Internal Audit Function and Preliminary Earnings Quality

As one of the fundamental elements of corporate governance, an internal audit function (IAF) can improve the quality of the preliminary earnings by performing a monitoring role that supports the work of the audit (committee) and internal audit practices on a year-round basis. Thus, we posit that if a firm voluntarily establishes an IAF or employs a high-quality IAF, the firm’s preliminary earnings would have high quality and thus be less revised. Then, the difference between preliminary earnings and reported earnings would be reduced. The results are as follows. The difference becomes smaller when a firm has an IAF, when an IAF is exclusively dedicated to internal audit work, and as the head and members of an IAF have more work experience. These results, however, are observed only in the subsample where earnings are overstated. The result suggests that an IAF effectively control the opportunistic behavior of managers who are likely to overestimate earnings, thereby improving the quality of preliminary earnings. This study is the first study that uses disclosure data on IAFs, being reported from 2018. The results of this study suggest that both the existence of IAFs and how IAFs are operated are important determinants of preliminary earnings’ quality. The results also provide important implication that regulators should enforce non-financial firms to install IAFs.