The Voluntary Implementation of an Internal Audit Function:

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The Voluntary Implementation

of an Internal Audit Function:

A Cross-Country Analysis

Master Thesis

Master of Science in International Business and Management Specialization in International Financial Management

Rijksuniversiteit Groningen Faculty of Business and Management

Postbus 800, 9700 AV Groningen The Netherlands

and

University of Uppsala Department of Business Studies Ekonomikum, Kyrkogårdsg. 10 Box 513, 751 20 Uppsala Sweden Date of Submission: 17.03.2010 Kristin Spandau Valentin-Feldmann-Straße 13 39218 Schönebeck Germany Student ID: S1840924 Kristin.Spandau@email-4you.de First Supervisors: Prof. Dr. C.L.M. Niels Hermes

c.l.m.hermes@rug.nl Second Supervisor:

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Abstract

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1. Introduction

The field of good corporate governance has recently received a high level of attention from both public as well as legislative sources. This is partially based upon the occurrence of fraudulent conduct and numerous accounting scandals – notably, the outstanding events at Enron and WorldCom. Consequently, the severances of the impact on internal and external stakeholders avalanched stricter treatment of firms’ internal control systems, which in turn led to the endorsement of internal auditing as an essential corporate governance mechanism. It serves as one of the corporate governance cornerstones separated from external audit, the general management and the audit committee (e.g. Deloitte, 2006; Gramling et al., 2004; Institute of Internal Auditors [IIA], 2009b).

So far, most of the advancements to encourage more transparency and investor confidence occurred in Anglo-Saxon countries such as the U.S. or the U.K., while the E.U. acted more conservatively (Paape, 2007). In particular, the most radical act on corporate governance was clearly the Public Company Accounting Reform and Investor Protection Act by the U.S. Congress in 2002, better known as Sarbanes-Oxley (SOX). Surprisingly, its direct influence on the position and role of internal audit was limited (Paape, 2007). However, as a consequence of its enactment, in 2004 the New York Stock Exchange (NYSE) required listed companies to “maintain an internal audit function to provide management and the audit committee with ongoing assessments of the company’s risk management process and system of control” (NYSE, 2004, Sec. 303A.07). By introducing this requirement the U.S. acted as initiators, which stipulated such an obligation for organizations other than financial institutions (Paape, 2007). Overall, the spillover effect of SOX is expected to be also felt in other regions of the world due to globalization and beyond border listing rules.

Because of both the requirements of stock exchanges and an increased emphasis on the concept of corporate governance, nearly all the large and medium sized publically traded firms have introduced an internal audit function (IAF) (Prawitt et al., 2009). Hence, the relevant question to be asked is whether the existence of internal audit function would still be observable, if these very incentives would not be available to push for an implementation. This research will focus on identifying factors motivating the voluntary implementation of an internal audit department in absence of any binding legislation concerning the existence of internal audit functions.

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2. Prior Findings and Relevant Research

2.1. The Role of an Internal Audit Function

Initially, it is important to specify the meaning behind the notion of an internal audit function. In the aftermath of cases like Enron, the organizational role of the internal auditing has gained significant importance. Following from a loss of reputation, the reliance of the assurance was increasingly shifted from external auditors to embedded internal audit functions (Holmes, 2002). This is also based upon shareholders requirements, as external auditors were no longer expected to provide the necessary assurance investors were asking for. Overall, the IAF was even perceived as a gap filler for the difference between actual and expected performance of statutory auditors (Aguolu, 2009). Thus, in order to satisfy the current shareholders or even attract new shareholder, firms generally became aware of the vital role of internal auditing.

In addition to the advantageous shift in perception of internal auditing, the literature presents further arguments encouraging firms to create IAFs. Al-Twaijry et al. (2003) states that there are two main benefits for a firm stemming from the implementation of an internal audit department. Firstly, its primary role is to prevent and detect irregularities in an organization caused by accidently wrongdoing or even fraud. In particular, the internal audit function is responsible for detecting weaknesses in a companies’ internal control system, identifying intentional fraud (e.g. Beasley et al., 2000; Coram et al., 2008) and providing reliability, and assurance (Paape, 2007). From an external stakeholder’s perspective, an internal audit function enhances transparency and “adds value through improving the control and monitoring environment” (Coram et al., 2008, p. 543). While internal stakeholders can easily access information to ensure transparency, external stakeholders such as shareholders mostly lack direct relevant information about the internal audit function (Archambeault et al., 2008). By providing greater transparency, shareholder’s confidence to invest or keep investing in a company is likely to be enhanced. Evidence is provided by Carcello et al. (2005) who state that internal auditing is a part of general measures gaining investor’s confidence.

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All these aspects are included in the definition published by the IIA (2009a) that declares IAF to be:

“…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.”

Overall, the role of an IAF has shifted from formerly being associated with ‘corporate policemen’ to a proactive partner of management (Aguolu, 2009). Its initial work was aiming at the provision of employee incentives to work in the interest of the firms. It is currently also considered to provide general encouragement and support for the managerial decision-making process (Brody and Lowe, 2000; Penno, 1990).

Since the choice of managers is among others also influenced by risk, both being aware of risk and managing it properly has become a matter of growing concern in today’s global economy (Aguolu, 2009). One of the responsibilities for internal auditors is the appropriate management of risk within organizations (Brody and Lowe, 2000; Walker et al., 2003). According to Aguolu (2009), organizations that on a strategic level assign priority to risk management are able to make the best decisions about the future of the organization. Moreover, the implementation of an internal audit function is even perceived to provide a mechanism that helps to convert risk into a profitable opportunity for the business (Aguolu, 2009).

From the arguments provided above, considering the question of installing an internal audit function appears relevant for every organization. Due to the variety of tasks and benefits associated with the adoption of an internal audit function, taking advantage of internal auditing may enhance the firm’s competitive position in the market place. However, the implementation of an IAF becomes only economically relevant to a firm in an unregulated business environment, if the benefits of introducing as well as sustaining an internal audit function exceed its respective costs. Generally, there is not global answer applicable to serve all companies; consequently, the decision to implement such a function needs to be considered on an individual firm level. In consistency with the findings of prior research, it is likely that there are indicators that either encourage or discourage the adoption of an internal audit function. These results will be addressed in the following section.

2.2. Adopting an Internal Audit Function

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audit committee (e.g. Zain and Subramaniam, 2007; Raghunandan et al., 2001). Regarding the existence of internal auditing, we find two main elements that have been addressed in the literature, i.e. the general adoption of internal audit departments and the organizational characteristics of companies having an internal audit department (e.g. Wallace and Kreutzfeldt, 1991; Al-Twaijry et al., 2003; Goodwin and Kent, 2004).

