external auditors evalutions of internal a conjoint measurrment approach

Tae development of internal anditing has had an impact on the audits made by external auditors, who may rely on the work performed by the internal auditors.. A survey by Ward & Robertso

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8214139

Schneider, Arnold

EXTERNAL AUDITORS' EVALUATIONS OF INTERNAL AUDITING: A CONJOINT MEASUREMENT APPROACH

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EXTERNAL AUDITORS* EVALUATIONS OF INTERNAL AUDITING: A CONJOINT MEASUREMENT APPROACH

DISSERTATION

Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate

School of The Ohio State University By Arnold Schneider, B.S., M.A * + # @ & The Shio State University 1982 Reading Conmittees Approved By Daniel L Jensen Ernest L Hicks Douglas A Wolfe Thogas EB Nygren

Thomas J Burns, Chairman Therrnéou 9v

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ACKNOWLEDGEMENTS

This, the final stage of ay formal academic training, could not have been completed vithout the contributions of the following people:

Members of my dissertation committee, Thomas d Burns (Chairman), Daniel L Jensen, Ernest L Hicks, Thomas & Nygren, ana Bouglas A Rolfe, all of whom provided many helpful commerts about my research;

Auditors who participated as subjects in my research (their identities must remain anonymous) ;

Ernst § khinney, for their generous dissertation fellowship; Rodger & Holland, who helped immensely with the word processing system that was used to type this dissertation; My mother, who sacraficea a great deal for my education and who Supported my decision to pursue a doctorate;

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June 30, 1953 Born - New York, New York 1975 2 = « » « « « © « Bede, Case Western Reserve

University, Cleveland, Ohio 1975-1976 « « « « « Auditor, H.S General Accounting

Office, Washington, D.C

1976-1981 Teaching Associate, Department of Accounting, The Ohio State University 1980 , « «4 w= 4 + © « 2 N.À«, The Chio State University

PIELDS OF STUDY

Major Field: Accounting

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ACKNOWLEDGEMENTS «© 2 2 2 2 ew ew V VITA » LIST OF TABLES + 2 2 we wo 1 V CHAPTER +1 TI 111 ry TABLE OF CONTESTS - 5 a » ° s « « « ` » s ° s ˆ e a - INTRODUCTION > ` e « » - oo e -

Statement of the Problem «4 « «4 se Ÿ Qbjective and Contributions Summary of Results 2 + 2 2 se ew wo V A MODEL RELATING INTERNAL AUDIT

ASSESSMENT TO THE AUDIT PROCESS A Model of the Audit Process .- Incorporation of Internal Andit :

Evaluation in the Model «4 2 2 0 « LITERATURE REVIEW: INTERBAL CONTROL

EVAL UAPION » - ea « = so a - - - - * -

Evaluation of Internal Auditing Evaluation of Internal Control Systems ˆ Limitation of Previous Studies AN OVERVIER OF CONJOINT MEASOREMENT Conjoint Neasurement Theory Applications of CJ# in Non-Accounting

Studies - oe ee ew we ewe Applications of căn to Accounting Issues Limitations of Conjoint Measurement

viii

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VI

VII

VIII

APPENDIX

Overview of Research Procedures Phase I: Factor Definition Phase II: Level Selection Phase III: Judgment Modeling Subjects «4 2 2 we oe - oe » eo » a Contents of Questionnaires ANALYSES OF RESULTS FOR PHASES I se @ @ 8 8 * @ 6 © @ @ AND Phase I (Pactor Determination) Analyses Results for the Competence Pactor Results for the Objectivity Pactor Results for the Work Factor Phase II (Level Selection) Analyses Methodology Used to Select Levels Level Selection Results "sms e

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Ẹ PART-WORTH FUNCTIONS 4 4 4 eo Q we ow Ố 185

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TABLE 2s 3 Re S 6 7 8 9 0 11 12 13 1u „ 15 16 1? 18

CRITICISHS AND COMMENTS ON

MORIARITY & BARROW (1979) RESPONSE RATES OF SUBJECTS

DESOGRAPHIC INFORMATION ABOUT SUBJECTS PROPILE COMPARISON FOR DIMENSION I OP CMP CONTINGENCY TABLES ~ DIMENSIOW I OF CMP CONTINGENCY TABLES ~ DIMENSION I1 OF CMP STATISTICAL ANALYSIS POR COMPETERCE CONTINGENCY TABLES - DIMENSION I GF OBJ CONTINGENCY TABLES ~ DIMENSION II OF OBJ STATISTICAL ANALYSIS FOR OBJECTIVITY CONTINGENCY TABLES - DIMENSION Y OF WRK CONTINGENCY TAGLES ~ DIMENSION II OP WRK STATISTICAL ANALYSIS POR WORK 2 2 STIMULI ASSOCIATED WITH CHARACTERISTICS, RESPONSE RATES IM PHASE IT - » » » *

