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The association between external and internal auditors has been the center of attention of several professional standards and researches. SAS No. 65 (AICPA 1991) outlines the nature of this relationship and suggests specific ways using which the external auditor can improve efficiency and effectiveness by making use of internal auditors' work.
Internal auditors usually assist management in ensuring that there is a proper internal control system in place and that the operations of the company are carried out efficiently, economically and effectively. External auditors, on the other hand, are interested in the truth and fairness of the financial statements. In order to achieve this objective, the external auditors will usually evaluate the internal control system of the company to ensure that it is capable of preventing and detecting material mis-statements from occurring. External auditing standards require external auditors to determine whether or not, and if so to what extent, they will rely on their clients' systems of internal financial control in order to obtain assurance that their clients' financial statements are reliable.
There is thus renewed interest on the likely contribution that the internal audit function of an organisation may make towards reducing financial statement audit costs through external auditors' reliance on work undertaken by the internal auditor (Felix, Gramling, & Maletta, 2001; Wallace, 1984; Elliot & Korpi, 1978).
Findings gathered from empirical studies show an increasing trend in internal audit providing support for external audit (FelixÂ et al., 2001;Â HaronÂ et al., 2004). Proponents of higher levels of internal audit participation and contribution to the external audit argue that this participation is favorable to both external and internal auditors. In contrast, external auditors may use the experience of the internal auditors to reduce the duplication of work and, effectively, the cost of the external audit. Additionally, internal auditors can help external auditors understand the firm's internal control system and the level of conformity with it. Alternatively, internal auditors may benefit from the expertise of external auditors in areas that the internal audit department needs. Internal auditors may also benefit from exposure to different audit techniques employed by the external auditors (Reckers and Lee, 1997;Â HaronÂ et al., 2004;Â Schneider, 2009).
Despite the fact that client firms are interested in getting the maximum benefits from their internal audit investments, they are continually looking for ways to control external audit fees. For instance,Â FelixÂ et al.Â (2001)Â discovered that the extent to which internal audit contributes to external audit is a major variable in determining external audit fees. This suggests that client firms have financial incentives to encourage external auditors to rely on internal auditors in the conduct of their external audit.
Nonetheless, the decision of external auditors concerning the degree to which they may rely on the internal audit work during an audit engagement should be sustained by a full understanding of the strength of their client's internal audit function. This kind of understanding is usually achieved during the test of controls period in which external auditors appraise their clients' internal controls to ensure that they are capable of preventing and detecting material misstatement occurring. In this regard, the issuance of professional auditing standards has tried to provide guidance for external auditors on the proper use of the internal audit during an external audit.
In 1975, Statement on Auditing Standards (SAS) 9 was the first professional standard to see to the relationship between external and internal auditors. SAS 9 required external auditors to assess the internal auditors' objectivity, competence and work performance before determining the extent to which they may place reliance on the work of internal auditors. However, SAS 9 was condemned on the basis that it did not provide specific guidance for the completion of this evaluation, leaving the degree of reliance up to the judgment of the individual auditors (Reckers and Lee, 1997). Thus, SAS 65 was issued in 1991 to shed light on the working relationship that must exist between the external and internal auditors, and to provide better guidance for external auditors on how to estimate and test the internal auditor's objectivity, competence and work performance (ReinsteinÂ et al., 1994).
It should be noted that SAS 65 permits external auditors to rely heavily on the work of the internal auditors. However, the SAS does not require reliance on the internal auditor's work. Therefore, there is no obligation for external auditors to rely on internal auditors; they may or may not rely.
A majority of external auditors rely on internal auditors to some extent and this reliance should increase in the future (Ward and Robinson, 1980). It is a generally accepted belief that external auditors should review and appraise internal audit quality before deciding upon the degree of reliance on internal auditors. Various attempts have been made through a number of studies so as to investigate the extent of the contribution of internal auditors in the external audit work.
