except the questions concerning to risk assessment as part of audit
planning, preliminary survey before an audit, and using of analytical audit procedures in
examination. These results signifies that the internal audit function planning and execution
performs well that contribute to the effectiveness of IA works (Al-Twaijry et al., 2004; Mihret and
Woldeyohannes, 2008; Mihret et al., 2010) though there exists high deviation of results of
respondents from the average respondents result like the other responses. Audit quality is arguably
a function of reasonableness of the scope of service; and effective planning, execution and
communication of internal audits and audit quality significantly influence audit effectiveness
(Mihret and Yismaw, 2007).
Internal Audit Reporting and Follow-up

Table 4.4.1.2 Internal Audit Reporting and Follow-up
N Minimum Maximum Mean Std. Dev.
IA supervisor or manager supervise fieldwork 93 1.00 5.00 4.0108 .92660
IA supervisor reviews IA working paper 94 1.00 5.00 3.8936 1.02094
Audit finding discuss with auditees before report 94 1.00 5.00 4.3936 .79268
IA follow up implementation of corrective

94 1.00 5.00 4.2447 .82548
actions
Reporting level varies with importance of IA
91 1.00 5.00 3.9560 1.04256
findings
Corrective action plan agrees with mgt before
92 1.00 5.00 3.8261 1.06502
report
Mgt takes timely action based on IA
91 1.00 5.00 3.7802 .95222
recommendation
audit purpose and scope include in IA reports 92 1.00 5.00 4.3478 .74767
Audit findings and conclusions include in IA

93 1.00 5.00 4.4301 .74305
reports
Audit recommendations include in IA reports 91 1.00 5.00 4.4615 .74993
Auditees comments audit findings include in IA

93 1.00 5.00 4.1828 .95492
reports
The office's ability to properly plan, perform and communicate the results of audits is a proxy for
audit quality and this in turn significantly influence audit effectiveness (Mihret and Yismaw,
2007). The questionnaire result shows that (mean of above 3.78) internal audit reporting and
follow-up of the institutions performs well that contributes positively to audit effectiveness (Mihret
and Yismaw, 2007).
Management action on Internal Audit recommendations

Table 4.5.1. Management action on Internal Audit recommendations
N Minimum Maximum Mean Std. Dev.
Minor IC breaches reported implemented by mgt 90 1.00 5.00 3.4556 .95000
Major IC breaches reported implemented by mgt 92 1.00 5.00 3.9130 .94523
Minor frauds reported implemented by mgt 92 1.00 5.00 3.8370 .98647
Major frauds reported implemented by mgt 92 1.00 5.00 4.1087 .96598
Major breaches of Institutional Policy reported

92 1.00 5.00 3.9565 .95977
implemented by mgt
The effectiveness of internal audit as measured by the rate of implementation of audit

recommendations compared favorably (Mihret and Yismaw, 2007). The result reveals that
management takes action on internal audit recommendation except below the expectation on
implementation of reports of minor internal control breaches (mean of below 3.46). This indicates
that internal audit function practices of the institutions are good though there is a room for
improvement.
Reliability analysis
Reliability analysis is undertaken for internal audit effectiveness indicators using Cronbach‘s
alpha. This statistic is appropriate because Likert-type scale is considered to be able to generate
data that approximates interval data (Bohrnstedt and Knoke 1994, cited in Mihret et al. 2010). This
measure has also been employed in prior auditing research (e.g., Mihret eat al. 2010) using a
Likert-type scale. The results of reliability analysis are reported in Table 4.3.
Table 4.3. Reliability statistics
Variable Cronbach's Cronbach's Alpha Based

Alpha on Standardized Items
Internal Audit Objectivity and
.720 .735
Independence
Proficiency of Internal Audit .825 .821
Internal Audit Planning and
.910 .914
Execution
Internal Audit Reporting and
.884 .890
Follow-up
Management action on Internal
.764 .764
Audit recommendations
Source: SPSS reliability test results, 2015
Most researchers use 0.70 as a minimum acceptable level of coefficient alpha, while, in some cases
0.6 and 0.5 are also considered satisfactory (Kerlinger & Lee 2000, cited in Mihret eat al. 2010).
In this study, Cronbach's alpha is 0.720 and above. The level of alpha was considered to be reliable
enough to proceed with the data analysis.
Hypotheses Testing
Table: Inferential statistics results for hypothesis 1 and 2
Spearman correlation of internal audit effectiveness with ROA and ROE
Control Variables IA effect ROA ROE

