Internal auditing practices and internal control system

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MIA - MAREF Outstanding Research Paper Award 2005

3rd

Prize Winner

Author: Assoc Prof Dr. Faudziah Hanim Hj. Fadzil

Contact: [email protected]

Co-researcher(s):

1. Assoc Prof Dr. Hasnah Haron

2. Prof Dr. Muhamad Bin Jantan

Note: This article will be published in Managerial Auditing Journal (MAJ) Vol 20 Issue 8

October(2005). Only the abstract and some excerpts can be used for any other publication.

INTERNAL AUDITING PRACTICES AND INTERNAL CONTROL SYSTEM IN

MALAYSIAN LISTED COMPANY

ABSTRACT

Using data from 250 auditing practitioners from Kuala Lumpur Stock Exchange

(currently known as Bursa Malaysia) - listed companies, this study suggests that

independence, scope of audit work, audit reporting, audit programs, management of

internal audit department, performance of audit work, audit reviews, objectivity and

professional proficiency are important internal auditing practices from the perception of

internal auditors. This study also suggests that risk assessment, control activities, control

environment, information and communication and monitoring are important quality of

internal control system from the perception of audit committee.

This study also set out to examine the influence of internal auditing practices on the

quality of internal control system. Management of internal audit department, professional

proficiency, objectivity and audit review of the internal auditing practices were shown to

be statistically influence the monitoring aspect of internal control system. Scope of audit

work and performance of audit work influence the information and communication

aspect of internal control system. Performance of audit work, professional proficiency

and objectivity statistically influence the control environment. Management of internal

audit department, performance of audit work, audit program and audit reporting

statistically influence the risk assessment of the internal control system while

performance of audit work and audit reporting statistically influence the control activities.

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INTRODUCTION

Internal auditing has undergone dramatic changes that have expanded its scope in a way

that allows it to make greater contributions to the organization it serves. Internal auditing

is also performed in diverse legal and cultural environments; within organizations that

vary in purpose, size, and structure; and also by persons within or outside the

organization. Furthermore, the internal auditing profession also walks a tightrope

between serving as a management consultant and an independent professional. A survey

done by the Malaysian Institute of Corporate Governance (MICG), The Institute of

Internal Auditors Malaysia (IIAM) and Ernst & Young concluded that internal auditors

are best placed to understand and appreciate the business processes of a company and

they act as management consultant to reduce risks. Internal auditors also help run a

company more efficiently and effectively to increase shareholders’ value.

As this is the case, internal auditors need to be out in front, leading the business

units with regards to the internal control system and also focusing on strategic business

objectives. The internal auditors also need to establish themselves as vital cogs in their

organizations, rather than as observers who watch from the periphery and wait for events

to impact them (Sawyer & Vinten, 1996).

One issue that has emerged related to the internal auditing practices is; “what is a

proper and sound measurement of the internal auditing practices?” Barrett (1986) notes,

“effectiveness (of internal audit) can be described, but it is difficult to quantify and in the

final analysis, effectiveness is determined by the perception of auditees.” In the company

environment, management is the most important auditee of the internal audit department

since effectiveness of the internal auditing practices can be described through the

expectations of management with regard to the internal auditing practices. The

management will expect the internal auditors to perform their internal auditing practices

to a certain level that is complying with the SPPIA {now known as the Professional

Practice Framework (PPF)}, since it can be easily described. Compliance with SPPIA is

therefore an indication of the effectiveness of the Internal Audi Department.

The auditing profession, both internal and external, has come under increasing

scrutiny since the highly publicised collapse of energy trader, Enron (Vinten, 2003) in the

USA last year. The uncovering of alleged irregularities at Technology Resources

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Industries Berhad (TRI) has highlighted the need for greater corporate governance in

Malaysia.

TRI had issued false invoices between 1998 and 1999, which amounts to

MYR260 million (USD 68 million). According to Dato’ Samad Alias, the President of

the Malaysian Institute of Accountants, “This could be the largest accounting fraud in

Malaysian history”. The false invoices were discovered by Telekom Malaysia, who took

control of the TRI in June 2002, after conducting several internal audits, when Arthur

Andersen was TRI’s auditor. “We had to rely on the information prepared by the

company’s accountants, “said Dato’ Abdul Samad, who was then head of the Andersen’s

Malaysian office. If TRI was to restate 1998 and 1999 accounts, its net book value will

reduce as much as MYR 198 million (Financial Times, September 13, 2002). The case

has certainly shed a light on the importance of the role of internal auditors, which was

only recognised and emphasised after irregularities were discovered.

Internal auditors are often described as both a business partner and a policeman

because of his work as a business partner with client management and also because he

acts as an independent reviewer of management. As a business partner, the internal

auditor is expected to provide expertise to assist an organization in meeting its objectives

while as a policeman; an internal auditor is often thought of as an adversary looking for

flaws. As such, the extent of the internal auditing practices plays an important factor on

these roles. This study will provide empirical evidence whether compliance with internal

auditing practices will lead to a better internal control system.

The Development of SPPIA

SPPIA are the criteria by which the operations of an internal auditing department

are evaluated and measured and intended to represent the internal auditing practices, as it

should be. It is also meant to serve the entire profession of internal auditing, in all types

of organisations where internal auditors are found. It was first developed in June 1978, at

the Internal Auditors International Conference in San Francisco. The SPPIA comprise of

five general standards of: (1) independence, (2) professional proficiency, (3) scope of

work, (4) performance of audit work and (5) management of the internal audit

department. This framework allowed the future expansion of the internal auditing

practices until the new framework was released in January 2002.

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A new framework, called Professional Practices Framework (PPF) was released

in January 20021 and it consisted of three sets of standards: Attribute, Performance, and

Implementation Standards. The Attribute Standards address the attributes of organisations

and individuals performing internal audit services while the Performance Standards

describe the nature of internal audit services and provide quality criteria against which

performance of these services can be measured. The Implementation Standards on the

other hand provide guidance applicable in specific types of engagements. However, this

new framework is not utilised in this study because of the timing of its release.

