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Managerial Auditing Journal

Characteristics of the Internal Audit and External Audit Hours: Evidence from S. Korea
Ho-Young Lee Hyun-Young Park
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Ho-Young Lee Hyun-Young Park , (2016),"Characteristics of the Internal Audit and External Audit Hours: Evidence from S.
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Characteristics of the Internal Audit and External Audit Hours: Evidence from S.
Korea

Ho-Young Lee *
Professor of Accounting
School of Business, Yonsei University, Seoul, S. Korea
hylee@yonsei.ac.kr
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Hyun-Young Park
Ph.D. Candidate of Accounting
School of Business, Yonsei University, Seoul, S. Korea

* Corresponding author

Acknowledgments: This work was supported by the National Research Foundation of Korea
Grant funded by the Korean Government (NRF-2014S1A5A2A01014863)

1
Abstract

Purpose: Using 5,055 sample firm-years in Korea between 2009 and 2013, we examine the
association between the characteristics of the internal audit and the number of external audit
hours as a proxy for audit efficiency.

Methodology: Our study is motivated by the International Standard on Auditing No. 610:
“Using the work of internal auditors”. This auditing standard guides external auditors in using
the work of internal auditors to obtain audit evidence and consult internal auditors for direct
assistance. We expect that external audit efficiency will increase when the work of competent
internal auditors is utilized.

Findings: We find that the number of internal auditors relative to the number of employees is
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associated with the number of external audit hours. This result suggests that the greater the
availability of internal auditors, the greater their contribution will be to the financial
statement audit and the more efficient the audit. We find evidence that external auditors
utilize the work of internal auditors with accounting and legal expertise to improve audit
efficiency. We also find some evidence that the work of internal auditors with greater
availability is more effective during initial external audit engagements.

Value: This study adds to the extant literature on the contributions of internal auditors to
external audits by using archival data and by measuring audit effort using a large database of
audit hours. In addition, our findings have practical implications for firms and external
auditors who are evaluating the role and value of using the work of internal auditors. We also
believe our findings will be of interest to regulators or auditing standards boards.

Keywords: internal auditor, external audit hours, characteristics of the internal audit, internal
audit contribution

Article Classification: Research paper

JEL Classification: M42

2
Characteristics of the Internal Audit and External Audit Hours: Evidence from S.
Korea

I. Introduction
This study examines the association between characteristics of the internal audit and
external audit hours as a proxy for audit efficiency. Holding audit effectiveness constant,
audit efficiency can be determined by the total amount of effort required to achieve a
successful audit (Davidson and Gist 1996). In this study, using a sample consisting of firms
that maintain a certain level of audit quality, we investigate whether the resources and
expertise related to the internal audit are associated with the number of audit hours.
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International Standard on Auditing (ISA) No. 315, “Identifying and assessing the
risks of material misstatement through understanding the entity and its environment”, directs
external auditors to identify and assess the risk of material misstatement by understanding the
entity being audited and its environment, including internal controls. 1 External audit
procedures and audit efficiency are affected by the risk of material misstatement, as assessed
by external auditors. ISA No. 610, “Using the work of internal auditors”, and Statements on
Auditing Standards (SAS) No. 65, “Auditors' consideration of the internal audit function in
an audit of financial statements”, guide external auditors to consider using the work of
internal auditors in the process of obtaining audit evidence and consulting internal auditors to
provide direct assistance under the direction, supervision, and review of external auditors.2
The risk of material misstatement is affected by the strength of the internal audit
function (ISA No. 315). Direct use of the work of internal auditors modifies the nature or

1
ISA No. 315 states that “the external auditor shall identify and assess the risk of material misstatement at (1)
the financial statement level and (2) the assertion level for classes of transactions, account balances, and
disclosures to provide a basis for designing and performing further audit procedures.” The risk of material
misstatement at the financial statement level refers to risk that relates pervasively to financial statements as a
whole and potentially affects many assertions. The auditor’s understanding of internal control, including the
internal audit function, may raise doubts at the financial statement level.
2
ISA No. 610 directs external auditors to evaluate the level of objectivity and competence of internal auditors
to determine whether and to what extent the work of internal auditors can be used. External auditors are required
to consider the competence of internal auditors by reviewing whether (1) the internal audit function is
adequately and appropriately resourced relative to the size of the entity and the nature of its operations, (2) there
are established policies for hiring, training, and assigning internal auditors to internal audit engagements, (3) the
internal auditors have adequate technical training and proficiency in auditing, (4) the internal auditors possess
the required knowledge relating to the entity’s financial reporting procedures and the applicable financial
reporting framework, (5) and the internal auditors possess the necessary skills to perform work related to the
entity's financial statements.
3
timing of the external audit and reduces the number of audit procedures to be performed by
the external auditors (ISA No. 610). Regarding the contribution of internal auditors to the
external audit, prior researchers have usually focused on the relationship between usage of
the internal audit function and external audit fee reductions using survey data (Felix et al.,
2001; Prawitt et al., 2011; Abbott et al., 2012a). These studies generally document a negative
association between assistance from internal auditors in performing the external audit and
audit fees. However, O'Keefe et al. (1994) argue that using the number of audit hours is a
more reliable proxy for audit effort because audit fees may introduce bias due to differences
in price policies and varying levels of audit quality. However, the unavailability of large
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datasets limits the use of audit hours as a measure of audit effort.3


Abbott et al. (2012b) examine the effect of internal audit assistance on external audit
timeliness using the extent of external audit delay, which relates to the timing of the
completion of audit procedures and audit hours. They assert that internal audit assistance
results in more efficient audits. However, audit delay measures only the length of time from a
company's fiscal year-end to the date of the auditor's report; this measure thus has the
limitation that it does not include interim audit procedures. Thus, use of audit hours is a more
direct and appropriate proxy for overall audit efficiency.
In this study, we examine the association between the resources and expertise of
internal auditors and external audit hours.4 We expect that external auditors will increase
audit efficiency by lowering the assessed risk of material misstatement and utilizing the work
of competent internal auditors, thus decreasing the number of external audit hours by means
of the resources and expertise of internal auditors.
For some clients, the internal audit function may be organized so as to provide
resources to assist the external auditors, while for other clients, information about the internal
audit function may be largely unavailable (Felix et al., 1998). The greater the availability of
internal auditors to assist the external auditors, the greater their contribution will be to the
financial statement audit (Felix et al., 2001). The expertise of internal auditors in the areas of

3
In Korea, firms are required to disclose information regarding audit hours in their annual reports; the data used
in this study were acquired from these reports for the purpose of academic research.
4
In Korea, audit fees are determined at the time of entering into an audit contract. Therefore, audit fees are not
adjusted even when auditors work harder than expected.
4
accounting and financial reporting, internal controls, and auditing influences the effectiveness
of internal controls (POB, 1993). Knowledgeable internal auditors can better support and
contribute more to the external audit. The findings of previous researchers support a positive
relationship between internal audit quality and the contribution made by internal auditors to
the external audit (Abdel-khalik et al., 1983; Brown, 1983; Clark et al., 1980; Schneider 1984;
Schneider, 1985; Maletta, 1993; Felix et al., 2001).
Examining 5,055 sample firm-years in Korea between 2009 and 2013, we find that
the number of internal auditors relative to the number of employees is associated with a lower
number of external audit hours, which suggests that the greater the availability of internal
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auditors, the greater their contribution will be to the financial statement audit, and the more
efficient the audit. Also, our findings provide evidence that strong accounting abilities and
legal expertise of internal auditors are associated with fewer external audit hours. Thus, we
recommend that external auditors increase the degree to which they rely on internal auditors
with good accounting ability and legal expertise, in order to improve audit efficiency.
Moreover, we find evidence that the association between internal auditors’ availability and
external audit efficiency is more pronounced in the initial audit engagement.
The COSO (Committee of Sponsoring Organizations of the Treadway Commission)
framework identified risk assessment as one of the five components of internal control
(COSO, 1992; COSO, 2013). The role of the internal audit has evolved from a narrow focus
on control to include risk management and corporate governance principles (Brody and Lowe,
2000; Spira and Page, 2003).5 Internal auditors may play a key role in a company’s risk