It is open to discussion why companies despite its apparently value-adding impact, as outlined in the prior section, may still neglect to voluntarily implement an internal audit department under unregulated market conditions. In the literature it has been argued that companies rely to a large extent on the service and assurance work provided by external auditors (Al-Twaijry, et al., 2003). Thus, the need to obtain an additional department entirely responsible for auditing appears unreasonable for some corporations. Al-Twaijry et al. (2003) even refers to this incidence as a corporate confusion of the roles regarding internal and external auditors. A similar finding was provided by Carey et al. (2000), who investigated the voluntary demand for both internal and external auditing within a family business environment. According to Carey et al. (2000), internal auditing serves as a substitute for external auditing, which is in contrary to their hypothesis of both being complements to each other. In other words, the research sample revealed that Australian family-owned companies that engage in external audits are less likely to simultaneously also commit to internal auditing. Surprisingly, both functions were found to not represent complementing ideas; even though this might have been suggested as both often strive for similar objectives (Carey et al., 2000). In contradiction to family-owned businesses, other research of listed public companies provides indeed evidence for a complementing relationship (Wallace, 1984). Further support for both auditing services rather being complements to each other is found by Wallace (1984). When a company decides to rely on both external and internal audits, a reduction in external audit costs may be attained. This is due to improved accounting controls and the further assistance provided by the IAF to the external audit team (Wallace, 1984). A reduction in external audit costs may encourage managers to employ both internal auditor as well as external auditors to complement each other.

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Generally, external auditors are less valued than their internal counterparty. A survey conducted by KPMG International (2002) shows that external auditors failed to convince businesses of their quality in all of the five categories, namely respected within the organization; seen as a value adding resource; business objective orientated; sounding board for directors; and training ground for senior management. In contrast, internal auditors were well respected within the organization and perceived to be a value-adding resource with a business objective orientation (KPMG International, 2002). However, despite these findings, unexpectedly not all companies identify to have an IAF set up. Adams (1994) argues that more complex firms are more likely to have an IAF implemented as compared to firms with simple business structures. Complexity of operations tends to increase with firm size. Thus, smaller companies are anticipated to lack the necessary resources that make setting up a separated internal audit function affordable at all. Another explanation for the importance of firm size may be that smaller firms do not view internal audit to be cost effective (Goodwin-Stewart and Kent, 2006). Specifically, a study by Al-Twaijry et al. (2003) identified a smaller firm size and thus the limited scope of activities to be the driving forces to consider the implementation of an internal audit department as inefficient.

Evidence for a positive relation between the size of a company and an IAF is provided by for instance Wallace and Kreutzfeldt (1991), Goodwin and Kent (2004) and Arena and Azzone (2007). An exploratory study by Carcello et al. (2005) found that larger companies also provide a greater internal audit budget to be invested than smaller companies do, based on the factors of corporate resources and risk exposure. In particular, companies that have a high risk exposure will increase the level of corporate monitoring. According to Carcello et al. (2005), the level of risk exposure positively affects the demand for more corporate monitoring in order to identify and properly manage potential sources of risk for the organization. Internal auditing serves as an effective monitoring tool, so that risk consequently promotes more investment in internal auditing per se.

By studying a sample of Italian companies, Arena and Azzone (2007) found size to be the most significant driver that influenced the firm’s choice of implementing an internal audit department. Supplementing this argument, they also identified size to be the most frequently used explanation for the absence of an internal audit department. In contrast, the Carey et al. (2000) failed to identify a significant relation between an internal audit function and firm size. A possible explanation for this inconsistency with the rest of the empirical results might be the unproportional underrepresentation of small and large sized family businesses in the sample.

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reliability depend largely on the disclosure of internal audit information (Holt and DeZoort, 2008). Potential benefits of reporting on internal control outlined by the literature are improved transparency (Archambeault et al., 2008), the enhanced investors’ confidence and increased attractiveness of the stock (Holt and DeZoort, 2008).

The internal audit reporting is an advanced way to approach the field of internal control. It per se is not satisfied with the pure existence of an IAF, as it proactively takes advantage of information disclosure to highlight its adoption to external stakeholders. An internal audit function needs to be established first in order to benefits from internal audit reporting. Due to this expected contingent relationship, the economic incentives to report on internal auditing may be similar to the drivers of adopting an IAF. Voluntary disclosure of internal auditing information by companies has been researched by for instance Deumes and Knechel (2008). By investigating publicly traded firms in The Netherlands in the late 1990s, they hypnotized and approved that voluntary reporting on risk management and internal control increases with the level of information and agency problems. In the next section, this theoretical background also applied by Deumes and Knechel (2008) will be outlined.

3. Theoretical Framework – An Agency Approach

In the academic literature many investigations have based their methodological approach on an agency theory background when researching internal audit (e.g. Carey et al., 2000; Carcello et al., 2005; Paape, 2007; Archambeault et al., 2008). According to Adams (1994), “agency theory can help explain the existence of internal audit” (p.11) reinforcing that firms represent a collection of contractual agreements between the owners of resources (principal) and those managing these resources (agents). In this setting, the shareholders have difficulties to properly monitor the actions of the managers on a regular basis so that information is unequally distributed between the two parties. Put differently, the greater the degree of information asymmetry between the two parties, the more agency costs are incurred. In the theoretical background of agency theory, the implementation of an IAF can be either thought of as bonding cost incurred by the agents “to signal to the principal/ owners that they are acting responsibly” or as monitoring costs “incurred by the principal/ owners to protect their economic interest” (Adams, 1994, p. 8-9).

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be caused by an insufficient or non-existing internal control system. As a result, it cannot be confirmed that adequate compliance with regulations or valid assurance regarding accurate accounting and reporting standards is present. The existence of an internal audit function as a part of the internal control systems can succeed in building up trust and granting transparency instead (e.g. Coram et al., 2008). A win-win situation is created as the shareholders are assured higher credibility and transparency; while the company can benefit from enhanced efficiency and lower propensity to engage in fraudulent behavior on a manager and employee level.

To conclude, it is also in the interest of the agent, the managers, to conduct internal audits. In contrast to risk-neutral principles, agencies are characterized to be rather risk-adverse. Regarding decisions affecting the corporation they intent to limit the risk exposure of their personal wealth and wellbeing (Williamson, 1963). In case of publication of fraud or incorrect accounting methods to the public, job security, compensation and reputational standing are at risk for the management. This provides managerial incentives to create or even enhance an internal audit function due to the high risk aversion of managers and their value at risk regarding for example their general employment, status and compensation.

Due to both the broad academic acceptation and its explanatory power in providing rationalization for the existence of an internal audit function, this paper will also take advantage of an agency setting to investigate the voluntary adoption of internal audit departments. However, despite ‘snap shooting’ the rationale behind the existence of IAFs at a certain point in time using agency theory, both an analysis of change as well as a European country scale are included as well. In this way we add to the current body of literature, as we failed to find prior research combining these three dimensions to investigate the existence of an internal audit function. In the next section the hypothesized relations regarding all three areas are outlined including an elaboration on the respective theoretical background underlying the time series dimension as well as the European country scale.