Internal Control System

The internal control system plays an important role in the internal auditing

practices since the internal auditors might be considered as being specialists in

management control (Chambers, Selim & Vinten, 1987). Internal auditing practices

appraise the effectiveness of internal control systems, which is a definition of internal

auditing and which also includes an appraisal of the actions by management to correct

situations, which are at variance with planned outcomes. The definition of internal

control systems reveals that it is not fundamentally different from management control,

which has an essential component of control such as planning, organising, staffing and

directing (Chambers et al., 1987). Senior management and the audit committee normally

expect that the CAE will perform sufficient audit work and gather other available

information during the year so as to form a judgement about the adequacy and

effectiveness of the control processes. The CAE should then communicate that overall

judgement about the organisation’s system of controls to the senior management and the

audit committee. This is necessary since internal auditors play an intermediary role and

assist in the discharge of the oversight function of audit committee. If the above internal

audit function is not available, the management needs to apply other monitoring

processes in order to assure itself and the board that the system of internal control system

is functioning as intended. In these circumstances, the board of the company will need to

assess whether such processes provide sufficient and objective assurance or regular

review and appraisal of the adequacy and the integrity of the internal control systems in

the company.

1 Please refer to http://www.theiia.org/iia for detail explanation of PPF (2002).

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Bursa Listing Requirements has established industry taskforce which formulated

the “Statement on Internal Control: Guidance For Directors of Public Listed Companies”

to fulfil the above circumstances. The aim of this guidance is to assist listed companies in

making disclosures in their annual reports on the state of internal control, in compliance

with the Listing Requirements of the KLSE. Pursuant to the requirements of the Code in

relation to the Internal Audit Function, in May 2001, the Securities Commission

appointed the Institute of Internal Auditors Malaysia to establish a separate industry

taskforce to formulate these Guidelines to assist the board of public listed companies in

effectively discharging their responsibilities in relation to establishing an Internal Audit

Function. Risk assessment, control environment, control activities, information and

communication and monitoring are five important characteristics in this guideline.

The Roles of Internal Auditors

In the revised Statement of responsibilities of Internal Auditing issued by the

Institute of Internal Auditors (1990) as part of the Standards framework, the section on

objectives states:

“The objective of internal auditing is to assist all members of management in the

effective discharge of their responsibilities by furnishing them with analyses, appraisals,

recommendations and pertinent comments concerning the activities reviewed. The

internal auditor is concerned with any phase of business activity where he can be of

service to management. This involves going beyond accounting and financial records to

obtain a full understanding of the operations under review” (p. 3).

Sawyer and Vinten (1996) noted four benefits managers have gained from

internal auditing assistance. These benefits were providing managers with the bases for

judgement and action, helping managers by reporting weaknesses in control and

performance and in recommending improvements, providing counsel to managers and

boards of directors on the solutions of business problems, and supplying information that

is timely, reliable and useful to all levels of management.

Additionally, the Statement sets forth the types of services that should be

performed and the kinds of activities carried on by the internal audit function in attaining

the overall objective. Internal auditors should first review and appraise the soundness and

adequacy of the accounting, financial, and other operating controls, and promote effective

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controls at reasonable cost. Secondly, the internal auditors should ascertain the extent of

compliance with established policies, plans, procedures, laws and regulations, which

could have a significant impact on the company’s’ operations. Then the internal auditors

review the means of safeguarding assets and when appropriate, verify the existence of

such assets and appraise the economy and efficiency with which resources are employed.

Lastly, the internal auditors review operations or programs to ascertain whether results

are consistent with established objectives and goals and whether the operations or

programs are being carried out as planned.

Reviewing and evaluating the adequacy and effectiveness of an organisation’s

internal control system and the quality of performance in carrying out assigned

responsibilities is representative of several primary core activities of internal audit work.

The purpose of the review of the adequacy of the internal auditing is to ascertain whether

the established system provides reasonable assurance that the organisation’s objectives

and goals will be met efficiently and economically.

Adequate control is considered to be present if administrative management has

planned and organised in a manner, which provides reasonable assurance that the

organisation’s objectives and goals will be achieved efficiently and economically.

Reasonable assurance is provided when cost-effective actions are taken to restrict

deviations, such as improper or illegal acts, to a tolerable level.

The role of internal auditing in the review of effectiveness of the system of

internal control is to ascertain whether the system is functioning as intended. Effective

control is present when the administrative management directs the system in such as way

as to provide reasonable assurance that the organisation’s objectives and goals will be

achieved. The purpose of the review for quality of performance is to ascertain whether

the organisation’s objectives and goals have been achieved.

The primary objectives of an organisation’s system of internal control are to

provide administrative management with reasonable assurance that financial information

is accurate and reliable; the organisation complies with policies, plans, procedures, laws,

regulations and contracts; assets are safeguarded against loss and theft; resources are used

economically and efficiently; and established objectives and goals for operations or

programs can be met. Internal auditing focuses on an evaluation of this system or

framework of internal control.

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A second type of audit work that internal auditors are guided to perform is

reviewing the accuracy and reliability of financial and operating information and the

means used to identify, measure, classify and report such information. Information

systems provide data for decision-making, control, and compliance with external

requirement. Therefore, internal auditors should examine information systems and

determine whether financial and operating records and reports contain accurate, reliable,

timely, complete and useful information, and controls over record keeping and reporting

are adequate and effective.

The performance of reviews of the systems established to ensure compliance with

policies, plans, procedures, laws, regulations and contracts represents a third element of

audit activity described by the Standards. Administrative management is responsible for

establishing the systems designed to ensure compliance with such requirements as laws,

rules, regulations, policies and procedures. The internal auditor’s role is to determine

whether the systems designed by management are adequate and effective and whether the

activities audited are complying with the appropriate requirements.

Further, as described by the Standards, the internal auditor’s role includes

providing appraisals with recommendations regarding administration management

established objectives and goals for operations and programs.

