To Outsource or Not? Evidence from Changes in Component Auditor Use after the Disclosure of An Internal Control Material Weaknesses

Abstract

This paper investigates how increases in client audit risk influence the use of component auditors. Auditors respond to increases in audit risk by making adjustments to the audit engagement such as increasing fees and/or increasing effort. As more audit resources are demanded by clients with increased audit risk, one way for the lead auditor to free up resources is to allocate more work to component auditors. Using a difference-in-difference research design, with the revelation of an internal control material weakness (ICMW) as an event for increased audit risk, we find that component auditor use increases after the revelation of an ICMW, and increases even more when the ICMW is severe. We also find that the increase in component auditor use after an ICMW is positively associated with the likelihood of ICMW remediation. Thus, we identify a situation where component auditor use enhances audit quality and provides a benefit to the company (i.e., increased likelihood of ICMW remediation). Our study should be of interest to regulators, given the criticism by the PCAOB regarding firms’ use of component auditors and the evidence in prior literature on how component auditor use influences audit quality.