4. Hypotheses

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order to account for agency problems, we take advantage of three proxies in our analysis - proportion of managerial ownership, concentration of ownership by shareholders and financial leverage.

We find evidence in the literature that the same agency proxies are valid concepts in helping to explain information and agency problems (Deumes and Knechel, 2008; Goodwin-Stewart and Kent, 2006). For instance Deumes and Knechel (2008) used the same variables of agency theory proxies to investigate the voluntary disclosure of information on internal auditing. As was discussed above in section 2.2., the installment of an internal control system is a necessary pre-step in order to be able to successfully report on internal control. Gramling et al. (2004) points out the role of IAF as one of the cornerstones of the corporate governance system of corporations. Both internal auditing and internal control disclosure aim at the mitigation of agency costs. As these proxies for agency conflicts succeeded in approving a significant relationship with voluntary internal audit reporting, we also anticipate them to help explaining the voluntary adoption of internal audit departments.

In contrast to Deumes and Knechel (2008), Goodwin-Stewart and Kent (2006) failed to find a significant association between the use of internal auditing and managerial ownership, concentration of outside shareholdings and level of debt. Goodwin-Stewart and Kent (2006) explored the voluntary use of internal auditing in Australian public companies in 2000 and accounted for these proxies of agency costs in terms of control variables. A partial explanation for this deviation in results might be the different approaches to measure the variables. Only the level of debt is accounted for in the same way, whereas Goodwin-Stewart and Kent (2006) measure the existence of managerial shareholdings in terms of a dummy variable and only account for the 20 largest shareholders when quantifying the concentration of ownership. Due to the lack of significant results, measurement of these agency costs proxies in this paper will resemble the underlying methodology of Deumes and Knechel (2008).

4.1. Agency Theory Related Hypotheses

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less demand for internal auditing. Thus, we conclude that managerial ownership may be negatively associated with the existence of an internal audit function.

Hypothesis 1: There is a negative association between the degree of management ownership and

the existence of an internal audit function, ceteris paribus.

The second hypothesis relates to the degree of outside ownership concentration. The higher the degree of outside ownership concentration, the lower the underlying information asymmetry and therefore the lower are the agency costs incurred. Intuitively, this originates from the assumption that block holders are more willing and able to actively monitor the activities of management (e.g. Jensen and Meckling, 1976; Dyl, 1988; Milgrom and Roberts, 1992; Xu and Wang, 1999). Consequently, in absence of ownership concentration to promote shareholder’s interests, managerial opportunism may prevail to be a common aspect of internal corporate governance (Leng, 2008). In particular, it is relatively more expensive and complicated for dispersed shareholders to monitor the management actively, so that agency problems may increase (Jensen and Meckling, 1976). As a result, in case of more outside ownership dispersion the need to implement an additional control mechanism is significantly higher than for the same setting with highly concentrated ownership. The importance of the role of internal auditing rises consequently. Taken all the prior information into account, we anticipate a negative relation between outside ownership concentration and the implementation of an additional internal audit function.

Hypothesis 2: There is a negative association between the degree of outside ownership

concentration and the existence of an internal audit function, ceteris paribus.

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invest more heavily in internal audit monitoring. They explanation for this finding is linked to the corporate intention to mitigate greater agency costs.

A different argument also supporting a positive relation of internal control and financial leverage is supplied by Carey et al. (2000) and Chow (1982). According to them the association between company’s debt level and the demand for external auditing ought to be positive in nature. If a higher debt level provokes the need for external auditing, a similar outcome may occur for internal auditing. This is based on the argument that both external and internal auditing serve as complements to each other. Carey et al. (2000) finds divergent results, however, for a sample of family-owned businesses. In their setting of family-owned firms neither external nor internal auditing was mandatory. Among listed publicly traded firms, Wallace (1984) found evidence for a complementing relationship of external and internal auditing. As described before, the presence of an IAF stimulates the reduction of external audit cost to the firm. Internal auditors are able to effectively assist the external audit team leading to an improved level of accounting control (Wallace, 1982). Hence, companies apparently benefit from the combining the two services adequately. As a result, when the demand for external auditing rises with financial leverage, it will also rise for internal auditing. Following from the all prior elaborations, it can be hypothesized that there is a positive impact of financial leverage on the introduction of an internal audit function.

Hypothesis 3: There is a positive association between the degree financial leverage and the

existence of an internal audit function, ceteris paribus.

These hypotheses coped with the agency conflict arising either between managers and shareholders or shareholders and debt holders. In the next subsection, the expectations regarding the use of internal auditing in a cross-country study will be discussed and elaborated on the respective theoretical background used for this.

4.2. Cross-Country Dimension

The literature research coping with the adoption of internal audit functions are normally found to be limited to single country studies (e.g. Wallace and Kreutzfeldt, 1991; Al-Twaijry et al., 2003; Arena and Azzone, 2007; Paape, 2007). However, KPMG International (2002) examined the corporate acceptation of an IAF and succeeded in finding a great deviation among European countries. Its Corporate Governance Report of 2002 concluded that already 85 percent of the participating firms1 in Germany and the U.K. affirmed the existence of an IAF, whereas many other businesses from

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Belgium, Switzerland and The Netherlands did not have such a function at that time. Even more remarkable, among all European member states Luxembourg is the only one devoid of any publications of corporate governance codes (Allegrini et al., 2006). When taking these findings into consideration, we presume that the local country setting influences the corporate approach towards internal control at least to some extent. It is subject to the current discussion to identify the reasoning behind the great diversity of different approaches pertaining to the implementing an IAF.

Academic literature provides evidence for cross-country deviation in legal institutions and investor protection, and their impact on the way accounting is practiced (La Porta et al., 1998; La Porta et al., 2006). Furthermore, different legal traditions mitigate the chances of harmonization and a one-size-fits-all mentality (Allegrini et al., 2006). As a result, the individual country background needs to be considered when analyzing the voluntary implementation of an IAF in several heterogeneous countries as available in a European setting. From prior studies we find evidence for the driving force of country-specific legal systems. By taking a cross-country perspective, Francis and Wang (2008) as well as Choi et al. (2008) succeeded in demonstrating the considerable impact the underlying legal regime of countries has on factors such as accounting earnings quality and audit pricing, respectively. Due the differences in the underlying legal traditions, every country takes a diverse approach towards legal rights incorporating the protection of property rights (Francis and Wang, 2008). A prominent framework developed by La Porta et al. (2006) expressed the exposure of the way investor protection is designed to legal traditions, corporate law and security law. Overall, legal regimes can be distinguished between common- and civil-law countries (David and Brierly, 1985). In the borders of Europe (prior to the 2004 East expansion) common-law practices are found in England and Ireland, whereas civil-law countries further subdivide into French-, German- and Scandinavian-originating countries. Generally, common-law countries characterize both to rely less on statutes and to prefer contractual agreements as well as private litigation in cases of disputes (La Porta et al., 1998). Conversely, civil-law countries tend to rely to a large extent on legal and procedural codes, while preferring governmental regulation over private litigation (La Porta et al., 1998).

