Abstract

Authoritative standards encourage external auditors to coordinate their efforts with the client’s internal audit function (IAF) as part of a financial statement audit. Academic research on this relationship finds that it has the potential to improve audit quality and efficiency. The objective of this research is to better understand how coordination can impact the external auditor’s decision to rely on the IAF. Prior research has shown that the reliance decision is complex and involves several factors that must be considered simultaneously. In this study, we surveyed external auditors to better understand the benefits of coordinating efforts, the antecedents to successful coordination, and the elements that potentially inhibit external auditors from relying on the work of internal auditors. We find that external auditors are coordinating with the IAF to achieve more efficient and effective audits. The degree of this reliance, however, does vary between audits and is largely dependent upon the perceived competence and objectivity of the IAF as well as effective communication. Our findings are informative to external audit practitioners and their decision to rely on IAFs and work towards a successful arrangement where the integrated audit is applied more efficiently and effectively. This additional insight also helps inform and direct future research into external auditors’ coordination decisions.

Introduction

High-quality financial statement audits largely depend on practitioners reaching appropriate judgements and decisions based on their clients’ circumstances. Auditing standards issued by the Public Company Accounting Oversight Board (PCAOB), the American Institute of Certified Public Accountants (AICPA), and the Institute of Internal Auditors (IIA) all emphasize the significance of effective communication and coordination between external auditors and a company’s internal audit function (IAF) to achieve an efficient and effective financial statement audit (e.g., CIIA 2020; CAQ 2015; ECIIA 2019; PCAOB 2024). While none of these standards explicitly mandate any particular arrangement, they all recognize the importance of understanding and considering the work performed by internal auditors. Academic research on this coordination, which is largely derived from experiment-based research designs, finds involvement by external auditors in developing the IAF’s work plans increases reliance and influences the evidence-gathering choices of external auditors (Pike et al. 2016; Felix et al. 2005). What is less understood are the elements that affect the individual judgments of external auditors as they make IAF reliance decisions. These are critical decisions as reliance determinations can vary significantly between audits and directly affect audit quality. Therefore, the purpose of this paper is to examine the circumstances that influence external auditors’ involvement and reliance decisions related to the client’s IAF, as well as the critical antecedents and challenges to coordination. To provide a deeper understanding of auditor involvement and reliance decisions, we survey external auditors related to their experience with IAF coordination and the subsequent impact on audit judgements related to quality and efficiency. Our findings are informative to practice as auditors continue to work towards the optimal level of involvement and coordination with the client’s IAF, to achieve an efficient and effective audit. We also contribute to the extant academia by providing external validity to some of the findings of prior research, identifying additional elements that enhance the reliance relationship between external and internal auditors, and highlighting some of the impediments to successful coordination, paving the way for future research.

Results

Question 1: In your audit experience, please describe the extent of the coordination you have had with the internal audit department of your clients?

Participants describe extensive coordination with the IAF, with 70.7% of the respondents indicating a medium to high level of coordination on most audit engagements. This coordination includes significant involvement in the planning, review, and suggested improvements to the IAF’s testwork. The purpose of these efforts is to align testing approaches, establish sample sizes, and assess the competence and objectivity of IAF. Some respondents highlight challenges related to maintaining independence and encountering issues with the IAF’s competencies. For example, a participant mentioned the importance and challenges of coordination in a resource-limited scenario:

[I] worked with a mid-market public client that devoted limited resources to designing, testing, and monitoring their internal control environment. I worked closely with them [the IAF] to ensure they were compliant with the SOX 404 requirements. Independence was maintained, but at times we may have come close to the boundaries of those rules.

Abstract

he purpose of this study is to investigate how the level of controls testing coordination with the external auditor affects internal auditors’ effort. The internal auditor’s planned substantive testing audit hours are the measure of effort in this study. Regulators and stakeholder organizations have encouraged more collaboration between external and internal auditors to improve audit efficiency. The effect of external auditor coordination on internal auditors’ planned audit hours has important implications for audit efficiency and effectiveness. An experiment is conducted with 112 internal auditors to examine the hypothesized effect. The study uses a 2  2 between-subjects design and manipulates fraud risk and external auditor coordination. Consistent with my prediction, I find that coordination moderates the relationship between fraud risk and planned audit hours. The results illustrate that although high external auditor controls testing coordination decreases internal auditors’ planned substantive testing audit hours, internal auditors are more sensitive to responding to fraud risk when external auditor controls testing coordination is high.