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20 21 22 236 24 25 26« 27 28 INDEPENDENCE * « - e » a ° » *

KENDALL*S W FOR TESTS OP JOINT INDEPENDENCE VIOLATIONS OF DOUBLE CANCELLATION 2 2 « « SUMMARY OF ACJB EESULTS, 2 ô ôâ

FACTOR WEIGHTINGS POR SUBJECTS

VIOLATING SFI 2 2 © © we wo { PRECAP VALUES FOR ADDITIVE AND

DISTRIBUTIVE MODELS «4 4 +4 6 ew ew RELATIVE PACTOR WEIGHTS MULTIPLE COMPARISONS -— ALL TREATMERTS

RANKING OF PROPILES BY STRENGTH

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I¥TRODUCTION

1.3 SPATEREWT OF THE PROBLEA

The phenomena of large, decentralized organizations and recent government actions (discussed later) have given rise to the existence and growth of internal auditing đepar taents Tasks of internal auditors include, but are not lisited to, “studying and ewaluating internal accounting control, reviewing operating practices to promote increased efficiency and econony, and making special inquiries at mahagesent*s direction" (AICPA, 1975} In recent years, the humber of companies having internal auditing departsents has increased and the average size of internal audit staffs has grown (Hacchiaverna, 1978)

Tae development of internal anditing has had an impact on the audits made by external auditors, who may rely on the work performed by the internal auditors fvo general forms

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(1} External auditors say reduce? their audit procedures based on their evaluation of the internal auditors*® contribution to internal controls

(2) Subsequent to their internal control evaluation, external auditors say, under their direct supervision, use internal auditors to perfors substantive audit procedures

A survey by Ward & Robertson (1980) showed that “virtually all independent auditors rely on internal auditors to sore extent.*

The importance of reliance can be illustrated by conclusions from Ward (1979), who found “the position of both response groups (external and internal auditors) was that the external audit costs should usually be materially

less when internal auditors are relied upon than what they

would have been without reliance" According to Statesent on Auditing Standards (SAS) No 9, this decision on reliance should be preceded by an evaluation of the internal audit

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The

The independent auditor should acquire an understanding (emphasis added) of the internal audit function as it relates to his study and evaluation of internal accounting control The work performed by internal auditors way be a factor in determing the hature, timing, and extent of the independent auditor's procedures (AICPA, 1975)

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Flow Diagram of the Reliance Process {states of internal bu aes el s [ auditing strength t T~ ˆ { n inforgation | systen ' f£ " ơ L #8âSSages y=n (s) | about states I + j Li £ information | evaluation , ˆ I judgment | r=£ (y) t about states | t " › I d decision | rule { reliance { a=d (r) i actions t i T «i ° outcone † £unction | $ - + "† o(a,s} { outcorzes |

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tend to be inforrzal* The significance of the internal audit function has often been pointed out by external auditors Price Waterhouse & Co (1980), for instance, comments that "internal auditing is a management resource ~- an important part of the internal control systea for which management is primarily responsible." Research by Ward (1979) indicated that external auditors believe “the internal audit function should be viewed as an integral part of the internal control system rather than Nerely a check on that systea."

In 1975, the American Institute of Certified Public Accountants (AICPA) yublished SAS No 9%, which provides guidance to the auditor? on factors that should be considered when evaluating the strength of internal auditing aS a basis for reliance SAS No 9 identified three general factors external auditors should consider: {1) competence of the internal auditors, (2 objectivity of the internal auditors, and (3) work of the internal auditors

Two other recent developeents have given additional impetus to the issue of internal audit assessment These developuents, related to internal controls in general, affect internal auditing because it is a component of a

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company*s internal control systea Pirst, the Poreign Corrupt Practices Act of 1977 (FCPA) imposed on coapanies that are subject to the periodic reporting requiresents of the Securities and Exchange Act of 1934 new statutory requirements to devise and Maintain internal control systeas that will provide reasonable assurances that transactions are properly authorized and recorded and that assets are adequately safeguarded Based on a survey of 119 firmus, Worgaard 6 Granov (1979) report that 33 firms said they had increased or planned to increase the size of their internal audit departagents as a result of the enactment of the PCPA Another effect of the YFCPA is that corporate audit committees have increased their involvement with the internal auditors Por instance, Norgaard & Granow report that 14% of the companies they surveyed indicated that the number of regular meetings between audit committees and internal auditors had increased as a result of the FCPA