5
Examining these circumstances, recent archival research reports a positive or non-significant relationship
between the contribution of the internal audit and external audit fees (Goodwin-Stewart and Kent 2006; Hay et
al. 2006; Singh et al. 2014). For example, Goodwin-Stewart and Kent (2006) report a significant positive
association between the internal audit and audit fees, suggesting that internal and external audits can be regarded
as complementary means of increasing overall monitoring in a firm. However, Singh et al. (2014), who replicate
the work of Goodwin-Stewart and Kent (2006), find evidence that this significant positive association
disappears when substituting control variables. Mixed results arise from problems associated with the empirical
models used to measure audit fees, including the selection and measurement of internal audit proxies and control
variables and endogeneity (Hay et al. 2006; Prawitt et al. 2011; Singh et al. 2014). Our sensitivity analyses
address these issues. In addition to their monitoring role, internal auditors may also occupy an advisory role (IIA
Practice Advisories 2110-3). For example, in assessing the effectiveness and efficiency of operations, internal
auditors must also possess a comprehensive understanding of their firms when evaluating internal controls
across the organization and its divisions, operational units, or functions (COSO 2013). To maximize profits, they
are expected to provide internal reports to management on how to improve operations based on a thorough
understanding of those operations (Hermanson and Rittenberg 2003; Allegrini et al. 2006; Cooper et al. 2006).
5
management, and their contribution to internal control is very important. For example, the
large-scale study of Leung et al. (2004) in Australian companies revealed that a large
majority of internal auditors regarded risk management (74%) and internal control (91%) as
important objectives of the internal audit.
Unlike most prior studies on internal auditors, which rely on survey data and are
therefore vulnerable to unknown response bias, we use large amounts of reliable data which
are available to the general public. 6 This study adds to the extant literature on the
contribution of the internal audit function to external audits through use of archival data. Our
study also contributes to the literature by measuring audit effort using a large database of
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audit hours. In addition, our findings have practical implications for firms and external
auditors who must evaluate the role and economic implications of use of internal auditors in
the external audit. We also believe our findings will be of interest to regulators or auditing
standards boards.7
We organize the remainder of the paper as follows. Section II reviews prior studies
and develops our hypotheses. Section III describes our sample and research design. Section
IV presents the results of the empirical analysis, and Section V concludes the paper.

II. Literature Review and Hypothesis Development

2.1 Prior literature on internal auditor assistance


Though the importance of internal auditors in overall governance has increased in the
post-SOX era, there is little existing research on internal auditors due to the lack of available

Thus, external auditors may rely much less on work performed by internal auditors, though prior research
provides evidence that the internal audit contributes to the external audit (Felix et al. 2001; Abbott et al. 2012a;
Abbott et al. 2012b; Prawitt et al. 2011).
6
However, the ability of archival proxies to capture the contribution of the internal audit to the external audit
may be limited due to lack of public data. For example, the number of internal audit hours spent directly on
external audit-related activities may be a better proxy than the number of internal auditors. Future studies may
investigate the association between the contribution and quality of the internal audit, which is difficult to
measure based on survey data, and external audit hours.
7
For example, the PCAOB (2010) has sought to restrict the use of internal audit work in the area of
confirmation of procedures for specific accounts. Academic research supports the effectiveness of confirmation
procedures in testing the existence of receivables, and audit evidence from a third party is generally more
reliable than audit evidence generated internally by a company or provided directly by a company. However,
these restrictions result in more audit procedures at the year-end audit, which consequently increases audit hours
and causes audit delay in many cases.
6
data . Most studies (e.g., Felix et al., 2001; DeZoort et al., 2001; Carcello et al., 2005; Abbott
et al., 2012a; Abbott et al., 2012b) rely on survey data. For example, Carcello et al. (2005)
investigate factors associated with U.S. firms' investment in internal auditing using survey
data from 217 companies. They find that budgets of internal audits are positively associated
with firm size, leverage, and operating cash flow. DeZoort et al. (2001) examine how internal
auditors’ incentive compensation and their consulting role affect external audit planning
based on survey data from 76 cases from Big 5 accounting firms.
Regarding the contribution of internal auditors to external audits, prior studies have
usually focused on the relationship between usage of the work of internal auditors and
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external audit fee reductions (Elliott and Korpi, 1978; Palmrose, 1986; Felix et al., 2001;
Abbott et al., 2012a; Prawitt et al., 2011). Felix et al. (2001) provide evidence that the
internal audit contribution is a significant determinant of external audit fees. The extent to
which the internal audit contributes to the external audit is influenced by internal audit quality,
the availability of information related to the internal audit, and the extent of coordination
between internal and external auditors. Abbott et al. (2012a) investigate the influence of the
internal audit function on organizational oversight status and the impact of budgetary
resources on external audit fees, using these constructs as proxies for objectivity and
competence of internal auditors, respectively. They find a negative relationship between the
objectivity and competence of internal auditors and external audit fees. Prawitt et al. (2011)
find evidence that the internal audit contributes to a reduction in external audit fees, but that
this is only realized when internal auditors work as assistants under the direct supervision of
external auditors, and not when the internal audit function performs work upon which the
external auditor may later choose to rely.
Unfortunately, this line of research has not considered the impact of internal auditors'
assistance on the number of audit hours. Abbott et al. (2012b) examine the effect of internal
audit assistance on external audit timeliness via the extent of external audit delay, which
relates to the timing of audit procedure completion and audit hours. They assert that internal
audit assistance may not only result in audit cost savings, but also in greater audit efficiency.
However, the number of audit hours is a more direct and appropriate proxy for audit effort
and audit efficiency because audit delay represents the length of time from a company's fiscal
7
year-end to the date of the auditor's report and thus does not capture the impact of interim
audit procedures.
While extant experimental and survey-based studies provide consistent evidence that
internal auditors can contribute in ways that decrease audit fees or audit delay, archival
research examining the relation between characteristics of the internal audit and external
audit fees has had mixed results (Goodwin-Stewart and Kent, 2006; Hay et al., 2006; Singh et
al., 2014; Carey et al., 2000; Gerrard et al., 1994). Research results that reveal a significant
positive relation between the internal audit and audit fees suggest that internal and external
audits can be regarded as complementary means of increasing the overall monitoring of a
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firm.
Hay et al. (2006) assert that these mixed results arise from problems associated with
the empirical models used to measure audit fees, particularly identifying three potential
problems: omitted variables8, specification of control variables9, and endogeneity/omission of
the demand attributes of an audit.10 Prawitt et al. (2011) also express concern about proxies
for internal audit used in prior archival studies, which have limited ability to capture its
contribution to the external audit.

2.2 Prior literature on audit effort and audit efficiency


Audit risk is a function of the risk of material misstatement and detection risk.11 As
audit effort increases, the quantity and/or quality of audit evidence also increases, resulting in

8
Factors affecting audit fees may have been omitted from the empirical models due to a lack of internal firm
data. The mixed results for internal audit proxies illustrate the difficulties of obtaining reliable measures for
attributes that may be important to the empirical specification of audit fees, but for which public data are lacking
(Hay et al. 2006; Prawitt et al. 2011).
9
Even when data are available for control variables, problems may arise related to measurement and calibration.
Hay et al. (2006) suggest performing and reporting adequate sensitivity analyses using alternative control
variables.
10
The fact that demand for auditing can affect other control mechanisms within a firm creates a potential
problem of endogeneity between the internal audit, audit committee, form of ownership, and non-audit services.
For example, the existence of governance mechanisms may create more demand for an external audit, which can
increase audit fees because of changes in the assurance provided by the auditor, not in the audit process; this is
demonstrated in a production model of the audit (Hay et al. 2006). Goodwin-Stewart and Kent (2006) show that
their audit committee variable appears to be endogenously related to audit fees, specifying this as a limitation of
their empirical analysis.
11
The risk of material misstatement consists of inherent risk and control risk (ISA No. 200). Detection risk is
the risk that the procedures performed by the auditor to reduce audit risk to an acceptably low level will disallow
detection of an existing misstatement that could be material (ISA No. 200).
8
a lower detection risk. For a given level of audit risk, the acceptable level of detection risk
bears an inverse relationship to the assessed risk of material misstatement. For example, the
greater the risk of material misstatement the auditor believes to exist, the lower the acceptable
detection risk, and, accordingly, the more persuasive the audit evidence must be in order to
satisfy the auditor (ISA No. 200, SAS No. 47). Regarding this relationship, some researchers
examine whether audit effort varies with material misstatement risk. For example, Pratt and
Stice (1994) find that a client's overall financial condition influences auditors’ assessments of
litigation risk, their recommendations for the amount of evidence required to reduce the risk
of a material misstatement to an acceptable level, and audit fees. In addition, Abbott et al.
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(2006) and Gul et al. (2003) find that auditors charge higher fees for firms with higher levels
of earnings management, which reflect higher material misstatement risk.
While the studies discussed above use audit fees as a proxy for audit effort, O'Keefe
et al. (1994) argue that the number of audit hours is a more reliable proxy for audit effort
because audit fees may introduce bias due to different pricing policies and varying levels of
audit quality. In addition, Menon and Williams (2001) observe that audit costs are comprised
of two components: (1) expected future losses and (2) production costs related to the amount
of audit effort, in which audit effort is directly related to the time spent on the engagement.
Audit fees, therefore, may introduce significant bias into the measurement of audit effort
because they reflect audit profit and expected future losses in addition to production costs.
With only a few exceptions, however, the unavailability of large datasets limits the
use of audit hours as a measure of audit effort. Using proprietary data derived from a single
audit firm, O’Keefe et al. (1994) examine whether the number of audit hours is affected by
the client’s inherent risk and control risk. They find that increases in a client’s inherent risk
and control risk, as well as its size, increase the number of audit hours. Bell et al. (2001),
using survey data collected by a single accounting firm, show that the number of audit hours
increases with the client’s business risk. However, the results of these studies are subject to
external validity problems due to their censored samples.