Introduction

The Institute of Internal Auditors (IIA) and the American Institute of Certified Public Accountants’ (AICPA) Auditing Standards Board (ASB) provide guidance regarding the coordination between internal and external auditors. IIA standards state that the chief audit executive should coordinate activities with external providers of assurance (e.g., external auditors) to ensure proper coverage and minimize duplication of effort (Institute of Internal Auditors, 2017). The ASB’s Auditing Standard AU Section 322 (2003, paragraph 0.23) suggests that external auditors and internal auditors coordinate their work by “holding periodic meetings, scheduling audit work, providing access to internal auditors’ working papers, reviewing audit reports, and discussing possible accounting and auditing issues.” AU Section 322 also states that external auditors may request direct assistance from internal auditors with external auditors supervising, reviewing, evaluating and testing the work performed by internal auditors (American Institute of Certified Public Accountants’ Auditing Standards Board (ASB), 2003). While the auditing literature provides evidence about how coordination impacts the work of external auditors (Gramling, Maletta, Schneider, & Church, 2004; Krishnamoorthy & Maletta, 2016; Lin, Pizzini, Vargus, & Bardhan, 2011; Pizzini, Lin, & Ziegenfuss, 2015), little is known about how external auditor coordination impacts the work of internal auditors. Understanding how internal auditors’ behavior is affected by their coordination with external auditors is important because it is an economically important relationship that can be facilitated by a richer understanding of the nuanced interaction between both types of auditors.

Conclusion

This study investigates internal auditors’ sensitivity to fraud risk and the effect of the level of external auditor controls testing coordination on internal auditors’ audit effort as measured by planned substantive testing internal audit hours. The findings indicate that the level of external auditor coordination influences internal auditors’ effort. While increased external auditor CTC results in fewer planned internal audit substantive testing hours, an interaction effect indicates that the effect of fraud risk on internal auditors’ planned audit hours is moderated by the extent of coordination with the external auditor. That is, the effect of fraud risk on internal auditors’ planned substantive testing audit hours depends on external auditor coordination (specifically high external auditor CTC). An interesting finding is that the magnitude of the planned substantive testing hours changes at a different rate when external auditors participate in the controls testing work (under the high external auditor coordination condition) with internal auditors seeming to be less sensitive to high fraud risk under the low external auditor CTC condition. Since DeZoort and Harrison (2008) provide evidence that internal auditors report moderate levels of responsibility for fraud detection, this finding provides insight that more CTC with the external auditor could raise internal auditors’ accountability for responding to fraud risk and detecting fraud.

This paper provides a meta‐analysis of the determinants of audit report lag, defined as the period between a company’s fiscal year end and the audit report date. We group the meta‐analyzed studies into three categories: (a) audit and audit‐related determinants, (b) corporate governance‐related determinants, and (c) firm‐specific determinants. We find that audit opinion and audit season variables increase audit report lag, whereas Big 4 affiliation, nonaudit services, and auditor tenure decrease audit report lag. Among the corporate governance determinants, the existence of a financial expert member on an audit committee, and ownership concentration, reduce audit report lag. Finally, an examination of firm‐level characteristics reveals that firm complexity increases audit report lag, whereas profitability reduces it. We employ a meta‐regression technique and identify publication bias. Although we find some evidence of journal quality as a contributor to publication bias, the extent of publication bias from this source is small.
KEYWORDS: audit report lag, corporate governance, external audit

