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Auditing: A Journal of Practice & Theory American Accounting AssociationVol. 30, No. 1 DOI: 10.2308/aud.2011.30.1.149February 2011pp. 149–171

Internal Audit Sourcing Arrangements andReliance by External Auditors

Naman K. Desai, Gregory J. Gerard, and Arindam Tripathy

SUMMARY: A company’s internal audit �IA� function can be maintained in-house, out-sourced to an IA service provider, or cosourced �a combination of the in-house andoutsourced IA functions�. This study explores the effect of these sourcing arrangementson the external auditor’s assessed quality and reliance on the IA function. We predictthat external auditors consider the cosourced and outsourced IA functions to be equalin terms of assessed quality and reliance. Furthermore, we predict that the externalauditors’ assessments of objectivity and competence will be greater for cosourced andoutsourced IA functions compared to in-house IA functions; therefore, external auditorswill have greater reliance on the cosourced and outsourced IA functions. Finally, wepredict that when the IA service provider also provides additional tax services to theclient, external auditor reliance is significantly decreased compared to when the serviceprovider does not provide tax services. One hundred and eight CPAs participated in thisstudy and were randomly assigned to one of five treatment conditions: in-house, co-source, outsource, cosource with tax services, and outsource with tax services. Theresults support our predictions and indicate that external auditors place more relianceon cosourced and outsourced IA functions compared to in-house IA functions. Further-more, external auditors’ reliance on cosourced and outsourced IA functions decreaseswhen tax services are also provided by the IA service provider.

Keywords: cosourcing; external auditor reliance; internal audit; sourcing.

Data Availability: Please contact the authors regarding data availability.

INTRODUCTIONAccording to Statement on Auditing Standards No. 65 �SAS No. 65�, The Auditor’s Consid-

ration of the Internal Audit Function in an Audit of Financial Statements, the external auditor is

aman K. Desai is an Assistant Professor at the University of Central Florida, Gregory J. Gerard is anssociate Professor at Florida State University, and Arindam Tripathy is an Assistant Professor at Theniversity of Washington Tacoma.

e appreciate the insightful comments and suggestions of Audrey Gramling �Associate Editor�, two anonymous reviewers,ina Carpenter, Bill Hillison, Malcolm McLelland, Jane Reimers, and conference participants at the 2007 Americanccounting Association Annual Meeting in Chicago, IL. We also specifically thank Dr. Ann Norris for advice on path

nalysis. We are grateful to The Institute of Internal Auditors Research Foundation �IIARF� for providing research funding.lthough financially supported by the IIARF, the views expressed in this paper are those of the authors and do notecessarily represent positions or opinions of the IIARF or The Institute of Internal Auditors �IIA�.

ditor’s note: Accepted by Audrey A. Gramling, Ad Hoc Associate Editor, under Dan Simunic’s Editorship.

Submitted: October 2007Accepted: April 2010

Published Online: February 2011

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ble to rely on the internal auditor’s work if the external auditor is satisfied that standards ofompetence and objectivity have been met �American Institute of Certified Public AccountantsAICPA� 1991�. Recently, in Auditing Standard No. 5, the Public Company Accounting Oversightoard �PCAOB� made the decision to retain SAS No. 65 �PCAOB 2007, 13�. However, since the

ime that SAS No. 65 was issued, different IA sourcing arrangements such as outsourcing andosourcing have evolved �Serafini et al. 2003�.

The general description of three possible sourcing arrangements is as follows: �1� in-house,here a company maintains its own IA function, �2� outsourced, where an independent IA servicerovider maintains the IA function, or �3� cosourced, where there is a partnership between ann-house IA function and an independent IA service provider.1 Each sourcing arrangement hasdvantages and disadvantages in terms of control of the IA function, business knowledge, costs,nd objectivity.2

Despite the various IA sourcing arrangements, recent guidance from the Institute of Internaluditors �IIA� does not recommend any single sourcing arrangement as being preferable to thethers �IIA 2009�, and to our knowledge there is no empirical research specifically on IAosourcing.3 However, studies indicate that the sourcing �in-house versus outsourced� of the IAunction has a significant effect on external auditors’ perceptions about the quality of the IAunction and the planned external audit effort for any particular audit engagement.4 For example,n outsourced IA function is likely to be more objective than an in-house IA function �Ahlawatnd Lowe 2004�. Moreover, external auditors consider an outsourced IA function to be of a higheruality only if the inherent risk associated with the company is high; external auditors are indif-erent between outsourcing and in-house arrangements when the inherent risk associated with theompany is low �Glover et al. 2008�.

Since cosourcing is a combination of in-house and outsourcing, the extent of reliance placedy the external auditor could either be lower �due to the in-house personnel� than the extent ofeliance on a purely outsourced IA function, or the same as that for a �due to the presence of thendependent firm personnel� purely outsourced IA function. Therefore, the first purpose of ouresearch is to investigate cosourcing �where the high-risk areas are audited by a combination ofn-house internal audit employees and employees of an independent IA service provider� as itompares to in-house and outsourced IA functions, with respect to the external auditor’s reliancen the IA function.

The second purpose of our research is to investigate the external auditor’s reliance decision inhe context of nonaudit services �such as tax services� provided by the IA service provider.lthough the Sarbanes-Oxley Act of 2002 �SOX; U.S. House of Representatives 2002� prohibits

he external �financial statement� auditor from providing internal audit and certain other nonauditervices to an external audit client, there are no such prohibitions placed on IA cosourcing orutsourcing service providers. Thus, we are interested in whether the external auditor’s relianceecision changes when an IA cosourcing �or outsourcing� provider also provides nonaudit servicessuch as tax services� which might potentially compromise objectivity.

An independent IA service provider can be a public accounting firm �e.g., one of the Big 4 firms� or it can be an internalaudit firm �e.g., Protiviti�.For example, see Del Vecchio and Clinton �2003�, Rittenberg et al. �1999�, Smith �2002�, Aldhizer and Cashell �1997�,and Thomas and Parish �1999� for detailed discussions on the various advantages and disadvantages of thesearrangements.A recent position paper �IIA 2009� shows that the IIA has taken a neutral position on sourcing alternatives; instead ofadvocating for a certain sourcing arrangement, the IIA has issued guidance on evaluating the optimal sourcing structurefor the IA function �also see Schneider 2008; IIA 2001�.In this paper, the term internal audit quality refers to competence, objectivity, and technical skills of the IA function.

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Internal Audit Sourcing Arrangements and Reliance by External Auditors 151

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One hundred and eight CPAs were randomly assigned to one of five treatments �cases� as partf a 3 � 2 incomplete between-subjects factorial design. In three of the cases, the IA function isescribed as either an in-house, cosourcing, or outsourcing arrangement. In the remaining twoases, the IA function is described as either a cosourcing or outsourcing arrangement where the IAervice provider also provided tax services. The participants responded to questions about reliance,erceptions about the quality of the IA function, planned external audit effort, and overall auditisk and control risk.