RESEARCH FRAMEWORK AND METHODOLOGY

The main source of data is annual reports of Malaysian public listed companies.

Data collected from the firm’s report were used to examine the existence of internal audit

in the firms and if any, the functions of the internal auditors. Corporate annual reports

were used because it is seen to be the main form of company communication (Zeghal &

Ahmed, 1990; Unerman, 2000) and also they were widely available (Buhr, 1998; Gray et

al., 1995; Unerman, 2000).

Research Framework

This study focuses on two variables: Internal Auditing Practices and quality of the

internal control system. The theoretical framework is as follows:

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Figure 1: Theoretical Framework

Figure 1 model proposed is based on the postulate in the agency theory where the

principal will incur the agency cost in order for them to observe the agent’s action. The

relationship between principals and agents is that the principals will incur monitoring

expenditures while the agents incur bonding costs to ensure that the work of looking after

the wealth of the principals is done (Adams, 1994). The cost of internal audit is an

example of this bonding cost. Sherer and Kent (1983) perceived internal auditing to be “a

bonding cost borne by the senior manager to satisfy the demands for accountability made

by external participants especially shareholders”. Not internal audit professionals argue

that an effective audit function will correlate with an organisation’s success in meeting

management objectives and whether the internal control system is functioning as

intended.

Research Hypotheses

The research hypotheses will examine the compliance of the internal auditing

practices to the quality of the internal control system. There are 45 sub-hypotheses

relating the internal auditing practices to internal control system.

2 After factor analysis, upon doing factor analysis, 3 more components were added in, and they are: (6) Audit Reviews, (7) Audit Programs and (8) Audit Reporting. The components,

Independence and Objectivity have been split up into two components. This gives a total of nine

components for SPPIA and the study makes use of these nine components in the analysis.

Internal Auditing

Practices2

• Independence &

objectivity

• Professional

proficiency

• Scope of work

• Performance of

audit work

• Management of

internal audit

department

Quality of the

Internal Control

System

• Risk

assessment

• Control

environment

• Control

activities

• Information &

communication

• monitoring

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Hypothesis 1: The better the compliance of internal audit department to the

Standards of Internal Auditing Practices, the higher the

quality of the internal control system.

H1a relates monitoring of the internal control quality with the 9 components of the

internal auditing practices.

H1a1: The better the management of the internal audit department of the internal

auditing practices, the higher the monitoring of the quality of the internal

control system.

H1a2: The greater the scope of work of the internal auditing practices, the higher

the monitoring of the quality of the internal control system.

H1a3: The higher the performance of audit work of the internal auditing practices,

the higher the monitoring of the quality of the internal control system.

H1a4: The higher professional proficiency of the internal auditing practices, the

higher the monitoring of the quality of the internal control system.

H1a5: The higher the independence of the internal auditing practices, the higher the

monitoring of the quality of the internal control system.

H1a6: The higher the objectivity of the internal auditing practices, the higher the


H1a7: The better the audit reviews of the internal auditing practices, the higher the


H1a8: The better the audit programs of the internal auditing practices, the higher


H1a9: The better the audit reporting of the internal auditing practices, the higher


H1b relates information and communication of the internal control quality with the 9

components of the internal auditing practices.

H1b1: The better the management of the internal audit department of the internal

auditing practices, the better the information and communication of the

quality of the internal control system.

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H1b2: The greater the scope of work of the internal auditing practices, the better

the information and communication of the quality of the internal control

system.

H1b3: The better the performance of audit work of the internal auditing practices,

the better the information and communication of the quality of the internal

control system.

H1b4: The higher the professional proficiency of the internal auditing practices, the

better the information and communication of the quality of the internal

control system.

H1b5: The higher the independence of the internal auditing practices, the better the

information and communication of the quality of the internal control

system.

H1b6: The higher the objectivity of the internal auditing practices, the better the


system.

H1b7: The better the audit reviews of the internal auditing practices, the better the


system.

H1b8: The better the audit programs of the internal auditing practices, the better


system.

H1b9: The better the audit reporting of the internal auditing practices, the better


system.

H1c relates control environment of the internal control quality with the 9 components of

the internal auditing practices.

H1c1: The better the management of the internal audit department of the internal

auditing practices, the higher the control environment of the quality of the

internal control system.

H1c2: The greater the scope of work of the internal auditing practices, the higher

the control environment of the quality of the internal control system.

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H1c3: The higher the performance of audit work of the internal auditing practices,

the higher the control environment of the quality of the internal control

system.

H1c4: The higher the professional proficiency of the internal auditing practices,

the higher the control environment of the quality of the internal control

system.

H1c5: The higher the independence of the internal auditing practices, the higher


H1c6: The higher the objectivity of the internal auditing practices, the higher the

control environment of the quality of the internal control system.

H1c7: The better the audit reviews of the internal auditing practices, the higher the

control environment of the quality of the internal control system.

H1c8: The better the audit programs of the internal auditing practices, the higher


H1c9: The better the audit reporting of the internal auditing practices, the higher


H1d relates risk assessment of the internal control quality with the 9 components of the


H1d1: The better the management of the internal audit department of the internal

auditing practices, the higher the risk assessment of the quality of the


H1d2: The greater the scope of work of the internal auditing practices, the higher

the risk assessment of the quality of the internal control system.

H1d3: The higher the performance of audit work of the internal auditing practices,

the higher the risk assessment of the quality of the internal control system.

H1d4: The higher the professional proficiency of the internal auditing practices, the

higher the risk assessment of the quality of the internal control system.

H1d5: The higher the independence of the internal auditing practices, the higher


H1d6: The higher the objectivity of the internal auditing practices, the higher the

risk assessment of the quality of the internal control system.

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H1d7: The better the audit reviews of the internal auditing practices, the higher the

risk assessment of the quality of the internal control system.

H1d8: The better the audit programs of the internal auditing practices, the higher


H1d9: The better the audit reporting of the internal auditing practices, the higher


H1e relates control activities of the internal control quality with the 9 components

of the internal auditing practices.

