Academic journal article Academy of Accounting and Financial Studies Journal

The Effect of an Internal Audit Function on Audit Effort

Academic journal article Academy of Accounting and Financial Studies Journal

The Effect of an Internal Audit Function on Audit Effort

Article excerpt

ABSTRACT

This study utilizes workpaper evidence from a Big 4 firm to examine how the degree of reliance placed on an internal audit function influences the nature, timing and extent of external audit effort. After controlling for assessed misstatement risk, the degree of reliance is found to significantly influence the timing, but not nature and extent of evidential effort. When the degree of reliance is assessed as high, the external auditor shifts effort from year-end procedures to interim procedures. Because tests of controls are conventionally performed at interim, and substantive tests at year-end, this shift seems to suggest that a "reliance approach" to auditing is followed in the presence of a reliable internal audit function.

INTRODUCTION

The Public Oversight Board Panel on Audit Effectiveness was established in recognition that the effectiveness of external audits is an important issue in the operation of capital markets (AICPA, 2000). One means of increasing the effectiveness of audits would be for the external auditor to make better use of the internal audit function (IAF). Felix, Gramling and Maletta (2001) find that internal audit characteristics have a significant influence on external audit fees, indicating that external auditors utilize the IAF in compiling evidential evidence. Where Felix et al. (2001) examines the influence of IAF characteristics on external audit fees, the objective of this paper is to provide evidence on the effect of the IAF on audit effort decisions. Specifically, we examine how the degree of reliance placed on the IAF, by the external auditor, impacts the nature, timing and extent of audit evidence gathered. The evidence used in this study is unique in that it is obtained from documented utilization of the IAF from the external auditor's working papers.

The recent proposal by the New York Stock Exchange requiring firms to employ an IAF illustrates the importance an IAF plays in corporate governance (IIA, 2003). If the external auditor deems the IAF reliable, it can have an affect on the external financial statement audit. Extant literature has provided primarily indirect evidence on the influence an IAF can have on a financial statement audit due to the lack of availability of audit workpapers. This evidence includes surveys and experimental studies (e.g., Whittington and Margheim, 1993). In contrast with these prior studies, this paper uses data from working papers to provide evidence on the degree to which an IAF affects evidential requirements in the financial statement audit.

SAS 65 (1991) provides the external auditor with guidelines concerning the assessment of the competence and objectivity of the IAF and the subsequent use of internal audit reports and personnel during the audit. In accordance with this guidance, the data-granting firm requires their auditors to assess and document a level of reliance on the IAF. We hypothesize that the level of reliance placed on the IAF will influence evidential planning decisions either indirectly through preliminary risk assessments, and/or directly through the use of prior and concurrent procedures conducted by the IAF. Different levels of reliance on the IAF should result in differences in the nature, timing and extent of audit evidence collected.

This study examines the direct affect of the reliance on an IAF on these three evidential planning characteristics independently within the revenue cycle audit program, while controlling for potential trade-offs between nature, timing and extent decisions. Our findings indicate that reliance on an IAF significantly impacts the timing decision (i.e., as the external auditor's reliance on the IAF increased, evidential effort shifted from year-end to interim period testing.)

This study contributes to the extant literature in several ways. Prior literature has provided mixed results using field-based evidence to examine the expected relationship between risk assessments and evidence plans (Bedard, Mock & Wright, 1999). …

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