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Internal Audit Sourcing Arrangement and the

External Auditor's Reliance Decision

Article in Contemporary Accounting Research · April 2007

Impact Factor: 1.43 · DOI: 10.2139/ssrn.898800

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 INTERNAL AUDIT SOURCING ARRANGEMENT AND THE EXTERNAL AUDITOR’S
RELIANCE DECISION

Steven M. Glover
Marriott School of Management
Brigham Young University

Douglas F. Prawitt
540 TNRB
Marriott School of Management
Brigham Young University
Provo, UT 84602
prawitt@byu.edu
801-422-2351

David A. Wood
Kelley School of Business
Indiana University

April 2007

We are grateful for the comments of the associate editor Steven Salterio, two anonymous reviewers
and Geoff Bartlett, Greg Burton, Ted Christensen, Bill Felix, Audrey Gramling, Noel Harding,
Dana Hermanson, Laureen Maines, Matt May, Bill Messier, Mark Peecher, Jamie Pratt, Adrian
Reynolds, Scott Summers, and Jeff Wilks. We also gratefully acknowledge helpful comments by
workshop participants at Brigham Young University and participants at the 2006 CAR conference
and the 2005 International Symposium on Auditing Research. We thank the
PricewaterhouseCoopers Foundation, the Accounting Development Fund at Brigham Young
University, and the Office of Research and Creative Activities at Brigham Young University for
financial support.

Electronic copy of this paper is available at: http://ssrn.com/abstract=898800

 INTERNAL AUDIT SOURCING ARRANGEMENT AND THE EXTERNAL AUDITOR’S
RELIANCE DECISION

ABSTRACT: This paper examines the effects of internal audit sourcing arrangement on the
external auditor’s reliance decision in the presence of different levels of inherent risk and task
subjectivity. We posit that external auditors will rely more on outsourced than in-house internal
audit functions (IAFs) and that this difference will be more pronounced when inherent risk is high
or when the work performed by internal auditors relates to a subjective task. Participants in the
study were 127 external auditors from a Big 4 firm who completed an experimental case in which
we manipulated internal audit sourcing, inherent risk, and task subjectivity. Results from the
experiment indicate an interaction between sourcing and inherent risk such that external auditors
rely more on outsourced than in-house internal auditors when the level of inherent risk is high but
do not differentiate based on sourcing arrangement when inherent risk is low. While we find that
reliance is lower for subjective than for objective tasks, we do not find an interaction between
sourcing arrangement and the subjectivity of the work performed. We do find a marginally
significant interaction between inherent risk and subjectivity of work performed: external auditors
are less willing to rely on subjective work performed by internal auditors when inherent risk is high
but do not differentiate based on task subjectivity when inherent risk is low. Additional analyses
indicate that sourcing arrangement affects the reliance decision both directly and indirectly. The
indirect effect appears to be mediated through external auditors’ perceptions of internal auditor
objectivity.

Key Words: Internal Audit, Outsourcing, External Auditor Reliance, Earnings Management

Data Availability: Requests for data may be made to the authors.

Electronic copy of this paper is available at: http://ssrn.com/abstract=898800

 I. INTRODUCTION

In today’s environment of increased emphasis on corporate governance, the roles of both the

internal and external audit functions are receiving increased prominence and attention. At the same

time, outsourcing of various accounting functions, including internal auditing, has grown in

popularity as companies seek to reduce costs and focus on core business competencies (Margulius

2005). Competing claims for and against internal audit outsourcing are readily found in practice,

with third-party internal audit outsourcing providers arguing the merits of outsourcing (e.g., see

Cherry, Bekaert, and Holland 2006; Deloitte 2006; PwC 2006), while others, including the Institute

of Internal Auditors (IIA), maintain that an internal audit function (IAF) primarily “housed

internally within the organization” (IIA 1998) is ideal. Competing claims notwithstanding, the

potentially important implications of alternative internal audit sourcing arrangements have received

little attention in the academic literature.

This study focuses on the effects of sourcing arrangements on the external auditor’s decision

to rely on the work of the internal auditor, a decision which has taken on increased importance as a

result of rule 404 of the Sarbanes-Oxley Act of 2002, and PCAOB Auditing Standard No. 2. The

external auditor’s reliance decision has been shown to have important potential economic

consequences (e.g., see Felix et al. 2001) and has potential implications for audit efficiency and

effectiveness. We extend prior research examining the external auditor’s reliance decision by

examining how alternative sourcing arrangements affect this decision in the context of varying

levels of inherent risk and task subjectivity.

We investigate whether external auditors are sensitive to differences in internal auditors’

sourcing arrangements by examining external auditors’ willingness to rely on the work of

outsourced versus in-house internal auditors. In-house and outsourced internal auditors likely differ
in motives and incentives as a result of differences in institutional arrangements (e.g., nature of

relationship with management, economic dependence, legal liability, etc.), which may affect

external auditor perceptions of internal auditor objectivity.

Appropriately evaluating and relying on the IAF becomes more critical as the inherent risk

of a material misstatement in the financial statements increases or when the work of the internal

auditor is more subjective and thus more susceptible to personal bias (AICPA 1990). Several studies

demonstrate that the external auditor’s decision to rely on the IAF is affected by the risk of a

material misstatement occurring in the financial statements (e.g., Felix et al. 2001; Maletta 1993;

Maletta and Kida 1993; Whittington and Margheim 1993), and is negatively affected by the

subjectivity of the task performed by the IAF (DeZoort et al. 2001). We extend these studies by

examining the effect of sourcing arrangement on the external auditor’s reliance decision in the

presence of varying levels of inherent risk and task subjectivity.

