Abstract:
The attributes that enhance the effectiveness of the internal audit function in mitigating
earnings management still remains as a topic of ongoing debate. This study aims to
examine this phenomenon within the context of a developing country, where the risk
of earnings management is notably higher. The data window consists of 30 banks and
diversified financial companies listed on the Colombo Stock Exchange from 2018 to
2021. Panel data analysis with fixed effects is employed to examine the impact of
internal audit function attributes on earnings management. The findings reveal that
larger, more independent, and financially knowledgeable internal audit functions
significantly reduce the tendency of management to engage in earnings management.
Conversely, the frequency of internal audit meetings alone does not significantly
impact earnings management, which implies that the quality and substance of audit
activities are more important than mere frequency. Therefore, it is concluded that an
internal audit function characterized by greater staff size with their higher
independence and financial expertise is crucial in reducing earnings management in
banks and diversified financial companies. These findings have significant theoretical
and practical implications. Theoretically, the findings extend the understanding of
agency theory, stakeholder theory, the resource-based view, and institutional theory
by providing evidence that supports their theoretical predictions. Practically, they offer
clear guidance for regulators, corporate governance practitioners, company
management in establishing frameworks and policies for internal audit function, which,
in turn, promote ethical financial practices and strong corporate governance,
supporting the achievement of the Sustainable Development Goals.