Another contrasting element characterizing legal families is their approach towards shareholder protection. On a corporate law level, La Porta et al. (1998) developed a general framework to measure shareholders protection by considering Antidirector rights. Six dichotomous elements such as proxy by

mail allowed or preemptive right to new issues2 were used to quantify to which extent minority or outside shareholder are protected against managers or other dominant shareholders in a country’s corporate law setting. According to La Porta et al. (1998), countries originating from a common-law background (i.e. Ireland and the U.K.) specify to have a stronger legal protection of shareholders as

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compared to civil-law countries. When taking both legal families into account, German civil-law countries (i.e. Austria, Germany) hold the last position in this ranking of legal shareholder protection, while Scandinavian (i.e. Denmark, Finland, Sweden) and French civil-law countries (i.e. Belgium including Luxembourg, France, Greece, Italy, The Netherlands, Portugal) classify with intermediate results ranking second and third, respectively3.

When considering the great deviation in shareholder protection among European countries, it is subject to question in which way individual countries handle this divergence. A plausible response to weaker legal protection is emphasized by La Porta et al. (1998). They find that “heavily concentrated ownership results from, and perhaps substitutes for, weak protection of investors in a corporate governance system” (p. 1151). In other words, businesses originating from countries that characterize to eagerly protect their investors by law to a great extent are more likely to possess a dispersed ownership structure and vice versa. Concentration of shareholders ownership is approved to be effective in providing investors with the necessary incentives to properly monitor the management (Jensen and Meckling, 1976). When combining ownership and the level of legal protection, we expect companies of countries ranking high in protecting shareholders’ rights to have dispersed ownership structures and consequently provide less incentive to monitor managers effectively. In this case, demand for a well-established internal control system is higher due to increased agency costs and a greater level of asymmetric information. Hence, we expect countries with well-established investor protection and consequently lower concentration of ownership to have a higher need for the implementation of an internal audit function than the remaining countries.

Hypothesis 4: There is a stronger positive association between common-law countries and the

existence of an internal audit function (a) than for least protective German civil-law countries (b), while Scandinavian (c) and French (d) civil-law countries rank as the second and third, respectively, ceteris paribus.

As a second country related aspect the cultural setting and its effect on the approach towards corporate governance will be addressed. In general, internal auditing is a costly tool to mitigate asymmetric information and individual opportunism within corporations. The association between cultural values and internal auditing needs to be investigated, since culturally-diversified societies may act differently towards the concept of internal auditing, which may possibly provoking unnecessary cost and

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dysfunctional behavior (Kachelmeier and Shehata, 1997). Despite these results, prior research surprisingly shows that even identical control systems are used by numerous multinationals to manage both foreign as well as domestic operations (Choi and Mueller, 1992). In contrast to Choi and Mueller (1992), Ueno and Wu (1993) and Cohen et al. (1993) state that control systems may indeed be sensitive to culture. This suggests rather an individually adapted approach towards internal auditing depending on the specific cultural characteristics of a country.

Chan and Cheung (2008) have investigated the impact of Hofstede’s (1980) well-known cultural dimensions on corporate governance practices. They identify the cultural dimension of uncertainty avoidance (UA) to be a significant predictor for the development of corporate governance practices. Generally, companies with a low UA had stronger measures in position to guarantee a wider accountability and governance over the firm (Sweeney, 2008). Individuals of these countries are both more comfortable with facing uncertainty and additionally tend to show more tolerance towards difference in opinions (Hofstede, 1983). Moreover, low uncertainty avoidance generally associates with greater risk-taking and higher acceptance of change and innovation. Based on these arguments, countries that rank low on uncertainty avoidance may have fewer difficulties in successfully implementing and developing an appropriate corporate governance system as compared to their risk adverse counterparts. Countries with a high uncertainly avoidance, however, tend to be more conservative as they like to both obey the existing social system and stick to given management practices in business life (Chan and Cheung, 2008). Thus, introducing a reform to develop corporate governance in the high UA societies is likely to provide difficulties as they generally dislike change. Due to the dominance of these cultural values in low uncertainly avoidance societies, stakeholders are more prone to speak out against poor corporate governance practices and injustice, while also being more willing to monitor managers closely (Chan and Cheung, 2008). Likewise, corporate managers of these societies “should be more accustomed to handling such diversity, conflict, and feedback from shareholders” (Sweeney, 2008, p. 119).

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These findings suggest that individuals from countries ranking low on UA tend to also face lower implicit costs to personally address critical topics to managers or vice versa. In cases of poor corporate governance, shareholders with lower UA feel more comfortable to speak out their concerns and tackle problems proactively. As demonstrated by Chan and Cheung (2008), this increases the likelihood of establishing a sound corporate governance system in corporation pertaining to low UA societies. Based on the evident findings that lower UA is viable in predicting wider accountability and corporate governance practices, we expect a predicting relation between UA and internal auditing. Generally, internal auditing is indeed known as a vital aspect of a general corporate governance mechanism (e.g. Deloitte, 2006; Gramling et al., 2004; Institute of Internal Auditors [IIA], 2009b), that contributes to a well-structured internal control system. Leading from this discussion, we anticipate negative relation between uncertainty avoidance and the implementation of an internal audit function.

Hypothesis 5: There is a negative association between uncertainty avoidance and the existence of

an internal audit function, ceteris paribus.

4.3. Analysis of Change

Corporate governance issues have recently been attracting increasing interest from the public as well as governmental institutions. The trends of globalized markets and the alteration in the ownership structure of firms have increased the need to enhance the effectiveness of the underlying corporate monitoring systems (Aguilera and Cuervo-Cazurra, 2004). These trends do not only spread across organizations on a country perspective, likewise, they also diffuse across national borders over time (Aguilera and Cuervo-Cazurra, 2004). As a result, we see the need to investigate in which way the approach towards the adoption of internal audit functions changes over time.

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organizations, once practices have become institutionalized. According to Tolbert and Zucker (1983, p. 25), institutionalism is “the process through which components of formal structure become widely accepted, as both appropriate and necessary, and serve to legitimate organizations”.