The results indicate that participants assessed the quality and extent of reliance on the out-ourced and cosourced �where the IA services for the high-risk areas were provided by a combi-ation of in-house employees and an independent IA service provider� IA functions to be signifi-antly greater than that of an in-house IA function. The assessed external audit effort for theosourced and outsourced IA functions was significantly lower than the external audit effort forhe in-house IA function. However, there were no significant differences in these measures be-ween the cosourced and outsourced IA functions. The results also indicate that relative to cases inhich the IA service provider does not supply additional services, when cosourcing or outsourcing

ervice providers also provide tax services, it �1� reduces the perceived quality of, and the extentf reliance on, the outsourced or cosourced IA functions, and �2� increases the associated externaludit effort.

Our study contributes to the extant literature in the following ways. First, we extend the workf Glover et al. �2008� and Ahlawat and Lowe �2004� to investigate how cosourcing compares ton-house and outsourced IA functions in relation to external auditors’ assessment of and reliancen the IA function. Second, we investigate how these external auditor decisions are affected whenn independent IA firm providing IA cosourcing �or outsourcing� services provides additionalervices such as tax services.

The rest of the paper is organized as follows. In the second section we describe IA sourcingrrangements, review related literature, and present our hypotheses. The third section discussesur research method, and section four presents the results. We conclude the paper with a summarynd discussion.

BACKGROUND AND HYPOTHESESA Sourcing Arrangements

Typically, the IA function is structured as one of the following arrangements: �1� in-house, inhich a company maintains its own IA function, �2� outsourced, in which an independent firm

onducts the IA, or �3� cosourced, where there is a partnership between the in-house IA functionnd an independent firm. There are various advantages and disadvantages in terms of control of IAunction, business knowledge, costs, independence, etc., related to each of these sourcing arrange-ents �for detailed discussion, see Del Vecchio and Clinton 2003; Rittenberg et al. 1999; Smith

002; Thomas and Parish 1999�.For example, some of the advantages of an in-house IA function are: greater control over

udit operations, thereby protecting proprietary information; better understanding of business pro-esses and associated risks than outsiders and nonemployees; and opportunities to train futureanagers. Some disadvantages are: limited availability of specialized knowledge; limited geo-

raphical coverage of IA function; and higher probability of IA employees giving in to manage-ent pressures �Del Vecchio and Clinton 2003�.

The outsourcing of the IA function to an external independent firm provides benefits such as:ccess to specialized knowledge of the independent firm which specializes in providing auditervices; greater geographic coverage of IA activities; greater flexibility in planning of IA activi-ies because the company does not have to hire new employees when a temporary need for expertnowledge arises; and relatively lower probability that outside IA personnel would give in to

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anagement pressures �Del Vecchio and Clinton 2003�. Some of the drawbacks of this sourcingrrangement are: loss of proprietary information; IA personnel have limited exposure to the com-any’s business processes and hence may require more time in understanding the workings of theompany; and lack of learning opportunities for the company’s own employees �Del Vecchio andlinton 2003; Rittenberg et al. 1999�.

Aldhizer and Cashell �1997� and Aldhizer et al. �2003� discuss cosourcing as a cheaper andore efficient way of providing the IA function in which in-house auditors can provide the

ctivities requiring constant attention, and external independent internal auditors can be utilizedor functions requiring special skills. Additional advantages of cosourcing arrangements are: de-ired level of control over IA services can be maintained by employing an IA management teamhat coordinates IA services with a third party that has the expertise to carry out specific auditunctions; increased knowledge-sharing between the company’s employees and outside firm em-loyees; and if the appropriate IA areas are cosourced, the IA function is perceived to be of a highuality in the opinions of investors, financial institutions, and external auditors �Del Vecchio andlinton 2003; Smith 2002; Thomas and Parish 1999�. These perceptions, in turn, could reduce thexternal auditor’s assessed likelihood of the IA’s findings being misrepresented or biased in someanner. We will return to this point below.

actors Affecting the External Auditor’s Evaluation of the IA Function

According to SAS No. 65 �AICPA 1991�, when an external auditor considers whether to relyn the IA function, the external auditor must obtain a sufficient understanding of the IA function.n this process the external auditor needs to assess the internal auditor’s competence �e.g., educa-ion, experience, certifications, supervision, etc.� and objectivity �e.g., to whom does the internaluditor report�. In the post-Sarbanes-Oxley �SOX� era, because of the new requirements imposedy SOX Sections 302 and 404, there is a potential for IA to play an increasingly important roleelated to the controls of an organization �Adamec et al. 2005�. For example, SOX Section 302equires management to certify the effectiveness of disclosure controls and procedures with re-pect to the firm’s quarterly and annual reports. In the same vein, SOX Section 404 requires firmanagement to evaluate and report on the effectiveness of internal controls over financial report-

ng. More recently, Auditing Standard No. 5 �PCAOB 2007� requires external auditors to conductn integrated audit, which focuses on two things: �1� expressing an opinion on whether thenancial statements are fairly stated, and �2� expressing an opinion on the effectiveness of theompany’s internal control over financial reporting. These recent changes underscore the impor-ance of the external auditor’s decision to rely �or not rely� on the IA function, especially since theA function is one of the key cornerstones of a company’s corporate governance �Adamec et al.005�. Furthermore, the increased cost of complying with SOX �Levinsohn 2004� also suggestshat companies are looking for effective ways to control audit costs, and cost savings will bettained when the external auditor can rely on the internal auditor’s work �Felix et al. 2001;rishnamoorthy 2002; Prawitt et al. 2009a; Gramling et al. 2004�.

The evaluation of the IA function helps external auditors make decisions regarding the extentf audit work to be performed during the year-end annual audit engagement, and it also helps indentifying the specific areas of the business on which to focus the audit effort. Prior researchndicates that the external auditor’s decision to rely on the IA function is affected by variousriteria such as objectivity, competence, and work performance �Clark et al. 1981; Brown 1983;chneider 1984, 1985; Brown and Karan 1986; Margheim 1986�. Studies have shown that externaluditors are also sensitive to factors like the reporting structure for the director of the IA functionAbdel-khalik et al. 1983� and the source of evidence �Hirst 1994�.


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A Sourcing and External Auditors’ Evaluation of the IA FunctionSAS No. 65 does not specifically address the sourcing of IA function as one of the factors to

e evaluated by the external auditors while assessing the quality of the IA function. However, prioresearch indicates that the sourcing �specifically, in-house versus outsourcing� of the IA functionas a significant effect on �1� external auditors’ perceptions about the quality of the IA function,2� the extent of reliance placed on the IA function, and �3� the planned external audit effort forny particular audit engagement. For example, Ahlawat and Lowe �2004� propose that an out-ourced IA function is likely to be more objective than an in-house IA function, and that in-housenternal auditors are more likely to acquiesce to management pressures than outsourced internaluditors who are independent of company management. Similarly, external auditors considernternal auditors to be more objective and independent when the internal auditors are not employ-es of the company �Gramling and Vandervelde 2006�.