Audit fees call for study for two reasons: first, to evaluate the competitiveness of audit markets
(especially given the small number of international providers of such services); and, second,
to inspect issues relating to contracting and independence (Hay et al. 2006). Much of the
research in audit fee markets has followed Simunic (1980) and investigated client and auditor
attributes associated with the variation of audit fees. A common tactic has developed from the literature examining the determinants of audit fees, largely based on Simunic's (1980) seminal work. Typically, an estimation model is created by regressing audit fees against a range of measures which substitute for attributes hypothesised to increase or decrease audit fees.
Past researches on the impact of internal audit on audit fees have reported:
(1) a negative association accredited to external auditors' reliance on the internal auditors' work (Elliot & Korpi 1978; Felix, Gramling & Maletta 2001; Turpin 1990; Wallace 1984);
(2) a positive association based on a firm's wish to indicate a high level of
control or monitoring environment (Anderson & Zeghal 1994; Carey, Craswell & Simnett
2000; Goodwin-Stewart & Kent 2006); or
(3) no significant association between internal audit and audit fees (Carey et al. 2000; Chung & Lindsay 1988; Gerrard, Houghton & Woodliff 1994; Gist 1994; Johnson, Walker & Westergaard 1995; Maher, Tiessen, Colson & Broman 1992; Palmrose 1986; Raman & Wilson 1992; Stein, Simunic & O'Keefe 1994; Walker & Casterella 2000; Willekens & Achmadi 2003).
Surveys of internal and external auditors were conducted by Ward (1979) and Ward and Robertson (1980), to gather information on "the extent to and the manner in which independent auditors already rely on the internal audit functionâ€¦whether both groups of auditors believe this extent and manner of reliance is sufficientâ€¦and how the extent and manner of reliance may change"
Barett and Brink (1980)Â examined 150 business organisations with both internal and external audit and then visited 20 organisations that consist of an effective board. The results of the survey revealed that the level of coordination between internal and external auditors should be evaluated using the extent of reliance, that is "much", "moderate" and "little" coordination.
One of the first studies was performed byÂ Brown (1983), whoÂ carried out a thorough investigation of the factors that might be deemed important by external auditors in the appraisal of the reliability of the internal audit function. Approximately 101 external auditors, representing four auditing firms of the "Big Eight" firms in the USA were contacted through questionnaires. The results of the survey showed that the auditor's judgments of internal audit work were influenced by three factors, which are:
independence of the internal auditor,
satisfaction of the external auditor with the internal audit function during previous audits (known as work performance), and
competence of the internal auditor.
The first two listed above were termed as the main factors. As for the competence factor, it was found to be the least important factor, though significant.
As per ISA 610, external auditors are required to assess four factors in deciding whether internal audit work is sufficient for the purpose of their audit. In a similar vein, results of an experiment conducted by Arnold Schneider (1984)Â stated that work performance was viewed as the most important factor, followed by competence and objectivity.The results were obtained through an examinination of the perception of auditors towards the internal audit function, in terms of the evaluation of the strength of the internal audit function by auditors. According to Statement on Auditing Standards (SAS) 9, an investigation of three factors was conducted, including internal auditors' competence, objectivity and work performance. The methodology adopted in this study involved designing and distributing a questionnaire to Certified Public Accountant (CPA) firms in the State of Ohio, found in USA.
The efforts done by internal auditors to coordinate with external auditors was examined by Berry (1984), who looked at the whole situation by putting himself in the shoes of an internal auditor. The sample chosen consisted of 14 large companies who were interviewed. Satisfactory results were obtained which were able to present ranked criteria for assessing an internal auditor's competence, objectivity and performance, and also on how to initiate a coordination programme.
Using data from 1975 to 1981, Wallace (1984)Â investigated the link between a company's spending on internal auditing and external audit fees. Results of a regression analysis performed using a sample of 31 companies used variables that are related with external audit fees, including revenue from operating activities, total assets, net revenue, number of ancillary firms and the total spending on the internal audit department. Finally, the conclusion was that there exists a noteworthy negative relationship between spending on internal audit department and external audit fees paid. The results also indicated that the internal audit function had changed over time, thus becoming more refined and therefore increasing the likelihood of external auditors' reliance on internal auditors.
