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  • Jennifer M Mueller-Phillips
    Internal auditors’ use of interpersonal likability, a...
    research summary posted July 20, 2015 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors 
    Title:
    Internal auditors’ use of interpersonal likability, arguments, and accounting information in a corporate governance setting.
    Practical Implications:

    The findings illustrate how and when internal auditors can achieve agreement from managers using tactics that can be effective even when the underlying information supporting their position is not particularly strong. The findings should also be informative to external auditors, managers, researchers, and others interested in influencing managers’ judgments and corporate governance. The study can help develop a theory about day-to-day behavioral factors that drive variance in internal auditors’ influence over managers’ judgments.

    Citation:

    Fanning, K., & David Piercey, M. 2014. Internal auditors’ use of interpersonal likability, arguments, and accounting information in a corporate governance setting. Accounting, Organizations & Society 39 (8): 575-589.

    Keywords:
    internal auditors, interpersonal relations, corporate governance, disclosure of information
    Purpose of the Study:

    In this study, the authors examine how three variables, each fundamental to internal auditors’ interactions with managers, explain internal auditors’ influence on managers’ judgments:

    1. Internal auditors’ interpersonal likability,
       
    2. The underlying information supporting their positions, and
       
    3. Their use of thematically organized arguments to present that information to managers.

    Internal auditors tend to interact with managers frequently, and are “often the party primarily responsible for the day-to-day monitoring of management’s actions, including those related to external financial reporting.” Internal audit lacks the client services incentives of external audit, allowing internal auditors to adopt a “policeman approach,” which places little emphasis on positive interpersonal interactions with managers as clients, compared to external audit. The “police” approach to internal audit can harm the managerinternal auditor relationship. A dysfunctional relationship between managers and internal auditors is a contributing cause, and in some cases, a primary cause of a variety of accounting problems, including material weaknesses, financial restatement, regulatory compliance, and the like. 

    Design/Method/ Approach:

    The experimental case within places participants into the role of a mid-level manager who provides input to a controller about whether the value of inventory should be written down in the financial statements as obsolete. The authors recruited managers, executives, and other professionals in management training programs to participate in the study. The 133 participants averaged 8.5 years of professional business experience and 4.4 years of managerial experience. The evidence was gather prior to 2014.

    Findings:

    The authors found that because people find the thematically structured flow of an argument appealing, and because positive affective states lead to heuristic processing, managers will heuristically agree more with an internal auditor who is both likable and uses an argument structure, beyond the effects of how supportive or unsupportive the internal auditor’s information is of his position.

    • Managers agree more with an auditor who uses more supportive information than one who uses less supportive information.
    • However, beyond that, they also agree more with an internal auditor who is both likable and uses a thematically organized argument structure, regardless of whether the information presented is relatively supportive or unsupportive of the internal auditor’s
      position.
    • The results demonstrate that an internal auditor can achieve (on average) agreement from managers simply because he is likable and uses a flowing argument structure, even when the underlying information is relatively unsupportive and managers otherwise (on average) do not to agree with the internal auditor.

    Overall, the findings suggest that internal auditors can achieve additional agreement from managers on important corporate governance issues, above and beyond how supportive or unsupportive their information is, by using an argument structure and likability jointly, as a fairly straightforward presentation tactic.

    Category:
    Auditing Procedures - Nature - Timing and Extent
    Sub-category:
    Reliance on Internal Auditors
  • Jennifer M Mueller-Phillips
    Reconciling Archival and Experimental Research: Does...
    research summary posted February 16, 2015 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors, 10.0 Engagement Management, 10.06 Audit Fees and Fee Negotiations 
    Title:
    Reconciling Archival and Experimental Research: Does Internal Audit Contribution Affect the External Audit Fee?
    Practical Implications:

     The results of this study are useful to managers, boards of directors, and audit committees to benchmark their own organizations and determine areas in which they may be able to realize cost savings.  Standard setters for external auditors could consider these results in terms of whether external auditors are appropriately relying on specified characteristics of the IAF when making their reliance decisions.  Client companies and their auditors might both find it worthwhile to examine whether external auditors could make better use of financial work performed by internal auditors on which the external auditors might later rely.  Finally researchers may wish to consider the results of this study when examining the external auditor’s reliance decision or when performing other audit fee analyses, especially considering whether proxies used in this study would be appropriate control variables or experimental variables of interest with respect to the contribution of internal auditing.

    For more information on this study, please contact David A. Wood.

