Corporate Governance, Audit Quality and the Sarbanes-Oxley Act: Evidence from Internal Audit Outsourcing

Abstract

The objective of this study is to extend the current literature related to non-audit services by investigating the area of internal audit outsourcing to the external auditor. We posit that certain types of internal audit outsourcing (i.e. those which are non-routine, and thus tend to be non-recurring in nature) are unlikely to lead to economic bonding, while offering significant potential for improvements in audit coverage and scope when provided by the external auditor. Alternatively, outsourcing routine internal audit tasks is more likely to lead to economic bonding, as well as creating disincentives for internal auditor independence. We obtain data from a survey of 219 Chief Internal Auditors and from relevant proxy statements in the year 2000, prior to the Sarbanes-Oxley Act. Our results are consistent with firms with strong audit committee governance being less likely to outsource routine internal auditing activities to the external auditor. The audit committee's authority to dismiss the chief internal auditor enhances this effect. However, the outsourcing of non-routine internal audit activities such as special projects and EDP consulting are not negatively related to audit committee effectiveness. Additionally, outsourcing of either type of internal audit activity to an outside service provider other than the external auditor is not related to audit committee effectiveness. Collectively, we interpret these findings as supportive of an effective audit committee's ability to monitor the sourcing of the firm's total (i.e. internal and external) audit coverage, while simultaneously exhibiting concern for external auditor independence. Our findings call into question the need for the existing restrictions on some types of internal audit outsourcing to the external auditor, particularly in light of other corporate reporting environment changes enacted by the SOX.