an empirical study of external auditor reliance on internal auditors

Specifically, acase study dealing with an audit of accounts receivable was used to examine whether external auditors adjusted the initial audit program based on work already performed by

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RELIANCE ON INTERNAL AUDITORS

by

Loren L Margheim

A Dissertation Presented in Partial Fulfillment

of the Requirements for the Degree

Doctor of Business Administration

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LOREN L MARGHEIM

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Generally accepted auditing standards provide external auditors with general guidelines as ta the types and quantities of evidence which should be gathered to support an audit cpinion., However, auditors must still use "professional judgment" to make decisions concerning how much reliance may be placed on various types and quantities of evidence This study examined one such type of decision: the evaluation and reliance upon information provided by

internal auditors

Specifically, acase study dealing with an audit of accounts receivable was used to examine whether external auditors adjusted the initial audit program based on work already performed by the internal auditors and whether the credibility of the internal auditors affected these judgments Auditing standards and the related literature were used to construct two dichotomously scaled factors which described internal auditor credibility internal auditor competence/work performance and internal auditor objectivity Both of these factors were tested at a nigh and low level

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internal auditor involvement was used Five groups of two hundred CPAs were each mailed one of the five cases Two hundred sixty-seven usable cases were returned The degree of reliance on the internal auditors was assessed using Multivariate Analysis of Variance (MANOVA) and Analysis of

Variance (ANOVA) testing procedures to examine differences

in the audit program plans between the five cases

The results indicated that internal auditor competence/work performance impacted on the external auditors’ judgments As internal auditor competence/work

performance went from a low level to a high level the

external auditors reduced the planned amount of audit time However, internal auditor objectivity and the interaction between the two factors had no effect on the external auditers' audit programs The study also indicated that

internal auditors had to perform specific, documented work before the external auditors would aiter the amount of planned audit hours

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I wish to express sincere gratitude to Dr Kurt Pany for his very helpful guidance through the course of this dissertation I also wish to thank Or J Hal Reneau, Or Philip Mid Reckers, Dr Andrew A Haried and Dr M Austin Betz for their assistance and advice

In addition, the financial assistance provided by the American Institute of ertified Public Accountants is gratefully acknowledged The financial assistance provided by the Departments of Accounting and Quantitative Systems during my tenure at Arizona State University is also gratefully acknowledged

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age

LIST OF TABLES 2 ew ee ew ew we ee ew VIG

CHAPTER I - INTRODUCTION e ee eo  â â #â 8 w&» @ - * s s _

Statement of the Problem 1 « ws a Significance of the Problem «

Need for Reliance Research Need for Source Credibility Research Scope of the Study eee

Type, Size and Stability of Client Stage and Program Area of Audit Type of Reliance 1 6 ew ew eo CHAPTER If = LITERATURE REVIEW 4 su < ._ 28 © 2 8 8 @ & es = â = 8 wp ee ô 8 8» © 8 tha & se © &© @ & @&@ e 8 © ° © © 8 & Wns A MON ar “ * + * Re ~

Internal Control Evaluations « vs vo + vo ko VU cá Internal Auditor Relationships + «+ vo +

Internal Auditor Relationship with External Auditors se ew ew ew Internal Auditor Relationship with

Management eo 8 ee ew ew

Source Credibility Evaluations ee 1 1 1ˆ ŸÝ s vs 23 CHAPTER ITI - RESEARCH METHOD 2 1 1 ee ew we ww ew ew 28 Case Development 2 6 6 6 © 6 8 ew we ew wt we et lw 09 Subjects « « ‹ ee ee ee ew te lw wt lll tl le 3ã Independent Variables” ee ee we ew ww 6 1 ww 9S Dependent Variables 2 «6 © «© «© © © ww oe oe ts 38 Statistical Techniques 2 1 6 8 0 ww ew ew ew et ee 38 Validity Analyses 2 «© 26 6 6 © ew ew ew we we ew ew ow 40 Hypothesis Testing Procedures « « ôâ ôâ w ô ô « 40 CHAPTER IV - RESULTS 2 1 0 ee ee ew we x ew ew AG Response Rate k1 rr 2 <)

