Research " AN EMPIRICAL STUDY OF EXTERNAL AUDITOR RELIANCE ON INTERNAL AUDITORS " pdf

Specifically, a case 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 b

AN EMPIRICAL STUDY OF EXTERNAL AUDITOR RELIANCE ON INTERNAL AUDITORS

by Loren L Margheim

A Dissertation Presented in Partial Fulfillment

of the Requirements for the Degree

Doctor of Business Administration

ARIZONA STATE UNIVERSITY

May 1984

LOREN L MARGHEIM

All Rights Reserved

RELIANCE ON INTERNAL AUDITORS

by Loren L Margheim

has been approved February 1984

Generally accepted auditing standards provide external

quantities of evidence which should be gathered to support

"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, a case 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

auditor competence/work performance and internal auditor

objectivity Both of these factors were tested at a nigh

and low level

The development and use of four cases containing the four

performance and objectivity resulted in a completely crossed

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

in the audit program plans between the five cases

The results indicated that internal auditor competence/work performance impacted on the external

external auditors reduced the planned amount of audit time

between the two factors had no effect on the external

before the external auditors would alter the amount of planned audit hours

iv

I wish to express sincere gratitude to Dr Kurt Pany for

dissertation I also wish to thank Or J Hal Reneau, Dr

Philip M.d Reckers, Dr Andrew A Haried and Dr M Austin Betz for their assistance and advice

American Institute of Certified Pubiic Accountants is

by the Departments of Accounting and Quantitative Systems

gratefully acknowledged

Special thanks to my proofreader, Raymond C Valli, who contributed greatly to both this manuscript and my knowledge

extended to my parents and the rest of my family for their support during my graduate studies.

page

LIST OF TABLES e e e ° e ° e e e ° e e e * e ° e e viii

CHAPTER I = INTRODUCTION 2 2 2 1 2 «© « we we we we we 1

Significance of the Problem - + + c 3

Scope of the Study ` oe ee ee ee 5

Type of Reliance w e-s oe oe 9 CHAPTER II = LITERATURE REVIEW 2 « we es eee Lil

Internal Control Evaluations L1

Internal Auditor Relationship with External

Internal Auditor Relationship with

CHAPTER ITI =- RESEARCH METHOD 2 1 2 «1 © ww ew 28

Independent Variables ¬ ee ee a + 35 Dependent Variables .4.e6- ` 38 Statistical Techniques + » « «we we » « 39

Hypothesis Hl Hypothesis H2

B HIGH CŨMPETENCE/HORK PERFORMANCE

C LOW CO MPETENCE/WORK PERFORMANCE 2 ese

D HIGH AND LOW OBJECTIVITY 2.2 2 eee

vii

98

109

112 115

Table page

1 Usable Responses by Case 2 «2 «© «© © ww we we

2 Manipulation Check of Competence, Objectivity

and Work Performance 2 « « « «© © © «© « © «© «© 48

3 Frequency Table of Subject Experience 50

4 Frequency Table of Subject Education 51

5 Frequency Table of Subject Specialization Area 51

6 Frequency Table of Subject Position in the Firm 52

8 Subjective Opinions of the Subjects 55

9 MANOVAS Comparing the Control Case to the

Internal Auditor Cases 2 « «© © «© © vs 2 2 « 60

11 Mean Total Hours 2 2 2 2 2 ew ewe ee

12 MANOVA and ANOVAs for Total Compliance and

Substantive Hours 2 2 2 6 6 © © © @ we ew we ww 6B

13 Mean Total Compliance Hours 2 2 6 2 © © © + © 66

14, Mean Total Substantive Hours 2 2 2 « « «© 2 2 © 67

15 MANOVA on Individual Compliance Test Hours 68

16 ANOVAs on Individual Compliance Test Hours 70

17 Mean Individual Compliance Test Hours 71

viii

19

20

ANOVAS on Individual Substantive Test Hours

Mean Individual Substantive Test Hours

ix

75 77

External auditors must gather and interpret evidential information to support their professional opinion on whether

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

costs and yet maintain a high quality audit Difficult

evaluation and reliance upon information provided by

Statement of the Problem

other individuals Statement on Auditing Standard (SAS) #9

(AICPA, 1975), "The Effect of an Internal Audit Function on

internal auditor work The standard allows external

procedures due to such reliance

Surveys by Ward (1979), Ward and Robertson (1980) and the Institute of Internal Auditors (1975) indicate that external

