Outsourcing and Audit Risk for Internal Audit Services*

Abstract

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.

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

“…Consistent with these contradictory arguments, empirical research provides inconsistent evidence, with some results favoring an inhouse IAF (Coram et al, 2008;Johl et al, 2013;Munro & Stewart, 2010) and others an outsourced IAF (Abbott et al, 2012;Ahlawat & Lowe, 2004;Christ et al, 2015;Desai et al, 2011;Glover et al, 2008;Prawitt et al, 2012). Despite these contradictory arguments and evidence, outsourcing IAF practice is a rapidly growing phenomenon (Caplan & Kirschenheiter, 2000). Carey et al (2000) reported that 45% of their study sample outsourced part or all IAF activities.…”

“…This is consistent with prior external audit and IAF literature that suggested Big4 audit firms are able to provide a higher quality audit than other types of auditor. (e.g., Caplan & Kirschenheiter, 2000;DeAngelo, 1981;Francis, Maydew, & Sparks, 1999;Francis & Yu, 2009;Munro & Stewart, 2010). We use audit fees and audit report lag to identify audit efficiency, and use 711 observations from companies listed on the Omani capital market to test our hypotheses.…”

“…Furthermore, we extend the work of Prawitt et al's (2012) by empirically examining whether the type of IAF external provider is associated with audit fees and audit report lag. Caplan and Kirschenheiter (2000) suggested that outside internal audit providers offer high-quality services because they have a greater level of expertise, especially with regard to specialist knowledge, such as technology skills. Our results are germane given the worldwide increase in outsourcing IAF to external providers.…”

Manifold Conceptions of the Internal Auditing of Risk Culture in the Financial Sector

“…While rotation might improve the quality of reporting (Christ et al 2015), it could discourage employees and newcomers from joining IA teams by pointing to the general nature of the IA work (Bartlett et al 2016). In a similar vein, studies exploring outsourcing of IA to third parties suggest that outsourcing improves the independence and objectivity of IA, but discourages auditee managers from sharing information, resulting in lower audit quality (Abdolmohammadi 2013;Caplan et al 2000;Prawitt et al 2012;Speklé et al 2007). Overall, these studies reveal that due to lack of content knowledge on the heterogeneity of processes (including risk management, corporate governance, and internal control), IA has developed its techniques to merely verify the process of decision-making (Pentland 2000;Power 1999).…”

The Interface between Internal and External Audit in the Australian Public Sector

“…There has been extensive research on the importance of an internal control function as part of an effective corporate governance structure. Prior internal audit research has evaluated: objectivity issues (Church and Schneider ; Brody and Lowe ; Stewart and Sabramaniam ); the interaction between internal and external audit (Stein et al ; Brody et al ; Felix et al ; Mihret and Admassu ; Prawitt et al ); the trend to outsource internal audit functions (Caplan and Kirschenheiter ; Dickins and O'Reilly ; Majdalawieh and Alkafaji ); and the relationship between internal audit and the audit committee (Leung et al ; Christopher et al ; Davies ; Sarens et al ).…”