Validity Analyses Results ee ee ew ew ee we ww AF Manipulation Check 2 6 0 2 we wie ew ew we et ww 48 Subjects’ Backgrounds 2 4 + vs ©» ww ee we 49

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CHAPTER V REFERENCES Appendix SAMPLE CASE s e e a _* a a a s » e s J s s ° * S3 Oo œ >

Subjective Opinions of Subjects Hypothesis Test Results Limitations « « « « e « v Future Research 6s Hypothesis Hi Hypothesis H2 Hypothesis H3 Hypothesis H4 Hypothesis H5 Ancillary Test Summary «9 « » * ° s s ` * a 2 » s s s s * e » ® a s * - «a « * * s a a a ô s đ s ằ s s “ “ “ » « ° ~ CONCLUSIONS, LIMITATIONS AND POTENTIAL FUTURE RESEARCH 2 2 1 6 ew ew ew ew ° a Research Design Case Development Statistical Assumptions e a * * * » * * + ° s s * * s « * a * ° a a ° » s * a e + « « a » ° e ° s * ° e s s * # * e ®

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Table page 1, Usable Responses by Case 1 6 6 ew ew Q

2, Manipulation Check of Competence, Objectivity

and Work Performance ô ôâ ôâ ôâ â â â ôâ < ôâ ôâ ô 48 3 Frequency Table of Subject Experience 50 4 Frequency Table of Subject Education 51 3» Frequency Table of Subject Specialization ÄĂrea 51 6 Frequency Table of Subject Position in the Firm 52 7 Frequency Table of Case Completion Times 53 8 Subjective Opinions of the Subjects 55 9 MANOVAS Comparing the Control Case to the

Internal Auditor Cases 1 2 «© e «© we we ew ew + - 60

10, ANOVA Table for Total Audit Hours .« 62

11 Mean Total Hours 2 2 6 ee ew we ee we ee ew 63

12 MANOVA and ANOVAs for Total Compliance and Substantive Hours 2 6 6 6 © we © ee ew

13 Mean Total Compliance Hours 2 + và w© + + ew ew + 66 14 Mean Total Substantive Hours 2 1 6 we 2 we tw Ÿ we ew - 67 15 MANOVA on Individual Compliance Test Hours 68 l6, ANOVAs on Individual Compliance Test Hours 70 17 Mean Individual Compliance Test Hours 4 71 18 MANOVA on Individual Substantive Test Hours 74

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19 ANOVAS on Individual Substantive Test Hours 75 20 Mean Individual Substantive Test Hours , 7?

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External auditors must gather and interpret evidential information to support their professional opinion on whether a client's financial statements are prepared in accordance with generally accepted accounting principles Although generally accepted auditing standards provide general guidelines as to the types and quantities of evidence which should be gathered, auditors still must use "professional judgment" to make many evidence accumulation decisions

When making these decisions auditors attempt to control costs and yet maintain a high quality audit Difficult decisions must, therefore, be made as to how much reliance may be placed on various types and quantities of evidence This study examines one such type of decision: the evaluation and reliance upon information provided by internal auditors

Statement of the Problem

External auditors are continually looking for ways to control increasing audit costs One way external auditors can control such costs is by relying on work performed by

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(AICPA, 1975), "The Effect of an Internal Audit Function on the Scope of the Independent Auditor's Examination,” has given external auditors significant latitude to rely on internal auditor work The Standard allows external

auditors to adjust the nature and extent of.external audit

procedures due to such reliance

Surveys by Ward (1979), Ward and Robertson (1980) and the Institute of Internal Auditors (1975) indicate that external auditors rely on tnternal auditors to a substantial extent Their research is based on survey data collected by asking external and internal auditors for their subjective opinions as to the amount of reliance placed on internal auditors Yet, research has indicated that subjective opinions often do not translate into objective actions (see Slovic,

