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    Internal Audit Outsourcing and the Risk of Misleading or...
    research summary posted October 22, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 04.0 Independence and Ethics, 04.03 Non-Audit Services 
    Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get It Wrong?
    Practical Implications:

    The results of this study support the knowledge spillover argument — that financial reporting quality improves when the external auditor performs at least some internal audit work. In addition, the authors found evidence that higher quality IAFs, regardless of outsourcing arrangement, are associated with lower accounting risk. This study also provides insights on the impact of the SOX prohibition on external auditors’ provision of internal audit services to their clients, and provides evidence concerning whether private companies may benefit from a similar practice. Finally, this study provides insight on how increased interaction among different parties involved in corporate governance can positively influence financial reporting quality.


    Prawitt, D. F., N. Y. Sharp, and D. A. Wood. 2012. Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get It Wrong? Contemporary Accounting Research 29(4): 1109-1136.

    Purpose of the Study:

    A significant change imposed by the Sarbanes-Oxley Act of 2002 (SOX) was to prohibit the outsourcing of internal audit services to firms’ external auditors. There are two competing arguments of how outsourcing the internal audit function (IAF) to the external auditor potentially impacts financial reporting quality. The knowledge spillover argument suggests that by both performing the external audit and providing non-audit services, auditors improve overall audit quality through a deeper understanding of the client. The economic bonding argument suggests that overall audit quality is compromised when the external auditor provides non-audit services, essentially because the external auditor is unwilling to stand up to aggressive or abusive accounting practices for fear of losing a lucrative client engagement Therefore, the purpose of this study was to examine whether outsourcing internal audit services to the external auditor in the pre-SOX period is associated with higher or lower accounting risk, where accounting risk is defined as the risk that clients’ financial statements contain misleading or fraudulently reported numbers. The authors specifically examined the association between accounting risk and four forms of internal audit sourcing:

    • The firm outsources at least some portion of their IAF to their Big N external auditor (pre-SOX).
    • The firm outsources its IAF to other Big N service providers.
    • The firm outsources its IAF to other non–Big N, third-party service providers
    • The firm keeps their IAF entirely in-house.
    Design/Method/ Approach:

        The authors used data from the Institute of Internal Auditor’s GAIN database concerning the IAFs of publicly traded companies during the years 2000 to 2002. To test accounting risk, the authors used data from Audit Integrity, LLP, which is a financial analytics organization. Audit Integrity uses publicly available accounting information as inputs to a proprietary model that measures the risk of potentially fraudulent or misleading financial reporting. The authors then developed a model to evaluate the relationship between internal audit sourcing and accounting risk.


    Companies that outsourced at least some portion of their IAF to their Big N external auditor (pre- SOX) had lower accounting risk than companies that (1) outsourced to other Big N service providers, (2) outsourced to other non–Big N, third-party service providers, and (3) kept their IAF entirely in-house.
    Outsourcing to the external auditor reduces accounting risk by 23 percent relative to firms that kept the IAF in-house (holding other factors constant).
    Accounting risk decreases as the percentage of work outsourced to the external auditor increases.
    Evidence that higher quality in-house IAFs are positively associated with accounting quality.

    Independence & Ethics, Standard Setting
    Impact of SOX, Non-audit Services