Academic journal article Auditing: A Journal of Practice & Theory

The Effect of Internal Audit Outsourcing on Financial Analysts' Perceptions of External Auditor Independence

Academic journal article Auditing: A Journal of Practice & Theory

The Effect of Internal Audit Outsourcing on Financial Analysts' Perceptions of External Auditor Independence

Article excerpt

Financial analysts play an important role in the U.S. financial market system. Not only do their actions affect markets, but they are also in a unique position to assess how capital market participants may view certain issues. Accordingly, we gathered information from analysts about their perceptions of auditor independence under various internal audit outsourcing arrangements. Under the newly enacted SEC independence rules, limits are now placed on internal audit outsourcing.

Two hundred fifty analysts evaluated historical, prospective, and other information about a hypothetical publicly owned company. The analysts were asked to evaluate auditor independence. Participants received one of five versions of the case: (1) own internal audit; (2) outsourcing to the current external auditor; (3) outsourcing to another CPA firm; (4) separating the staff performing the internal and external audits; and (5) outsourcing only a part of the internal audit function.

Our results show that financial analysts' perceptions of auditor independence are negatively affected when the internal and external audits are performed by the same CPA firm, but only if there is no separation of the two audit staffs. Thus, staff separation appears to be a viable way to safeguard auditor independence. Our results also show that analysts do not perceive a difference between partial and full outsourcing of the internal audit function. Therefore, our study does not provide support for the outsourcing restriction in the recent SEC rule that allows firms to outsource no more than 40 percent of the internal audit function to their own external audit firm.

INTRODUCTION

Competition among public accounting firms and the merger activity of the 1980s and 1990s has led to a stagnation of auditing revenues. In an effort to maintain growth and profitability, auditing firms have sought alternative sources of revenue by offering various types of professional services including internal audit, risk management, and a variety of assurance and consulting services. Regulators and critics of the profession contend that the provision of these services threatens auditor independence. Interviews and focus groups reveal that pressures on the objectivity and independence of auditors have been growing over time and are described as "somewhat worrisome" (Earnscliffe Research & Communications 1999, 9). In contrast, the profession asserts that these new services do not compromise auditor independence, a position supported by a report on audit effectiveness prepared by the Public Oversight Board (2000).

At the urging of the U.S. Securities and Exchange Commission (SEC) and in conjunction with the American Institute of Certified Public Accountants (AICPA), a new regulatory board, called the Independence Standards Board (ISB), was created in early 1997. Shortly after formation of the ISB, a "White Paper" (AICPA 1997) was issued by the public accounting profession that proposes a model for evaluating independence. The White Paper states, "If regulation is to continue on the basis of appearance, it will be necessary to determine the actual perceptions of reasonable users of financial statements on a basis that utilizes relevant professional methodologies" (AICPA 1997).

Significant research effort has been devoted to investigating the independence issue when the external auditor performs management advisory services (MAS) for a client. Yet, to date little research has examined how financial statement users perceive auditor independence when the CPA firm provides both internal and external audit services for the same client. The purpose of this study is to examine financial analysts' perceptions of auditor independence when the CPA firm provides both internal and external audit services to the client firm. We also examine perceptions of auditor independence when the firm's external auditor performs only a portion of the internal audit services, and when different divisions of the external audit firm perform the internal and external audit work. …

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