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Related party transactions and audit fees: the role of the internal audit function

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Abstract

Related party transactions (RPTs) are viewed as genuine transactions that rationally fulfil other economic demands of a company. However, RPTs can also be used to transfer wealth from minority shareholders to controlling shareholders. The existence of such transactions may deteriorate financial reporting quality, increase audit risk, and as a result increase audit fees. This study examines the relationship between RPTs and audit fees in Malaysia, where ownership is often concentrated within a controlling family and corporate governance mechanisms are poor. It also investigates the moderating effect of the internal audit function (IAF) on this relationship. We find that external auditors base their fees on the types of RPTs undertaken. Specifically, our results show that audit fees are higher for firms that undertake RPTs involving the sale and purchase of assets, goods, and services. We also document that external auditors rely on the IAF, and thus their fees are lower for firms that undertake RPTs and that have made a large investment in an IAF. Our study is the first to provide evidence that RPTs in Malaysian firms may be abused as a channel to facilitate tunnelling and that the IAF plays a vital role in controlling such transactions.

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Notes

  1. If indeed sourcing arrangements affect the association between RPTs and audit fees, the sign on the interaction variable of outsourced IAF and RPTs may be either positive or negative. A positive sign is supported by the prior research, which suggests that compared to outsourced internal audit providers, external auditors utilize in-house internal auditors to assist in the discovery of fraud and misstatement. This is due to in-house internal auditors being more familiar with the day-to-day operations of the firm.

  2. As shown in Panel B of Table 1, financial firms account for 16% of the sample. We deliberately do not exclude financial firms as these firms may represent cases with RP sales and/or purchases of assets, goods, and services. If such cases are discarded, we may lose information on firms with RP sales and/or purchases. However, this study controls for financial firms to ensure that these firms do not affect our findings.

  3. We also perform the variance inflation factor (VIF) test to ascertain whether the multicollinearity problem exists in the regression analysis. The findings (not reported in the paper but available from the authors on request) show that the highest VIF is 8.69 and that the VIFs of all the other explanatory variables are below the critical value of 10. Again, the results suggest that the multicollinearity problem is not a major concern of the study.

  4. Here, RPTs represents the total amount of all related party transactions. Other types of RPTs include lending arrangements, provision of guarantees or collateral, and leases.

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Acknowledgements

We wish to thank Associate Professor Dr. Rohaida Abdul Latif, Professor Wan Nordin Wan Hussin, and Associate Professor Asghar Afshar Jahanshahi for their valuable comments and suggestions. We gratefully acknowledge the generous financial support from Universiti Utara Malaysia (UUM). Our gratitude also goes to the anonymous reviewers of this paper.

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Authors and Affiliations

  1. College of Business, Tunku Puteri Intan Safinaz School of Accountancy, Universiti Utara Malaysia (UUM), Sintok, Kedah, Malaysia

    Redhwan Ahmed Al-Dhamari, Bakr Al-Gamrh & Ku Nor Izah Ku Ismail

  2. Kulliyyah of Economics and Management Sciences, International Islamic University Malaysia (IIUM), Kuala Lumpur, Malaysia

    Bakr Al-Gamrh

  3. College of Arts and Sciences (CAS), School of General Studies, Universiti Utara Malaysia (UUM), Sintok, Kedah, Malaysia

    Samihah Saad Haji Ismail

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  1. Redhwan Ahmed Al-Dhamari
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Correspondence to Bakr Al-Gamrh.

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Al-Dhamari, R.A., Al-Gamrh, B., Ku Ismail, K. et al. Related party transactions and audit fees: the role of the internal audit function. J Manag Gov 22, 187–212 (2018). https://doi.org/10.1007/s10997-017-9376-6

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