    Citation:

    Prawitt, D. F., N. Y. Sharp, and D. A. Wood. 2011. Reconciling archival and experimental research:  Does internal audit contribution affect the external audit fee. Behavioral Research in Accounting 23 (2): 187-206

    Keywords:
    Internal audit function, internal audit costs, internal audit quality, external audit fee, SAS No. 65, AS 5
    Purpose of the Study:

    Experimental and survey research consistently have found evidence of a negative relation between measures of internal audit contribution and external audit fees. By contrast, past archival research typically has documented either no relation or a positive relation.  While it has provided important insights, prior archival research examining the relation between internal auditing and external audit fees has been limited by the unavailability of detailed data about internal audit functions (IAF).  With newly available archival data, this paper examines the internal audit contribution/external audit fee relation using direct measures of the amount of time internal auditors work directly assisting external auditors, and the amount of time internal auditors spend performing tasks upon which the external auditor is likely to rely.

    Understanding the association between the contribution of internal auditing and external audit fees is important because this is an economically important relationship.  External auditing standards allow the external auditor to either use internal auditors as assistants or to rely on work previously performed by the IAF.  This paper also addresses which of the two methods of reliance results in a greater reduction in the external audit fee.

    The conflict mentioned earlier between the results of previous research using surveys and experiments versus those found in archival studies have led a number of researchers to call for additional work in the area.  This paper also suggests an explanation for the divergent findings in the experimental and archival studies in this area.

    Design/Method/ Approach:

    The data set examined in the research is from the IIA’s GAIN database relating to fiscal years 2000 to 2005.  The authors restricted their analysis to these years because of availability of IIA data (they have no data after 2005) and because of availability of external audit fees (audit fee data were not made public before 2000).  

    Findings:
    • The authors find that external audit fees are negatively associated with internal audit contribution.
    • The authors find that the amount of time internal auditors spend performing tasks of a financial nature is not associated with lower external audit fees, but that the time spent working under direct supervision of the external auditor is associated with lower external audit fees.
    • The authors find that proxies used in past archival studies are positively associated with measures of the host companies’ size and complexity, and are negatively associated or are not associated with this study’s relatively direct measures of the contribution of the IAF to the external audit. In other words, proxies used in past archival studies likely did not do a good job of capturing IAF contribution, which explains their contradictory results.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Engagement Management
    Sub-category:
    Audit Fees & Fee Negotiations, Reliance on Internal Auditors
  • Jennifer M Mueller-Phillips
    Internal Audit Sourcing Arrangements and Reliance by...
    research summary posted September 26, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.01 Scope of Testing, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    Internal Audit Sourcing Arrangements and Reliance by External Auditors
    Practical Implications:

    The authors note a couple of implications for practitioners resulting from this study.  First, given the fact that external auditors assess internal audit quality and rely upon the work similarly for outsourced and cosourced internal audit functions, it may be worthwhile for companies to consider engaging some level of independent outside service provider to work along with their in-house internal auditors for high risk areas. 
        Second, having the same 3rd party internal audit service provider also provide tax services results in less reliance upon the work performed by internal audit, even though those services are approved by the audit committee and performed by different individuals.  Therefore, external audit increases their audit effort, thereby implying that external audit must see this additional service provision to be detrimental to the internal audit service provider’s objectivity. 
     
    For more information on this study, please contact Naman K. Desai.
     

    Citation:

    Desai, N. K., G. J. Gerard, and A. Tripathy. 2011. Internal Audit Sourcing Arrangements and Reliance by External Auditors. Auditing: A Journal of Practice & Theory 30 (1):149-171.

    Keywords:
    cosourcing; external auditor reliance; internal audit; sourcing
    Purpose of the Study:

      The purpose of this study is to investigate potential internal audit (IA) sourcing arrangements (in-house, outsource, and cosource) and to determine how that impacts an external auditor’s evaluation of the IA function’s competency, objectivity, and technical skills. The extent to which the audit team will rely upon work performed by the internal auditors can also be determined this way.  This study also looks at whether tax services provided by the IA service provider impacts the extent of reliance for outsourced or cosourced IA.
    This study is important because the Institute of Internal Auditors makes no preference between any of these sourcing arrangements.  Prior research has shown that outsourcing the IA function results in higher ratings of objectivity and more reliance upon their work when inherent risk is high (but no differences when inherent risk is low).  However, no studies test how cosourcing arrangements are evaluated.  This question is important to answer since a cosourced arrangement is a blend of in-house and outsourced internal auditors, which indicates that results could go either way. 
     

    Design/Method/ Approach:

    The authors conducted an experiment including experienced CPAs from Big 4 and regional firms prior to October 2007.  The design results in only 5 groups – in-house, outsource, or cosource without mention of tax services and outsource or cosource with the service firm also providing tax services.  External auditors were asked to provide ratings related to internal audit’s quality, reliance on internal audit work, audit risk, planned external audit effort, and likelihood that IA would give in to management regarding potential findings.