Glover et al. �2008� show that external auditors’ reliance on the IA function is related to thenteraction between whether the IA function is outsourced and the level of inherent risk. In otherords, when inherent risk is low, external auditors’ reliance on the IA function is the same

egardless of whether the IA function is in-house or outsourced; however, when inherent risk isigh, external auditors’ reliance on the IA function is greater when the IA function is outsourcedcompared to in-house�. Glover et al. �2008� posit attribution theory �see, e.g., Jaspars et al. 1983;agly and Chaiken 1993� as the reason for this perceived higher reliance on the IA function in theresence of high inherent risk. Attribution theory suggests that when individuals evaluate aource’s message, individuals assess a source’s incentives to bias the message. Glover et al. �2008�rgue that in-house internal auditors are usually directly or indirectly accountable to the manage-ent, and their job continuity, promotions, and incentives are decided by that management. On the

ther hand, the outsourced internal auditor is not directly under management’s chain of command,or is the outsourced internal auditor likely to lose his/her job if a client company fails. Due to thebove factors, there exists a close alignment between an in-house IA function and managementhich could adversely affect the external auditor’s perception of objectivity and reliance on

n-house IA function compared to outsourced IA function. According to Glover et al. �2008, 197�,xternal auditors will “attribute favorable reports by in-house internal auditors to incentives tolease or align with management rather than to work performed by the internal auditors.”

Prior research also indicates that the assessed inherent risk of an audit influences the externaluditor’s decision to rely on the work of the IA function �Maletta 1993� and that external auditorsill spend more audit effort when assessed inherent risk is high �Maletta and Kida 1993�. Glover

t al. �2008� suggest that external auditors “attribute” the work of internal auditors with incentiveso please or align with management only when the inherent risk associated with a company is highin their study, low/high inherent risk was manipulated via high/low fixed salary for managers,mall/large bonuses for managers, and conservative/aggressive accounting positions by managers�.hey do not find a significant difference in the assessed objectivity of, and reliance on, the

n-house and outsourced IA functions when the assessed inherent risk is low. Glover et al. �2008�o not specifically mention the accounts or functions of the company that are affected by highnherent risk. It is unlikely that all the accounts or functions of a company will be equally affectedy the high inherent risk. Usually certain key accounts and functions of the company wouldequire greater attention compared to others. Therefore, insights can be gained through researchhat specifically identifies the accounts and functions that are affected by the high risk and then

anipulate the sourcing of IA function.Based on attribution theory, if the external auditors attribute internal auditors’ reports to their

ncentives only in scenarios where risk is relatively high �Glover et al. 2008�, a company couldosource IA work related to the relatively high-risk areas �a combination of in-house employees


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nd employees of an independent firm would perform this work� and maintain an in-house func-ion to perform the remaining work. Such a cosourcing arrangement could help ensure that theerceptions regarding the quality of the IA function, and extent of reliance placed on the IAunction, are not compromised. This, in turn, would ensure that the external audit effort �and costs�ould be similarly low for both the outsourced and cosourced IA functions compared to the

n-house IA function �Felix et al. 2001; Gramling et al. 2004; Prawitt et al. 2009b�.5 Based on thebove discussion, we posit the following hypotheses:

H1a: External auditors’ perceptions about the quality of the IA function will be �1� the samefor a cosourced IA function where the high-risk areas are audited by an independentfirm and a pure outsourced IA function, and �2� significantly lower for an in-house IAfunction compared to an outsourced or cosourced IA function.

H1b: External auditors’ extent of reliance placed on the IA function will be �1� the same fora cosourced IA function where the high-risk areas are audited by an independent firmand for a pure outsourced IA function, and �2� significantly lower for an in-house IAfunction compared to an outsourced or cosourced IA function.

Prior studies, such as Margheim �1986�, Gaumnitz et al. �1982�, Schneider �1985�, DeZoort etl. �2001�, and Prawitt et al. �2009a�, have shown that external auditors’ effort is negativelyorrelated with the overall quality of the IA function. Therefore, if the perceived quality of theutsourced and cosourced IA functions is equally high in comparison to the in-house IA function,here will be no significant difference in the planned audit effort for the cosourced and outsourcedA functions. However, the planned audit effort will be significantly higher for the in-house IAunction.

H1c: External auditors’ planned effort for the year-end annual audit will be �1� the same fora cosourced IA function where the high-risk areas are audited by an independent firmand for an outsourced IA function, and �2� significantly higher for an in-house IAfunction compared to an outsourced or cosourced IA function.

ourcing the IA Function and Provision of Additional Services by the IA Service ProviderSOX and related standards mandate that external auditors cannot provide IA or certain con-

ulting services for their financial statement audit clients. A primary motivation underlying SOXas to enhance objectivity. For example, if an accounting firm provided certain consulting ser-ices and also performed the financial statement audit, the firm’s external auditors might compro-ise their objectivity. Internal auditors, on the other hand, are under no such restrictions. There-

ore, firms which provide cosourced or outsourced IA services could seek to provide additionalervices beyond IA cosourcing and outsourcing �provided they are not the external auditor asell�. For example, in a recent KPMG report on the evolution of internal auditing, one of the areas

dentified for value creation by the IA function is tax strategy and planning: “to create value, IAan help analyze existing tax structure to help determine the tax strategy the organization mayant to pursue in light of new initiatives and their potential effects. It would consider whether the

ax planning strategy aligns with strategic objectives” �KPMG 2007, 7�. Therefore, an independentutside firm could be hired to do IA cosourcing or outsourcing, as well as other consulting servicesuch as tax.

In an internal audit context, there is very little prior research that examines how external

The internal audit function is an important factor affecting external audit costs �Felix et al. 2001�.


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uditors perceive IA functions that also perform consulting work �and receive compensation foruch work�. DeZoort et al. �2001� conducted an experiment to investigate how internal auditorompensation �fixed salary versus salary plus incentive compensation�, role �traditional versusonsulting�, and task �objective versus subjective� relate to external auditor reliance on the IAunction and related audit effort.6 They found that consulting services provided by the IA functiono not relate to the external auditor’s reliance decision. Furthermore, the provision of consultingervices does not increase audit effort �i.e., budgeted audit hours� unless the internal auditorseceive incentive compensation. To our knowledge, there is no other research that investigates IAunctions and provision of consulting services. Therefore, to gain additional insight, we examineesearch related to the context of external auditors and the provision of nonaudit services �NAS�.

