Internal audit function and accounting estimates: Causal evidence from private firms

Internal audit function (IAF) has long been recognized as a key component of corporate governance with an important monitoring role. The Institute of Internal Auditors defines an effective IAF as one of four building blocks of corporate governance. In response to egregious accounting frauds in the 2000s, the IAF has received greater attention from financial media, standard setters, and regulators. Prior literature focuses on the existence or quality of an IAF and examines various outcomes of the IAF. However, none of these studies provide strong causal inferences because the presence or quality of an IAF is likely to be endogenously determined.

In this proposal, I plan to study the causal effect of IAF on accounting estimates using a novel regulatory setting in the U.S. insurance industry. U.S. insurers, which are largely private firms, are regulated at the state level and each state has the authority to determine when and how to adopt certain regulatory requirements. U.S. states adopted the IAF regulation on a staggered basis between 2016 and 2021. The staggered adoption across states, along with the exemption threshold for small insurers, allows for a staggered difference-in-differences research design to provide causal evidence on the effect of an IAF.

Given that IAF is an important governance mechanism, I hypothesize that IAF can reduce the bias in accounting estimates. The insurance industry provides a unique setting to study accounting estimates because of the special statutory reporting requirements regarding loss reserves. Insurers’ loss reserve is the single largest estimation item in the balance sheet, representing around 50 percent of total liabilities. U.S. insurers must disclose the gradual settlement of claims over time and record all revisions of the loss reserve estimate. Data on future settlement and revisions corresponding to each prior year’s loss reserve estimation provide an indication of the bias in this accounting estimate.

To the best of my knowledge, the proposed study is the first to study the causal effect of an IAF using an exogenous shock affecting a large sample of private firms. My proposed research can improve our understanding of how IAF affects insurers’ accounting practice which is important to the stability of the financial system. The findings are likely to have policy implications such as allowing for an evidence-based approach in consideration of whether to mandate IAF requirements for other industries.