Audit committees' involvement and the effects of quality in the internal audit function on corporate governance

• Author: Zubaidah Ismail,Razimah Abdullah,Malcolm Smith
• Published date: 01 November 2018
• Date: 01 November 2018
• DOI: http://doi.org/10.1111/ijau.12124

ORIGINAL ARTICLE

Audit committees'involvement and the effects of quality in the

internal audit function on corporate governance

Razimah Abdullah

1

|Zubaidah Ismail

1

|Malcolm Smith

2

1

School of Business and Law, Edith Cowan

University, Perth, WA, Australia

2

University of South Australia, Adelaide, SA,

Australia

Correspondence

Razimah Abdullah, Edith Cowan University,

Faculty of Business and Law, 270 Joondalup

Drive, Joondalup, Perth, WA, Australia.

Email: arazimah@gmail.com

Extant literature has investigated extensively the structure of the internal audit func-

tions and the structure of audit committees and their associations with internal audit

quality and the effectiveness of internal audit functions. However, few studies have

investigated the activities and processes involved in internal audits. This study goes

beyond the “black box”approach to investigate an audit committee's involvement in

the four stages of the internal audit performance—planning, execution, reporting,

and monitoring—and its corresponding impact on internal audit performance quality.

In this study, data were collected by questionnaires sent to the chief internal auditors

of Malaysian public listed companies. The study establishes the link between internal

audit quality to corporate governance by relating internal audit quality to the number

and nature of recommendations made by the internal audit teams to improve on the

various dimensions of corporate governance as identified by the World Bank's corpo-

rate governance framework. The results indicate that high performance in internal

auditing is associated with more recommendations to improve corporate governance

dimensions. The results also suggest that specific reviews by the audit committees on

internal audit activities affect audit quality or overall internal audit performance and in

the quality of various stages of internal audit, particularly audit planning.

KEYWORDS

audit committee,corporate governance,Internal audit function,internal audit quality, WorldBank's

governance framework

1|INTRODUCTION

One of the governance areas subject to scrutiny by the public and

legislators when a corporate failure occurs is the performance of the

internal audit function. Various aspects of internal audit and the

active involvement of audit committees continue to be researched

(e.g., Fadzil, Haron, & Jantan, 2005; Haron, Ibrahim, Jeyaraman, &

Chye, 2010; Mohamad & Muhamad Sori, 2011; Sarens, 2009). Internal

auditors are deemed to be part of the senior management team and

are expected to conduct audits that are of quality, giving added‐value

services to their organizations, and their reports should be useful in

helping management to make improvements (Dittenhofer, 1997;

Gramling & Hermanson, 2009; Sarens, 2009). With the current focus

on business improvements, the scope for the internal audit functions

in Malaysia has expanded so that an increasing number of internal

auditors, with diverse skills and competencies, are now employed

(The Institute of Internal Auditors Malaysia [IIAM], 2009).

All listed companies in Malaysia are mandated to have an internal

audit function in place (IIAM, 2015), either as an in‐house function or

outsourced. Additionally, internal audit activities must be disclosed in

the annual reports. We target chief internal auditors for our survey

The latest amendment to the Malaysian listing requirements was made effective

from 1 July 2016. The disclosure requirements provide for the terms of refer-

ence to the audit committees' authority and duties in the companies' website

instead of disclosure in the annual report. The significant change for Chapter

15 Corporate Governance pertaining to Audit Committee under Part C is the

need to provide a summary of the work of the audit committee in the discharge

of its functions and duties for that financial year of the listed issuer and how it

has met its responsibilities. This requirement for the manner in which the

responsibilities are met implies that prior disclosures are limited in providing

insight on the work of audit committees.

Received: 13 February 2017 Revised: 27 March 2018 Accepted: 6 May 2018

DOI: 10.1111/ijau.12124

Int J Audit. 2018;22:385–403. © 2018 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 385

because they are appointed to assist audit committees in the oversight

of internal control and corporate governance of their organizations.

The chief internal auditors are thus responsible to ensure adequate

scoping and coverage of internal audits in all governance areas and

are in the best position to provide insights into the different types

of internal audit findings raised.

Our study supports the active reviews by the audit committee on

the internal audit process, in the internal audit planning stage, which

contributes to the overall effectiveness of internal audit function and

to the other stages of internal audit. It appears that the reviews listed

by the regulators (specifically Bursa Malaysia) are vital in the audit

committee's oversight responsibilities, although there is still some evi-

dence that not all reviews were actively engaged in, such as the review

of internal audit programs. Additionally, the quality of internal audit

could now be related to its impact on corporate governance by linking

the types of internal audit findings to specific corporate governance

areas for improvements to be made by senior management.

We contribute to the literature on auditing and corporate gover-

nance in two ways. First, the calls for better governance include calls

for better internal controls, specifically quality relationships and inter-

actions between internal audit functions and audit committees (e.g.,

Mat Zain & Subramaniam, 2007; Zaman & Sarens, 2013). Prior studies

have focused on the relationships of internal audit practices with

internal control and audit committees (e.g., Fadzil et al., 2005; Mat

Zain & Subramaniam, 2007; Turley & Zaman, 2007). Fadzil et al.

(2005) investigated the effect of internal audit practices on internal

control of Malaysian listed companies. Mat Zain and Subramaniam

(2007) compared Malaysian chief internal auditors' opinions on the

effects of audit committees on the authority and influence of internal

audit functions relating to their independence and objectivity, and the

communication efficacy between audit committees and internal audit

functions. Elsewhere, Turley and Zaman (2007) examined the informal

interactions between audit committees and the internal audit func-

tions. Other Malaysian studies found that even though annual reports

disclose the activities of audit committees, evidencing the discharge of

their responsibilities in ensuring good management control, the level

of compliance to the mandates by the securities commission and the

audit committees' ability to strengthen the internal audit functions

warrant further investigation (Haron, Jantan, & Pheng, 2005; Mat Zain

& Subramaniam, 2007). We provide insights on the effect of audit

committees' active involvement on the review of internal audit activi-

ties and on the level of internal audit performance in Malaysian listed

companies. The audit committee is required to make reviews on inter-

nal audit activities as well as the adequacy in scoping of auditable

areas, competency and resources of the internal audit function. Other

specified reviews relate to the internal audit programs, audit pro-

cesses, the results of audits, and the status of audit findings. In this

paper, we examine the relationship of the audit committees' reviews

on these areas and the internal auditor's performance. This insight into

the reviews by audit committees is important since the required regu-

latory reviews by audit committees on internal audit functions are part

of the mandate on corporate governance (IIAM, 2015), and questions

have been raised about the compliance level.

Second, this study initiates the exploration of internal audit impact

on areas of corporate governance using the The World Bank's (1991)

framework on governance rather than the Organisation of Economic

Co‐operation and Development's (OECD, 2004) framework. Sarens

(2009) commented that an audit of quality “has a positive impact on

the quality of corporate governance.”This linkage between internal

audit findings and corporate governance areas in this study provides

insight into internal audit function quality, specifically the outcomes

of internal auditing. The earlier measurement of internal audit perfor-

mance of the internal audit function using the audit activities or prac-

tices identified in The Institute of Internal Auditors' (IIA) Professional

Practice Framework—for example, by Fadzil et al. (2005)—and the

intended outcomes of internal audit by Dittenhofer (2001a) served

as the building blocks in this study. Dittenhofer (2001a) stated that

the complexity in the internal audit process ends with the report on

audit findings and recommendations. The audit findings and recom-

mendations for improvements arising from the assessments made on

various business and managerial processes within an organization, if

any, may affect corporate governance. As such, the link between such

findings and dimensions of corporate governance is vital and is

undoubtedly warranted. Moreover, the key dimensions in The World

Bank's framework already encompass specific activities relating to

internal controls which include risk management, revenue collection,

expenditure controls, and operating procedures. These activities could

be monitored either by internal auditors or senior management based

on where such process improvements are made. In contrast, the

OECD's framework has not specified the role of internal audit within

its principles on disclosure and transparency, although specific state-

ments were made on financial disclosure items, rights of shareholders,

and directors' duties. The questionnaire in this study was used to elicit

the nature of audit findings relating to the areas or dimensions of cor-

porate governance as well as the frequency of such audit findings.

2|BACKGROUND

Following the worldwide financial crises since the 1980s, the study of

good governancehas become topical, with therole of audit committees

and the quality of internal audit frequently debated. Internal audit is

defined by The Institute of Internal Auditors as an objective assurance

with the aim to evaluate and improve the effectiveness of an

organization's risk management, control and corporate governance

processes. Various studies since the 1990s have investigated the

role of internal auditors in independently evaluating the performance

of management activities, compliance programs, and internal controls

(e.g., Cooper, Leung, & Mathews, 1996; Zakaria, Selvaraj, & Zakaria,

2006). In the area of risk management, studies have included the

involvementof internal auditors in environmentalmanagement systems

(Tucker & Kasper, 1998) and their support to audit committees in the

assessment of risk management and risk processes (Soh & Martinov‐

Bennie, 2011). However, there are still unanswered questions relating

to the usefulnessof internal audit reportsto management (e.g., Gramling

& Hermanson, 2009; Sarens, 2009). Therefore, the evaluation of the

impact of internalaudit function on corporate governanceremains rele-

vant; whether suchinternal audit reports could be tied to specificareas

of corporate governance and how the numbers of recommendations

reported by the chiefinternal auditors progresses duringthe years.

386 ABDULLAH ET AL.