FIJI

NATIONAL
UNIVERSITY
ACC802: ADVANCED AUDITING & ASSURANCE

THEME: EXTERNAL AUDITORS RELIANCE ON THE WORK

OF INTERNAL AUDITORS

ACC802 -Assignment 1 Trimester 3, 2018 Elizabeth T.T.Teatu

Page 1
 ABTRACT

External auditors often rely on other professionals for the audit of the financial statements of their clients.
Generally, external auditors rely on clients internal auditors. Reliance on internal audit will reduce cost
savings to the client. The main purpose of this study is to find out why external auditors are reliance on the
work of an internal audit and what are that factors that may impact the decision of external auditors to rely
on the work of an internal audit. External auditors rely on the work of an internal audit to reduce the external
audit time and fees. ISA 610 outlines the auditor’s responsibilities in relation to using the work of internal
auditing. It evaluates the effect of internal auditor’s objectivity, competence and work performance which
can influence external auditor’s decisions to rely on the work of an internal audit. Further discuss, this study
will provide some major developments through the revised ISA to better reflect the current internal auditing
environment. Consideration should be given to the increased reliance that external auditors place on the
work of internal auditors and to situations when the internal audit function is outsourced. However, it is
important that auditors are in compliance with the code of professional ethics and enhancing auditor’s
integrity and independence in order to maintain audit quality.

Keywords: Objectivity, Competence, Work performance, Integrity, independence, internal audit, audit
quality

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INTRODUCTION

External auditor reliance on the work of internal audit is relevant to any organization seeking to secure
increased value from its internal audit function. Auditing is being defined as a process of evaluating the
accounting information presented in the financial statements of the Organization. It ensures that financial
reports are accurate, fairly presented, ethically prepared and whether reports are in compliance with the
accepted accounting principles and standards. Not only based on financial reports but used for taxation
purposes and also reveals any misuse of funds, any dishonest business activities, and misrepresentation in
financial statement. However, there are internal audit and independent audits which is also known as
external auditors who are always reliance on the work on internal audit. In particular, internal auditor’s
objectivity, competence and work performance can influence external auditor’s decisions to rely on the
work of an internal audit.

Internal audits are usually conducted by the organization to make sure that the financial records are in
compliance with auditing standards. By law, many commercial and non- profit organization around the
world must be independently audited. To meet this requirement, independent audit (External auditors) will
review the work of an internal audit so that the firm may obtain an unbiased view of its financial statements
and ensure that data provides are true and fair representation of the firm’s financial status. After completing
an audit, the organization management team must review the audit findings to ensure that they are
adhering to rules, codes of practice, business ethics, internal guidelines and principles.

In addition, auditors should place a strong emphasis on quality audit work and professional skepticism. In
order to meet this, they must maintain fundamental principles which are; integrity, objectivity, professional
competence and due care, confidentiality and professional behavior. They must perform their task properly
by having an enquiry mind as they need to question reliability of documents, information, explanation
provided by management, critically challenging management judgments and being alert to contradictory
evidence identifying and responding to risk of fraud. Audit managers were asked to modify a preliminary
time budget for completing the audit in which they could be told that the preliminary budget was appropriate
unless the manager was willing to rely on work already completed by the client’s internal auditors which
was described as questionable. If audit client want to lower audit fees, managers should decreased audit
hours, thus the work of an external auditor may not be based on quality audit work and professional
skepticism.

Moreover, experts agree that external auditors will rely more on the work of internal auditors. Internal
auditors perform similar procedures and assessments as external auditors on a more continual basis and
they are commonly viewed as qualified, objective and somewhat independent from the corporate side of
the business. Reliance by external auditors on the procedures performed by internal auditors will allow
them to dedicate more time to riskier issues/areas of a company. This shift could lead to a reduction in
audit time and consequently audit costs.

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LITERATURE REVIEW

Relying on the work of internal audit refers to using their work in preparing for and conducting an external
audit. This work can include past reports and documentation produced by internal audit as well as using
internal audit as assistants or advisers for the external audits (Rusak & Johnson, 2007).According to John
(2013), he differentiate internal auditors as those auditors who work within an organization or firms and
report to its audit committees and/ or board of directors whereas External auditors are independent of the
organization they are auditing which report to the company’s shareholders.

