The Effects of The Internal Audit Function on Real and Accrual Earnings Management during the Global Financial Crisis in the US Market

Abstract

Drawing on the agency theory and positive accounting theory, the primary objective of this thesis is to investigate whether the internal audit function (IAF) mitigates accrual (AEM) and real earnings management (REM) in the US market. In addition, it investigates the role of the IAF in constraining AEM and REM activities during the global financial crisis. Finally, it investigates whether the characteristics of the CFO have an impact on the relationship between the IAF and AEM and REM. The sample used in this study comprises 789 firm-year observations over the period from 2005 to 2015. A quantitative methodology has been employed in this research to conduct the analysis. In particular, the thesis utilises OLS regression to conduct its multivariate analysis and models such as the Kothari model, modified Jones model and the accrual error estimation model are used to measure AEM. In order to obtain a measure for REM, the thesis uses three well known models developed by Roychowdhury (2006). Quantitative results indicate that the IAF plays a significant role in mitigating AEM. In contrast, REM is a characteristic of firms with a high quality IAF; an indicator that these firms shift to more REM when they are constrained from using AEM by the IAF and therefore REM seems to be the unintended cost of having a high quality IAF. Furthermore, the results show that CFO characteristics affect the relationship between the IAF and EM. Moreover, the results showed that firms engaged in REM suffered a low future performance which indicates the adverse effects of REM activities. Furthermore, the findings of the thesis have important implications for regulators who it is argued may be focusing to a greater extent on AEM while being neglectful of the issues linked to REM. The time has come to call for more regulations constraining the use of REM given its cost and impact not only in the short-run, but longer term also. Finally, the inclusion of other EM methods and other motivations and factors such as CFO characteristics and financial crises could prove useful to other researchers in the subject of EM. In summary, the results of this thesis are robust across different statistical mechanic and alternative measurements. Consequently, this means they have important ramifications for the IIA and regulators and policy makers in general as well as to the US market specifically.