The literature on external auditors and the provision of NAS contains mixed results regardinghether auditor independence/objectivity is impaired by the provision of NAS. In a comprehen-

ive review of the literature on NAS and auditor independence, Schneider et al. �2006, 170�onclude “a myriad of studies have examined this issue, though the findings are difficult toummarize due to differences in user groups, time periods, and the specific type of NAS exam-ned.” Although the stakeholder groups in the literature classified by Schneider et al. �2006�nclude auditors, financial statement users, and managers, we will focus on findings from theuditor literature. For example, Frankel et al. �2002� suggest that providing NAS affects externaluditor independence because the auditor is more likely to allow discretionary accruals. However,number of studies either do not find a significant relationship between provision of NAS and

mpaired auditor independence �e.g., Prawitt et al. 2010; Ashbaugh et al. 2003; DeFond et al.002; Kinney et al. 2004; Davis et al. 1993�. The results of Jenkins and Krawczyk �2003� andavin �1976� suggest that accountants view only certain types of NAS as leading to independence

mpairment �e.g., legal consulting, bookkeeping�.The provisions of SOX are only relevant to external auditors, not internal auditors. Therefore,

hile SOX prohibits external auditors from providing most tax services �as well as internal auditnd certain other consulting services� to their financial statement audit clients, internal audit firmsre allowed to provide such services. The Institute of Internal Auditors does not restrict thenternal auditor from providing consulting services. It actually defines the IA function as anndependent, objective, assurance and consulting activity designed to add value and improve anrganization’s operations �Reding et al. 2009�. The boards of directors can �likely subject topproval of the audit committee� allow an outside firm that provides IA services to a company tolso provide tax services. However, the objectivity concern underlying the SOX requirement toeparate external auditing from other services could extend to the IA function—especially givenhe possible cosourcing and outsourcing arrangements with independent outside firms providing

ultiple services. It is possible that external auditors could perceive these sourcing arrangementss affecting the IA function’s objectivity. Moreover, based on attribution theory �Jaspars et al.983; Eagly and Chaiken 1993�, the provision of tax services by the IA service provider shouldncrease the perceived incentive to align with the management. This is because now the IAervices provider has an additional incentive to gain financial benefits arising from providing taxervices. This, in turn, could lower the perceived objectivity of the IA function in the eyes of thexternal auditor.

DeZoort et al.’s �2001� manipulation of role is different from the one in this study. Here we manipulate whether taxservices are provided by the IA function �as opposed to saying that the role of the IA function is traditional versusconsulting�. Furthermore, because DeZoort et al. �2001� manipulated compensation as fixed salary versus fixed salaryplus incentive compensation, the IA function was an in-house function �the incentive compensation plan would not existfor an outsourced function and likely not for a cosourced function; at any rate, sourcing was not included in theirexperiment�.


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Although DeZoort et al. �2001� did not find a relationship between the IA function’s provisionf consulting services and the external auditor’s reliance decision, they did find that externaluditors assess the objectivity of the IA function as lower compared to when the IA functionrovided traditional internal auditing. However, that study pre-dates SOX, and it only looked atn-house IA arrangements, so it is unclear whether the reliance result �no relationship betweenroviding consulting and external auditor reliance� generalizes to the present time or to situationsnvolving cosourcing or outsourcing. Based on the heightened objectivity concerns of regulators inhe post-SOX era, we hypothesize that when IA cosourcing/outsourcing service providers addi-ionally provide tax services, external auditors will view the IA function as less objective andndependent and will rely less on the IA function �even if the company’s audit committee approvedf the outsourcing arrangement and even if the personnel providing tax and IA services areifferent�. Stated formally:

H2a: The perceived quality of the IA function will be significantly lower when the indepen-dent firm to which the IA function is outsourced or cosourced also provides additional�tax� services to the company than when the independent firm to which the IA functionis outsourced or cosourced provides only IA services.

H2b: The extent of reliance placed on the IA function will be significantly lower when theindependent firm to which the IA function is outsourced or cosourced also providesadditional �tax� services to the company than when the independent firm to which theIA function is outsourced or cosourced provides only IA services.

H2c: The planned external audit effort will be significantly higher when the independent firmto which the IA function is outsourced or cosourced also provides additional �tax�services to the company than when the independent firm to which the IA function isoutsourced or cosourced provides only IA services.

RESEARCH METHODarticipants

A total of 108 experienced CPAs from one Big 4 and a number of regional accounting firmsarticipated in the experiment �however, three participants failed the manipulation checks andere removed from the final analysis�. The data were collected by one of the researchers on-siteuring firm training sessions. The participants had an average of 6.67 years of auditing experienceith a standard deviation of 4.06 years. The minimum experience was two years and the maxi-um was nine years. Out of the 105 usable responses, 76 were current Big 4 auditors, while the

est were CPAs employed by regional firms �all of the non-Big 4 CPAs had prior Big 4 auditxperience�. Our analysis indicates no significant differences in responses between past Big 4 andurrent Big 4 participants. We also measured other demographic variables such as years of expe-ience in public accounting, and self-assessed experience with evaluating internal audit functions.o statistically significant differences were noted across treatments with respect to any of theseariables.7

esearch DesignThe design was a 3 � 2 incomplete between-subjects factorial. The factors were sourcing

rrangement �in-house, cosourcing, or outsourcing� and provision of tax services by cosourcing or

We conducted an analysis using the following covariates: Big 4 versus non-Big 4, self-assessed experience in evaluatingclients’ internal audit functions, and years of experience as an external auditor. These covariates did not significantlyvary with our manipulations, nor did they significantly correlate with our measured variables.


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utsourcing service provider �tax services provided or not�. The in-house group was not exposedo the provision of tax service manipulation; therefore, there were five treatment groups.8 Table 1llustrates the design. All the participants were randomly assigned, within all training sessionsisited, to one of five treatments.

xperimental Task and ProceduresWe developed three cases designed to manipulate sourcing as in-house, cosourced, or out-

ourced. Additionally, to manipulate provision of tax services by cosourcing or outsourcing servicerovider, we developed two additional cases by stating that �1� the Big 4 accounting firm to whichhe IA function was outsourced �or cosourced� also provided tax services to the company, and �2�he company’s audit committee approved such an arrangement and that the personnel providingax services were different from the personnel providing IA services to the company. In each of theve cases, the overall pressures on management associated with the company’s operations wereescribed to be moderately high �i.e., manager compensation was based on performance, theompany was in a very competitive industry, and it was involved in complex business operations�.e also indicated the specific accounts that would be exposed to high misstatement risk as a result

f these high pressures. This was necessary because in the cosourcing case we indicate that theseomplex and high-risk areas were audited by a combination of in-house IA department employeesnd employees of an independent Big 4 accounting firm, while the in-house internal audit depart-ent audited all the other areas. In all cases involving outsourcing and cosourcing, the participantsere specifically told that the Big 4 firm providing the internal audit services was not the samerm providing external audit services.