Participants in the study were 127 external auditors from a Big 4 firm who completed an

experimental case in which we manipulated internal audit sourcing, inherent risk, and task

subjectivity. Our results indicate that external auditors are about equally likely to rely on in-house

versus outsourced internal auditors’ work when inherent risk is low, but are significantly more

likely to rely on the work of outsourced than in-house internal auditors when inherent risk is high.

We also find that external auditors rely more on work performed by internal auditors for objective

tasks than subjective tasks when inherent risk is high but not when inherent risk is low. We do not

find evidence of an interaction between sourcing arrangement and the subjectivity of the task

performed by the IAF.

Before relying on work performed by internal auditors, external auditors are required to

evaluate the objectivity, competence, and work performed by internal auditors (AICPA 1990). In an

2
analysis designed to provide additional insight into our primary results, we find that outsourcing has

an indirect effect on the reliance decision via differences in perceived objectivity and a direct effect

on reliance even after taking into account the external auditor’s assessment of IAF objectivity and

competence and attempting to hold work performed constant.

This study contributes to an improved understanding of the role of the IAF, an important

component of corporate governance, and provides further insight into external auditors’ judgments

and decisions as their work interrelates with that of internal auditors. Our results also have potential

practical implications for external and internal auditors, companies that employ internal auditors,

and standard-setters seeking to understand factors affecting external auditors’ reliance decisions.

For example, companies might consider whether they can gain efficiencies by using outsourced

providers or by otherwise enhancing external auditor perceptions of their in-house functions.

The next section reviews relevant prior research and presents our hypotheses. The third

section explains the study’s methodology, followed by the fourth section, which explains the

study’s results. The final section discusses potential implications and limitations of our findings and

suggests ideas for future research.

II. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

The factors that influence external auditors in making the reliance decision have important

economic implications. Felix et al. (2001) demonstrate that the companies in their sample are able

to decrease their annual external audit fee by approximately 18% annually through coordination

between the external auditor and the IAF. Much of the research examining the reliance decision has

focused on examining which of the areas specified by SAS No. 65—competence, objectivity, and

nature of work performed—are important in the reliance decision (Brown 1983; Brown and Karan

1986; Edge and Farley 1991; Maletta 1993; Maletta and Kida 1993; Margheim 1986; Messier and

3
Schneider 1988; and Schneider 1984, 1985a, 1985b Whittington and Margheim 1993). These

studies differ in how they rank the importance of these three attributes, but they provide evidence

that characteristics of the IAF in these three areas do influence the extent to which external auditors

rely on work performed by internal auditors. Analytical research suggests that ranking these three

attributes is futile because no one attribute uniformly dominates the others in all conditions

(Krishnamoorthy 2002).

Additional research has considered whether factors outside of the prescriptive SAS No. 65

model affect the reliance decision. Although this research does not consider whether the SAS No.

65 model captures these factors through the prescribed consideration of objectivity, competence,

and work performed, the research has shown that factors such as task subjectivity (DeZoort et al.

2001, Whittington and Margheim 1993), fee pressure (Gramling 1999), internal auditor availability

(Felix et al. 2001), audit partner preferences (Gramling 1999), client pressure (Felix et al. 2005),

and internal auditor compensation (DeZoort et al. 2001) influence the external auditors’ evaluation.1

Internal Audit Sourcing Arrangement

A survey conducted by the Institute of Internal Auditors (IIA) indicates that as of 2002, 54

percent of the surveyed companies were using third parties to perform some or all of the internal

auditing work performed within the entity (IIA 2002). By contrast, in 1997 only about 22 percent of

organizations used third parties to perform internal audit work (IIA 1997). Despite the fact that

outsourcing arrangements are becoming increasingly common, relatively little research has been

conducted on the effects of sourcing arrangement on external auditors’ judgments, and no prior

research has specifically examined whether IAF sourcing arrangement affects external auditors’

reliance on the work of internal auditors.

4
 Previous research has identified differences between in-house and outsourced service

providers (Alhawat and Lowe 2004; Caplan and Emby 2005). Caplan and Emby (2005) find that

outsourced and in-house internal audit groups provide similar quality or equally competent work in

the context of controls evaluation. Alhawat and Lowe (2004) find that both in-house and outsourced

internal auditors advocate management’s position when selling/purchasing a new division but that

outsourced internal auditors advocate management’s position to a lesser degree than in-house

internal auditors. Prior research has also examined how users of external auditor reports change

their behavior based on whether the external auditor relied on an in-house or outsourced IAF

(Lowe, Geiger, and Pany 1999; Swanger and Chewning 2001). Lowe et al. (1999) and Swanger and

Chewning (2001) demonstrate that loan officers and financial analysts do not differentiate between

external auditor reports that are based on the external auditors’ reliance on work performed by in-

house versus outsourced IAF. Finally, prior research has also examined how users of financial

information change their behavior depending on the sourcing arrangement of the IAF (James 2003).

James (2003) finds that lending officers do not differentiate based on IAF sourcing arrangement in

their loan granting decisions when relevant financial reports are based primarily on work performed

by the IAF.

Our study extends prior research by examining whether external auditors’ reliance decisions

depend on the sourcing arrangement of the IAF. Our predictions are based on attribution theory (see

Jaspars, Fincham, and Hewstone 1983 and Eagly and Chaiken 1993 for reviews of attribution

theory research). Attribution theory proposes that evaluators (e.g. external auditors) assess a

source’s (e.g., internal auditors) incentives to bias their message when evaluating the source’s

message. In our setting, if the external auditor perceives that an internal auditor has incentives to

report in a particular way the external auditor will perceive the internal auditor’s work to be less

5
persuasive because the external auditor attributes the internal auditors’ reported results to these

incentives. The external auditor will therefore rely to a lesser extent on the work of the internal

auditor.