H1e1: The better the management of the internal audit department of the internal

auditing practices, the higher the control activities of the quality of the


H1e2: The greater the scope of work of the internal auditing practices, the higher

the control activities of the quality of the internal control system.

H1e3: The higher the performance of audit work of the internal auditing practices,

the higher the control activities of the quality of the internal control system.

H1e4: The higher the professional proficiency of the internal auditing practices, the

higher the control activities of the quality of the internal control system.

H1e5: The higher the independence of the internal auditing practices, the higher


H1e6: The higher the objectivity of the internal auditing practices, the higher the

control activities of the quality of the internal control system.

H1e7: The better the audit reviews of the internal auditing practices, the higher the

control activities of the quality of the internal control system.

H1e8: The better the audit programs of the internal auditing practices, the higher


H1e9: The better the audit reporting of the internal auditing practices, the higher


Internal Auditing Practices and the Quality of Internal Control System

Independence and objectivity is seen as an important attribute to the quality of

internal audit function (IIA, 2000; Bethea, 1992; Traver, 1991; Farbo, 1985; Clark et al.,

1981; and Glazer & Janicke, 1980). If internal auditors are not independent and objective,

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they are of little value to those who demand their service (Clark et al., 1981, Elliot &

Willingham, 1980; Ward & Robertson, 1980; Phillips, 1978; Williams, 1978). The

internal audit department must be granted the license to carry out its responsibilities

freely and objectively and also their judgements reached must be unbiased.

Most internal audit professionals argue that an effective internal audit function

unequivocally correlates with an organisation’s success in meeting management

objectives and whether the internal control system is functioning as intended.

Research Design

The basic research design utilised for this study was a survey design. The

collection of primary data was accomplished through the use of a mail survey instrument

(questionnaire). Data collected from the questionnaire is divided into two components: 1)

the measurement of the internal auditing practices was sent to the CAE/Head of Internal

Auditing Department and, 2) questionnaire on the measurement of the quality of internal

control system was sent to the Audit Committee.

Sample and Method of Data Analysis

All the companies (812 companies) listed in the Bursa Malaysia in year 2001

were used as the population in this study. The year of 2001 was chosen due to the

availability of the data and the current status of the data.

This study used both descriptive and inferential analyses. Descriptive analysis is

used to determine if Bursa Malaysia listed companies comply with the standards in their

internal audit practices while the inferential analyses (multiple regression analyses) were

used to test the hypotheses. The variables have met the assumptions of multiple

regression analysis.

Factor analysis was run on the internal auditing practices variable and the internal

control system. As a result, the internal auditing practices variables have been broken up

into 9 components instead of the present 5. Please refer to footnote 2. The components of

the internal controls system remains the same.

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ANALYSIS AND FINDINGS

Table 1 shows information on sampling and return rates of the questionnaires sent

to the internal auditors and the audit committees of the Bursa Malaysia listed companies.

Of the 812 questionnaires mailed, 654 subjects were contacted but only 250 responses

from both internal auditors and audit committees were received resulting in a response

rate of 38.23%.

Table 1: Summary of Response Rates

Questionnaires mailed 812

Undelivered 158

Subjects contacted 654

No. of responses 250

Responses rates (250/654) 38.23%

Certain demographic information was gathered from each subject. While the data

was not collected to address a specific research question, it provides an insight into the

subjects and may assist in interpreting results of the analysis. The demographic variables

are: current position, qualification, professional accounting and/or auditing qualification,

name of external auditors, establishment of the internal audit department and number of

employees of the internal audit department.

Summaries of the demographic data collected from the internal auditors are

shown in Table 2 and the audit committees in Table 3.

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Table 2: Summary of Demographic Data on Respondents from Internal Auditors

Demographic

Characteristics Frequency Percent

Current

Position

Manager of the IAD

Senior Auditor

Others

178

17

55

71.2

6.8

22.0

Qualification

(Excluding

professional)

First degree in

Post graduate

Diploma

Certificate

Others

106

88

22

5

29

42.4

35.2

8.8

2.0

11.6

Professional

Accounting/

Auditing

qualification

Professional

qualifications (CPA

Aust., CACA,

ACCA,

MICPA3, CIMA).

No professional

qualifications

174

76

69.6

30.4

Type of

business of the

company

under KLSE

Listing

Trading

Industrial Products

Consumer Products

Properties

Finance

Construction

Plantation

Technology

Hotels

Mining

Trust

Infrastructure

49

45

40

37

30

20

12

5

4

3

3

2

19.6

18.0

16.0

14.8

12.0

8.0

4.8

2.0

1.6

1.2

1.2

0.8

External

Auditor of the

Company

‘Big 4’ Audit Firms

Others

166

84

66.4

33.6

Existence of

Internal Audit

Department

Existence

Non Existence

231

19

92.4

7.6

Number of

Employees of

the Internal

Audit

Department

5 employees

6-10 employees

> 10 employees

Outsourced

144

54

42

10

57.6

21.6

16.8

4.0

3 MICPA- Malaysian Institute of Certified Public Accountants

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Table 3: Summary of Demographic Data on Respondents from Audit Committees

Demographic

Characteristics Frequency Percent

Current

Position

Qualification

Manager

Director

Audit Committee

Senior

Others

First degree

Post graduate

Diploma

Certificate

Others

88

59

57

6

40

82

34

6

4

124

35.2

23.6

22.8

2.4

16.0

32.8

13.6

2.4

1.6

49.6

Descriptive Analysis

The Extent of Internal Auditing Practices

Table 4 shows the mean results of the extent of the internal auditing practices

items. From the results, independence is a highly rated item of internal auditing practices

from the perspective of the internal auditors with a mean of 4.46 while the least rated

items is professional proficiency with a mean of 3.88.

