Does internal audit function quality deter management misconduct?
Ege, Matthew Stephen
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Standard-setters believe high-quality internal audit functions (IAFs) serve as a key resource to audit committees for monitoring senior management. However, regulators do not enforce IAF quality or require disclosures relating to IAF quality, which is in stark contrast to regulatory requirements placed on boards, audit committees, and external auditors. Using proprietary data, I find that a composite measure of IAF quality is negatively associated with the likelihood of management misconduct even after controlling for board, audit committee, and external auditor quality. A difference-in-differences analysis suggests that misconduct firms improve IAF quality after misconduct is revealed by increasing IAF competence. Finally, IAF quality is a predictor of accounting-related management misconduct even after controlling for other observable predictors of misconduct. These findings suggest that regulators and audit committees should consider ways to improve IAF quality and that investors would benefit from disclosures relating to IAF quality.