Fleissner and Bauman (1972) and Wright (1977a and b))

Abdel-khalik, Snowball and Wragge (1983) went beyond subjective opinions and objectively examined external auditor reaction to the use of EDP internal audit techniques However, they did not attempt to assess external auditor reaction to other work performed by the internal auditors

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auditors when making reliance decisions As such, the study addresses whether internal auditor reliance resuits in changes in audit scope,

Significance of the Problem

The Foreign Corrupt Practices Act of 1977 requires publicly held companies to have a working system of internal control To ensure compliance with the law, companies have expanded and upgraded their internal audit departments, As companies continue the upgrading process, the potential for external auditor reliance on internal auditors increases

Ward and Robertson's (1980, p 64) survey indicated that

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Currently, very little descriptive or normative research on the relationship between external and internal auditors has been performed As noted in the problem statement, descriptive research consists mainly of opinion surveys in which the results are based on subjective opinions of the surveyed subjects Normative research is virtually nonexistent The very general nature of the only normative Standard on this issue, SAS #9, reflects this lack of research The Commission on Auditors’ Responsibilities (1978, p 134) has criticized this general nature of SAS #9 and suggested that almost any practice is permissible,

This objective descriptive research may lead to normative research and ultimately to more specific guidance being given to external auditors as to the optimum usage of internal auditors Optimum usage of internal auditors could result in substantial cost reductions These reductions may occur due to:

1 less duplication of effort,

2 better use of internal auditor expertise,

3 shifting of clerical tasks to internal auditors,

4, more efficient and effective external audit plans based on anticipated internal auditor

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There are risks t 2 assumed when relying on internal auditors If an external auditor relies on work performed by an incompetent or nonobjective internal auditor the

quality of the audit is likely to decline This could lead

to an increase in the legal problems sustained by the external auditor

This research examines external auditors’ reactions to the source credibility of the internal auditors A study by Joyce and Biddle (1981b) found that external auditors may be insensitive to the credibility of information's source If external euditors are insensitive to the credibility of internal auditors, normative research would need to more Fully address the issue before the benefits of increased use of internal auditors could be achieved without undue risk being assumed by external auditors

Scope of the Study

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To help increase the potential generalizability of results the audit situation utilized in this study has general characteristics that are applicable to many audits The type and size of the company as well as the stability of the company are characteristics that have been explicitly considered in defining the audit situation

The client company utilized in this study is a medium-sized manufacturer of electrical kitchen appliances Medium-sized manufacturers are typical businesses, hence the external auditors used as subjects should feel relatively comfortable with the audit situation

Stability of the company is avery important factor affecting an external auditor's reliance decisions If an external auditor perceives the client company to be unstable

(i.e., risky), it is likely that less reliance will be

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While external auditor reliance on internal auditors is likely to vary between audits, it is also likely to vary within an audit There are numerous factors that can impact on an external auditor's reliance decision Major factors considered in this study include (1) the stage of the audit and (2) the audit program area being examined The specific levels of these factors that were defined for use in this study are described below

Different types of work are performed at each stage of the audit Therefore, it is likely that the nature and extent of external auditor reliance on interna] auditors may be different at the various audit stages

Felix and Kinney (1982) suggest that research into the

opinion formulation process can be broken down into categories These categories correspond to the sequentical stages of an audit They include:

1 Orientation, forming priors and planning, 2 System evaluation and testing,

3 Substantive testing,

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audit, a study and evaluation of internal control and the obtaining of sufficient competent evidential matter in order to reach an opinion regarding the financial statements

This study is restricted to an examination of external auditor reliance on internal auditors at the orientation, forming priors and planning stage of the audit Research by Gibbins and Wolf (1982, p.117) seems to indicate that the importance of internal auditors to external auditors declines as an audit progresses from the planning or design stage to the evaluation and opinion formulation stage Thus, it is appropriate to examine external auditor reliance on internal auditors at the planning stage where much of the reliance is likely to occur