-none-a IA effect Correlation 1.000 .190 .253
Significance (2-tailed) . .352 .213
Df 0 24 24
ROA Correlation .190 1.000 .205
Significance (2-tailed) .352 . .315
Df 24 0 24
ROE Correlation .253 .205 1.000
Significance (2-tailed) .213 .315 .
Df 24 24 0
IA effect mgt action IA effect Correlation
1.000 .209 .255
Significance (2-tailed) . .315 .219

Df 0 23 23
ROA Correlation .209 1.000 .217
Significance (2-tailed) .315 . .297
Df 23 0 23
ROE Correlation .255 .217 1.000
Significance (2-tailed) .219 .297 .
Df 23 23 0
Sources: SPSS correlation Results, 2015
The hypothesis for the effects of internal audit effectiveness on the performance of financial
institutions was tested. The first two hypotheses were tested without the moderating variable.
H1a. Internal Audit effectiveness is positively associated with ROA.
H1b. Internal Audit effectiveness is positively associated with ROE.
Individuals are units of response for internal audit effectiveness and financial institutions are units
of analysis for these hypotheses. Thus, responses of individuals from the same institutions were
combined (Mihret et al. 2010) for the purpose of testing the above hypotheses. These hypotheses
are tested using Spearman’s correlation coefficient because internal audit effectiveness is ordinal.
In contrast, since ROA and ROE are metric data it is converted into rank order data to make it
suitable for use in Spearman’s rank order correlation (Mihret et al. 2010). The conversion was
undertaken by assigning 1 for ROA and ROE less than 10 per cent, 2 for ROA and ROE of 11 to
20 per cent, 3 for ROA and ROE of 21 to 30 per cent, 4 for ROA and ROE of 31 to 40 per cent,
and 5 when ROA and ROE are over 40 per cent. As shown in the above table, the results show that
Spearman’s coefficient of correlation between internal audit effectiveness and ROA is not
statistically significant (rs = -0.190; p = 0.352). This indicates that statistically the association
between these two variables for the sample is not different from zero. Thus, hypothesis 1a, internal
audit effectiveness is positively associated with ROA is not supported. Likewise, the correlation
between internal audit effectiveness and ROE is statistically insignificant (rs = -0.253; p = 0.213).
Statistically, the association between these two variables for the sample is not different from zero.
Therefore, hypothesis 1b, internal audit effectiveness is positively associated with ROE is not
supported.
Management action on internal audit recommendations is considered as having a moderating effect

on the relationship of internal audit effectiveness with ROA and ROE. Thus, hypotheses 2a and
2b are tested to see if the levels of improving the relationship of internal audit effectiveness with
ROA and ROE:
The result of the partial correlation shows that the relationship of internal audit effectiveness with
ROA (rs = -0.209; p = 0.315) and ROE (rs = -0.255; p = 0.219) is statistically insignificant. Hence,
management action on internal audit findings does not appear to make a significance difference in
the correlation of ROA and ROE with internal audit effectiveness in the financial institutions
studied. As a result, hypothesis 2a, management’s action on internal audit recommendations
positively moderates the association between internal audit effectiveness and ROA, is not
supported. Similarly, hypothesis 2b, management’s action on internal audit recommendations
positively moderates the association between internal audit effectiveness and ROE, is not
supported. The current study findings are consistent with previous results (Mihret et al. 2010;
Kiabel, 2012; Ejoh and Ejom, 2014) that internal audit effectiveness has no significant effect on
the financial performance.
Conclusions and Recommendations

