THE ROLE OF INTERNAL AUDIT QUALITY IN MITIGATING EARNINGS MANAGEMENT

Abstract

The attributes that enhance the effectiveness of the internal audit function in mitigating earnings management still remains as a topic of ongoing debate. This study aims to examine this phenomenon within the context of a developing country, where the risk of earnings management is notably higher. The data window consists of 30 banks and diversified financial companies listed on the Colombo Stock Exchange from 2018 to 2021. Panel data analysis with fixed effects is employed to examine the impact of internal audit function attributes on earnings management. The findings reveal that larger, more independent, and financially knowledgeable internal audit functions significantly reduce the tendency of management to engage in earnings management. Conversely, the frequency of internal audit meetings alone does not significantly impact earnings management, which implies that the quality and substance of audit activities are more important than mere frequency. Therefore, it is concluded that an internal audit function characterized by greater staff size with their higher independence and financial expertise is crucial in reducing earnings management in banks and diversified financial companies. These findings have significant theoretical and practical implications. Theoretically, the findings extend the understanding of agency theory, stakeholder theory, the resource-based view, and institutional theory by providing evidence that supports their theoretical predictions. Practically, they offer clear guidance for regulators, corporate governance practitioners, company management in establishing frameworks and policies for internal audit function, which, in turn, promote ethical financial practices and strong corporate governance, supporting the achievement of the Sustainable Development Goals.