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Experimental evidence on external auditor reliance on the internal audit

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Abstract

With the revised version of ISA 610 (revised 2013), external auditors now face both requirements and guidance addressing their responsibilities when relying on the internal audit function (IAF). The reliance decision of an external auditor has important economic consequences and implications for the efficiency and effectiveness of the annual audit. Using an experimental design, we explore how German external auditors’ reliance decisions regarding the IAF are affected by varying levels of environmental factors, like client business risk, effectiveness of the internal control system, and quality of the corporate governance. Furthermore, the experiences of external auditors in collaborating with an IAF are taken into consideration. The results indicate main effects for each factor and a two-way interaction between the effectiveness of the internal control system and the quality of corporate governance. Specifically, a strong internal control system can compensate for weaknesses in corporate governance with respect to the confidence of external auditors in the IAF. Also, the type of audit procedure influences the willingness of auditors to rely on the IAF, and the inherent risk of the examined transaction strengthens the negative impact of client business risk on the reliance decision. Moreover, past experiences of external auditors with an IAF have a significant impact on their reliance decision. Overall, the findings suggest that organizations can foster internal–external auditor coordination by enhancing corporate governance effectiveness and strengthening the internal control system.

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Notes

  1. The activities of internal auditors and external auditors are complementary and sometimes similar and overlapping. However, there are distinct differences in the roles and in the boundaries of the work that they perform. For more details see The Institute of Internal Auditors (2017) and the extensive discussion on a complementary or a substitutional relationship between internal and external provided by Eulerich (2016).

  2. Consultations with external auditors (28%) and requests from external auditors (19%) are relevant sources used by the IAF to establish the audit plan (O’Loughlin and Swauger 2016).

  3. The IIA’s International Standards for the Professional Practice of Internal Auditors refer to the cooperation between external auditors only in a general way by saying that the chief internal audit executive should share information and coordinate activities with the external auditor to ensure an adequate coverage and to avoid duplication of efforts (Standard 2050). Further guidance is provided by the Implementation Guide 2050, which e.g. says that the chief internal audit executive may rely in the work of external auditors.

  4. The two-tier board system exists in many other European countries, such as in Belgium, Denmark, Finland, France, Greece, Netherlands, and Sweden, either on a mandatory or at least on voluntary basis (Weil et al. 2002).

  5. Likewise the COSO Enterprise Risk Management Framework refers to the internal environment as an important component (COSO 2017).

  6. According to Sect. 5.4.1 of the German Corporate Governance Code, the composition of the supervisory board has to ensure that its members collectively have the knowledge, skills, and professional expertise required to properly perform all duties, and Sect. 5.4.1 recommends that the supervisory board shall include an appropriate number of independent members.

  7. Thus, the share of subjects having prior experience with the IAF is surprisingly high. This may be caused by the fact that many participants, currently working for a Non Big Four audit firm, have prior working experience with a Big Four audit firm. Further analyses reveal that the percentage of clients having a IAF differs significantly between the two groups (mean Big Four = 48.8%, mean Non Big Four = 27.6%, t = 4.228, p < 0.001).

  8. There are highly significant positive correlations between all eight COMM questions.

  9. The covariates do not interact with any of the independent variables, so the homogeneity of regression slopes assumptions is not violated.

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Authors and Affiliations

  1. Department of Accounting and Auditing, Darmstadt University of Technology, Hochschulstraße 1, 64289, Darmstadt, Germany

    Reiner Quick

  2. Lucerne University of Applied Sciences and Arts, Lucerne, Switzerland

    Philipp Henrizi

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Correspondence to Reiner Quick.

Appendix: Experimental materials

Appendix: Experimental materials

1.1 MetalTec Inc. Case

Assume that you are engaged with the integrated audit of MetalTec Inc. for the third time. During thelast two audits a good working relationship between you and the client has developed. The employees of the client work reliably and competently.

1.2 Client business

MetalTec is a supplier for the machine industry and manufactures forged and machined components, such as gear wheels, sprockets and axles, which are used in the further processing of engines and transmissions. The company has concluded long-term supply agreements with some well-known major European machine manufacturers. Sales volume and prices are renegotiated annually.

MetalTec is specialized in the production of machine motors. Its customers mainly include large European companies. For the production specific semi-finished components are used, which are purchased from a single supplier who has adopted the specifications of MetalTec.

The strategic focus of the company is market expansion; market growth is expected especially in the Arab and North-African countries. In this area several new customers have already been gained and the company is planning to further increase sales. In order to accelerate the market share gain variable compensation and kickbacks were set for sales management, which are linked to the sales figures.

1.3 Internal control system

In the previous audit periods no major material misstatements have been detected, thus an unqualified opinion has been issued. The internal control system has been extensively tested and documented in recent annual audits. Overall, the implemented internal controls can be described as effective and functional.

In the previous audit periods the financial statements contained misstatements, which have been satisfactorily resolved by the client, hence an unqualified opinion could be issued. However, some weaknesses in the internal control system have been detected, e.g. the segregation of duties is not always consistently applied and there is no standardized approval process implemented. Because no fraud or violations have occurred yet, the management of the client sees no need for action to improve the internal control system.

1.4 Corporate governance

The Board of Management consists of two persons managing the company by mutual agreement. Their main tasks are the strategic management of the company as well as setting up and monitoring an efficient risk management system. This is done in close coordination with the Supervisory Board. The two General Managers receive a fixed salary and an agreed bonus payment.

The Supervisory Board comprises 5 members, including 1 employee representative. Each member receives a fixed compensation. The composition of the Supervisory Board allows qualified supervision and advising on management matters. An audit committee has been implemented to monitor and oversee responsibilities in relation to financial reporting, internal control system, risk management system and audit functions.

Overall, in recent audit periods the quality of corporate governance could be assessed as high.

The General Manager leads the company on his own responsibility. His main tasks are the strategic management of the company as well as setting up and monitoring an efficient risk management system. He receives a fixed salary and stated percentage on sales.

He meets once a year with the Supervisory Board as part of an annual debriefing. The Supervisory Board comprises 2 members and a chairman. Each member receives an individual fee annually. An audit committee is not implemented.

Overall, in recent audit periods the quality of corporate governance has been assessed as low.

1.5 Internal audit function

The company’s internal audit department employs 8 personnel: a director, 3 managers, and 4 senior auditors. The audit team’s evaluation has concluded that there are internal audit activities relevant to the integrated audit and that it is cost efficient to consider the internal auditors’ work. All of the members of the internal audit function (IAF) have at least bachelor degrees in accounting and are either CPAs or CIAs. The members of the IAF have an average of 5 years of audit experience with a range of 2–20 years. The head of internal audit reports directly to the chairman of the audit committee. The audit team has determined that the IAF is competent and objective. Your audit team has relied on the IAF in prior years.

1.6 Part I

To what extent would you rely on the work of the internal audit function to perform the following audit procedures 1–4 on an integrated audit?

The following tests of controls are scheduled to be completed:

figure a

1.7 Part II: Supplementary questions

figure b
figure c

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Quick, R., Henrizi, P. Experimental evidence on external auditor reliance on the internal audit. Rev Manag Sci 13, 1143–1176 (2019). https://doi.org/10.1007/s11846-018-0285-0

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