The relation between the existence of an internal audit
and external audit fees within Dutch public listed firms
Sven de Witt (10492739)
Date: 23-06-2014
First supervisor: dr. R.S. Boomsma
MSc Accountancy & Control, track: Accountancy University of Amsterdam Faculty of Economics and Business
Table of contents
1. Introduction ... 3
1.1 Background ... 3
1.2 Research Question ... 7
1.3 Motivation of your study ... 7
2. Literature review & hypothesis development... 9
2.1 Internal audit function ... 9
2.2 Audit fees ... 14
2.3 Relation between IAF and audit fee ... 15
2.4 Other factors affecting the relation between IAF and audit fee ... 15
2.4.1 Limited number of changes in regulatory internal audit ... 15
2.4.2 Reliance of external auditor on the internal audit ... 16
2.4.3 Additional theory and models ... 17
3 Research design ... 19
3.1 Hypothesis development ... 19
3.2 Methodology ... 20
3.2.1 Measuring audit fees ... 20
3.2.2 Measuring the existence of an internal audit function ... 21
3.2.3 Control variables ... 21 3.3 Sample selection ... 22 3.4 Research model ... 23 4 Empirical Results ... 24 4.1 Descriptive statistics ... 24 4.2 Correlations ... 25 4.3 Statistical results ... 27 5. Discussion... 30 6. Conclusion ... 32 Appendix: References ... 33
Appendix A: List of companies + audit fee per company ... 38
Appendix B: Overview distribution of auditors of 60 of the 75 Dutch public listed companies (2010 – 2012) ... 40
1. Introduction
1.1 Background
The definition of an audit fee implies: “a fee a company pays an external auditor in exchange for
performing an audit”. An audit fee is a product of unit price and the quantity of audit services
demanded by the management of the auditee. Francis (2004, p. 352) stated that ‘higher external audit fees imply higher audit quality’. This higher audit quality should improve the quality of financial reporting and therefore reduce the risk of an incorrect audit opinion (2004, p. 352). The internal auditing function (IAF) is an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes (Larcker, 2011). Thus, on the other hand, when there is an adequate internal audit function within a firm, the external auditor can rely on their internal controls and system, and therefore limit the amount of hours spent on the audit. As a result, the external audit fee can be reduced. Various academic studies claim that the IAF hours reduce audit fees (Abbott, 2011). Abbott et al. (2011) for example investigated how organizational oversight status and commitment to budgetary resources of the IAF impact the external auditor’s reliance on IAF-provided financial statement audit assistance. The Dutch Corporate Governance Code (DCGC) (2008) refers to internal audit as a function for assessing the internal risk management and control systems. The Code advises and/or requires every listed company to have an internal audit department. If a listed company does not have an internal audit department, the Supervisory Board should evaluate every year the necessity of such a department. Furthermore, the Dutch Central Bank (De Nederlandsche Bank (DNB)) requires that every financial institution must have an IAF. Because my research focuses on Dutch public listed firms, the study of Swinkels (2012) is a relevant study for my research, because he did necessary pre work with regard to the existence of IAFs within companies in the Netherlands. Swinkels (2012) looked at the theoretical foundations of internal audit in relation to the nature and the control systems of Dutch public listed firms. Swinkels (2012) showed that, in the year 2011, not every Dutch public listed firm had an internal audit department, although some academics argue that internal audit is one of the most important pillars of corporate governance (Holt et al., 2009; Stewart et al., 2010; Strand Norman et al., 2010).
Paape (2007) noted that theoretical research on the existence of internal audit is limited. In his study, Paape (2007) examined the impact of corporate governance on the role, position and scope of services of internal audit. The study of Swinkels (2012) focuses on the existence of an internal audit department within Dutch public listed firms. The analysis of his criteria provides more insight into the fundamental premises of internal audit. Furthermore, the non-existence of IAFs at some listed firms in the Netherlands provides new perspectives. Several studies have described the existence and the characteristics of internal audit in various settings (Arena et al., 2007, 2009; Carcello et al., 2005b; Goodwin-Stewart et al., 2006b; Wallace & Kreutzfeldt, 1991; Swinkels, 2012). Arena et al. (2007) use the new institutional theory as described by Meyer & Rowan in 1977 and DiMaggio & Powell in 1983 for the analysis of the existence and scope of IAFs in Italy. There are external forces that may lead to the choice to set up an IAF, e.g. laws and/or regulations, the choice of other organizations, consulting or professional bodies (2007). The studies show a strong influence of regulations when they impose sanctions, which is the case with a listing on the New York Stock Exchange. According to DiMaggio et al. (1983) companies seek to model themselves on the practices of similar organizations in the same field, which they perceive to be more legitimate or successful and were influenced by professional organizations (such as Big-4 firms) or bodies (such as IIA). Arena et al. (2007) provided empirical evidence on factors driving the adoption and characteristics of internal audit departments in 364 Italian companies. Arena et al. (2007) identified the following additional reasons for management to establish an IAF: efficiency and effectiveness of business processes, identification and evaluation of enterprises’ risks, additional attention for reliability of financial information and safeguarding of firm assets (Arena
et al., 2007). Furthermore, their study suggests significant correlations between the adoption of
internal audit and the size (large versus small), industry (bank and insurance) and affiliation to the IIA. Their study also identified certain reasons likefear of increasing bureaucratic complexity, cost-benefit analysis or the size of the firm (being too small) to not set up an IAF.
Two years later Arena et al. (2009) describe the development from traditional accounting and financial control, into operational control, risk management and corporate governance (Arena
et al., 2009). Arena et al. (2009) based their research on 153 Italian companies and provided
empirical evidence of the organizational choices that could help improve the effectiveness of internal audit. They describe the activities ranging from regular assessments of the design and operating effectiveness of a risk and control system and training management to facilitating the implementation of enterprise risk management. Furthermore, the element 'corporate governance' can be interpreted as supporting the Audit Committee and external auditors in their duties with regard to monitoring the internal risk and control system. Carcello et al. (2005b) examines factors
associated with U.S. public companies’ investment in internal auditing and to the understanding of IAF, it allowed companies to benchmark their investment in internal auditing. Carcello et al. (2005b) find evidence, through survey administered to Chief Audit Executives of mid-sized US public companies, that internal audit budgets are positively related to company size, leverage, financial, service, and utility industries, relative amount of inventory, operating cash flows, and audit committee review of the internal audit budget. Total internal audit budgets are negatively related to the percentage of internal auditing that is outsourced (2005b).
Goodwin-Stewart et al. (2006b) explores the voluntary use of internal audit by Australian listed companies and identified factors that lead listed companies to have an IAF. Goodwin-Stewart et al. (2006b) predicts that internal audit use is associated with factors related to risk management, strong internal controls and strong corporate governance. To test the predictions, the study combines data from a survey of listed companies with information from corporate annual reports. The results indicate that only one-third of the sample companies use internal audit. While size appears to be the dominant driver, there is also a strong association between internal audit and the level of commitment to risk management. However, the study finds only weak support for an association between the use of internal audit and strong corporate governance (2006b).
