Case 2 (Chapter 6)

The Influence of Internal Auditing on Effective Corporate Governance in the Banking Sector in Oman (Zaroug Osman and Omar Igbal, 2018)

Internal Auditing Functions and Standards

Historically, internal audit has been considered as a monitoring

function. It is regarded as the organizational policeman and watchdog

(Morgan, 1980). However, it is tolerated as a necessary component of

organizational control but deemed subservient to the achievement of major

corporate objectives.

According to the Institute of Internal Auditors (IIA), internal auditing

has been defined as an independent, objective assurance and consulting

activity designed to add value and improve an organizations operations

(Nagy & Cenker, 2002). Also, Internal control is defined by Al- jabali et al.

(2011) as: Independent activity objectively, confirmatory, and consultant

determined to add value and improve the organization's operations, and in

helping them achieve their objectives through a systematic and disciplined

method to evaluate and improve the effectiveness of risk management and control processes and governance. Currently, internal auditors can be

portrayed as consultants and the internal audit function of companies which is

used to achieve corporate objectives and add value. As noted by Sarens and

De Beelde (2006), internal auditors are currently expected to make things

happen rather than just waiting to respond to it.

It is argued that an effective internal audit function enables the board

to perform its corporate governance duties. For example, Gramling et al.

(2004) believed that the internal audit function is one of the four cornerstones

of corporate governance, and that the internal auditing function of internal

auditors has an important role to play in assisting the board to monitor the

effectiveness of its governance.

In developed countries, the role of the internal auditor has recently been

affected by the dramatic changes in regulations, mainly from corporate

governance standards and the emphasis of strengthening the internal controls

of organizations of these standards (Holm & Laursen, 2007).

Mihret and Yismaw (2012) stated that internal audit effectiveness can

be guaranteed with the help of four interlinked components: internal audit

quality, management support, organizational setting, and attributes of the

auditees. They argued that the internal audit function needs to be able to

produce quality audits. Vinten (1999) believes that internal audit effectiveness

is achieved when there is independence, sufficient resources, and support from

management.

International Standards for the Professional Practice of Internal

Auditing (Standards) is essential in meeting the responsibilities of internal

auditors and the internal audit activity.

The Institute of Internal Auditors (IIA) 1978 issued the Internal Audit

Standards as follows: Independence and Objectivity, Proficiency and Due

Professional Care, Quality Assurance and Improvement Program, Nature of

Work, and Managing the Internal Audit Activity.

Corporate Governance

Corporate governance has received increased attention and scrutiny

over the last two decades. Corporate governance is defined as the total

operations and controls of an organization (Fama & Jensen, 1983) or as an

overall structured system of principles (Dey Committee, 1994). A

comprehensive definition proposed by John and Senbet (1998) in their study

stated that corporate governance deals with mechanisms by which

stakeholders of a corporation exercise control over corporate insiders and

management such that their interests are protected. More recently, Roe (2004)

defines corporate governance as the relationships that exist at the top of the

firm: the board of directors, the senior managers, and the stockholders.

Corporate governance is based on a set of attributes, including

ensuring accountability to shareholders or stakeholders (Keasey & Wright,

1997). It is considered to be the top extensively studied topics which serve as

a tool for mitigating conflicts of interests between managers and investors.

Corporate governance primarily aims to protect the capital owners from the

opportunistic activities of management (Abdurrouf, 2011; Jensen & Meckling,

1976; Pandya, 2011). In addition, corporate governance offers the directors the

right to create effective decisions in favor of the shareholders interests in order

to realize goals (Shleifer &Vishny, 1997). It is evident that firms with superior

corporate governance enhanced their operating performance (Irina &

Nadezhda, 2009).

Corporate governance represents the system by which companies are

directed and controlled (Cadbury, 2000, 8). The control aspect of corporate

governance includes the notions of compliance, accountability, and

transparency (MacMillan et al., 2004).

The Relationship between Internal Auditing and Corporate Governance

It has been widely recognized that the role of the internal auditor

becomes increasingly more important in terms of creating good corporate

governance structures (Allegrini et al., 2006; Carcello et al., 2005; Nagy &

Cenker, 2002). In todays business environment, internal auditors are now

providing management with a far broader range of information concerning the

organizations financial, operational and compliance activities to improve

effectiveness, efficiency, and the economy of management performance and

activities (Rezaee, 1996). Corporate governance is expected to enhance the

role of the internal auditor; and at the same time, the internal auditor also

provides benefits to the external auditor (Holm & Laursen, 2007).

