What extent of cooperation that external auditors receive from internal control and client organization’s management permissible to retain independence?

An assessment of how poor internal controls impact the role of external audit.  A literature-based investigation.

1 Introduction:

The scope and visibility of internal audit controls of large organizations in the US and across the globe, significantly altered after the Sarbanes-Oxley (SOX) Act in 2002. Within the UK, the Turnbull Report, published in 1999, changed the way organizations control internal processes and report them (Rajab and Handley-Schachler, 2009). A strong focus on risk management in the Turnbull Report stressed the significance of internal audit guidance in the UK (Selim, Woodward and Allegrini, 2009). Internal audit has hence come under the limelight as an important and intrinsic component of corporate governance. Therefore, the extent of progress made by organizational internal audit functions is a topic of interest. Furthermore, the impact of the controls on external auditor functions is a critical subject.

1.1 Background of the study:

The Committee of Sponsoring Organization (COSO, 2004) defines internal control as: “a process, effected by an entity’s board of directors, management and other personnel designed to provide reasonable assurance regarding the achievement of objectives in the following categories: effectiveness and efficiency of operations, reliability of financial reporting and compliance with applicable laws and objectives’’ It aligns corporate goals and disclosure requirements (Rae and Subramaniam, 2008).

The primary role of the audit committee is to act as a consulting body of the supervising arm that oversees financial reporting (Delloite, 2018).  It monitors the annual statements, assess business risks and checks on the business risk management techniques. Under the oversight function, it should advise the management on identification and determination of appropriate accounting policies, judgments and estimates (Tusek, 2014). For instance, NYSE listing standards require the organizations’ audit committees to have a voice in reviews of major issues. Such aspects include the changes in the accounting principles, internal controls and any special steps adopted in material control deficiencies (Delloite, 2018).

A more operational duty of the unit is to monitor the internal and external auditing procedures (Tusek, 2014). Clearly, the two functions must work closely in collaboration to achieve the above responsibilities.  The internal audit and audit committees operate under stringent codes. In spite of this, there have been multiple reports of employee financial fraud at the management level that costs organizations millions of pounds annually (Norman, Rose and Rose, 2010). It poses strong questions for organisational internal control and mandatory audit committees that monitor the systems.

Delloite (2018) reaffirms the central role of the board as delegated to the audit committee in ensuring effective corporate governance through over sighting internal control. For instance, it clarifies the ethical and integrity expectations, operational code of conduct and instances of conflict of interest (PCAOB, 2019). Besides, the board is tasked with ensuring the operation of alternative modes of information flow such as whistle blowers. The above duties placed on the body weighs so much on the outcomes of the internal financial control processes executed by the management.

1.2 Research Problem:

Section 404 of the Sarbanes-Oxley Act (SOX) and the Public Company Accounting Oversight Board (PCAOB) acted to facilitate transparency. The above requires the external audit is responsible for the giving reliable audit statements. Performing the duty requires much cooperation from the management represented by the internal audit and the oversight committee.  Some significant research has been done on how internal audit functions assist external auditors. The degree of reliance that can be placed by these external auditors on internal audit reports has been explored. However, the practice regarding the treatment of deficient financial material is not clear. The aim of the study is to examine the way external auditors corroborate the evidence of poor internal control in organizations. Therefore, it will assess the practices adopted by external auditors in evaluating corporate activities and assessing internal audit reports for presentation of final audit statements. Furthermore, it will establish the communication between the audit functions as well as the degree of cooperation that exists between the two in order to perform independent audits.

 

1.3 Aim and Objectives of the study:

The main aim of the study is to examine the manner in which external auditors verify the evidence of poor internal control in organizations. In order to fulfill the purpose, the following objectives are proposed:

• To explore the degree of external auditors’ reliance on internal audit control of organisations
• To analyze the communication barriers between external and internal auditors that lead to poor internal audit control
• To assess the extent of cooperation that external auditors receive from internal control and management teams for effective organizational audit
• To establish the procedures adopted in corroborating poor internal control evidence of organizations.

2 Literature review:

The field of auditing has received much attention from the academic studies of enhancing the corporate governance. Particular areas of interest have been the efficacy and effectiveness of internal financial control processes in the contemporary business world. However, a significant number of authors have examined the implications of engaging independent auditors.   The gaps in literature regarding the manner of corroborating poor internal controls in organizations will be established by the section.