Table 4: Means Scores of the Extent of the Internal Auditing Practices From the

Internal Auditor’s Perspectives

Rank Item Mean Standard

Deviation

1

2

3

4

5

6

7

8

9

Independence

Scope of Audit Work

Audit Reporting

Audit Programs

Management of IAD

Performance of Audit Work

Audit Reviews

Objectivity

Professional Proficiency

4.46

4.22

4.17

4.12

4.12

4.11

4.11

4.04

3.88

.59

0.49

0.54

0.57

0.53

0.62

0.68

0.60

0.57

The analysis of the results also reveals that, of the 50 internal auditing practices

items, there are 35 items having a score between 4.00 and 5.00 and 15 items between

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3.00 and 4.00. Items having scores ranging from 4.00 and 5.00 are strongly compliant

with SPPIA (2000) and PPF (2002).

The Extent of Existence of the Quality of the Internal Control System

Table 5 shows the means of the components of the internal control system. From

the results, the risk assessment component of internal control system is a highly rated

item with a mean of 4.29 while information and communication is the least rated item

with a mean of 4.12.

Table 5: Mean Scores of the Extent of Existence of the Internal

Control Systems

Rank Item Mean Standard

Deviation

1

2

3

4

5

Risk Assessment

Control Activities

Monitoring

Control Environment

Information & Communication

4.29

4.28

4.15

4.14

4.12

0.51

0.45

0.61

0.59

0.46

An analysis of the results also reveals that, of the 25 items stated, there are 23

items having a score between 4.00 and 5.00. This suggests that the respondents consider

the 23 items identified earlier exist in their internal control systems. This is because items

having scores between 4.00 and 5.00 are perceived to be very important in this study.

Hypotheses Testing

Several methods of analyses were utilised to test these alternative hypotheses. The

analyses used to test the hypotheses include descriptive and statistical analysis. The

hypotheses sought to test for a significance difference of nine variables of internal

auditing practices and five variables of internal control system.

Hypotheses:

Hypothesis 1a: The better the management of the internal audit department of the

internal auditing practices, the greater the scope of work of the internal auditing practices,

the higher the performance of audit work of the internal auditing practices, the higher

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professional proficiency of the internal auditing practices, the higher the independence of

the internal auditing practices, the higher the objectivity of the internal auditing practices,

the better the audit reviews of the internal auditing practices, the better the audit

programs of the internal auditing practices, the better the audit reporting of the internal

auditing practices, the higher the monitoring of the quality of the internal control system.

Table 6 show, the model is significant (F = 2.502) (Sig. F = 0.009). However, the

model only explained 8.6% of the variation in monitoring. Internal auditing practices of

significant influence in their order of impact are management of internal audit department

(Beta = 0.327, p ≤ 0.05) (sig. F = 0.013), professional proficiency (Beta = -0.197, p ≤

0.05) (sig. F = 0.024), objectivity (Beta = -.146, p ≤ 0.01) and audit reviews (Beta = -

0.174, p ≤ 0.05) (sig. F = 0.038). The following Table 6 summarises the results.

Table 6: Results of Hypothesis 1a

R2: 0.086

F: 2.502

Internal Auditing Practices Beta t Sig.

(Constant)

Management of IAD

Scope of audit work

Performance of audit work


Independence

Objectivity

Audit reviews

Audit Programs

Audit Reporting

.327

-.084

.126

-.197

-.009

-.146

-.174

-.020

.131

10.672

2.515

-.866

1.433

-2.264

-.122

-1.765

-2.092

-.223

1.453

.000

.013**

.388

.153

.024**

903

.079*

.038**

.824

.148

Dependent variable: Monitoring

* at 0.01 significant level

** at 0.05 significant level

Thus, there is evidence to support that management of internal audit department

of the internal auditing practices positively influences the monitoring aspect of internal

control system while professional proficiency, objectivity and audit reviews of the

internal auditing practices negatively influence the monitoring aspect of internal control

system. Therefore only Hypothesis 1a1 is accepted while hypotheses 1a2 to 1a9 are rejected.

19

Hypothesis 1b: The better the management of the internal audit department of the







auditing practices, the better the information and communication of the quality of the

internal control system. Table 7 summarises the results.

Table 7: Results of Hypothesis 1b

R2: 0.062

F: 1.752


(Constant)

Management of IAD

Scope of audit work



Independence

Objectivity

Audit reviews

Audit Programs

Audit Reporting

.058

-.212

.207

-.065

.020

.015

-.118

-.026

-.023

16.009

.437

-2.175

2.321

-.738

.251

.184

-1.399

-.296

-.251

.000

.662

.031**

.021**

.461

.802

.854

.163

.768

.802

Dependent variable: Information and communication


Table 7 suggests that the model is significant (F = 1.752) (Sig. F = 0.078, p ≤

0.01). However, the model only explained 6.2% of the variation in information and

communication. Internal auditing practices of significant influence in their order of

impact are scope of audit work (Beta = -0.212, p ≤ 0.05) (sig. F = 0.031) and performance

of audit work (Beta = 0.207, p ≤ 0.05) (sig. F = 0.021).

The results suggested that scope of audit work of the internal auditing practices

negatively influence the information and communication aspect of internal control system

while performance of audit work of the internal auditing practices positively influence the

20

information and communication aspect of internal control system. Therefore, only

Hypothesis 1b3 is accepted while the rest of the hypotheses are rejected.

Hypothesis 1c: The better the management of the internal audit department of the







auditing practices, the higher the control environment of the quality of the internal control

system. Table 8 summarizes the result.

Table 8: Result of Hypothesis 1c

R2: 0.118

F: 3.470

Internal Auditing

Practices

Beta t Sig.

(Constant)

Management of IAD

Scope of audit work



Independence

Objectivity

Audit reviews

Audit programs

Audit Reporting

.169

.015

.315

-.266

.086

-.249

.058

.040

-.110

11.820

1.336

.162

3.671

-3.087

1.117

-3.093

.699

.469

-1.257

.000

.183

.871

.000**

.002**

.265

.002**

.485

.640

.210

Dependent variable: Control Environment


Table 8 suggests that the model is significant (F = 3.470) (Sig. F = 0.000, p ≤

0.05). However, the model only explained 11.8% of the variation in control environment.

