Strengthening the third line: internal audit quality and earnings management in emerging market

What the paper says

Purpose Earnings management through real activities manipulation (REM) or accrual-based earnings management (AEM) is a challenge to the credibility of financial reporting, particularly in emerging markets such as Indonesia. As regulatory enforcement in such settings is often weak, firms rely on internal governance mechanisms to maintain reporting integrity. Therefore, this study investigated the association of internal audit quality (IAQ) with both REM and AEM in publicly listed manufacturing firms. Design/methodology/approach This study uses a sample of 1,047 firm-year observations from 143 firms between 2016 and 2023. IAQ was assessed using a composite index that captures competence, independence, and performance, while REM and AEM were estimated in accordance with Roychowdhury (2006) and Kothari et al. (2005), respectively. Data were collected from hand-collected annual report disclosures and secondary sources. Feasible generalized least squares regression with firm, year, and industry fixed effects was used to address econometric concerns. To corroborate the results, this study used coarsened exact matching and ordinary least squares regression with robust standard errors. Findings The results shows that IAQ was negatively and significantly associated with both REM and AEM. These findings emphasize the role of a high-quality internal audit as an important governance mechanism that constrains opportunistic financial reporting. Originality/value This study contributes to the literature by developing a multidimensional IAQ index for archival study, moving beyond prior studies that relied on individual attributes such as the existence, sourcing, or cost of the internal audit function. It also provided novel evidence from Indonesia, where internal audit is mandatory, but governance enforcement remains weak.