The Nature, Impact and Facilitation of External Auditor Reliance on Internal Auditing

INTRODUCTION The growth of internal auditing over the years has led to much consideration for relying on internal audit work by external auditors. This paper discusses issues relating to ways in which external auditors rely on internal audit work, the impact of such reliance on external audit fees, and facilitating reliance. The contributions of this paper are that it synthesizes and integrates three diverse literatures--professional audit standards, surveys from practice-oriented sources, and findings from academic research studies--and analyzes the issues by providing recommendations, including examples that serve as recommendations, for guidance to internal and external auditors. As background, the first section of the paper provides an overview of how internal auditing has developed in recent decades. The second section discusses three ways in which external auditors typically rely on the internal audit function. In the third section, the corroboration of internal audit work is addressed The fourth section discusses how internal audit work affects external audit fees, the fifth section deals with coordination of internal and external audit work, and the sixth section contains comments about communication issues. The final section summarizes and offers concluding remarks. GROWTH OF INTERNAL AUDITING Events since the mid-1970s have contributed to the growth of internal auditing. The Foreign Corrupt Practices Act of 1977 mandated public companies to establish and maintain effective internal accounting controls to provide reasonable assurance that assets are safeguarded and that transactions are properly authorized and recorded. To accomplish this, many companies established internal audit functions, increased internal audit staffing, and strengthened internal audit independence. Beasley et al. (2000) show that these investments in internal auditing have been effective, as companies with internal audit staffs are less prone to financial fraud than companies without internal auditing. Also, Coram et al. (2008) find that organizations with internal audit staffs are more likely than those without internal auditing to detect and self-report occurrences of fraud. In 1987, a report by the Treadway Commission recommended that public companies establish an internal audit function to be fully supported by top management and have effective reporting relationships. This means that "the internal auditors' qualifications, staff, status within the company, reporting lines, and relationship with the audit committee of the board of directors must be adequate to ensure the internal audit function's effectiveness and objectivity (Treadway Commission, 1987, p. 11). " The report urged that the internal audit function be "staffed with an adequate number of qualified personnel appropriate to the size and the nature of the company (Treadway Commission, 1987, p. 37). " The New York Stock Exchange enacted a requirement in 2003 that all listed companies must have an internal audit function, either in-house or outsourced. This requirement was approved by the Securities and Exchange Commission (SEC) later in that year. The Sarbanes-Oxley Act of 2002 has also contributed to the growth of internal auditing. "Internal auditors have enjoyed increased prominence, higher salaries, and a greater public appreciation for the role that internal auditing can play in a well-governed organization (Hermanson, 2006). " In particular, companies are using internal auditors to strengthen and evaluate their internal control systems to comply with the internal controls provisions of Sarbanes-Oxley. A 2003 survey by The Institute of Internal Auditors indicated that 20% of companies included in the Fortune 1,000 did not yet have internal audit departments but 50% of the Fortune 1,000 companies planned to increase their internal audit staffs to comply with Sarbanes-Oxley (Harrington, 2004). A later survey of 117 chief audit executives of public companies subject to the provisions of Sarbanes-Oxley indicated that 111 reported their companies increased internal audit budgets from 2002 to 2005 (Kaplan & Schultz, 2006). …