We obtained measures of a number of variables, including level of objectivity, competence,echnical skills, control risk, overall audit risk, the extent to which the internal auditors were likelyo acquiesce to management, and the extent of reliance placed on the IA function for the high-risknd low-risk areas �please see the Appendix� which were used to develop our dependenteasures.9 We conducted a factor analysis on these measures to obtain the three constructs or

actors �quality, reliance, and effort� that were used as dependent measures to test our hypotheses.xternal audit effort was measured by the extent to which external auditors would adjust thelanned audit hours for the relatively complex and high inherent risk areas and the other relativelyow inherent risk areas. This was measured on a scale of �5 �substantially reduce effort� to �5substantially increase effort�, with 0 being no change in effort. As an additional check, we alsoollected information about the perceived inherent risk associated with the company on a scale of–10 �low to high�. Ideally, the perceived level of inherent risk should not change acrossreatments.10

RESULTSanipulation and Other Checks

We incorporated the following three manipulation checks in our experiments to ensure thearticipants carefully read the cases and attended to the manipulations. First, participants were

Because H1a–H1c make predictions about in-house versus cosourcing and outsourcing, and H2a–H2c make predictionsabout cosourcing and outsourcing �with and without also providing tax services�, a complete between-subjects factorialdesign is not used.These scales are similar to the ones used by Glover et al. �2008� and DeZoort et al. �2001�.

0 Participants also answered specific questions about reliance on low-risk areas, and adjustment to budgeted audit hoursfor low-risk areas. For the reliance and budget hours measures in the low-risk areas, there were no significant differencesacross treatment conditions �and in comparing reliance on low-risk areas to reliance on high-risk areas, we found theexpected theoretical relationship of more reliance on low-risk areas�. Therefore, our primary analysis focuses on thehigh-risk areas.


N Does not provide Tax Services�Provides Tax Services�

T and presence or absence of tax services�

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TABLE 1

Experimental Design(3 � 2 Incomplete between-Subjects Factorial)

Sourcing Arrangement

o Tax ServicesTax Services

In-House Cosourcing �Does not provide Tax Services� Outsourcing �NA �see footnote 8� Cosourcing �Provides Tax Services� Outsourcing �

his table exhibits the basic research design of this study. The main variables are the sourcing arrangements �manipulated across three levels�manipulated across two levels�.

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sked to identify the appropriate description of the IA function from a set of choices. Second, theyere asked to list the high-risk areas specifically mentioned in the case. Third, they were asked to

dentify if the IA service provider also provided tax services. Three out of the 108 participantsailed this manipulation test and their responses were removed from the following analysis.

The cases were designed to hold inherent risk constant across treatments; the inherent riskas described in the cases as relatively high �e.g., management compensation consisted of rela-

ively low fixed salary and large bonuses based on earnings targets�. Statistical tests revealed noignificant differences across treatments for participants’ assessments of inherent risk.

esults: IA Sourcing and External Auditors’ Evaluation of the IA FunctionTable 2 presents means and standard deviations for the five treatments. The first three data

olumns of Table 2 are used to test the first hypotheses. The means show a clear pattern of resultsn which the in-house treatment appears to be different from the other two treatments. To obtain anverview of our multivariate results, we performed a one-way between-subject multivariate analy-is of variance on eight measures �the measures are described above and listed in Table 2�ssociated with external auditors’ perceptions about the IA function. This analysis revealed aignificant multivariate effect for sourcing arrangement, Wilks’ lambda � 0.08, F �16, 106� �6.38; p � 0.0001. Table 3 shows Pearson correlations for the dependent variables in theANOVA. Of the three measures related to the quality of the IA function �competence, objectiv-

ty, and technical skill�, only objectivity is significantly associated with the other measures.Since we are employing multiple variables to measure perceived IA quality and risk/reliance

elated to the IA function, we used exploratory factor analysis with varimax rotation to determinef the different variables related to quality and risk/reliance load on their respective single factors.he results indicate that two out of the three variables �competence and objectivity� measuringerceived quality of the IA function load on one factor �0.77 and 0.65, respectively� termed IAuality �we do not further analyze the technical skill variable because it did not load on any

actors; the means and standard deviations for technical skill are reported in Table 2�. Furthermore,ontrol risk, overall audit risk, likelihood of acquiescing to management, and reliance on high riskreas load on a second factor �factor scores: 0.69, 0.84, 0.86, and �0.85, respectively� termedisk/Reliance. The negative relationship between reliance and the other variables indicates thatigher assessed level of risks translates into lower assessed level of reliance. The Cronbach’slpha was 0.79 and 0.83 for the variables loading on the IA Quality and Risk/Reliance factors,

espectively. Also, the variances explained by the variables loading on the IA Quality and Risk/eliance factors were 1.32 and 2.35, respectively. These two factors, plus the measure of auditffort adjustment, were analyzed using univariate ANOVA and Tukey’s HSD �Honestly Significantifference� test �shown below�.

H1a predicts that external auditors’ perceptions about the quality of the IA function will be theame for a cosourced IA function and a pure outsourced IA function, and significantly lower for ann-house IA function. H1b predicts that external auditors’ extent of reliance placed on the IAunction will be the same for a cosourced IA function and a pure outsourced IA function, andignificantly lower for an in-house IA function. The results of an ANOVA analysis, conducted bysing the factor scores as proxies for IA quality and risk/reliance, indicate that there is a significantffect of sourcing arrangement on the assessed quality �F �2, 60� � 22.93; p � 0.0001� andeliance �F �2, 60� � 142.30; p � 0.0001� of the IA functions �see Table 4�. The results of Tukey’sSD tests indicate that there is no significant difference in the IA quality factor for the IA

unctions employing cosourcing and outsourcing. However, the IA quality factor was significantlyigher for the cosourcing/outsourcing IA functions than for the in-house function. These resultsupport H1a. The same pattern of results hold for the risk/reliance factor: the in-house IA functions assessed as more risky �i.e., there is less reliance; recall the negative factor loading for the


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eliance measure compared to the positive loadings for control risk, overall audit risk, likelihoodf acquiescing to management� than the cosourcing/outsourcing functions; however, the cosourc-ng and outsourcing functions did not significantly differ. These results support H1a and H1b.

Table 4 also presents results for the factors decomposed into their individual measures, andesults for adjustments to audit hours for high-risk areas. Of note, from the individual measures,he sourcing arrangement is affecting the external auditors’ assessments of objectivity �F �2, 60� �2.76; p � 0.0001�, but not competence. In designing the cases, we attempted to hold competenceonstant across treatments �the description of IA personnel across the three treatments had similarducational background, professional qualifications, and experience�, so the difference between

TABLE 2

Means and Standard Deviations for Measures as a Function of Sourcing Arrangement

easure

Data for Hypotheses 1a-1c

In-HouseM

(SD)

Data for Hypotheses 2a-2c

CosourceM

(SD)

OutsourceM

(SD)

Cosource/TaxM

(SD)

Outsource/TaxM

(SD)

bjectivity 5.67 7.86 7.90 5.10 5.81�0.73� �0.73� �0.94� �0.54� �0.75�

ompetence 7.95 8.19 8.33 8.14 8.24�0.67� �0.68� �0.73� �0.73� �0.70�

echnical Skills 8.14 8.43 8.48 8.29 8.43�0.65� �0.75� �0.68� �0.72� �0.68�

eliance—High-Risk Areas 5.52 7.52 7.52 4.86 4.90�0.60� �0.87� �1.08� �0.57� �0.62�

verall Control Risk 4.67 3.48 3.52 5.62 5.52�0.73� �1.03� �0.81� �0.80� �0.87�

verall Audit Risk 5.95 3.76 3.67 6.38 6.43�0.67� �0.83� �1.32� �0.80� �0.81�

cquiescence to Management 6.81 3.14 3.05 6.29 5.57�0.68� �1.01� �0.86� �0.72� �0.68�

dj. Audit Hrs.—High-Risk Areas 2.10 0.62 0.52 1.67 1.57�0.54� �0.50� �0.75� �0.73� �0.51�

his table exhibits mean responses across the five treatments for the eight measures.ample size equals 21 for each of the five treatments �columns�.

