Internal Auditor Turnover, Financial Reporting Quality, and Audit Risk Assessment

Internal audit serves a valuable monitoring role inside of companies; yet, we understand relatively little about factors that affect internal audit’s ability to monitor financial reporting. We study one factor — how turnover of the chief audit executive (CAE) position influences financial reporting quality and audit risk assessment. Using data from Taiwan where companies are required to disclose when and why CAEs change position, we find that a CAE turnover event is associated with a significant increase in the odds of a financial statement misstatement and an increase in discretionary accruals. Furthermore, we find that the relation only holds for firms with forced CAE changes (i.e., demotions, dismissals, or resignations) and not for unforced changes (i.e., lateral moves in the company, promotions, retirements, etc.). We exclude observations with contemporaneous CEO, CFO, or auditor switches and control for changes in signing audit partners. Results are robust to a generalized difference-in-difference design that includes both year and company fixed effects. We corroborate these findings by examining external auditors’ response to CAE turnover and find that external auditors charge higher fees the year there is a CAE change. The results provide evidence of the important monitoring role of internal auditing, and especially of the critical role the CAE plays in the internal audit function.