Paradigms

Print ISSN 1996-2800, Online ISSN 2410-0854

2020, Vol. SI, No. 1 Page 75-80
DOI: 10.24312/20000112
Effectiveness of the Role of Internal Audit Function: A Perception of External Auditors of Pakistan
Amer Shakeel1, Burhan Rasheed2, Dr. Muhammad Ahmed3, Allah Bakhsh3
University of Management and Technology, Lahore, Pakistan 12, University of Central Punjab, Lahore, Pakistan3,
Bahauddin Zakariya University, Multan, Pakistan4
Corresponding author email: amer.shakeel@umt.edu.pk
Cite this paper: Shakeel, A., Rasheed, B., Ahmed, M., & Bakhsh, A. (2020). Effectiveness of the role of internal audit function:
A perception of external auditors of Pakistan. Paradigms, SI(1), 75-80.
Internal Audit Function (IAF) is considered as an important element of corporate governance. It can contribute to good corporate
governance only if it operates effectively. There are many stakeholders of IAF like Board of Directors (BoD), the firm’s
management, external auditors etc. All these stakeholders have their different needs and also have different perception regarding
IAF. In this study, we tried to explore the perception of external auditors regarding the role and effectiveness of the IAF. For this
purpose, we interviewed with eight external auditors of different audit firms. As per the findings of this study, the role of IAF
includes checking the compliance and evaluation of internal controls, risk management and fraud risk management. This paper
further concluded that the current role of IAF can be more effective by making IAF independent and by the induction of the
personnel with right qualification, skills and relevant experience. External auditors can also get benefits from effective IAF.
Keywords: Internal audit function, corporate governance, external auditors, board of directors.
JEL Classifications: M42
INTRODUCTION objectivity and work performed (IFAC, 2017). It is very
The importance of good corporate governance has been important to understand the determinants of the quality of IAF
increased since the case of Enron and currently there is an and to see how these stakeholders judge the quality of IAF. In
intense emphasis on it in every firm (Anderson, Christ, case of better quality of IAF, confidence of external auditor
Johnstone & Rittenberg, 2012). Internal Audit Function (IAF) increases, which can improve the efficiency and effectiveness
is considered as one of the integral components of good of the external audit (Pizzini, Vargus & Ziegenfuss, 2012) and
corporate governance (Soh & Bennie, 2011). The significance because of the time saving in external audit assignment its fee
of IAF has been increased for the purpose of reducing is also reduced (Abbott, Parker & Peters, 2012). A strong
fraudulent and misleading financial reporting, detection and coordination between internal and external auditor leads to
prevention of material weaknesses (Prawitt, Sharp & Wood, good corporate governance, which helps in minimization of
2012), improving the internal control environment and chances of corporate collapse (Rusak & Johnson, 2007).
mitigation of fraud risk (Coram, Ferguson & Moroney, 2008). Despite increasing the role of IAF in good corporate
Governance stakeholders mostly rely on the IAF, which governance, only limited researches have examined the
increases the importance of IAF (Desai, Roberts & Srivastava, effectiveness of this function. Gramling, Maletta, Schneider
2010). According to The Institute of Internal Auditors (IIA); and Church (2004) suggested that consideration should be
audit committee, management, board of directors and audit given to the party relying on the work of the IAF, whether it is
clients are considered as major stakeholders of IAF (IIA, 2010). the Audit Committee (AC), the external auditor and the
If these stakeholders perceive the quality of IAF is not management. The authors suggested that quality may vary
effective, then they would not rely on the reports or information according to the party which is using the work of the IAF.
produced by the IAF (Desai, Roberts & Srivastava, 2010; Because of the importance of IAF there is a need to understand
Burton, Emett, Simon & Wood, 2012). External audit is also the role, effectiveness and the attributes which can make IAF
considered as one of the keystones of corporate governance, more effective.
particularly with respect to the prevention and detection of The main objective of this study is to explore the perception
frauds and errors in financial statements (Adamec, Leinicke, of external auditors regarding the role and effectiveness of the
Ostrosky & Rexroad, 2005; Davidson, Goodwin, Stewart & IAF. This study also tries to find those attributes which can
Kent, 2005). External auditor is also considered as an important make IAF more effective, in addition to that this study explores
stakeholder of IAF because the effectiveness of IAF leads to the fact that how much IAF is helpful for external auditors.