For our analysis it is of interest to apply this theoretical framework to the adoption of an internal audit function. When considering the rational account, we argue that the implementation of an internal audit function is indeed efficiency-driven. Companies will only introduce such a function given that it adds value to the company. Providing greater transparency (Paape, 2007), enhancing customer confidence (Carcello et al., 2005), a higher detection of fraud (Coram et al., 2008) and the minimization of losses which would occur in the absence of auditing (Miltz et al., 1991) are viable motivators likely to enhance internal efficiency of processes. The rising pressure of competition in the market place will provoke corporations to adopt an internal audit function. Globalization and the growing interaction of market places will push corporations to increasingly focus on making internal processes more efficient in order to withstand competitive pressures. This will, however, mainly apply to larger corporations, as they are more likely to regard internal auditing as cost effective as compared to their smaller counterparts (e.g. Goodwin-Stewart and Kent, 2006; Carcello et al., 2005). As a consequence, larger firms appear to be more sensitive to adopt an internal audit function pointing to efficiency improvements.

Adaption through legitimation is a second component addressing the spread of practices such as the enhanced support for internal auditing. This helps us to explore, if the institutional pressure to adopt an IAF increases over time. Within the literature we find confirmation for the use of institutional theory as it provides a suitable perspective to elaborate on the establishment of internal audit functions due to legitimation (Al-Twaijry et al., 2003; Arena et al., 2006; Arena and Azzone, 2007). While Al-Twaijry et al. (2003) focus on the corporate choice to establish an internal audit department considering an isomorphistic perspective, Arena and Azzone (2007) elaborate on the diffusion of internal audit departments across Italian firms emphasizing isomorphistic forces in encouraging firms to create an IAF. The relevance of coercive forces has been approved by Arena et al. (2006), who investigated the adaption of internal audit departments among Italian companies. As coercive pressures stems from political pressures such as codes, rules and regulations (DiMaggio and Powell, 1983), its impact on the implementation of internal auditing is of interest for this study.

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disseminated after 1997 (Paape, 2007). When taking a pan-European perspective, 71 percent of European firms on average engage in internal auditing, while we find the highest proportion of internal audit departments in England and Germany with 86 percent in 2001/02 (KPMG International, 2002). KPMG International (2002, p. 44) clearly links these results to the publication of corporate governance codes, particularly, “both the Turnbull report and KonTraG give a strong steer” for the adoption of internal audit departments in England and Germany, respectively. Similarly, Tettamanzi (2003) identified that most private companies located in the U.K. and Italy introduced an internal audit department to comply with codes of best practice. Following from these findings, we expect a connection between the increasing publication of codes addressing internal control and the existence of an IAF.

To summarize, both social legitimation and efficiency are suitable to explain the existence of internal audit departments within organizational settings. As was outlined before, we acknowledge the growing forces behind the drivers of legitimation and efficiency, which consequently provoke corporations to enhance their support with respect to internal auditing. Following from both the growing pressure of published codes and rising importance of efficiency-driven benefits to corporations, we hypothesize that over time more firms decided for the installment of an internal audit function.

Hypothesis 6: Over time the proportion of firms with an internal audit function as compared to

firms lacking such a function will increase over time, ceteris paribus.

5. Methodology

5.1. Setting

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pressure steadily increased as more and more best practice frameworks were published in Europe (Aguilera and Cuervo-Cazurra, 2004).

5.2. Data and Availability

Data was retrieved from publicly traded firms excluding financial companies from 14 European Union member states4 prior to the 2004 east expansion. Initially, a list of European public companies was generated by using the Amadeus5 database. The sample of companies was drawn from this list according to the accessibility of data.

The availability of the data developed into a considerable research obstacle. The majority of data was retrieved from annual reports of the respective years 1997 and 2001. However, the publication of annual reports exceeding a ten year time gap up to today were in most cases not displayed on the corporate website anymore. Due to their withdrawal, customized e-mail were sent out to corporate investor relations or the finance departments elaborating on the research content, the project background and the data request. As a result, firms provided their annual reports either electronically or sent out hard copies for the year(s) that were not available on the corporate website. In most cases the annual report for 1997 was difficult to obtain, as both a hard copy and an electronic version were mostly not available anymore. Thus, the sample mainly includes single corporate observations for either year. In particular, only approximately 16 percent of the sample firms could be used to retrieve data for both years.

Overall, the sample contains 313 observations including 154 and 159 sample firms for the years of 1997 and 2001, respectively. Due to utilization of 48 firms for both years, the sample obtains 265 unique corporations. With respect to the industry, approximately 32 percent of the sample companies have a service orientation, whereas 68 percent are manufacturing companies. In terms of selecting countries, we concluded to group the sample according to La Porta’s (La Porta et al., 1998) classification scheme that focuses on the legal system of countries (refer to section 4.2. for a description of the different law systems and the countries per system). This way, the individual sample groups will be sufficiently big enough to assure a valid analysis of the adoption of an IAF per legal system. Please refer to Table 1 for details on the sample descriptives.

4

i.e. Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The

Netherlands, Portugal, Sweden, UK (excluding Spain due to limited access to data). For Greece and Luxembourg no data could be retrieved for 1997. In Greece there was no legislative provision for annual reports before 2001, which constraints the availability of annual reports in 1997. In addition, we expect the size of Luxembourg to be the limiting factor for the data collection for 1997.

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Table 1: Sample Descriptives

1997 2001

(1) Common-law countries 23 26 49

(2) Scandinavian civil-law countries 51 42 93

(3) French civil-law countries 42 61 103

(4) German civil-law countries 38 30 68

Total: 154 159 313

For the respective groups of countries originating from the legislative background and legal family association, the sample embraces 49, 93, 103 and 68 from common-law, Scandinavian-, French- and German-origin countries, respectively. The information necessary for the dependent, independent and control variables were retrieved from annual reports. In case of missing data firm-specific inquires were sent out via e-mail specifically asking for the information lacking.

5.3. Dependent Variable

In order to measure whether the company contains an IAF, the existence of an internal audit department was taken as a proxy. The notion of IAF is expected to be perceived differently by companies based upon the lack of a standardized approach to measure it. In order to circumvent biased results from heterogeneous measurement approaches, accounting for the presence of a separate internal audit department appears to be a viable way to account for the variable of IAF.

Concerning its data collection, annual reports were thoroughly checked for explicit comments on internal audit departments. In absence of any information, the company was contacted and clearly asked to specify on the existence of a department solely dedicated to internal auditing for both years of interest, i.e. 1997 and 2001. The variable has generally a binary nature (1 when the existence of an internal audit department is affirmed and 0 otherwise) and is accounted for in terms of a dummy variable.

5.4. Test Variables

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 Managerial Ownership (MO) is measured by summing up the percentage of shares held by members of the management board. In particular, only shareholdings of more than 5 percent were considered replicating Deumes and Knechel’s approach (2008).