Wallace et al. (1991) identifies the characteristics that could potentially influence a choice to create an internal audit department and test whether such attributes significantly distinguish between companies with and without an internal audit department. A sample of 260 companies is examined. Companies with internal audit departments are observed to be significantly larger, more highly regulated, more competitive, more profitable, more liquid, more conservative and
accounting policies, more competent in their management and accounting personnel, and subject to better management controls. Key discriminant variables are the degree of regulation,
decentralization, size, the duration of association with present auditors, the existence of an audit committee, EDP control, and pressures by external parties on management to achieve budgetary goals (Wallace et al., 1991).
These international studies described the existence and the characteristics of IAFs in their specific countries and provide some theoretical angles from which to investigate the existence of internal audit. However, the results of these studies differ and did not focus on the Netherlands. In the Netherlands, an IAF is mandatory in the financial sector according to national regulations (Wet op het Financieel Toezicht (Wft)). Furthermore, companies are required to comply with the listing requirements of the exchanges on which their securities trade. The largest exchange in the United States is the New York Stock Exchange (NYSE). Companies that are listed on the U.S. NYSE are required to have an IAF due to the US regulation. From an academic perspective, it is interesting to
sort out the background surrounding IAFs and the way it has an impact on the audit fee an audit firm charges. Thus, it becomes interesting to see if the audit fee differs significantly when there is an existence of an IAF within the firm, and when there is none. Another interesting thing to research is if the audit fee per audit firm differs significantly, due to for example mandatory audit firm rotation.
In mid-2008, the Dutch Civil Code book 2 (article 2:382a), modified on the basis of the implementation of the European Directive 2006/43/EC; concerning income statutory audits of annual accountant and consolidated accounts. Dutch public listed companies are obliged to report information about the size and compilation of the audit fee in the notes of the annual report. This law is applied for the first time in the financial statements of financial year 2008, where the audit fee has to be split up into the following categories:
1. Audit of annual report 2. Other assurance activities 3. Fiscal advisory activities
4. Other non-assurance activities (Royal Nivra, 2010)
The law change in mid-2008 makes it interesting to examine the relation between the existence of an IAF and the audit fees in the Netherlands. Another reason is because of the financial crisis in the late ’00, more attention was paid to audit fees and audit fees were under pressure because companies made less profit.
Scheffe (2011) performed a high level empirical study of the existence of IAFs at Dutch listed firms. He was triggered by the publication of the Dutch Corporate Governance Code (DCGC/Committee Streppel) on 15 December 2010, as this publication ignored the best practice principles concerning internal audit. Somehow, the Dutch Monitoring Committee Corporate Governance Code overlooked the IAF, although it is part of the DCGC.In the DCGC’s (2008) view, every listed firm should, in principle, have an internal auditor under best practice provision (Appendix C). But on the other hand the DCGC provides listed firms with a possibility to deviate from the principle (Corporate Governance Code Monitoring Committee, 2008: p. 57). The Committee has therefore provided in V.3.3 (Appendix C) that if there is no IAF, the Audit Committee should review annually whether there is a need for an IAF.
This study contributes to the literature in several ways. First, this study provides a good overview on which Dutch public listed companies make use of an IAF. Second, this study provides initial empirical evidence related to the impact of the IAF on audit fees. Prior experimental research only provides evidence on the separate effects of oversight and resource commitment to the IAF on audit fees (Abbott, 2011). Third, the research design and data allows to separately
examining the impacts of existence and non-existence of IAFs on audit fees. Further, this study sheds additional light on the reasons companies with non-existence of IAFs disclose in their annual report.
1.2 Research Question
Is the existence of an internal audit function within Dutch public firms associated with audit fees?
1.3 Motivation of your study
This research will contribute to existing literature in several ways. Imprimis, previous research on the relation between audit fees and the use of internal audit has been inconclusive and provided conflicting results (Goodwin-Stewart et al., 2006). As mentioned before, prior literature merely examined the existence and the characteristics of internal audit in their specific countries (Arena et
al., 2007, 2009; Carcello et al., 2005b; Goodwin-Stewart et al., 2006b; Wallace & Kreutzfeldt,
1991), but never has been examined the combination of Dutch public listed firms and audit fees. From an academic perspective, it is interesting to sort out the background surrounding IAFs within Dutch public listed companies, and the way the IAF has an impact on the audit fee an audit firm charges. Although the Netherlands has a history of corporate governance committees and codes, Dutch society has had its fair share of governance incidents as well, such as Ahold, VNU, ABN AMRO and Van der Moolen. These firms reported that they were in-control, but from a strategic point of view these firms turned out to be out-of-control (Smit, 2008, Strikwerde, 2006, Swinkels, 2012). According to article 2:382a BW (Civil Code) of Dutch law, big Dutch companies are obliged to present information about the size and compilation of the audit fee in the notes of the annual report. As a result all audit fees are presented in the annual reports. Another reason is because of the financial crisis in the late ’00, more attention was paid to audit fees and audit firms and their audit fees were under pressure because companies made less profit.
This combination is very interesting. Moreover, since recent high profile scandals and the financial crisis, investor’s confidence in the management of the firms has changed drastically. These large corporate collapses have demonstrated that auditors have not uncovered material misstatement in the financial reports of these firms (Goodwin-Stewart et al., 2006). The scope of internal auditing within an organization is broad and may involve topics such as an organization's
governance, risk management and management controls over: efficiency and effectiveness of operations, the reliability of financial and management reporting, and compliance with laws and regulations. The IAF operates in the wide field of play that is known under GRC (Governance, Risk Management & Compliance). On one hand it is part of the governance of the organization, on the other hand, it has its own responsibilities (IIA & NIVRA, 2010). This responsibility is shaped by guidelines from various professional organizations (e.g. IIA) and through expectations of stakeholders inside and outside the organization. Key stakeholders include investors, policy makers, regulators, credit rating agencies, banks and financiers, legal, audit and consulting firms.
Although some academics mention that internal audit is one of the most important pillars of corporate governance (Holt et al., 2009; Stewart et al., 2010; Strand Norman et al., 2010) and internal audit is mentioned in the DCGC, the possibility to not have an internal audit seems to exist. The first analysis below shows that the existence of IAFs within the Dutch public listed firms on the Amsterdam Exchange Index (AEX), the Amsterdam Midkap Index (AMX) and the
Amsterdam Small Cap Index (AScX) are not always very common. The table below gives an overview about the existence of an internal audit (IA) based on the annual reports:
Table 1.1: Existence of IA at NYSE Euronext firms
IA YES/NO Data Year – Fiscal Total
2010 2011 2012
No 26 26 25 77
Yes 34 34 35 103
Total 60 60 60 180
No % 43% 43% 41% 43%
The remainder of the paper is structured as follows. The next section discusses the literature review, followed by the development of the hypotheses. Succeeding sections discuss sample selection, followed by the research methodology and results. The final sections contain a discussion and the conclusion of the research.