2.3 Hypothesis development


External auditors must identify and assess the risk of material misstatement through
9
understanding the entity and its environment, including the entity’s internal controls; based
on the risk of material misstatement, the nature, timing, and extent of further external audit
procedures are affected (ISA No. 315). The strength of the internal audit function is an
important component of the assessed level of material misstatement risk at the financial
statement level. Also, external auditors must consider whether or not to use the work of the
internal audit function in obtaining audit evidence and whether or not to solicit direct
assistance from internal auditors (ISA No. 610; SAS No. 65). Use of their work reduces the
extent of audit procedures to be performed by the external auditors and improves external
audit efficiency (Felix et al., 2001; Abbott et al., 2012a; Abbott et al., 2012b; Prawitt et al.,
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2011). Based on documents providing auditing guidance and the arguments of previous
researchers, we investigate the relationship between the characteristics of the internal audit,
that is, the resources and expertise associated with the internal audit, and the number of
external audit hours used as a proxy for audit efficiency.
For some clients, the internal audit may be organized so as to provide resources to
assist the external auditors, while for other clients, information related to the internal audit
may be largely unavailable (Felix et al., 1998). The greater the availability of internal
auditors to assist the external auditors, the greater their contribution will be to the financial
statement audit (Felix et al., 2001). An internal audit contribution to the external audit results
in greater audit efficiency (Abbott et al., 2012b). Also, an adequately supported internal audit
function affects external auditors’ perceptions of the strength of the internal audit function,
which consequently lowers their assessment of the level of material misstatement risk. Thus,
external auditors may adjust the nature, timing, and extent of external audit procedures in
order to achieve greater audit efficiency. Thus, we expect involvement of internal auditors
with adequate resources to be associated with fewer external audit hours.
We use the number of internal auditors relative to the number of employees and
internal auditor compensation as variables to capture the amount of resources allocated to the
internal audit function. When determining the number of internal auditors, we consider
working status, either full-time or part-time, because this variable has a powerful effect on an

10
internal auditor's availability.12 Thus, internal auditors’ availability to assist external auditors
may increase with the number of internal auditors relative to the size of the entity. Also,
compensation of internal auditors can represent their overall competence (Keizer, 2009;
Abbott et al., 2012a). Appropriate compensation for internal auditors, that is, adequate
budgetary resources allocated to the internal audit function, will influence external auditors’
perceptions of the strength of the internal audit. We expect that a higher number of internal
auditors and/or higher internal auditor compensation will be associated with greater use of the
work of internal auditors and fewer external audit hours. This leads to Hypothesis 1.
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Hypothesis 1: Ceteris paribus, an adequately resourced internal audit function is


associated with fewer external audit hours.

Hypothesis 1-1: A higher number of internal auditors is associated with fewer external
audit hours.
Hypothesis 1-2: Higher internal auditor compensation is associated with fewer external
audit hours.

The POB (1993) states that the effectiveness of the internal audit is affected by the
expertise of internal auditors in the areas of accounting and financial reporting, internal
controls, and auditing. Knowledgeable internal auditors are better equipped to understand
auditor judgments and discern the substance of disagreements between management and
external auditors (Abbott et al., 2003). The results of prior research support a positive
relationship between internal audit quality and the contribution made by internal auditors to
the external audit (Abdel-khalik et al., 1983; Brown, 1983; Clark et al., 1980; Schneider,
1984; Schneider, 1985; Maletta, 1993; Felix et al., 2001). Based on the arguments leading to
Hypothesis 1, we posit that greater expertise of internal auditors is associated with fewer
external audit hours.
We compare internal auditors with accounting expertise and legal expertise and newly
hired internal auditors to capture the level of expertise of internal auditors. An internal

12
Section 191-12 of the Security Act of Korea classifies internal auditors by their working status into two
groups: (1) full-time and (2) part-time. The qualification for a full-time internal auditor is that he/she works for
the firm regularly during the firm's operating hours as his/her primary job. In contrast, part-time internal auditors
usually engage in the minimum amount of audit activity required by law to be classified as an auditor, according
to the Institute of Internal Auditors Korea.
11
auditor is considered to be an accounting expert when he/she is a professor of accounting,
holds a Ph.D. in accounting, has a CPA/CTA certificate, or has a certain amount of
experience in an accounting field. An internal auditor with accounting expertise is expected
to possess knowledge relevant to the entity’s financial reporting procedures and to be
proficient in auditing. We expect that an internal auditor with greater accounting expertise
will assess the level of material misstatement risk more accurately and thus an external
auditor will make greater use of the work of internal auditors. Also, an internal auditor with
greater accounting expertise may potentially provide support for external auditors when
discussing or negotiating audit issues with management, thereby increasing efficiency; thus,
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strong accounting expertise of the internal auditor will be associated with fewer external audit
hours.
An internal auditor is considered to be a legal expert when he/she is a lawyer or a
professor of law. Effective corporate governance and the control environment may afford the
external auditor with more confidence in the internal controls and reliability of internally
generated audit evidence; thus, external audit efficiency will increase. External auditors may
view internal auditors with legal expertise as better able to ensure low levels of material
misstatement risk through effective internal controls. Thus, we expect that having an internal
auditor with legal expertise will be associated with fewer external audit hours.
In other studies, a positive association has been found between auditor tenure and
earnings quality (Myer et al., 2003; Ghosh and Moon, 2005). This finding suggests that long
tenure increases the competence of external auditors, who can base audit decisions on
extensive client knowledge that has developed over time. As internal auditors within firms
play a role similar to that of external auditors, to extrapolate from previous findings in studies
on external auditors to the internal context, we may posit that newly hired internal auditors
know less about firms and their industries, and therefore their expertise may be less extensive
than that of auditors with more experience.13 We expect that newly hired internal auditors
will be viewed as lacking adequate knowledge relating to financial reporting of client firms.

13
The number of years internal auditors have held relevant certificates and/or academic degrees would be a
more accurate proxy for internal auditor expertise. However, public data are unavailable to determine this
parameter. We therefore acknowledge that our study may have this limitation.
12
External auditors may evaluate the assessed level of material misstatement risk at the
financial statement level as high, and may therefore not utilize work performed by less
experienced internal auditors, choosing to do it themselves, thereby decreasing efficiency.
However, the effect of auditor tenure on audit quality has become a controversial issue in the
U.S.A. For example, Chief Accountant of the SEC, Lynn Turner, and the Chairman of the
SEC, Arthur Levitt, stated that the quality of financial reporting may deteriorate as client
managers develop long-lasting relationships with their auditors (Turner, 1999; Levitt, 2002).
While they concern was about external auditor tenure, similar concern can be applied to
internal auditors. If so, new internal auditors may bring fresh and more independent eyes in
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dealing with internal control issues and the quality of financial statements. Thus, the effect of
newly hired internal auditors on the number of external audit hours is an empirical question.
This leads to Hypothesis 2.

Hypothesis 2: Ceteris paribus, greater expertise of internal auditors is associated with


fewer external audit hours.
Hypothesis 2-1: Accounting expertise of internal auditors is associated with fewer
external audit hours.
Hypothesis 2-2: Legal expertise of internal auditors is associated with fewer external
audit hours.
Hypothesis 2-3: Short tenure of internal auditors is associated with a number of
external audit hours.