We argue that in-house and outsourced internal auditors differ in a number of ways that may

affect external auditors’ perceptions of their incentives and thus influence the reliance decision. For

example, on one hand the Institute of Internal Auditors and in-house internal auditors assert that in-

house internal auditors have more day-to-day contact with the company, which allows them to have

more opportunities for discovering problems, helps them develop loyalty and build relationships

with employees so employees are more willing to reveal critical facts or issues, and enables them to

exert more influence over managements’ daily decisions (e.g., see Crawford et. al 1996; Rittenberg

and Covaleski 1997; Chadwick 2000; Fitzpatrick 2001). On the other hand, in-house internal

auditors are often directly or indirectly accountable to management, their promotions may be more

influenced by company personnel, and their economic ties are in many cases more direct than those

of outsourced internal auditors. For example, in-house internal auditors’ compensation often

depends on the performance of the organization (Stapp 1991; DeZoort et al. 2000), and their

opportunities for promotion either within the IAF or into management positions may depend at least

partially on their interactions with those they are responsible for auditing (Haas 2001). Further, an

outsourced internal auditor is not as likely to lose his or her job if a client company fails. We argue

that the factors outlined above indicate a relatively close alignment between an in-house IAF and

management, which may cause external auditors’ perceptions of the objectivity of in-house internal

auditors to be lower than outsourced internal auditors. Thus, the external auditor will, to some

degree, attribute favorable reports by in-house internal auditors to incentives to please or align with

management rather than to the work performed by the internal auditors (e.g., see DeZoort et. al

6
2001; Rittenberg and Covaleski 1997). Along these lines, in an ancillary analysis Ahlawat and

Lowe (2004) find that outsourced and in-house internal auditors reported significantly different

underlying motives in evaluating inventory obsolescence. Among other differences, outsourced

internal auditors reported more concern with potential litigation, while in-house internal auditors

placed more weight on “advocating the most advantageous position for its client.”

SAS No. 65 requires that the external auditor base his or her reliance decision on the

competence and objectivity of the internal auditor as well as consideration of the work performed.

We expect external auditors will be sensitive to the differences in incentives and motives faced by

in-house and outsourced internal auditors and will be more likely to rely on the work of outsourced

IAF, which leads to our first hypothesis:

H1 - External auditors will rely to a greater extent on work performed by outsourced internal
auditors than on work performed by in-house internal auditors.

Inherent Risk

Several previous studies have addressed the effects of inherent risk on the external auditor’s

decision to rely on the IAF. Maletta (1993) and Maletta and Kida (1993) both note that inherent risk

affects the reliance decision of external auditors.2 More specifically, Maletta (1993) finds that in

high risk situations external auditors use more complex configural decision processes to evaluate

the IAF. These more complex decision processes include evaluating the interaction between

objectivity and work performed when inherent risk is high. Maletta and Kida (1993) find that

external auditor’s reliance on the IAF in high risk situations depends on the design of the

accounting control policies and procedures within the area audited. Felix et al. (2001) find that

external auditors are less likely to rely on the work of internal auditors in high-risk situations.

Collectively, these studies suggest that auditors will more carefully scrutinize attributes of

internal auditors when making their IAF reliance determination when inherent risk is high. This

7
scrutiny may result in more or less reliance on the IAF, depending on the attributes of the internal

auditors, risk factors related to the audit area, and characteristics of the organization.

Accordingly, in this study we examine whether inherent risk moderates the relation between

sourcing arrangement and reliance on the work of internal auditors. As noted previously, outsourced

internal auditors face differing incentives and have differing motives for performing their work than

do in-house internal auditors. Since external auditors appear to scrutinize attributes of internal

auditors in terms of the reliance decision more closely in high risk situations (Maletta 1993),

varying the level of inherent risk creates a powerful test to observe whether external auditors’

perception of the objectivity of the IAF differs by sourcing arrangement and whether these

differences in perceptions influence the external auditor’s reliance decision. In this study, the high

inherent risk condition includes heightened incentive for management to inappropriately engage in

earnings management. Consistent with attribution theory (Nisbett and Ross 1980; Jones 1990), we

argue that when a heightened inherent risk of material misstatement involves possible pressure from

management, external auditors will partially attribute favorable in-house IAF reported results to

management’s incentive to manage earnings because in-house auditors will be perceived to have

greater incentive to align with management. Thus, we predict that the effect posited in H1 will be

more pronounced when inherent risk is high than when inherent risk is low. This leads to our

second hypothesis:

H2 –The external auditor’s tendency to rely more on the work performed by an

outsourced internal auditor as compared to an in-house internal auditor will be
more pronounced when inherent risk is high than when inherent risk is low.

8
Task Subjectivity

The external auditor’s reliance decision may also depend on the subjectivity of the task

performed by the internal auditor. Auditing standards recognize the subjective nature of accounting

estimates and that there is greater potential for uncertainty and bias in subjective estimates than in

objective amounts involved in the accounting process (SAS No. 57: Auditing Accounting Estimates,

AICPA 1988). For instance, the likelihood that management could or would misstate an account

balance increases as the degree of judgment (subjectivity) in determining the account balance

increases (e.g., see Peters et al., 1989).

Research in psychology suggests that source attributes and task characteristics often interact

to affect evaluators’ decisions (see Petty and Wegener 1998 for a more detailed discussion). This

research suggests source attributes tend to be more heavily scrutinized by evaluators when bias is

harder to detect in communications (e.g., communications are ambiguous). In accounting, DeZoort

et al. (2001) find evidence consistent with these findings in that external auditors are less willing to

rely on the work of internal auditors when the internal auditors perform subjective tasks, especially

if the internal auditors are compensated with incentive-based compensation rather than fixed

compensation.