Purpose – The purpose of this paper is to evaluate the impact of external audit on the management of the Common Fund of the Mozambique National Institute of Statistics (INE). Design/methodology/approach – This paper followed a case study approach of the INE Common Fund that was based on the qualitative evidence from the content analysis of the external audit reports, annual plans of activities and budget for the past seven years and interviews with middle managers of the INE. Findings – The research found that external audit has a relatively significant impact on the management of the INE Common Fund. The authors attribute the positive impact to the high concern of management to implement the external audit recommendations, associated with the financial dependence between the agent (the National Institute of Statistics) and the principal (Fund Donors), explained through Laughlin’s Model of Accountability. Practical implications – The results indicate that external audit associated with the financial dependence of the agent on the principal has a significant impact on the accountability. Thus, it contributes to assist in the formulation of public policies on external financing to developing countries. Originality/value – Most of the studies on external audit and accountability are from countries with more developed economies than Mozambique’s, without heavy reliance on external financing, and these studies analyse the audits carried out by public audit institutions. This research explores the phenomenon in the context of external financing to the State Budget by governments and international organisations.

Introduction

Despite recording high levels of economic growth, Mozambique continues to be heavily dependent on the foreign aid for the State Budget financing (Castel-Branco, 2011). One of the main financing mechanisms for the State Budget is the Common Fund, which refers to the common mechanism that gathers the financial contributions from foreign aid. The INE activities are funded about 50 per cent by external organisations and governments through the Common Fund. In the past years, there has been a growing importance of external audit of public finances in developing countries such as Mozambique to ensure transparency and accountability of foreign-aid funds. External audit is described as a mechanism that provides reliability of accounts both in public and private organisations and that serves as assurance for the interested parties regarding the correct information about efficacy and efficiency in the management of organisational resources (Mzenzi and Gaspar, 2015; Ng, 2002). The Memorandum of Understanding (MOU) between the INE and the Cooperating Partners (2013) establish a mandatory annual external audit of all funds received under the Common Fund to be undertaken by a firm of auditors, selected according to the public procurement rules of the country. Therefore, the main objective of this paper is to evaluate the impact of external audit on the management of the INE Common Fund. The study was motivated by the lack of surveys on the impact of external audit on the management of public funds, especially in developing countries that are heavily dependent on the international financial aid to finance their budgets. In Mozambique, for example, we could not find a similar study or survey on this topic. In many countries (Tanzania: Tulli, 2014; Mzenzi and Gaspar, 2015; Nigeria: Salawu and Agbeja, 2007; Estonia: Raudla et al., 2016; China: Gong, 2009) studies on the impact of external audit on the management of public funds/accountability have been conducted. However, in other countries, with more developed economies than Mozambique’s and without heavy reliance on external financing, such studies have been focusing on the audits carried out by public audit institutions. Thus, the main research question was formulated as follows: RQ1. What is the impact of external audit on the accountability of the INE Common Fund? This article is divided into seven parts: introduction, prior studies, Laughlin’s Model of Accountability, the study context, research method, presentation and discussion of results and conclusions. First, in the introduction, we present the context of our research, motivation and objective. In the prior studies, we provide a discussion on the accountability and auditing in public sector organisations and then the Laughlin’s (1990) Model of Accountability. Next, we explain the methodology used in our research. Finally, we present the discussion of the results and conclusions of the investigation.

