The aim of this study is to investigate how the board of directors, audit committee (AC), external auditor and management explain the outsourced internal audit function (IAF) practice. Although prior studies provide some insights into the determinants of IAF, we have little understanding of how their characteristics are associated with outsourced IAF. Using 767 observations from an emerging market, we find that board independence and AC accounting expertise are negatively associated with outsourced IAF. We also observe a positive association between board expertise, AC independence, CEO with accounting expertise, and the size of the external audit firm and outsourced IAF. Corroborating these findings, additional tests show that the type of outsourced IAF provider, either big4 or non-big4, plays a significant role in these associations. We also extend the recent literature on the governance role of an AC chair with accounting expertise and report that a chair with accounting expertise is associated with outsourced IAF if the provider is a big4 audit firm. These findings may serve a large number of stakeholders who are interested in audit practices in general and IAF practices in particular.
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In the period preceding well known corporate scandals (e.g., Enron; WorldCom), most capital markets allowed companies to purchase IAF services from their external auditor. This is no longer permissible, and any outsourcing must be to a third party other than the external auditor.
We follow Baatwah et al. (2015) concerning why these two characteristics are chosen. For example, they noted that tenure and financial expertise can reflect other characteristics of the CEO, such as education, career background, and experience. Further, we believe these characteristics will influence the CEO’s decision in regard to outsourcing IAF because they may equip him/her with qualifications which undermine the expected benefits from in-house IAF. For example, the tenure of the CEO in the company will increase his/her knowledge and experience about business and operations, industry indicators, and most threats and opportunities surrounding the company. This knowledge and experience may motivate the CEO to hesitate in investing in IAF, and focus investment on the core-business process.
We observe 30 observations during the sample period co-sourcing the IAF. However, these observations do not disclose how many IAF activities are outsourced to external providers. Therefore, we consider these observations as in-house IAF. For robustness, we delete these observations and report quantitatively similar results. Further, we add these observations to our outsource IAF measure and find that all results are identical to the main results, except that board independence in the main model becomes insignificant.
We should note that the explanatory power of our model is higher than most prior evidence. For example, Abdolmohammadi (2013) reported that the included explantory varaibles explain 18% of outsourcing IAF decisions. Similarly, Abbott et al. (2007) reported 11% as the explantory power of their model. However, Carey et al. (2006) revealed higher explantory power, 44%, although we attribute this to the small sample of only 99 observations.
In untabulated results, we find that 10% of our sampled observations have IAF provided by big4 audit firms, whereas 46% use non-big4 audit firms.
We recognize that the literature (e.g., Cassell et al. 2013; Boone et al. 2010; Francis et al. 2013) found that second-tier non-big4 audit firms, especially Grant and BDO, provide high-quality audit. Thus, we replace the OUTIAFNBIG4 measure by a second-tier IAF provider (OUTIAFSCNDTIR) measure which equals 1 if the IAF provider is Grant or BDO, 0 otherwise. In the unreported results, we find that on average, 15% of sampled observations outsource their IAF to second-tier audit firms. We also find results consistent with those reported in columns 4 and 5, except that BODEXPT, ACACEXPT, and ACSZ are not significantly associated, and that BODSZ and ADFINEXPT are negatively associated with second-tier audit firms.
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Baatwah, S.R., Al-Qadasi, A.A. Determinants of outsourced internal audit function: a further analysis. Eurasian Bus Rev 10, 629–659 (2020). https://doi.org/10.1007/s40821-019-00142-9
- Outsourced IAF
- Board of directors
- Audit committee
- External auditor
- Emerging market