The external audit is normally subdivided into specific areas where audit work is to be performed These audit program areas usually include audits of revenues, receivables, cash, inventories, et cetera The amount of work performed by internal auditors in each of these areas should affect the amount of external auditor reliance

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lower level of importance in keeping the company efficient and effective

This study examines external auditor reliance on internal auditors while planning the receivables audit program area This area was chosen due to its importance to the external auditors in reaching an opinion and to the internal auditors in developing a more efficient and effective company management Internal auditors are likely to have performed agreat deal of work in the receivables area Thus, tha potential for external auditor reliance on the internal auditors should be quite high

Type of Reliance

In addition to specifying the audit situation, it is necessary to specify the type of reliance being examined SAS #9 implicitly suggests two ways external auditors can rely on internal auditors:

1 rely on the role and prior work already performed by the internal auditors, or

2 rely on direct assistance by the internal auditor during the course of the external audit

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In summary, the scope of this study is limited to a specific audit situation External auditor reliance on prior internal auditor work for a stable, medium-sized manufacturing company during the planning of the receivables

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Behavioral research in accounting has been common in recent years Within the auditing literature, auditor judgment has receji ‘ed extensive research attention Judgment research on (1) internal control evaluations, (2) internal auditor relationships, and (3) source credibility evaluations has specific relevance to this study Major studies within these areas are reviewed below

Internal Control Evaluations

Libby (1981) classifies most of the judgment related

internal control evaluation studies as being policy capturing research Between-judge consensus, relative importance of individual cues in the judgment process, the functional form of an individual's judgment rule, and individual self-insight are often the major concerns of policy capturing studies

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the functional form of an individual's judgment rule and self-insight require the use of a within-subjects design Internal] controi evaluation studies utilizing a

within-subjects design include Ashton (1974), Joyce (1976),

Reckers and Taylor (1979), and Ashton and Brown (1980)

Mock and Turner (1980) examined internal contro} evaluations

through the use of a between-subjects design

Ashton (1974) asked sixty-three auditors to judge the

strength of a payroll internal control subsystem Each auditor received thirty-two cases containing Six dichotomously scaled indicators (i.e., independent variables) of internal control strength These auditors received the same cases six to thirteen weeks later so that judgment consistency over time could be studied

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Joyce (1976) asked thirty-five “auditors to assign audit

hours to five categories of accounts receivable substantive tests for either twenty or thirty-six cases Three internal control variables and two accounting ratios were dichotomously scaled and used as the independent variables Joyce was attempting to reconcile Ashton's finding of high between-auditor consensus with the findings of other studies showing low consensus (See Aly and Duboff, 1971; Corless, 1972)

Joyce found (1) high judgment consistency over time, (2)

Tow consensus between auditors, (3) highly linear individual decision rules, and (4) separation of duties was the most important cue to the auditors These results are similiar to Ashton's except for the finding of low between-auditor consensus

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more internal control indicators presented to auditors the more variability in judgments

Ashton and Brown (1980) also modified Ashton's original

instrument to make it more realistic However, unlike the Reckers and Taylor study, only two additional independent variables were added The results of this study were virtually identical to those of Ashton's original study The addition of two additional cues thus appeared to have no effect on the auditors’ judaments

Mock and Turner (1979) examined auditor internal contro} evaluations through the use of an extremely realistic audit case Their study focused on the effects of changes in internal control from one year to the next and the effects of guidance on sample size judgments Each of the seventy-three auditors was assigned to one of ten possible cases The results of the study indicated (1) that the change in internal control strength had a significant effect on planned sample sizes, (2) guidance had no effect on

planned sample sizes, (3) between-auditor consensus was low

but sample sizes for the strong internal control cases varied less than did the sample sizes for the fair internal control cases, (4) subjects given planned sample sizes

(anchors) supplied sample size recommendations closer to the

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2 low consensus between auditors,

3 highly linear auditor decision rules

These results imply that external auditors’ judgments regarding use of internal auditor work will remain consistent over time In addition, external auditors will likely have divergent views as to how internal auditor work should impact on the external audit Further, external auditors will likely use specific factors to make judgments concerning the use of the work of internal auditors Interactions between factors will probably not effect their judgments