In our study, if the external auditor perceives differences between outsourced and in-house

internal auditors in terms of incentives and objectivity, we expect that the external auditor will more

closely scrutinize these differences when the degree of subjectivity in the internal audit task is

greater. Thus, we predict that sourcing arrangement and task subjectivity will interactively affect the

reliance decision; specifically, external auditors’ tendency to rely more on the work of outsourced

internal auditors will be greater for subjective tasks than for objective tasks. This leads to our third

hypothesis:

9
 H3 - The external auditor’s tendency to rely more on the work performed by an
outsourced internal auditor as compared to an in-house internal auditor will be
more pronounced when the task is subjective than when the task is objective.

While the primary focus of this study is on the effect of IAF sourcing arrangement on the

external auditor’s reliance decision, we also predict that task subjectivity and inherent risk will

interact such that external auditors will rely less on internal auditors’ work when the task is

subjective and inherent risk is high. As noted above, DeZoort et al. (2001) find evidence that

external auditors are less willing to rely on the work of internal auditors for subjective tasks than for

objective tasks. Subjective tasks and high inherent risk situations provide both a greater opportunity

for and greater pressure on the internal auditors to be less than completely objective. External

auditors are likely to recognize the potential implications of such a combination and rely less on the

internal auditors’ work under such circumstances. This leads to our fourth hypothesis:

H4 – The external auditor’s tendency to rely less on the work of internal auditors
when the task is subjective than when it is objective will be more pronounced
when inherent risk is high than when inherent risk is low.

III. METHOD

To test our hypotheses, we employ a 2x2x2, between-subjects experiment, fully crossing

IAF sourcing arrangement (in-house and outsourced) with inherent risk (low and high) and with the

subjectivity of the task performed by the internal auditors (subjective and objective).

Participants

We administered our experimental instrument to 138 external auditors at training sessions

for one Big 4 accounting firm.3 Reported results are based on 127 participants because eleven

participants failed manipulation checks (described below). As seen in Table 1, the average

participant had 3.6 years of Big 4 audit experience and 1.5 years of other business experience. The

external auditors reported that they had a moderate amount of experience in evaluating internal

10
audit departments in the course of conducting audits, with an average rating of 4.41 on a scale of 0

(Never) to 10 (Very often). The majority of the participants held the position of senior auditor

within the firm (59 percent). Nearly half the remaining participants were more experienced

(manager or higher—20 percent) and the other half less experienced (staff—21 percent).4 Of the

participants, 84 (66 percent) had earned a professional accounting certification (CPA, CMA, etc.).

Insert Table 1 about here

Task

We adapted the case used by DeZoort et al. (2001) for our study.5 Each participant was

randomly assigned one of eight versions of the experimental instrument containing information

regarding a hypothetical manufacturer of specialty products serving commercial and governmental

enterprises. The experimental instrument had four sections. The first section contained background

information about the company, including a description of the prior year audit and the manipulation

of inherent risk (described below). The second section gave a description of the internal audit

department and included the sourcing/staffing arrangement manipulation (also described below) and

general questions about the internal auditors’ objectivity and competence. The third section

explained the audit procedures conducted (testing controls or valuing inventory) and asked

questions concerning such factors as reliance on the IAF and degree of judgment involved in the

internal auditors’ work. Finally, the fourth section contained additional questions, manipulation

checks, and biographical questions.

Independent Variables

We manipulated sourcing arrangement (sourcing) at two levels, in-house and outsourced.

We told participants in the in-house condition that the company employs 12 internal auditors

including one director, two managers, three audit seniors, and six staff auditors. For the outsourced

11
condition, we told participants that the company employs one audit director but that the audit work

was performed by 11 employees from a Big 4 accounting firm (not the company’s external audit

firm) including two managers, three audit seniors, and six staff auditors. In both conditions, the

materials portray the internal auditors as equally competent (i.e., similar education, certification and

knowledge of the company’s operations, processes and procedures) and objective (i.e., report to the

audit committee, have authority to investigate any portion of the company, compensated on a fixed

salary).

We manipulated inherent risk of a material misstatement (risk) at two levels. In the low

(high) risk condition, management was compensated with a high (low) fixed salary, had the

opportunity to earn relatively insignificant bonuses (large bonuses that were based on meeting

earnings targets), and tended to be conservative (aggressive) in their accounting positions. In the

low risk condition, the company had also been performing well for the previous five quarters

causing key stockholders to be pleased with the management team. In the high risk condition, the

company had missed analysts’ earnings expectations for five quarters, causing speculation that key

shareholders might want to replace management.

Following DeZoort et al. (2001), we manipulate task subjectivity (task) at two levels,

objective tests of controls and subjective valuation of inventory. In the objective task, the case

indicated that the internal auditors “performed several procedures such as (1) accounting for pre-

numbered documents, and (2) verifying that purchase orders were properly authorized and matched

with vendor invoices, receiving reports, and cash disbursements. After completing these procedures,

the internal auditors reported that the controls were working as prescribed.” In the subjective task,

the case indicated that the internal auditors “completed procedures such as (1) reviewing costs

included as overhead and used in the determination of overhead rates, and (2) reviewing inventory

12
turnover ratios and sales trends to identify obsolete items. After completing these procedures, the

internal auditors reported that the inventory account was properly valued.”

Dependent Variables

The primary dependent variable in this study is planned reliance (reliance). We asked

participants to what extent their firm should rely on work already performed by internal auditors.