Our hypotheses center on the potential benefits of relying on the competence of


internal auditors to enhance external audit efficiency. However, prior research suggests that
internal and external audits can be regarded as complementary means of increasing the
overall monitoring of a firm (Spira and Page, 2003; Goodwin-Stewart and Kent, 2006). This
is consistent with the broader role of the internal audit in the post-2000 period, which has
evolved from one narrowly focused on controls to one that embraces risk management and
corporate governance principles. Given the potential for differential effects, we ask the
empirical question whether resources associated with the internal audit function and/or
expertise of internal auditors are associated with fewer external audit hours.

III. Research Design and Sample Selection


13
3.1 Research model
We estimate the following Model (1) in order to test Hypotheses 1-1, 1-2, 2-1, 2-2,
and 2-3.
 =  + 
  +   +   +   +   +   
+   +   +    + 
  + 

 + 
 
+ 
   + 
 ! + 
   + 
   + 
 
+ " #$%&&' + #$%&&' + ( (1)
where:

LNAH = the natural logarithm of external audit hours;


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IANUM = the number of internal auditors/the total number of employees (working


status, either full-time or part-time, is weighted so as to measure the number
of internal auditors, as follows: 1 for full-time internal auditors and 0.5 for
part-time internal auditors);

IAFEE = internal auditor compensation/total salaries;

ACC = 1 if an internal auditor is an accounting expert, and 0 otherwise;

LAW = 1 if an internal auditor is a legal expert, and 0 otherwise;

NEW = 1 if an internal auditor is in his/her first year with the firm, and 0 otherwise;

SIZE = the natural logarithm of market value;

LEV = total non-current liabilities/total assets;

CON = the natural logarithm of the number of consolidated subsidiaries;

ARINV = (accounts receivable + inventory)/total assets;

LOSS = 1 if net income is negative, and 0 otherwise;

OWN = the percentage of majority shareholder ownership;

FOR = the percentage of foreign investor ownership;

OUT = the number of outside directors/total number of members on the board of


directors;

BIG = 1 if auditing is done by one of the Big 4 accounting firms, and 0 otherwise;

14
FIRST = 1 if this is the initial external audit, and 0 otherwise;

LIST = 1 if a firm trades its shares on the KSE, and 0 if it does so on the KOSDAQ;

IFRS = 1 if a firm applied the IFRS, and 0 otherwise.

In Model (1), our dependent variable is the natural logarithm of the number of
external audit hours (LNAH). The variables of interest are IANUM, IAFEE, ACC, LAW, and
NEW. IANUM is the number of internal auditors divided by the total number of firm
employees. The number of internal auditors is measured by assigning a weight of 1 if an
internal auditor is working full-time and a weight of 0.5 if an internal auditor is working part-
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time, because an internal auditor's availability is influenced by his/her working status. IAFEE
is internal auditor compensation scaled by the total amount spent on salaries. IANUM and
IAFEE are variables representing the level of resources relative to the size of the entity. If the
work of an adequately resourced internal auditor is associated with fewer external audit hours,
consistent with our hypotheses (1-1 and 1-2), we predict negative coefficients of IANUM and
IAFEE. ACC is a dummy variable that equals 1 if an internal auditor is an accounting expert
and 0 otherwise. Following Hypothesis 2-1, if an internal auditor's accounting expertise is
associated with fewer external audit hours, we predict a negative coefficient of ACC. LAW is
a dummy variable that equals 1 if an internal auditor is a legal expert and 0 otherwise.
Following Hypothesis 2-2, if an internal auditor's legal expertise is associated with fewer
external audit hours, we predict a negative coefficient of LAW. NEW is a dummy variable
that equals 1 if an internal auditor is in his/her first year with the firm and 0 otherwise.
Following Hypothesis 2-3, we expect NEW not to be associated with the number of external
audit hours; thus, we do not predict the sign of the coefficient of NEW.
Based on previous studies (e.g., O’Keefe et al. 1994; Abbott et al. 2006; Caramanis
and Lennoex 2008; Blankley et al. 2012), we control for a number of other factors that are
likely to be generally associated with the number of audit hours, including client size,
complexity, risk, auditor type, and the corporate governance factor. We include the natural
logarithm of total assets (SIZE), the natural logarithm of the number of consolidated
subsidiaries (CON), the ratio of total assets to accounts receivable and inventory (ARINV),

15
and the ratio of foreign sales to total sales (EXPORT) to control for client size and
complexity. We include LEV, LOSS, and LIST to control for the financial risk and business
risk of client firms. LEV is the ratio of total liabilities to total assets. LOSS is a dummy
variable coded as 1 if net income is negative. LIST is a dummy variable that equals 1 if a firm
trades its shares on the KSE (Korea Stock Exchange) and 0 if it does so on the KOSDAQ
(Korea Securities Dealers Automated Quotation). We include BIG and FIRST to control for
auditor type. BIG is a dummy variable coded as 1 if the auditor is one of the Big 4 accounting
firms. FIRST is a dummy variable coded as 1 in cases of initial audit engagement. OWN and
FOR, the percentages of majority shareholder ownership and foreign investor ownership,
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respectively, are included to control for the effects of corporate ownership structure. OUT,
the ratio of outside directors to the total number of members on the board of directors, is
included to control for corporate governance structure. In addition, the model is estimated
with industry- and year-fixed effects.

3.2 Data description


The sample of this study encompasses firms listed on the KSE and KOSDAQ
markets during the period 2009–2013. We exclude firm-year observations of firms that are
under stock market surveillance, following the standard practice in the literature. In order to
examine audit efficiency while holding audit effectiveness constant, we exclude observations
of firms that announced restatements and those of firms that were subject to enforcement
action by the Financial Supervisory Service of Korea (equivalent to the U.S. SEC).
We also exclude observations of non-December 31 fiscal year-end firms and financial
institutions in order to ensure comparative analyses, observations of firms whose total assets
exceed 2 trillion Korean Won, and observations of firms that have voluntarily adopted audit
committees. Finally, we exclude observations lacking data regarding audit hours, information
regarding the characteristics of the internal audit, and other necessary control variables, resulting in a
final sample of 5,055 firm-years. Table 1 presents attrition details related to the sample.

******************
Insert Table 1 here
******************
16
IV. Results of the Empirical Analysis
4.1 Descriptive statistics
Table 2 provides descriptive statistics for our 5,055 firm-year observations.
Observations with values greater than the 99th percentile (less than the 1st percentile) of their
respective distributions were winsorized and made equal to the value at the 99th percentile
(or 1st percentile). The mean (median) value of our dependent variable, which is the natural
logarithm of external audit hours (LNAH), is 6.585 (6.567), which represents 854.2 hours
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(710.0 hours). The mean value of IANUM is 0.007, which means that the ratio of the number
of internal auditors to the number of total employees, on average, is 0.7 percent when internal
auditors’ working status is considered. The mean value of IAFEE is 0.007, which means that
the ratio of internal auditor compensation to the total amount spent on salaries, on average, is
0.7 percent. In the sample, 18.1 percent of internal auditors are identified as accounting
experts, 6.0 percent as legal experts, and 15.7 percent as newly hired to their respective firms.
The mean firm size, as measured by the natural logarithm of total market value, is
11.122, which represents 131 billion Korean Won (about $120 million). The mean value of
CON is 0.766, suggesting that firms, on average, have 1.26 consolidated subsidiaries. The
ratio of total non-current liabilities to total assets is, on average, 9.8 percent. The ratio of
accounts receivable and inventory to total assets is, on average, 29.0 percent. During the
study period, 27.1 percent of sample firms reported a loss. The percentages of majority
shareholder ownership and foreign investor ownership, on average, are 40.3 percent and 4.3
percent, respectively. The ratio of outside directors to the total number of members on the
board of directors is, on average, 40.0 percent. In total, 50.6 percent of our sample firms
hired one of the Big 4 auditors in the sample year and 13.5 percent of firms experienced an
initial audit engagement. As for trading, 34.6 percent of our sample firms trade their shares
on the KSE and 65.4 percent of them do so on the KOSDAQ. Lastly, 63.5 percent of firms
perform audits according to the IFRS, and 36.5 percent of firms applied the K-GAAP.14

