Some companies now outsource their internal audit function to public accountants. Internal auditors and accounting firms disagree about the merits of outsourcing. Each type of auditor claims to provide more cost‐effective services and appears to claim superior expertise. This paper uses agency theory to examine outsourcing and reconciles the outsourcing debate without resorting to differential auditor expertise. Under the assumptions that public accountants' “deep pockets” provide incentives to outsource and their higher opportunity cost provides a disincentive, we characterize the optimal employment contract with each auditor. We find that public accountants provide higher levels of testing, but possibly for a higher expected fee. This result supports both the internal auditor's claim as the lower cost provider, and the public accountant's claim of higher quality. We also find that incentives to outsource generally increase in various measures of risk, including the risk that a control weakness exists and the size of the loss that can result from an undetected control weakness.
SUMMARY
This paper examines the effect of the quality of a firm's internal control over financial reporting (ICFR) on the quality of corporate M&A decisions. We use material weaknesses in internal control (ICMWs) from SOX 404 audits as a proxy for the quality of a firm's ICFR and use future goodwill impairment to proxy for the quality of managers' M&A decisions. We find that goodwill recognized from acquisitions in years concurrent with ICMWs has a greater rate of impairment in subsequent years than goodwill recognized from acquisitions in years without ICMWs, thereby establishing a link between ICMW and goodwill impairment. We further show that disclosure and remediation of ICMWs appear to improve valuations of subsequent acquisitions. Our study contributes to the literature on internal controls by documenting unanticipated benefits of SOX 404 audits on managerial performance, and to the goodwill literature by identifying ICMWs as a determinant of goodwill impairment.
In 2011, Japan was shocked by the revelation of a fraud at one of its most prominent companies, Olympus. What was more shocking was that the fraud was perpetrated by its Chairman of the Board and past president, Tsuyoshi Kikukawa, in collusion with several other Board members and officers. The whistleblower was Michael Woodford, a British citizen and the Company's first non-Japanese president and CEO. Woodford had held the post of president for just six months before he was precipitously fired at a Board of Director's meeting on October 14, 2011.
The case has been successfully used in both undergraduate and graduate courses that include intermediate financial accounting, advanced accounting, auditing, and forensic accounting. It demonstrates how poor governance structures allowed company executives and directors to circumvent accounting rules and hide investment losses for over two decades. The accounting topics include (1) methods of accounting for investments in financial instruments, (2) recognition and measurement of goodwill at the time of acquisition, and (3) consolidation accounting. The case requires students to link economic events to business decisions, and understand the financial reporting ramifications of those decisions. The case also requires students to critically analyze corporate governance mechanisms, and to consider the external auditor's responsibility for detecting and communicating financial statement fraud.
scite is a Brooklyn-based organization that helps researchers better discover and understand research articles through Smart Citations–citations that display the context of the citation and describe whether the article provides supporting or contrasting evidence. scite is used by students and researchers from around the world and is funded in part by the National Science Foundation and the National Institute on Drug Abuse of the National Institutes of Health.