INTRODUCTION

The aim of this study is to explore the content of internal audit (IA) disclosures in annual reports and explain the relationship between IA disclosures and external audit fees. Although the IA function (IAF) is seen as an important governance mechanism (Gramling, Maletta, Schneider, & Church, 2004), there are generally no statutory requirements to disclose information about the composition and activities of the IAF (Holt & DeZoort, 2009). Current governance disclosures focus mainly on management, the audit committee, and external auditors, while little information is disclosed about the nature of the IAF (Archambeault, DeZoort, & Holt, 2008). According to the Swedish corporate governance code (the Code), the use of an IAF is recommended and the absence of an IAF needs to be evaluated on an annual basis and clarified in the corporate governance report (Swedish Corporate Governance Board, 2010). However, there are no additional reporting requirements connected to IA. Companies that want to share information can do so by voluntary disclosures. Therefore, managers have the opportunity to voluntarily disclose information that they believe is relevant and useful to external stakeholders (Meek, Roberts, & Gray, 1995). According to Beekes and Brown (2006), companies with superior governance quality differentiate themselves from other companies by the use of more informative disclosures in the annual report. By considering both internal and external auditing as important elements of corporate governance, previous IA research has examined whether the existence of an IAF (Goodwin‐Stewart & Kent, 2006; Hay, Knechel, & Ling, 2008; Singh & Newby, 2010), IAF quality (Gros, Koch, & Wallek, 2017; Zain, Zaman, & Zulkifflee, 2015), and external auditors’ reliance on the IAF (Abbott, Parker, & Peters, 2012; Felix, Gramling, & Maletta, 2001; Messier, Reynolds, Simon, & Wood, 2011) are associated with the external audit fees. Owing to mixed results and different theoretical perspectives, it has been argued that the IA can act, at least in part, as either a substitute for or a complement to the external audit. This study extends existing IA research by examining the relationship between IA disclosures and external audit fees. Based on previous findings that more informative disclosures signal actual investments in disclosed activities (Toms, 2002) and increased governance quality (Beekes & Brown, 2006), this study posits that companies with more informative IA disclosures have higher IAF quality, which will likely have an impact on the external audit fees. Yatim, Kent, and Clarkson (2006) argue that good corporate governance practice improves both risk management and internal control processes, which affects auditors’ risk assessments and, in the end, leads to lower external audit fees. Conversely, investments in IA may also signal that those charged with governance are willing to pay more for an external audit, and hence demand a higher quality audit (Goodwin‐Stewart & Kent, 2006).

INTRODUCTION

Prior auditor–client negotiation research has considered auditors’ use of different negotiation strategies that are employed when resolving disputed financial reporting issues (e.g., Brown & Wright, 2008). Some nonexperimental studies exist in this stream of research, including interview or survey‐based studies (e.g., Beattie, Brandt, & Fearnley, 2000; Beattie, Fearnley, & Brandt, 2004; Gibbins, McCracken, & Salterio, 2007; Gibbins, Salterio, & Webb, 2001; Hollindale, Kent, & McNamara, 2011), but most auditor–client negotiation studies are conducted using the experimental method. Building on the studies of Gibbins and coworkers (Gibbins et al., 2007, 2001; Gibbins, McCracken, & Salterio, 2005), the main purpose of this paper is to complement prior experimental findings, in particular in Gibbins, McCracken, and Salterio (2010), on auditors’ use of different negotiation strategies and tactics using survey‐based retrospective recall of auditors regarding how they recently resolved a disputed misstatement in the financial statements with their clients. More specifically, we first investigate which negotiation strategies and tactics auditors used in an experiential setting. We then focus on audit partners’ use of contending tactics in relation to three context variables identified by previous research (Gibbins et al., 2005, 2001) as likely to be associated (either positively or negatively) with the use of a contending negotiation strategy by the auditor. The choice of variables is based on the importance ratings in Gibbins et al. (2001), as well as mixed findings or a lack of findings on the impact of the variables in prior research. These variables are: (i) the precision of the accounting standard related to the issue under dispute (expected positive relationship); (ii) the audit partner’s negotiation experience, measured both as years of partner experience (a general experience measure) and task‐specific negotiation experience (expected positive relationship); and (iii) the auditor–client relationship, measured as how positively it is perceived by the auditor (expected negative relationship). Finally, we complement the findings in Gibbins et al. (2001) as we investigate the relative importance of different context variables on auditors’ use of the contending negotiation strategy and on the accounting outcome of the negotiation (i.e., who is “winning” the negotiation).