14
As of 2011, all listed firms in Korea are required to adopt the IFRS. As firms were given the option to adopt
17
******************
Insert Table 2 here
******************

Table 3 presents the Pearson correlation matrix for the variables used in the
regression model. Consistent with our expectation, the number of audit hours (LNAH) is
negatively and significantly associated with our test variables, the number of internal auditors
(IANUM), internal auditor compensation (IAFEE), and an indicator variable of accounting
(ACC) and legal (LAW) expertise. Audit hours (LNAH) are, however, not significantly
associated with the indicator associated with newly hired internal auditors (NEW).
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Consistent with previous findings (e.g., O'Keefe et al. 1994; Abbott et al. 2006),
LNAH is positively and significantly correlated with total market value (SIZE), leverage
(LEV), the number of consolidated subsidiaries (CON), majority shareholder ownership
(OWN), foreign investor ownership (FOR), board of directors independence (OUT), an
indicator variable of being audited by Big 4 auditors (BIG), an indicator variable of being
involved in the trade market (LIST), and an indicator variable of applying the IFRS (IFRS).
Contrary to our expectation, LNAH is negatively correlated with the ratio of total assets to
accounts receivable and inventory (ARINV), an indicator variable of reporting loss (LOSS),
and an indicator variable of having an initial external audit (FIRST). It should be noted,
however, that these are the results without controlling for other factors that affect audit hours.
None of the correlations between control variables are high enough to cause concern, and an
analysis of variance inflation factors (VIF) associated with our regression model suggests that
multicollinearity is not a concern.

******************
Insert Table 3 here
******************

4.2 Results of the univariate analysis


Table 4 shows our univariate comparisons. The differences are generally consistent

the IFRS earlier than required, some firms have filed their financial statements according to the IFRS since 2009.
18
with our expectations. We find that the number of external audit hours is lower for companies
with values for IANUM greater than the median value. Compared to those companies with
values for IANUM less than or equal to the median value (714 hours versus 993 hours, a
difference significant at p-value <.01), the differences are consistent, indicating that the
number of internal auditors has a negative association with the number of external audit hours.
The results also show that the number of external audit hours is lower for companies with
IAFEE greater than the median value (844 hours versus 864 hours); however, the differences
are not statistically significant. Moreover, we find that the number of external audit hours is
lower for companies with internal auditors who have accounting expertise. Compared to
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those companies without internal auditors who are accounting experts (743 hours versus 878
hours, difference significant at p-value <.01), the differences are consistent, indicating that
internal auditors’ accounting expertise is associated with fewer external audit hours.
The results also show that the number of external audit hours is lower for companies
with internal auditors with legal expertise. Compared to those companies without internal
auditors who are legal experts (760 hours versus 860 hours, difference significant at p-value
<.01), the differences are consistent, indicating that internal auditors’ legal expertise has a
negative association with the number of external audit hours. This number is slightly lower
for companies with newly hired internal auditors (831 hours versus 858 hours); however, the
differences are not statistically significant. Our univariate test results thus support Hypotheses
1-1, 2-1, and 2-2. It should be noted, however, that these are the results without controlling
for other factors that affect audit hours. Therefore, we report the results of a multivariate
analysis in the next sub-section.

******************
Insert Table 4 here
******************

4.3 Results of the multivariate analysis


Table 5 reports the results of a multivariate analysis estimating the regression model
specified in Eq. (1). Columns (1), (2), (3), (4), and (5) show the results of the reduced model
using IANUM, IAFEE, ACC, LAW, and NEW, respectively. In columns (1), (2), (3), and (4),
19
the coefficients of the measures of internal audit characteristics (IANUM, IAFEE, ACC, and
LAW) are significant and negative (p-value <.01), suggesting that the number of audit hours
decreases with increased resources and expertise associated with the internal audit. In column
(5), the coefficients of the internal auditor incompetence measure (NEW) are positive, but not
significant. This insignificant result may be caused by the two conflicting influences from
lacking knowledge and experience and having independent fresh eyes of new internal
auditors. Column (6) shows the results of the regression using the full model. The coefficients
of IANUM, ACC, and LAW remain significant and negative (p-value <.01) and the
coefficients of IAFEE and NEW are not significant. In accordance with the univariate test
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results, the multivariate results also support Hypotheses 1-1, 2-1, and 2-2, indicating that
having a higher number of internal auditors relative to the size of the firm and the accounting
and legal expertise of internal auditors are associated with fewer external audit hours.
The results for the control variables are generally consistent with those in prior
studies (e.g., O'Keefe et al. 1994; Abbott et al. 2006). The coefficients for total market value
(SIZE), leverage (LEV), the number of consolidated subsidiaries (CON), an indicator
variable of negative net income (LOSS), foreign investor ownership (FOR), board of
directors independence (OUT)15, an indicator variable of auditing by a Big 4 auditor (BIG),
an indicator variable of trade market involvement (LIST), and an indicator variable of
applying the IFRS (IFRS) denote significantly positive results. On the other hand, the
coefficient of OWN is negative and significant at the one percent level, suggesting that a high
proportion of ownership by majority shareholders reduces audit risk, possibly because of
reduced information asymmetry between managers and owners.

******************
Insert Table 5 here
******************

15
Interestingly, board of director independence increases external audit hours, while availability and expertise
associated with the internal audit decreases external audit hours. This implies that the roles of the board of
directors and internal auditors differ in terms of both corporate governance and the external audit. An
independent board of directors may create more demand for an external audit, but may not necessarily
contribute to the audit, which can increase audit hours. On the other hand, internal auditors are more likely to
contribute to an external audit, which may in turn increase audit efficiency.
20
4.4 Additional test: Effect of initial audit engagement
As an additional analysis, we estimate our regression model after considering the
effects of initial audit engagement on the number of audit hours. Prior literature documents
that long tenure increases the competence of external auditors, as they can base their
decisions on extensive client knowledge that has developed over time (Myer et al. 2003;
Ghosh and Moon 2005). New auditors who lack client-specific knowledge may depend more
on internal auditors who are familiar with the firm’s financial reporting procedures and
understand the firm and its environment. Also, new external auditors may require support
from internal auditors when discussing or negotiating audit issues and the scope of an audit
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with management. During their initial audit engagement, however, external auditors face
greater uncertainty and higher risk; thus, they may not rely directly on work performed by
internal auditors. Instead, external auditors may obtain audit evidence by performing further
reliable audit procedures.
Table 6 provides the results of estimating the regression model specified in Eq. (1)
including five interaction variables, IANUM×FIRST, IAFEE×FIRST, ACC×FIRST,
LAW×FIRST, and NEW×FIRST. The coefficients of IANUM, ACC, and LAW are still
significant and negative (p-value <.01). Moreover, the coefficient of the interaction term of
IANUM and FIRST is significant and negative (p-value <.01), suggesting that reducing the
number of audit hours by using the work of internal auditors with greater human resources is
more effective when external auditors have been newly engaged by the client firm because
they lack extensive client knowledge.
******************
Insert Table 6 here
******************

