ROLE OF INTERNAL AUDIT FUNCTION, EXTERNAL AUDIT FUNCTIONS AND FINANCIAL REPORTING QUALITY

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By CPA Sahado Steve

The significance of accurate financial reporting in today’s corporate contexts cannot be over-emphasized. This is the foundation of open and responsible corporate governance aimed at giving crucial information to stakeholders for decision-making.

 However, there is mounting anxiety that the quality of financial reports may have serious consequences for the internal audit function and the board’s supervision role inside the organization especially if such a report is full of errors that can legally put internal auditors and management into problems. 

In recent years, here in Kenya, there have been numerous scandals and embezzlements (Auditor General Report 2022) of public funds by accounting officers entrusted with the responsibility of protecting public funds. Public Finance Management Act (PFM Act, 2012), spells out the roles and responsibilities of accounting officers which requires them to be accountable at all times and ensure that the resources are well protected from misappropriation. In the same breath for example in some African countries like South Africa, Transport Network and Electricity Generation was involved in scandals that auditors did not detect even though internal audit departments exists. This has made the company fail to make all the necessary disclosures as required by IAS No.1.  

The effectiveness of the internal audit and the audit committee oversight role would have helped the Agencies to detect frauds and errors at the earliest time possible before the financial report was shared with the shareholders or the general public. This then begs the question, is Internal audit independent? 

Across the globe there are well crafted regulations and procedures which if implemented would help entities detect frauds and errors at the earliest time possible. Therefore, the nexus between the role of audit committee and internal audit function must be enhanced to ensure the quality of financial reports is above board and meet all the requirements of IFRS, IPSAS, and PFM Act 2012. Management of corporate institutions will be required to account for their omissions and misappropriation of funds e.g. ESKON (Neef, 2005). These scandals have taken place despite the fact that some of their internal audit functions and audit committees exist.

Islam et al. (2023) opined that following the corporate scandals and the recent financial statement distortions witnessed in various companies around the globe, the significance of internal monitoring mechanisms has been increasing among various government agencies and other professions to improve the quality of financial reporting. Financial reporting involves the preparation of the books of accounts in accordance with the laid down procedures, processes and regulations as directed by various Acts of parliament and other conventional rules. As reported in the case of Enron and Parmalat, failure to implement appropriate strong monitoring and evaluation procedures inside the company’s governance framework exposed it to abuse of power and fraudulent activities. It is almost simple and true for a similar situation to happen to any parastatal in Kenya and other parts of the world if appropriate measures are not undertaken to detect frauds and other wrongdoings in the entity by either the board members or by the internal audit which should be independent of the preparation of financial statements. Importance of observing code of conducts by auditors and the financial report preparers helps in mitigating adverse effects of presenting a financial report that ignores the requirements of an effective corporate governance requirements. The full disclosures and adherence to the various International Accounting Standards is an indication that Accountants observe codes of conducts and they are technically competent to handle any financial management aspects. The fall of various international entities such as Enron in the USA, Parmalat amongst others have given the external auditors and the internal audit function a new lease of life to be strictly evaluating internal control mechanism that have been either neglected or not implemented as required by various regulations and laws that govern entities.  In Kenya the significance of the internal audit has been enshrined in various legal frameworks and it has been provided for in the Public Finance Management Act (PFMA 2012, p.89), Public Finance Management Regulations 2015 (PFMR p.86), and other circulars which are all in agreement with Constitution of Kenya 2010 that support the spirit of good corporate governance.  

As pointed out by YR & Apandi (2012), government parastatals must regularly publish their financial reports in order to be accountable to all stakeholders for all the funds they manage. The requirement for transparency and accountability encourages management to produce high-quality financial reports that are free of errors and material misstatements that would give rise to a qualified audit opinion. (Chambers & Odar, 2015). Evidence as suggested by Saleh et al., (2007) have shown that, having a totally independent audit committee minimizes earnings management practices. Businesses with more experienced audit committee members and more audit committee meetings were also found to have less earnings management practices than other businesses. (Chambers & Odar, 2015). 

Internal audit function is accepted to be practiced across the globe as one of the strategic firm’s corporate governance structure that all public institutions need to institute as one of the requirements to enhance accountability and transparency. This is a commitment to the rule of law and values that will enhance corporate governance structure in an entity. Internal audit competency and implementation of strong internal controls within the internal audit function will help external auditors to be able to rely on the financial report that passed quality assurance tests. (Bame-Aldred, et al, 2013).   The growing number of litigations filed against internal auditors and audit firms have become a wake-up call for the entire accounting and auditing profession.