Variable Definitions:Objectivity � perceived objectivity of IAF by external auditors �range 0–10�;

Competence � perceived competence of IAF by external auditors �range 0–10�;Technical Skills � perceived technical skills of IAF by external auditors �range 0–10�;

Reliance—High-Risk Areas � extent of external auditors’ reliance on high-risk areas �range 0–10�;Overall Inherent Risk � overall inherent risk assessed by external auditor �range 0–10�;Overall Control Risk � overall control risk assessed by external auditor �range 0–10�;

Overall Audit Risk � overall audit risk assessed by external auditor �range 0–10�;Acquiescence to Management � the perceived likelihood that internal auditors will acquiesce to management and

not report honestly �range 0–10�;Adj. Audit Hrs—High-Risk Areas � extent to which external auditors want to increase or decrease audit effort �range

�5 to �5� for high-risk areas;M � mean; and

SD � std. dev.


reatments

iescence tonagement

Adj. Audit Hrs.(High Risk Areas)

O .72*** �0.61***C .18 �0.19T .17 �0.14R .67*** �0.53***O .51*** 0.40**O .59*** 0.56***A 0.76***

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TABLE 3

Correlations Coefficients for Measures from In-House, Cosourcing, and Outsourcing T

CompetenceTechnical

SkillsReliance

(High Risk Areas)Overall

Control RiskOverall

Audit RiskAcqu

Ma

bjectivity 0.18 0.10 0.57*** �0.49*** �0.57*** �0ompetence �0.12 �0.01 �0.18 �0.12 �0echnical Skills 0.36** �0.13 �0..28* �0eliance (High-Risk Areas) �0.36** �0.67*** �0verall Control Risk 0.47*** 0verall Audit Risk 0cquiescence to Management

, **, *** Indicates p � .05, p � .01, and p � .0001, respectively.� 63.

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bjectivity and competence is reasonable. Additionally, there is a significant effect of sourcingrrangement on the adjustment of audit hours for high-risk areas �F �2, 60� � 44.46; p � 0.0001�.he adjustment to audit effort is higher for the in-house IA function compared to the cosourced/utsourced functions, and not significantly different between cosourced and outsourced functions.hese results support H1c.

esults: Sourcing the IA Function and Provision of Additional Services by the IA Servicerovider

The last four columns of Table 2 show the means and standard deviations for the fourreatments related to the second set of hypotheses. The means show a pattern of results in whichhe provision of tax services has an effect on most measures. For an overview of our multivariateesults, we performed a 2 �cosourcing/outsourcing� � 2 �presence or absence of tax serviceserformed by service provider� between-subjects multivariate analysis of variance on nine mea-ures �the measures are described above and listed in Table 2� associated with external auditors’erceptions of the IA function. This analysis revealed a significant multivariate main effect for tax;ilks’ lambda � 0.065, F �8, 73� � 130.86; p � 0.0001. The sourcing by tax multivariate

nteraction was not significant �Wilks’ lambda � 0.91, F �8, 73� � 0.91; p � 0.53� and neither washe sourcing multivariate main effect �Wilks’ lambda � 0.86, F �8, 73� � 1.42; p � 0.20�. Table

shows Pearson correlations for the dependent variables in the MANOVA. These results oncegain show that of the three measures related to the quality of the IA function �competence,bjectivity, and technical skill�, only objectivity is significantly associated with the other mea-ures.

We conduct another exploratory factor analysis with varimax rotation, as we did when testinghe first set of hypotheses. The factor analysis results indicate that two out of the three measures

TABLE 4

Means for Measures as a Function of Sourcing Arrangement

easure F-values HSD Test

actor 1: IA Quality 22.93*** I � C � Oactor 2: Risk/Reliance 142.30*** I � C � O

actor 1 Decomposed Into Individual MeasuresObjectivity 52.76*** I � C � OCompetence 1.62 I � C � O

actor 2 Decomposed Into Individual MeasuresReliance (High-Risk Areas) 36.75*** I � C � OOverall Control Risk 12.68*** I � C � OOverall Audit Risk 36.68*** I � C � OAcquiescence to Management 129.51*** I � C � O

dj. Audit Hrs. (High-Risk Areas) 44.46*** I � C � O

** Indicates p � .0001.his table exhibits the F-test �2, 60 df� and Tukey’s HSD test investigating differences in means across the three treatments:

n-House, Cosource, and Outsource.ukey’s HSD test � � .01; I, C, and O are for in-house, cosource, and outsource.nterpretation of Tukey HSD results: e.g., Factor 1 IA Quality: “I” �In-House� is significantly less than “C,” and “C” andO” are not significantly different.


rcing/Tax Treatments

iescence tonagement

Adj. Audit Hrs.(High Risk Areas)

O �0.73*** �0.56***C 0.01 �0.12T �0.11 0.06R �0.73*** �0.54***O 0.69*** 0.48***O 0.62*** 0.52***A 0.60***

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TABLE 5

Correlations Coefficients for Measures from Cosourcing, Cosourcing/Tax, Outsourcing, and Outsou

CompetenceTechnical

SkillsReliance

(High Risk Areas)Overall

Control RiskOverall

Audit RiskAcqu

Ma

bjectivity 0.12 0.06 0.71*** �0.65*** �0.71***ompetence �0.14 �0.01 �0.10 �0.06echnical Skills 0.14 �0.05 �0.12eliance (High-Risk Areas) �0.62*** �0.74***verall Control Risk 0.64***verall Audit Riskcquiescence to Management

** Indicates p � 0.0001.� 84.

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competence and objectivity� load on a single factor �0.52 and 0.88, respectively� termed IAuality, as before. The results also indicate that control risk, overall audit risk, likelihood of

cquiescing with management, and reliance �high-risk areas� load on a second factor �factorcores: 0.85, 0.86, 0.88, and �0.89, respectively� termed Risk/Reliance, as before. The Cronbach’slpha was 0.72 and 0.86 for the variables loading on the IA Quality and Risk/Reliance factors,

espectively. Also, the variances explained by the variables loading on the IA Quality and Risk/eliance factors were 1.34 and 2.47, respectively. The negative relationship between reliance and

he other variables indicates that higher assessed level of risks translates into lower assessed levelsf reliance.

