Outsourced internal audit function and real earnings management: The role of industry and firm expertise of external providers

Abstract

As the outsourced internal audit function (IAF) and real earnings management are attracting widespread attention among firms, it is vital for stakeholders to understand how these two practices affect the quality of financial reporting. This study examines how the expertise of an external IAF provider reduces real earnings management. Using a pooled panel data regression of 928 firm‐observations, we find that the external IAF provider's firm‐specific expertise is significantly associated with lower real earnings management. Conversely, we report no such association for external IAF providers with industry expertise. These findings are robust under a battery of sensitive analyses. The results of additional analyses show that the industry and firm‐specific expertise of external IAF provider interact with each other, resulting in a significant reduction in real earnings management. We also find significant differences in the IAF quality between big4 and second‐tier audit firms in which the latter are associated with lower real earnings management and the former with higher real earnings management. Finally, we observe low real earnings management for important clients and/or those with influential CEOs if the external IAF provider has firm‐specific expertise.