The impact of PCAOB regulatory actions and engagement risk on auditors’ internal audit reliance decisions

Abstract

This paper examines how two Public Company Accounting Oversight Board (PCAOB) regulatory actions (the risk-based audit approach required by auditing standards and a change in the focus of the PCAOB inspection process) interact with engagement risk to affect external auditors’ decisions to rely on the internal audit function (IAF). We predicted that when the focus of the PCAOB inspection process is based on effectiveness, there would be no difference in the external auditors’ planned reliance on the IAF (sensitivity to the risks of the tests) across the two levels of engagement risk and when the focus of the PCAOB inspection process is balanced (meaning both an effective and a efficiency focus), the external auditors’ planned reliance will be higher in the low engagement risk condition compared to the high engagement risk condition. Contrary to our prediction, we find that when the focus of the PCAOB inspection process is balanced, auditors’ reliance on the IAF is not impacted by engagement risk. However, when the PCAOB inspection process is focused on effectiveness, the auditors rely more on the IAF when engagement risk is low than when it is high. Thus, if the goal of Auditing Standard No. 5 (AS5) is to have external auditors be more sensitive to the risk of the tests to be performed, then the PCAOB’s efficiency focus for inspections did not have the intended effect.