Mihaela and Iulian (2012) analyzed the effectiveness of internal

control and the Impact of Corporate governance on companies listed on

Bucharest Stock Exchange. An effective internal control leads to a fair

presentation of the financial statements and thus increases stakeholders

confidence in the financial statements. In addition, Yassin et al. (2012) carried

out a research that examines the relationship between internal audit and

corporate governance in various commercial banks in Lebanon. The statistical

analysis showed several significant tests supporting the hypothesis that the

internal audit improves the quality of corporate governance.

Kibet (2008) in his study carried out a survey on the role of internal

audit in promoting good corporate governance in State owned Enterprises

(SOEs). His survey, however, is aimed to explore the role and the use of

internal audit function in promoting good corporate governance in public

sector enterprises and also the challenges faced by the internal auditors in

SOEs. The study concluded that internal audit function played a significant role in corporate governance. Siddiqui and Podder (2002) examined the

effectiveness of financial audit of banking companies operating within

Bangladesh. For the purpose of this study, the audited financial statements of

14 sample banking companies have been analyzed. The study identifies seven

(7) sample companies that have actually overstated their profits. Also, the

research explores the level of independence, objectivity and competence of the

auditors, assigned for auditing banking companies.

From the above discussion, it is clear that the internal auditing is

probably one of the most dynamic and yet important subjects to come to our

attention and become increasingly more important in terms of creating good

corporate governance structures.

From the above, it is clear that the regulation of corporate governance

is the governments attempt to ensure that the corporation pursues its defined

purposes and protects the interests of its owners (Chang et al., 2006).

Hypothesis Development

As we illustrated earlier, the main objective of this research is to

investigate the impact of internal auditing on effective corporate governance.

Internal auditing is an integral part of the corporate governance mosaic in both

the public and the private sectors (Cohen et al., 2002). In the previous

literature, there are many research that analyzed the effectiveness of internal

control and its Impact on corporate governance. Thus, the majority of the

results present that the internal audit improves the quality of corporate

governance. In Oman, the old code on corporate governance (the Old Code)

was issued in 2002. Before the introduction of the new code in 2015, banks

were the only entities that were forced to implement corporate governance.

The role for a compliance governance in a bank is vital as its role is to

investigate and manage the areas of banking regulations and laws, banking

policies, and consumer protection. Also, little research of managers

perceptions on the impact of internal auditor on corporate governance in Oman

has been conducted.

In order to study the impact of internal audit on effective corporate

governance, the following dependent and independent variable were used:

Dependent variable: Corporate governance.

Independent variables: Five independent variables were chosen for the

study. They are:

1-Internal audit independence

2-Proficiency and due professional Care

3- Nature of work

4-Quality assurance and improvement Program

5- Managing the internal audit Activity

Some of the above mentioned variables were used by the study of

Vinten (1999), Yassin et al. (2012), and Kibet (2008).

On the basis of the relationship and variables discussed above, the

following hypotheses were formulated and tested:

H1: Internal audit independence has a significant impact on corporate

governance

H2: Proficiency and due professional Care has a significant impact on

corporate governance

H3: Quality assurance and improvement Program has a significant

impact on corporate governance

H4: Quality assurance and improvement Program has a significant

impact on corporate governance

H5: Managing the internal audit activity has a significant impact on

corporate governance

Research Method

As the research in this area is very descriptive in nature, a survey

questionnaire is considered to be the best approach to collect the data (Alleyne

et al., 2006; Paper et al., 2003). The study population consists of internal

auditors working in Omani commercial banks listed in Muscat Security

Market. The research method of this study was a constructed questionnaire,

which was sent to the 100 top senior level officials and the internal audit

department of the commercial banks in Oman.

The questionnaire was designed to seek management perceptions on

corporate governance and the role of internal audit. The questionnaire covers

some important issues relating to the enhancement of the corporate governance

system.

Subsequently, the regression model that was used in this study is;

CG= a + B1X1 + B2X2 + B3X3 + B4X4 +B4X4+B5x e

Where: CG = Effective corporate governance; a = constant term, X1

= internal audit independence; X2 proficiency and due professional care; X3

= nature of work; X4 = quality assurance and improvement program; X5 =

managing the internal audit activity, = Error Term.

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