Internal Auditor Relationships

Internal auditors must form working relationships with external auditors and management Research examining these relationships is discussed below

Internal Auditor Relationship with External Audi

Clark, Gibbs and Schroeder (1980) developed an exhaustive

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These criteria, along with those developed by Schneider (1982a), were used to develop the independent variables utilized within this study

The Five most important criteria for evaluating competence were:

1 The internal audit staff's knowledge of company

operations, processes, and procedures

2 The educational background of the internal audit staff

3 The internal audit staff's knowledge of new trends and techniques in auditing

4, The existance and quality of a continuing education program

5 Quality and quantity of supervision within the internal audit department

The most important objectivity criteria were found to be: 1, The independence of the internal audit

department

2, The level at which the internal audit staff reports

3 The ability of the intenal audit department to investigate any area of company activity

4, The extent of top management support for the work of the internal audit department

5 The form, content, and nature of internal audit department reports

Performance criteria ranking the highest included:

1 Management readiness to act upon internal audit recommendations

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3 The ability of the internal audit department to investigate any area of company activity

4 The internal audit staff's knowledge of new trends and techniques in auditing

5 Acceptance of internal audit staff findings and recommendations by auditees

Schneider (1982a) conducted a study with an objective similiar to Clark, Gibbs and Schroeder, The study does, however, differ in a number of significant respects First, Schneider's study provided subjects with background material on a hypothetical company in order to control for confounding variables This was not done by Ciark, Gibbs and Schroeder Secondly, multidimensional scaling (MDS), which analyzes data at an ordinal level, was used by Schneider to analyze his data Clark, Gibbs and Schroeder assumed interval level data and used Analysis of Variance for their analysis

Competence, objectivity and work performance were each described by five criteria Using yes/no combinations of the criteria, thirty-two profiles were developed for each of the three factors Seven or eight subjects were asked to provide ratings for one of the three sets of profiles using a ten-point rating scale

Results of the MDS analysis on the competence profiles

showed (1) internal auditor experience and (2) instruction

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Important criteria The analysis of the objectivity profiles indicated the most important criteria to be (1) top management support for the internal audit department, (2) organizational level to which the internal audit department reports and (3) freedom from conflicting duties Work performance criteria found to be significant included (1) the scope of the internal auditor's work and (2) the quantity and quality of the internal audit documentation

Schneider (1982b) developed a descriptive model of how external auditors combined their individual evaluations of competence, objectivity and work performance to form an overall evaluation of the internal auditors Eighteen auditors were asked to rate the strength of sixty-four internal audit profiles ona one hundred point scale Competence, objectivity and work performance were each described by two criteria Four levels of each of these criteria were defined for use in the study

Conjoint measurement analysis of the data indicated (1) additive composition rules were appropriate for fifteen of the eighteen auditors, (2) work performance was viewed as the most important factor followed by competence and objectivity and (3) there is a high degree of consensus among auditors with respect to the evaluation of internal

auditors The author concludes that if differential amounts

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attributed to a divergence in the evaluation of the auditors

Clay and Haskin (1981) surveyed one hundred chief financial officers selected from the Fortune 500 list of largest companies Survey results indicated that most of the surveyed companies maintained high quality hiring and training practices for their internal auditors In addition, a majority of chief financial officers indicated that they felt their internal audit departments were “organizationally independent." The authors concluded that there was justification for the expanded use of internal audit departments by external auditors for large companies

Ward (1979) and Ward and Robertson (1980) used a Delphi survey to determine (1) the manner and extent of current external auditor reliance on internal auditors, (2) respondents’ beliefs on what should be the manner and extent of reliance, and (3) respondents' beliefs on what will be the manner and extent of reliance in the future Both external and internal auditors were surveyed in the study

The Delphi method was used because it was believed that an

iterative questionnaire process allowed for conclusions resulting from more thoroughly rationalized arguments

