When Does the Internal Audit Function Enhance Audit Committee Effectiveness?

Abstract

I examine whether audit committees (ACs) improve financial reporting reliability by utilizing an internal audit function (IAF) as a resource. By exploiting data in AC charters, I construct novel measures of how and the extent to which ACs utilize IAFs. I first document an improvement in financial reporting reliability (fewer restatements) for firms that introduce an IAF under a NYSE mandate. This reporting improvement is concentrated among firms with ACs that utilize the new IAF significantly. Next, using more precise, hand-coded measures of IAF utilization, I show that the value of the IAF as a resource to the AC increases when (1) the AC meets privately with the IAF to discuss the activities of the IAF and relevant internal audit findings and ensures open communication between them, (2) the AC promotes the independence of the IAF, and (3) AC members are stretched thin with multiple board positions. Finally, I document an economic benefit to utilizing the IAF as a resource in the form of lower loan spreads.