英文1-9

Abstract

This study explores whether the relation between internal audit quality and firm performance is

associated with firm characteristics of information asymmetry and uncertainty (growth

opportunities) and certain governance controls (audit committee effectiveness). The results from

this preliminary study of 60 Malaysian companies show that the association between internal

audit quality and firm performance is stronger for firms with high growth opportunities and that

this positive association is weakened by increasing audit committee independence. These

findings demonstrate the internal auditors conflicting roles and question the governance

recommendations that require all members of the audit committee to be non-executive directors.

Key words: Growth opportunities, internal audits, audit committee, agency costs, firm1. Introduction

This paper explores the role of internal audit quality on firm performance in a sample of

Malaysian firms. It extends prior research on the role of internal audits (e.g., Carcello, Hermanson,

and Raghunandan, 2005; Jensen and Payne, 2003; Nagy and Cenker, 2002), including whether the

role should be outsourced (e.g. Caplan and Kirschenheiter, 2000). The study is motivated by three

factors. First, prior research suggests that internal audits can have a positive influence on

corporate governance, including reporting quality and firm performance (e.g. Gramling, Maletta,

Schneider and Church, 2004). Despite widespread acceptance of the benefits of internal auditing,

there is relatively little documented empirical research on the role of internal auditing on firm

performance. Further, it appears that the quality of the internal audit department is more

important than the existence of an internal audit department. For example, Davidson,

Goodwin-Stewart and Kent (2005) find no significant association between voluntary establishing

an internal audit function and a reduction in the level of discretionary accruals. This finding

suggests that merely establishing an internal audit does not control managers‟ incentives to

manage earnings. Second, organizational theory and contracting theory suggests that only certain

types of organizations with particular firm characteristics could benefit from internal audit quality

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(IAQ).1 According to organizational contingency theory, linkages between specific management

control systems and firm performance are likely to depend on contextual and environmental

factors (Chenhall, 2003). Similarly, according to contracting theory the relationship between

management control systems and firm performance depends on the costs of writing and enforcing

contracts which may vary depending on firm characteristics (Watts and Zimmerman 1986). In

this study we draw on contracting theory to investigate whether growth opportunities and audit

committee independence affect the relationship between IAQ and firm performance. Third, while

several studies have focused on internal auditing issues in developed countries, such as the USA

and UK, there is little evidence from emerging markets such as Malaysia. Malaysian firms are of

interest to this area of research because during this period it was mandatory for listed Malaysian

companies to have an audit committee2 while forming an internal audit function was voluntary.3

Therefore, establishing an internal audit department is a relatively recent phenomenon inMalaysian companies.4 In addition, the necessity for stringent corporate governance in Malaysia

is demonstrated by the alleged accounting fraud at Technology Resources Industries Berhad (see

Fadzil, Haron and Jantan, 2005). In this paper we provide some insights on whether internal

auditing as a monitoring/control mechanism is linked to firm performance in Malaysian firms.

The first objective of this paper is to determine if there is an association between internal

audit quality and firm performance. The professional literature identifies both accounting

qualifications and prior auditing experience of the internal audit staff as important ingredients for

an effective internal audit function (e.g. the Research Committee of the Institute of Chartered

Accountants of Scotland in McInnes, 1993). However, the relation between IAQ and firm

performance is unlikely to be straightforward since both organizational theory and contracting

theory suggests that only certain types of organizations with particular firm characteristics could

benefit from IAQ. Since, prior evidence drawn from contracting theory suggests that growth (or

investment) opportunities is likely to affect firm performance (see Smith and Watts, 1993; Baber

et al. 1996) we us also examine if growth opportunities affects the linkage between IAQ and firm

performance. Contracting theory suggests that firms with high growth opportunities are

associated with high information asymmetry and managers of these high growth firms are more

difficult to monitor (Smith and Watts, 1992; Gaver and Gaver, 1993; Baber et al. 1996). Therefore,

the role of IAQ is expected to be more beneficial for such firms. This study seeks to determinewhether the link between IAQ and firm performance is dependent on the level of growth

opportunities of the firm.