    Findings:
    • The authors find that in high risk areas, external auditors’ rate outsourced and cosourced internal auditors as having higher levels of quality than in-house internal audit.
    • They similarly find that external audit is more likely to rely upon the internal audit work performed if it is performed by outsourced or cosourced IA.
    • Further, the authors find no differences in quality or reliance ratings between outsourced and cosourced IA. 
    • However, when outsourced or cosourced internal audit service providers also provide tax services (which are performed by individuals other than those who perform the internal audit work) external auditors perceive the quality of the internal audit work to be lower.  As a consequence, they rely less upon the internal auditor’s work and instead increase their own external audit efforts. 
       
    Category:
    Auditing Procedures - Nature - Timing and Extent, Governance, Internal Control
    Sub-category:
    Internal auditor role and involvement in controls and reporting, Reliance on Internal Auditors, Scope of Testing
  • Jennifer M Mueller-Phillips
    The Effects of Employer and Client Identification on...
    research summary posted September 12, 2013 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors 
    Title:
    The Effects of Employer and Client Identification on Internal and External Auditors' Evaluation of Control Deficiencies
    Practical Implications:

    The Primary implication of this study is that reliance on the work of internal auditors may improve audit quality. AS5 recommends reliance on the work of internal auditors for lower-risk areas because it is presumed to improve efficiency. This paper, however, suggests that quality will be improved as well. Therefore, auditors may want to evaluate policies regarding regarding using the work of internal auditors and do so more heavily in the future.
     

    For more information on this study, please contact C.M. Stefaniak.

    Citation:

    Stefaniak, C., R. Houston, and R. Cornell. 2012. The Effects of Employer and Client Identification on Internal and External Auditors' Evaluations of Internal Control Deficiencies. Auditing: A Journal of Practice and Theory. (31)1:39 –56.

    Keywords:
    Auditor judgment, organizational identification, internal auditor, external auditor
    Purpose of the Study:

    Auditing Standard No. 5 (AS5) encourages external auditors to rely on internal auditors to increase the efficiency of lower-risk internal control evaluations. This study uses experimental data to determine whether internal auditors or external auditors are more lenient and by extension, which auditors perform higher quality audits.

    Design/Method/ Approach:

    In the post-Sarbanes Oxley period, the authors conducted an experiment with 40 internal auditors and 48 external auditors. Participants were given a hypothetical scenario, and were asked to evaluate the internal controls of the hypothetical firm.

    Findings:

    The main differences between internal and external auditors are as follows:

    • Internal auditors perceive a greater level employer identification when compared to external auditors
    • Internal auditors are less lenient than external auditors
       
    Category:
    Auditing Procedures - Nature - Timing and Extent
    Sub-category:
    Reliance on Internal Auditors
  • The Auditing Section
    Internal Audit Quality and Earnings Management
    research summary posted May 7, 2012 by The Auditing Section, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    Internal Audit Quality and Earnings Management
    Practical Implications:

    This study develops an empirical measure of internal audit quality, and provides evidence supporting companies’ use and  development of an IAF as part of improvements to its overall governance environment.  Regulators and other parties interested in corporate governance may find it helpful to more explicitly consider the role of internal auditor in the evaluation of the firm. 

    Citation:

    Prawitt, D., J. Smith, D. A. Wood 2009. Internal Audit Quality and Earnings Management. The Accounting Review 84 (4): 1255-1280.

    Keywords:
    corporate governance; internal audit function; internal audit quality; earnings management; abnormal accruals; analyst forecasts
    Purpose of the Study:

    Standards promulgated by the AICPA and PCAOB recognize the impact that a high-quality internal audit function (IAF) can have on reducing control risk, and by extension, audit risk.  As such, regulators permit and encourage external auditors to rely on the work of others if that work is deemed to be performed by “competent and objective persons” (PCAOB 2007).  Similarly, the Institute of Internal Auditors (IIA) recognizes the IAF as one of the four cornerstones of corporate governance, along with the audit committee, executive management, and the external auditor.  However, while several prior studies establish a negative association between the quality of firm’s corporate governance mechanisms and management’s tendency and ability to manipulate reported financial results, there is little evidence that relies on archival data concerning the impact of a quality IAF on firms’ earnings manipulation activities.

    The purpose of this study is to examine archival data to determine whether differences in the quality of firms’ IAF impact firms’ earnings management activities.

    Design/Method/ Approach:

    The authors rely on the IIA maintained GAIN database (a proprietary database), that is composed of survey responses from chief audit executives associated with IIA member organizations.  Member organizations responding to the survey include publicly traded and private companies, educational and governmental institutions, as well as individual divisions within companies.  The study covers the fiscal years of 2000-2005. 

    The authors create an index based on six factors that SAS No. 65 suggests external auditors should consider when evaluating whether to rely on the work of the internal auditors, and therefore differentiate IAF quality.  Those factors include the IAF’s professional experience, professional certifications, training, objectivity, relevance of their work to the financial reporting function, and the IAF’s relevance to the organization based on how much resources the corporation invests in the IAF group.  To capture management’s earnings management activities, the authors rely on measures of abnormal accruals and whether the firm just misses or beats analysts’ forecasts.