Internal auditing practices of significant influence in their order of impact are

performance of audit work (Beta = 0.315, p ≤ 0.05) (sig. F = 0.000), professional

proficiency (Beta = -0.266, p ≤ 0.05) (sig. F = 0.002) and objectivity (Beta = -0.249, p ≤

0.05) (sig. F = 0.002).

21

Therefore, the results show that performance of audit work positively influences

the control environment aspect of internal control system while professional proficiency

and objectivity of the internal auditing practices negatively influence the control

environment aspect of internal control system and therefore the null hypothesis is

accepted. Therefore, Hypotheses 1c3 is accepted while hypotheses 1c1 to 1 c2 and 1 c4 to 1 c9

are rejected.

Hypothesis 1d: The better the management of the internal audit department of the







auditing practices, the higher the risk assessment of the quality of the internal control

system. Table 9 summarises the results.

Table 9: Result of Hypothesis 1d

R2: 0.101

F: 2.983


(Constant)

Management of IAD

Scope of audit work



Independence

Objectivity

Audit reviews

Audit Programs

Audit Reports

-.254

-.157

.193

-.121

.071

.045

.015

.211

.238

11.395

-1.975

-1.640

2.218

-1.411

.932

.554

.184

2.438

2.655

.000

.049**

.102

.027**

.160

.352

.580

.855

.016**

.008**

Dependent variable: Risk assessment


Table 9 suggested that the model is significant (F = 2.983) (Sig. F = 0.002, p ≤

0.05). However, the model only explained 10.1% of the variation in risk assessment.


22

management of internal audit department (Beta = -0.254, p ≤ 0.05) (sig. F = 0.049),

performance of audit work (Beta = 0.193, p ≤ 0.05) (sig. F = 0.027), audit program (Beta

= 0.211, p ≤0.05) (sig. F = 0.016) and audit reporting (Beta = 0.238, p ≤ 0.05) (sig. F =

0.008).

Therefore, the results show that management of internal audit department

negatively influence the risk assessment aspect of internal control system while

performance of audit work, audit program and audit reporting of the internal audit

practices positively influence the risk assessment aspect of internal control system.

Hypothesis 1 d3, 1 d8 and 1 d9 are accepted while the rest are rejected.

Hypothesis 1e: The better the management of the internal audit department of the







auditing practices, the higher the control activities of the quality of the internal control

system.

Table 10: Result of Hypothesis 1e

R2: 0.061

F: 1.734


(Constant)

Management of IAD

Scope of audit work



Independence

Objectivity

Audit reviews

Audit Programs

Audit Reporting

-.098

-.136

.176

-.049

.123

-.063

.043

-.078

.175

14.046

-.748

-1.399

1.979

-.560

1.576

-.751

.507

-.876

1.915

.000

.455

.163

.049**

.576

.116

.453

.613

.382

.057*

Dependent variable: Control activities

* at 0.01 significant level


23

Table 10 suggested that the model is significant (F = 1.734) (Sig. F = 0.082, p ≤

0.01). However, the model only explained 6.1% of the variation in control activities.


performance of audit work (Beta = 0.176, p ≤ 0.05) (sig. F = 0.049) and audit reporting

(Beta = 0.175, p ≤ 0.01) (sig. F = 0.057).

The results support the hypothesis that both performance of audit work and audit

reporting of the internal audit practices positively influence the control activities aspect of

quality of the internal control system. Therefore, hypotheses 1e3 and 1e9, which positively

influence the control activities of the quality of the internal control systems, are accepted

while the rest of the hypotheses are rejected.

Summary of results

The management of internal audit department of internal auditing practices

positively influences the monitoring aspect of the quality of the internal control system

but it is negatively influenced by the professional proficiency, objectivity and audit

review of the internal auditing practices.

Information and communication aspect of the quality of the internal control system is

negatively influenced by scope of work of the internal auditing practices but is positively

influenced by performance of audit work of the internal auditing practices.

The control environment aspect of the quality internal control system is positively

influenced by performance of audit work of the internal auditing practices while it is

negatively influenced by professional proficiency and objectivity of the internal auditing

practices.

The risk assessment aspect of the quality of the internal control system is

negatively influenced by management of internal audit department of the internal auditing

practices but is positively influenced by performance of audit work, audit program and

audit reporting of the internal auditing practices.

The control activities aspect of the quality of the internal control system is positively

influenced by performance of audit work and audit reporting of the internal auditing

practices.

24

DISCUSSION AND CONCLUSION

This study examined the extent of the internal auditing practices by the internal

audit department and the effects of the practices have on the quality of the internal

control system. Analyses were done from the Internal Audit Practice Scale and Internal

Control System Scale that were sent to all internal auditors and audit committees of the

Malaysian Public Listed Companies for the year 2001.

The Extent of the Internal Auditing Practices

One of the major findings in this study is the extent of internal auditing practices

in Malaysian Public Listed Companies. The five variables were derived from the SPPIA

(2000), which were: independence and objectivity, professional proficiency, scope of

work, performance of audit work and management of the internal auditing department.

However, this study suggests that the internal auditing practices should comprise of nine

functions instead of only five functions as suggested by the SPPIA (2000). The functions

suggested are as follows: management of internal audit department, performance of audit

work, independence, audit reviews, audit reporting, scope of audit work, professional

proficiency, objectivity and audit programs. The four new functions are objectivity

(separated from independence), audit reviews, audit programs and audit reporting.

Comparison was also made between the variables of this study and PPF (2002).

Under PPF (2002), the standards consists of ten variables: purpose, authority, and

responsibility; independence and objectivity; proficiency and due professional care;

quality assurance and improvement program; managing the internal audit activity; nature

of audit work; engagement planning; performing the engagement; communicating results;

monitoring progress; and management’s acceptance of risks. The difference between this

study’s variables and PPF (2002) is the additional of five new audit functions that is the

monitoring progress; communicating results; engagement planning; purpose, authority

and responsibility; and management’s acceptance of risks.