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the survey found that seventy-five percent of the respondents agreed that internal auditors should be relied upon in most audit areas As to the extent of future reliance, -the survey found eighty-one percent of the external auditors and eighty-three percent of the internal auditors believe that reliance will increase

Abdel-khalik, Snowball and Wragge (1983) studied the effects of three internal audit EDP techniques and two organizational variables upon external auditors’ audit planning judgments The three EDP techniques included Integrated Test Facility, Test Data and Generalized Audit Software The level to which the internal audit department reports and the internal auditor's level of responsibility in reviewing changes in application programs served as the two organizational variables Peer discussion was also introduced as an independent variable part-way through the experiment The study did not examine the impact of internal audit review of programs and procedures since these variables were introduced as a reference point to the subjects The dependent variables related to (1) the external auditor's assessment of the reliance that is to be placed on the internal audit staff and (2) the extent of testing planned by the external auditor

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properties These internal audit systems related to either accounts receivable or accounts payable

Subjects' judgments were analyzed using Analysis of Variance (ANOVA) and Multivariate Analysis of Variance (MANOVA) testing procedures Results showed (1) the level to which the internal audit department reported was the dominant factor, (2) the three EDP techniques were of equal importance, (3) within-subject consistency was high and was not affected by peer discussion and (4) between=subject consistency was moderate

A study by Gibbins and Wolf (1982) identified environmental factors that had an important impact on auditors’ judgments The client's internal audit staff was included on the list of potential environmental factors influencing an auditor's judgment Subjects were asked to select environmental factors that were either predictors or related factors to the likely occurance of significant audit problems

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Overall, the literature has concentrated on examining the criteria external auditors use in evaluating internal auditors Generally, there is a high degree of consensus among external auditors as to the criteria used in evaluating internal auditors Internal auditor descriptions were developed through the use of these criteria for use in this study

Research concerning the actual extent of reliance on internal auditors has been sparce Surveys of auditors opinions indicate that internal auditor information is being relied upon by external auditors The surveys also indicate that increased reliance is possible Abdel-khalik, Snowball and Wragge found that when a within-subjects design is used external auditors react to internal auditor objectivity

The results of these studies imply

1 external auditors are relying on internal auditor work,

2 the amount of reliance on internal auditor work ic a function of the external auditor é-uluation of the internal auditor

Internal Auditor Relationship with Management

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Aggressiveness was defined as a function of the level to which the internal auditors reported and the extent to which they were depicted as being strong and active within the organization The dependent variable consisted of managers' judgments about the amount of allowance for doubtful accounts from company officials A full factorial between-subjects design was used

The study found that internal auditor aggressiveness did not have a significant effect on subjects! judgments To support the validity of the results the authors used a manipulation check which indicated that subjects had appropriately interpreted the information presented In addition, the study provided evidence that the managers understood and became involved in the task

This study implies that the level to which internal auditors report may not have an affect on management or external auditor usage of internal auditor work Further, the manipulation check illustrates an effective way of empirically testing internal validity

Source Credibility Evaluations

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simplified information processing rules (i.e., heuristics) Tne use of a representaciveness heuristic often leads an Individual to ignore source credibility

The representativeness heuristic suggests that an individual's determination of the likelihood that A comes from population B will be based on the extent to which the individual perceives A to be similiar to B (Kahneman and Tversky, 1972) Considerations other than perceived Similarity will be ignored Studies by đdoyce and Biddle

(1981b) and Bamber (1981 a and b) have examined whether

auditors use a representativeness heuristic and ignore specific considerations such as source credibility

Joyce and Biddle (1981b) asked auditors to judge the probability of collection of an overdue account on the basis of a credit report from either an independent credit agency or the credit manager of the client The results of the study showed that in a within-subjects design auditors did react to the source of the credit report However, in a between-subjects design they did not react to source credibility While no explicit manipulation check was used in the between-subjects design, the authors indicated that the use of a within-subjects design “permitted an inference concerning whether the credit manager and the credit agency were perceived as differentially reliable" (Joyce and