    Findings:
    • Overall, the results suggest that higher quality IAFs reduce management’s ability to manipulate earnings.
    • Specifically, higher quality IAFs appear to be associated with smaller negative abnormal accruals.
    • Companies with higher quality IAFs appear more likely to just miss analysts’ earnings forecasts, a measure of less earnings management.
    Category:
    Auditing Procedures - Nature - Timing and Extent, Governance
    Sub-category:
    Reliance on Internal Auditors, Internal auditor role and involvement in controls and reporting
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  • The Auditing Section
    Internal Audit Reporting Lines, Fraud Risk Decomposition,...
    research summary posted May 4, 2012 by The Auditing Section, tagged 06.0 Risk and Risk Management, Including Fraud Risk, 06.01 Fraud Risk Assessment, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.11 Reliance on Internal Auditors, 13.0 Governance, 13.07 Internal auditor role and involvement in controls and reporting 
    Title:
    Internal Audit Reporting Lines, Fraud Risk Decomposition, and Assessments of Fraud Risk
    Practical Implications:

    The results of this study are important for audit firms to consider when determining the extent of reliance on internal auditor’s fraud risk assessments.  Internal auditor judgments may be influenced by pressures to decrease risk assessments when reporting to the audit committee.  Thus, the recent suggested improvements for improving audit practice and risk assessment processes by reporting to the audit committee may have adverse and unexpected consequences.  Additionally, internal auditor judgments may be influenced by an over-reliance on attitude cues, even when decomposing fraud risk assessments.  Thus, decomposition may amplify the problem that prompted its use.

    Citation:

    Norman, C.S., A.M. Rose, and J.M. Rose. 2010. Internal audit reporting lines, fraud risk decomposition, and assessments of fraud risk. Accounting, Organizations and Society 35: 546-557.

    Keywords:
    internal audit, fraud risk assessment, audit committee
    Purpose of the Study:

    The internal auditor function is one of the four cornerstones of corporate governance along with senior management, the board, and external auditors.  External auditors frequently rely on the work of internal auditors, including firm risk assessments per AS5, An Audit of Internal Control over Financial Reporting that is Integrated with an Audit of Financial Statements.  Internal auditors may report to management or to the audit committee.  Many investors and regulators have suggested that internal auditors should report directly to the audit committee to minimize the threats to independence and objectivity that may potentially occur when internal auditors report to management.  However, if the audit committee is given power over the internal audit function, this may create potential new threats to internal auditor independence not previously considered.  For example, many audit committees now have the authority to hire or fire the Chief Audit Executive.  This paper addresses the effects of internal audit reporting lines on the fraud risk assessment judgments of internal auditors.  Below are two objectives that the authors address in their study: 

    • Examine the extent that internal auditors may be subconsciously motivated to avoid reporting higher levels of fraud risk to the audit committee, relative to when the risks are reported to management.
    • Examine whether decomposition of fraud risk into the components of the fraud triangle (management attitude, incentives, and opportunities) improves the internal auditor’s sensitivity to opportunity and incentive cues.
    Design/Method/ Approach:

    The authors collected their evidence from highly experienced internal auditors (mean experience of 15.3 years) via survey instruments. The authors then collected additional evidence using an experiment where participants were asked to complete a simulated task. Experiment participants were experienced internal auditors with mean experience of 9.6 years.  Survey participants were asked five questions about risk assessment discussions, reporting lines, and reactions.  In the simulated task participants were asked to assess the level of fraud risk in a hypothetical firm.  Participants were assigned to either a higher or lower level of fraud risk and to a reporting line of either audit committee or management.  The research was conducted in the mid- to late-2000s time period.

    Findings:
    • The authors find that internal auditors perceive greater personal threats when reporting high levels of fraud risk to the audit committee than when reporting to management.  Internal auditors fear overreaction from the audit committee, potentially leading to increased workload and management reprisals.   
    • The perception of greater perceived threats leads internal auditors to reduce assessed levels of fraud risk when reporting to the audit committee relative to reporting to management.  This finding is contrary to expectations and reveals additional unexpected threats created by having internal audit report to the audit committee.
    • Internal auditors increase attention to management attitude when risk assessments are decomposed, without a corresponding increase to incentive or opportunity cues.  Thus, unlike external auditors, fraud decomposition does not appear to mitigate perceived problems associated with insensitivity to incentive and opportunity cues.    
    Category:
    Risk & Risk Management - Including Fraud Risk, Auditing Procedures - Nature - Timing and Extent, Governance
    Sub-category:
    Fraud Risk Assessment, Reliance on Internal Auditors, Internal auditor role and involvement in controls and reporting
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