Shareholder Value Implications of the Internal Audit Function

Abstract

SYNOPSIS In 2013, NASDAQ Stock Market LLC (NASDAQ) issued a proposal to mandate the internal audit functions (IAFs) for all listed companies but later withdrew the proposal. In this study, I investigate whether the mandatory IAF adds shareholder value and how the value implications vary across companies. For companies without IAFs before the proposal, I document a positive (negative) price response to the NASDAQ IAF proposal filing (withdrawal). This evidence suggests that, on average, investors perceive mandatory IAF as value enhancing. I find that the positive market reaction is concentrated among firms with lower external audit quality and institutional ownership. Additionally, I document that the return responses are higher for companies with smaller book-to-market ratios, multiple business segments, and lower Altman z-scores. Those results suggest that investors' perceptions of the mandatory IAF are more positive for weakly monitored firms, firms with high-growth prospects and complex business, and firms in financial distress.