Internal Auditing and Real Earnings Management

This study examines whether the presence and strength of internal auditing affect real earnings management behavior. In an experiment using the randomized response technique, 112 MBA students made decisions pertaining to earnings improvement involving overproduction to reduce cost of sales. Participants were assigned to one of three internal audit treatment groups – no internal auditing, weak internal auditing, or strong internal auditing. Results indicate that the effects of internal auditing on overproduction decisions were in the hypothesized direction and statistically significant. While the presence of internal auditing had a significant deterrent effect on overproducing, the effects of internal audit strength are mixed. For a reduced sample, the stronger internal audit function had a greater deterrent effect, but for the full sample this deterrent effect was not statistically significantly different between the strong and weak internal audit groups.