better quality of external audit with lower audit fee (Abbott, There are different researches on the role of IAF (For
Parker & Peters, 2012). example Burton, Emett, Simon & Wood, 2012; Cohen,
According to the International Standard on Auditing (610), Krishnamoorthy & Wright, 2010; Gramling, Nuhoglu & Wood,
external auditor always evaluates IAF before using its 2012). In the past few years, many changes have occurred in
information for audit purpose (IFAC, 2017), but the general the business environment after that need and challenges of the
understanding of the quality of IAF is limited. The measure of role of IAF has become broader. Currently, the role of IAF also
quality normally focuses on three components; competence, covers the control, governance and risk management (Moeller,

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2009). The IAF can add value only when it would be effective regulatory function only. There are many studies in which
(Mihret, James and Mula 2010). Due to the wider consulting researchers tried to explore the attributes and characteristics,
role of the IAF, it is important to measure the effectiveness of which can make IAF more effective. Coetzee and Lubbe (2014)
the IAF (Alzeban & Gwilliam, 2014). The work of IAF is used also analyzed the efficiency and effectiveness of the IAF. They
by external auditors which can modify audit procedures. If IAF interviewed with five chief audit executives of companies,
is efficient, it can reduce the work of the external auditor and listed on the stock exchange of South Africa. They
ultimately causes reduction in audit fees (Abbott, Parker & recommended that the emphasis on audit processes should be
Peters, 2012). Last but not least, this study also tries to find out more, so IAF can be improved by adopting the risk-based audit
the attributes, which can make the role of IAF more effective. approach. Udeh and Nwadialor (2016) tried to evaluate the IAF
In Pakistan it is mandatory for listed companies to have IAF in the public sector of Nigeria. They used questionnaire
in Pakistan (SECP, 2017). This study is the pioneer in the field techniques for data collection and this study concluded that IAF
of internal audit in Pakistan. There is not a single study is not enough effective in public sector organizations. Arena
regarding perception of external auditor regarding the role and and Azzone (2009) studied the organizational factors which
effectiveness of IAF, so this study is covering this research gap drive the effectiveness of the IAF, they found that
by exploring the area. characteristics of the internal audit team, internal audit
LITERATURE REVIEW processes and organizational links affect the effectiveness of
The role of IAF studied from different aspects in the past the IAF.
literature, just like Prawitt, Smith and Wood (2009) measured Ebaid (2011) studied the nature and characteristics of the IAF
the association between earning management and IAF quality. in Egyptian firms. He analyzed the aspects of insourcing or
The measurement of quality of IAF based on six factors outsourcing of IAF, interaction with external auditor and
included objectivity, experience, training, focus on financial organizational settings. The results of this study are, the internal
work, certification and investment of the firm in IAF. They audit function of these firms is not independent and mature.
concluded that earning management is moderated by the quality Sarens, Abdolmohammadi and Lenz (2012) examined the
of IAF. Ahmad, Othman and Jusoff (2009) explored the factors which are associated with the IAF for having an active
significance and influence of the IAF in the public sector of role in effective corporate governance. They used the responses
Malaysia. In this study data is collected from different persons, of 782 chief audit executives from different US firms, found a
which are working in internal audit function of different significant role of IAF in an effective corporate governance.
organizations. They concluded that top management does not Alzeban and Gwilliam (2014) assessed the factors which
support the IAF adequately. Lin, Pizzini, Vargus, and Bardhan influence the effectiveness of the IAF. This study was
(2011) investigated the role of the IAF in the disclosure of conducted on the Saudi Arabian corporate sector, for this
material weaknesses in the internal control system of the firms. purpose they collected data from the business managers and
For this purpose, they used the data of 214 US firms. The internal auditors. This research work concluded that persons
Results of this study showed that material weakness disclosures working in IAF, have lack of appropriate knowledge and
are negatively associated with the education level of the people training. Kien (2015) in his latest study analyzed the
which are involved in IAF. performance measurement of the IAF in the construction firms
Another study was conducted on the role of the IAF in in Vietnam. He collected the data through reports and
promoting effective corporate governance in the banks of interviews. As per the results many organizations did not have a
Kenya (Changwony and Rotich, 2015). They used proper performance measurement system for the IAF. In
questionnaires to collect data and received 89 responses from another study by George and Konstantinos (2015) investigated
respondents. They found a positive and significant role of the factors associated with the effectiveness of the IAF in
internal audit function for promoting effective corporate Greek business environment. Data was collected through
governance. In Pakistan, Khan (2016) investigated the mailed survey and as per the results, the factors which affect
relationship of internal audit with corporate governance. In this the effectiveness of the IAF is quality, competence team,
study, data was collected from questionnaires and the results independence and management support.