Another relevant study conducted by Schneider (1985) led to the conclusion that competence and work performance were reagarded as having equal importance in the evaluation of the strength of internal audit. Findings also provided clear evidence that external auditors place heavy reliance on internal audit so as to decrease their external audit work.
Messier and Schneider (1988) adopted the Analytical Hierarchy Process to evaluate the relative importance of the attributes that are deemed important by external auditors in assessing the internal audit function. Findings stated that auditors consider competence as the most important aspect, after that objectivity and work performance.
Using a sample of 25 disbursements from an actual international airport company, and with an objective to assess the detection rate of internal and external auditors in the testing of controls, Wagonner and Rickette (1989) conducted an experimental study. The internal auditors were found to have an overall detection rate of 63.2 per cent, while the external auditors' rate was 59 per cent, which was considered to be statistically insignificant. Consequently, these results were used by external auditors to document, test and appraise a client's control system to support the use of internal auditors to test controls.
In a study by Tiessen and Colson (1990), it was found that internal auditors' specific work performed accounted for most of the variance in the external auditors' assessment of the degree of reliance they could place on the internal audit department.
Using a sample of Australian external auditors, Edge and Farley (1991) assessed the factors that are used to appraise a client's internal audit function. Results led to the conclusion that technical competence was the most dominant factor as deemed by the auditors, followed by work performance. Prior audit work was considered to be the third most determining factor and objectivity (organizational status) the least important of the factors.
Research studies by Maletta (1993) and Maletta & Kida (1993) carried out investigations on the factors considered by external auditors' before deciding to employ internal auditors as assistants. The factors included inherent risk, strength of internal control and quality of internal audit. Internal control strength highly determines reliance on internal audit when work is already done by internal auditors, while internal control strength has no effect on the decision to rely when internal auditors function as direct assistants to external auditors. The results indicated that when a company's internal control strength is regarded as being poor, external auditors should refrain from relying on the work performed by internal auditors, but may instead employ internal auditors as direct assistants.
SteinÂ et al.Â (1994)Â conducted an examintation as to the effect of internal audit contribution, among other variables, on audit fees paid to external auditors. The results were not as per expectations and it was found that this variable was not a significant determinant of external audit fees.
In Australia,Â GerrardÂ et al.Â (1994)Â addressed the issue concerning the impact of the internal audit function on external audit fees. The sample from which data were collected from consisted of 300 publicly listed companies in Australia during the 1980s. The method used to model audit fees involved a linear regression. Results revealed that the size, complexity of audited companies and industry differences are major variables in determining deviation in audit fees. Moreover, it was found that no significant relationship existed between internal audit function and audit fees.
A study was carried out by Haron (1996) as to how internal and external auditors evaluate the quality of a payroll internal control system. Findings reported that there was no major difference between the two parties' evaluation, thereby concluding that the work or judgement of internal auditors can be relied upon by external auditors.
The impact of the contribution of internal auditors on the external audit work in respect of audit fees and the factors that influence this contribution was analysed by FelixÂ et al.Â (2001). With a view to achieve the objectives of the study, two questionnaires were designed, with the first being sent to audited companies and the other to external auditors. The results indicated that the contribution of internal audit in external audit work significantly determines audit fees. It was found that the higher the coordination of external audit with internal audit, the lower are audit fees, thus stating a negative relationship. The findings further revealed that audit fees were more or less 18 percent lower when external auditors placed reliance on internal audit.
The level of coordination between internal auditors and external auditors in Saudi Arabia was examined by Al-TwaijryÂ et al.Â (2004).Â Through the use of questionnaires and interviews, it was found that external auditors are dissatisfied with the current internal auditing practice since they believed that many companies lacked professionalism. On the other hand, the level of cooperation between internal and external auditors was regarded as limited by internal auditors. The results also revealed that the extent to which external auditors place reliance on the work of internal auditors varies with the quality of internal audit. It was agreed that external auditors considered objectivity, competence and work experience of internal auditors as key factors which influence their decision to rely.