According to the Blue Ribbon Committee (1999), they present a report stating that the three-legged-stool of
corporate governance are audit committees , internal audit and external audit which help ensure reliability
of financial reports. Many researchers also stated that internal audit and external audit help enhance audit
committee effectiveness by serving as a resource to boards of directors ( DeZoort et al.2002). Internal
audit is a crucial resource in a corporate governance system as it provides services to the other three
components of corporate governance (Gramling et al..2004: DeZoort et al.2002). International Standards
on Auditing (ISA) 610 provides guidelines on external auditor’s consideration of internal audit work in the
conduct of financial statement audits.

Previous researchers argue that external auditor’s reliance on internal audit work could produce a
significant cost saving through reduction of external audit time. They stated that external auditors assess
the work of an internal auditor to determine their reliance on internal audit. Such reliance is also considered
as an area where internal audits adds value through reduced audit fees (Krishnamoorthy, 2001, Morrill and
Sneak, 2003; Mihret 2010; Mihret, James and Mula 2010). The intention to reduce external audit costs in a
bid to reduce audit fees and maintain competitiveness in the audit service market motivates external
auditor’s decisions to rely on internal auditors work (Morrill and Sneak, 2003). When the client did not
express a preference for lower audit fees, managers still reduced planned hours, despite the questionable
quality of the internal auditors’ work (O’ Kneefe et, 1994). John (2000) pointed out that reducing hours is a
way of lowering fees, which might make managers’ firms more competitive in the market, even if reducing
audit hours compromises audit independence and effectiveness.

Furthermore, the extent of the reliance external auditors can place on the work performed by others is
determined by competency of the internal audit function, objectivity of the internal audit function, scope of
audit, period of audit coverage quality of deliverables and timing of deliverables (Mihret 2010).. Internal
audit should play a very significant but advisory role in the compliance project. Documentation is very
important because External Audit engagement team will need to indicate that controls are operating
effectively based on the examination of the Internal Audit’s documentation (Morill and sneak 2013).

In addition, identifying a significantly higher audit risk for an audit client leads to increases in audit fees,
although there is no evidence that the increased effort is connected to the internal audit deficiency (Felix et
al. 2001, Hackenbrack and Kneckel 1997, O’Kneefe et al. 1994). Recent studies confirm a correlation
between increased auditor fees and labor hours which finds that auditors increase the tests performed, and
consequently the total labor hours, for clients with an identified internal control deficiency in an effort to
lower inherent and information risks of the audit (Hogan and Wilkings 2008).

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Internal control deficiencies also have an impact on external auditor reliance on internal audit work.
External auditors are willing to rely more on internal audit work in a continuous audit environment than in a
traditional environment, and this effect is exaggerated when the prior year audit report on the effectiveness
of internal controls indicates that controls were working properly. Felix (2001) pointed out that by the
deficiency in internal controls over financial reporting been discovered can affect the reliance of the work of
internal audit. Auditors are not responsible for designing or creating internal controls procedure as this was
supposed to be done by the management team. Previous researchers revealed that communication
between internal auditors and external auditors, prior cases of fraud or significant financial misstatement
identified, expectation of future strategic financial transactions ( e.g merger) and the degree of corporation
between internal audit and external audit also had an impact on external auditors decision to rely on the
internal audit work (Felix et al. 2001, Hackenbrack and Kneckel 1997, O’Kneefe et al. 1994). However,
such factors may increase the risk of the external audit (e.g, prior cases of fraud, future mergers) and might
conceivably change the way external auditors make judgments (Hogan and Wilkings (2008).

According to Felix (2001), he argues that reliance decision of the external auditor has important economic
consequences and implications for efficiency and effectiveness of the overall audit. In accordance with
these findings, the Public Company Accounting Board (PCAOB) issued Auditing Standard No. 5 urging
external auditors to make more noteworthy utilization of work completed by the internal auditor (PCAOB
2007)( Bedard 1989). Several researchers’ studies examined the degree of reliance of external auditors
work on the work of internal audits, particularly in relation to internal audits objectivity, competence and
work performance. They rank the three factors in order of importance that objectivity of internal audits had
the greatest effect on the external auditors’ reliance on the work of an internal auditor. The second most
important factor was competence and the least influential factor affecting reliance on the work of internal
audits was work performance. (Felix 2001, Rusak and Johnson 2007, Gramling 2004).