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

Fleissner and Bauman (1972) and Wright (1977a and b)) Abdel-khalik, Snowball and Wragge (1983) went beyond

auditor reaction to the use of EDP internal audit

auditor reaction to other work performed by the internal auditors

This study is concerned with whether external auditors

auditors when making reliance decisions As such, the study

changes in audit scope

Significance of the Problem

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

a substantial number of both external and internal auditors

internal auditors it is important that both descriptive and normative research be performed on the relationship between external and internal auditors and on the impact of the relationship on the audit Without such research, the potential benefits (discussed below) to an external auditor

of the expanding internal audit profession may be lost

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

(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

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,

auditors,

plans based on anticipated internal auditor contributions (Clay and Haskin, 1981, p 69)

There are risks ti 2 assumed when relying on internal

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

Joyce and Biddle (1981b) found that external auditors may be

fully address the issue before the benefits of increased use

of internal auditors could be achieved without undue risk

Scope of the Study

External auditors must make reliance decisions on a

will vary within an individual audit This study examines external auditor reliance on internal auditors for a single, unique audit situation Generalizability of the results of

To help increase the potential generalizability of

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

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

affecting an external auditor's reliance decisions If an

external auditor perceives the client company to be unstable

placed on internal auditors and their work On the other hand, if the external auditor perceives a stable company

where few serious changes in the company's position have

taken place, internal auditors will probably be relied upon

relatively stable from year to year.

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

extent of external auditor reliance on internal 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,

4 Evidence aggregation and opinion formation These stazes appear appropriate in light of the three

Standards, sec AU 310, 320 and 326) The standards of field work require adequate planning and supervision of the

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

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

work performed by internal auditors in each of these areas should affect the amount of external auditor reliance

auditors will examine some audit program areas very closely

Other areas will, however, remain unexamined due to their

lower level of importance in keeping the company efficient

management Internal auditors are likely to have performed

a great deal of work in the receivables area Thus, the

auditors should be quite high

Type of Reliance

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

audit

Direct assistance will not likely occur until the audit

is under way Thus, reliance at the planning stage will be based on the role and prior work performed by the internal auditor For this reason, only external auditor reliance on internal auditor work performed prior to the external audit

is examined in this study.

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 audit program area is examined.

Behavioral research in accounting has been common in

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

importance of individual cues in the judgment process, the

individual self-insight are often the major concerns of policy capturing studies

The data-gathering method has a direct effect on the

individual cues can be evaluated through the use of either a between-subjects or a within-subjects design Evaluation of

the functional form of an individual's judgment rule and self-insight require the use of a within-subjects design

within-subjects design include Ashton (1974), Joyce (1976), Reckers and Taylor (1979), and Ashton and Brown (1980) Mock and Turner (1980) examined internal control evaluations through the use of a between-subjects design

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

received the same cases six to thirteen weeks later so that

judgment consistency over time could be studied

The results of Ashton's study of auditors' judgments

showed (1) high consistency for individual auditors over

time, (2) considerable consensus between auditors, (3) that

“auditor judgments could be modeled effectively with linear decision rules (i.e., main effects accounted for most of the

variance in judgments), and (4) that the two separation of duties indicators had the most impact on the auditors' judgments It was also found that the independent variable

significant and was only preceded by the two separation of

duties indicators in importance

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

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) low 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 iliow between-auditor

consensus

Reckers and Taylor (1979) extended the internal control

evaluation research over payroll These researchers felt that the results of Ashton's study may have been affected by

an artificially simple task Instead of using only six

internal control indicators, this study utilized a standard

internal control questionnaire representative of one that

might be encountered within a real audit Five cases were

devised and given to thirty auditors The results of the

auditors This result supported the contention that the

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

effect on the auditors' judaments

cases The results of the study indicated (1) that the

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

(anchors) supplied sample size recommendations closer to the

Overall, internal control evaluation research has found

2 low consensus between auditors,

consistent over time In addition, external auditors wil]

should impact on the external audit Further, external

Interactions between factors will probably not effect their

judgments

relationships is discussed below

list of criteria that could be used to evaluate internal

exhaustive list the major criteria were identified by asking

both internal and external auditors to rank the criteria in

used to identify these major criteria which are shown below

These criteria, along with those developed by Schneider

utilized within this study

The most important objectivity criteria were found to be:

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

2 The independence of the internal audit department

3 The ability of the internal audit department to

investigate any area of company activity

trends and techniques in auditing

recommendations by auditees

Schneider (1982a) conducted a study with an objective

Schneider's study provided subjects with background material

confounding variables This was not done by Clark, Gibbs

for their analysis

the criteria, thirty-two profiles were developed for each of

a ten-point rating scale

Results of the MDS analysis on the competence profiles

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

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

internal audit profiles ona one hundred point scale,

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

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

of reliance on internal auditors exists, it should not be

attributed to a divergence in the evaluation of the

auditors

financial officers selected from the Fortune 500 list of

the surveyed companies maintained high quality hiring and

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

The research results showed that virtually all external

internal auditors are found to be competent and objective,

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

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

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

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

properties These internal audit systems related to either

accounts receivable or accounts payable

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

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

The results of the study indicated that internal auditors were chosen quite often as related factors, but rarely as predictors In addition, the internal auditors were given

indicated that the overall importance of the internal

auditors declined as the audit progressed.