Another survey undertaken by Haron et al (2004) laid emphasis on the fact that external auditors often place reliance on their clients' internal auditors because doing so leads to cost savings to the client. The study was carried out to determine which of the criteria (objectivity, competence and internal audit quality) considered by external auditors mostly affects their decision to rely on internal auditors. Results were clear enough to indicate that work performed and competence are the two most significant determinants which affect reliance on internal auditors. Haron et al. also listed the results of the most important researches undertaken regarding the key criteria influencing external auditors' reliance on internal auditors:
In a study conducted by FelixÂ et al.Â (2005), it was found that when major non-audit services are provided, client pressure considerably increases the extent of external auditor reliance. On the contrary, when significant non-audit services are not provided to a client, the quality of internal audit and the level of coordination between internal and external auditors have a positive effect on external auditors' decision to place reliance.
Group affiliation theory, adopted by Gramling and Vandervelde (2006), revealed that external auditors might be subjective in evaluating the quality of internal audit when another public accounting firm performs the service. Based on an experiment conducted with both internal and external auditors, no difference was found in either party's judgment of competence and work performance. Nevertheless, the external auditor respondents considered internal audit objectivity to be higher when the provider was another accounting firm, which was different from the internal auditor respondents, according to whom objectivity was higher when internal audit was provided within the firm.
It was put forward by Hay, Knechel & Wong (2006) that the choice of variable may drive the significance or insignificance of internal audit as an explanatory variable for deviations in audit fees. Nevertheless, there are other likely reasons for the mixed results reported by Hay et al. (2006). For instance, according to SAS 65 and 78 in the United States of America (USA), external auditors are required to rely on an internal auditor's work, wherever possible. In contrast, auditing standards in some other parts of the world (such as Australia and Canada) do not allow this. For that reason, a adverse association in USA markets and a positive association in other markets could arise owing to contradictory institutional frameworks.
Goodwin-Stewart and Kent (2006)Â reported through their findings that the existence of an internal audit function in a firm is highly and positively associated with external audit fees. Results pointed out that this positive association has strengthened since 2000. "This observation suggests that firms that engage in greater internal monitoring through the use of internal audit also demand higher quality external auditing" (Goodwin-Stewart and Kent, 2006, p. 388).
In a more recent study, GloverÂ et al.Â (2008)Â analysed how sourcing arrangements influence external auditors' decision to rely on the internal audit. According to a study effected on 127 external auditors, results showed that the likelihood of external auditors to rely on in-house or outsourced internal auditors' work is equal when inherent risk is low. Similarly, external auditors are more prone to rely on the work of outsourced rather than in-house internal auditors when inherent risk is high. In addition to what has been said, it was found that when inherent risk is high, external auditors place more reliance on work done by internal auditors for tasks which are objective, rather than subjective tasks, but not when inherent risk is low.
Finally,Â Munro and Stewart (2009)Â carried out a survey to know how internal audit sourcing arrangement and internal audit's consulting affect external auditors' reliance on internal auditors' work. Results led to the conclusion that external auditors are less likely to use internal auditors' work for substantive testing of account balances than for the assessment of internal financial control. It is to be noted that an exception was identified; that is external auditors employ internal auditors mostly as assistants for substantive testing when internal audit is provided in-house.
To sum up, earlier studies have made use of a explanatory and experimental approach with no proper model to guide the research hypotheses. As revealed in Table 1 above, the findings from these studies have been varied and indecisive. While one study (Abdel-khalik et al. 1983) identifies objectivity as the most important factor, others (Brown 1983; Schneider 1984, 1985a, 1985b; Margheim 1986) term work performance as the most significant. On the contrary, latest studies (Margheim 1986; Messier and Schneider 1988; Edge and Farley 1991; Maletta 1993) identify that external auditors believe competence to be the most significant factor in the assessment of the internal audit function. Hence, though a noteworthy amount of previous research has been carried out, yet there are no clear conclusions concerning how external auditors really evaluate and combine these factors so as to appraise the strength of the internal audit function and therefore how much reliance to place on internal auditors.