According to the International Auditing Standards (IAS) and the Statement on Auditing Standards (SAS), external auditors have the final responsibility of auditing financial reports. Irrespective of the reliance on the internal audit function, the duty cannot be shared by the IA. Therefore, the regulators established formalities that guide any form of drawing from the work of in-built organizational assessors.  According to Azad (2017), the standards reinforce a disciplined systematic approach to be used if any. Some of the significant attributes emphasized by the study is the objectivity and competence. Internal audit process and outcomes is much affected by a set of factors that would impact the reliance of users like eternal assessors. Professional and technical competence of the auditors is prerequisites. Secondly, the environmental conditions under which the process is done relate to aspects of integrity, fairness and ability to make sound judgments. Furthermore, the dedication of internal audit function to the organizational goals, consistency in the role, alertness and the critical attitude of the team affect the reliability of financial reports. The author also examined Jenny Stewart and Luis Munro’s evaluation of audit priorities of EA. For instance, the duo sought to establish the areas of interest that internal auditing serves to independent appraisals. Accordingly, the evaluators are inclined to determine the effectiveness of the internal control systems using the IA work than testing the account balances. Desai (2011) investigated the effect of outsourcing internal audit on reliance decision. The author posited that the external auditors likely to assess the professional competence and objectivity of an in-house team less favorably. On the other hand, the EA will likely rely on the work of the outsourced IA than the non-outsource IA. However, the findings were discounted by Stewart and Munro (2009) in earlier studies. In similar line of studies, Cohn (2011) examined both the internal and environmental factors that determine the EA reliance on the IA reports. The author supported other research findings that low risk areas can be agreed upon by both auditors unlike the tense matters. Furthermore, the author established that management pressure of the client company can directly affect the reliance decision of external auditors. Suwaidan and Qasim (2010) sought to examine the extent of reliance of the EA on the reports compiled by the IAF as well as determine the factors used by external auditors to make the decision. The findings of the duo complied with majority of research in the field. Besides the objectivity and competence of the in-house auditing function, the work performance was a vital aspect.

Paino et al (2017) assessed a new perspective of reliance based on the influence of the external auditors’ working style, communication barriers and the enterprise risk management. The authors established that only the obstacles to interaction and operational mode of the EA are significant. Aspects that presented barriers included the defensiveness and prejudices held by both teams, lack of trust, delaying or not giving feedback and resistance to change. The factors hindered effective cooperation and collaboration with the internal team. Consequently, they were negatively related to the reliance decision. Therefore, the authors supported the finding by other researchers that objectivity is the main factor. It affects the eternal auditors’ willingness to rely on the already undertaken work of the in-house audit function. However, the effectiveness of the client enterprise’s internal control systems had a moderating effect on the external audit reliance on internal auditors’ work.

Strong audit committees have a significant impact on quality of internal control and this positively impacts EA assessments (Khalif and Samaha, 2016). Cooperation is defined as an act of acting or working together to achieve a common benefit or pursue a purpose. It involves establishing elements of trust, open and honest communication, full commitment and teamwork. Besides, the cooperating parties should balance the social and business priorities (KPMG, 2017). The above elements build a good working relationship that facilitates proper reporting and risk management. Objective barriers of communication can also be mitigated by a proper framework of collaboration. Endaya (2014) argued that effective coordination and cooperation between internal and external auditors is beneficial to both players and the client organization. Accordingly, it reduces the applicable audit fees, increases the effectiveness and efficiency of an audit. For instance, it leads to attainment of the organizational objectives. Furthermore, the collaboration minimizes the disagreements between the independent examiner and the management on applicable accounting policies. Endaya (2014) also pointed out the impact on service to audit, detection of possible fraud and cost of the exercise. Cooperation enhances the willingness of the external auditors to rely on the in-house auditing team. However, the effect of collaboration on independence of the party raises questions on the desirable extent of teamwork. Grammling et al (2004) argued that corporate governance advocates for the coordination of the EA, IA, audit committees and the organizational management team. Although the auditors can be in a position to cooperate, the executive support is important (Endaya, 2014). A company that invests in the in-house financial controls builds an effective supervisory board. It enhances the internal audit objectivity that raises the confidence of the external examiners in the IA reports. On the other hand, absence of the transparency culture affects coordination and cooperation negatively. The audit committee plays a significant role between conjoining the stakeholders and corporate governance elements. Endaya (2014) postulated that effective communication is critical in developing a collaborative environment. According to Wood (2004), providing access to relevant internal audit reports and holding regular meetings ensure seamless interactions. Furthermore, an assessment of each other’s audit techniques, methods and arising issues ensures confidence between the teams. The author also argued that setting an overall tone of acceptance of results and implementation of recommendations would improve coordination (Endaya, 2014).  However, the authors failed to consider the ramifications of cooperation on the independence of the external auditor and reliability of audit statements. Therefore, more research is needed to determine the extent of support that external auditors receive from internal control and management teams for effective organizational audit.