Comparison with the findings of this study and the PPF (2002) were also made.

There are only two new functions of the internal auditing practices in the PPF (2002):

purpose, authority and responsibility, and management’s acceptance of risks. The rests of

the internal auditing practices functions in this study are consistent to the SPPIA (2000)

25

and the PPF (2002). Table 11 shows the summary of comparisons of the extent of the


Table 11: Summary of Comparisons of the Extent of the Internal Auditing Practices

SPPIA (2000) This Study (2001) PPF (2002)

• Independence &

objectivity

• Professional

proficiency

• Scope of work

• Performance of

audit work

• Management of

internal audit

department

• Independence

• Objectivity

• Professional

proficiency

• Scope of work

• Performance of

audit work

• Management of

internal audit

department

• Audit reviews

• Audit reporting

• Audit programs

• Independence &

objectivity

• Proficiency and due

professional care

• Nature of audit work

• Performing the

engagement

• Managing the

internal audit

activity

• Monitoring progress

• Communicating

results

• Engagement planning

• Purpose, authority &

responsibility

• Management’s

acceptance of risks

Internal Auditing Practices and the Quality of the Internal Control System

This study also examines the influence of internal auditing practices and the

quality of internal control system. It is shown that only the monitoring aspect of the

quality of internal control system positively influenced by the management of the internal

audit department. However, it is negatively influenced by the professional proficiency,

objectivity and audit review of the internal auditing practices. By managing the

department, the work performed by the internal audit department has been implemented

in the past and the work schedules have taken into consideration the goal of the internal

audit department and also the general purposes of company management. Therefore this

will positively influence the monitoring of the internal control system since this will have

an effective impact on the monitoring process and also reports on illegal acts are properly

monitored. However, this study suggests that professional proficiency such as adequate

26

knowledge, professional membership, certification, and training in electronic data

processing (EDP) system lead to lower monitoring of the quality of the internal control

system. This is because when the internal auditors have all the above-mentioned criteria,

it would imply that they are competent to do the work and therefore lower monitoring of

the quality of the internal control system is needed since the internal auditors have a clear

understanding of the internal control system. This is also true for objectivity and audit

reviews of the internal auditing practices on the monitoring of the quality of the internal

control system. Objectivity involves the unbiased attitude and avoidance of conflict of

interest by the internal auditors while audit reviews are efficiently conducted in respect to

the necessary audit operations. Therefore, internal auditors need lower monitoring of the

quality of the internal control system since the entire necessary audit operations has been

well conducted.

This study also suggests that scope of work of the internal auditing practices

negatively influences the information and communication aspect of the quality of the

internal control system while the performance of audit work of the internal auditing

practices positively influences the information and communication aspect of the quality

of the internal control system. Scope of work of the internal auditing practices involves

reviewing the system to ensure compliance with procedures, policies, laws and regulation

and planning of the work and there is also better coordination between external and

internal auditors. This means that if there is better scope of work of the internal auditing

practices, this will lead to lesser control procedures of computer information system and

lesser assessment of information needed on the quality of the internal control system. The

internal auditors follow all the necessary procedures in doing the audit work and

therefore lesser information and communication of the quality of the internal control

system is needed. However, the better the performance of audit work, the greater is the

information and communication since in performing the audit work, the internal auditors

need to identify, analyse, evaluate and record sufficient information to achieve the

engagement objectives.

This study also perceived that the performance of audit work of the internal

auditing practices positively influences the control environment aspect of the quality of

the internal control system while professional proficiency and objectivity of the internal

27

auditing practices negatively influences the control environment aspect of the quality of

the internal control system. Performance of audit work plays a great impact on the control

environment of the quality of the internal control system. Therefore, the better the

performance of the audit work, the greater is the control environment on the quality of the

internal control system. In performing the audit work, the internal auditors have been

trained and are competent to do the audit work. Consequently, they are able to identify

and analyse the necessary records to achieve the audit objective. This will have a positive

impact on the control environment of the quality of the internal control systems since the

senior management will demonstrate a higher climate of trust with better performance of

the audit work.

This study also suggests that management of internal audit department of the

internal auditing practices negatively influences the risk assessment aspect of the quality

of the internal control system. However, the performance of audit work, audit program

and audit reporting of the internal auditing practices positively influences the risk

assessment aspect of the quality of the internal control system. Since the work performed

by the internal audit department has been implemented in the past and the work schedules

take into consideration the goals of internal audit department, therefore, this will lead to

lower risk assessment of the quality of the internal control system. This is because; the

necessary proper procedures are already applied in managing the internal audit

department. However, the better the performance of audit work, audit program and audit

reporting of the internal auditing practices lead to better risk assessment. In performing

the audit work, the internal auditors will identify better risk management framework and

risk management policy and also better procedures should be installed in monitoring the

applications of policies and procedures of the organisation. This is also true for audit

programs and audit reporting. The better the audit program and audit reporting, the

installation of the procedures and application of policies in assessing the risk of the

organisation will further improve.

Performance of audit work and audit reporting of the internal auditing practices

positively influence the control activities aspect of the quality of the internal control

system. With trained and competent internal audit staff and better evaluation to achieve

the engagement objectives, this will lead to better control activities of the quality of the

28

internal control system. In this case, higher board of director’s approval on the audit work

performed is achieved and the internal auditors would diligently investigate the variances.

There are also improved recommendations made by the internal audit department through

audit reporting.

