David Wood and Dr. Douglas F. Prawitt, School of Accountancy and Information Systems
Internal audit has undergone significant changes in the last few years. In particular, outsourcing of the internal audit function (IAF), often to large CPA firms, has grown in popularity as companies seek to reduce costs and to focus on core business competencies. While third-party providers claim to offer comparable or superior services to those of in-house IAFs (for example see Moss Adams 2005), the Institute of Internal Auditors (IIA) maintains that an IAF “housed internally within the organization (IIA 1998)” is the ideal structure for internal auditors.
The implications of alternative internal audit sourcing arrangements have received little attention in the academic literature. While there are a number of important implications to consider, one critical factor in evaluating the effects of sourcing arrangements revolves around the external auditor’s reliance on the work of the internal auditor. We examine whether external auditors differ in their level of reliance on the IAF depending on sourcing arrangement—in-house versus outsourced. We also examine how the sourcing/reliance relationship is affected by (1) the level of incentives for aggressive earnings management and (2) the subjectivity of the task undertaken by the internal auditor.
Ahlawat and Lowe (2004) find that outsourced internal auditors advocate their client’s position less than do in-house internal auditors in certain situations. Although there appears to be a difference in the objectivity of internal auditors based on the sourcing arrangement, studies examining users of external auditors’ information have found no difference in the decisions made by financial statement users based on whether the external auditor relied on the work performed by in-house or outsourced internal auditors (James 2004; Lowe, Geiger, and Pany 1999; and Swanger and Chewning 2001). In this study, we specifically examine the effects of IAF sourcing arrangement on the reliance decision and investigate whether external auditors’ reliance decisions are affected by task subjectivity and incentives for management to manipulate earnings.
To test our predictions, we administered an experimental case instrument to 127 external auditors from one of the Big 4 accounting firms. Our results indicate that external auditors are about equally likely to rely on in-house versus outsourced internal auditors’ work when management’s incentive to manipulate earnings is low, but are significantly more likely to rely on the work of outsourced than in-house internal auditors when management has a high incentive to manipulate earnings. The results also suggest that external auditors rely more on work performed by internal auditors for objective tasks than subjective tasks and that this difference is greater when managers have a clear incentive to manage earnings. However, we found no interaction between sourcing arrangement and task subjectivity on the reliance decision.
In addition to examining if differing sourcing arrangements affect the external auditors’ reliance decision, we examine on an ex-post basis how the sourcing arrangement affects the reliance decision. Before relying on work performed by internal auditors, external auditors are required to evaluate the objectivity and competence of internal auditors (AICPA 1990). Using path analysis, we test whether these and other variables (perceptions of internal auditor legal liability and similarity) mediate the effects of outsourcing on the reliance decision. Results of our ancillary analyses suggest that outsourcing has a direct effect on the reliance decision and that the external auditor’s assessment of objectivity partially mediates the effect of outsourcing on the reliance decision. Our data do not indicate that differences in the legal liability faced by in-house and outsourced external auditors provide additional explanatory power about how sourcing arrangement affects the reliance decision. However, consistent with research in psychology, the perceived similarity of the internal auditors to the external auditor does provide additional explanatory power. Our results suggest that external auditors perceive outsourced internal auditors to be more similar to themselves and that this similarity effect partially mediates the direct effect of outsourcing on the reliance decision.
This study contributes to a rigorous understanding of the role of the internal audit function—an important component of corporate governance, and specifically provides insight into external auditors’ judgments and decisions as their work interrelates with that of internal auditors. Our results have potential practical implications for external auditors, internal auditors, companies that employ internal auditors, and standard-setters seeking to understand factors affecting external auditors’ reliance decisions. Entities with an internal audit function might consider the implications of how external auditors perceive internal auditors, especially in high-risk situations. Companies might find our results useful in considering the current sourcing arrangements of their IAF and explore whether they can gain efficiencies by using outsourced providers or by otherwise enhancing external auditor perceptions of their in-house functions.