Remediation of IA weaknesses is an important step for organization credibility and reputation. Often, when weak internal controls are highlighted, and audit committees are able to detect material weaknesses, remediation is sought so as to portray a fair financial picture. This ultimately has an important impact not only on stakeholder trust but also on the financial cost of capital of the organization and reflects its financially ethical and responsible behaviour and attitude. External auditors’ remediation of internal audit weaknesses is a sign of its degree of reliance on IA reports and on the accuracy of its own investigations (Ashbaugh-Skaife et al, 2009). Inattentiveness of external auditors to the errors in financial reporting internal control mechanisms and IA practices are considered within the context of financial fraud by many researchers. For instance, Di Fabrizio (2016) also hypothesized that inaction by external auditors in the context of mismanaged or fraudulent internal financial reporting may lead to replacement of the external auditors. The current literature has limited direction on treatment of poor internal controls.

 

3. Research Methodology

The study will adopt a descriptive qualitative design. It will utilize a systematic literature review. The method identifies, critically evaluates and integrates the findings of high quality and relevant studies that address the research question (Saltikov, 2012, p. 8). It seeks to solve the sampling variation that causes differences in same subject studies conducted by many researchers.  Furthermore, it will also identify the relations, gaps, contradictions and inconsistencies in current study findings. Finally, the systematic literature review will describe directions for future studies. Craig and Smith (2007) argued that the method is useful as a shortcut in establishing evidence-based process. Only relevant sources are identified, appraised and synthesized irrespective of the design used.

The study will be deductive in synthesis of existing literature as well as inductive in formulation of new theoretical frameworks out of the data.  Relationships between the reliance of external auditors on internal audit reports, communication barriers, coordination and corroboration of evidences of poor financial controls will be deduced.

A qualitative literature review will synthesize groups of methodically diverse studies that cannot be aggregated using the meta-analysis. For instance, it will facilitate critiquing the existing body of body of knowledge and developing a new theory.

3.2 The research questions:

The study will focus on the four major items.

1. To what extent is the external auditors’ reliance on internal control of organizations appropriate?
2. What communication barriers between the internal and external auditors lead to poor internal audit control?

• What extent of cooperation that external auditors receive from internal control and client organization’s management permissible to retain independence? And finally,

1. What are the effective processes adopted in corroborating the evidence of poor internal controls by external auditors.

3.3 The search plan:

An updated systematic review will be undertaken to fill the gaps in studies conducted ten years ago. In current times, technology has assisted scientific research and made electronic academic material more accessible. The study will employ the keyword practice, (Cronin, Ryan and Coughlan, 2008). It will construct a relevant list of keywords from the research question and aims. Additionally, alternate keywords will be used for electronic searches. Google Scholar will be used by the researcher as the online database the tool has been acknowledged as a source of peer-reviewed scholarly work. The inclusion/exclusion criteria define the parameters within which the academic studies to be extracted will be limited (Aveyard, 2014). For this study, the predetermined inclusion/ exclusion criteria can be seen below in appendix 1.

 

3.4 Paper assessment and presentation of findings:

The studies extracted will be tabulated in a Matrix. It will list out the research name and authors, its location, the aim, the methodology and relevant findings. The findings will be compared and contrasted with each other.  The dual basis of methodological rigor and results will be used to ascertain the quality of the conclusions derived.

 

4 Ethical considerations:

The main ethical considerations are regarding the analysis and interpretation of prior relevant research. It means that the researcher needs to ensure that he evaluates and establishes findings fairly. Secondly, if primary research is being reviewed, it would need to clarify whether it has obtained ethical approval for the investigation.