IMPLICATIONS OF THE STUDY

The logical question at this juncture is: What do the results of this study imply? In

other words, how does the research contribute to theory building, provide guidance to the

internal auditors and serve as input for the next SPPIA? These questions are addressed as

follows:

Theoretical Implications

The first theoretical implication is that this study has contributed to the agency

theory and internal audit paradigm where this study supported how the agency theory

provide more meaningful research in the internal audit discipline based on the premise

monitoring expenditure incurred by the principal and the agent. This study also explains

the existence of agency theory postulated and its influence on the extent of internal

auditing practices in Malaysian public listed companies and its effect on the firm’s


Practical Implications

An important finding of this research pertains to the extent of the internal auditing

practices among internal auditors in Malaysian public listed companies. The first

practical implications refer to changing of internal auditing practices functions from five

to nine. The standard setter such as the Institute of Internal Auditors (IIA) has the

important role to revise the Professional Practices Framework or the SPPIA based on this

study. The SPPIA (2000) basically described the criteria by which the operations of an

internal auditing department are evaluated and measured and they are intended to

represent the practice of internal auditing, as it should be. This includes independence

and objectivity, professional proficiency, scope of work, performance of audit work and

management of internal audit department. The study implied that the IIA should include

29

nine factors in building up the SPPIA, that is independence, scope of work, audit

reporting, audit programs, management of internal audit department, performance of

audit work, audit reviews, objectivity and professional proficiency since these factors

revealed that CAEs placed much importance on above factors. The assistance of internal

auditing practices benefit managers in providing bases for judgement and action, helping

managers by reporting weaknesses in control and performance, providing counsel to

managers and board of directors on the solutions of business problems and supplying

information that is timely, reliable and useful to all levels of management. Therefore,

compliance to the SPPIA is very important to internal auditors in the extent of the

internal auditing practices and IIA must play its role in representing the practice of

internal auditing, as it should be. Another implication is that all the variables in this study

are consistent with the PPF (2002).

The rationale behind the extent of the internal audit practices is that it provides

opportunity for the Chief Audit Executives or internal auditors to get the management’s

undivided attention to the extent of internal auditing practices on the quality of the

internal control system. Reporting significant audit results and recommendations give

Chief Audit Executives an avenue for presenting their internal audit practices to the

president and other top management team members. The reasonable and meaningful

findings and recommendations contained in the audit report are symbols of their

contribution, which result in improvements to the organisation as a whole.

Further, Chief Audit Executives might have perceived more importance to the

ability to provide independent reviews to the president or other top management team

members. Again, in order to comply with the SPPIA, Chief Audit Executives believe that

their departments should be independent, have bigger scope of audit work, better

management of internal audit department, higher performance of audit work, better

application of auditing standards to audit work, professional and proficient in internal

audit practices.

The results show that the five functions of the quality of the internal control

system are as per Committee of Sponsoring Organizations (COSO) standard. Currently,

Malaysian approved auditing standards have incorporated this and also adopted the

Statement on Internal Control: Guidance for Directors of Public Listed Companies (MIA,

30

2001). Internal auditing department also should be seen to conduct their work effectively

and have trained staff.

LIMITATIONS OF THE STUDY

This study provides empirical evidence that the internal auditing practices of the

public listed companies in Malaysia comply with the SPPIA (2000) and statistically

influence the quality of the internal control systems. This may be due to the auditing

standards enforced by the Institute of Internal Auditors (Malaysia) and Malaysian

Institute of Accountants.

This study, however, has its limitations. Of 250 public listed companies included

in this study, it is only representative of 38.23% of public listed companies for the year

2001. Consequently, the results may not be generalisable to the population of internal

auditors as a whole. Furthermore, the extent of the internal auditing practices is only

limited to the SPPIA (2000).

Internal auditors typically work as a team in its normal internal audit practices.

This study is limited as only individuals who are Chief Audit Executives were examined.

The dynamics of group interaction were not considered. However, the Chief Audit

Executives represent the internal audit department suggesting that the study of this

individual is the logical first step.

This study assumed that auditors are of the same calibre across firms for each

designation. However, this may not be a valid assumption since years of experience of

the internal auditors are not included in the study.

CONCLUSION

While the results in this study are by no means conclusive, it is hope that this

study has contributed to the research done in the extent of the internal auditing practices.

This study has also provided some evidence on the extent of the internal auditing

practices and the influence it has on the internal control system.

31

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33

Profile:

Associate Professor Dr. Faudziah Hanim Haji Fadzil academic career started in

November 1987 when she joint the Faculty of Accountancy, Universiti Utara Malaysia.

Before, she was an internal auditor at the Universiti Sains Malaysia. She pursued her

doctoral studies in the area of auditing at the Universiti Sains Malaysia. Currently she is

the Head of the Professional Accounting Department. She teaches in the area of

management accounting, auditing and financial accounting for the undergraduates as well

as for the graduate studies.

She has written several books and modules on management accounting, auditing and

financial accounting. She has also published her research papers in the above areas in

national and international journals. She has also been appointed as reviewers for national

journals and editor of management accounting and financial accounting textbooks. Dr.

Faudziah Hanim is currently a member of CMA (Australia).

Associate Professor Dr. Hasnah Haji Haron began her career in October, 1983 as a

lecturer at the Faculty of Accountancy, University Teknologi MARA. Beginning

December, 1986 she was seconded to Univeristi Sains Malaysia to teach in the areas of

accounting, auditing and taxation. In 1996, she pursued her doctoral studies in the area of

Auditing, at the University of Hull, United Kingdom. In October 1996 she was made the

Chairperson for the Accounting Program.

She has written several books and modules on management and financial accounting. She

has also been appointed as reviewers for international journals and as editors of auditing

textbooks. Other than teaching, research and consultation activities, Dr. Hasnah is also

active in professional activities. She is currently a member of MIA Penang Branch and

the Accounting and Auditing Committee.

Dr. Muhamad Jantan is a Professor of operations management at the University

Science of Malaysia. His research interests are in the area of quality management,

information and technology management. He has presented various articles in these areas

at International Conferences in the region. He also sits on the Editorial Board for Asian

Academy of Mangement Journal and the International Journal of Quality and

Productivity, and has reviewed articles for international journals. He has done various

consultancy projects for big national corporations and conducted executive development

programs for both local and multinational companies.

Internal auditing practices and internal control system

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