4.5 Sensitivity analysis


While extant experimental and survey-based studies provide consistent evidence that
internal auditors can contribute in ways that lead to decreased audit fees or audit delay, the
archival research examining the relation between characteristics of the internal audit and
external audit fees produces mixed results (Goodwin-Stewart and Kent 2006; Hay et al. 2006;
Singh et al. 2014; Carey et al. 2000). These issues arise from problems associated with the
21
empirical models used to measure audit fees, the selection and measurement of internal audit
proxies and control variables, and endogeneity (Hay et al. 2006; Prawitt et al 2011; Singh et
al. 2014).
As a first sensitivity analysis, we use stepwise regression techniques similar to those
used in Singh et al. (2014), in which control variables16 in the OLS regression model are
selected stepwise (based on an α of 0.05) with variables related to internal audit
characteristics included regardless of their level of significance. The untabulated results of
estimating the stepwise regression show that the coefficients of IANUM, ACC, and LAW are
still significant and negative; moreover, the coefficient of IAFEE is significant and negative,
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16
We identify independent variables used in prior research on the relationship between audit fees and audit
hours. The independent variables used were categorized according to Hay et al. (2006) and Singh et al. (2014) as
follows:
Category Variable Definition of Proxy Measures
Size SIZE_MARKET natural logarithm of market value
SIZE_ASSET natural logarithm of total assets
SIZE_SALES natural logarithm of sales
Firm Complexity CON natural logarithm of the number of consolidated subsidiaries
FOREIGN_SALES ratio of foreign sales to total sales
Inherent Risk AR ratio of accounts receivable to total assets
INV ratio of inventory to total assets
ARINV ratio of accounts receivable and inventory to total assets
Profitability ROA ratio of net income to total assets
ROE ratio of net income to book value of equity
LOSS dummy variable coded as 1 if net income is negative
Leverage DEBT_ASSET ratio of total liabilities to total assets
DEBT_EQUITY ratio of total liabilities to book value of equity
LTDEBT_ASSET ratio of total non-current liabilities to total assets
CURRENT ratio of current assets to current liabilities
LIQUID ratio of current assets to total assets
Ownership OWN percentage of majority shareholder ownership
FOR percentage of foreign investor ownership
Governance OUT ratio of outside directors to total board of directors
Other Client Attributes LIST dummy variable coded as 1 if a firm trades its shares on the
KSE, and 0 if it does so on the KOSDAQ
IFRS dummy variable coded as 1 if an accounting standard
applied to a firm-year is among the International Financial
Reporting Standards (IFRS), and 0 if it is from the Korean
Generally Accepted Accounting Principles (K-GAAP)
Auditor Attributes BIG dummy variable coded as 1 if the auditor is one of the Big 4
accounting firms, and 0 otherwise
FIRST dummy variable coded as 1 if this is the initial audit
engagement, and 0 otherwise
OPINION dummy variable coded as 1 if the audit report is unqualified,
and 0 otherwise
NAF ratio of named auditors’ other service fees to sum of named
auditors’ audit fees and other service fees

22
suggesting that audit hours are lower when resources are adequate and expertise of the
internal audit function is high.17
As a second sensitivity analysis, we test for the possibility of endogeneity among
audit hours, all internal audit characteristics (IANUM, IAFEE, ACC, LAW) except the short
tenure of internal auditors (NEW), and board of directors’ independence (OUT) by
conducting a two-stage least squares regression analysis similar to that of Goodwin-Stewart
and Kent (2006).18 The results indicate that the coefficients for IANUM, ACC, and LAW are
still significant and negative, and that of OUT is still significant and positive, indicating that
endogeneity is not a problem. This supports our hypothesis that adequate resources and high
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expertise of the internal audit are associated with fewer audit hours.
Finally, we replicate our analysis using the archival measures (total internal audit
expenditures, ratio of internal auditor compensation to assets, and the number of internal
auditors) used in Prawitt et al. (2011) to test their effect in our sample. When we include
these three measures in our model instead of IANUM and IAFEE, we find that the
coefficients of ACC and LAW are still significant and negative; in addition, the ratio of
internal auditor compensation to assets is significant and negative, but values related to the
total amount of internal audit expenditure and the number of internal auditors are positive.
We argue that variables related to the internal audit (total internal audit expenditures, the
number of internal auditors) used in previous archival research, which is not scaled by firm
size (e.g., assets, the total number of employees, total salaries), are simply another measure of
firm size.

V. Conclusions
Based on ISA No. 315 and ISA No. 610, we investigate how external auditors
improve audit efficiency by utilizing the work of internal auditors. Specifically, we examine

17
SIZE_MARKET, SIZE_ASSET, CON, ROA, LOSS, DEBT_ASSET, LTDEBT_ASSET, CURRENT, OWN,
OUT, LIST, IFRS, BIG, and NAF are selected as control variables. All values for control variables are
significant at least at the 0.05 level and in the predicted direction. Adjusted R2 of the model is 41.91%.
18
In the first stage, we use total market value (SIZE), leverage (LEV), the number of consolidated subsidiaries
(CON), the ratio of total assets to accounts receivable and inventory (ARINV), majority shareholder ownership
(OWN), foreign investor ownership (FOR), and an indicator variable of being audited by Big 4 auditors (BIG).
These variables are suggested by Carcello et al. (2005) as those associated with investment in internal audits.
23
the association between the characteristics of the internal audit and the number of external
audit hours using a sample consisting of firms maintaining a certain level of audit quality. We
expect that external auditors will increase audit efficiency by lowering the assessed risk of
material misstatement and utilizing the work of competent internal auditors, thus decreasing
the number of external audit hours by means of internal audit quality.
We find that a high number of internal auditors relative to the number of employees
and high accounting and legal expertise of internal auditors are associated with fewer external
audit hours. These results suggest that the greater the availability of internal auditors, the
greater their contribution will be to the financial statement audit, resulting in greater audit
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efficiency. Also, our findings provide evidence that external auditors utilize the work of
internal auditors with accounting and legal expertise in order to improve audit efficiency.
Moreover, we find that the association between the number of internal auditors relative to the
number of employees and external audit efficiency is more pronounced for first-time audit
engagements.
Despite the increase in regulatory and professional attention to internal audit issues,
there is a relative scarcity of empirical research related to the internal audit, particularly in the
post-SOX environment. This study adds to the extant literature on internal auditor
contributions to external audits by examining the association between internal audit
characteristics and the number of external audit hours using archival data. While prior studies
on internal auditors mostly rely on survey data, which is vulnerable to unknown response bias,
we use extensive, reliable data available to the general public.
Our study also makes a unique contribution in that audit effort is measured using a
large database of audit hours. Due to the unavailability of large datasets of audit hours, some
studies (e.g., Pratt and Stice 1994) focus on proprietary data of audit hours derived from a
single audit firm. However, questions may be raised about the external validity of the results
of these studies due to the censored nature of their samples. Other studies measure audit
efficiency using audit fees or audit delay. However, O'Keefe et al. (1994) argue that audit
fees have the potential to introduce bias into the measurement of audit effort due to
differences in pricing policies, showing that the number of audit hours is a more reliable
proxy. Likewise, audit delay measures only the length of time from a company's fiscal year-
24
end to the date of the auditor's report; thus, this measure, too, has limitations in that it does
not include interim audit procedures. In addition, our findings have practical implications for
firms and external auditors who must evaluate the role and use of internal auditors as it has
economic implications. We also believe our findings will be of interest to regulators or
auditing standards boards.
Our study, however, is subject to some limitations. First, we only analyze the
characteristics of the heads of internal audit divisions due to data limitations. Second, our
sample consists only of Korean data, which may make it difficult to generalize the results to
other countries with different legal settings related to the internal audit. Future studies may
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investigate cross-country differences in internal audit-related practices and the association


between the contribution of internal auditors and audit efficiency.

25
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28
Table 1
Sample Selection
Sample Selection Criteria Number of Firm-years
Total listed firms in the sample 2009~2013 10,046
Less (1) Non-December 31 fiscal year-end firms (2,014)
(2) Financial institutions (89)
(3) Firms with assets exceeding KRW 2 trillion (the point above
which firms are required to have audit committees instead of
(480)
internal auditors) or firms that chose to have audit committees
voluntarily
(4) Firms without data for audit hours (586)
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(5) Firms without data for internal auditor characteristics (1,782)


(6) Firms without other necessary data for control variables (40)
Total 5,055

29
Table 2
Descriptive Statistics
(N=5,055)
Standard First Third
Variable Mean Min Median Max
deviation quartile quartile
AH 854.16 576.82 40 508 710 1,010 13,000
LNAH 6.585 0.560 4.796 6.232 6.567 6.919 7.987
IANUM 0.007 0.011 0.000 0.002 0.004 0.007 0.083
IAFEE 0.007 0.014 0.000 0.001 0.003 0.007 0.102
ACC 0.181 0.385 0.000 0.000 0.000 0.000 1.000
LAW 0.060 0.237 0.000 0.000 0.000 0.000 1.000
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NEW 0.157 0.366 0.000 0.000 0.000 0.000 2.000


SIZE 11.112 1.072 9.032 10.349 11.001 11.753 14.269
LEV 0.098 0.090 0.000 0.029 0.072 0.141 0.432
CON 0.766 0.262 0.693 0.693 0.693 0.693 2.197
ARINV 0.290 0.163 0.000 0.170 0.277 0.397 0.728
LOSS 0.271 0.444 0.000 0.000 0.000 1.000 1.000
OWN 0.403 0.164 0.082 0.280 0.402 0.515 0.790
FOR 0.043 0.085 0.000 0.001 0.008 0.039 0.490
OUT 0.390 0.147 0.000 0.375 0.400 0.500 0.750
BIG 0.506 0.500 0.000 0.000 1.000 1.000 1.000
FIRST 0.135 0.342 0.000 0.000 0.000 0.000 1.000
LIST 0.346 0.476 0.000 0.000 0.000 1.000 1.000
IFRS 0.635 0.482 0.000 0.000 1.000 1.000 1.000