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investors, and that auditor involverzent with such a report may be needed Accordingly the Commission intends to monitor closely the results of voluntary efforts and private-sector initiatives in this area." (SEC, 1980) Norgaard 6 Granow (1979) have found that 26.5% of the companies they surveyed already had or planned to have a management report on internal control in their 1979 annual reports The SEC intends to formally review its proposal in 1982, based on a three year analysis of voluntary efforts

These PCPA and S&C developments have enhanced the importance of the internal audit function Over 80% of the external and internal auditors surveyed by Ward & Robertson (1980) predicted that external auditors* reliance on internal auditing will increase in the next decade In turn, the need for external auditors to evaluate the strength of internal auditing will become greater

1.2 OE EE AEE ONE OBJECTIVE AND CowTRIBUTIONS

The objective of this research is to obtain descriptive models which are representative of the ways in which external auditors combine and weigh the three evaluation factors identified in SAS 9 3 These ncdels, which are

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illustrated as r = f(y) in Diagrams 1, are analyzed to provide insights in answering the following research questions:

(a) How do auditors combine information on the three factors in forging overall ewaluations of internal auditing?

(>) What level of importance do auditors attach to each of the factors?

(Cc) Which combinations of factor levels đo auditors associate with strong (and weak) internal auditing? (a} Is there consensus aNong auditors in their

evaluations?

AnSwers to these questions contribute to a needed understanding of how auditors judge internal auditing ‘This understanding is needed for several reasons:

(1) The AICPA should be aware of how SAS No 93 has been applied The results of research such as this might help it in setting future standards dealing with evaluation of internal auditing

(2) Auditors may be able to improve their judgments on interhal auditing if they have a good anderstanding of how they nake their judgments at present *The principal means of iaproving human judgsent in auditing appears to be some type of educational or training program that begius with the judgment process as modeled® (Ashton & Brown, 1980)

(3) The reliance that external auditors place on internal auditing depends, in part, on their judgaents about its strength { see Diagram 4) Thus, &@ more complete understanding of how external

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auditors rely on internal auditing reguires an understanding of how they judge the strength of internal auditing

(4) The reliance that external auditors Shoul@ place on internal auditing is a function of the internal audit ewaluation (i.e., a=d(r} in the normative analog of Diagram 1) Thus, a normative aodel of the reliance process vould be aided by knowledge of internal audit evaluation in that the sodelts parameters would be more completely specified (5) Business firas would gain from an understanding of

how their external auditers rate the strength of internal auditing These firms are interested in minimizing external audit fees, ang thus would want to Know how to strengthen their internal auditing departaents to enable external auditors to place more reliance on thes Furthernore, tfiras that must comply with the PCPA will want inforeation about internal auditing strength

Evaluations of internal auditing may differ between the two forms of reliance sentioned in the previous section This research uses the first of the two forgags as the scenario This approach is justified by Ward*s (1979) resalts, which indicate that "external auditors rely upon internal auditors more in connection with internal control than for direct assistance in performing audit procedures"

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opinions on the fairness of the financial statenents The eapirical evidence from the psychology literature (see Goldberg (1968)) has generally shown poor judgmental convergence {i.@., lack of agrees ent among different subjects*® judgments on some trait when using different data sources) In general, consensus is a necessary condition for the existence of professional expertise (Einhorn, 1971) Since the basis of the auditor's authority is professional expertise, lack of consensus on audit opinions about financial statements may undermine the stature of the auditing profession (For a more detailed argument along these lines, see Joyce (1976) ) A second reason for addressing consensus here is that in addition to the importance of expertise with respect to opinions about financial stateaents, the PCPA and possible future auditor-attestation of management reports make the evaluation of internal auditing itself a sore significant

expert judgment

1.3 SDBBARY OF RESULTS 'Vhvngie-duinisAduipe đhơng in talnei-

Three inter-related experiments were conducted in this study The objective of the first was to obtain operational definitions for the three SAS Wo 9 factors (competence, objectivity, and work) to be used as the -independent Variables in the last experiment A multidimensional

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scaling (MDS) analysis on auditors' ratings of 30 case profiles for each factor revealed the following characteristics to be the nost important: Coapetence (1) Instruction and supervision by senior internal audit personnel (2) Internal auditors" experience Objectivity

(1) Organizational level to which the internal audit department reports fandings

(2) Freedom from conflicting duties Work

(3} Scope of internal audits

(2) Quantity and quality of internal audit docurgentation

The objective of the second experiment was to obtain four materially different levels at which to describe each of the above six characteristics Another MDS analysis was performed on auditors* ratings of dissimilarity among eight levels (resulting in comparisons between 28 pairs of levels) for each characteristic The chatacteristics and levels selected served as inputs for the 43 design of internal audit case profiles used in the third experiment

The purpose ot the third experiment, which vas the focus of this study, was to obtain descriptive aodels representing