 Ownership Concentration (OC) is measured by the summing up the percentage of company’s outstanding stock owned by outside block holders, which we define as shareholdings of non-managers greater than 5 percent.

 Financial Leverage (FL) is measured by the ratio of long-term debt divided by total assets.

Apart from the agency theory-driven test variables, we also examine the effect of the underlying legal system, the attitude towards uncertainty and the impact of time on the use of an internal audit function for the respective years of 1997 and 2001. Therefore, the following test variables are also of interest:

 Shareholder Protection as outlined by La Porta et al. (1998) is accounted for by coding three separate dummy variables, particularly for countries belonging either to a

Scandinavian-origin, French -origin or common-law legislative background. Scandinavian-origin (SCAN)

countries encompass Denmark, Sweden and Finland, while French civil-law (FRENCH) countries consist of Belgium including Luxembourg, France, Greece, Italy, The Netherlands and Portugal. The U.K. and Ireland pertain to common-law (COMMON) countries. If a country belongs to a certain legal regime it is coded by 1 and 0 for the residual country groups. Following from the specific degrees of freedom, German-origin countries will serve as the baseline.

 Uncertainty Avoidance (UA) helps to account for cultural differences among the European countries. The concept of risk and the reaction towards it is captured by Hofstede’s (1980) prominent dimension of uncertainty avoidance. Each country is allocated to its respective level of uncertainty avoidance resembling the findings of the study by Hofstede (1980). For instance businesses originating from Denmark are clearly assigned the lowest score in this collection of countries with 23, while corporations from a Greek background rank to have the highest uncertainty avoidance with 112.

 Time (TIME): The binary nature of this variable becomes clear, since 0 (i.e. 1997) or 1 (i.e. 2001) is allocated to the respective set of company information.

5.5. Control Variables

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are in addition to the dependent and independent variables also retrieved from the publically available annual reports of each firm for the years of 1997 and 2001, respectively.

 Company Size (SIZE) has been found to have a substantial impact on the corporate choice of firms with respect to internal auditing. Stemming from prior research, the implementation of an internal audit function was presented to relate positively to firm size (e.g. Wallace and Kreutzfeldt, 1991; Goodwin and Kent, 2004; Arena and Azzone, 2007). Resulting from higher complexity and variety of operations, larger firms tend to be exposed to more internal risk and in turn organizations that face higher risk will enhance their corporate monitoring (Carcello et al., 2005). In addition to increasing the need for more monitoring, through larger firm size companies may also have the necessary resources available that makes an increased devotion to monitoring even possible (Carcello et al., 2005). As a consequence of the evident linkage of company size and the adoption of an internal auditing function, we expect a similar outcome for our European sample. Company size will be measured as the sum of total assets adjusted by the log function.

 Foreign Operations (FO) is considered to provoke the need for more monitoring as additional political, economic and cultural risk is added to the corporation (Deumes and Knechel, 2008). A wider complexity due to foreign operation (e.g. foreign exchange transactions, transfer pricing, joint ventures) may cause more inherent risk, which makes the implementation of an internal audit department more probable. Not only the organizational complexity increases with a higher proportion of foreign subsidiaries, a higher level of foreign operations is also associated with a greater degree of decentralization. This in turn stimulates the need for monitoring (Carcello et al., 2005; Wallace and Kreutzfeldt, 1991), possibly provoked due to the absence of incremental control measures readily available for organizations with a steep hierarchical structure. Thus, we expect a positive impact on the existence of internal auditing in firms, when the degree of foreign operations is considerably high. Foreign Operations will be quantified by putting foreign subsidiaries into relation with the total amount of subsidiaries in the corporation, i.e. FO = total number of foreign subsidiaries divided by total number of subsidiaries.

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large enough to audit all aspects of the company properly. This argument suggests, that fast growing companies may demand more monitoring in terms of internal audits to provide the adequate level of financial assurance and transparency to external stakeholders. In this study sales growth is measured as the proportion of year-to-year sales growth from 1996 to 1997 and from 2000 to 2001, respectively.

 Higher Receivables (REC) are likely to expose the company to greater accounting risks (Kinney and McDaniel, 1989). In the literature accounts receivable are even declared to be one of the areas most prone to errors and fraud (e.g. Beasley et al., 1999; Kreutzfeldt and Wallace, 1986). In particular, according to Francis and Stokes (1986) a higher level of receivables tends to relate to material misstatements in financial reports. Consequently, we would expect a higher need for the use of an IAF, when the company possesses a large proportion of receivables. The provision of an IAF would encourage the internal monitoring process, so that material misstatements in financial reports due to fraud or personal errors will be mitigated. Thus, a high level of receivables provides incentives for more internal auditing to assure more transparency and eliminate default risk. Indeed, Goodwin-Stewart and Kent (2006) succeed in determining the level of receivables to be positively linked to the use of an internal auditing. Similarly, we expect receivables to be positively linked to the existence of internal audit departments. We measure receivables as the ratio of receivables to total assets, i.e. REC = receivable divided by total assets.

 Audit Quality (AQ): Goodwin-Steward and Kent (2006) identify a negative relation between internal audit size and the use of high quality external auditors belonging to the Big Five6. This association suggests a substitution effect between internal auditors and auditors pertaining to the Big Five accounting companies. Due to these findings, we expect that companies purchasing auditing service offered by the Big Five will be less likely to also build up an internal audit function in their organization. Moreover, shareholders may see less demand for additional monitoring aid as provided by internal auditors, when the company is already being audited by one of the Big Five accounting companies. As a result, managers have fewer incentives to create a costly internal audit department. Despite these expectations for the contingent relationship between internal auditing and the Big Five, in the literature a complementary association between external and internal auditing is found for public firms (Wallace, 1984). However, we assume that the reputational standing of the Big Five is convincing enough to assure greater shareholder confidence, which in turn leaves less demand for internal auditing. Having an auditor of the Big Five (before the demise of Arthur Anderson

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in 2002 subsequent to its involvement in the Enron case) is measured as equal to 1 and 0 otherwise.

 Industry Grouping (IND) is essential as inherent risk may stem from the specific industrial environment of a firm according to Knechel and Willekens (2005). Some industries may be exposed to a more regulated market environment than others; indeed, firms operating in regulated industries are more prone to adopt an internal audit function (Wallace and Kreutzfeldt, 1991). As identified by Beasley et al. (1999), some service industries were found to have a comparatively higher likelihood to engage in accounting fraud, which in turn encourages these companies to strengthen their internal monitoring system in terms of conducting internal audits. With respect to manufacturing companies, internal audit departments seem to be less common as for instance compared to financial or insurance firms, which naturally face a higher coercive pressure to adopt IAFs (Arena and Azzone, 2007). As a result, we expect businesses originating from the service industry to be more prone to have an IAF as compared to manufacturing companies. For this dichotomous variable, companies belonging to the manufacturing industry are coded with 1 and 0 otherwise.