Notes: AH is the number of external audit hours; LNAH is the natural logarithm of the
number of external audit hours; IANUM is the number of internal auditors scaled by the total
number of employees (working status, either full-time or part-time, is weighted so as to
measure the number of internal auditors as follows: 1 for full-time internal auditors and 0.5
for part-time internal auditors); IAFEE is internal auditor compensation scaled by total
amount spent on salaries; ACC is a dummy variable coded as 1 if an internal auditor is an
accounting expert; LAW is a dummy variable coded as 1 if an internal auditor is a legal
expert; NEW is a dummy variable coded as 1 if an internal auditor is in his/her first year with
the firm; SIZE is the natural logarithm of market value; LEV is the ratio of total non-current
liabilities to total assets; CON is the natural logarithm of the number of consolidated
subsidiaries; ARINV is the ratio of accounts receivable and inventory to total assets; LOSS is
a dummy variable coded as 1 if net income is negative; OWN is the percentage of majority
shareholder ownership; FOR is the percentage of foreign investor ownership; OUT is the
30
ratio of outside directors to the total number of members on the board of directors; BIG is a
dummy variable coded as 1 if the auditor is one of the Big 4 accounting firms; FIRST is a
dummy variable coded as 1 if this is the initial audit engagement; LIST is a dummy variable
equaling 1 if a firm trades its shares on the KSE, and 0 if it does so on the KOSDAQ; IFRS is
a dummy variable equaling 1 if an accounting standard applied to a firm-year is among the
International Financial Reporting Standards (IFRS), and 0 if it is from the Korean Generally
Accepted Accounting Principles (K-GAAP).
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31
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Table 3
Pearson's Correlation
(N=5,055)
Variable IANUM IAFEE ACC LAW NEW SIZE LEV CON ARINV LOSS OWN FOR OUT BIG FIRST LIST IFRS
LNAH −0.137 −0.058 −0.098 −0.043 −0.023 0.419 0.085 0.119 −0.026 −0.031 0.059 0.201 0.168 0.364 −0.040 0.318 0.217
(<.0001) (<.0001) (<.0001) (0.002) (0.110) (<.0001) (<.0001) (<.0001) (0.062) (0.026) (<.0001) (<.0001) (<.0001) (<.0001) (0.004) (<.0001) (<.0001)
IANUM 0.674 −0.022 0.000 0.031 −0.129 −0.115 0.060 −0.257 0.114 −0.013 −0.039 0.042 −0.082 0.048 0.021 0.000
(<.0001) (0.121) (0.973) (0.029) (<.0001) (<.0001) (<.0001) (<.0001) (<.0001) (0.363) (0.005) (0.007) (<.0001) (0.001) (0.130) (0.980)
IAFEE −0.053 −0.030 0.000 −0.060 −0.071 0.069 −0.172 0.047 0.006 −0.015 0.131 −0.057 0.028 0.084 −0.012
(0.000) (0.033) (0.976) (<.0001) (<.0001) (<.0001) (<.0001) (0.001) (0.656) (0.282) (<.0001) (<.0001) (0.046) (<.0001) (0.393)
ACC −0.097 −0.016 −0.072 −0.035 −0.039 −0.007 0.017 −0.057 −0.055 -0.064 −0.015 −0.003 −0.087 0.044
(<.0001) (0.256) (<.0001) (0.012) (0.006) (0.614) (0.223) (<.0001) (<.0001) (<.0001) (0.284) (0.839) (<.0001) (0.002)
LAW 0.026 −0.003 −0.006 −0.043 −0.033 0.072 −0.050 −0.029 -0.018 0.007 0.015 −0.030 0.047
(0.064) (0.821) (0.666) (0.002) (0.019) (<.0001) (0.000) (0.040) (0.264) (0.610) (0.282) (0.030) (0.001)
NEW −0.014 0.019 0.056 −0.035 0.074 −0.004 −0.016 -0.002 −0.006 0.061 0.007 −0.138
(0.311) (0.168) (<.0001) (0.013) (<.0001) (0.776) (0.248) (0.891) (0.674) (<.0001) (0.634) (<.0001)
SIZE 0.014 0.187 −0.106 −0.251 0.085 0.353 0.125 0.277 −0.055 0.249 0.058
(0.321) (<.0001) (<.0001) (<.0001) (<.0001) (<.0001) (<.0001) (<.0001) (<.0001) (<.0001) (<.0001)
LEV 0.031 −0.106 0.126 −0.042 −0.036 0.021 0.038 −0.017 0.073 0.017
(0.029) (<.0001) (<.0001) (0.003) (0.010) (0.193) (0.007) (0.232) (<.0001) (0.231)
CON −0.081 −0.066 0.047 0.122 0.031 0.082 −0.018 0.192 −0.343
(<.0001) (<.0001) (0.001) (<.0001) (0.051) (<.0001) (0.212) (<.0001) (<.0001)
ARINV −0.056 −0.025 −0.061 0.004 −0.046 −0.013 0.032 −0.046
(<.0001) (0.076) (<.0001) (0.785) (0.001) (0.350) (0.021) (0.001)
LOSS −0.211 −0.119 -0.003 −0.098 0.047 −0.068 0.050
(<.0001) (<.0001) (0.818) (<.0001) (0.001) (<.0001) (0.000)
OWN 0.042 0.077 0.152 −0.033 0.171 0.003

32
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(0.003) (<.0001) (<.0001) (0.018) (<.0001) (0.849)


FOR 0.024 0.151 −0.051 0.161 0.009
(0.140) (<.0001) (0.000) (<.0001) (0.541)
OUT 0.048 0.005 0.218 0.002
(0.003) (0.739) (<.0001) (0.913)
BIG −0.084 0.189 0.007
(<.0001) (<.0001) (0.603)
FIRST −0.021 −0.023
(0.140) (0.097)
LIST −0.036
(0.011)
Notes: P-values are in parentheses. LNAH is the natural logarithm of the number of external audit hours; IANUM is the number of internal
auditors scaled by the total number of employees (working status, either full-time or part-time, is weighted so as to measure the number of
internal auditors as follows: 1 for full-time internal auditors and 0.5 for part-time internal auditors); IAFEE is internal auditor compensation
scaled by total amount spent on salaries; ACC is a dummy variable coded as 1 if an internal auditor is an accounting expert; LAW is a dummy
variable coded as 1 if an internal auditor is a legal expert; NEW is a dummy variable coded as 1 if an internal auditor is in his/her first year
with the firm; SIZE is the natural logarithm of market value; LEV is the ratio of total non-current liabilities to total assets; CON is the natural
logarithm of the number of consolidated subsidiaries; ARINV is the ratio of accounts receivable and inventory to total assets; LOSS is a
dummy variable coded as 1 if net income is negative; OWN is the percentage of majority shareholder ownership; FOR is the percentage of
foreign investor ownership; OUT is the ratio of outside directors to the total number of members on the board of directors; BIG is a dummy
variable coded as 1 if the auditor is one of the Big 4 accounting firms; FIRST is a dummy variable coded as 1 if this is the initial audit
engagement; LIST is a dummy variable equaling 1 if a firm trades its shares on the KSE, and 0 if it does so o
n the KOSDAQ; IFRS is a dummy variable equaling 1 if an accounting standard applied to a firm-year is among the International Financial
Reporting Standards (IFRS), and 0 if it is from the Korean Generally Accepted Accounting Principles (K-GAAP).

33
Table 4
Univariate Analysis: IA Characteristics and External Audit Hours
Variable Mean of AH N
IANUM HIGH 714 2,535
LOW 993 2,520
***
Diff.(T-value) −279 (−17.73)
IAFEE HIGH 844 2,528
LOW 864 2,527
Diff.(T-value) −20 (−1.22)
ACC 1 743 917
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0 878 4,138
***
Diff.(T-value) −135 (−7.70)
LAW 1 760 302
0 860 4,753
Diff.(T-value) −100 (−3.79)***
NEW 1 831 792
0 858 4,263
Diff.(T-value) −27 (0.21)
*** ** *
Notes: , , and represent significance at the 1, 5, and 10 percent levels, respectively.
IANUM is the number of internal auditors scaled by the number of total employees (working
status, either full-time or part-time, is weighted so as to measure the number of internal
auditors, as follows: 1 for full-time internal auditors and 0.5 for part-time internal auditors);
IAFEE is internal auditor compensation scaled by total salaries; ACC is a dummy variable
coded as 1 if an internal auditor is an accounting expert; LAW is a dummy variable coded as
1 if an internal auditor is a legal expert; NEW is a dummy variable coded as 1 if an internal
auditor is in his/her first year with the firm.