showed a significant relationship between the characteristics of There are also some researches regarding IAF in relation to
internal audit quality and corporate governance. external audit. Haron, Chambers, Ramsi and Ismail (2004)
In some other studies effectiveness of the role of the IAF was studied the criteria used by external auditors to evaluate the
also measured. Cohen and Sayag (2010) measured the IAF of a company. They used the Malaysian firms’ data, which
effectiveness of the IAF in Israeli organizations. They collected is received from the auditors belonged to big-four and non-big-
the data from 180 organizations. Results showed that support four audit firm. They found that while relying on the work of
and priority level of the top management is the main factor internal audit, external auditors use technical competence and
which influences the effectiveness of the IAF, second main scope of functions as the most important factors. In another
factor is the independence of the IAF. Ramachandran, study, Brandon (2010) investigated the extent of reliance by
Subramanian and Kisoka (2012) measured the effectiveness of external auditors on outsourced internal audit function when
the IAF in Tanzanian Commercial Banks, results showed that internal auditor is also providing non audit services to the
IAF is not a value-added activity and it is added as a mandatory organization. Data was obtained from 89 auditors of different

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USA audit firms. As per the results of this study, internal compliance of policies and procedures. After 2000,
auditor’s objectivity was negatively affected if it is also because of growth in size and volume of businesses,
providing non audit services. In this case external auditor’s IAF is supposed to check everything and play a vital
reliance on the internal audit work is also affected. role in risk management.”
Another challenge is being faced by the firms is financial
frauds. As per respondents, fraud risk management is also
METHODOLOGY considered as the function of IAF but detection of fraud is not
This is an exploratory type of qualitative research. We used the core responsibility of the IAF. They only see the fraud risk
semi structured interviews for the purpose of collecting data. and red flags of fraud. One of the respondents said, “IAF
This method is widely used by researchers in this kind of directly does not detect fraud, but identifies fraud risk and see
researches (Bedard, Westermann & Earley, 2012). Due to the the fraud from that angle, IAF sees the red flags”.
flexibility, semi structured interviews give researchers to Another respondent endorsed this statement in the following
explore the paths observed while during these interviews words:
(Gendron, Bédard & Gosselin, 2004). “It (IAF) can detect fraud in a complete investigation
Participants and detailed evaluation of controls, but it comes in a
In this study purposive sampling is used and only those special arrangement. Regularly they do not work for
persons are selected for interviews which are information rich. the fraud identification and detection. But when the
Participants included persons working in audit firms at senior matter arises and there is a red flag, they do identify
level. We conducted interviews with seven partners of audit it”.
firms and one director of a big4 audit firm. Selecting a sample But as per one of the respondents, detection of the fraud is
size that yields data that have a realistic chance of reaching data also the responsibility of the IAF, he said, “Detection of fraud
saturation, theoretical saturation, or informational redundancy becomes the responsibility of IAF”.
is necessary in qualitative research. Purposive sampling is more Current Effectiveness of IAF
appropriate for this (Onwuegbuzie & Daniel, 2003). As per respondents, IAF is not performing its above roles
Length of the interviews was from 12 to 15 minutes each and effectively. One respondent said,
all these interviews were conducted in Lahore from May to “It is not so effective in performing above roles. Our
June 2017. A standard interview guide was used while corporate sector does not have the right perception
conducting interviews. regarding IAF”. Another respondent said, “In
Interview Questions Pakistan, there should be a risk-based role of IAF, but
Interview questions were developed with the help of it is not like this”.
literature review and by using different theories of There are many reasons behind this phenomenon like
measurement of the quality of services in different disciplines. perception of businessmen about IAF, weak independence of
Validity and Reliability Issues IAF, lack of proper support of top management and considering
Validity and reliability of the data are ensured by recording it as a cost not a value adding function. One respondent said,
interviews (Cohen, Krishnamoorthy & Wright, 2010). Because “Businesses are family owned, if they are not family
it is an exploratory research, we recorded the interviews and owned, like listed companies they are family
during the interview brief notes of thoughts and ideas were also dominated. IAF has limited capacity to hit
taken and right after the interview, these notes were expanded management function. They are reporting to the
into more detail. management, the people who are supposed to be
Findings and Discussions evaluated by them”.
Role of Internal Audit Another respondent said,
The role of IAF consists of to check the compliance and to do “Our owners think the IAF as mere a cost. Only few
an evaluation of internal controls, financial risk management people have it right perception and they want to invest
and fraud risk management in the firms. All the respondents on IAF”. But one respondent identifies one exception
agree on these roles of IAF. One of the respondents said, “It to this reality, he said, “In big companies like
(IAF) advises the organizations on matters such as acquisition multinationals they are playing good role”.
