The Effect of the Internal Audit and Firm Performance: A Proposed Research Framework

International Review of Management and Marketing
Vol. 4, No. 1, 2014, pp.34-41
ISSN: 2146-4405
www.econjournals.com
34
The Effect of the Internal Audit and Firm Performance:
A Proposed Research Framework
Ebrahim Mohammed Al-Matari
Faculty of Business and Economics, Ammran University,
Yemen and Faculty of Accountancy, Universiti Utara Malaysia,
Malaysia. Email: [e-mail]
Abdullah Kaid Al-Swidi
Othman Yeop Abdullah Graduate School of Business,
University Utara Malaysia, Sintok, Malaysia.
Email: [e-mail]
Faudziah Hanim Binti Fadzil
Othman Yeop Abdullah Graduate School of Business,
University Utara Malaysia, Sintok, Malaysia.
Email: [e-mail]
ABSTRACT: This study attempts to propose a structure of the relationships between the internal
audits characteristics (IAC); such as professional qualifications of the chief audit executive of the
Internal Audit (IA), size, experience, and qualification; and firm performance. The presence of an
internal audit department is significant as it is considered as the main element in employing
accounting systems and this, in turn, assists in evaluating the department’s work. The internal audit is
deemed as the core of business accounting as it is the section that keeps track of all businesses
associated with the sector. The internal audit efficiency assists in developing the company’s work
because the financial reports present the internal audit department’s quality. In addition, an internal
audit is a crucial part of corporate governance structure in an organization and corporate governance
(CG) covers the activities of oversight conducted by the board of directors and audit committees to
ensure credible financial reporting process (Public Oversight Board, 1994). Consistent with previous
studies of the importance of internal audit, this study provides comprehensive oversights on the
relationship between internal audit and firm performance. The past literature reveals there is a paucity
of studies exploring the association between internal audit characteristics (IAC) and firm performance
whether conceptual or empirical. The main objective of this study is to fill up the gap in the literature
and provide an opportunity for future research to deeply to investigate this relationship.
Keywords: Internal Audit Characteristics (IAC); Agency Theory (AT); Resource Dependence Theory
(RDT); Firm Performance (FP).
JEL Classifications: M40; M41; M42
1. Introduction
The internal audit department is very important inside a firm that the internal audit is regarded
as the key element in the application of accounting systems which in turn, helps in evaluating the work
of the department. The internal audit is considered as the backbone of the business accounting as it is
the section that records all businesses related to the sector. The efficiency of internal audit helps
develop the work of the company because the financial reports reflect the internal audit department’s
quality. Moreover, an internal audit is a significant part of the CG structure in an organization and CG
encompasses oversight activities taken by the board of directors and audit committees to make sure
that the financial reporting process is credible (Public Oversight Board, 1994). Three monitoring
mechanisms have been highlighted in the CG literature, namely, external auditing, internal auditing

The Effect of the Internal Audit and Firm Performance: A proposed Research Framework
35
and directorship (Al Matarneh, 2011; Anderson et al. 1993; Blue Ribbon Committee, 1999; IIA,
2003).
The financial and corporate strategy of a company is underpinned by effective internal
systems in which the internal audit has an important role in raising the reliability of the internal control
system, improving the process of risk management and above all, satisfying the needs of internal
users. The internal audit support enhances the system of responsibility that the executive directors and
employees have towards the owners and other stakeholders (Eighme & Cashell, 2002). Taken
together, the internal audit department provides a reliable, objective, and neutral service to the
management, board of directors, and audit committee, while stakeholders are interested in return on
investments, sustainable growth, strong leadership, and reliable reporting on the financial performance
and business practices of a company (Ljubisavljević & Jovanovi, 2011).
2. Internal Audit function
Internal audit makes a large contribution to the achievement of company goals, and the
implementation of strategies for their achievement (Ljubisavljević & Jovanovi, 2011). In addition, the
internal audit function is responsible for reinforcing management and audit committee (Hutchinson &
Zain, 2009).
Likewise, internal audit determines the reliability, reality, and integrity of financial and
operational information that comes from different organizational units, on which appropriate business
decisions at all levels of management are based. Successful implementation of internal audit tasks
means that it must be independent, i.e., company management should in no way influenced by its
work, information, conclusions, and evaluations. In this way the internal audit report becomes a means
of communication between internal audit and management, and an important guideline for the
successful management of the company (Ljubisavljević & Jovanovi, 2011).
Furthermore, the internal audit function facilitates the operation and effective working of the
audit committee as the audit function goals are consistent with the former’s financial reporting
oversight responsibilities (Goodwin and Yeo, 2001; Goodwin, 2003; Scarbrough, Rama &
Raghunandan, 1998). The creation of an internal audit function is supported by the governance reports
(NYSE, 2002) and previous studies (Collier & Gregory 1996; Goodwin & Kent, 2003) as a
mechanism to enhance internal governance processes.
Along this line of argument, Al-Shammari (2010) mentioned many factors of internal audit
functions and they are provided below:
1. The internal control systems and arithmetic evaluations in an attempt to; ensure that the
accounting system and internal controls systems are appropriate, ensure that the systems are
suitable for the facility and propos system enhancements.
2. Assessing plans and procedures to determine weaknesses or defects in the systems and
procedures used by the company and to propose modifications and enhancements needed, and
to provide authority to the internal auditor for the examination of the aspects of establishment
activity.
3. Taking into consideration the staff commitment to the company policies and procedures and
therefore, internal auditor has to monitor these policies and procedures’ implementation and to
clarify them to the employees.
4. Safeguarding established funds as the development and implementation of systems is an
attempt to make sure that the facility safeguards assets and funds against manipulation and
fraud, to detect fraud and minimize losses stemming from neglect/abuse (e.g. loss of proper
storage).
IAC in this study comprises four factors namely, qualifications of the chief audit executive, size,
qualification and experience of the audit department. Generally, the previous study dedicated to
examining the relationship between internal audit and firm performance is so limited in both
developed countries and developing countries. Several studies have called for further studies to
conduct extensive investigations; for instance, Hutchinson and Zain (2009), explored the association
between internal (audit experience and accounting qualification) audit and firm performance (ROA)
with growth opportunities and audit committee independence in the context of Malaysia. Their study
has two future recommendations. First, future studies should examine the role of the board and the
interaction between internal audit quality and audit committee independence. Secondly, this study