34
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Table 5
Multivariate Analysis: IA Characteristics and External Audit Hours
 =  + 
  +   +   +   +   +    +   +   +   
+ 
  + 

 + 
  + 
 ! + 
   + 
   + 
   + 
 
+ " #$%&&' + #$%&&' + ( (1)
Dep. = LNAH
Variable (1) (2) (3) (4) (5) (6)
Coeff. T-value Coeff. T-value Coeff. T-value Coeff. T-value Coeff. T-value Coeff. T-value
*** *** *** *** ***
Intercept 4.413 35.09 4.323 34.40 4.301 34.34 4.276 34.15 4.275 34.08 4.446 35.48 ***
***
IANUM -4.962 -8.11 *** -5.513 -6.98
IAFEE -2.066 -4.33 *** 0.431 0.70
*** ***
ACC -0.082 -4.88 -0.096 -5.73
*** ***
LAW -0.110 -4.09 -0.134 -4.96
NEW 0.009 0.49 0.013 0.72
SIZE 0.142 20.25 *** 0.147 21.04 *** 0.148 21.16 *** 0.150 21.53 *** 0.150 21.41 *** 0.140 20.01 ***
** *** *** *** *** *
LEV 0.156 2.14 0.212 2.91 0.232 3.20 0.237 3.26 0.239 3.28 0.142 1.95
*** *** *** *** *** ***
CON 0.191 7.02 0.182 6.66 0.175 6.40 0.172 6.29 0.175 6.39 0.187 6.90
*** *** *** ***
ARINV 0.063 1.45 0.119 2.74 0.144 3.37 0.144 3.36 0.147 3.42 0.056 1.27
*** *** *** *** *** ***
LOSS 0.081 5.31 0.074 4.81 0.072 4.70 0.076 4.97 0.072 4.68 0.085 5.54
*** ** ***
OWN -0.001 -2.54 ** -0.001 -2.54 ** -0.001 -2.69 *** -0.001 -2.64 -0.001 -2.55 -0.001 -2.85
** ** ** ** ** **
FOR 0.002 2.38 0.002 2.41 0.002 2.29 0.002 2.33 0.002 2.46 0.002 2.05
*** *** *** *** *** ***
OUT 0.210 5.55 0.221 5.81 0.205 5.40 0.206 5.43 0.210 5.52 0.196 5.19

35
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BIG 0.271 20.00 *** 0.274 20.17 *** 0.279 20.60 *** 0.279 20.55 *** 0.278 20.44 *** 0.274 20.31 ***
FIRST 0.023 1.23 0.020 1.07 0.019 0.99 0.020 1.07 0.019 0.99 0.023 1.26
*** *** *** *** ***
LIST 0.200 13.10 0.196 12.78 0.189 12.34 0.191 12.47 0.190 12.41 0.199 13.06 ***
*** *** *** *** *** ***
IFRS 0.417 5.00 0.422 5.04 0.436 5.21 0.431 5.15 0.428 5.10 0.433 5.22
Industry
Included Included Included Included Included Included
Dummy
Year
Included Included Included Included Included Included
Dummy
Adj-R² 36.48% 35.88% 35.95% 35.86% 35.65% 37.14%
*** *** *** *** ***
F-value 96.16 93.72 93.99 93.62 92.77 87.23***
N 5,055 5,055 5,055 5,055 5,055 5,055
*** ** *
Notes: , , and represent significance at the 1, 5, and 10 percent levels, respectively. LNAH is the natural logarithm of the number of
external audit hours; IANUM is the number of internal auditors scaled by the total number of employees (working status, either full-time or
part-time, is weighted so as to measure the number of internal auditors, as follows: 1 for full-time internal auditors and 0.5 for part-time
internal auditors); IAFEE is internal auditor compensation scaled by total amount spent on salaries; ACC is a dummy variable coded as 1 if an
internal auditor is an accounting expert; LAW is a dummy variable coded as 1 if an internal auditor is a legal expert; NEW is a dummy
variable coded as 1 if an internal auditor is in his/her first year with the firm; SIZE is the natural logarithm of market value; LEV is the ratio
of total non-current liabilities to total assets; CON is the natural logarithm of the number of consolidated subsidiaries; ARINV is the ratio of
accounts receivable and inventory to total assets; LOSS is a dummy variable coded as 1 if net income is negative; OWN is the percentage of
majority shareholder ownership; FOR is the percentage of foreign investor ownership; OUT is the ratio of outside directors to the total
number of members on the board of directors; BIG is a dummy variable coded as 1 if the auditor is one of the Big 4 accounting firms; FIRST
is a dummy variable coded as 1 if this is the initial audit engagement; LIST is a dummy variable equaling 1 if a firm trades its shares on the
KSE, and 0 if it does so on the KOSDAQ; IFRS is a dummy variable equaling 1 if an accounting standard applied to a firm-year is among the
International Financial Reporting Standards (IFRS), and 0 if it is from the Korean Generally Accepted Accounting Principles (K-GAAP).

36
Table 6
IA Characteristics and External Audit Hours:
Effect of Initial External Audit Engagement
 =  + 
  +   +   +   +  
+    ×   +   ×   +   ×  
+   ×   + 
  ×   + 

  + 
 
+ 
  + 
   + 
  + 
  + 
 
+ 
   + 
 ! +    + 
  +  
+ " #$%&&' + #$%&&' + (
Dep. = LNAH
Variable
Coeff. T-value
Intercept 4.461 35.60***
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IANUM -4.787 -5.84***


IAFEE 0.228 0.35
ACC -0.099 -5.55***
LAW -0.134 -4.59***
NEW 0.005 0.28
IANUM×FIRST -14.406 -3.43***
IAFEE×FIRST 2.841 0.97
ACC×FIRST 0.030 0.63
LAW×FIRST 0.021 0.28
NEW×FIRST 0.042 0.91
SIZE 0.139 19.83***
LEV 0.137 1.89*
CON 0.187 6.90***
ARINV 0.051 1.16
LOSS 0.086 5.64***
OWN -0.001 -2.89***
FOR 0.002 2.07**
OUT 0.196 5.20***
BIG 0.272 20.18***
FIRST 0.079 2.46**
LIST 0.198 13.03***
IFRS 0.433 5.22***
Industry Dummy Included

37
Year Dummy Included
Adj-R² 37.31%
F-value 76.53***
N 5,055
*** ** *
Notes: , , and represent significance at the 1, 5, and 10 percent levels, respectively.
LNAH is the natural logarithm of the number of external audit hours; IANUM is the number
of internal auditors scaled by the total number of employees (working status, either full-time
or part-time, is weighted so as to measure the number of internal auditors, as follows: 1 for
full-time internal auditors and 0.5 for part-time internal auditors); IAFEE is internal auditor
compensation scaled by total amount spent on salaries; ACC is a dummy variable coded as 1
if an internal auditor is an accounting expert; LAW is a dummy variable coded as 1 if an
internal auditor is a legal expert; NEW is a dummy variable coded as 1 if an internal auditor
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is in his/her first year with the firm; SIZE is the natural logarithm of market value; LEV is the
ratio total non-current liabilities to total assets; CON is the natural logarithm of the number of
consolidated subsidiaries; ARINV is the ratio of accounts receivable and inventory to total
assets; LOSS is a dummy variable coded as 1 if net income is negative; OWN is the
percentage of majority shareholder ownership; FOR is the percentage of foreign investor
ownership; OUT is the ratio of outside directors to the total number of members on the board
of directors; BIG is a dummy variable coded as 1 if the auditor is one of the Big 4 accounting
firms; FIRST is a dummy variable coded as 1 if this is the initial audit engagement; LIST is a
dummy variable equaling 1 if a firm trades its shares on the KSE, and 0 if it does so on the
KOSDAQ; IFRS is a dummy variable equals 1 if an accounting standard applied to a firm-
year is among the International Financial Reporting Standards (IFRS), and 0 if it is from the
Korean Generally Accepted Accounting Principles (K-GAAP).

38

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