The 11-point scale was anchored at “No reliance” (0), “Moderate reliance” (5), and “Extensive

reliance” (10). We also asked participants the extent to which they would adjust audit hours already

budgeted for valuing inventory. The participants were informed that the audit program, including

budgeted audit hours, currently assumes zero reliance on the IAF.

In addition to the primary variables discussed above, we also measured external auditors’

perceptions of internal auditor objectivity and competence. These variables were measured on 11-

point scales relating to the external auditors’ assessment of the objectivity of the internal auditors,

competence of the internal auditors.6

IV. RESULTS

Manipulation Checks

At the end of the case, participants were asked to indicate the sourcing arrangement of the

IAF (in-house or outsourced). Eleven of the 138 external auditors failed this manipulation check

and are therefore excluded from the reported analysis. To determine whether the task and risk

manipulations were effective, we asked the participants how much judgment was involved in the

procedures the internal auditors performed (0 = “Little judgment,” 5 = “Moderate judgment,” 10 =

“Great deal of judgment”), and how likely was it that management would pursue aggressive

accounting practices (0 = “Very unlikely,” 10 = “Very likely”). Results from these two questions

indicate that participants viewed the subjective inventory task as more subjective than the objective

13
controls task (means 6.35 and 4.19, respectively; t = 5.51, p-value < 0.001), and viewed

management as being more likely to pursue aggressive accounting practices in the high risk

condition than in the low risk condition (means of 7.79 and 5.44, respectively; t = 6.41, p-value <

0.001). Overall, the experimental manipulations appear to have been successful.

Tests of Hypotheses

We tested our hypotheses using an ANOVA, fully crossing risk, sourcing, and task. The

results of testing this model are presented in Tables 2 and 3. We tested covariates by adding

external auditing experience, total business experience, professional certification attainment, self-

assessed IAF rating experience, and position in the firm. None of the covariates was statistically

significant.7 Similarly, if we interact each of these variables with the variables in our model, the

variables and the interactions including the variables are not significant.

Insert Tables 2 and 3 about here

Our first hypothesis predicts that external auditors will rely to a greater extent on outsourced

than in-house internal auditors. Our results are consistent with H1; the sourcing variable is highly

significant in the expected direction (outsource = 4.96, in-house = 4.06, p-value = 0.004).8

However, interpretation of this main effect is subject to the interaction predicted in H2.

H2 predicts that risk and sourcing will interact such that the difference in reliance between

in-house and outsourced internal auditors will be greater when inherent risk is high. ANOVA results

support the predicted interaction (F = 3.56, p-value = 0.031). As seen in Table 3, Panel A, the

external auditors relied significantly less on the work of in-house internal auditors when risk was

high (in-house, high-risk mean = 3.53, compared to in-house, low-risk mean = 4.58, t = 1.99, p-

value = 0.025). In the outsourced condition, external auditors’ reliance decisions did not differ

significantly between risk conditions (means of 5.05 and 4.88 for high and low risk, respectively; t

14
= 0.35, p-value = 0.364). Further analysis of simple main effects indicates that the reliance

difference across sourcing conditions within the low risk condition is not significant (t = 0.60, p-

value = 0.276) while the difference across sourcing conditions within the high risk condition is

highly significant (t = 2.90, p-value = 0.003). Thus, the significant main effect predicted by H1 is

not supported across both risk conditions as we observe a difference only in the high inherent-risk

condition. In other words, the perceived difference in the attribution of favorable reports (i.e., to

align or please management) between in-house and outsourced internal auditors is present in our

study only when inherent risk is high.

H3 predicts that task and sourcing will interact such that the difference in reliance between

in-house and outsourced conditions will be greater when internal auditors are performing subjective

tasks. We find a significant main effect for task suggesting that external auditors are more willing to

rely on internal auditors’ work when they perceive the internal auditors to be performing an

objective rather than a subjective task (F = 8.99, p-value = 0.002). This finding is consistent with

the results reported in DeZoort et al. (2001). However, we do not find evidence to support an

interaction effect between task and sourcing. The interaction is in the predicted direction, (see Table

3, Panel B), but the difference is not statistically significant (F = 0.08, p-value = 0.387). In our

study, the effect of task subjectivity had the same dampening effect on external auditor reliance

decisions regardless of sourcing arrangement. Whether our results generalize to other task settings

is a potential avenue for future research. It is possible that the lack of significant results for this

predicted interaction is due to the fact that the Dezoort et al. (2001) task subjectivity manipulation,

which we follow, manipulates both the nature and the subjectivity of the task.

H4 predicts that task subjectivity and inherent risk will interact such that external auditors’

tendency to rely less on internal auditors when the task is subjective will be more pronounced when

15
inherent risk is high than when inherent risk is low. Consistent with this expectation, results indicate

that there is no difference in reliance between high and low risk conditions when the task is

objective (t = -0.03, p-value = 0.978), but there is a significant difference in reliance between high

and low risk conditions when the task is subjective (t = 1.90, p-value = 0.032). The task by risk

interaction term is marginally significant (F = 2.02, p-value = 0.079) in the predicted direction. See

Table 3, Panel C.9,10

Path Analysis to Investigate How Sourcing Affects Reliance

Research examining the external audit reliance decision can be divided into two categories:

(1) research examining factors related to the normative model specified by SAS No. 65 (i.e.,

objectivity, competence, and work performed by the IAF; e.g., see Brown 1983; Schneider 1984,

1985a, 1985b; Margheim 1986, Messier and Schneider 1988; Edge and Farley 1991; Maletta 1993);

and (2) research examining factors not formally included in the SAS No. 65 model (e.g., see

Gramling 1999; DeZoort, et al. 2001). Research in the latter category, while providing useful

insights, has not considered whether the SAS No. 65 model’s required assessments of objectivity,

competence, and work performed account for the observed differences found in these studies.