H2a and H2b posit that the perceived quality of the IA function and external auditors’ reliancen the IA function will be relatively lower when the accounting firm �to which the IA function isutsourced or cosourced� also provides tax services to the company. H2c posits that the plannedxternal audit effort will be higher when the accounting firm to which the IA function is out-ourced or cosourced also provides tax services. We conducted a two-way ANOVA with twoetween-subjects factors, sourcing �cosourcing versus outsourcing� and tax �presence or absencef tax services performed by service provider� on the two factor scores �see Table 6�. The resultsndicate that the sourcing arrangement by tax interaction was not statistically significant. Thereas a significant main effect of providing tax services on the perceived quality of the IA function

F �1, 80� � 767.59; p � 0.0001�. When the IA service provider also provides tax services, thexternal auditor’s assessment of IA quality decreases. The sourcing arrangement had a significantain effect on the perceived quality of the IA function �F �1, 80� � 4.76; p � 0.05�. Outsourcingas perceived as higher quality compared to cosourcing.

Analysis of the individual measures �not shown in Table 6� indicates that the differences in IAuality factor are due to the objectivity measure and not the competence measure. Furthermore, forhe objectivity measure there is a significant sourcing arrangement by tax interaction �F �3, 80� �

TABLE 6

Two-Way ANOVAs for Measures as a Function of Sourcing Arrangement and Tax

easure and Source MS F

actor 1: IA QualitySourcing Arrangement 2.178 4.76*Tax 74.96 767.59***Sourcing Arrangement � Tax 0.743 0.21

actor 2: Risk/RelianceSourcing Arrangement 0.15 1.53Tax 43.49 95.07**Sourcing Arrangement � Tax 0.01 0.02

djust Audit Hrs. �High Risk�Sourcing Arrangement 0.19 0.48Tax 23.05 57.62***Sourcing Arrangement � Tax 0.00 0.00

, **, *** Indicates p � .05, p � .01, and p � .0001, respectively.f � 1, 80his table tabulates results of a two way ANOVA; sourcing arrangement is at two levels �cosourcing or outsourcing� and

ax is at two levels �presence or absence of tax services performed by the IA service provider�.


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.11; p � 0.05�. This interaction indicates that the perceived objectivity is adversely affected whenhe IA service provider to whom the IA function is cosourced or outsourced also provides taxervices. However, such an adverse effect is greater for a cosourced IA function than for anutsourced IA function.

The results indicate a significant main effect of providing tax services on the perceivedisk/reliance of the IA function �F �1, 80� � 95.07; p � 0.0001�. The results also indicate that theres no effect of sourcing arrangement �F �1, 80� � 1.53; p � 0.21� on the perceived risk/reliance ofA function. Overall, these results provide strong evidence in support of H2a and H2b.

There is a significant main effect for tax �Table 6, F �1, 80� � 57.62; p � 0.0001� indicatingn increase in the planned external audit effort in the treatments where the internal auditorsrovide tax services compared to the treatments where the internal auditors do not provide taxervices. In the “cosource with tax” and “outsource with tax” scenarios, the planned increase inxternal audit effort is 1.67 and 1.57, respectively, while the planned increase in the “cosource noax” and “outsource no tax” scenarios is only 0.62 and 0.52 �Table 2�. These results providevidence in support of H2c.

iscussion of Results Related to Low-Risk AreasAs we mentioned above, although we had measures of �1� reliance on low-risk areas, and �2�

djustments of audit hours for low-risk areas, the primary analysis focused on the related measuresor high-risk areas. When we analyzed the measures related to low-risk areas, an interestingattern was found. Using a one-way ANOVA �with IA sourcing arrangement as a between-subjectsactor with three levels: in-house, cosourcing, or outsourcing� we found that there was no effect ofourcing arrangement on either reliance on low-risk areas or adjustments of audit hours for low-isk areas. However, the results changed significantly when we examined the cosourcing andutsourcing treatments that included the additional provision of tax services. Using a two-wayNOVA with two between-subjects factors, sourcing �cosourcing versus outsourcing� and tax

presence or absence of tax services performed by service provider�, we found that tax had aignificant main effect �the sourcing by tax interaction was not statistically significant� for �1�eliance on low-risk areas �F �1, 80� � 210.86; p � 0.0001�, and �2� adjustments of audit hours forow-risk areas �F �1, 80� � 6.60; p � 0.05�. The cosourced and outsourced IA functions’ provisionf tax services resulted in reduced reliance on low-risk areas and increased adjustments to auditours �effort�. These results suggest that even for the low-risk areas �where the sourcing of the IAunction had no effect on the quality, reliance, and effort�, the additional incentive to receiveompensation for tax services is viewed as something that would reduce the objectivity andndependence of the IA function. In turn, this reduces the external auditors’ assessed quality of,nd reliance on, the IA function and results in an increase in external audit effort.

ath AnalysisTo complement our analysis, we investigate whether sourcing arrangement plays a separate

ole in the external auditor’s reliance decision beyond the normative factors mentioned in SAS No.5 �objectivity and competence�. Therefore, we conduct a path analysis to determine whether theffect of sourcing is �in-house, outsourcing, and cosourcing� fully mediated by external auditors’ssessments of objectivity and competence or whether the sourcing arrangement has explanatoryower in addition to �i.e., not fully mediated by� the assessments of objectivity and competence.

Figure 1 presents the path analysis results; overall, the model fits the data well. The goodnessf fit index and adjusted goodness of fit index are 0.81 and 0.79, respectively, and the Chi-squaretatistic is insignificant ��2 = 7.90, p-value � 0.196�. The results of the path analysis suggest thator the high-risk areas, sourcing arrangement has a significant effect on the extent of reliance


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laced on the IA function.11 This effect is beyond the effect on reliance that is explained by thessessment of objectivity �there is no difference in the assessed technical skills and competencecross the three sourcing arrangements�.

For the high-risk areas, the type of sourcing arrangement has a significant effect only on auditisk and likelihood of acquiescing to management. Similarly, the assessed audit risk and likelihoodf internal auditors acquiescing to management have a significant effect on the extent of reliancelaced on the IA function. There is no effect of the assessed control risk and inherent risk on the

1 Please refer to Norris �2005� and Glover et al. �2008� for a more detailed description of the method used to conduct thepath analysis.

FIGURE 1Path Analysis Examining Sourcing Arrangements (In-House, Cosourcing, Outsourcing) and

Related Decisions

-0.269*-0.352*-0.109-0.108

0.424*

Sourcing Arrangement

Competence ObjectivityTechnical Skill

Audit RiskControl Risk

Reliance(High Risk Areas)

Inherent Risk Acquiesce

0.414*0.1670.138

0.121 0.235* 0.245*

0.410*

Auditor Effort

-0.020 -0.013 -0.169* -0.256*

-0.105

Note: *p < .05


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xtent of reliance placed on the IA function. The results also indicate that sourcing arrangementas a significant effect on audit effort; however, that effect is fully mediated by the effect ofourcing arrangement on reliance.