 Cross-Listing of Shares (TRADE) provides coercive pressure to a firm concerning the adoption of an internal audit function (Arena and Azzone, 2007). The country-based listing is essential, since especially in the U.S. the awareness and the need for internal auditing grew substantially due to for instance the existence of Committee of Sponsoring Organizations of the Treadway Commission (COSO, 1992) and the requirement of the NYSE. Overall, the listing rules in the U.S. have been more encouraging concerning the application of internal control, even though the implementation of an internal audit function was not required during the years of 1997 and 2001. Hence, companies cross-listed at the U.S. stock exchange may have a greater tendency to enhance their internal control system even prior to SOX. The cross-listing in the U.S. is measured by a dichotomous variable, i.e. 1 if listed at the NYSE and 0 otherwise.

6. Empirical Results

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6.1. Descriptive Statistics

Table 2 displays the descriptive statistics of the dependent and all relevant independent and control variables are displayed. Supplementing the descriptive statistics in Panel A, the frequencies of IAF among the individual legal regimes are exhibited in Panel B (for frequencies of an IAF among the individual European member states refer to the appendix7). Overall, the sample companies characterize to possess on average 5,000 million EUR of assets, grow by 16 percent annually and have 50 percent of their subsidiaries set up in a foreign country. Moreover, Panel A shows that managerial ownership (MO), ownership concentration (OC) and financial leverage (FL) are on average 0.06, 0.42 and 0.16, respectively. The sample firms originate from countries with a great deviation regarding their attitude towards uncertainty. Denmark represents the lower boundary with a level of 23 with respect to the cultural dimension of uncertainty avoidance, while Greece ranks the highest with 112. Further, the sample consists to 68 percent of manufacturing companies. Approximately one third of the firms have a French-origin, whereas the proportion of firms from Scandinavian-origin or common-law background amounts to 30 and 16 percent, respectively. Only 21 percent of the sample firms pertain to the group of countries with a German-origin.

Regarding the existence of an internal audit department, the Panel B of Table 2 reveals that in 1997 about 43 percent of all companies included in our sample affirmed the existence of a separate internal audit department. In 2001, this number even increased to a total of 60 percent of all researched firms. In order to proof the validity of the amount, the value is set into relation with the findings of KPMG International (2002). KPMG conducted a cross-country study and found that on average 71 percent of the European sample companies had an internal audit department installed. This small deviation to our results seems plausible, as their sample was retrieved from companies of only eight8 European countries, whereas our sample includes firms from 14 European countries.

Generally, the relationship between internal auditing and external auditing is crucial, as their level of dependency may provide explanation for the voluntary use of internal auditing. From the literature we find both, evidence for a complementing relationship (Wallace, 1984) as well as substitution effect for internal and external auditing (Carey et al., 2000). Therefore, we take a closer look at the presence of external auditing in the sample. In a similar manner as internal auditing increase over time, we also find that the reliance on the Big Five increased from 1997 to 2001. In 1997, already 66 percent of the

7

This table was not displayed in the section of descriptive statistics, since its content is not of primary interest for this study. Moreover, when interpreting the content of the table, it should be borne in mind that due to availability issues discussed above the implication of the results are limited. This supports the methodological approach to investigate country groups classified by legal systems in order to have a sufficient amount of data per group available.

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Table 2, Panel A:

Descriptive Statistics of all Relevant Test and Control Variables

N Minimum Maximum Mean S.D. a

Time (1997 or 2001) 340 0.00 1.00 0.51 0.50

Internal Audit Function 313 0.00 1.00 0.51 0.50

Managerial Ownership 288 0.00 0.80 0.06 0.16

Ownership Concentration 286 0.00 1.00 0.42 0.26

Financial Leverage 311 0.00 0.69 0.16 0.13

Company Size (million EUR) 311 0.24 207,410.00 4,994.55 18,084.36

Foreign Operations 306 0.00 1.00 0.50 0.33 Sales Growth 312 -0.27 3.41 0.16 0.28 Receivables 311 0.00 0.65 0.18 0.12 Audit Quality 312 0.00 1.00 0.75 0.43 Industry 313 0.00 1.00 0.68 0.47 Trade 313 0.00 1.00 0.11 0.32 Uncertainty Avoidance 311 23.00 112.00 56.71 23.77 SCAN 313 0.00 1.00 0.30 0.46 FRENCH 313 0.00 1.00 0.33 0.47 COMMON 313 0.00 1.00 0.16 0.36 a Standard Deviation Panel B:

Frequencies of IAF, Audit Quality and Frequencies of IAF among Legal Regimes

Frequencies 1997 (N=154) Frequencies 2001 (N=159) Total 1997 and 2001

Number % Number % Number %

Internal Audit Function

Implemented 66 (43) 95 (60) 161 (51)

Not implemented 88 (57) 64 (40) 152 (49)

Total 154 (100) 159 (100) 313 (100)

Audit Quality Big Five 112 (66) 140 (83) 252 (75)

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sample firms received auditing service provided by one of the prominent multinational auditing firms, while this number grow to 83 percent in 2001.

In order to gain more specific insights into the distribution of internal audit functions among the different legal systems, an additional data set is provided under Panel B. In Panel B of Table 2, the frequencies regarding the existence of an IAF for the respective legal systems are displayed in percent and number. Generally, for three out of the four legal system classifications, i.e. common-law, Scandinavian- and German-origin countries, more than half of the researched firms have installed an internal audit function in form of a separate department. In particular, sample firms from countries with a Scandinavian-origin characterize to rely less on internal auditing per se, as in both years examined on average only 29 percent of all sample firms reported to have an internal audit department. In contrast to the rather low reliance on an IAF for Scandinavian firms, approximately 71 percent of all firms originating from common-law countries committed to internal control in terms of a separated internal audit division.

Moreover, we find common-law based corporations to be less affected by time, since the percentage of internal audit departments remained rather constant over the two years researched. We assume this is due to the fact that already a rather high level of firms used internal auditing in 1997. A study by KPMG International (2002) demonstrated the high reliance on internal auditing in these countries. All Irish respondents as well as 86 percent of the participants in the U.K. stated that their firms have an IAF. Further, the coercive pressure of corporate governance codes such as the Combined Code and Turnbull were mentioned as a direct cause for this (KPMG International, 2002).

