Internal Audit Sourcing Arrangements and Reliance by External Auditors

Abstract

SUMMARY: A company’s internal audit (IA) function can be maintained in-house, outsourced to an IA service provider, or cosourced (a combination of the in-house and outsourced IA functions). This study explores the effect of these sourcing arrangements on the external auditor’s assessed quality and reliance on the IA function. We predict that external auditors consider the cosourced and outsourced IA functions to be equal in terms of assessed quality and reliance. Furthermore, we predict that the external auditors’ assessments of objectivity and competence will be greater for cosourced and outsourced IA functions compared to in-house IA functions; therefore, external auditors will have greater reliance on the cosourced and outsourced IA functions. Finally, we predict that when the IA service provider also provides additional tax services to the client, external auditor reliance is significantly decreased compared to when the service provider does not provide tax services. One hundred and eight CPAs participated in this study and were randomly assigned to one of five treatment conditions: in-house, cosource, outsource, cosource with tax services, and outsource with tax services. The results support our predictions and indicate that external auditors place more reliance on cosourced and outsourced IA functions compared to in-house IA functions. Furthermore, external auditors’ reliance on cosourced and outsourced IA functions decreases when tax services are also provided by the IA service provider.