Towards a Decision Aid for External Audit Evaluation of the Internal Audit Function

Article excerpt

ABSTRACT

The purpose of this paper is to inform practitioners about leading research in the field of internal audit and corporate governance. There has been considerable progress in academic research towards the development of a decision aid for External Audit evaluation of the Internal Audit Function. Desai et al. (2009) developed a theoretical model of the decision process used by external auditors to determine the strength of their client's internal audit function. They further tested this model using computer simulations. The model is based on three factors identified by auditing standards and prior academic research: Competence, Work Performance, and Objectivity. The results of the analysis revealed that modelling the "And" relationship is essential for assessing the strength of the IA function. As far as interrelationships are concerned, the analysis revealed that when the three factors have a strong or a perfect relationship, the strength of the IA function remains high even if we have positive or negative evidence about one of the factors. The model developed by Desai et al. (2009) is an important step towards developing a decision aid for external auditors for evaluating the internal audit function. To advance the development of this model the next step will be to test the assumptions of the model empirically in the real audit world among real external auditors.

Introduction

The purpose of this paper is to inform practioners about leading research in the field of internal audit and corporate governance. There has been considerable progress in academic research towards the development of a decision aid for External Audit evaluation of the Internal Audit Function. Desai et al. (2009) developed a theoretical model of the decision process used by external auditors to determine the strength of their client's internal audit function. The structure of the model is represented in Figure 1. They further tested this model using computer simulations. The model is based on three factors identified by auditing standards and prior academic research: Competence, Work Performance, and Objectivity (SAS 65 1991; Messier and Schneider 1988; Krishnamoorthy 2002; PCAOB 2007). Desai et al. (2009) developed an analytical expression of the model using the belief function framework. By using this framework they overcame limitations of prior research regarding the modelling of interrelationships among factors and regarding difficulties in application. The results of their analysis revealed that modelling the "And" relationship is essential for assessing the strength of the IA function. As far as interrelationships are concerned, the analysis showed that when the three factors have a strong or a perfect relationship, the strength of the IA function remains high even if there is positive or negative evidence about one of the factors. This result holds as long as there are high levels of beliefs about the other two factors. Further, they demonstrated how the quality of corporate governance affects the evaluation of the IA function.

Internal Audit Function Evaluation Model

Need for a Decision Aid

The Sarbanes-Oxley Act of 2002 (hereafter SOX), significantly elevated the role of the internal audit (IA) function. Section 302 of SOX requires management to report on and certify to the effectiveness of its internal control structure and procedures with respect to the firm's quarterly and annual reports. Section 404 of SOX requires management to document, evaluate, and report on the effectiveness of internal control over financial reporting, and requires the external auditor to evaluate and opine on management's assessment of internal control. In May 2007, the Public Company Accounting

Oversight Board (PCAOB) revised their guidance on auditing internal control by adopting Auditing Standard No. 5, An Audit of Internal Control over Financial Reporting That is Integrated with an Audit of Financial Statements. …