In the aftermath of corporate scandals and the global fnancial crisis, the role of external auditors and of the internal audit function (IAF) has been critically scrutinized, and consequently, became even more in the focus of attention of external and internal stakeholders such as investors, regulators or corporate boards. Companies are under constant pressure to improve the reliability and accountability of their fnancial information, in order to comply with regulations and to compete efectively for capital in the global business environment. Since there is a certain degree of overlap between the tasks of internal and external auditors, e.g. regarding an evaluation of the efectiveness of internal controls,1 there are many opportunities for coordination and cooperation between the two functions that may yield synergistic outcomes for both sides, such as higher quality audits and economic benefts. On the one hand, external auditors may utilize the experience of the internal auditors to reduce work duplication and, in efect, the cost of the external audit (Stein et  al. 1994; Felix et  al. 2001; Al-Twaijry et  al. 2004; Lin et al. 2011; Pizzini et al. 2015). In addition, internal auditors could help external auditors to understand the company’s internal control system and the level of compliance with it.2 Due to its unique position within a company as a supporting and assuring instrument of the board and the audit committee, the IAF will potentially collaborate with the external auditors, because such collaboration potentially increases the efectiveness as well as the efciency of the external audit and the realisation of such a potential is valuable for a company. On the other hand, internal auditors may beneft from the expertise of external auditors in areas where the internal audit department needs support (Haron et al. 2004; Schneider 2009). In certain situations, an assistance from the external auditors is preferable in comparison to outsourcing or co-sourcing arrangements, because of their particular knowledge and expertise and because additional cost might be avoided. Coordination and cooperation between internal and external auditors might enable the internal auditor to beneft from the external auditors’ exposure to a wider variety of fnancial issues and knowledge about similar businesses or organizations (Fowzia 2010; Endaya 2014). Moreover, it avoids that internal auditors duplicate external auditors’ work, which results in wasted internal audit time. The elimination of redundant work will possibly leave time and resources for better audit coverage (Morrill and Morrill 2003). In addition, the IAF could use the fndings of external auditors to assess risks and to determine areas that need their future attention (Saidin 2010). Mutual communication between internal and external auditors potentially provides the IAF further insights into audit techniques and methods.3 However, it is important to note that a useful cooperation between internal and external auditors does not only require similar audit objectives but also similar audit scopes.

The availability of bank financing for small- and medium-sized enterprises (SMEs) is a topic of significant research interest among academics and a crucial issue for policymakers (Berger and Udell 2006; De la Torre et al. 2010). This interest is driven in part by the fact that SMEs play a key role in the creation of wealth and employment of any economy. In addition, banks are the main source of finance for small firms (Cosh and Hughes 1994). Regardless, a number of papers find that SMEs are more financially constrained than large firms, so they frequently experience problems obtaining both their required levels of bank financing and sufficiently favourable conditions of borrowing (see, among others, Cressy 2002; Beck et al. 2005, 2006). One of the often-cited main factors that hampers SMEs financing is opaqueness, which accentuates information asymmetries (Berger and Udell 1998; Berger et al. 2001; Hyytinen and Pajarinen 2008). In the literature, ‘‘opaqueness’’ is often referred to the greater difficulties SMEs encounter in transmitting reliable information about their real status and performance, so that it is difficult for lenders to ascertain if firms have the capacity to pay (risk of adverse selection) and/or the willingness to pay (risk of moral hazard) (Hyytinen and Va¨a¨na¨nen 2006). In an attempt to reduce the inherent risk when granting credit to SMEs, banks seek to formalize both the information gathering process and the loan officer’s decision process. Application forms are developed to standardize information gathering. Banks provide training to loan officers that conveys explicit criteria that should be used to determine the creditworthiness of the borrower (Bruns et al. 2008). Nevertheless, despite banks’ efforts to homogenize the credit decisionmaking process, as De la Torre et al. (2010, 2288) state, ‘‘SME ratings do not lead to the automatic approval of loans, but they rather provide the basis for the risk analyst to evaluate loans and decide on their approval’’. Thus, it is logical to assume that loan officers play a key role in producing and interpreting information, and therefore, personal, perceptual or psychological variables also matter in the credit granting decision (Toft 2002; Scott 2006).