Overall, the literature has concentrated on examining the

criteria external auditors use in evaluating internal

auditors Generally, there is a high degree of consensus

evaluating internal auditors Internal auditor descriptions

were developed through the use of these criteria for use in this study

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

auditor work,

2 the amount of reliance on internal auditor work

€“zluation of the internal auditor,

Internal Auditor Relationship with Management

Uecker, Brief and Kinney (1981) investigated whether

“aggressiveness” served as a deterrent to corporate irregularities In an "in-basket" exercise internal

auditors were depicted as having high or low aggressiveness.

Aggressiveness was defined as a function of the level to

which the internal auditors reported and the extent to which

accounts from company officials  full factorial

between-subjects design was used

The study found that internal auditor aggressiveness did

understood and became involved in the task

This study implies that the level to which internal

empirically testing internal validity

Source Credibility Evaluations

simplified information processing rules (i.e., heuristics)

The use of a representaciveness heuristic often leads an

_individual to ignore source credibility

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

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

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, ina

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 Biddle, 1981b, p 341)

Joyce and Biddle interpreted their results as indicating that auditors do not make reliability descriminations unless

they consider what they would do if the information had come

consider alternative information Sources would likely result

Bamber (198la) examined audit managers' reactions to the

an audit case and asked to assess the likelihood that the

then given compliance test results and recommendations of an

asked to revise their likelihood estimates Source

study

Bamber (1981b) followed up on his earlier study by attempting to identify specific characteristics of an audit senior that influenced an audit manager's source credibility

audit manager's reaction to the work performed by the senior A case approach was used where subjects were asked

to supply sample size recommendations for all levels of the independent variables The results of the study indicated that the managers did react to experience and performance

approach was found

The results of both of Bamber's studies are similar to

those of Joyce and Biddie's within-subjects design Bamber

(1981b) justified the use of the within-subjects design by

suggesting that audit managers are likely to compare seniors

and differentially rely upon them in actual practice Thus,

supplying the managers with cases containing all levels of

the independent variables would not, in this instance, lead

to “artifically induced" significance

Overall, the results of source credibility research

indicates that auditors will react to source credibility if

before a judgment is made However, if only one level of

between-subjects design, auditors may be more inclined to

use a representativeness heuristic and ignore source credibility These results imply that an internal auditor's

competence, objectivity and work performance may not effect

explicity considers alternative levels of these factors when making a judgment.

CPAs were asked to reply to cases in which internal auditor credibility was manipulated The cases, which were

formulate an audit program plan for an upcoming audit For

and substantive test areas made during the planning stage of

the audit

An integral part of each case was the involvement of the

receivable internal control system and in evaluating the appropriateness of account balances Internal auditor findings were held constant over all cases Information

performance and objectivity Both of these factors were

unrealistic combinations of competence and work performance

were matched together to form a single factor

The development and use of four cases containing the four different combinations of internal auditor competence/work

performance and objectivity resulted in a completely crossed

factorial design In addition, a fifth control case with no

Variance (ANOVA) testing procedures to examine differences

in the audit program plans between the five cases

Case Development

Case materials consisted of five parts: (1) the preliminary instructions, (2) background information on the company and its accounts receivable, (3) internal auditor findings and recommendations, (4) the audit program plan to

The preliminary instructions informed the subject that s/he has just been placed in charge of the audit of Cookware

kitchen appliances The subject was then told that s/he was currently constructing the audit program plan for the accounts receivable area

The second part of each case described the company with

variables can affect the audit of accounts receivable Examples include job rotation policies, credit policies and competitive conditions To study the effect of internal

auditors on external auditor judgments, as many of these

variables as possible must be held constant This part of the case attempted to briefly describe these extraneous

used in all cases

Unchanging background information was developed utilizing

annual reports, SEC 10-K reports, and industry sales figures

of aonumber of medium-sized electrical kitchen appliance

and the priser year's evaluation of the accounts receivable

information is included in the sample case shown in Appendix

A

The background information attempted to portray Cookware

Incorporated as a rather stable company This was

consistant with the defined scope of the project (See Scope

of Study in Chapter I)

The third part of the case discussed internal auditor

findings and recommendations in the accounts receivable area