|
|
||
|
|
||
|
|
|
||
|
|
||
|
|
Internal Audit Sourcing Arrangement and the External Auditor's Reliance Decision
Steven M. Glover, Douglas F. Prawitt, and David A. Wood
Internal Audit Sourcing Arrangement and the External Auditor’s Reliance Decision
Steven M. Glover, Douglas F. Prawitt, and David A. Wood
Executive Summary
This study focuses on the effects of internal audit sourcing arrangement on the external auditor’s decision to rely on the work of the internal auditor, a decision that has taken on increased importance as a result of section 404 of the Sarbanes-Oxley Act of 2002 and Public Company Auditing Oversight Board Auditing Standard No. 2. Outsourcing of various accounting functions, including internal auditing, has grown in popularity as companies seek to reduce costs and focus on core business competencies. A survey conducted by the Institute of Internal Auditors (IIA) indicates that as of 2002, 54 percent of the surveyed companies used third parties to perform some or all of the internal auditing work performed within the entity -- an increase from 30 percent of organizations surveyed in 1995.
Competing claims for and against internal audit outsourcing are readily found in practice, with third-party internal audit outsourcing providers arguing the merits of outsourcing, while others, including the IIA, maintain that internal audit function (IAF) primarily housed within the organization is ideal. Competing claims notwithstanding, the potentially important implications of alternative internal audit sourcing arrangements have received little attention in the academic literature.
Prior research indicates that companies are able to decrease their external audit fee on average by about 18 percent annually through external auditor reliance on the IAF. Much of the research examining the external auditor’s reliance decision has focused on examining which of the areas specified by Statement on Auditing Standards (SAS) No. 65 -- competence, objectivity, and nature of work performed — are important in the reliance decision. These studies provide evidence that characteristics of the IAF in these three areas do influence the extent to which external auditors rely on work performed by internal auditors. Additional research has considered whether factors outside the prescriptive SAS No. 65 model also affect the reliance decision, demonstrating that factors such as task subjectivity, fee pressure, internal auditor availability, audit partner preferences, client pressure, and internal auditor compensation influence the external auditors’ evaluation. However, this research has not examined whether these factors have a direct effect on external auditor reliance or whether the effect of these factors is mediated through the external auditor’s consideration of objectivity, competence, and work performed.
The external auditor’s decision to rely on the IAF has important potential economic consequences as well as implications for audit efficiency and effectiveness. We extend prior research examining the external auditor’s reliance decision by examining how alternative sourcing arrangements affect this decision in the context of varying levels of inherent risk and task subjectivity. We also extend prior research by examining whether outsourcing affects the reliance decision directly or whether its effects are mediated through the SAS No. 65 variables.
We argue that in-house and outsourced internal auditors likely differ in motives and incentives as a result of differences in institutional arrangements (e.g., the nature of the relationship with management, economic dependence, legal liability), which may affect external auditor perceptions of internal auditor objectivity. These differences in institutional arrangements indicate a relatively close alignment between an in-house IAF and management, which may result in lower external auditor perceptions of the objectivity of in-house internal auditors than outsourced internal auditors. Thus, the external auditor will, to some degree, attribute favorable reports by in-house internal auditors to incentives to please or align with management rather than to the work performed by the internal auditors. In prior research, among other differences, outsourced internal auditors indicated more concern with potential litigation, while in-house internal auditors placed more weight on "advocating the most advantageous position for its client".
Our predictions are based on attribution theory, which proposes that evaluators (e.g., external auditors) assess a source’s incentives to bias their message when evaluating the source s message. In our setting, if the external auditor perceives that an internal auditor has incentives to report in a particular way, the external auditor will perceive the internal auditor’s work to be less persuasive because the external auditor attributes the internal auditors’ reported results to these incentives. The external auditor will therefore rely to a lesser extent on the work of the internal auditor.
Appropriately evaluating and relying on the IAF becomes more critical as the inherent risk of a material misstatement in the financial statements increases or when the work of the internal auditor is more subjective and thus more susceptible to bias. Thus, we examine the effect of sourcing arrangement on the external auditor’s reliance decision in the presence of varying levels of inherent risk and task subjectivity.
We report results for 127 external audit participants from one Big 4 accounting firm. The average participant had 3.6 years of Big 4 audit experience and 1.5 years of other business experience. In the experimental materials, we manipulate internal audit sourcing, inherent risk, and task subjectivity. Our results indicate that external auditors are about equally likely to rely on in-house versus outsourced internal auditors’ work when inherent risk is low, but are significantly more likely to rely on the work of outsourced than in-house internal auditors when inherent risk is high. We also find that external auditors rely more on work performed by internal auditors for objective tasks than subjective tasks when inherent risk is high but not when inherent risk is low.
SAS No. 65 requires external auditors to evaluate the objectivity, competence, and work performed by internal auditors. In an analysis designed to provide additional insight into our primary results, we find that outsourcing has an indirect effect on the reliance decision by means of differences in perceived objectivity and a direct effect on reliance even after taking into account the external auditor’s assessment of IAF objectivity and competence and attempting to hold work performed constant. These results suggest that outsourcing is a variable that influences the reliance decision beyond that specified by SAS No. 65.
This study contributes to our understanding of external auditors’ judgements and decisions as their work interrelates with that of internal auditors. Our results have potential practical implications for external and internal auditors, companies that employ internal auditors, and standard-setters seeking to understand factors affecting external auditors’ reliance decisions. For example, both standard-setters and policysetters for external auditors may wish to consider whether sourcing arrangement is an appropriate factor to be considered in the reliance decision, and if and how this factor should be incorporated into standards and audit firm policy. IAFs and audit clients may wish to consider how external auditors react to different sourcing arrangements, especially when significant inherent risk factors are present. Finally, companies may consider how outsourcing some or all of their IAFs, or possibly taking action to alter their external auditors’ perceptions of their in-house IAFs, might affect external auditors’ reliance decisions and hence external audit costs.