To investigate whether a non-SAS No. 65 factor plays a role separate from the SAS No. 65

normative factors of objectivity, competence, and work performed in a descriptive model of the

reliance decision, it must be established that such potential descriptive factors provide explanatory

power beyond that provided by the factors in the normative SAS No. 65 model. We conduct a path

analysis to determine whether the sourcing variable is fully mediated by external auditors’

assessments of objectivity and competence or whether sourcing arrangement has explanatory power

in addition to (i.e. not fully mediated by) the assessments of objectivity and competence.

16
 Note that in addition to competence and objectivity, SAS No. 65 requires external auditors

to evaluate “work performed” by internal auditors. We attempt to control for possible differences in

external auditors’ perceptions of the quality of work performed by holding statements relating to

work quality constant across sourcing conditions (e.g., work performed was “well-documented” and

“well-supervised”). An overall tendency by external auditors to believe that work performed by

outsourced internal auditors is superior to that of in-house internal auditors is likely to be captured

by the competence variable, which is not significantly different between the two groups (mean

competence for outsource and in-house = 8.22 and 7.88 respectively; t = 1.37, p-value = 0.174). In

terms of the nature of work performed, we manipulate task subjectivity via the two different tasks in

our analysis and capture variance related to that manipulation by including a task variable in our

model.

The Figure presents the results of our path analysis (correlations related to the variables

included in the Figure are presented in Table 4). Overall, the model fits the data well. The goodness

of fit index and adjusted goodness of fit index are both above 0.90, the RMSEA is below 0.05, and

the chi-square statistic is insignificant (χ = 10.30, p-value = 0.240); all indicating good model fit.11

The results of the path analysis suggest that even after controlling for the task subjectivity

and inherent risk manipulations, the required assessments of objectivity and competence do not

completely mediate the relation between sourcing and reliance, as the direct path from sourcing to

reliance is significant (CR = 2.34, p-value < 0.01).12 In addition to the path from sourcing to

reliance being significant, the indirect path of sourcing to reliance through objectivity is also

significant (sourcing to objectivity, CR = 1.99, p-value = 0.024; objectivity to reliance, CR = 2.20,

p-value = 0.014).13

17
 This analysis suggests that external auditors consider the objectivity of in-house and

outsourced internal auditors to be significantly different and that this difference influences how

willing the external auditors are to rely on the work of the IAF. In addition, this analysis suggests

that the sourcing arrangement of the internal auditors provides explanatory power above and beyond

the required assessments of objectivity and competence stipulated by SAS No. 65. These results

indicate that the sourcing arrangement may be an important explanatory variable for researchers

attempting to develop a descriptive model of the reliance decision above and beyond its effects on

assessments of competence and objectivity.

Insert the Figure and Table 4 about here

V. SUMMARY & CONCLUSION

This study examines the effects of outsourcing the internal audit function (IAF) on the

external auditor’s reliance decision. Consistent with our predictions based on attribution theory, we

find that 1) external auditors perceive outsourced internal auditors to be more objective and 2) they

tend to rely more on an outsourced IAF when inherent risk is high but not when inherent risk is low.

We also find that external auditors are more willing to rely on the work of internal auditors when

they perform objective tasks as opposed to subjective tasks, and we provide marginally significant

evidence that this effect is magnified by the presence of inherent risk. While we find that reliance is

lower for subjective than for objective tasks, we do not find an interaction between sourcing

arrangement and the subjectivity of the work performed. Examining the conditions under which

task subjectivity does or does not interact with sourcing may be a fruitful area for future research.

Finally, we show that sourcing arrangement has a significant effect on the reliance decision even

after attempting to hold work performance constant and controlling for the required assessments of

the internal auditors’ objectivity and competence. These findings are consistent with the idea that

18
when opportunity and incentives exist for internal auditors to bias their conclusions, external

auditors tend to partially attribute favorable internal auditor conclusions to such bias and thus rely to

a lesser extent on their work.

Policy setters for external auditors and external auditing firms may wish to consider whether

sourcing arrangement is an appropriate factor to be considered in the reliance decision, and if and

how this factor should be incorporated into policy. IAFs and audit clients may also wish to consider

how external auditors react to different sourcing arrangements, especially when management has a

relatively high incentive to manage earnings or when other similar inherent risk factors are present.

Finally, companies may consider how outsourcing some or all of their IAF, or possibly taking

action to alter their external auditors’ perceptions of their in-house IAF, might impact external

auditors’ reliance decisions and hence external audit costs (Felix et al. 2001).

The results of this study are subject to several limitations, several of which present

opportunities for future research. First, the external auditors were presented with limited

information about the internal auditors, the work they performed, and the environment in which

they operated. Second, this study did not allow for higher-level review of auditor recommendations,

which might impact final reliance decision outcomes. Third, all of the subjects in this study were

from a single Big 4 audit firm. Fourth, while we followed prior research in our task subjectivity

manipulation, future research could attempt to manipulate task subjectivity without varying the

underlying task. It is possible that the dual nature of the task subjectivity manipulation contributed

to the insignificant results for the expected interaction between subjectivity and sourcing. Fifth, our

manipulation of outsourcing did not include non-accounting firm providers of internal audit

services. On a related note, while we attempted to hold competence and other characteristics

constant between sourcing conditions, this study was limited to a single description of the

19
background of the in-house and outsourced internal auditors. We are thus limited in our ability to

identify the extent to which different internal auditor backgrounds could moderate the influence of

sourcing. For example, future research could examine the effects of sourcing on the reliance

decision when in-house internal auditors have prior experience in public accounting. Finally, our

study examines the external auditors’ reliance decision in the first year of an engagement. In

practice, the nature of the internal/external auditing relationship may evolve in subsequent years of

the engagement as familiarity increases.

