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Research Summary 4: The Effects of Internal Audit Outsourcing on Perceived External Auditor Independence

It’s not so much a question of outsourcing as it is one of personnel.

BY D. JORDAN LOWE, MARSHALL A. GEIGER AND KURT PANY

Please note: This item is from our archives and was published in 2001. It is provided for historical reference. The content may be out of date and links may no longer function.

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he accounting profession is attempting to redefine itself, in part by expanding the types of services it provides. This expansion of services has raised questions about whether CPA firms can maintain their independence and still provide an ever-increasing array of other types of services to audit clients. In this study we addressed financial statement user perceptions about CPA firms performing internal auditing outsourcing activities—an area in which CPAs are becoming increasingly involved.

One hundred and seventy-seven loan officers were furnished with a realistic loan application for a medium-sized retail grocery company and asked to evaluate auditor independence, assess the reliability of financial statements and make a loan decision. All loan application materials were the same across participants except for the description of the internal audit arrangement, which varied as follows:

  1. Not outsourced, done in-house.
  2. Outsourced to an external auditor other than the one that performed the company’s external audits.
  3. Outsourced to its own external auditor—which performed management functions.
  4. Outsourced to its own external auditor—same personnel used for the internal and external audits.
  5. Outsourced to its own external auditor—different personnel used for the internal and external audits.

Loan officers receiving the case in which the external auditor performed management functions for the outsourced internal audit gave the case the lowest independence ratings, financial statement reliability scores and loan approval rate. In contrast, loan officers receiving the case where the internal audit was outsourced to the company’s external audit firm using different personnel not only had significantly higher ratings than when using the same personnel, but also uniformly had the highest perceptions of auditor independence and financial statement reliability and the highest loan approval rate. These results were consistent with the AICPA’s position of allowing external auditors to perform outsourced internal audit activities for clients as long as they did not perform management functions in connection with the internal audit. However, the results also show that perceived auditor independence and financial statement reliability could be enhanced by requiring CPA firms that perform internal audit services for audit clients to use different personnel for each type of engagement.

For the full text of the research paper, see Auditing: A Journal of Practice & Theory, vol. 18, Supplement, 1999.

D. Jordan Lowe is associate professor at the University of Nevada, Las Vegas. His e-mail address is dlowe@ccmail.nevada.edu . Marshall A. Geiger is associate professor of accounting at the University of Richmond. His e-mail address is mgeiger@richmond.edu . Kurt Pany is professor of accounting at Arizona State University. His e-mail address is kurt.pany@asu.edu .

This series is based on work published in Auditing: A Journal of Practice & Theory. Copyright 1999, 2000 and 2001 by the American Accounting Association. The intent is to bridge the gap between researchers and practitioners by offering concise practice summaries of cutting-edge research in the field of auditing. This material is used with permission of the publisher.