Effective association between audit committees and the internal audit function and its impact on financial reporting quality: Empirical evidence from Omani listed firms

• Published date: 01 July 2018
• Author: Quentin Lefebvre,Charbel Salloum,Hajer Jarrar,Elias Gebrayel
• DOI: http://doi.org/10.1111/ijau.12113
• Date: 01 July 2018

ORIGINAL ARTICLE

Effective association between audit committees and the

internal audit function and its impact on financial reporting

quality: Empirical evidence from Omani listed firms

Elias Gebrayel

1

|Hajer Jarrar

1

|Charbel Salloum

1

|Quentin Lefebvre

2

1

Faculty of Business and Commercial

Sciences, Holy Spirit University of Kaslik,

Jounieh, Lebanon

2

Laboratoire LARGEPA, Université

Panthéon‐Assas Paris 2, Paris, France

Correspondence

Professor Charbel Salloum, Faculty of Business

and Commercial Sciences, Holy Spirit

University of Kaslik, P.O. Box 446, Jounieh,

Lebanon.

Email: charbelsalloum@usek.edu.lb

Theroleoftheauditcommitteeinoversightoftheinternalcontrolandinternalauditfunction

has grown in the last de cades as corporate gov ernance mechanism s after the dramatic

scandals and failures. This paper examines the impact of the audit committee and the presence

of internal audit function on a company's financial reporting quality. Moreover, this study

focus on the associat ion between the audit committee and inter nal audit function a nd

company's financial reporting quality m easured as accruals q uality and absolute d iscretionary

accruals. It is hypot hesized that the finan cial reporting qua lity is related to the str ength of

internal corporate governance mechanisms, including audit committee and internal audit and

its association. Different mechanisms are being examined: audit committee size and indepen-

dence, frequency of meeting, financial literacy, existence of internal audit function and its

meeting independently. To test our hypothesis, we employ panel dat a analysis for 71 non-

financial firms through 139 observations listed on the Muscat Securities Market during the

period of 2013 and 2014. T he data used in the analysi s were collected from the co mpanies'

annual reports published by the Muscat Securities Market. Ordinary least squares is used to

regress financial r eporting quality li near variables on au dit committee and int ernal audit. The

findings suggest that audit committee meetings frequency and the presence of internal audit

function positivel y affect a company's fina ncial reporting qual ity. Hence, an audit com mittee

that meets more freque ntly provides effec tive monitoring of fin ancial reporting and i ncreases

the likelihood of discussing and following up any problems and findings in the financial

statements and audit reports. Thus, frequent audit committee meetings provide better

oversight of the annua l accounts. Likewise, the internal audit f unction is considered an impor-

tant corporate governance mechanism to safeguard the quality of financial reporting by

monitoring organiz ational risks, assessing internal co ntrols and detecting possible manipu lation

because the internal auditor evaluates financial procedures. However, results suggest that

the relationship bet ween other corporate g overnance mechanis ms and financial repor ting

quality is not significant.

KEYWORDS

audit committee, Corporate governance, internal audit, Oman

1|INTRODUCTION

Over the last decades, the world has witnessed dramatic financial

scandals, which has led the regulators to concentrate on audit and cor-

porate governance topics. New rules and recommendations were pro-

mulgated in order to enhance corporate governance practice within

companies. Hence, rules and regulations helped to provide better qual-

ity of financial reporting to safeguard the interest of shareholders.

From this perspective, governments resorted to new mechanisms

(board of directors, board subcommittees, etc.) to oversee internal con-

trol. In the Middle East region, different codes and regulations of cor-

porate governance were issued in order to enhance the integrity of

financial reporting and the control of management (such as the corpo-

rate governance codes and regulations in Oman (2002), in the UAE

(2007), in Qatar (2009), and in Lebanon (2008)). The majority of these

codes recommend best corporate governance practice in order to

Received: 29 March 2017 Revised: 22 December 2017 Accepted: 18 January 2018

DOI: 10.1111/ijau.12113

Int J Audit. 2018;22:197–213. © 2018 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 197

enhance the transparency of financial information through a control

mechanism such as an independent board of directors (presence of

nonexecutive and independent members and separation of the chief

executive officer (CEO) and chairman function) and an effective audit

committee (independence, financial literacy members, frequency of

meetings, etc.). According to Gramling and Hermanson (2009), the

audit committee and internal audit form two key elements in the

corporate governance process. Hence, an internal audit is considered

as a major source of information, analysis, and assurance for the audit

committee on internal control. From this perspective, the role of the

internal audit is to concentrate on strategic, operational, and business

risks and to provide assurance to the audit committee on relevant risks

and controls.

Corporate governance in Oman is well developed and sophisti-

cated. In 1998, different steps were taken by the Government of

Oman to enhance internal controls, financial reporting quality, and to

define the roles and responsibilities of board members (Dry, 2003).