International Review of Management and Marketing, Vol. 4, No.1, 2014, pp.34-41
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encourages future studies to look into alternate models of factors that would possibly impact IAQ and
improve corporate governance.
There are some studies that have concentrated on problems concerning internal auditing in
developed countries including the U.S. and the U.K. but little evidence is found in emerging markets.
Hutchinson and Zain’s (2009) study involved the examination of the relationship between internal
(audit experience and accounting qualification) audit and firm performance (ROA) with growth
opportunities and audit committee independence in Malaysia. They recommended future research to
consider different factor models that may impact quality of internal audit and improve corporate
governance. From this recommendation, the current study focuses on investigating the association
between internal audit function and performance of firm both accounting measurement and market
measurement while taking some new variables such as qualification of the chairman of internal audit,
the internal audit size, experience of internal audit and internal audit qualification and consider
moderators such as audit quality between internal audit and firm performance. More importantly, there
is a lack of research in both developed and emerging nations concerning the direct relationship
between internal audits functions with performance of firm. In addition to that, Al-Matari et al. (2012)
investigated the relationship between board characteristics and firm performance in Kuwait. They
recommended that future researchers examine the association between internal audit and firm
performance whether directly or through a moderator. Moreover, the qualification of chairman of the
internal audit is a new variable added by the present study.
In a related study, Davidson, Goodwin-Stewart and Kent (2005) investigated the relationship
between internal governance structure comprising of board of directors, audit committee, internal audit
function and the selection of external auditors, and earnings management in Australia. They used
broad cross-sectional regression to test the association between independent variables and dependent
variable. The sample comprised of 434 firms which were listed on the Australian stock exchange
during 2000. The outcome disclosed no significant relation between the internal audit function and the
choice of external auditors. In the same context, Ljubisavljević and Jovanovi (2011) studied the
relationship between the roles of internal audit in Serbian firms. The sample comprised of 200 small
and medium firms during 2011. This study used questionnaire survey and found that the effectiveness
of the internal audit entity is weak.
Consistent with the above is Hutchinson and Zain (2009) who aimed to explore the relationship
between internal audit quality (audit experience and accounting qualification) and firm performance
(ROA) in Malaysia. The data were collected by a mail questionnaire among public listed companies in
Malaysia during the period 2003. The results showed a strong relationship between internal audit
quality and firm performance with opportunities of high growth and that this positive link is decreased
by the increasing independence of audit committee. This study preferred an independent audit
committee.
3. Internal Audit Characteristics and Firm Performance
3.1 Qualifications of the Chief Audit Executive and Firm Performance
In today’s dynamic business environment, it is imperative that internal auditors are qualified
as they should be thorough in their knowledge of business, systems, developments and other business
topics. They should be able to decipher what works and what doesn’t, the strengths, weaknesses of
standards, code systems and procedures (Hala, 2003; Clikeman, 2003). In addition, the high quality
profession of a chief audit executive is to improve the quality of audit and hence, the current study
measured this variable through the questionnaire.
The head of internal audit qualified with auditing certification such as the Certified Internal
Auditor (CIA), Certified Government Auditing Professional (CGAP), Certified Financial Services
Auditor (CFSA), Certification in Control Self-Assessment (CCSA), and Certification in Risk
Management Assurance (CRMA) where useful feedback for any mistake is provided. A certified
auditor is able to make a good decision in the fastest time without having to wait or to consult with
another team. The current study expects the qualification of a chief audit executive to absolutely
enhance performance (Eighme & Cashell, 2002).
Firms that have undergone a period of strong performance may be in a more appropriate
position to employ external directors. The prestige that an external director holds stems from various
sources such as the director’s title and the job position (D’Aveni, 1990). Moreover, those with higher