An attempt has made to examine the effects of internal audit on performance of Ethiopian financial
institutions by using quantitative research approach. Supplementary, the study tried to assess the
internal audit effectiveness of the financial institutions. Financial institutions performance was
measured using ROA and ROE as a proxy. ROA as measurement of firm performance was used
by Mihret et al. (2010). Kiabel (2012), Hitchinson and Zain (2009) were used both ROA and ROE
as proxies to measure firm performance. A total of 134 questionnaires were distributed to 26
financial institutions, out of which, 97 questionnaires were completed and returned, and 94 (70.15
%) were usable. The reliability of the measures were assessed using Cronbach‘s alpha for Likert-
type data. Spearman‘s zero order correlation was employed to test H1. Hypotheses 2 aims at testing
the moderating impact of management action on internal audit findings on the relationship claimed
in H1. Spearman’s partial correlation was run controlling for management’s action on internal audit
recommendations.
Hutchinson and Zain (2009) study of 60 Malaysian companies found a strong association between
internal audit quality and firm performance. This result supports the theory of internal audit
function contribution Hermanson and Rittenberg (2003) that the existence of an effective internal
audit function is associated with superior organizational performance. However, the present study
results reveal that internal audit effectiveness has no significant effect on the financial performance
consistent with previous results (Mihret et al. 2010; Kiabel, 2012; Ejoh and Ejom, 2014) that
statistically there is no association between internal audit effectiveness and financial performance.
The conclusions seem to demonstrate practical value and the findings appear to pave the way for
further research. The internal audit functions concerning independence and objectivity, proficiency
of internal auditor, and internal audit planning and execution needs to execute by internal auditors
and the management as of the manual issued by MoFED that might help the effectiveness of
internal audit effectiveness.
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Journal of Finance, Accounting and Management, 7(2), 1-30, July 2016 1

The Effects of Internal Audit on Performance of Ethiopian Financial Institutions

Abraham Gebregiorgis Berhe, Asmamaw Getie Mihret, Mohammed Seid Ali

Background and Justification

Internal Audit Effectiveness

Internal Audits Objectivity

Internal Audits Proficiency

Scope of Audit Work

Internal Audit association with Firm Performance

Management Action on Internal Audit Recommendations

Conceptual model and measures

Internal audit effectiveness

Management Action on Internal Audit Recommendations

The contribution of internal audit to performance of financial institutions is expected to be

Quantitative Research Methods

Measurement and Instrumentation

Data Collection Instruments

A total of 134 questionnaires were distributed to 26 financial institutions, out of which, 97

Sampling Methods and Strategy

Procedures for testing hypothesis 1

Procedures for testing hypothesis 2

Discussion and Analysis

Financial Institutions Background

General information of Internal Audit

Frequency Percent Valid Percent

Sources: Questionnaire Results, 2015

Table 4.1.2. Distribution of Internal Auditors service

Ranges Frequency Percent Valid Percent

Sources: Questionnaire Results, 2015

Internal Audit Effectiveness

Internal Audit Independence and Objectivity

Table 4.2.1 Internal Audit Independence and Objectivity

Questions N Minimum Maximum Mean Std. Dev.

IA free from intervention 92 1.00 5.00 3.9674 1.14307

IA provide reports to BOD or AC 94 1.00 5.00 3.8191 1.24402

BOD or AC always oversee IA 87 1.00 5.00 2.9080 1.09579

IA not assigned to areas they participated 89 1.00 5.00 3.1461 1.25726

IA not participated in areas they responsible 92 1.00 5.00 3.1413 1.50151

IA assignments are rotated periodically 90 1.00 5.00 3.3444 1.20076

Sources: Questionnaire Results, 2015

Proficiency of Internal Audits

Questions N Minimum Maximum Mean Std. Dev.

IA obtains sufficient budget 94 1.00 5.00 3.5106 1.10468

IA possess knowledge & skills 94 1.00 5.00 3.6915 1.02681

IA has policies for training IA staff 92 1.00 5.00 3.4891 1.10438

IA undertake continuous professional

Competent IA manual exists to guide IA work 93 1.00 5.00 3.9140 .85537

Sources: Questionnaire Results, 2015

Scope of Audit Work

Internal Audit Planning and Execution

Questions N Minimum Maximum Mean Std. Dev.

Annual IA plan is prepared constantly 89 1.00 5.00 4.3820 .85951

Preliminary survey is performed before an audit 91 1.00 5.00 3.3626 1.02758

Analytical audit procedures used in examination 89 1.00 5.00 3.4944 .93083

Objectives of activities to be audited reviewed 94 1.00 5.00 3.9681 .92110

Preliminary communication made with auditees 91 1.00 5.00 3.6703 1.17431

Resources necessary to perform audit reviewed 92 1.00 5.00 3.8261 .93302

Audit objectives are always established 92 1.00 5.00 4.1522 .78355

Sources: Questionnaire Results, 2015

Internal Audit Reporting and Follow-up

N Minimum Maximum Mean Std. Dev.

IA supervisor or manager supervise fieldwork 93 1.00 5.00 4.0108 .92660

IA supervisor reviews IA working paper 94 1.00 5.00 3.8936 1.02094

IA follow up implementation of corrective