The Real Effects of Internal Audit Function Quality: Evidence From Investment Strategies

Abstract

This article examines the relation between internal audit function (IAF) quality and investment efficiency, a recurring value-added corporate activity critical to firm survival and profitability. We argue that an IAF, unlike other information intermediaries, is uniquely positioned to have access to firm-specific, private information—particularly related to localized, firm-specific risks. If a more competent IAF incrementally improves the information that is generated and communicated to management (while not participating directly in decision-making), we should observe more productive capital investment decisions from firms with higher quality IAFs relative to firms with lower quality IAFs. Through this enhanced information channel, we find that IAF quality is associated with investment efficiency. This result holds for both under- and overinvestment, although not in tests of all subsamples. We also document that this effect is more pronounced for firms with more complexity and for firms with greater investment opportunities. Our evidence indicates that IAF quality provides measurable and economically meaningful value to an organization.