References

1. Altamuro, J. and Beatty, A., 2010. How does internal control regulation affect financial reporting?. Journal of accounting and Economics, 49(1-2), pp.58-74.
2. Ashbaugh‐Skaife, H., Collins, D.W., Kinney Jr, W.R. and LaFond, R., 2009. The effect of SOX internal control deficiencies on firm risk and cost of equity. Journal of Accounting research, 47(1), pp.1-43.
3. Cohen, A. and Sayag, G., 2010. The effectiveness of internal auditing: an empirical examination of its determinants in Israeli organisations. Australian Accounting Review, 20(3), pp.296-307.
4. COSO, 2004, “Enterprise risk management – integrated framework”, Committee of Sponsoring Organizations, available at: coso.org/Publications/ERM/COSO_ERM_Executive Summary.pdf, accessed on April 8 2019
5. Di Fabrizio, L.F., 2016. THE PATTERN OF FRAUDULENT ACCOUNTING: ETHICS, EXTERNAL AUDITING AND INTERNAL WHISTLE-BLOWING PROCESS. Journal of Governance and Regulation/Volume, 5(4).
6. Dyck, A., Morse, A. and Zingales, L., 2010. Who blows the whistle on corporate fraud?. The Journal of Finance, 65(6), pp.2213-2253.
7. Estep, C., 2017. Auditor Integration of IT Specialist Input on Internal Control Issues: How a Weaker Team Identity Can Be Beneficial.
8. Goh, B.W. and Li, D., 2011. Internal controls and conditional conservatism. The Accounting Review, 86(3), pp.975-1005.
9. Khlif, H. and Samaha, K., 2016. Audit committee activity and internal control quality in Egypt: does external auditor’s size matter?. Managerial Auditing Journal, 31(3), pp.269-289.
10. Kristo, E., 2013. Survey on bank internal audit function. European Scientific Journal, ESJ, 9(13).
11. Norman, C.S., Rose, A.M. and Rose, J.M., 2010. Internal audit reporting lines, fraud risk decomposition, and assessments of fraud risk. Accounting, Organizations and Society, 35(5), pp.546-557.
12. Okaro, S.C., Okafor, G.O., Nwanna, I.O. and Igbinovia, I.M., 2017. Empowering the Internal Audit Function for Effective Role in Risk Management: A Study of Micro Finance Banks in Anambra State, South East, Nigeria. International Journal of Academic Research in Accounting, Finance and Management Sciences, 7(3), pp.14-23.
13. Rae, K. and Subramaniam, N., 2008. Quality of internal control procedures: Antecedents and moderating effect on organisational justice and employee fraud. Managerial Auditing Journal, 23(2), pp.104-124.
14. Rajab, B. and Handley-Schachler, M., 2009. Corporate risk disclosure by UK firms: trends and determinants. World Review of Entrepreneurship Management and Sustainable Development.
15. Said Suwaidan, M. and Qasim, A., 2010. External auditors’ reliance on internal auditors and its impact on audit fees: An empirical investigation. Managerial Auditing Journal, 25(6), pp.509-525.
16. Selim, G., Woodward, S. and Allegrini, M., 2009. Internal auditing and consulting practice: A comparison between UK/Ireland and Italy. International Journal of Auditing, 13(1), pp.9-25.
17. Skaife, H.A., Veenman, D. and Wangerin, D., 2013. Internal control over financial reporting and managerial rent extraction: Evidence from the profitability of insider trading. Journal of Accounting and Economics, 55(1), pp.91-110.
18. Soh, D.S. and Martinov-Bennie, N., 2011. The internal audit function: Perceptions of internal audit roles, effectiveness and evaluation. Managerial Auditing Journal, 26(7), pp.605-622.
19. Stewart, J. and Subramaniam, N., 2010. Internal audit independence and objectivity: emerging research opportunities. Managerial auditing journal, 25(4), pp.328-360.
20. Suwaidan, M. S., & Qasim, A. 2010. External auditors’ reliance on internal auditors and its impact on audit fees An empirical investigation. Managerial Auditing Journal, 25(6): 509-525.
21. Zain, M.M., Subramaniam, N. and Stewart, J., 2006. Internal auditors’ assessment of their contribution to financial statement audits: The relation with audit committee and internal audit function characteristics. International Journal of Auditing, 10(1), pp.1-18.
22. (2018). The role of the audit committee. London: Center for Board Effectiveness.
23. Endaya, K. (2014). Coordination and Cooperation between Internal and External Auditors. Research Journal of Finance and Accounting, 5(9), 76-80.
24. (2017). A Case For Cooperation Between the Audit Committee and Management. London: ICPAK.
25. Paino, H., Jabar, F., & Razali, F. (2015). The Influence of External Auditor’s Working Style, Communication Barriers and Enterprise Risk Management toward Reliance on Internal Auditor’s Work. Procedia Economics and Finance, 28(15), 151-155.
26. (2019, April). AS 2201: An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements . Retrieved April 30, 2019, from Public Company Accounting Oversight Board: https://pcaobus.org/Standards/Auditing/Pages/AS2201.aspx
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28. Tusek, B. (2014). The influence of the audit committee on the internal audit operations in the system of corporate governance – evidence from Croatia. Economic Research, 28(1), 187-203.

Appendix 1

Inclusion criteria	Exclusion criteria
Only English language papers to be used.	Academic studies in language other than English not to be consulted.
Only papers that speak about internal control weaknesses, reliance on internal audit works, communication barriers, coordination, corroboration of evidence of poor financial controls and external auditor responses will be extracted.	Papers that consider different internal audit issues not to be extracted.
Articles with concepts related to internal audit reports, coordination, corroboration, validation of internal control systems, barriers to communication, external audit feedback will be included.	Papers with other terms not related to auditing will be excluded.
Only papers that had key variables as external auditor reliance on internal audit works, objectivity, communication barriers, cooperation, evidence of poor internal controls among other related factors will be included.	Academic articles with variables not related to the stated ones will be excluded.
The paper will include papers with all research designs.	Articles with experimental designs will be excluded.