of new ventures, evaluation of controls, whether controls are Another respondent told about the prerequisites for effective
effective or not?” Another respondent said, “IAF does internal performance of IAF. He said:
control evaluation and also find out the root causes of the “It depends on how much liberty and control is given
happening of the issues.” As per the respondents, checking the by organizations to IAF through a charter which is
compliance of internal controls, its evaluation and advising to approved by the board of directors and the audit
make them better are core responsibilities of IAF. committee. If IAF is independent and has some
Regarding the risk management function of IAF, one of the authority and capability in the form of right resources
respondents said: and right skills, then off course its role becomes very
“When the IAF evolved in the 80s and 90s, it had no effective to manage the risks”.
relation to risk management. It was just limited to the

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Support of IAF to External Auditors A team of IAF should consist of professionals, having
The nature and extent of the work of external auditors are relevant qualification, proper skills set and relevant diversified
entirely different from internal audit. But if IAF performs experience, another important skill is IT skill. As per
effectively, it helps in external audit. One of the respondents respondents, members of IAF must have relevant knowledge of
said: IT function and software solutions like SAP, Oracle Financial
“In the organization where this function is working etc. One of the respondents said, “IT and information system
properly it can help external auditors. In the absence audit is a part of IAF. It is the skill which is highly appreciated
of IAF, external auditor needs to increase the extent of and required in the IAF as a whole”.
tests on figures”. The attributes which should exist in the IAF include
Another respondent said, “If IAF is strong and also fulfill the independence, authority, direction, free communication and
quality parameters, it can reduce the extent of substantive support of Audit Committee (AC) and IAF should be
procedures performed by external auditors”. In result of this, answerable to AC only. One of the respondents said:
time span on external audit may be reduced and leads to low “IAF must be independent. Direction should be given
audit fee. Reduction in the work of external auditor depends by the AC to IAF. IAF would not be under CEO. The
upon the effective work of IAF and availability of all the IAF should be answerable to AC only. Audit plan
reports to external auditors. Opinion of another respondent on should be approved by AC”.
this issue is reproduced here, he said: Another respondent said, “Though IAF needs to link to the
“If the external auditor gets a reasonable assurance board of directors. In listed companies it happened through the
that IAF is working properly and its reports are AC. The IAF should have the voice at Audit Committee”.
shared with external auditor which show that IAF One of the respondents emphasized on the need to create
covered those areas and their conclusion is awareness in the management of the firms regarding the
satisfactory, then the extent of the work of external effectiveness of the IAF, he said:
auditor would be reduced”. “We need a cultural shift to make IAF effective.
Attributes of an Effective IAF Cultural shift means a change in the perception of top
If the work of the IAF is highly beneficial then what management and other personnel because no one like
attributes can make the IAF so effective? As per respondents’ to be criticized or checked. People have perception
proper qualification and experience of internal audit personnel, about both IAF and external auditor that they are
training, support of top management, free communication with criticizing them, but IAF does not do this. IAF is
the board of directors and audit committee and independence working for your betterment and advising you the best
can make IAF an effective function. ways to do the work”.
One of the respondents said: CONCLUSION
“IAF should be given some authority, charter, Terms The results of this research paper showed that the IAF is very
of Reference (TOR). The board of directors assigned beneficial not only for external auditor but also for every
to the Audit Committee and Audit Committee delegates stakeholder. The role of IAF includes the checking of
this function to IAF. This can be effective if they have compliance with policies and procedures, evaluation of internal
right skills set which is the competencies of the staff controls, risk management and up to some extent fraud risk
and the diversity of the experience”. management. The current role of the IAF is not so effective, we
As per the respondents, attributes of IAF personnel depend can make it effective by making IAF independent and strong
upon the functions of the organizations and the areas which are and by the induction of the personnel with right qualification,
being catered. But relevant qualification and experience are skills and relevant experience. If the IAF performs in the
inevitable. IAF function should be led by an appropriate person organization effectively, external auditor can get help from its
having a high level of knowledge, skills and experience. One of working and findings and it can reduce the time and efforts on
the respondents said: external audit assignment.
“Above all it is a good function headed by good Limitations and Future Research Directions
qualified person. The audit team of different areas The participants of this study selected from Pakistani
must have all skills which are required to do the audit environment; therefore we cannot generalize the results of the
of those areas”. study on greater population. We conducted the research only on
About the head of IAF function one of the respondents the perception of external auditors regarding IAF and other
said: stakeholders which are not included in this study may have a
“The head of IAF must have the proper relevant different opinion regarding the effectiveness of the IAF. Based
qualification and he should regularly update his on this work, following are the future research opportunities:
knowledge. He must know the changes in the 1. In this study, semi structured interviews are used for data
profession and knowledge of the industry in which he collection, other techniques like questionnaire and case
is working. Industry specific knowledge is also studies can also be used in future.
necessary”.

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this research Experiences. Contemporary Accounting Research 27
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arrangement of IAF? Alternative Internal Audit Structures and the Level of
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