Findings from previous studies stated that addressing material weaknesses identified during the annual
audit provides mixed results regarding external auditor’s reliance on internal audit’s work (Bedard 1989,
Mock and Wright 1993, John 2000). More recent studies highlight a correlation between higher quality
internal audit functions and lower likelihoods of material weaknesses, as well as management being less
likely to manipulate earnings (Gramling 2004) .With respect to the objectivity of internal audit, it can be
argued that auditors, whether external or internal can never be totally independent and free of bias or other
considerations (Rusak and Johnson 2007). Auditors are required by international audit standards to be free
enough such that their ability to expressed an unbiased audit opinion is not significantly compromised
(John 2000).

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Major Developments

Some of the developments that are needs to be done are the need to revise the ISA to better reflect the
current internal auditing environment. The institutes of internal auditors (IIA) needs to clarify further the
roles and responsibilities of internal auditors in the context of the external audit. The extent ISA 610 1 was
last revised in March 1994. Conforming amendments were made to the standard when the IAASB issued
the audit risk standards (ISAs 3152, 3303 and 5004) in October 2003. Since the extant ISA 610 was last
revised, there have been developments in the internal audit function that have resulted in changes to the
work requirements of internal auditors. (ISA 610, Revised: Using the work of internal auditors)

 IAA has developed its International Professional Practices Framework which includes a revised
definition of internal auditing, Code of ethics and international standards for the professional Practice of
international auditing. Redrafting the extant ISA 610 suggest that a number of the references to internal
audit activities in the extant ISA are inconsistent with the IIA’s international standards on internal
auditing.
 External auditors tend to employ the assistance of internal auditors in number of areas such as
identifying key risks facing the entity, assessing the effectiveness of mitigating controls, providing
insight into the adequacy of financial controls and executing a risk based audit plan addressing
financial risks and relevant IT controls.
 The external auditor will be guided by a strengthened framework, focused on the necessary attributes
of a well-functioning internal audit function (objectivity, competence and application of a systematic and
disciplined approach), for determining whether the work of the internal audit function can be used for
purposes of the audit.
 The external auditor may obtain the direct assistance of internal auditors on the audit engagement to
perform procedures that would otherwise be performed by the external auditors themselves. The
internal audit function will be expected to assist the external auditor in accessing and understanding the
relevant reports relating to the work of the internal audit function that the external auditor plans to use.
 Threats to the perceived independence of the external auditor may be created if the direct assistance
of internal auditors are obtain for purposes of the audit because internal auditors are not independent
of the entity as is required of the external auditor in an audit of financial statements.

1 ISA 610, “ Considering the work of internal audit”

2 ISA 315 “Understanding the entity and Its environment and assessing the risk of material Misstatement.

3 ISA 330, “ The Auditor’s Procedures in Response to assessed Risks”

4
ISA 500 “ Audit Evidence”

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Conclusion

When the entity has an internal audit function and the external auditor expects to use the work of internal
auditors to modify the nature or timing, or reduce the extent, of audit procedures to be performed directly by
the external auditor, they have to determine whether to use the work of the internal audit function in
obtaining audit evidence or to use internal auditors to provide direct assistance, and if so, in which areas
and to what extent and having made that determination. If using the work of the internal audit function in
obtaining audit evidence, they have to determine whether that work is adequate for purposes of the audit.
Objectivity, competence and work performance are three main influential factors that impact the decision of
external auditors in reliance to the work of an internal audit. Auditors should be free enough that when
expressing an unbiased audit opinion must not be compromise. Internal auditors must possess the
knowledge, skills and other competencies needed to perform the work in accordance with auditing
standards. They must apply develop and document working programs that achieve the engagement
practices. However, it is important that auditors maintain ethical principles and professional skepticism.

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