20
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24
 FIGURE
Results for Reliance Decision Model

Sourcing

0.174** 0.121

Objectivity 0.197** Competence

0.184** -0.055

Task Reliance Risk

-0.233** -0.083

Model Statistics:
Goodness of Fit Index: 0.974 Chi-Square = 10.39, p-value = 0.240
Adjusted Goodness of Fit Index: 0.933 RMSEA = 0.049

Where:
Sourcing = A dichotomous variable representing whether the work of the IAF is outsourced
to a third-party provider (Sourcing = 1) or the work is performed by an in-house
IAF (Sourcing = 0).
Objectivity = The assessed objectivity of internal auditors by external auditors, ranging from 0
(Not at all Objective) to 10 (Extremely Objective).
Competence = The assessed technical ability of internal auditors by external auditors, ranging
from 0 (Doesn’t have any Technical Skills) to 10 (Has Sufficient Technical
Skills).
Task = A dichotomous variable representing whether the work performed by the IAF was
a subjective inventory valuation task (Task = 1) or an objective test of controls
over inventory task (Task = 0).
Risk = A dichotomous variable representing whether inherent risk was high (Risk = 1) or
inherent risk was low (Risk = 0).
Reliance = The amount of reliance the external auditor would place on the work of the IAF,
ranging from 0 (No Reliance) to 5 (Moderate Reliance) to 10 (Extensive
Reliance).
--Paths that are significant at p ≤ 0.05 are indicated by **; all other paths’ p-values > 0.10.
--Error terms were included for Objectivity, Competence, and Reliance, variables as these
measures are continuous.
--Reported numbers are standardized regression weights computed using Amos statistical
software.
 Table 1
Descriptive Statistics of External Audit Subjects

In-House Outsource Overall

Mean (Std. Dev) Mean (Std. Dev) Mean (Std. Dev)
Variables n = 63 n = 64 n = 127
Years of Big 4 Audit Experience 3.45 3.72 3.59
(2.69) (2.51) (2.6)
Years of Other Business 1.74 1.19 1.46
Experience (3.09) (2.54) (2.82)

Professional Accounting 69.8% 62.5% 66.1%

Certification (CPA, CMA, etc.).

Self-Assessed Experience in 4.13 4.68 4.41

Evaluating IAFs (2.56) (2.86) (2.72)

Position
Staff 10 17 27
Senior 41 34 75
Manager 12 13 25
Partner 0 1 1

Tests for differences between the characteristics of subjects in the in-house and outsourced
conditions are not statistically different at the p-value ≤ 0.10 level.
 TABLE 2
Statistical Analysis of External Auditor’s Reliance on the IAF

Dependent Variable: Reliance

Sum of Mean
Source Squares df Square F Sig.a
Sourcing 27.68 1 27.68 7.15 0.004
Risk 6.70 1 6.70 1.73 0.096
Task 34.80 1 34.80 8.99 0.002
Sourcing * Risk 13.78 1 13.78 3.56 0.031
Sourcing * Task 0.32 1 0.32 0.08 0.387
Risk * Task 7.82 1 7.82 2.02 0.079
Sourcing * Risk * Task 1.84 1 1.84 0.48 0.492
Error 460.81 119 3.87
a
Reported p-values are one-tailed with the exception of the Sourcing * Risk * Task interaction, which is two-tailed.

Where:
Reliance = The amount of reliance the external auditor would place on the work of the IAF,
ranging from 0 (No Reliance) to 5 (Moderate Reliance) to 10 (Extensive
Reliance).
Sourcing = A dichotomous variable representing if the work of the IAF is outsourced to a
third-party provider (Sourcing= 1) or the work is performed by an in-house IAF
(Sourcing = 0).
Risk = A dichotomous variable representing if inherent risk was high (Risk = 1) or
inherent risk was low (Risk = 0).
Task = A dichotomous variable representing if the work performed by the IAF was a
subjective inventory valuation task (Task = 1) or an objective test of controls over
inventory task (Task = 0).

27
 TABLE 3
Individual Cell Means for Interaction Effects

Panel A: Cell Means, (Standard Deviations), and Cell Sizes for Sourcing x Risk Interaction
High Risk Low Risk Total
6
In-House 3.53 4.58 4.06
(2.33) (1.83) (2.14) 5.5
Outso urce
n=31 n=32 5

Reliance
4.5
Outsource 5.05 4.88 4.96 4
(1.79) (2.12) (1.95) In-Ho use
3.5
n=32 n=32
3
High Risk Low Risk
Total 4.30 4.73
(2.19) (1.97)

Panel B: Cell Means, (Standard Deviations), and Cell Sizes for Sourcing x Task Interaction
Objective Subjective Total
In-House 4.49 3.57 4.06 6
(2.24) (1.93) (2.14) 5.5
n=34 n=29 5
Outso urce
Reliance

4.5
Outsource 5.52 4.37 4.96
(1.97) (1.77) (1.95) 4
In-Ho use
n=33 n=31 3.5
3
Total 4.99 3.98 Objective Task Subjective Task
(2.16) (1.88)

Panel C: Cell Means, (Standard Deviations), and Cell Sizes for Risk x Task Interaction
Objective Subjective Total
Low Risk 4.99 4.43 4.73 6
(2.07) (1.84) (1.97) 5.5
n=34 n=30 5
Reliance