Lennox and Li (2014) compiled a list of 830 lawsuits against auditors during 2001-2010 as a result of the misstatement of the client’s financial reports which did not meet the quality assurance.  Litigation will be two folds if the management can also be sued and if the regulations and governing laws are out rightly discarded by the management. In the recent past, there are several scandals that have taken place under the watch of internal auditors. e.g. Toshiba reported a huge profit of over USD 1.8 billion and Silver Bird Berhad overstated its invoices by over RM 64.7 million. In all these frauds, internal auditors were accused of not detecting improprieties that have tainted the picture of the companies involved. Stakeholders have indeed been forced to carefully monitor and scrutinize the operations of the companies as stipulated by Ibrahim et al, (2020). In its assurance role, Internal Audit improves governance through a variety of activities such as (but not limited to) promoting an ethical tone at the top, preventing and detecting fraud, improving internal controls over financial reporting, and assisting firms in managing risk and avoiding potential fraud that will result in financial losses to the Agent. Auditors must be aware of the responsibility they bear at all times when it comes to the quality of financial reports. ASA (240 para.10) specifies the types of fraud and errors that auditors deal with, such as: intentional misstatements resulting from misappropriation of financial statement assets and misstatement resulting from fraudulent financial reports. In the normal operations of the internal audit functions, it is therefore important that audit managers always conduct due diligence to ensure that the financial reports presented are free from these errors and possible misstatements of facts. 

 It is also true that the skills and the competence of the internal audit committee matters as far as the preparations of the financial statements are concerned.  In fact, it is very important that every public entity provide as much information as possible Hassan (2014), as this will attract interested parties in such entities to make the right decisions as far as investment is concerned. Donors who would want to supplement government efforts through the provision of additional revenues would want to see financial reports that disclose every aspect of the prudent management of the finances that have been allocated to the ministry or government departments. One of the most effective ways to represent a company’s success and shareholder value is through financial reporting quality. (Karajeh & Ibrahim 2017)

References

Charles W. Bame-Aldred, Duane M. Brandon, William F. Messier, Larry E. Rittenberg, Chad M. Stefaniak; A Summary of Research on External Auditor Reliance on the Internal Audit Function. AUDITING: A Journal of Practice & Theory 1 May 2013; 32 (Supplement 1): 251–286. https://doi.org/10.2308/ajpt-50342

Chambers, A. D., & Odar, M. (2015). A new vision for internal audit. Managerial Auditing Journal, 30(1), 34-55. https://doi.org/10.1108/MAJ-08-2014-1073

Garba Ibrahim, Noorhayati Mansor, Ali Umar Ahmad (2020); Mediating Effect Of Internal Audit Committee On The Relationship Between Firms Financial Audits And Real Earnings Management; International Journal Of Scientific & Technology Research Volume 9, Issue 04, 

Hassan, M. K. (2014). Risk narrative disclosure strategies to enhance organizational legitimacy: Evidence from UAE financial institutions. International Journal of Disclosure and Governance, 11(1), 1-17.

Karajeh, A. I. & Ibrahim, M. Y. B. (2017). Impact of Audit Committee on the Association Between Financial Reporting Quality and Shareholder Valu . International Journal of Economics and Financial Issues, 7 (3), 14-19 . Retrieved from https://dergipark.org.tr/en/pub/ijefi/issue/32021/354185

International Accounting Standards No. 1

Lennox, C., & Li, B. (2014). Accounting misstatements following lawsuits against auditors. Journal of Accounting and Economics, 57(1), 58-75.

Neef, D. (2005). Managing corporate risk through better knowledge management. The Learning Organization, 12(2), 112-124.

Norman Mohd Saleh, Takiah Mohd Iskandar, Mohd Mohid Rahmat (2007), Audit committee characteristics and earnings management: Evidence from Malaysia

Norman Mohd Saleh, Takiah Mohd Iskandar, Mohd Mohid Rahmat (2007) Asian Review of Accounting, Emerald Group Publishing Limited volume 15, page 147-163

Public Finance Management Act (PFM Act, 2012)

YR, R. D., & Apandi, R. N. N. (2012). Gejala Fraud dan Peran Auditor Internal Dalam Pendeteksian Fraud Di Lingkungan Perguruan Tinggi (Studi Kualitatif). Prosiding Simposium Nasional Akuntansi, 15, 1–28.

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