This paper investigates the relationship between external auditor characteristics and the likelihood of bankruptcy. We supplement Ohlson’s (1980) logit model for bankruptcy prediction with auditor attributes to test whether the latter are associated with default and whether the inclusion of such attributes improves the model’s predictive ability. There are several reasons for further research about external audit and bankruptcy prediction. Research has, thus far, paid little attention to the question whether external auditing helps to predict bankruptcy. Certain studies have investigated the relationships between qualifed audit reports and fnancial failure, but have delivered conficting results. Hopwood et  al. (1989) found that bankrupt companies receive a qualifed going concern opinion in the year before the default, while Lennox (1999) found that audit reports are not accurate indicators of fnancial failure. This stream of research only focused on qualifed going concern opinions, whereas other auditor attributes can be associated with bankruptcy, especially in the years preceding the bankruptcy and the issuing of a qualifed going concern opinion. Such attributes can include fees, size, tenure and industry expertise. The bankruptcy setting is particularly salient for analyses concerning auditors’ activities, given the high probability of reputational risk and litigation costs that auditors can incur when reviewing insolvent or fnancially distressed companies (Robinson 2008; Blay and Geiger 2013). Another reason for further research on this topic arises from the bankruptcy prediction literature. Standard, accounting-based bankruptcy prediction models only use fnancial ratios and studies have found that their predictive ability has dwindled in the last decades (Beaver et  al. 2005, 2012). Hence, researchers argue for additional explanatory variables to be included in the models (Agarwal and Tafer 2008; Beaver et al. 2012). The decline in predictive power is attributed to factors such as the perception of investors and lenders that there is an increase in managerial discretion in fair value accounting environments (such as the US GAAP and the IAS/ IFRS) (Beaver et al. 2012). An efective external audit can assure external users in an appropriate way that the fnancial statements are reliable and that they accurately represent the frm’s performance and fnancial position (Bratten et al. 2013). We analyse a sample of U.S. frms for the period 1992–2014. We supplement Ohlson’s (1980) logit model for bankruptcy prediction with auditors characteristics. The model includes the most common fnancial ratios, which were applied in prior bankruptcy literature (Bellovary et al. 2007; Altman et al. 2015). We complement the model with the following auditor attributes: fees, size, tenure and industry expertise. To the best of our knowledge, no prior research has yet tried to supplement a standard bankruptcy prediction model with audit data to test for possible associations, as well as an increase in predictive ability. We also analyse our model’s accuracy by using a table classifcation approach and a receiver operating characteristic (ROC) curve to assess whether auditor attributes improve the predictive ability of Ohlson’s (1980) model. As a robustness check, we also control for Altman’s (1968) Z-Score.

The availability of external finance for small- and medium-size enterprises (SMEs) is a topic of significant research interest among academics and a crucial issue for policymakers (Berger and Udell 2006; De la Torre et al. 2010). Especially, a high rate of interest is set on bank debt, as it is the most common source of external finance1 since their size precludes them from accessing capital markets. Even so, SMEs frequently experience problems when trying to access credit (Schiffer and Weder 2001; Beck et al. 2005, 2006, 2008; Hyytinen and Väänänen 2006). The most common argument is the opaqueness generally attributed to SMEs, which accentuates information asymmetries (Berger and Udell 1998; Berger et al. 2001; Mason and Stark 2004; Berger and Frame 2007; Hyytinen and Pajarinen 2008). It can be particularly challenging to collect information about SMEs. It is not unusual for small businesses to have a short history, a lack of formal or public records, or a deficiency of formal control systems (Bruns et al. 2008). This lack of information can put the banks at a disadvantage, by making it difficult to differentiate between high-risk and low-risk borrowers (Stiglitz and Weiss 1981; Berger and Udell 1998). Within this context, relationship lending is particularly relevant (Petersen and Rajan 1994; Boot 2000), as asymmetric information problems tend to be more acute for SMEs than for large firms (Berger et al. 2001). In relationship lending, the bank relies on a range of private information gathered through contact with the firm, their owners and managers and the local community in which they operate (Berger and Udell 2006). Furthermore, banks also use other lending techniques in order to evaluate the firm’s riskiness, such as the evaluation of financial statements or credit-scoring (Berger and Udell 2006). In addition, trying to minimise the probability of error, banks seek to formalise both the information-gathering process and the loan officer’s decision process (Bruns et al. 2008). However, despite all formal procedures to support the decision to grant credit, in many (or even most) cases, credit risk management is not automated, and it is ultimately based on a loan officer’s judgement and perceptions (De la Torre et al. 2010).