Is the type of outsourced internal audit function provider associated with audit efficiency? Empirical evidence from Oman

Abstract

The main aim of this study is to provide empirical evidence examining how outsourced internal audit function (IAF) providers are associated with audit efficiency, and how such providers interact with high‐quality external auditors. We use a sample of 711 observations for companies listed on the Muscat Security Market during the period 2005–2014. Based on pooled regression, we find that audit efficiency is significantly improved when the IAF provider is from a Big4 audit firm, whereas a non‐Big4 audit firm IAF provider is associated with reduced audit efficiency. Furthermore, we find evidence suggesting significant interaction between the external auditor and IAF in relation to audit efficiency if the outsourced IAF provider is from a Big4 audit firm. In additional analysis, we construct a new measure for audit efficiency, dividing the IAF providers into Big4, second tier, and other non‐Big4, and consider the time of connection between such providers and their clients. We still observe that Big4, as an outsourced IAF provider, is more significantly associated with audit efficiency than other types of IAF provider. This paper is important because there is currently little evidence concerning the type of outsourced IAF provider; it contains useful information for auditors, companies, and regulators.

Outsourced internal audit function and real earnings management: The role of industry and firm expertise of external providers

“…First, the establishment of IAF and the disclosure related to it have been required by the Capital Market Authority (CMA) in Oman since 2002. This requirement makes outsourcing of IAF common practice, with 58% of listed firms outsourcing IAF to external providers (Baatwah, Al‐Ebel, & Amrah, 2019). Data on IAF are therefore available, and we have a long sample period from 2005 to 2017.…”

“…Second, Oman has introduced a number of regulatory frameworks related to corporate business practices. These regulatory frameworks are described as the most sophisticated in emerging markets (Baatwah, Al‐Ebel, & Amrah, 2019), compatible with those of more developed countries such as the United States (Al‐Yahyaee, Pham, & Walter, 2010). For example, all types of firms listed under the Commercial Companies Law are required to prepare annual reports; joint‐stock firms (listed firms) also have to prepare audited financial reports in accordance with international financial standards (IFRS) and publish these reports within 2 months.…”

“…Further, these regulations stipulate that external auditors scrutinize annual financial reports in accordance with International Auditing Standards (IAS). They also stipulate that external auditors are prohibited from providing nonaudit services (amongst IAF) to their audit clients and must be rotated within four consecutive years (Baatwah, Al‐Ebel, & Amrah, 2019).…”

“…Third, we extend research on outsourced IAF (Baatwah, Al‐Ebel, & Amrah, 2019; Prawitt, Sharp, & Wood, 2012) by examining whether the firm type of the external IAF provider affects REM. Our findings suggest that big4 and second‐tier audit firms, as well as their expertise level as external IAF providers, significantly impact REM.…”

“…Given the continuous presence of the IAF provider, compared to the external auditor, we expect that IAF is a more relevant mechanism in reducing REM because it is charged with operational audits (Jiang, William, Messier, & Wood, 2020), and it may face audit committee pressure to constrain and limit REM activities (Bajra & Cadez, 2018a; Sarens, De Beelde, & Everaert, 2009; Sultana, Cahan, & Rahman, 2020). Specifically, we consider external IAF providers to be in a position to detect and deter REM activities more effectively than in‐house IAF providers because they have greater objectivity and expertise (Caplan & Kirschenheiter, 2000; James, 2003) and can provide high‐quality internal audit (Baatwah, Al‐Ebel, & Amrah, 2019; Prawitt, Sharp, & Wood, 2012). This quality may be further improved if the external IAF provider has knowledge of the industry and the client's business operation.…”