Lo w Risk
4.5
High Risk 5.00 3.53 4.3
(2.28) (1.84) (2.19) 4 High Risk

n=33 n=30 3.5

3
Total 4.99 3.98 Objective Task Subjective Task
(2.16) (1.88)
 TABLE 4
Correlations and Means for Variables in Model

Mean Stdev Sourcing Objectivity Competence Task Risk Reliance

Sourcing 0.50 0.50 0.189 0.142 0.024 0.008 0.210
Objectivity 5.63 2.17 0.174 0.198 -0.020 -0.112 0.194
Competence 8.05 1.40 0.121 0.262 0.028 -0.024 -0.032
Task 5.21 2.46 0.024 -0.066 0.028 0.007 -0.262
Risk 6.62 2.36 0.008 -0.105 -0.008 0.007 -0.096
Reliance 4.52 2.09 0.216 0.228 0.011 -0.242 -0.102
Pearson (Spearman) correlations are presented below (above) the diagonal
Bold correlations indicate significant statistical significance at p-value ≤ 0.05.

Where:
Sourcing = A dichotomous variable representing if the work of the IAF is outsourced to a
third-party provider (Sourcing = 1) or the work is performed by an in-house IAF
(Sourcing = 0).
Objectivity = The assessed objectivity of internal auditors by external auditors, ranging from 0
(Not at all Objective) to 10 (Extremely Objective).
Competence = The assessed technical ability of internal auditors by external auditors, ranging
from 0 (Doesn’t have any Technical Skills) to 10 (Has Sufficient Technical
Skills).
Task = A dichotomous variable representing if the work performed by the IAF was a
subjective inventory valuation task (Task = 1) or an objective test of controls over
inventory task (Task = 0).
Risk = A dichotomous variable representing if inherent risk was high (Risk = 1) or
inherent risk was low (Risk = 0).
Reliance = The amount of reliance the external auditor would place on the work of the IAF,
ranging from 0 (No Reliance) to 5 (Moderate Reliance) to 10 (Extensive
Reliance).
Endnotes
1
See Gramling et al. (2004) for a thorough review of the literature investigating the external auditor’s decision to
rely on the work of internal auditors.
2
Whittington and Margheim (1993) also consider how inherent risk influences the external auditor’s reliance
decision, but they find that inherent risk has no effect on the decision. They do note that their manipulation may not
have been sufficiently strong to induce a noticeable difference in the reliance decision.
3
The case was administered in 2003 and 2004, subsequent to the SEC’s final rule prohibiting external auditing firms
from providing internal audit services for their clients under the Sarbanes-Oxley Act in 2002.
4
While senior auditors are not likely to make the final decision as to the amount of reliance on the internal auditors,
they are typically part of the process in deciding how much to rely on the internal auditors. Our experiment is
consistent with practice in that senior auditors would perform preliminary assessments of the IAF and then report
their recommendation to a manager or partner.
5
We conducted pilot tests with external auditors and made appropriate changes to the DeZoort et al. (2001)
instrument to test the research questions posed by our study.
6
The scale for objectivity was anchored at “Not at all objective” (0) and “Extremely objective” (10). The scale for
competence was anchored at “Doesn’t have any technical skills” (0) and “Has sufficient technical skills” (10).
7
We performed additional sensitivity analyses to determine if the results are sensitive to demographic variables.
Using ANOVAs, we found no statistically significant differences among the eight cells in terms of the number of
CPAs, experience, and their self-assessed experience at evaluating the IAF.
8
P-values are one-tailed when a directional prediction is made, otherwise they are two-tailed and marked by an * in
the text.
9
As previously indicated, we also asked participants to what extent they would adjust audit hours already budgeted
for valuing inventory. The 11-point scale was anchored at “Significantly Decrease” (-5), “Do Not Adjust” (0), and
“Significantly Increase” (5). Although reliance and budgeted hours are correlated in the expected direction (Pearson
correlation = -0.288, p-value < 0.001), variance in the budgeted hours responses is high. Thus, an ANOVA using
budgeted hours as the dependent variable did not produce statistically significant results. We believe the noisy
results in budgeted hours are due to the turmoil the auditing profession has been experiencing, with considerable
uncertainty over the number of audit hours required in the new environment. Even with the noisy budged hours
variable, a MANOVA with budgeted hours and reliance as the dependent variables yields significant main effects
for sourcing and task (one-sided p-values of 0.015 and 0.007, respectively), and marginally significant results in the
expected direction for the sourcing x risk interaction term (p-value of 0.087).
10
The three-way interaction between sourcing, risk, and task on reliance is not significant (p-value = 0.492).
11
While continuous variables are commonly used in structural equations modeling, the use of dichotomous variables
is acceptable in path analysis when the dichotomous variables are exogenous, as is the case in our analysis.
However, it should be noted that the use of endogenous dichotomous variables is potentially problematic (e.g., see
Israёls, 1987). Substituting the continuous manipulation check measures relating to the task and risk variables yields
qualitatively similar path results to those reported in the paper except that the risk to reliance path becomes
marginally significant (p-value < 0.10), and the model fit indices are degraded due to the fact that the manipulation
check measures are noisy proxies for the task and risk manipulations.
12
The critical ratio is computed by dividing the unstandardized estimate for each parameter by its standard error.
Critical ratios greater than 1.96 are significant at the p-value < 0.05 level.
13
The path from Sourcing to Competence is not significant (C.R. 1.37, p-value = 0.170), suggesting that our attempt
to hold competence constant across sourcing arrangement was successful. In addition, the path from Task to
Reliance is significant (C.R. -2.83, p-value = 0.010), which corresponds to the results reported in the ANOVA table
that the external auditors were more willing to rely on the internal auditors’ work when the internal auditors
performed a relatively subjective task.

30