CONCLUSIONPrior research has examined the effects of maintaining an in-house IA function versus out-

ourcing an IA function on external auditors’ perceptions and reliance decisions. This study con-ributes to the extant literature by examining the effects of a third sourcing arrangement, cosourc-ng �relative to in-house or outsourced sourcing arrangements� on the external auditor’sssessments of quality, reliance, and external audit effort. We find that external auditors assess theuality of outsourced and cosourced �where the IA services related to high-risk areas are providedy an outside firm� IA functions to be higher than the quality of an in-house IA function. Likewise,xternal auditors are willing to rely on cosourced and outsourced IA functions to a greater extenthan in-house IA functions. Our findings suggest that there is no significant difference in externaluditors’ assessments of objectivity, competence, and reliance for the outsourced and cosourced IAunctions in the high inherent risk areas. We also find that the greater reliance on the cosourcednd outsourced IA functions is correlated with significantly lower external audit effort relative tohe in-house function. However, there is no significant difference in external audit effort for theosourced and outsourced IA functions. The results also indicate that there were no significantifferences in external auditors’ assessments of their willingness to rely on the IA function andatings of related effort for the low-risk areas across the three sourcing arrangements.

The overall results indicate that the quality of the IA function affects external auditors’ssessments of reliance on the IA function and related ratings of effort only for the high-risk areas.he results also imply that in a cosourcing arrangement, the presence of independent outside IAersonnel during the audit of high-risk areas �despite the presence of in-house IA personnel�itigates the probability of the external auditors attributing the work of the IA function to incen-

ives to please or align with management. Hence, it could be beneficial for companies to haveome independent outside firm personnel be part of the IA personnel who provide IA services forigh inherent risk areas.

With the exception of DeZoort et al. �2001� and now this study, there are no other studies thatxamine an IA function that also performs other NAS. The board of directors can �subject topproval of the audit committee� allow an outside internal audit firm to additionally provide taxervices. Therefore, our study evaluates the effect of IA cosourcing and outsourcing when addi-ional services �i.e., tax services� are provided on external auditors’ assessments of quality, reli-nce, and audit effort. We find an adverse effect on assessments of IA quality and external auditoreliance on the IA function in cases where the outside IA firm also provides tax services. Thisdverse effect on assessed quality and reliance also translates into a significant increase in externaludit effort. This result implies that the objectivity concerns that prevent an external auditor fromroviding other NAS are also prevalent in an internal audit context. The sample used for this studyonsisted entirely of external auditors. It is possible that since external auditors are prevented fromroviding other NAS, they would consider the provision of NAS by the internal auditor to have andverse effect on objectivity. It would be interesting to observe if other stakeholders have the sameerceptions as the external auditors.

Our study finds that external audit effort associated with a cosourcing arrangement whereigh-risk areas are cosourced to an independent firm are �1� lower than that for an in-house IAunction, and �2� equal to that for an outsourced IA function. Although we do not specificallyxamine any monetary benefits accruing to the company, prior literature �e.g., Felix et al. 2001�oes suggest that enhanced reliance and lower effort leads to lower external audit costs. Thendings of this research are limited to the extent that we do not attempt to identify an optimal


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osourcing arrangement from the viewpoint of controlling external audit efforts and costs androm the viewpoint of a company. The results indicate that external auditors consider cosourcedi.e., the IA services for high-risk areas are provided by an independent firm� and outsourced IAunctions to be equal in terms of quality and reliance. However, this result could potentiallyhange if the design of the cosourcing arrangement differed.

Practitioner literature suggests that there are several benefits of cosourcing �Serafini et al.003; Smith 2002; Thomas and Parish 1999�. A detailed field study analysis on a firm-by-firmasis could be useful in identifying detailed characteristics �in terms of which specific activitiesnd sub-functions of IA should be outsourced and others which should be handled in-house� of anptimal cosourcing arrangement. Finding such an optimal arrangement could potentially be annteresting future research opportunity. There are various types of cosourcing arrangements �Delecchio and Clinton 2003�, and future research could examine the effects of these various arrange-ents on external auditors’ judgments related to assessed quality, reliance, and effort. Another

nteresting research avenue would be to examine the difference in external audit reliance and effortn IA functions in situations where the outsourced and cosourced internal audit service provider isBig 4 firm versus a non-Big 4 firm, or when the IA service provider is a public accounting firmersus a nonaccounting firm that specializes in providing IA services, or when the IA serviceroviders also provide other ancillary services �other than tax� to their IA clients.

APPENDIXIST OF QUESTIONS RELATED TO THE DEPENDENT VARIABLESQuality” Related Questions

1. Based on the information given, to what extent do you believe the internal audit departments objective when performing compliance testing and financial auditing tasks?

ot at all Extremelybjective Objective

_____________________________________________________________| | | | | | | | | | |0 1 2 3 4 5 6 7 8 9 10

2. Based on the information given, to what extent do you believe the internal audit departments competent in performing compliance testing and financial auditing tasks?

ot at all Extremelyompetent Competent

_____________________________________________________________| | | | | | | | | | |0 1 2 3 4 5 6 7 8 9 10

3. Based on the information given, do you believe the internal audit function has sufficientechnical skills �e.g., education level and professional certification� to effectively perform compli-nce testing and financial auditing tasks?

oesn’t have any Has sufficientechnical Skills Technical Skills

_____________________________________________________________| | | | | | | | | | |0 1 2 3 4 5 6 7 8 9 10


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Risk/Reliance” Related Questions

1. Based on the information presented in this case, to what extent do you recommend thatour firm rely on tests of controls already performed by internal auditors on the relatively highnherent risk areas?

o Reliance Moderate Reliance Extensive Reliance

_____________________________________________________________| | | | | | | | | | |0 1 2 3 4 5 6 7 8 9 10

2. Based on the information presented in the case, what is the overall assessed Control Riskssociated with the company?

ow Risk Moderate Risk High Risk

_____________________________________________________________| | | | | | | | | | |0 1 2 3 4 5 6 7 8 9 10

3. Based on the information presented in the case, what is the overall assessed Audit Riskssociated with the company?

ow Risk Moderate Risk High Risk

_____________________________________________________________| | | | | | | | | | |0 1 2 3 4 5 6 7 8 9 10

4. How likely do you believe it is that the internal auditors might give in �i.e., acquiesce� tohe company’s management and fail to issue an appropriate finding in the event of a disagreement?

ot at all ExtremelyLikely Likely

_____________________________________________________________| | | | | | | | | | |0 1 2 3 4 5 6 7 8 9 10

Audit Effort” Related Question

1. Based on the information given in this case, how would you suggest adjusting audit hoursor testing controls over the relatively high-risk areas?

ignificantly SignificantlyDecrease Do Not Adjust Increase

_____________________________________________________________| | | | | | | | | | |-5 -4 -3 -2 -1 0 1 2 3 4 5

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Internal Audit Sourcing Arrangements and Reliance by External Auditors

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