Formatted: Normal, Indent: Left: 0
2. Literature review & hypothesis development
In this chapter, the current state of knowledge in the field of IAFs, audit fees and the relationship between these two factors will be discussed.
2.1 Internal audit function
Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes (Larcker, 2011). Internal auditors are employees of the company they are auditing. They are often referred to as “the eyes and ears of the
management”. Internal audit staffs can operate with either narrow or broad characters, and the breadth of charter is one of the major determinants of the size of the staff. A narrow charter, which would necessitate a relatively small internal audit staff only, leads to mostly compliance audits and performance of some functions for the external auditors (such as preparation of audit schedules and documentation of internal controls) to reduce external audit fees. At the other extreme, some staffs operate with a broad charter that can include many forms of performance auditing, involvement in the design and improvement of business processes and internal control systems, and other forms of what would usually be classified as management consulting (Merchant, 2011). The main premises for the present internal audit functions were defined in 1999, covering elements such as scope (assurance and consulting activities to add value and remain viable; a broader scope than that of financial audit by covering governance, risk management and control), organization (internal and/or (partly) outsourced), governance (relation with management, the Audit Committee and the external auditor) and being a standard based profession. There have been a limited number of changes in the field of internal audit since the new IIA definition in 1999. Several corporate failures provided a boost for internal audit during the Sox period from 2004-2006, but silence reigned during the financial crisis of 2008-2010 (Swinkels, 2012).
The size of internal audit staffs varies widely across firms. Small firms typically have no internal auditors. Large firms may have a small or a large staff. Internal auditor backgrounds vary with their staff’s charter. Many internal auditors have an accounting background, but as internal audit charters have broadened, many firms’ audit staffs have become more diverse and include, among others, information system specialists, computer experts, and consultants. Moreover, and mainly because the charter of internal audit can be so varied, IAFs frequently turn to subject matter
experts to assist in audit coverage requiring deeper knowledge of the specific business, process or function. What most internal audit staffs have in common, however, is that they are typically headed by experienced professionals: the vast majority of chief audit executives and internal audit managers have our eight years of experience (nearly 80% and 60% of them, respectively)
(PricewaterhouseCoopers, 2009).
Most internal auditors have ties to a professional association. In the United States, the Institute of Internal Auditors (IIA), a professional association with more than 75,000 members, has defined professional standards and responsibilities, a code of ethics, and a common body of knowledge for internal auditors. It has also instituted a certification program (Certified Internal Auditor).
Organizationally, the IAF operates in a staff capacity and almost always reports high in the organization, at least to the corporate controller or CFO/VP Finance. However, experts recommend that the internal audit staff should report directly to the audit committee of the board of directors to enhance their independence, credibility, and visibility. Related, many IAFs are said to be still heavily stuck in the past, focusing on financial and compliance audits, presumably still hallmarks of the earlier Sarbanes-Oxley period. One survey suggests that only 13% of the respondents indicated that their departments allocated at least 25% of resources to strategic and business audits (performance audits), while a majority (57%) assigned this degree of resources to traditional financial audits (Merchant, 2011). The survey also suggests, however, that strategic, business, and operational audits are among the fastest-growing areas of internal audit focus
(PricewaterhouseCoopers, 2009).
The study of Holt et al. (2009) evaluates the extent that a descriptive Internal Audit Report (IAR) affects investor confidence and investment decisions. The importance of internal audit for outside stakeholders is mostly related to the prevention of fraud and/or the detection of fraudulent activity (Marden, et al., 1997; Strand Norman et al., 2010), based on internal audits' perceived intimate knowledge of the organization and processes. Also, the existence of an IAF is perceived as an advantage, to prevent losses associated with fraud. Holt et al. (2009) even suggest firms to consider providing an internal audit report to external stakeholders, to provide additional transparency (Holt et al., 2009). Their survey revealed that this report increases investors' perceived oversight effectiveness and confidence in financial reporting reliability.
An important study paper for this research is Swinkels (2012), which is a study on the theoretical foundations of internal audit in relation to the nature and the control systems of Dutch public listed firms. Swinkels’ study investigates five different areas of attention to answer the
different areas of the central research question. Swinkels’ study investigates five different areas of attention to answer the different areas of his central research question.
The first area of attention relates to the literature on the origins, purpose and scope of internal audit. In general, internal audit has developed from traditional accountancy and financial control into operational control testing and training, consulting activities such as risk management facilitation and corporate governance support to the Audit Committee and external auditors as part of their duty to monitor the internal risk and control system. During the implementation of Sarbanes Oxley regulation (SOx) there was some fear of damaging its professional status, but this now seems to have been resolved. The IIA research and their suggestions for expansion of internal audit’s scope of work do not always seem to be theory-driven or demand-driven, but opportunity driven. Furthermore, the perspective chosen seems to have a closed systems perspective that does not cover changes in the institutional context of firms and its environment. From an academic perspective, there are limited fundamental, integrative articles on internal audit, and no articles that suggest new theoretical insights, approaches and/or methods on additional value provided by an internal audit function. This study has closed this gap by exploring its origins, development and raison d’être and by structuring the different articles, theories used and latest theoretical insights (Swinkels, 2012).
The second area of attention, the exploration of a theoretical foundation, looks at the firm as a meta-theory on analyzing its control system from an economic point of view, as well as the role of internal audit. The theory of the firm is far from homogenous and involves different views. These different views (agency, transaction costs (TCE), property rights and the resource and knowledge-based view (RBV, KBV)) provide different dimensions/issues that can be
complementary to each other and to the internal auditor, by analyzing control issues within a firm. Fundamental assumptions are bounded rationality (agency theory, TCE), information asymmetry (agency theory) or information impactedness (TCE), the importance of boundaries of a firm by ownership or access to assets (property rights view, RBV, KBV) or asset specificity (TCE) and maximizing behaviour and related incentive issues (agency theory, property rights view). The advantage of internal audit over external monitors is their greater freedom of action, its wider scope, its understanding of the language of the firm and the possibility to rely on less formal evidence (Swinkels, 2012).
The third area of attention covers the exploration of a theoretical foundation from a control perspective. Various views on control are investigated to explore broader theories and elements of a control system of a firm. On the whole, biological cybernetics, information theory and
view. The current internal audit standards are too generic and high level to provide sufficient guidance on the question whether a firm is really in control in the previously described areas. Internal audit as a profession should be keen on sensing fundamental changes, and should prevent adopting management hypes or fads. Therefore, the cybernetic theory of control, together with the insights from administrative behavior, organization theory and the theory of the firm (such as the resource and knowledge-based view and the dynamic capabilities view) provide a more
comprehensive view on control for internal audit functions and the determination of their scope and required knowledge and skills (Swinkels, 2012).
The fourth area of attention is the exploration of possible critical explanatory variables for the existence of internal audit in the Netherlands, taking into account previous international
research on this topic and contributing to the growing body of literature. Swinkels’ study indicates that the following significant variables could be linked to the existence of internal audit: Turnover,
Total Assets, FTE, and Number of Countries. These variables are indications of the Size and Complexity of a firm. This is consistent with the earlier research of Wallace & Kreutzfeldt (1991),
Carcello et al. (2005) and Stewart and Kent (2006). However, contrary to Goodwin-Stewart and Kent (2006), this research found a significant relation between complexity and the existence of internal audit. The reason may be the selection of another measure (number of countries instead of business segments) (Swinkels, 2012).
The fifth area of attention concerns the confrontation of the actual scope of work of internal audit functions of AEX listed firms in the Netherlands with a broader, multidisciplinary view on a control system of a firm. The confrontation shows that the interviewed internal audit functions not
only focus on the existing organization and processes (also called ‘maintenance of status quo’) but that they are also involved in the monitoring of the adaptation and in some cases the
reprogramming of their firm. Internal audit functions seem to be aware that locking the stable door
after the horse has bolted is useless. However, the main focus is related to assurance engagement
covering the maintenance of status quo level of control. Most interviewed (not all) internal audit functions seem to be followers regarding what to audit or not, for example, based on their rotation scheme and on the approach and/or scope of external auditors. As a consequence, the broader comprehensive view of control is applied limitedly. A more focused definition or an
operationalization of the IIA definition may provide more clarity for the internal audit function itself and its environment. The familiar control elements such as budgets and performance management, process control, reliability of financial reporting, compliance and information technology are part of the scope of the interviewed internal audit functions. Broader management control elements such as strategy setting, execution, core values, structure, leadership and
capabilities are less standard elements of the scope of all internal audit functions due to lack of knowledge, experience and confidence. However, the control problem of the firm, as the events of the various scandals and crises suggest, rest within these elements as well. Furthermore, the interviews indicated limited connection with institutional developments, meaning the emergence of intangible assets and decreasing importance of tangible assets, requiring a different approach to control and to audit (Swinkels, 2012). Swinkels’ study shows that the broadness of the scope of the internal audit functions is closely related to the size and team composition of internal audit
functions and less directly influenced by their purpose and reporting line (Swinkels, 2012). Swinkels (2012) showed that not every Dutch public listed firm has an IAF, although some academics mention that internal audit is one of the most important pillars of corporate governance (Holt et al., 2009; Stewart et al., 2010; Strand Norman et al., 2010). There are only a few studies that did research to the purpose of existence of internal audit within a firm. The first three articles explain the existence of internal audit as a monitoring mechanism to reduce agency costs (Carcello
et al., 2005b; Goodwin-Stewart & Kent, 2006b; Sarens et al., 2006). The analysis of Swinkels
(2012) provided more insight into the fundamental premises of the existence of the function of internal audit in the firm. Furthermore, the non-existence of IAFs at some of the listed firms in the Netherlands provided new understanding of or arguments why their management does not consider internal audit to be relevant for the firm to remain in control. Swinkels (2012) noted that the purpose of his study is to explore the academic and professional literature and current practice to develop clarity regarding the theoretical and practical contributions to and limits of the existence and the scope of work of internal audit in relation to the control system of the firm. With this research I can expand Swinkels’ research
The first to conclude, that since 2001, the IAF within firms increased due to regulations in the U.S. (requirements of NYSE) was Carcello et al. (2005). They conclude that the establishment of an IAF, their size and scope of work is explained by a firm’s risks, their ability to pay for monitoring, and their audit characteristics. Furthermore, they investigated the size of IAFs, associated with the following variables (Carcello et al., 2005b: p. 70):
Size of firm; Leverage;
Type of industry, e.g. firms operating in the financial, service and utility industries; Relative level of inventory;
Size of operating cash flows and
2.2 Audit fees
The external audit fee consists of all fees necessary to perform the audit or review in accordance with IFRS. This category also may include services that generally only the independent external auditor reasonably can provide, such as comfort letters, statutory audits, attest services, consents and assistance with and review of documents filed with the AFM. The definition of an audit fee implies: “a fee a company pays an external auditor in exchange for performing an audit”. An audit fee is a product of unit price and the quantity of audit services demanded by the
management of the auditee. Therefore, differences in audit fees can show the effect of differences in quantity or in price (Simunic, 1980). A simple agency model suggests that, as a result of information asymmetries and self-interest, principals (e.g. shareholders) lack reasons to trust their agents (e.g. directors) and will seek to resolve these concerns by putting in place mechanisms to align the interests of agents with principals and to reduce the scope for information asymmetries and opportunistic behavior. Agents are likely to have different motives to principals. They may be influenced by factors such as financial rewards, labour market opportunities, and relationships with other parties that are not directly relevant to principals. This can, for example, result in a tendency for agents to be more optimistic about the economic performance of an entity or their performance under a contract than the reality would suggest. Agents may also be more risk averse than
principals. As a result of these differing interests, agents may have an incentive to bias information flows. Principals may also express concerns about information asymmetries where agents are in possession of information to which principals do not have access. Differing motivations and information asymmetries lead to concern about the reliability of information, which impacts on the level of trust that principals will have in their agents. There are various mechanisms that may be used to try to align the interests of agents with principals and to allow principals to measure and control the behaviour of their agents and reinforce trust in agents. One of those mechanisms is an audit which provides an independent check on the work of agents and of the information provided by an agent, which helps to maintain confidence and trust (ICA, 2005). Simunic mentions that the ambiguity of the relationship between auditors and audited companies has to be understood. An auditor should act to a code of ethics and always be independent and objective, auditors need to be conscious of threats to objectivity and apply suitable safeguards where necessary. Reputation is a key factor in promoting trust and auditor independence is an important quality that shareholders look for. Auditors have an important incentive to maintain independence to protect their reputation and thereby help them to retain and win audits. But the same auditor is hired and compensated by audited companies, which puts pressure to the objective of the auditor for outsiders (Simunic, 1980
pp. 188-189). Audit fees are a topic that comes forward in a lot of research in auditing (Deis and Giroux, 1996), Hoitash et al. (2005), Hoitash et al. (2007), Iyer et al. (2003), Lennox (1999), Simunic (1980)). Independence of auditors is very important, but because the audit profession is not a governmental institution, audit firms have to make profit to exist. Auditors are getting paid by their clients to check the financial statements in order to give an unqualified opinion.
The Securities and Exchange Commission (SEC) adopted in 2000 a new rule that requires companies to disclose information about the fees paid to auditors (Iyer et al. 2003)). Since 2003, the SEC requires the same distinction as Dutch law: audit fees, audit-related fees, tax fees and all other fees (Hoitash et al. 2005)).
2.3 Relation between IAF and audit fee
There are only a few studies that have examined the relation between internal audit and external audit fees and results have been mixed. Some studies find a negative association between audit fees and the contribution of internal audit to the external audit (Elliott et. al., 1978; Felix et al., 2001). This suggests that internal audit can be regarded as a substitute for external audit (Wallace, 1984). The reduction in fees might also be a result of a lower assessment of audit risk resulting from internal audit involvement in strengthening controls. The definition of audit risk implies the risk (consisting of inherent and control risk) that the account balance or class of transactions contain misstatements that could be material to the financial statements whether individually or when aggregated with misstatements in other balances or classes and the risk (detection risk) that the auditor will not detect such misstatements. On the other hand, both Carey et al. (2000a) and Stein et al. (1994) find no significant association between audit fees and the level of internal audit contribution. Another explanation for the reduction of external audit fees might also be the result of mandatory audit firm rotation. This has not yet been researched.
2.4 Other factors affecting the relation between IAF and audit fee
2.4.1 Limited number of changes in regulatory internal audit
Regulatory and legislative changes are important reasons why firms have an IAF. Some examples of regulations: the existence of an IAF is mandatory with firms that suffice the New York Stock Exchange corporate governance standards, but also with regulation in the financial industry. This
regulation institutionalizes the existence of IAFs within firms. However, the regulatory context, in response to a number of affairs, has regressed to a narrow view of control, mostly to the reliability of the annual report. Big concerns are the limited number of changes in the field of internal audit since the new IIA definition in 1999, neither initiated from its professional organization (IIA), nor from academic research. The only change is in the regulatory environment that positioned IAFs in the area of corporate governance requirements after several corporate failures in the period from 2004-2006, but silence reigned during the financial crisis of 2008-2010. Furthermore, IAFs are closely related to external auditors in the governance requirements.
2.4.2 Reliance of external auditor on the internal audit
Another related topic is the relationship between the reliance of external on internal audit and the level of external audit fees. The economic benefits of coordination of and reliance on work of internal audit (e.g. lower fees) are recognized in several studies (Glover et al., 2008; Munro et al., 2010). Some others investigated the fees in relationship with the existence of internal audit and the attention for higher quality external audit. In this relationship, the external audit fees were higher when firms had an IAF and were committed to strong corporate governance, preferring good quality external audit (Goodwin-Stewart et al., 2006a; Singh et al., 2010). Goodwin-Stewart et al. (2006) find that the use of internal audit is associated with higher external audit fees. This result suggest that firms that engage in greater internal monitoring through the use of internal audit also demand higher quality external auditing. This implies that directors of these firms recognize the importance of both types of audit as mechanisms to strengthen corporate governance. Their findings imply that internal audit is a complementary mechanism within the governance
framework. Although some internal audit activities might substitute for external audit work (Felix
et al., 2001), their findings suggest that firms with large IAFs also engage in a higher overall level
of monitoring (Goodwin-Stewart et al., 2006).
Felix et al. (2001) examined whether external audit reliance on internal audit was a function of factors prescribed by auditing standards including internal audit quality, internal audit
availability, the level of coordination between internal and external audit, and inherent risk. The results revealed that inherent risk mitigates the role that internal audit availability has on auditors’ decisions (that is, the effect of availability is smaller when inherent risk is high), and it increases the effect of internal–external auditor coordination (that is, coordination has a greater effect in high versus low risk conditions). In addition, internal audit quality was positively associated with external auditor reliance on the work of internal auditors regardless of the level of inherent risk.
2.4.3 Additional theory and models
During this study I explored the COSO framework and the revised COS 610 to get a better understanding about the tasks of an internal auditor. The latter deals with the external auditor’s responsibilities if using the work of internal auditors. This includes (a) using the work of the IAF in obtaining evidence and; (b) using internal auditors to provide direct assistance under the direction, supervision and review of the external auditor (IFAC, 2013).
Several additional models can be considered relevant, there are some other models that are relevant: the audit risk model (Houston, 1999) which provides a framework for evaluating the relationship between overall audit risk, inherent risk, control risk, and detection risk (AICPA, 1997) and the Three Lines of Defense model (IIA, 2013):
1. Audit Risk model:
AR = IR * CR * DR
Audit Risk may be considered as the product of the various risks, which may be encountered in the performance of the audit. In order to keep the overall Audit Risk of engagements below acceptable limit, the auditor must assess the level of risk pertaining to each component of Audit Risk.
The Dutch IIA updated its position paper in 2008 with a further extension of the position and claimed added value and scope of internal audit activities in relation to the more formal position paper of 2005 (IIA, 2008).In this position paper, internal audit is linked to the so-called three lines of defense model.
2. ‘Three Lines of Defense’ model
The three lines of defense model (3LoD) distinguishes among three groups (or lines) involved in effective risk management:
1st line = Risk Owners/Managers; functions that own and manage risks.
2nd
line = Risk Control & Compliance; functions that oversee risks.
3rd line = Internal Audit; functions that provide independent assurance.
4th
line = External Audit additional lines of defense; functions that provide assurance to the organization’s shareholders, including the governing body and senior management.
Combining the models:
One of the main purposes of this study is to connect the 3LoD-model with the audit risk model to capture the relation between the existence of an internal audit and audit risk. Therefore the internal audit risk in included in the audit risk model (AICPA, 1997), mentioned earlier (1). Therefore I estimate the following model:
AR = IR * CR * (IAR) * DR (3LoD + DR) (1/2) (3) (4)
CR that stands for Control Risk can be connected to the 1st (Risk Owners/Managers) and 2nd (Risk Control & Compliance) line of defense. IAR that stands for Internal Audit Risk can be connected to the 3rd line of defense (Internal Audit). DR that stands for Detection Risk can be connected to the additional 4th line of defense (External Audit).
Where:
• AR = Audit Risk: The risk that an auditor will not discover errors or intentional
miscalculations (e.g. fraud) while reviewing a firm’s or individual's financial statements. There are two general categories of Audit Risk – risk regarding assessment of the financial materials and risk regarding the assertions produced by evaluation of the financial
materials. Audit Risk may be considered as the product of the various risks, which may be encountered in the performance of the audit. In order to keep the overall Audit Risk of engagements below acceptable limit, the auditor must assess the level of risk pertaining to each component of Audit Risk.
• IR = Inherent Risk: the risk of a material misstatement in the financial statements arising due to error or omission as a result of factors other than the failure of controls.
• CR = Control Risk: the risk of a material misstatement in the financial statements arising due to absence or failure in the operation of relevant controls of the entity.
• (Take IR and CR together = ROMM: Risk Of Material Misstatement)
• DR = Detection risk: The chance that an auditor will not find material misstatements relating to an assertion in an entity's financial statements through substantive tests and analysis. Detection risk is the risk that the auditor will conclude that no material errors are present when in fact there are. Detection risk is one of the three elements that comprise audit risk, the other two being inherent risk and internal control risk, named before.
3 Research design
In this chapter the research method will be discussed. The first section discusses how the hypothesis that is tested in this thesis is developed. Afterwards will be explained how audit fees and the existence of an IAF are measured and a description of the sample will be given.
3.1 Hypothesis development
The research question, as stated in the introduction, of this thesis is: ‘Is the existence of an internal audit function within Dutch public firms associated with external audit fees?’. To answer this question, a hypothesis is developed to test the relation between the variables ‘audit fee’ and ‘IAF’ in a quantitative manner. The reason for quantitative research is that audit fees contain sensitive information for both audit companies and clients. An audit firm doesn’t want to be too open about this sort of information; therefore a qualitative research by means of interviews is not applicable in this thesis.
When linking the earlier discussed agency theory with IAF: the traditional nature of internal audit relates to the verification of the accuracy, timeliness and completeness of the accounting information (Courtemanche, 1991) or in a broader sense, to evaluating evidence on accounting information in order to determine and report on how well this accounting information complies with established criteria (Arens & Loebbecke, 2000; Swinkels, 2012). Traditionally, the annual statement is based on historical information and is conceptually based on accounting profit. As economic profit is increasingly used to determine the value of a firm, management and external stakeholders are more interested in a firm’s future cash flows, and assurance that these future cash flows will materialize (Strikwerda, 2012). Swinkels claims that as a result of asymmetry of information and possible goal conflict, the Management Board may lose control of the firm. As a consequence, it is to be expected that the economic reason of existence of an internal audit function is to reduce information asymmetry, complementary to other measures the Management Board takes. The Audit Committee is also expected to require an internal audit function for this reason, as is researched by Goodwin-Stewart et al (2006) and Sarens & De Beelde (2006) (Swinkels, 2012).
There are some studies that examine the relation between audit fees and the existence of internal audit find that fees are higher when companies use internal audit (Carey et al., 2000a; Hay and Knechel, 2002). This suggests that internal and external audit is regarded as complementary means of increasing overall monitoring. This is consistent with a broader role of internal audit, which in
recent years has evolved from a narrow focus on control to embrace risk management and corporate governance (Brody and Lowe, 2000; Carey et al., 2000b; Leung et al., 2004). Hence, firms that are more committed to strong corporate governance are likely to engage in greater levels of internal auditing as well as being prepared to pay for a higher quality external audit (Goodwin-Stewart, 2006), that comes with a higher audit fee. This leads to the following hypothesis:
H1: Higher external audit fees are associated with a greater use of the internal audit
function within companies that are listed on the Dutch Stock Exchange (AEX, AMX, AScX)
But on the other hand, when a firm does have an IAF, the auditor can rely even more on the internal control functions within a firm. As a result there is less work that has to be done to get sufficient comfort on an audit. Less work means, less hours, which can result in lower audit fees. The findings of Felix (2001) indicate that the extent to which internal audit contributes to the financial statement audit is a significant determinant of external audit fees. They find that the greater the contribution made by internal audit, the lower the external audit fee is. Therefore I stated the following hypothesis:
H2: Lower external audit fees are associated with firms where an internal audit function
exists within companies that are listed on the Dutch Stock Exchange (AEX, AMX, AScX)
3.2 Methodology
In this section, the methodology and the operationalization of the variables audit fees and IAF are discussed. The research in this thesis is quantitative and a model is used to prepare a regression analysis.
3.2.1 Measuring audit fees
Audit fees are manually collected for each company, through their annual report of the years 2010, 2011 and 2012. The audit firms that have audited the financial statements of 2010, 2011 and 2012 used in this thesis contains Big-4 audit firms (Deloitte, PwC, EY and KPMG) and two smaller audit firms (BDO and Mazars). The Big-4 firms audited together 57 of the 60 sample companies, while the smaller firms audited the other 3 companies. A list of all companies and their audit fees (2010, 2011 and 2012) are added in Appendix A. In Appendix B there is a total overview (pie
chart) added of the distribution of audits within the Dutch public listed companies throughout the years from 2010 till 2012.
3.2.2 Measuring the existence of an internal audit function
The existence of an IAF within researched companies in 2010 is based on the findings of Swinkels (2012). Swinkels’ (2012) aim was to measure the significance of the independent variable on the dependent variable, being the existence of internal audit. Therefore, the first step is to verify whether the independent variables are relevant to be associated to the dependent variable. This is measured using the cross-tabs for qualitative variables with a Yes/No answer (Bailey, 1994). A logistic regression will be run in which the existence of internal audit will be predicted by relevant, independent qualitative variables (Hosmer & Lemeshow, 1989).
The second step is to measure the predictability of the existence of internal audit per relevant variable via a logistic regression analysis. This analysis provides first insights into the match between the population with respect to the existence or non-existence of an IAF (2012).
The third step Swinkels (2012) performs is to verify the correlation between the different independent variables, to ensure that there is no impending multicollinearity (Schroeder et al., 1990). Multicollinearity occurs when independent variables are strongly correlated and will result in a decreased predictive validity of the equation. Unacceptable multicollinearity is considered if a bivariate correlation is stronger than 0,80 (Schroeder et al., 1990). The latter approach will also be taken into account in this study (2012).
Therefore, I received a list from Swinkels of companies in the year 2010 that were indicated with a ‘0’ if they didn’t have an IAF, and a ‘1’ if they have an IAF. Furthermore, every annual report is checked for the years 2010, 2011 and 2012 if the company mentions anything about having an IAF, or planning to have an IAF in the near future. When it doesn’t become clear out of the annual reports if an IAF exists within a company, I searched the website of the company for any references about an IAF. For the years 2011, and 2012 every company that has an IAF is indicated with a ‘1’, and every company that doesn’t have an IAF is indicated with a ‘0’.
3.2.3 Control variables
In the previous chapter, also some factors are mentioned that could influence the audit fee. The three most important control variables, to control for Size, used in prior literature are: the Total
Assets, the number of employees, and the Turnover/sales (net). Other control variables are; Inventories, Receivables, Number of Subsidiaries and whether a company is audited by a Big-4
audit firm (Deloitte, PwC, EY and KPMG) or not. This last control variable is not applicable in this thesis because Big-4 auditor firms audit 57 out of 60 companies in the sample. The other six control variables: total assets, employees, turnover/sales (net), inventories, receivables, number of
subsidiaries are included in this thesis in the regression analysis.
3.3 Sample selection
Swinkels (2012) conducted a research model that can be used to measure the existence of an internal audit. The scope of research regarding the existence of internal audit in the Netherlands focuses on the NYSE Euronext in Amsterdam, covering all AEX, AMX and AScX firms (N = 75). For this research, the composition of the indices as of February 2014 is used as point of reference. The sample of Dutch public listed companies includes both large and small firms. Data have been obtained through WRDS’s Compustat, the 2010, 2011 and 2012 annual reports of the sample firms, and have been complemented with data from the firm’s website. Finally, I extend the models used in previous studies (Swinkels, 2012; Goodwin-Stewart, 2006) by including additional control variables.
This research excludes firms with the U.S. regulation and financial industry profile on the NYSE Euronext in Amsterdam. Reason for this exclusion was that firms listed on the U.S. NYSE are required to have an IAF; furthermore an IAF is mandatory in the financial sector according to national regulations (Wft). There was also some data (e.g. total assets) missing from financial industry companies, because some line items are too difficult to address. Therefore 15 firms are left out of the sample. The final number of firms included in the sample is 60 over three years time, thus that makes a total of 180 samples.
TABLE 1
Sample and industry composition
Panel A: Sample derivation
Description N
Initial sample (AEX, AMX, AScX) from COMPUSTAT 75 Deletion of companies with incomplete data 15
The sample used in this thesis consists big Dutch firms that have to report their annual reports in according to article 2:382a of the Dutch Civil Code. Companies that did not report information about any of the variables: Sales/turnover (net), Inventories, Receivables, or Audit Fee in the year 2010, 2011 or 2012, are excluded from the sample. This results in a population of 60 firms of the AEX, AMX and AScX. The population of 60 firms is based on the indices of 2014. In example: Wereldhaven changed from the AEX-index to the AMX-index, but because they are still on the AMX-index in 2014, I will classify Wereldhaven as an AMX-fund.
3.4 Research model
The following research model will be used and tested for explaining the existence of IAF, where:
Model 1: The existence of an internal audit
audit fees = b0 + b1internalaudit + b2size(1) + b3size(2) + b4size(3) + b5complexity +
b6receivables + b7inventory + b8big4auditor + e
• IA = internal audit (1) / no internal audit (0) • Size (1) = Turnover (SALE -- Sales/Turnover (Net)) • Size (2) = Number of total assets (AT -- Assets – Total) • Size (3) = Number of FTE (EMP – Employees) • Complexity = Number of subsidiaries
• Receivables = accounts receivable divided by total assets (RECT -- Receivables – Total) • Inventory = inventory divided by total assets (INVT -- Inventories – Total)
• Big4 Auditor = a dummy variable given the value 1 if a Big4 auditor is used, 0 otherwise
This analysis will lead to a predictive model for the existence of internal audit based on the selected population of firms. Furthermore, I want to research if the audit fee is higher within firms that haven’t got an IAF and lower within firms that do have an IAF. Therefore, I add a dummy variable that calculates the following:
(Size (1) Turnover + Size (2) Current assets + Size (3) FTE) / Total audit fee / 1,000 = ratio, that results in the variable: “SIZE (TOTAL) / Audit fee / 1000”.
4 Empirical Results
In this chapter, the empirical results that come forward from testing the hypothesis of the previous chapter are showed. First, I will describe the descriptive statistics. Secondly, I will describe the correlations and the regression analysis.
4.1 Descriptive statistics
Table 2 below shows the descriptive statistics for the variables in the models and Table 3 reports the correlations coefficients for the variables in the model.
Table 2: Descriptive statistics (n = 180)
The mean audit fee for companies in the sample is 4.2 million, ranging from a minimum of .03 million to a maximum of 56 million. The mean percentage of the existence of an IAF in the test is 57%, thus approximately more than 40% of the sample do not have an IAF. Furthermore, Big-4 auditors are auditing over 93% of the total sample. When looking at the sizes of the company, I combined three variables namely: Sales/Turnover (Net), Total Assets and Employees. The mean Sales/Turnover (Net) is 11,938 million, ranging from a minimum of .6 million (Pharming Group: 2010) to a maximum of 470,171 million (Royal Dutch Shell: 2011). The mean of Total Assets of the sample is 10,733 million, ranging from a minimum of 9.6 million (AND International Publisher NV: 2011) to a maximum of 360,325 million (Royal Dutch Shell: 2012). The mean Employees (FTEs) is 31, ranging from a minimum of 61 employees (Pharming Group: 2012) to a
maximum of 611,000 employees (Randstad: 2012). These variables give a good indication about the size of the Dutch public listed firms that has been selected in my sample.
The other variables namely Inventories, Receivables and Number of subsidiaries have been added to add value and strengthen the research model. Not every firm has inventories, but the mean is 897 million, ranging from a minimum of zero to a maximum of 30,781 million (Royal Dutch Shell: 2012). The mean of the total receivables is 1,582 million, ranging from a minimum of 0.306 million (AND International Publisher NV: 2012) to a maximum of 59,742 million (Royal Dutch Shell: 2011). Furthermore, the number of subsidiaries has a mean of 58, ranging from a minimum of zero subsidiaries to a maximum of 614 subsidiaries (Koninklijke BAM Groep NV)
4.2 Correlations
The correlations between audit quality and the different control variables are shown using the Pearson correlation test in table 3 (see: page 26). The most important independent variables will be discussed. Internal audit function is positively correlated with the audit fee, which means that the existence of an internal audit will lead to a higher audit fee. Sales/Turnover (net) is positively associated with the audit fee, thus this means a higher turnover results in a higher audit fee. Total
Assets is positively associated with the audit fee, thus this means a higher number of total assets
results in a higher audit fee. Employees are also positively associated with the audit fee, which means that the higher the number of employees, the higher the audit fee will be. I combined these three independent variables (Sales/Turnover (net) + Total Assets + Employees) in the dummy variable Size and divided that number with the audit fee that is charged that year, this number is then divided again by the number of 1000. This dummy variable is created to improve the equality of the data. This dummy variable is nevertheless also positively correlated with the variable audit
fee.
Furthermore, I used other independent variables to add value and to strengthen the research model, such as Inventories, Receivables, Number of subsidiaries, Big-4 auditor. These other independent variables are all positively correlated with the audit fee. The higher the inventories and receivables are the higher the charged audit fee will be, furthermore the higher the number of subsidiaries will be, the higher the audit fee will be. When a Big-4 auditor audits a company, then the audit fee will be slightly higher than when a non-Big-4 auditor audits the company, but this is not a significant result.
4.3 Statistical results
The correlations between audit quality and the different control variables are shown using the Pearson correlation test in table 3 (see: page 26). The most important independent variables will be discussed.
Internal audit function is positively correlated with the audit fee, which means that the existence of an
internal audit will lead to a higher audit fee. Sales/Turnover (net) is positively associated with the audit fee, thus this means a higher turnover results in a higher audit fee. Total Assets is positively associated with the audit fee, thus this means a higher number of total assets results in a higher audit fee. Employees are also positively associated with the audit fee, which means that the higher the number of employees, the higher the audit fee will be. I combined these three independent variables (Sales/Turnover (net) +
Total Assets + Employees) in the dummy variable Total Size and divided that number with the audit fee
that is charged that year, this number is then divided again by the number of 1000. This dummy variable is created to improve the model and the equality of the data. This dummy variable is nevertheless also positively correlated with the variable audit fee.
Furthermore, I used other independent variables to add value and to strengthen the research model, such as Inventories, Receivables, Number of subsidiaries, Big-4 auditor. These other independent variables are all positively correlated with the audit fee. The higher the inventories and receivables are the higher the charged audit fee will be, furthermore the higher the number of subsidiaries will be, the higher the audit fee will be. When a Big-4 auditor audits a company, then the audit fee will be slightly higher than when a non-Big-4 auditor audits the company, but this is not a significant result.
To test the validity of the models, I first regress audit fees on the control variables only. Consistent with prior studies, audit fees are associated with size (including sales/turnover (net), total assets and
employees), receivables, inventories, the number of subsidiaries, and the use of a Big-4 auditor (all positively associated at p = 0.000). Furthermore, consistent with Stewart et al. (2006) I find a significant association between higher audit fees and the existence of an IAF within the company (p = 0.000).
28 The adjusted R2 of the IAF regression has a value of 0.129, which means 13% of the variation in audit fees is explained by the variation in existence and non-existence of an IAF. The Derbin-Watson test in Table 4 (see: page 27) can be concluded that for α = 0,05, there is no evidence of positive autocorrelation (Keller, 2005). Thus, the results suggest that an IAF do predict audit fees in the Netherlands, because although the R2 is quite low (13%), the results are significant.
The regression result of the model is reported in Table 5 (see: page 29). The adjusted R2 of the regression is 0,894, which means that 89,4% of the variation in total audit fee is explained by the number of control variables. The Durbin-Watson test helps to detect the presence of autocorrelation. From the value of the Durbin-Watson test in Table 3 can be concluded that there is no evidence of positive autocorrelation for α = 0,05 (Keller, 2005).
Hypothesis 1
Hypothesis 1 predicts an association between higher external audit fees and the existence of an internal audit function and this is tested in Model 1 (R2 = 0.894) in table 5 (see: page 29). In the correlation coefficients in Table 3 (see: page 26) you can see that higher audit fees are strongly associated with the existence of an internal audit function (p = 0.000) and, therefore, Hypothesis 1 is supported. My results show that the existence of an IAF will lead to higher external audit fees. Francis (2004, p. 352) stated that ‘higher external audit fees imply higher audit quality’. Thus, the existence of an IAF will lead to higher external audit fees, thus as a result this implies a higher audit quality. This higher audit quality should improve the quality of financial reporting and therefore reduce the audit risk.
Hypothesis 2
Hypothesis 2 predicts an association between lower external audit fees and the existence of an internal audit function and this is tested in Model 1 (R2 = 0.894) in table 5 (see: page 29). The expectation of hypothesis 2 is that the existence of an internal audit is negatively associated with the audit fee. In the correlation coefficients in Table 3 (see: page 26) you can see that audit fees are significantly positively associated with the existence of an internal audit function (p = 0.000) so this correlation is positive, therefore, Hypothesis 2 is not supported. My test results are not in line with Abbott et al. (2003) who are claiming that the IAF hours reduce audit fees, and thus found a significant negative association between audit fees and the existence of an IAF. They are also not in line with by Felix et al. (2001) who found that the greater the contribution made by internal audit, the lower the external audit fee is. My results show that when there is an IAF within a company, the audit fee will become higher, and not lower.
5. Discussion
The main discussion in this paper is whether the existence of an IAF will lead to a higher or a lower external audit fee. There are academics that believe an IAF is one of the most important pillars of corporate governance (Holt et al., 2009; Stewart et al., 2010; Strand Norman et al., 2010). The traditional nature of internal audit relates to the verification of the accuracy, timeliness and completeness of the accounting information (Courtemanche, 1991). To evaluate evidence on accounting information in order to determine and report on how well this accounting information complies with established criteria (Arens & Loebbecke, 2000; Swinkels, 2012). In order to be of value for firms, the economy and society, internal audit should focus on the part beyond control of the firm and develop skills and core competence needed for this role. Its primary role is to provide insight into and assurance of the different elements of the comprehensive control system and to have its related natural advisory role. Internal audit does not provide consulting services (Swinkels, 2012). Although the annual statement is based on historical information, the stakeholders are more interested in a firm’s future cash flows, and assurance that these future cash flows will materialize (Strikwerda, 2012), thus this causes information asymmetry. When there is information
asymmetry, the Management Board may lose control of the firm, therefore an economic reason of existence of an IAF is to reduce information asymmetry.
Previous studies provide different results, which prove that a definite answer on the question, whether the audit fee is higher or lower, isn’t clear. Goodwin-Stewart et al. (2006b) results indicate that firms with higher audit fees are more likely to use a greater level of internal auditing. Their findings imply that audit committees, internal audit and external audit are complementary mechanisms within the governance framework. But Goodwin-Stewart’s results are not in line with Abbott et al. (2003) who are claiming that IAF hours reduce audit fees, and thus found a
significant negative association between audit fees and the existence of an IAF. The results of my study indicate that audit fee is significant positive associated with the existence of an IAF within a company. Furthermore, the findings of Felix (2001) indicate that the greater the contribution made by internal audit, the lower the external audit fee is. In other words this means that if there is an IAF within a company, the audit fee will be higher in comparison to companies who don’t have an IAF, the audit fee will be lower. Although the Dutch Corporate Governance Code (DCGC, 2008) suggests that every public listed company in the Netherlands should have an IAF, there is, in my sample, still over more than 40% that haven’t got an IAF.
When there is no IAF, the Audit Committee should review annually for the need for an internal auditor. Based on this review, the supervisory board shall make a recommendation on this to the management board in line with the proposal of the Audit Committee, and shall include this recommendation in the report of the supervisory board. The latter is thus mentioned in the annual report of a company. The main reason concerning non-existence of IAF that companies disclose is:
‘on the basis of the size of the company, there is no need for an IAF’. My research shows that size
is not an adequate argument, because the size (assets + employees + sales/turnover (net)) of a company is significantly positive associated with the external audit fee and the existence of an IAF. Thus, this argument is invalid. The firms that don’t have an IAF do not let the external environment (e.g. DCGC) influence them to set up an IAF. The importance of internal audit for stakeholders is mostly related to the prevention of fraud and/or detection of fraudulent activity (Marden et a., 1997; Strand Norman et al. 2010, Swinkels, 2012), based on the internal auditors’ perceived intimate knowledge of the organization and processes. Furthermore, academics state that an IAF can be seen as one of the most important pillars in the corporate governance of a company. This shows that an IAF can be seen as important and crucial function to prevent fraud and abuse and to prepare accurate financial statements by focusing on the control in relation to reliable financial reporting (Holt et al., 2009; Swinkels, 2012). My results show that the existence of an IAF will lead to higher external audit fees. Francis (2004, p. 352) stated that ‘higher external audit fees imply higher audit quality’. Thus, the existence of an IAF will lead to higher external audit fees, thus as a result this implies a higher audit quality. This higher audit quality should improve the quality of financial reporting and therefore reduce the audit risk.