The major one was the establishment of the Capital Market Authority

(CMA) promulgated by the Capital Market Law, which has the author-

ity to organize, license, and monitor the issue and trading of securities

and supervise the operations of the Muscat Securities Market (MSM).

In 2000, the CMA issued a circular that required the presence of audit

committees and defined the role of the internal audit to reduce finan-

cial troubles in many listed companies. In 2002, Oman was the first

country in the Middle East region that was issued the corporate gover-

nance code announced by the CMA for companies listed on the MSM

in order to enhance control and board independence. For, example,

this code specified the roles and responsibilities of the board of direc-

tors and the separation of function between CEO and chairman

(Abernathy, Barnes, Stefaniak, & Weisbarth, 2017; Baydoun, Maguire,

Ryan, & Willett, 2013). After a few months, His Majesty Sultan Qaboos

bin Said promulgated the 2002 Commercial Companies Law (CCL)

amendments, which focus in a particular way on the composition of

the board of directors and internal controls. The issue of the corporate

governance code and the 2002 CCL amendments were considered as

important steps in promoting a good corporate governance system

with regard to the board of directors, audit committee, and internal

audit function.

In this context, the corporate governance code and the 2002 CCL

amendments introduced the mandatory presence of an audit commit-

tee with independent members in order to safeguard shareholders'

interests. The corporate governance code recommended all listed

companies to have an audit committee with the majority of members

being independent. In addition to promoting the independence of the

audit committee, the code specified other characteristics of the audit

committee, such as the committee must be formed by three members

with at least one member having finance and accounting expertise.

Furthermore, it specified that the audit committee shall meet at least

four times a year, with the majority of independent directors remaining

present. The corporate governance code (2002) stated the role of

internal audit in Oman was reviewing the internal control procedure

of the company, reporting to the board and management about the

effectiveness of the accounting and financial control company system,

reviewing internal administrative control and all operations areas,

establishing and maintaining a quality assurance program, and

reviewing the internal control system. Also, the code required the pres-

ence of an internal audit function appointed by the board and over-

sight by the audit committee with having a high degree of

independence. As a result, the audit committee shall hear the views

of internal auditors separately, at least once every year without the

presence of the management. On the other hand, the ASX Corporate

Governance Council (2014) guidelines mentioned that the audit com-

mittee was responsible for ensuring the integrity of an organization's

financial reports, such as reducing abnormal accruals, incidences of

earnings restatements, and fraud (Asiedu & Deffor, 2017). Therefore,

an audit committee's characteristics generally enhance its effective-

ness (Lin & Hwang, 2010) and help the committee to fulfill its respon-

sibility efficiently. As has been widely noted, the regulators in Oman

required the different characteristics of the audit committee and the

presence of internal audit function with communication between dif-

ferent corporate governance mechanisms to enhance financial

reporting quality in listed companies (the 2002 Oman corporate gover-

nance code). First, the audit committee can affect the financial

reporting quality by its size, independence, frequency of meetings,

and financial literacy. The right audit committee size would allow mem-

bers to use their experience and expertise for the best interest of

stakeholders, and the size will be more effective in monitoring financial

reporting because the level of knowledge is higher with the inclusion

of qualified members (Ghosh, Marra, & Moon, 2010). Likewise, inde-

pendent directors can evaluate objectively management accounting,

internal control, and financial reporting practices (Abbott, Parker, &

Peters, 2004). The independence of the audit committee enhances

the objectivity and enables efficient monitoring of the financial

reporting process. Audit committee frequent meetings provide effec-

tive oversight of financial activities (Turner, 2001) by increasing the

likelihood of discussing and following up any financial problems. The

presence of financially literate members in audit committees can have

a positive impact on financial reporting by making better decisions in

evaluating internal controls (DeZoort, 1998). Second, the presence of

an internal audit function was considered an important mechanism to

safeguard the accountability of financial accounts by monitoring orga-

nizational risks and assessing internal controls (García, Barbadillo, &

Pérez, 2012). Finally, meetings between the audit committee and

internal auditors without the presence of the management are

important to increase the likelihood of discussing and following up

any problems and findings in the financial statements and audit reports

independently.

The aim of this paper is to determine the effect of the audit com-

mittee and internal audit on financial reporting quality. The audit com-

mittee is an important mechanism in corporate governance in ensuring

the efficiency of the internal audit function and the reliability of finan-

cial statements. This paper provides the requirement for a company's

policy to adopt efficiently the corporate governance mechanisms

(audit committee and internal audit function) and its impact on finan-

cial reporting quality, which are considered an important element to

oversee the interests of shareholders and monitor financial state-

ments. From this perspective, the audit committee should be effective

at fulfilling its responsibilities by providing transparency in financial

reporting and ensuring the efficiency of internal auditors. Moreover,

the presence of an internal audit function will help the audit committee

198 GEBRAYEL ET AL.