As audit committees are also part of the internal control system of a firm, the second

objective of this paper is to determine whether audit committee independence has an impact on

the association between IAQ and the performance of growth firms. Hermanson and Rittenberg

(2003) suggest that the role of the auditor is one of preeminent monitoring and reporting to the

board on the effectiveness of corporate governance. They foresee a possible conflict between the

role of the internal audit function and the role of the audit committee and these tensions could

affect organizational outcomes5. Together with Gramling et al (2004), they suggest that we need

to understand how the internal audit function interacts with the audit committee, management,

and the external auditors to achieve quality corporate governance. By examining the interaction

between IAQ and audit committee independence on the performance of growth firms we shed

some light on this question.

The data for this study of Malaysian firms is obtained from two sources. The first source is a

survey of Malaysian firms listed on the Bursa Malaysia Berhad6 to obtain data on internal auditing.

The second source is the annual reports of the firms responding to the survey. The data on firms‟

growth opportunities, audit committee and profitability is collected from the 2003 financialreports. Prior studies of Malaysian firms have examined the internal control practices of the

internal audit function but not the implications on firm performance. Research of Malaysian firms

demonstrate the importance of the internal audit by showing that management relies on internal

audits to provide assurance on matters relating to internal control such as the provision of an

independent review of efficient operations (Ernst and Young, 2005; Fadzil et al., 2005). Recent

research by Mak and Kusnadi (2005) examines the impact of corporate governance mechanisms

on the value of Singapore and Malaysia firms (as measured by Tobin's Q). The only significant

association they find is a negative relationship between board size and firm value. They fail to

find any significant association between either audit committee size or the proportion of

independent directors on the audit committee and firm value.The evidence provided in this study suggests links between the performance of firms

adopting a growth strategy and the quality of the internal audit function. Further, this study

demonstrates that these associations are moderated by audit committee independence. Using

observations from 60 Malaysian firms, this paper provides preliminary evidence that there is a

positive association between IAQ and firm performance for firms with high growth opportunities,

but not for firms with low growth opportunities. Further, we also show that, in the presence of an

independent audit committee, the positive association between IAQ and performance for high

growth firms disappears, suggesting a conflict effect between IAQ and audit committee. These

preliminary findings suggest that focusing attention on the composition of the audit committeeignores the essential skills required for an effective AC. “Overemphasis on monitoring and

control risks non-executive directors seeing themselves, and being seen, as an alien policing

influence….. An overemphasis on strategy risks non-executive directors becoming too close to

management… (Higgs Report 2003:27). An effective AC attains the appropriate balance between

internal and independent directors; a great proportion of either can swing the balance in the wrong

direction and cause conflict with the role of the IA.

This paper contributes to the literature in several ways. First, this study provides evidence

from an emerging economy, Malaysia. Given the globalization of business, there is increasing

interest in accounting and control issues in these countries. Second, this study demonstrates that

research can successfully utilize both survey methodology and accounting data to study

management control issues. Third, the results of this study are consistent with the notion that

internal audits provide higher levels of control and monitoring that are associated with

performance. However, this association is dependent on the firm‟s growth opportunities. Our

results imply that it may not be economically efficient to establish an internal audit function in the

absence of growth opportunities. Fourth, this study demonstrates the contingent nature of IAQ

and how IAQ is related to other corporate governance controls, such as audit committee. The

results of this study question whether firm performance is enhanced when internal audits are

expected to serve as a resource to the audit committee and management, placing the internal

auditor in a situation of possible conflict. Finally, this paper contributes to the literature by

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integrating management control and corporate governance theory in terms of the role of IAQ and

audit committees and shows that such integration provides a deeper understanding of how and

why these variables interact to affect firm performance. This evidence is not available in the

extant literature.

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