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6.2. Correlation Matrix

Table 3 presents the bivariate Pearson’s correlation coefficients among all test and control variables including all data retrieved for 1997 and 2001. The first column of Table 3 reveals the correlation between the dependent variable and all the residual test and control variables. In particular, IAF correlates with a number of test and control variables. With respect to test variables, IAF has a highly significant (p < 0.01) correlation with TIME (0.169), UA (0.179), SCAN (-0.291), FRENCH (0.150) and COMMON (0.172). Furthermore, IAF relates positively to SIZE (0.297), AQ (0.145) and TRADE (0.182) at p < 0.01, which are deployed as test variables. These findings are preliminary indicators for a predictive relationship of the regression analysis. Despite this auspicious outcome for a variety of variables, we fail to present any indicative correlation between the test variables MO, OC and FL and the dependent variable IAF. These findings are, however, seminal for the outcome of the regression analysis. In the next section the results of the multivariate analysis will be displayed, discussed and set into relation with the proposed hypothesis.

6.3. Multivariate Analysis

We applied a binary logistic regression model to explore the estimation power of all test and control variables. By using the Logit regression, we automatically account for the dichotomous nature of the dependent variable. In Table 4, the results of the Logit regression including all test and control variables are displayed, specifically, the data was used from observations embracing both 1997 as well as 2001. To demonstrate the impact of both control and test variables individually, three separate regression models are considered for this initial analysis.

The regression analysis is generally based upon a data set that has been adjusted for outliers. In addition to applying the log function on the data set of firm size, we also identified an outlier for sales growth by utilizing the visualization aid of a box plot graph. It revealed that one Danish company experience a significant growth rate of 341 percent of sales from 2000 to 2001. The company faced a rapid sales growth that was indeed three times higher than the highest value of the residual observations. Due to its relative stance with respect to the rest of the data, the data was emitted from the data set.

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Table 3:

Pearson’s Correlation Coefficient for IAF and all Test and Control Variables

IAF TIME MO OC FL SIZE FO GROW REC AQ IND TRADE UA SCAN FRENCH

TIME 0.169** MO -0.002 -0.022 OC -0.004 0.043 -0.397** FL 0.077 0.098* -0.090 0.056 SIZE 0.297** 0.287** -0.198** 0.099* 0.144** FO 0.022 0.096* 0.025 -0.066 0.045 0.144 ** GROW 0.025 0.054 0.058 0.017 0.010 -0.086 -0.089 REC 0.009 -0.084 0.105* -0.092 -0.112** -0.169 ** 0.099* 0.007 AQ 0.145** 0.182** -0.022 -0.129* 0.099* 0.141 ** 0.100* 0.005 -0.053 IND -0.055 -0.009 0.063 -0.119* -0.064 0.026 0.227** -0.127* 0.066 -0.062 TRADE 0.182** 0.045 -0.078 0.027 0.039 0.329 ** 0.087 -0.048 -0.166** 0.086 -0.102* UA 0.179** 0.116* 0.022 0.197** 0.032 0.174 ** -0.061 -0.014 -0.058 -0.169** -0.023 0.119* SCAN -0.291** -0.073 -0.036 -0.037 0.051 -0.046 0.058 0.108* -0.092 -0.005 0.030 -0.098* -0.532** FRENCH 0.150** 0.118* 0.002 0.185** 0.082 0.162 ** -0.020 0.024 -0.017 -0.041 -0.172** 0.140* 0.617** -0.455** COMMON 0.172** 0.019 -0.038 -0.282** -0.009 -0.167 ** -0.060 -0.074 -0.139** 0.186** 0.053 -0.125* -0.396** -0.280** -0.302 **

**. Correlation is significant at the 0.01 level (one-tailed); *. Correlation is significant at the 0.05 level (one-tailed).

IAF = internal audit function, i.e. the existence of an internal audit department

TIME = data was either retrieved from 1997 or 2001, so that each information is associated to a certain point in time (1997 = 0; 2001 = 1)

MO = managerial ownership, i.e. proportion of shares held by members of the management board, but only for shareholdings of more than 5 percent

OC = ownership concentration, i.e. proportion of shares owned by outside block holders, which we define as shareholdings of non-managers greater than 5 percent FL = financial leverage, i.e. ratio of long-term debt to sum of debt and equity

SIZE = size of firm, i.e. total assets

FO = foreign operations, i.e. ratio of number of foreign subsidiaries to total subsidiaries GROW = sales growth, i.e. proportion of year-to-year sales growth

REC = accounts receivables, i.e. ratio of accounts receivables to total assets

AQ = audit quality, i.e. indicator equal to 1, if firm is externally audited by one of the Big 5 multinational auditing firms or 0 otherwise IND = industry grouping, i.e. indicator equal to 1, if firm is from the manufacturing sector and 0 if firm operates in the service sector TRADE = cross listing of company, i.e. indicator equal to 1, if the firm is listed at the NYSE and 0 otherwise

UA = uncertainty avoidance, i.e. the country of origin is assigned the respective value of Hofstede’s (1980) uncertainty avoidance dimension SCAN = anti-director rights for countries with a Scandinavian-origin, i.e. indicator equal to 1, if from a Scandinavian-origin or 0 otherwise FRENCH = anti-director rights for countries with a French-origin, i.e. indicator equal to 1, if from a French-origin or 0 otherwise

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Table 4:

Logistic Regression Analysis of Voluntary Internal Auditing

Model 1 Model 2 Model 3

B Wald B Wald B Wald

TIME 0.52 4.02** 0.18 0.39 MO 0.17 0.04 1.24 1.68 OC 0.04 0.01 0.35 0.34 FL 1.15 1.15 0.73 0.41 UA 0.01 2.39* 0.02 4.06** SCAN -0.66 2.01 -0.418 0.72 FRENCH 0.04 0.01 -0.10 0.06 COMMON 1.14 4.55** 1.74 8.39*** SIZE 0.67 20.41*** 0.74 16.18*** FO -0.26 0.45 -0.09 0.04 GROW -0.10 0.03 -0.14 0.05 REC 1.59 2.20 1.60 1.58 AQ 0.44 2.35 0.28 0.67 IND -0.18 0.40 -0.26 0.69 TRADE 0.71 2.38 0.73 2.21 Constant -6.26 21.46*** -1.26 2.49 -8.46 20.10*** -2 Log Likelihood 382.95 349.98 313.62

Model Chi Square 36.93*** 35.99*** 62.73***

Pseudo R2 a 0.153 0.162 0.275

Sample Size (N) 303 279 272

*

, **, *** indicate significance level at p<0.1, p<0.05, p<0.01, respectively

a

Pseudo RCS2 – Nagelkerke R Square

Logically, the intention is to evaluate the predicting force of test variables for the magnitude of the dependent variable instead of having the control variable substantially account for the use of an IAF. Similar to -2LL, the Pseudo R Square (i.e. Nagelkerke R Square) measuring the strength of association reveals to be relatively low, when only control variables are taken into consideration. Concerning the individual control variables, only SIZE was found to have a significant and positive influence on IAF in the first model (B = 0.67, p < 0.01).

The Voluntary Implementation of an Internal Audit Function: