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Auditing profession has reached new expectations in the dynamic world we operate in.Both external auditing and internal auditing has developed over last three decades individually and together. External auditors started to rely on internal auditors from 1975 when the auditing standards in the United States first accommodated this reliance. Since then many researchers have been done on the factors which influence the reliance decision and external influences which drives the external auditors to rely on internal auditors. Eventhough these researches over three decades have covered developed countries very fewhave been done in the developing countries. This research is done in the Sri Lankanexternal audit environment to study the external auditors’ reliance on internal auditors.This research is a qualitative research using case study strategy. Primary data was collected using semi-structured interviews. Interviews were held with external auditors who work for a “big four” audit firm operating in Sri Lanka. External auditors were interviewed with answers and explanations derived from their experience. Qualitative data was analysed conceptually and with arguments by comparing and contrasting with prior literature. Research objectives for this research was developed based on the prior literature and the auditing standards practiced in Sri Lanka and internationally. This research is an excellent start for Sri Lanka and other developing countries to further develop on this area of study. Findings from this study show that the Sri Lankan auditing environment does not vary significantly from that of developed countries. But the regulatory requirements and the auditing standard practiced influences the results obtain.
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1
Submitted in part fulfilment of the requirement for the degree of Master of Science in
International Financial Management
External Auditors’ Reliance on Internal Audit in Sri Lanka
By
Dilukshan Manoharan
School of Management
University of Surrey
September 2011
Word count: 18456
© Dilukshan Manoharan
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Abstract
Auditing profession has reached new expectations in the dynamic world we operate in.
Both external auditing and internal auditing has developed over last three decades
individually and together. External auditors started to rely on internal auditors from 1975
when the auditing standards in the United States first accommodated this reliance. Since
then many researchers have been done on the factors which influence the reliance decision
and external influences which drives the external auditors to rely on internal auditors. Even
though these researches over three decades have covered developed countries very few
have been done in the developing countries. This research is done in the Sri Lankan
external audit environment to study the external auditors’ reliance on internal auditors.
This research is a qualitative research using case study strategy. Primary data was collected
using semi-structured interviews. Interviews were held with external auditors who work for
a “big four” audit firm operating in Sri Lanka. External auditors were interviewed with
answers and explanations derived from their experience. Qualitative data was analysed
conceptually and with arguments by comparing and contrasting with prior literature.
Research objectives for this research was developed based on the prior literature and the
auditing standards practiced in Sri Lanka and internationally. This research is an excellent
start for Sri Lanka and other developing countries to further develop on this area of study.
Findings from this study show that the Sri Lankan auditing environment does not vary
significantly from that of developed countries. But the regulatory requirements and the
auditing standard practiced influences the results obtain.
3
Declaration of Originality
I hereby declare that this thesis has been composed by myself and has not been presented
or accepted in any previous application for a degree. The work, of which this is a record,
has been carried out by myself unless otherwise stated and where the work is mine, it
reflects personal views and values. All quotations have been distinguished by quotation
marks and all sources of information have been acknowledged by means of references
including those of the internet. I agree that the University has the right to submit my work
to the plagiarism detection sources for originality checks.
……………………….
Dilukshan Manoharan
9th September 2011
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Table of Contents
Chapter 1: Introduction .......................................................................................................... 8
1.1 Background of the Dissertation ................................................................................................ 9
1.2 Methodology of the Dissertation ............................................................................................ 10
1.3 Structure of the Dissertation ................................................................................................... 10
Chapter 2: Literature Review .............................................................................................. 12
2.1 Introduction ............................................................................................................................ 12
2.2 Theoretical Aspects of Internal Audit and its Influence on Governance and Financial Reporting ...................................................................................................................................... 12
2.3 Auditing Standards and Theoretical Framework regarding External Auditors Reliance on Internal Audit Function/ Internal Audit Function ........................................................................ 14
2.4 Literature on External Auditors Reliance on Internal Audit .................................................. 17
2.5 External Auditors Reliance on Internal Auditors and the Impact of Audit fee and Partner Preference ..................................................................................................................................... 28
2.6 Sourcing arrangement of Internal Audit and its impact on Reliance Decision of External Auditors’ ...................................................................................................................................... 31
2.7 External Auditors reliance on Internal Audit and the role of Corporate Governance and Audit Committees .................................................................................................................................. 33
2.8 Background of Accounting and Auditing in Sri Lanka .......................................................... 34
2.9 Research Questions and Objective ......................................................................................... 35
2.10 Conclusion ............................................................................................................................ 37
Chapter 3: Methodology ...................................................................................................... 38
3.1 Introduction ............................................................................................................................ 38
3.2 Research Methodology ........................................................................................................... 38
3.3 Research Strategy ................................................................................................................... 39
3.4 Data Collection Techniques ................................................................................................... 39
3.4.1 Data Collection Method .................................................................................................. 39
3.4.2 Selection Method of Interviewees ................................................................................... 40
3.4.3 The Semi-structured Interview process ........................................................................... 41
3.5 Advantages of using Interviews and Qualitative data for Research ....................................... 43
3.6 Limitations and Overcoming the Limitations of this Methodology ....................................... 44
3.7 Data Analysis Techniques ...................................................................................................... 45
3.8 Summary ................................................................................................................................ 46
Chapter 4: Critical Analysis and Discussion ....................................................................... 48
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4.1 Introduction ............................................................................................................................ 48
4.2 External auditors’ reliance decision and the relationship among competence, objectivity and work performance of the internal audit function .......................................................................... 48
4.3 Impact of independence on the reliance decision ................................................................... 50
4.4 Impact of corporate governance and regulations on the reliance decision ............................. 51
4.5 Audit fee pressure and its influence on external auditors’ reliance decision ......................... 53
4.6 Sourcing arrangement of Internal Audit and its impact on Reliance Decision of External Auditors’ ...................................................................................................................................... 55
4.7 External Auditors Reliance on Internal Auditors for Direct assistance.................................. 55
4.8 Summary ................................................................................................................................ 56
Chapter 5: Conclusion ......................................................................................................... 57
5.1 Summary of Findings and Recommendations ........................................................................ 57
5.2 Contribution of this Dissertation ............................................................................................ 58
5.3 Limitations of this research .................................................................................................... 58
5.4 Suggestion for Future Researches .......................................................................................... 59
References ........................................................................................................................... 60
Appendix A – Ethical Approval .......................................................................................... 76
Appendix B – List of Interviewees ...................................................................................... 77
Appendix C – Sample of Interview Questions .................................................................... 78
Appendix D – The 3 key Factors Competence, objectivity and work performance ........... 81
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List of Abbreviations
AICPA American Institute of Certified Public Accountants
ASA Australian Auditing Standard
CAS Canadian Auditing Standard
CAATS Computer Aided Audit Tools
CSR Corporate Social Responsibility
EU European Union
FSA Financial Service Authority
IAS International Accounting Standards
ICOFR Internal Control over Financial Reporting
ICASL Institute of chartered Accountants of Sri Lanka
IFRS International Financial Reporting Standards
IIA Institute of Internal Auditors
ISA International Standards on Auditing
LSE London Stock Exchange
NED Independent Non-Executive Director
NYSE New York Stock Exchange
PCAOB Public Company Auditing Oversight Board
SAS Statement on Auditing Standards
SLAuS Sri Lanka Auditing Standard
SOX Sarbanes-Oxley Act 2002
TOR Terms of Reference
UK United Kingdom
USA United States of America
US SEC United States Securities and Exchange Commission
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Acknowledgement
I take this opportunity to thank the University of Surrey and its staff for providing the best
educational service during my one year period in Surrey. Special thanks to my personnel
tutor and Dissertation supervisor for giving advice and helping me during this year.
Special thanks to my previous Senior Audit colleague and lifelong friend Asanka
Karunathilaka for his friendship and continuous support in developing me as an auditor
and sharing his friendship.
My time here at the university wouldn’t have been a reality without my parents support
and love, thank you Amma and Appa.
I thank my uncle Mr.S.W.Kanagartnam for his continuous support to complete this degree.
“Imagination is more important than Knowledge” - (Albert Eienstein)
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Chapter 1: Introduction
Events which occurred since the mid 1970’s has significantly influenced towards the
growth of internal auditing. This was first initialised in the United States and gradually
other countries following the similar system quickly adopted. The foreign corrupt Practices
act of 1977 in United States required and made mandatory effective internal accounting
controls and effective internal control functions should be established by the public
companies. This was initiated so that there was reasonable assurance that the company
assets are safeguarded and the transactions are authorised and recorded properly. In
highlight of this background companies in the United States established strong and
effective internal audit departments or functions, increased their internal audit staff, and
strengthened internal audit independence.
Beasley (2000) identified that the investments made in internal auditing have been
effective and reaping benefit, as the companies with internal audit staffs have a lesser rate
of financial statement fraud than companies without internal auditing function. Coram et
al. (2008) argued that organisations having trained internal audit staffs are more likely to
detect and self-report occurrence of fraud than those without internal auditing. In 1987
Treadway Commission recommended that the top management of the public companies
should establish internal audit function and should implement an effective reporting
relationship. “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).Another highlight in the report is to urge that the internal audit
function should be staffed with adequate number of qualified auditing personnel
appropriate to the size and the nature of the company.
Schneider (2009) discussed that New York Stock Exchange imposed a requirement in 2003
for all listed companies, where they must implement an effective internal audit function, in
their organisation either in house or outsourced. This requirement was later approved by
the Securities and Exchange Commission. A survey done by the Institute of Internal
Auditors in 2003 revealed 20 percent of companies listed in the Fortune 1,000 did not
implement an internal audit department. And 50 percent of the Fortune 1,000 companies
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had plans to increase their audit staffs in order to be in compliance with Sarbanes-Oxley
(Harrington 2004).
1.1 Background of the Dissertation
After the development of external and internal audit regulators identified that unnecessarily
duplicated audit procedures done by both these auditors could be avoided and eventually
time and resources also could be saved. Auditing Standard Executive Committee in 1975
published a separate auditing standard. Statement on Auditing Standards (SAS) No. 9
(AICPA 1975), which provides guidance for external auditors on reliance of internal audit
function and the use of their work. In the year 1991 SAS No. 9 (AICPA 1975) was
superseded by SAS No. 65 (AICPA 1991). This change was done after extensive
researches done on the reliance decision by many such as Gibbs and Schroeder (1979);
Milton (1979); Clark (1981a; 1981b); Brown (1983); Abdel-Khalik, et al. (1983);
Schneider (1984); (1985a); (1985b); Margheim (1986); Messier and Schneider (1988).
Similar standards on External auditors’ reliance on internal auditors were issued
internationally. Where International Standards on Auditing (ISA) 610 , Sri Lanka Auditing
Standard (SLAuS) 610, Australian Auditing standard (ASA) 610 and Canadian Auditing
Standard (CAS) 610 outlines using the work of internal auditors by External auditors.
Kaplan & Schultz (2006) argued that by increasing their investments in internal audit
companies we able to reduce their external audit fees by substituting internal audit work. A
Survey done in 2005 among 117 chief internal audit executives revealed that in 88 percent
of their companies external auditors relied on internal audit in various capacities. It is also
argued and proven in many instances relying on internal auditing can avoid unnecessarily
duplicated audit procedures; it also can benefit external auditors because internal auditors
have certain advantages. It is also argued internal auditors generally have more knowledge
about the company’s procedures, policies and business environment than the external
auditors.
External auditors’ reliance decision on internal auditors has been researched and studied in
many developed countries especially mostly in the United States. But in a developing
country like Sri Lanka this study has not been done before. Internal audit function and
reliance over internal audit function is a developing phenomenon in Sri Lanka. As an
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external auditor who has worked for Sri Lanka for five years, this research will contribute
towards the growth of auditing in Sri Lanka and the reliance decision. Further this research
will contribute to the academics who are interested in this area of study, in order to develop
the knowledge on how difference the developing countries accounting and auditing
structure.
1.2 Methodology of the Dissertation
The methodology used was Qualitative, Case study strategy, where semi-structured
interviews were used to collect primary data. Ten external auditors from one “big four”1
audit firm operating in Sri Lanka were interviewed. Interviews’ were conducted through
the internet and interviews were recorded digitally.
1.3 Structure of the Dissertation
This Dissertation will be structured in the following way.
Chapter 2: Literature Review, This chapter will give an overview of the context and the
background of the research problem. Existing literature about External Auditor Reliance on
Internal audit will be critically reviewed. Theoretical background and regulatory
framework on External Auditor Reliance on Internal audit will be discussed and critically
analysed. Research problem definition and aims and objectives will be discussed.
Chapter 3: Research Methodology, in this chapter research methodology which will be
used to obtain the data to answer the research question will be justified. Data collection
method and validity of data will be discussed in details.
Chapter 4: Analysis and Discussion, in this chapter results obtained from the interviews
held with the external auditors will be presented and analysed. Results will be compared
and contrasted with the prior literature. Statements made by the interviewees will be
discussed and argued accordingly.
1 The Big 4 firms are Ernst & Young, Deloitte Touche Tohmatsu, Price Warehouse Coopers and KPMG.
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Chapter 5: Conclusion, brief overview and summary of finding will be presented in this
final chapter. Contribution made by this research and limitations of this research will be
presented. Future research opportunities and avenues will be listed.
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Chapter 2: Literature Review
2.1 Introduction
In this chapter Theoretical aspects of the External auditors’ reliance on Internal Audit will
be discussed to introduce the background to the research problem. Prior Literature on
External auditors’ reliance decision on internal auditors will be critically reviewed and
discussed by comparing and contrasting various literatures. Problems and Gaps in the
existing literature will be discussed and the research problem definition and aims and
objectives will be presented in this chapter. Literature on External Auditors’ Reliance on
Internal auditors was searched using various sources such as Journals, E-Journals and
books. Mainly using the EBSCO database Business source complete search engine
provided by the University of Surrey and ‘Google Scholar’ was used to search related
literature. Key words such as ‘External Auditors’, ‘Internal Auditors’, ‘Reliance decision’,
‘Auditing standards on Internal audit’, was used to search the databases.
2.2 Theoretical Aspects of Internal Audit and its Influence on Governance and Financial Reporting
The Institute of Internal Auditors (IIA 1999) defines internal audit as: “An independent,
objective assurance and consulting activity designed to add value and improve an
organization’s operations. It helps an organization accomplish its objectives by bringing a
systematic, disciplined approach to evaluate and improve the effectiveness of risk
management, control, and governance processes.”
International Standards on Auditing 610 defines Internal Auditors as “Those individuals
who perform the activities of the internal audit function. Internal auditors may belong to
an internal audit department or equivalent function.”
International Standards on Auditing 610 defines Internal Audit function as “An appraisal
activity established or provided as a service to the entity. Its functions include, amongst
13
other things, examining, evaluating and monitoring the adequacy and effectiveness of
internal control.”
The above definitions illustrate that internal audit today is a service which is value-added
assurance and consulting services through its role in monitoring, evaluating, and improving
risk management, control, and governance process which are critical to preserving and
enhancing stakeholders value (Bou-Raad 2000). This confirms that internal audit today is a
different phenomenon compared to its initial service which was restricted to compliance
assurance and safeguarding of assets of organisations. In the above definitions ‘Assurance’
and ‘Consulting’ means that internal audit becoming a proactive, consumer-focused
activity concerned with the importance issues of control, risk management, and governance
(Hass et al. 2006; Chapman and Anderson 2002). Munro and Stewart (2010) argues that
definition laid by the Institute of Internal Auditors (IIA) clearly identifies that internal
audit is both an assurance activity and a consulting activity which plays a key role in both
risk management and corporate governance of organisations. McCollum (2006) explains
that internal audit function has been redefined as a ‘cornerstone’ on which effective
corporate governance will be formulated. Arguments made by McCollum (2006) is been
endorsed by the academician Rittenberg et al. (1999) by explaining that internal audit
function is an integral part of corporate governance which also plays an important in
assisting management and the board in achieving their objectives.
In today’s corporate world internal audit plays a key role in supporting the management,
audit committee, Board of directors, external auditors and other stakeholders (Ruud 2003).
Internal audit report produced by the internal audit functions of the organisations has
potential in complementing the existing governance disclosures made by organisations and
in turn increases its stakeholders confidence in good governance and in the quality of the
financial statements produced (Archambeault et al. 2008). Asare et al. (2008) discussed the
negative role of internal auditors, where he argues internal auditors are sensitive to
management’s incentive to misreport financial information and, thus, they increase
budgeted work hours when management has a high incentive to misreport. Internal audit
function quality is linked to the moderation in the level of that if earnings management as
measured in terms of abnormal accruals and the propensity to meet or beat analysts’
earnings forecasts (Prawitt et al. 2009). The role of internal audit function in corporate
governance is well researched and documented in prior literature (Castanheira et al., 2010;
14
Hirth, 2008; Jeffrey, 2008; Gramling and Hermanson, 2006; Gramling and Myers, 2006;
Ramamoorthi, 2003).
2.3 Auditing Standards and Theoretical Framework regarding External Auditors Reliance on Internal Audit Function/ Internal Audit Function
The Sarbanes-Oxley Act (SOX) of 2002 significantly elevated the role of the internal audit
function in USA (Gramling, Maletta, Schneider, and Church 2004). Section 302 of SOX
requires the management to report on and certify to the effectiveness of its internal control
structure and procedures with respect to the firm’s quarterly and annual reports. Section
404 of SOX requires management to document, evaluate and report on the effectiveness of
internal control over financial reporting, and requires the external auditor to evaluate and
opine on management’s assessment of internal control. In order for the External auditor to
rely on the work performed by the internal audit function the external audit must assess the
quality of the internal audit function (AICPA 2003; PCAOB, 2007). It has been argued
stronger the internal audit function the more extensively the external auditors will be able
to use it (PCAOB, 2007). Auditing standards No.5 insist external auditors to use the
principles based approach in determining when and to what extent they can use the work of
others (PCAOB 2007). It is evident that even prior to SOX external auditors evaluated the
strength of the Internal Audit function with the objective of assessing the strength of
internal control structure of their client. SAS No 65 (AICPA 1991) prescribes the
relationship between the external auditors and the internal auditors.
SAS No.65 (AICPA 1997, AU 322) discusses two approaches that external auditors can
use to rely on a client’s internal audit department. One approach is that where external
auditor’s can use the client’s internal auditors as assistants during the financial statement
audit. The second approach is to rely on the work that was performed by the internal audit
department during the year. According to the requirement of the SAS No. 65 AICPA
(1991) before relying on the work performed by internal auditors, external auditors are
required to evaluate the objectivity, competence, and work performed by internal auditors.
Appropriately evaluating and relying on the internal audit function is critical as the
inherent risk of the material misstatement in the financial statement increases or when the
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work of the internal auditor is more subjective and more susceptible to bias (AICPA 1991-
SAS No. 65).
Since a great amount of literature is written and tested in the United States regarding the
internal auditors reliance decision SAS No.65 AICPA (1991) is discussed in the literature
review. The equivalent standard internationally is IAS 610 and in Sri Lanka it is SLAuS
610 (ICASL 1999).The main difference in these standards versus the SAS No 65 (AICPA
1991) is that using internal auditors as assistance by external auditors is not allowed in IAS
610 and SLAuS 610 (ICASL 1999).
Using the existing auditing standards and regulatory requirements Schneider (2009)
explained that external auditors’ reliance on internal auditing could be in three ways:
which will be discusses below in more detail.
1. Relying on the internal audit function as part of the company’s overall system of
internal controls.
2. Relying on work already done in internal audits relating to testing of internal
controls or testing of accounts, transactions or selected captions.
3. Relying on internal auditors to provide direct assistance to the external auditors.
External Auditors Reliance on Internal Audit as a part of Overall Control System
External auditors will have to test the design and operating effectiveness of the internal
control system of their audit client’s as this will directly affect the reliability of the
company’s financial information. When assessing the company’s overall control
environment. Auditing standards mandate the consideration of internal audit function.
Statement on Auditing Standards (SAS) No. 65 The Auditors’ Consideration of the
Internal Audit Function in an Audit of Financial Statements, states that:
“[W]hen obtaining an understanding of internal control, the auditor should obtain an
understanding of the internal audit function sufficient to identify those internal audit
activities that are relevant to planning the audit (AICPA, 1991, AU § 322.04).”
16
The above is evident in other standards such as ISA 610, SLAuS 610 etc. External auditors
could identify relevant internal audit activities by obtaining the company’s internal audit
plan from the internal audit department or the Audit committee. This will ensure the
external auditors to identify the nature, timing and extent of the internal audit work
planned by the internal auditors. It is the responsibility of the External Auditors to identify
and study how the internal audit function effectively contributes towards the overall
control environment. They also should evaluate internal audit’s organisational status within
the company and its ability to obtain unrestricted access to company documents and its
personnel. This will ensure that the external auditor identifies that the internal audit
function has an independence to effectively perform its work. Internal audit should report
functionally to the audit committee and administratively to the company’s Chief Executive
Officer.
External Auditors Reliance on Work Performed by Internal Auditors
External auditors may decide to rely on the work that has been already performed
independently by internal auditors. This could be for a single account balance or for
collectively for certain account balances. SAS 65 (AICPA 1991) and other related
standards clearly states that reliance decision is at the full discretion of the external
auditors. They need not rely on the work performed by internal auditors if the external
auditors decide that the internal audit activities are not relevant to their financial statement
audit. This will help to express the true and fair view of those statements. On the other
hand even though the work performed by internal auditors is identified as relevant still the
external auditors’ should decide whether using the work of internal auditors is efficient and
effective to perform their work. It should be noted that external auditor’s professional
skepticism and experience for the independent judgement should be used when deciding
the process described above.
External Auditors Reliance on Internal Auditors for Direct assistance
When using internal auditors as assistance the external auditors’ will specifically identify
and request the internal auditors to perform specific external audit work. External auditors
will plan the nature, timing and the extent of work or test to be performed.
17
“When direct assistance is provided, the auditor should assess the internal auditors’
competence and objectivity . . . and supervise, review, evaluate, and test the work
performed by the internal auditors to the extent appropriate in the circumstances (AICPA,
1991, AU § 322.27).”
A survey done by (Taylor 1997) is evident that external auditors use senior internal
auditors for junior work to be performed. There is a difference in the determinants of
internal audit reliance decisions depending on whether the decision by external auditors
relates to work that has been already performed against using the internal auditors as direct
assistants (Maletta 1993 and Maletta & Kida 1993). The determinants such as inherent
risk, internal control strength, and internal audit quality was texted in the prior researches
done (Maletta 1993 and Maletta & Kida 1993).The research concluded as work already
performed by internal auditors should be relied based upon internal control strength as it is
a significant determinant of internal audit reliance, where as when internal auditors
participate as direct assistants internal control strength does not affect the reliance decision
(Maletta 1993 and Maletta & Kida 1993).
2.4 Literature on External Auditors Reliance on Internal Audit
In Early stages after the issue of SAS 9 (AICPA 1975) Gibbs and Schroeder (1979) studied
the competency dimension of internal audit function where Clark (1981a; 1981b) studied
the performance and objectivity dimension of reliability assessment which should be done
by the external auditors before the reliance decision. The main drawback in their study was
that these three dimensions were considered individually, this was also criticized by Milton
(1979). Gibbs and Schroeder (1979) and Clark (1981a; 1981b) found the independence of
the internal audit function is the most important factor for external auditors to rely on
internal audit. Further Ward et al. (1980) found that external auditors rely on internal
auditors more in regard with work performed by internal control than for direct assistance
in performing audit procedures.
Brown (1983) initiated one of the pioneering studies on external auditors’ reliance on
internal audit. During his time relying on internal auditors was covered by standard SAS 9
(AICPA 1975). Brown (1983) argued the guidelines were general and not easily
18
implemented by the independent auditors. But as discussed earlier SAS 65 (AICPA 1991)
superseded SAS 9 (AICPA 1975) and a comprehensive standard is in place now. Similarly
ISA 610 is practised internationally. During this time there were less researches and
empirical evidence available in this area of study. Also there were less empirical evidence
and the four firms chosen by Brown (1983) from the “Big Eight”2 would have less
experience on relying on internal audit work. Initially Brown (1983) found that two factors
dominate the external auditors’ judgement (1) independence of the internal audit function
and (2) satisfaction with the internal audit function during prior audits. The first factor
identified has been a significant one even latter research found the same influencing factor
but the second factor satisfaction with the internal audit function during the prior years is
an arguable finding in contemporary context. As evident from the latter researches this
factor was not given much prominence as the Internal Audit Function developed in a
dynamic way year by year. New regulations and expectations were enforced to change the
dimension of Internal Audit Function. Nevertheless its understanding that this was a
significant finding by Brown (1983) since there were less empirical evidence available in
this area of study during his time. Brown (1983) also identified that Work performance
was the most important factor and then followed by objectivity and competence. Brown
(1983) used the ANOVA (Analysis of variance) model which is a statistical model and has
been used in prior auditing researches’ during his time. It is questionable whether this
model has been used effectively since he argues the influencing factors have been
considered in isolation. It is commendable that Brown (1983) identified that the future
researches should consider this and ensures the influencing factors should not be analysed
in isolation.
Abdel-Khalik, et al (1983) studied the factors influencing the external auditors’ judgment
on internal audit function during the planning stage of the audit based on three EDP-audit
techniques (Integrated test facility, Test data, and generalized audit software) and two
organisational variables (the level to which the internal auditing department reports and
internal auditor’s level of responsibility in reviewing changes in application programs).
They reported that the independence of internal auditors as the most important factor that
determines the reliance of external auditors on internal auditors work. This confirms the
prior findings on reliance of internal audit by external auditors’ by Brown (1983). But in
2 The Big 8 firms until 1987 were Arthur Anderson, Arthur Young & Co, Coopers & Lybrand, Ernst & Whinney, Deloitte Haskins & Sells, Price Warehouse, Peat Marwick Mitchell & Co.; and Touche Ross & Co.
19
contrast to Brown (1983) they found objectivity as the most important factor followed by
work performance and competence. Even in their research they found no significant
interaction among the three factors. Abdel-Khalik, et al (1983). This research was
conducted based experiment in two different groups where external auditors’ were asked to
prepare planning document for their clients based on the data of internal auditors given by
the research group. Studying the factors influencing external auditors in relying on work of
the internal audit function in a way of experiment is not so effective and rational, this is
because the gravity of the natural practical problems faced by the external auditors’ will
not be identified in this kind of experimental method. It should be noted that the use of
Generalised Auditing Software by the internal auditors and how the external auditors
response was an addition to the existing literature. It should be commended this was one of
the first research to study on the use of internal auditors as assistants. But they did not
examine much on the internal audit competence which could be a drawback.
Schneider (1984) identified work performance as the most important factor followed by
competence and objectivity for external auditors’ reliance on internal auditors. Schneider
(1985a) in his research identified the relationship between external auditors’ nature in
evaluation of the internal audit function and their reliance decision during the planning of
the audit. Outcome of the research was that auditors perceived competence and work
performance to be almost equally important factor and the objectivity factor as less
important but still a significant factor. Schneider (1985b) examined the degree of
consensus among external auditors in evaluating the internal audit function. An additive,
compensatory model was employed in an experiment atmosphere. Results indicated that
the additive combination strategy seemed to fit the profile of evaluations of 15 of the 18
auditors participated. Out of the 15 auditors 9 of them rated work performance as the most
significant factor and 8 out of those 9 identified the pattern which the study Schneider
(1984) found. These studies were statistical and done in an experiment environment, which
is questionable as discussed earlier.
Margheim (1986) examined the extent that the external auditor adjust the nature and
extend of audit procedures due to the reliance on internal auditors and if so whether any
such reliance was related to the source reliability of the internal auditors which is defined
by the three factors internal auditor competence, work performance and objectivity. His
study identified that the external auditors reduced planned audit hours if the internal
20
auditors had a high competence-work performance, and did not rely on internal auditors if
they had low competence-work performance. Also found they did not change or adjust
their tests in response to changes in the degree of internal auditors’ objectivity. This is
complementing Schneider (1985) findings where he argues internal auditor competence
and work performance were perceived as almost equally important in reliance decisions
with objectivity less important although not trivial. The difference in Margheim (1986)
study was that he examined by way of treating Competence and work performance as a
single factor. Margheim (1986) treated these two factors as one single factor in order to
avoid unrealistic combinations such as low competence of internal audit function and high
work performance. This combination should be commended as the argument was clear and
true because when the competence of the auditors were high you expect them to perform
high but also one could argue against it depending on the weight age given and clearly
defining the three factors more in their research papers. But it should be understood that
these researches are based on criteria laid out SAS 9 during the time and revised standard
in future.
Margheim (1986) uses experimental methodology in a hypothetical company’s internal
auditors in evaluating the accounts receivable internal control system and in evaluating the
appropriateness of account balances. Margheim (1986) argues that the reason for the
selection of accounts receivable is that it is a general importance to both external and
internal auditors. Again using the experimental methodology and examining the three
factors from choosing only one caption like accounts receivable is debatable, but also one
would agree that there was no integrated Internal frame work such as COSO (1992) or
Turnbull (2005) guidance for internal control during his time of research. Margheim
(1986) found that external auditors did not react to internal auditor objectivity and did not
find any significant interaction effects between competence-work performance and
objectivity, this was surprising because earlier literature suggest otherwise. Brown (1983),
Abdel-Khalik, et al (1983), and Schneider (1984, 1985). The reason for the difference may
be due to the research designs used.
Messier and Schneider (1988) research on reliance decision was a hierarchical approach.
Where hierarchy of attributes that enter into the decision process was developed based on
prior research and with the assistance of “Big eight” audit managers. Interestingly contrary
to earlier studies such as Brown (1983), Schneider (1984; 1985) and Margheim (1986) the
21
conclusion of this research was that Competence of the internal auditors was the important
factor followed by objectivity and work performance. After the SAS 9 (AIPA 1975)
issuance and researchers done this was the first research to indicate that competence was
the important factor compared to the other two factors. The key difference in this research
work was rather unlike the previous researches where they used questionnaire, surveys and
experiments Messier and Schneider (1988) uses Analytic Hierarchy process (AHP) (Saaty
1980) to assess which of these attributes were most important to a group of experienced
external auditors as discussed above. The advantage in this methodology is that it is a
composition approach where as previous studies have been decomposition approach (e.g.
regression analysis, conjoint measurement). It should be identified the results found from
this research was totally in contrast to prior literature even though the prior finding have
been inbuilt in the hierarchy process as discussed earlier. This is a main drawback of this
research and also the limitations of Analytic Hierarchy Process discussed by Jensen (1983)
would be significant as these are discussed here as it is not relevant for our research.
Maletta (1993) concentrated his research on the decisions of external auditors to use
internal auditors as assistants to perform audit work during the audit process. Maletta
(1993) confirmed that external auditor’s decision comprised complex and rigid process
when deciding whether or not to use the internal auditors as assistants. He also found that
there is a strong relationship among competence, work performance, and objectivity in
assessing the strength of the internal audit function for reliance purpose. Maletta (1993)
interestingly concluded that when inherent risk is high external auditors considered the
work performance of the internal auditors only if the objectivity was high. On the other
hand when the inherent risk is low there was no interaction effects found between work
performance and objectivity.
Competence was identified as the most important factor in all inherent risk conditions
closely followed by objectivity and work performance. By this time now SAS 65 (AICPA
1991) superseded SAS 9 (AICPA 1975).After the study of Abdel-Khalik, et al (1983) the
research of Maletta (1993) examines using internal auditors as assistants where as other
prior researchers identified external auditors’ general evaluations of internal audit quality
and their decisions to rely based on the prior work of the internal audit function. (Maletta
and Kida 1992; Margheim 1986; Schneider 1984, 1985; Brown 1983; Clark, Gibbs, and
Schroeder 1981; Gibbs and Schroeder 1980).Maletta (1993) argues lack of prior research
22
on using internal auditors as assistants is surprising as the impact that it will have on the
audit process and the future of the auditing profession. Today one could agree with him
after the Sarbanes and Oxley act of 2002 and ICOFR requirements for public companies in
the USA and other regulators requirements internationally on internal audit and corporate
governance.
Another addition to the literature by Maletta (1993) was that he argues that the prior
researches were only considering the three factors which influenced the external auditors
which documented in SAS 9 & SAS 65 (AICPA 1975, 1990) rather he identifies a
potential effects of audit risk factor such as related to inherent risk was not considered.
Again it should be noted that SAS 65 (1991) did not provide a detail guidance on how the
inherent risk should be assessed or either should be considered cohesively with internal
audit objectivity, competence and work performed it was rather vague and ambiguous.
Maletta (1993) studied the how the inherent risk impacts on the three factors such as
objectivity, competence and work performed of internal auditors towards the reliance
decision when external auditors use the internal auditors as direct assistants to perform
certain tasks. Maletta (1993) further studied the impact of inherent risk on the complexity
of the decision processes that auditors use to evaluate the three internal audit factors in
making such judgements.
Under certain conditions auditors are relatively complex configural information processors
(Brown and Solomon 1990). The evaluation was on the decision processes that auditors
use when making decision on control risk assessments in cash disbursement area. They
found that auditor judgements were significantly affected by specific interactions between
information cues. This is where the result of their study indicates that auditors are not, as
some of the previous research suggests, merely simple additive information processors.
Brown and Solomon (1990) also argued these findings suggest that many auditors are able
to react and process patterns of information when such reaction and processing make sense
from an auditing perspective. It is a value addition to the thought process of how auditors
decision process is linked to some of the psychological concepts studied over time, even
though it is not directly linked to the research it is work discussing.
It is important and appropriate to discuss some theories on the relationship between the
complexity of individuals’ decision processes and decision importance, as psychological
23
research suggests that there may be relationship existing. This is directly related to the
prior researches and future ones as External Auditors need to make judgemental decisions
based on the level of risk involved. Christen-Szylanski (1978) found that when the benefits
of a certain decision task increase, individuals use more analytical decision processes.
Petty and Cacioppo (1984) found that information having a high personal relevance
generated more intense, complex information processing on the part decision makers.
Other Studies such as Murnigham and Leung 1976; Heslin, Blake and Rotton 1972; Bybee
1978) have provided evidence of similar tendencies. Hanno (1990) identified and argued
that the more important the decision, the more complex and analytic decision process used
by the decision maker (Beach and Mitchell 1978; Billings and Scherer 1988; Hagafbrs and
Brehmer 1983). This is very important for this research as the prior researches because in
an audit environment, auditors’ planning decisions increase in importance for situations in
which there is a high likelihood of financial statement error or, in other words, a high level
of inherent risk (Hanno 1990). Where we could rationalise that the audit-planning
decisions made in high inherent risk situations should be greater importance than similar
decisions made in low inherent risk. This was evident in the psychological researches
discussed above and in the research and investigation done by Maletta (1993).
When discussing the inherent risk assessments by auditors’ it is important to discuss the
concerns expressed by Cushing and Loebbecke (1983), where they argued auditors
assessments of inherent risk and control design strength may not be entirely independent.
This because the concern is that strong internal control systems may influence to reduce
auditors’ assessments of inherent risk. This clearly shows that even though inherent risk is
covered by separate auditing pronouncements, the concern is that the level of inherent risk
may affect the function of the strength of the systems control. Strong internal controls may
mitigate the effects of the high levels of the inherent risk and vice versa.
Whittington and Margheim (1993) examined the effects of inherent risk, materiality and
subjective nature of the assertion under audit on external auditors’ reliance on internal
auditors. This was a case study experiment among the “Big six”3 external audit managers.
Again here it should be noted that using experimental study in a hypothetical company
environment is not effective rather doesn’t brings out the actual picture of the external
3 The Big 6 firms (1989-1998) were Arthur Anderson, Ernst Young, Coopers & Lybrand, Deloitte & Touche , Price Warehouse and KPMG.
24
auditors’ reliance on internal auditors. This research used small samples around 10 or 11
observations for each case, which actually limits the generalisability of the result.
Whittington and Margheim (1993) found at low materiality level the subjects felt that
external auditors had an obligation to directly perform majority of the substantive work,
but they were willing to let the internal auditors a large majority of the test of control work.
This finding seems to be consistent with the survey Ward and Robertson (1979) that found
external auditors relied on the internal auditors more extensively when performing test of
control than for substantive test work.
Mills (1996) examined the effects of cognitive style on external auditors’ reliance
decisions on internal auditors or internal audit function. Mills (1996) also examines the
dimension of cognitive style, which is known as mobility-fixity, this is new to the auditing
literature as this has not been previously researched in an auditing or accounting context.
But also should be noted that Pincus (1990) studied the effects of field dependence/ field
independence on an audit judgement and found that cognitive style did significantly affect
auditors’ fairness and presentation decision. Similarly Bernadi (1994) studied and found
that field dependence/ field independence did not significantly affect auditors’ fairness of
presentation decision. This is one of the first researches to use field dependence/ field
independence on an audit judgement where prior to this it was used by Cardy and Kehoe
(1984) in raters’ accuracy in performance appraisal tasks and found it was significantly
affected.
Using models based on Bayesian (cascaded) inference theory and analysed using
numerical sensitivity Krishnamoorthy (2002) studied the factors that influences the
external auditors’ in relying on the work of internal audit. “Bayesian inference” is a
method of statistical inference in which the evidence is used to estimate the parameters and
predictions in a probability method. All uncertainty is summarised by a “posterior
distribution” which is a probability distribution for all uncertain quantities, given the data
and model. The term “Bayesian” is derived from the application of the Bayes’ theorem to
probabilities which have the interpretation as “Bayesian probabilities”. Krishnamoorthy
(2002) argued there have been significant amount of prior academic research done on
external auditors’ reliance decision on internal audit function but these results have been
mixed and inconclusive. Krishnamoorthy (2002) studied the interaction and relationship
these three factors (objectivity, work performance, and competence of the internal
25
auditors) identified by the auditing standards and prior research in determining the strength
of internal audit function.
His research was based on the interrelationship among these three factors and how they
affect the assessment of external auditors on internal audit function. The use of Bayesian
theory may be a questionable one in this research as they found evidence which had
conflicting results as some of the evidence obtained was positive and others were negative
but as he argued this is expected in auditing as human judgemental process is involved.
Another Limitation is that the results of this research is arrived using model and parameter
values which have been selected based on conditional independence and assumptions made
as these are necessary in developing mathematical expression which is used in this
research for Bayesian theory. Krishnamoorthy (2002) concluded that ranking the three
factors Competence, Objectivity and work performance of internal auditors as some prior
researches done is outdated as it is evident now that there is no single factor which will
dominate in all condition of the reliance decision.
Vikram et al. (2010) models the interrelationships between the three key factors
competence, work performance, and objectivity used by external auditors when evaluating
the strength of the Internal Audit function (SAS 65 AICPA 1991; Messier and Schneider
1988; Krishnamoorthy 2002). The addition to the literature is that Vikram et al. (2010)
explicitly models the ‘‘And’’ relationship between the internal audit function and the
factors such as competence, work performance, and objectivity. This is an addition to the
existing literature where earlier model by Krishnamoorthy (2002) failed to identify and
model this relationship. This work provided a structural approach to gather and aggregate
items of evidence pertaining to various internal Audit factors that will help the judgement
of external auditors is assessing the reliability of the clients internal control system and
determine the extent of reliance on the work of the internal auditors.
This model developed by Vikram et al. (2010) should be commended for the design and
ease of use by the external auditors when evaluating internal audit function. Since it is
presented in an evidential diagram external auditor could include or discard any items of
evident related to specific internal audit factors in a structural way in varying situations.
The finding of Vikram et al. (2010) contradicts with the results obtained in the prior
researches as the results of Vikram et al. (2010) demonstrated the objectivity factor was
26
not important as work performance and competence (Brown 1983; Schneider 1985a;
Margheim 1986; Maletta 1993). Vikram et al. (2010) findings differ from prior work since
they model the interrelationship between these three factors. According to their finding it
was revealed the strength of the internal audit function was high when the three factors
modelled had a strong or perfect relationship. This was satisfied even when there was
positive or negative evidence about one of the factors as long as they had high levels of
beliefs about the other two factors.But interestingly they also found that when objectivity is
negative the belief dips to zero this is where the external auditors are certain that the
objectivity of internal auditors has been defaulted or impaired. Vikram et al. (2010) also
found the external auditors rely less on internal audit if the expectations on litigation and
regulatory cost are high even when their evaluation on internal audit was strong. The use of
belief function in this research by Vikram et al. (2010) is one main limitation as some
would not agree on the outcome and findings based on the assumptions and model used.
Finally commendable inclusion in the research was a detail Table was included on the
three factors and determination criteria of those factors. This Table was used in this very
research as well when interviews were held with external auditors. This table is presented
in Appendix D of this research.
Prior empirical studies on the relationship of internal and external auditors are
predominantly in the context of developed economies. It is noted that the implications have
been under researched in the developing countries. Interestingly Haniffa and Cooke (2002)
suggest that as environmental factors influence audit practice, the techniques and
approaches prescribed for the use in developed economies may not apply to a similar
extent in countries with socio-economic settings that are different. This argument is also
supported by Ritchie and Khorwat (2007). Haron (2004) identified internal auditors’
competence and scope of work was the main factors that the external auditors considered
in making reliance decision. Carey (2006); Felix (2001) argued that another factor which
influences the reliance decision is the level of inherent risk that an audit client entails.
Carey (2006) also argued that the for high risk clients, external auditors’ use of internal
audit work may reduce inherent risk because internal auditors possess a greater awareness
of client operations than external auditors. Spraakman (1997) argued that the Internal
Auditors possess superior authority of access to organisational information than external
auditors.
27
Internal audit effectiveness as measured by management’s acceptance and implementation
of internal audit findings and recommendations may impact on external auditors’ reliance
on internal auditors work. Mihret and Woldeyohatmis, (2008); Mibret and Yismaw,
(2007); Roth, (2000) put forward that the extent of internal audit effectiveness exhibits
variation across organisations the level of external auditors’ reliance on internal audit work
may also vary accordingly. Higher level of acceptance of internal audit recommendations
by the management may lead to higher level of external auditor reliance than a situation
where internal audit is less effective. The variations in empirical research results on
factors that determine external auditors’ reliance on internal audit may raise interest to
explore associations between these factors and audit market characteristics, as mentioned
earlier the Socio-Economic environments in developed economies and the developing ones
like Sri Lanka should be taken into consideration. Differences also may be observed in the
level of external auditors’ reliance on internal audit work among external audit markets
when different levels of competition for clients prevail in external audit market. This is the
argument that the external auditors’ level of reliance on internal audit work varies
depending on the level of competition that exists in the external audit service market.
As most of the Literature on this topic is based on the developed world studies on
developing countries may contribute additional evidence and new insights into the
literature. One such evidence is that of Al-Twaijry et al. (2004) on Saudi Arabia, which
indicates that the extent of external auditors' reliance on internal audit work was associated
with external auditors' perceptions of internal audit's objectivity, competence and work
experience. Mihret et al. (2011) identified in Ethiopia external auditors’ perceptions of
internal auditors’ work performance are significantly associated with external auditors’
level of reliance on internal audit work. This also suggests that strengthening internal audit
could help improve internal-external audit linkages. This research focused on the External
auditors ' perceptions of internal audit practices in Ethiopian state-owned enterprises do not
differ from external auditors 'perceptions of internal audit practices in Ethiopian private
companies.
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2.5 External Auditors Reliance on Internal Auditors and the Impact of Audit fee and Partner Preference
It has been argued and even empirical evidence proves in many circumstances that external
auditors’ reliance on internal audit has reduced the external audit fees and eventually has
reduced the total cost of auditing for companies. It is also argued that this benefits both the
External auditors’ and its client’s, since the external auditors could compete well in the
market to win audit proposals and also the client’s could benefit by needing to pay less for
the service they obtained. Some academics also argue the margin is that total audit cost
either internal or external and this will not affect the total impact. But it is important to
have the balance between both internal auditing and external auditing today, as discussed
earlier both are mandatory by the regulators and need to be in place to achieve the high
standards in corporate governance. According to prior research done by Felix (2001) and
Al-Twaijry (2004) external Auditors Reliance on Internal Auditors work is beneficial for
Organisations. Felix (2001) also found that the contribution of internal auditors to financial
statement audit as a significant external audit fee determinant supported by Spraakman,
(1997). This will benefit both the client and the External auditors have an incentive to seek
greater extent of external auditors’ reliance on internal audit work.
According to the previous Literatures such as Krisnamoorthy (2001), (2002); Morrill and
Morrill (2003); Mihret (2010) and James and Mula (2010) argued that the external
auditor’s reliance on internal audit work could produce a significant cost saving through
reduction of external audit time and resources. External auditors assess Internal Audit work
to determine the extent of their reliance on internal audit, which is done at the planning
stage of the Audit. In the early stage of the reliance decision’s itself the external auditors
identified the reliance as a cost benefit method, as Brown (1983) argues that initially after
the issue of SAS 9 in 1975 external auditors were mainly interested on cost reduction by
the use of internal auditors’ work. Ward et al. (1980) also in early stages commented on the
cost saving factor where external auditors’ could save cost and reduce audit fees to be
attractive in the market by relying on the internal auditors. Morrill and Morrill (2003)
identified the intention to reduce external audit costs in a bid to reduce audit fees and
maintain the competitiveness in the audit service market motivates external auditors’
decision to rely on external auditors work. He also argues that the external auditors’ level
29
of reliance on internal audit work is associated with their perception of internal audit
practice of clients.
Felix et al (2001) concluded in his research that internal audit has a direct relationship with
external audit fee and rather it contributes towards the determinant of the external audit
fee. Felix et al. (2001) also states that the greater the contribution of the internal auditors to
the financial statement audit, the lower the audit fee. Felix et al. (2001) further mentioned
that the internal audit contribution is influence by internal audit quality. Inherent risk
increases, the effect of internal audit availability on contribution diminishes, while the
effect of coordination on contribution increases (Felix et al. 2001). Overall findings of
Felix et al. (2001) reveals that the contribution made by internal audit could lower the
external audit fees, and in order to influence the contribution made by internal audit clients
could invest further in internal audit quality, managing availability, and facilitating
coordination between the internal and external auditors.
Recent researches indicated that at planning stage auditors do reduce planned audit hours
in response to client’s fee pressure (Bierstaker and Wright 1999: Houston 1999). But also
argued that without the understanding the mechanisms through which auditors make these
hours reductions, it will be difficult to assess whether such reductions in planned audit
hours will affect negatively on audit effectiveness. Gramling (1999) focused in his research
whether and to what extent, client fee pressure and related partner preferences affect audit
mangers reliance decision. Before researches such as Ashton and Ashton (1988); Anderson
and Maletta (1999) suggested that the order in which information about the internal audit
department is received may affect the reliance decision of external auditors’ on internal
auditors. Further according to Gramling (1999) in the case of fee pressure applied by
clients external auditors may reduce the planned audit hours and pressure to rely on
internal audit is indirectly enforced on external auditors. This will cause concern over the
independence of auditor and the effectiveness of audit and in order to overcome this issue
auditors have viable mechanisms through which planned audit hours can be reduced.
Gramling (1999) argued that mechanism used by external auditors is to rely on internal
audit function.
Recent survey research indicates that key reason auditors rely on the work of internal
auditors’ to lower the audit cost. This Reliance on internal auditors is an outcome as
30
response to fee pressure and to the competitiveness of the market place (Felix et al. 1998).
Reliance on client’s internal audit department should result in less external audit work
being performed and also lower the audit fees, this intern might affect the effectiveness of
the audit work (Felix et al. 1999). They also argue that if an internal audit department is
compromised of quality internal auditors with objective and competent there is no reason
that they cannot contribute effectively to the financial statement audit. But if the quality of
the internal auditors is compromised then the question on audit effectiveness arises. SAS
65 (AICPA 1991) and SLAuS 610 (ICASL 2009) cautions external auditors on relying on
work performed by internal auditors who do not satisfy the required or sufficient level of
objectivity and competence. Trompeter (1994); (POB 1993) argues any individual partner
may emphasise audit efficiency and profitability because of the concern on audit firm’s
short term profitability. On the other hand because of a focus on the extent of litigation
faced by audit firms, a partner may explicitly emphasise the need of the audit quality, and
professional skepticism. Gramling (1999) suggested by his experimental investigation that
the audit mangers rely to a greater extent on the internal audit work when the client
explicitly emphasises the need for reduced or low audit fees, than when their client
explicitly emphasis a preference for audit quality. This has increased reliance even though
the internal audit department is characterised as being of low-to-moderate quality.
Gramling (1999) findings also proved that the partner preferences influence audit
managers’ reliance decision. However, the results did not provide any evidence of an
interactive effect between client fee pressure and partner preference on audit managers’
reliance decisions.
Bierstaker and Wright (1999); Gibbins and Newton (1994) discussed that audit managers
are not pressurised by client fee or engagement partner preference on an individual basis,
rather both of these factors would co-exist on any one engagement. This discussion pays
way to further discussion to whether these two factors have an interactive effect on audit
managers’ reliance decision (Gramling 1999). In his study he further questioned whether
the audit managers rely on internal audit work to a greater extent when client fee pressure
is combined with a partner emphasising on efficiency than when the client fee pressure is
combined with a partner emphasis on audit quality or professional skepticism. Gramling
(1999) also noted that concern for audit quality and audit independence emphasized by the
observers and the auditing profession with relevant standards. But the argument he kept
forward was interesting issue and question, whether an audit partner who emphasises audit
31
quality or professional skepticism would be able to limit the influence of a client who
exerts a high level of fee pressure. On the other hand Gibbins and Newton (1994)
suggested that an interactive effect may exist, but the experimental research does not
support such effect. Bierstaker and Wright (1999) found in their result that there was no
interactive effect among those two factors on auditors’ budgeted audit hours. But
Bierstaker and Wright (1999) found an interactive effect of these two factors on planned
tests, the nature of the interaction does not indicate that auditors who encounter both higher
client fee pressure and partner preference responded to a greater degree than did auditors
who were subject to just one form of pressure. Interestingly Bierstaker and Wright (1999)
did not include a condition in which audit partner emphasises audit quality or professional
skepticism in their experimental design that they have used. And their study does not allow
for examination of whether an explicit partner emphasis on audit quality or professional
skepticism. The main limitation in Gramling (1999); Bierstaker and Wright (1999) as the
prior researches they used an experimental research to identify the effects they reported.
2.6 Sourcing arrangement of Internal Audit and its impact on Reliance Decision of External Auditors’
Companies have also outsourced their internal audit facilities to experts such as the Public
Accountants and chartered Accountants. Many researchers have studied the impact and
effectiveness of in-house and outsourced internal audit functions in organisations. A
survey done by Wallace & Kreutzfeldt (1991) on external auditors revealed that the total
external audit hours increases by ten percentages on average with no internal audit
functions involved in audits. This result was an outcome from 26 companies which
indentified that the reliance in internal auditing had an impact of ten percentage reduction
in the average external audit fee (Wallace 1984).
A survey conducted by the Institute of Internal Audit (IIA) indicates that as of 2002, 54
percent of the surveyed companies used third party or outsourced some or all of their
internal auditing work performed within the entity (IIA 2002). But interestingly by
contrast, an earlier study in 1995 conducted by the IIA indicated only about 30 percent of
organisations used third parties to perform internal audit work (Rittenberg and Covaleski
1997) . In prior literature where researches such as Alhawat and Lowe (2004); Caplan and
Emby (2005) discussed and identified differences between in-house and outsourced
32
internal audit service providers. Caplan and Emby (2005) found that out-sourced and in-
house internal audit functions provided similar type of quality and equally competent work
when in the context of control evaluation. Alhawat and Lowe (2004) interestingly found
that both type of internal auditors advocate management’s position when selling or
purchasing a new department or division but the outsourced internal auditors advocates
management’s position to a lesser degree compared to the in-house internal auditors. The
reason for these findings could be linked to the management power where in-house internal
auditors are considered to work under the organisations management in certain
circumstances but the outsourced internak auditors tend to have more independency in
working environment. Lowe et al (1999); Swanger and Chewning (2001) examined how
the external audit report users change their behaviour based on whether the external
auditors relied on an in-house or outsourced internal audit function. Financial analyst and
Loan granters do not differentiate between external auditor reports that are based on
external auditors’ reliance on work performed by an in-house versus outsourced internal
audit function (Lowe et al 1999; Swanger and Chewning 2001). James (2003) in his
research examined how the users of financial information change their behaviour
depending on the sourcing arrangement of the internal audit function. He found that
lending officers do not differentiate their decision on granting loan on the basis of internal
audit function sourcing arrangement when relevant financial statements are based primarily
on the work performed by the internal audit function.
Practice of outsourcing internal audit has become increasingly prevalent, with internal
auditor services are provided by specialist and traditional accounting firms (Ernst & Young
2006); (Glover et al, 2008). These changes in the internal audit are likely to impact
external auditors’ reliance decision (Munro and Stewart 2010). Interestingly Munro and
Stewart (2010) argued that three decades of research has been done in exploring external
auditors’ reliance on the work internal audit but most of these researches were conducted
when the internal audit had a narrow focus and was only offered in-house, where
organisations had their own internal audit departments. They further argued that both the
provision of consulting services by the internal audit function and the sourcing
arrangement of internal audit have the potential to impact internal audit objectivity. Munro
and Stewart (2010) based on an experimental design studied whether these two factors
have an impact on the external auditors’ reliance decision.
33
Glover et al, (2008) discussed that the outsourcing of internal audit increased mostly after
the importance of section 404 of the Sarbanes-Oxley Act 2002. Glover et al, (2008)
investigated whether external auditors are sensitive to differences in internal audit sourcing
arrangements by examining the external auditors’ reliance decision on the work of
outsourced versus in-house internal auditors. Further in-house and outsourced internal
auditors have different motives and incentives as a result of the differences in the
institutional structures such as nature and relationship with management, economic
independence, legal liability, etc (Glover et al, 2008). Glover et al, (2008) results indicated
that external auditors relied on in-house versus outsourced internal auditors’ work equally
when the inherent risk is low, but significantly more likely to rely on the outsourced than
in-house internal auditors’ when the inherent risk is high. They also found that external
auditors relied more on internal auditors work for objective tasks than subjective tasks
when inherent risk is high and not when inherent risk is low. Interestingly Glover et al,
(2008) could not find any evidence of interaction between sourcing arrangement and the
subjectivity of the task performed by the internal audit function. Further outsourcing
internal audit was found to have an indirect effect on the reliance decision by means of
differences in perceived objectivity and direct effect on reliance even taking into account
the external auditor’s assessment of internal audit function objectivity and competence and
attempting to hold work performed constant (Glover et al, 2008). Glover et al, (2008)
research was conducted based on attribution theory. “Attribution theory proposes that
evaluators assess a source’s incentive to bias their message when evaluating the source’s
message” (Glover et al, 2008). Attribution is a concept used in social psychology referring
to how individuals explain causes of behaviour and events. This theory was first proposed
by Fritz Heider who was an Austrian psychologist in his book The Psychology of
interpersonal relations (1958) and later this theory was developed by Harold Kelley and
Bernard Weiner.
2.7 External Auditors reliance on Internal Audit and the role of Corporate Governance and Audit Committees
Cohen, Gaynor, Krishnamoorthy, and Wright (2007) suggested link between governance
quality, including the audit committee, and the internal audit function this was also
examined by Vikram et al. (2010). Vikram et al. (2010) found that even though the
external auditors had positive belief in all three factors such as competence, objectivity and
34
work performance they did not consider the internal audit function to be effective if they
have no prior knowledge or negative knowledge about the quality of corporate governance
of the organisation.The Blue Ribbon Committee (1999) report presents that the audit
committees of boards, internal audit and external audit as three legged stool of Good
corporate governance the help ensure reliability of financial reports. According to DeZoort
et al. 2002 Internal and external audit helps to enhance the audit committee effectiveness
by serving as the resource to board of directors.
2.8 Background of Accounting and Auditing in Sri Lanka
The Institute of Chartered Accountants in Sri Lanka (ICASL) is the main governing body
of the Accounting and Auditing profession in Sri Lanka. It has been enacted under the
parliament Act No. 23 of 1959. During that time the financial reporting requirements were
based on the British system. In 1970, the ICASL has issued its first accounting standard.
Subsequent to that collapse of several financial institutions during late 1980’s and early
1990’s has warned the government to regularize the financial reporting process. As a result
of that Sri Lanka Accounting and Auditing Standard Act No. 15 of 1995 has been enforced
by the government with the support of the accounting profession and business community.
This Act identifies some enterprises as Specified Business Enterprises (SBE’s) and
governs the preparation, presentation and audit of those entities. The Act also established
the Sri Lanka Accounting and Auditing Standards Monitoring Board (SLAASMB) which
monitors the accounting and auditing arrangements and practices. Act is administered by
the SLAASMB and all the SBE’s are required to prepare and present financial statement
based on the Sri Lanka Accounting Standards. As a result of the above changes Sri Lankan
accounting practices developed to an international level.
Currently ICASL has more than 4200 members and more than 30000 registered students.
The Institute is a member of the International Federation of Accountants (IFAC), The
Confederation of Asian and Pacific Accountants (CAPA) and a Founder member of the
South Asian Federation of the Accountants (SAFA).The Institute has issued Sri Lanka
Accounting Standards (SLAS), Sri Lanka Auditing Standards (SLAuS), Sri Lanka
Auditing Practice Statements (SLAPS) and Code of Ethics for Professional Accountants
based on international standards.Apart from the ICASL, The Association of Sri Lanka
Accounting Technicians (AAT) is operating as the next local professional body for the
35
development of the Accounting profession in Sri Lanka. Other than the above two (2)
professional bodies the Association of Certified Chartered Accountants (ACCA) is
operating as the main international body.
Apart from the above professional bodies there universities, offering well reputed
Accounting degrees in Sri Lanka. University of Colombo, University of Sri
Jayewardenepre and University of Kelaniya are among them. Auditing practices of Sri
Lanka has also been developed with accounting practices. According to Sri Lanka
Accounting and Auditing Standards Act, auditors are required to certify that the audit has
been conducted in accordance with SLAuS and that the financial statements have been
prepared and presented in accordance with SLAS. Based on the 1972 constitution public
sector institutions are to be audited by the Auditor General’s Department under the laws
relating to local authorities and state corporations. Currently there are three audit firms out
of “Big Four” audit firms operating in Sri Lanka, which are independent member firms of
the “Big Four” audit firms in the world. They are KPMG Ford, Rhodes, Thornton & Co.,
Pricewaterhouse Coopers and Ernst & Young. Apart from those firms, there are around
200 registered firms and members with practicing rights who is operating as small to
medium scale professional service providers.
2.9 Research Questions and Objective
As discussed above it is clear external auditors’ reliance on internal audit is a well
researched topic in the western world especially in United States and United Kingdom. But
this area has not been studied much in the developing countries. Developing country like
Sri Lanka has been involved in significant contribution towards the profession of
Accounting and Auditing. In Sri Lanka Institute of chartered Accountants is the national
professional accounting body of Sri Lanka established by Act of parliament. No 23 of
1959. Institute is a member of the International Federation of Accountants (IFAC) and the
International Accounting standards committee (IASC). It is also member of the
Confederation of Asian and Pacific Accountants (CAPA). Chartered accountants are the
only professionals’ who has the right to perform auditing in Sri Lanka according to the
above act. Sri Lanka is well known for running Business Process outsourcing companies
specialised in Accounting and Auditing. In the last three years post war period in Sri Lanka
36
many foreign investors have shown interest, but Sri Lankan regulatory frameworks such as
Data protection, corporate governance and internal audit has not developed to the high
international standards even though it has developed over the years. Extending the
research in this area here will be adding to the literature how the reliance decision is
influenced in a developing country.
As discussed above prior literature has concentrated mostly studying the three factors
(Objectivity, work performance and competence) and the relationship among these three
influences the reliance decision of external auditors on internal auditors. External auditor’s
reliance decision and the impact on audit fee and partner preference also were studied
separately by many academicians. Role of internal audit perceived in corporate governance
and audit committee responses also were studied which included the communication
among internal and external auditor and the reliance decision. Further sourcing
arrangements of internal audit and how they influence on the reliance decision of external
auditors were researched in detail as well.. In these research external auditors reliance
decision on internal auditors in Sri Lankan context will be researched. All factors which
influenced the reliance decision of the external auditors which identified in prior researches
will be tested in Sri Lankan external audit environment.
The Aim of this research will be External auditors’ reliance on internal auditors or internal
audit function in Sri Lankan perspective, following research objectives will be expected to
be achieved in the research.
1. To identify how the reliance of external auditors on internal audit function in Sri
Lanka is influenced by the three factors (Objectivity, work performance and
competence) and the relationship among these factors identified by auditing
standards and prior research.
2. In order to identify how the external factors identified by prior academics
influences the external auditors reliance decision on internal auditors in the Sri
Lankan phenomena.
37
3. Establish whether the difference in regulatory requirements among institutions for
Internal Audit function in Sri Lanka influences the reliance decision of the external
auditors.
2.10 Conclusion
Prior Literature on external auditors’ reliance decision was reviewed critically. Theoretical
frameworks of reliance decision of external auditors were presented. The findings by the
prior researches show that there are no major differences between researches done during a
given period on reliance decision. But over the last three decade external auditors’ reliance
decision has changed over the period. This is mainly because of the regulatory changes
which happened over the last three decades especially in United States. Even though the
three factors competence, objectivity and work performance have varied on importance
among external auditors over the periods the contemporary researches prove that all three
factors are equally considered and no one factor will dominate in all conditions.
38
Chapter 3: Methodology
3.1 Introduction
In this Chapter Research Methodology used in the research will be discussed in detail.
Various methods are used by students to conduct business research. Brief description about
different methodologies and data collection will be discussed and the relevant methods for
this research will be discussed in detail. Detailed data collection technique used in this
research and data analysis techniques used will be explored in this chapter. Also arguments
for choosing the methodology will be presented in detail. This will be also demonstrated
by justifying the research methodology used to obtain data to answer the research
questions and to achieve the research objectives.
3.2 Research Methodology
Any given Business research methodology could be categorised into two which is
quantitative and qualitative methodology. This categorisation of methodology is mainly
based on the data collection and analysis techniques used. Quantitative research is where
data is collected and analysed based on meanings which are derived from numbers. The
data collected will consist of numerical and standardised data. Quantitative research
analysis is mostly conducted through the use of diagrams and statistical analysis.
Qualitative research is based on meanings express through words and discussions
documented in prior literature. In qualitative research data is collected as non-standardised
data requiring classifications into categories. Analysis is done through the use of
conceptualisation and arguments. This research regarding the External auditors’ reliance
on internal audit in Sri Lankan perspective will be done based the qualitative methodology.
Prior literature and researches in this area of study were mostly based on the quantitative
approach. So one main reason choosing qualitative method for this research was to identify
and answer the research questions in a different perspective and also this is one of the
pioneering researches done in Sri Lanka on this field of study. Using qualitative
methodology was perceived to be helpful as it uses conceptualisation and arguments to
analyse the data so that future researches could benefit from this.
39
3.3 Research Strategy
In business researches today various research strategies are used which use both qualitative
and quantitative methodology. Those various business research strategies are experiment,
survey, case study, action research, grounded theory, ethnography and archival research.
Some of these research strategies belong to deductive approach and inductive approach,
and it should be noted that neither of these strategies are superior or inferior to any other
(Saunders 2009). Research strategy chosen will guide the research questions and the
objectives. Using certain strategies within another strategy also recommended for example
it is possible to use survey strategy as a part of a case study (Saunders 2009).
In this research we will be using Case study strategy to achieve our research questions and
objectives. According to Robson (2002) case study is defines as “a strategy for doing
research which involves an empirical investigation of a particular contemporary
phenomenon within its real life context using multiple source of evidence”. According to
Morris and Wood (1991) case study will be an ideal strategy when it comes to a particular
interest that the researcher would like to gain a rich understanding of the context of
research and processes which are being enacted. In this research the Reliance decision of
External auditors on internal auditors will be studied in the context of Sri Lanka, which
confirms that features identified by Morris and Wood (1991) is satisfied by this research
and the chosen research strategy which case study is well suited to achieve my identified
research questions and objectives. In this research as mention by Saunders (2009)
“Triangulation” is used where multiple sources are used to achieve the research question
and objective. Where qualitative data collected by the way of semi-structured interviews is
compared and contrasted with the existing literature available on external auditors’ reliance
on internal auditors. A “big four” auditing firm operating in Sri Lanka will be used in this
case study approach.
3.4 Data Collection Techniques
3.4.1 Data Collection Method To study the case of Sri Lankan external auditor’s reliance decision, primary Qualitative
data will be collected from Semi-structured interviews held with the external auditors.
40
According to the degree of structuring, interviews are divided into three categories; they
are structured interviews, semi-structured interviews and unstructured interviews (Fontana
& Frey 2005). In a structured interview set of predefined questions and the questions are
expected to be asked in the same order for all respondents or interviewees. This
standardisation is intended to reduce the effects of the instrument and the interviewer on
the research results obtained. Structured interviews are similar in nature to surveys, except
that they are administered orally rather than in black and white. Unstructured interviews
also known as informant interview is used to explore in depth a general area in which the
interviewer is interested or expected to explore. For this reasons unstructured interview is
also known as ‘in-depth interviews’. There will be no predetermined list of questions or
guide to work in this type of interview. Interviewee has the opportunity to comment and
express freely about events, behaviour and beliefs on the research topic area. Due to this
nature this type of interview is also known as ‘non-directive’. It has been labelled as
informant interview as it is the interviewee’s perceptions that guide the conduct of the
interview.
Finally the Semi-structured interviews are more flexible compared to the structured
interviews but streamlined than the unstructured interviews.. In semi-structured interviews
agenda for interview or rather an interview guide is presented to the potential interviewees.
This guide will contain both closed-ended and open-ended questions. During the
interviewee process the interviewer has certain flexibility where the sequence of the
questions could be manipulated based the responses from interviewee. Also further probing
questions could be asked based on the response of the interviewee. This will be done based
on the experience and new insights discussed by the interviewee regarding the research
topic.
3.4.2 Selection Method of Interviewees
Ten Experienced external auditors were selected to be interviewed from one of the “Big
four” Audit firm operating in Sri Lanka. All the auditors had worked in the external audit
department for at least 5 years or more and are professionally qualified Chartered
Accountants from Institute of Chartered Accountants of Sri Lanka (ICASL). Partner of the
“Big four” firm operating in Sri Lanka was approached and requested to identify Ten
External Auditors’ who had experience in various industries and exposure. Prior working
41
relationship with the Partner was used to gain access in to the organisation. The
interviewees were randomly selected by the partner.
3.4.3 The Semi-structured Interview process
The selected ten external auditors were interviewed using electronic interview technique.
Morgan and Symon (2004) used the term ‘electronic interview’s to refer to interviews held
both in real time using the internet and organisations’ intranets as well as that are in effect
undertaken off-line. This is sub-divided into asynchronous and synchronous where the
categorisation is based real time (synchronous) or off-line (asynchronous) interviews.
Asynchronous interviews could be done using internet technologies such as email, internet
forums and blogs, synchronous interviews could be done using chat rooms such as
Messenger, VoIP software’s and Skype. This interview used in this research was a
synchronous which is in real time. Interview was held over ‘Skype’ and reordered using
sound recorder which is available in Windows 7 and a freeware “MP3 Skype Recorder”.
Debates on suitability of internet and internet mediated communication for synchronous
interviewing has been reviewed by Mann and Stewart (2000). Some researches argued
that interviewing participants using online techniques such as using the web conferencing
or chat rooms are unlikely to achieve the same level on interactivity and spontaneous
communication that is obtained with face-to-face interviewing. This is mainly because of
the direct body language impacting on interviews and non verbal communication which
could be observed. This research is based on Sri Lankan external auditors done from
United Kingdom the limitation in direct travelling to conduct the interview should be
understood. On the other hand Sweet (2001) suggested that relative anonymity of online
interviews facilitates more open and honest responses, in particular with regard to sensitive
questions where participants have adopted pseudonyms. Neither gender nor age and
ethnicity had adverse effect on the interviewees as their experience in the firm was only
considered to be important in context of this research.
Permission was obtained from both the Partner of the Participating “Big Four” Audit firm
and the interviewees to record the interviews. During the interview written notes were also
taken on key points and statements made by the interviewees. All the interviews were held
in English and in case of clarification’s Sinhala and Tamil languages also were used when
42
needed. Recording the interview was helpful as the interviewer was able to concentrate in
listening and questioning the interviewee. It is understood that it is ethical to allow the
interviewee to maintain control over the recorder so that they could decide not to record
the interview at any given time but this viable since the interviewee was over ‘Skype’.
Contextual data such as the date and time of the interview, information about the
participant such as designation, experience and qualification was also recorded. On
average each interview lasted forty five minutes. Prior to the interview an agenda with
relevant themes of the area to be questioned were circulated among the participants with
the purpose of the research. They were also asked to refresh their knowledge on standards
ISA 610 and SLAuS 610 (ICASL 2009) and regulatory requirements on Sri Lankan Public
companies and financial institutions. Themes were derived from the knowledge gained
from prior literature during the literature review process. At the start of the interview an
introduction and brief background of the research was communicated to the interviewees.
This was done to built credibility and confidence among the interviewee to understand the
research questions and objectives and divulge the genuine information needed. Also the
themes presented to the interviewees’ proved to be helpful in reducing the anxieties and to
actively participate in the interview with genuine interest in the research as it will
contribute towards addition to the existing literature. Open questions were asked from the
participants and followed with probing questions accordingly from their answers. Long
questions and those made up of two or more questions were avoided since these will not
help to obtain response to each aspect that was interested to explore as explained by
Robson (2002).
Interviewees were asked to demonstrate and explain practical situations where they were
deciding to rely on internal auditors. This approach was key participant experience which
is known as Critical incident technique, in which they were asked to describe in detail a
critical incident or number of incidents that they experience in relying on internal auditors.
A Critical incident is defined as “an activity or event where the consequences were clear
that the participant has definite idea regarding the effect” (Keaveney 1995). At the end of
each interview the interviewer summarised by explaining the understanding obtained from
the interviewee. This will ensure the interviewee to evaluate the adequacy of the
interpretation and correct where necessary (Healey and Rawlinson 1994). This could be a
powerful way to avoid bias or incomplete interpretation, this also will help to explore and
43
probe the interviewee’s responses further. A sample of questions asked from the external
auditors is attached in Appendix C.
3.5 Advantages of using Interviews and Qualitative data for Research
It has been found that managers are more likely to be interviewed, rather than complete a
questionnaire; this is especially where the topic of the interview is interesting and relevant
to their current work (Saunders et al. 2009). This is mainly interview gives them an
opportunity to reflect on events without needing to write anything. Especially subjects in
this research External Auditors are very busy professionals who will be more reluctant to
fill in questionnaires in detail. Another key factor which was considered is to understand
the relationship among the research objectives as one cohesive unit to identify the external
auditors’ reliance on internal audit in Sri Lanka; this could be well achieved using
interviews. Healey (1991) identified that ‘the interviewer has more control over who
answers the questions’ in comparison with a questionnaire, which may be passed from one
to another. Easterby-Smith et al. (2008) and Jankowicz, A.D. (2005) argued that interview
will be the most advantageous approach to attempt to obtain data in the following
circumstances: 1) Where there is large number of questions to be answered, 2) Where the
questions are either complex or open-ended and 3) Where the order and logic of
questioning may need to be varied. These findings are well suiting this research as most of
the questions are open-ended and varied rather than a logic order.
The research approach will be a semi-structured interview as most questions need to be
varied according to the external auditors’ experience and industry exposure. Another key
advantage in using interviews is that the external auditors will be more comfortable in
discussing the questions openly with the interviewer as I was one time an external auditor
worked for a “Big four” for five years, until a year ago. Another advantage in semi-
structured interviews is that the questions could be modified according to the participants
and also according to their responses given. Some respondent might not be interested in
answering certain questions and some might prefer to answer that area as their expertise
varies. Some also identifies this as a disadvantage of semi-structured interviews as the
generalisation is not eminent, but according to our understanding this is a classical method
to achieve the identified objectives successfully as this is almost the first time this area is
44
been researched in a country like Sri Lanka. And this reason itself encourages us to use the
semi-structured interview methods as we could identify the variations and influencing
factors in a detail cohesive view. Interestingly Bryman (1988) argued that within case
study a wide range of different people and activities are invariably examined so that in
contrast to survey samples is not so acute as it appears at the first glance. This single case
could involve a study in a large organisation with sites across the country or even around
the world. In contrast to this Bryman (1988) identifies that many research projects adopting
a survey strategy use samples restricted to one particular locality. A well-completed and
rigorous case study is more likely to be useful in other contexts than one that lacks such
rigour. Saunders et al. (2009). Generalisabilty of qualitative research or a case study is
related to significance of this type of research to theoretical propositions (Bryman (1998)
and Yin (2003). Where we are able to relate our research findings to existing theory and
will be in a position to demonstrate that our findings have broader significance than the
case or cases that form the basis of our work (Marshall and Rossman 1999).
3.6 Limitations and Overcoming the Limitations of this Methodology
It has been discussed in many researches that the lack of standardisation in interview may
lead to concern about reliability. Relation to qualitative research reliability is concerned
with whether alternative researches would reveal similar information Easterby-Smith et al.
(2008) and Silverman (2007). The main concern about reliability in the interview is that of
bias. This could be divided into two namley interviewer bias and interviewee bias. It has
been argued that tone or the non verbal behaviour of the interviewer creates bias in the way
that interviewees respond to the question being asked Saunders et al. (2009). This is
because I as an external auditor could attempt to impose my own beliefs and frame of
reference through the questions that I ask. I have discussed the questions more openly as
this is the first time such a study in the context of Sri Lankan auditing environment is done
and this would encourage further research in depth and also could contribute towards the
growth of the auditing profession in Sri Lanka. Since this is an audio Interview through
Skype non verbal behaviours will not influence or affect the interview. Easterby-Smith et
al. (2008) also argues that one could also demonstrate bias in the way that responses are
interpreted. The other main concern is that developing the trust of the interviewee, or
perhaps where the interviewers credibility seem to be lacking, the information or response
45
given by the external auditors’ may be limited, creating doubts about the validity and
reliability.
The other concern is that interviewee may choose not to reveal and discuss certain topic
which interviewer would like to explore, because this may lead to probing question s that
would intrude on sensitive information that they do not wish or not empowered to discuss
with the interviewer Saunders et al. (2009). Healey and Rawlinson (1994) also argued that
assurance from the interviewer that confidential information is not being sought should
make the interviewees more relaxed and open about the information that they willing to
discuss. Combined with assurance about anonymity, Should increase the level of
confidence in trustworthy towards the interviewer and reduce possible interviewee or
response bias. This was overcome by, when permission was sorted from the Partner from
the “Big Four” firm which subjects are from, the partner clearly demonstrated there will be
no restriction on any information to be divulged except for any Individual client
information and their anonymity to be maintained. This was strictly taken into
consideration when questions were asked and interviewee’s only mentioned the industry
and size of their clients. Marshall and Rossman (1999) argued that the responses obtained
through the non-standardised research methods are not necessarily intended to be
repeatable since they reflect reality at the time they were collected, and which may be
subjected to change. This is the reason subjects selected were identified from auditors who
had at least five years of experience so that they have a good knowledge in the prevailing
culture and also could foresee the future of external auditors reliance on internal auditors
with great potential.
3.7 Data Analysis Techniques
Qualitative Research is more interested in the depth of the data rather than breadth and it
requires the researcher to play an active role in collecting the data Wimmeer and Dominik
(1997). Marshall and Rossman (2006) discussed that data analysis as one of the issue that
should be considered at the time of formulating a proposal to undertake a qualitative
research. Kvale (1996) discussed the process of anglicising qualitative data is likely to
begin at the same time as the data is collected and as well as continue afterwards. These
golden rules were taken into consideration when the data was analysed qualitatively. The
46
process of transcription is an important part in analysing the qualitative data obtained
through interviews. It was important to write down the key experience shared by the
auditors and also to make note of the tone of voice used so that the participants’ non-verbal
communication was understood well in analysing the data. In order to save time the entire
interviews were not transcribed fully. Recordings of the interviews were played back twice
and listened while short notes were taken. A mind map was created by differentiating the
topics covered by individual objective set in the research.
Data Analysis in qualitative research was proactive as the interactive nature of the data
collection and analysis allowed to recognise important themes, patterns and relationships
as the interviews were done. This was helpful to re-categorise the existing data to see
whether themes, patterns and relationships were present in both existing literature and
interviews held prior. As Strauss and Corbin (2008) pointed out in the research we were
able to adjust the future data collection to see whether data exist in cases where we intend
to conduct our research. Analysis were done using conceptual and argument techniques
and compared and contrasted with the existing literature.
3.8 Summary
The methodology used was Qualitative, Case study strategy, where semi-structured
interviews were used to collect primary data. This methodology is favoured as most of the
prior researches conducted were based on surveys, questionnaires, and experimental
methods. As discussed above these methods did not prove to reflect the actual intension of
the external auditors’. Frey and Oishi (1995) defines interviews as “a purposeful
conversation in which one person asks prepared questions (interviewer) and another
answers them (respondent)” This type of data collection supports toe research to obtain
information and understand a particular field of topic to be researched using qualitative
methodology. Interviews can be categorised as structured (closed interview style) or
unstructured/semi-structured (open interview style). Wimmeer and Dominik (1997)
discussed that open-ended question in semi-structured interviews allows the interviewer to
probe deeper into the initial responses of those respondents to gain more detailed answers
to the question asked. As Explained in the previous chapter Critical Literature Review was
done prior to identifying the research questions and objectives. Understanding the theory
47
on the Reliance of External Auditors on Internal Auditors was important for this research
and also the prior literature was useful in deriving at the research objectives and questions.
Based on this the case study strategy was chosen to study the Sri Lankan case regarding
external auditors reliance on internal auditors by collecting primary qualitative data
through semi-structured interviews.
48
Chapter 4: Critical Analysis and Discussion
4.1 Introduction
In this Chapter critical analysis and discussion of the data collected through interviews will
be presented. Interviews recorded were played again and listened where summary of the
key points that emerged from the interviews were documented. This summary will
compress long statements into briefer statements in which the main sense of what has been
said or observed is rephrased in few words (Kvale 1996). Statements or quotations made
by external auditors during the interview process will be quoted within double quotation
marks. Data obtained from the interviews will be critically analysed and discussed by
comparing and contrasting with the existing literature and the theoretical framework of
External auditors’ reliance on internal auditors.
4.2 External auditors’ reliance decision and the relationship among competence, objectivity and work performance of the internal audit function
During the interviews regarding the relationship between internal auditors’ competence
and the nature, timing and extent of external auditors’ audit procedures, a senior external
auditor mentioned “Depending on the internal auditors’ competency level, the external
auditors in Sri Lanka adjust the nature, timing and extent of audit procedures performed
after discussion with the audit partner”. When further explanation was requested the
external auditor shared an experience where they had to increase the audit procedures
performed on reliance on fixed asset verification during the year since the internal
auditors’ competency was low. When the clients internal audit competency was low
during the initial years external auditors increased the nature, timing and extent of the audit
procedures. In subsequent years when they identified that the client had a better or high
level of competence with more qualified and skilled audit staff external auditors reduced
the nature, timing and extent of the procedures performed in identified financial statement
caption during the reliance process. Senior external auditor further stated “It has been
evident that the work performed by the internal auditors was at a higher level when the
competency of the internal audit function was high and the work performed was low, when
the competency of the internal audit function is low”. This is complementing the prior
49
findings by Margheim (1986) and Schneider (1985) where they concluded there was a
similar relationship between the nature and audit procedures performed by external
auditors and the competency of the internal audit function.
Margheim (1986) also treated the competence and work performance as one single factor
and the explanation given by the senior auditor explains the reason of this combination is
vital and not to contradict with the fundamental rationalisation of the relationship between
competence and work performance of the internal audit function. Interview with the
external auditor on relationship between objectivity and the two factors such as
competence and work performance of internal audit function, one stated that “The
objectivity ensures the competence and work performance is achieved in an overall internal
control system”. External auditors’ argument is that there is a strong relationship between
these three factors and also they complement each other during the evaluation process of
the internal audit function during reliance decision. This is complementing the findings of
Maletta (1993) and Krishnamoorthy (2002) where they report the similar relationship but
contradicts with the findings of Margheim (1986).
When interviewed and discussed on the risk assessment and the reliance decision and
external audit manager stated that “High inherent risk is linked to more audit procedures by
nature, timing and extent, and when it comes to reliance competence and objectivity should
be high in order to rely on the work performed by internal auditors”. According to further
explanation from the auditor it is the high competence and objectivity of the internal
auditor that will ensure high level of work performance by internal auditors. This argument
is complementing the findings of Maletta (1993) where he found that when inherent risk
was high external auditors relied on the work of internal auditors only if the objectivity
was high. But there was no direct evidence on the competence level and the work
performance when the inherent risk was high; rather competence was the important factor
in all inherent risk conditions. But from the mangers explanation it is evident that both
competence and objectivity should be at higher level in order to rely on the work of the
internal auditors. The relationship between all three factors is confirmed once again.
The interviews regarding substantive and control testing in reliance decision revealed that
there was no much different in Sri Lankan auditing environment compared to other
developed countries and prior literature. One senior external auditor stated “Using external
50
auditors work in test of control is more preferred than in substantive work”. Further he
explained that the main reason for this preference is that external auditors feel comfortable
in using the control testing by internal auditors as it’s more transparent compared to
substantive work. This is because today the “big four” audit firms use more sophisticated
sampling methods and also external auditors consider that manipulation of sampling in
substantive work is higher than in control testing. This finding in Sri Lanka also
complements the prior findings by Ward and Robertson (1979) and Whittington and
Margheim (1993) as they concluded the same where external auditors preferred letting the
internal auditors perform more control testing rather than substantive work and eventually
this helped the external auditors reliance on internal auditors.
When questioned individually on the three factors such as competence, objectivity and
work performed the explanation given by external auditors did not vary significantly with
the prior literature as this is standardised or rather structuralise by the relevant auditing
standards used internationally on using the work of internal auditors by external auditors to
perform their financial statement audit. These findings are evident that no single factor
dominates others in all conditions.
4.3 Impact of independence on the reliance decision
According to a senior external auditor who had experience in evaluating the reliance
decision of the internal audit in Sri Lankan perspective stated that “Independence of the
internal audit is an important factor” which influenced his decision in deciding whether to
rely on internal audit or not. He also stressed that independence is an essential factor which
is expected to be fulfilled by the corporate governance requirements and also the
regulatory bodies. This independence factor was discussed long before by Gibbs and
Schroeder (1979); Clark (1981a; 1981b); Brown (1983) and Abdel-Khalik, et al. (1983) in
their researches respectively. When discussed further about the prior year experience on
the nature of the internal audit functions and whether it was an influencing factor in the
reliance decision, the senior auditor argued that prior year experience would be used only
if there are no major changes in the nature of the internal audit function. He further stated
that in the last five years he has witnessed various structural changes in the internal audit
departments in Sri Lanka where many listed firms have started to increase their staff
51
strength and invest more in internal audit function. According to the auditor this is mainly
due to two reasons which one of it is the increased pressure from the regulatory bodies and
the other is foreign investor’s willingness to invest in Sri Lanka in the post war period,
expecting high quality of effective internal controls and corporate governance practises in
the listed companies. Interestingly the senior auditor explained this development has
encouraged them to rely on internal auditors as the departments are effective and stronger
than ever before. Discussion with this senior external auditor revealed that the
effectiveness and importance given to internal audit function by their clients was a
significant factor in the reliance decision. When questioned about the three dimensions
such as competence, objectivity and work performance of the internal audit and the most
important factor out of these three, he explained in his experience all three factors were
equally important when evaluating the internal audit function for reliance purpose. He
mentioned that no single factor could be prioritised than the other.
According to a senior audit manager who had experience in also working with another “big
four” which operates in Sri Lanka stated “Audit procedures we use in the “big four” and
the tools such as Computer Aided Audit Tools (CAATS) significantly influences the
reliance decision on substantive procedures performed by internal audit function”. When
further clarifying this statement he explained that certain audit procedures performed using
CAATS by the external auditors restricts them in relying on the internal audit workings as
the requirements of the work performed are different, especially when it comes to the
substantive work. He also explained that his experience in confirming Information
technology controls had similar problems with certain clients as these tools conflict among
the external and internal auditors. This was an interesting finding in the research as there
were no such prior researches commenting on the tools used by external auditors and the
reliance decision.
4.4 Impact of corporate governance and regulations on the reliance decision
When questioned from an external audit manager who had experienced in auditing
Banking and other Financial Institutions in Sri Lanka stated “During the last decade
corporate governance rules have become more important towards the Listed companies
and Financial institutions, and this has increased the effectiveness of internal audit and this
52
leads to reliance decision of external auditors”. Further discussing on this subject he
explained that the Colombo Stock Exchange has made it mandatory for the listed
companies in Sri Lanka to be in compliance with the Corporate Governance Code which
was jointly issued by the Institute of chartered accountants of Sri Lanka and the Securities
and Exchange Commission of Sri Lanka effectively from April 1, 2008. He also explained
due to this reason all listed companies invested on establishing an internal audit function,
which eventually strengthened the internal control function in listed companies. When
asked about how this regulation has influenced the external auditors’ reliance decision on
internal auditors, he explained that before this the listed companies had a vague and
ineffective internal audit function. But after the regulations were imposed qualified internal
auditors were recruited to make the internal audit departments effective. This further
encouraged the external auditors to rely on internal audit.
The senior auditor confirmed that competence, objectivity and work performed, all three
factors were equally important when reliance decision was made, and he experienced that
reliance was more effective after the regulatory changes compared with the past. This
confirms that the recent regulatory changes in Sri Lanka influenced the reliance decision of
the external auditors. When explaining on Banking and financial institutions he mentioned
“During the year 2007 The Governor of the Central Bank of Sri Lanka has issued direction
to amend the Banking Act No.30 of 1988 relating to corporate governance requirements to
regulate the banking sector with strong internal audit functions”. When the Manager
explained in detail it was revealed that the banks in Sri Lanka did not have an effective
internal audit function before 2007 and the external auditors’ reliance on the internal audit
function was less effective. But after 2007 amendments to regulatory requirements, banks
have strengthened their internal audit functions. As a result of that the reliance decisions of
the external auditors increased to a greater extend. Again all three factors namely
competence, objectivity and work performed equally contributed towards the reliance
decision. When discussed about the same matter with another senior external auditor he
explained that in the banking sector after 2007 amendments to the regulation, work
performance was the most important factor which influenced the reliance decision. As he
stated “Bank supervision department of Central Bank in Sri Lanka reviews the internal
audit departments of banks once a year by reviewing the work performed by internal
auditors”. These reviews encouraged the external auditors’ to rely based on the work
performed by internal auditors. According to prior research Brown (1983); Schneider
53
(1984); (1985a); (1985b); and Margheim (1986) also identified work performance of the
internal auditors as the most important factor influencing the reliance decision of the
external auditors.
When discussion with Senior Manager on the Litigation and regulatory cost for external
auditors’ in Sri Lanka the manager mentioned “The cost of litigations and regulatory is not
a major threat on reliance decision, but the Sri Lanka Accounting and Auditing Standards
Monitoring Board (SLAASMB) in recent years has followed many recent scandals and
imposed strict fines on auditors who have not discharged their duties”. Further when
clarifying on this matter manager explained that if the litigation or legal cost is high the
reliance on internal audit function was minimum or none even if the client had a strong and
effective internal control function. This finding in Sri Lanka was complementing the
findings by Vikram et al. (2010). Senior manager who discussed on the audit committees
role and the reliance decision explained that effective communication among external
auditors and the clients audit committees positively influenced the reliance decision. This
is mainly because audit committees who followed the internal audit reports and findings
discussed the important matters in the meetings with the external auditors.
4.5 Audit fee pressure and its influence on external auditors’ reliance decision
During the interviews held to collect data external auditors were inquired on the reliance
decision of external auditors and its impact on the audit fee. Audit Senior Manager who
had a very good experience in the reliance decision and the audit fee structure stated
“Increasing audit fees has brought concerns in the board rooms and among the
shareholders” and interestingly he also stated “Directors and shareholders require effective
and efficient internal controls and audit’s than ever before”. This is a conflicting goal or
expectation from the board and shareholders he explained further. It is a known fact that
after introduction of the Sarbanes and Oxley (SOX) Act 2002 in The United States and the
introduction Internal Control over Financial Reporting internal audit work increased and
external auditors also needed to certify the work of the internal auditors. This showed a
great increase in related audit fees and SOX 404 working required by the act. This nature
of regulatory requirement is not in force in Sri Lanka but it should be understood that the
54
cost of auditing will be high when both the internal and external audit is at high level to
meet the expectations. When further asked about the reliance decision and how this
directly impacts the audit fee’s he stated that “Reliance on internal auditors’ do help to
reduce the planned work hours and nature and timing of certain audit procedures”. This
was evident that there is a relationship between reliance decision and audit fees, where the
reliance tends to reduce the external audit fees, prior findings by Felix (2001) and Al-
Twaijry (2004) also confirms the same.
When discussed about the reduction of planned audit hours based on the reliance on
internal audit and the it’s impact on audit effectiveness, manager replied saying “External
auditors will never compromise on audit effectiveness even when the audit fee is reduced
or reliance on internal auditors is agreed in engagement”. Further clarifying on the partner
preference the manager stated “Partners give importance to audit quality and effectiveness
by strictly following the required standards and professional skeptism”. He also stated that
“Client fee pressure doesn’t influence the partners’ preference or the reliance decision on
the internal auditors”. This evident that even though in Sri Lanka reliance decision on
internal auditors reduces the audit cost it is not driven by the client fee pressure. External
auditors give preference to the quality and the effectiveness of the audit. Partner preference
is also based on the audit quality and its effectiveness rather than client fee pressure. This
finding in Sri Lnaka complements the finding by Gramling (1999) where he didn’t find any
interactive effect between client fee pressure and partner preference on audit managers’
reliance decisions. But Gramling (1999) argued that client’s fee pressure had an effect on
mangers reliance decision as this is not the same in Sri Lanka as explained above by the
manager.
When questioned about the relevant auditing standards which is been used in Sri Lanka
regarding the external auditors reliance decision on internal auditors. Senior Manager
stated ”In Sri Lanka SLAuS 610 (ICASL 2009) is used and in the case of subsidiaries
which have their parent companies outside Sri Lanka will be reported in accordance with
ISA 610 and for the companies listed in United States SAS 65 (AICPA 1991) will be
considered”. He also explained that the main difference in SAS 65 (AICPA 1991) is that it
allows the external auditors to use internal auditors as direct assistance and other standard
doesn’t incorporate this. This difference is clearly discussed in the literature review chapter
under the theoretical and auditing standards in reliance decision section.
55
4.6 Sourcing arrangement of Internal Audit and its impact on Reliance Decision of External Auditors’
The interviews also consisted questions on sourcing arrangement of the internal auditors
and its impact on external auditors’ reliance decision. One manager stated that “In Sri
Lanka some companies have outsourced their internal audit departments to professional
internal auditors such as Chartered accountancy firms”. When further inquired how this
directly impacts on the reliance decision, he explained that outsourcing the internal audit
by the clients has increased the reliance on internal audit because these professional
internal auditors are independent from the management. He said that due to this
independence nature reliance on internal audit was high in clients who have out sourced
their internal audit departments. The other argument in the sourcing arrangement is that
regulations have restricted audit firms to conduct both internal and external audit in one
organisation. This has increased the independence of the internal audit function and
positively influences the reliance decision.
Senior external auditor shared his experience stating “Our client had an in-house internal
audit function in the past and last year outsourced the entire internal audit function to
another “big four” this immediately impacted on our reliance decision”. He further
explained saying that the outsourced internal audit function had effective scope of internal
auditing combined with effective procedures to encourage the reliance decision of external
auditors.
4.7 External Auditors Reliance on Internal Auditors for Direct assistance
External auditors were inquired on this area briefly and as expected the external auditors
mentioned that none of them had prior experience in using internal auditors as direct
assistants in performing any of the audit work or participated as a team member. This
reliance was clearly discussed in the literature review that neither ISA 610 nor SLAuS 610
covers or permits the use of the internal auditors’ to directly assist the external auditors.
This was clearly identified in the literature review as the key difference in the Auditing
standard SAS 65 which is followed in the United States and ISA 610 internationally. But a
56
senior external auditor explained that one of his clients was a subsidiary of listed company
in United States.
4.8 Summary
In this chapter qualitative data obtained through semi-structured interviews with external
auditors was discussed and analysed. External auditors statements were compared and
analysed with prior literature obtained through literature review. The results from this
discussion and analysis proves that external auditors reliance decision on internal auditors
in Sri Lanka does not vary significantly from the prior findings in other developed
countries. But it should be noted that discussion revealed that internal auditing in Sri Lanka
is still an emerging function and the reliance on internal function was at a lower level when
compared to developed countries. But it is encouraging that Sri Lankan internal audit
function has gradually developed in the last five years mainly due to the regulatory
requirements and pressure from shareholders. Thus it will increase the reliance decision in
future.
57
Chapter 5: Conclusion
5.1 Summary of Findings and Recommendations
The findings from this research on External Auditors’ reliance decision on internal
auditors’ in the Sri Lankan Case it is evident that the three factors such as Competence,
work performance and objectivity which are used to assess the internal auditors or internal
audit function has a significant and equally complementing relationship between all three
factors, and no single factor will dominate the other factors at any given condition. It is
evident from this research that in Sri Lanka reliance on internal auditors does reduce the
external audit fee thus eventually it reduces the total cost of auditing. But it is also evident
that client fee pressure does not directly influence the partner’s preference or the
manager’s reliance decision on internal audit. This research shows that communication
between external auditors and audit committees were a significant influence in external
auditors’ reliance decision on internal auditors in Sri Lanka. Effective communication
among external auditors and audit committees resulted in high and confident reliance over
the internal auditors by external auditors.
This research identifies that sourcing arrangement of the internal audit has an impact on the
reliance decision of external auditors. It is evident that the external auditors’ reliance
increased when the clients outsourced their internal audit functions to independent internal
audit consultants or professional audit firms. In this research it was evident that the
reliance decision of external auditors defers from companies in Sri Lanka as the internal
audit functions are different in accordance with industry specific regulatory requirements.
This research in Sri Lanka ensure that using internal auditors as direct assistants to perform
external auditors’ work is not accommodated in the International standards ISA 610 or in
SLAuS 610 (ICASL 1999). Using internal auditors as direct assistance has been practised
in the United States for decades and after the Sarbanes and Oxley Act 2002 it has increased
further. Developed countries and other developing countries should consider this option to
incorporate in their standards. Prior Literature reviewed for this research indicated that the
external auditors from the United States have benefited from using internal auditors as
direct assistance.
58
As summarised in the findings the results obtained from Sri Lanka has not significantly
varied from the prior literature. Even though the internal audit function and the reliance
decision in Sri Lanka has not developed to that extent of the developed nations.
5.2 Contribution of this Dissertation
This is one of the pioneering researches conducted in the case of Sri Lankan external
auditing environment. This research explains the external auditors’ reliance decision in Sri
Lankan perspective and how it is linked with the regulatory environment. This research
was done using Semi structured interviews conducted with the external auditors, and the
explanations and arguments obtained were more practical and actual experience of the
external auditors from Sri Lanka. Prior literature on reliance of external auditors’ decision
was evaluated mostly based on experiments conducted with external auditors in
hypothetical situation. This research develops a clear structural ground situation to future
researches that could be done in Sri Lanka and other developing countries on this area of
study
5.3 Limitations of this research
This research was done based on a case study using a selected “Big four” audit firms
external audit staff in Sri Lanka. Findings from this research will not be fully reflecting
the views of all Sri Lankan external auditors. As Bryman (1988) stated since the research
was done in one organisation with selected interviewees generalisation of the entire
external auditor’s population in Sri Lanka is not possible from this research. Since the
interviewees were randomly selected by the Partner who is the head of Audit in the
organisation, this random interviewees selection method was not verified or rather could
not be verified. The interviews selected may or may not be expressing the views of the
Partner involved and thus it might not reflect the actual views or experience face by the
external auditors in Sri Lanka. Interviews held by ‘Skype’ which was only voice
conversation where as the benefits attainable from head to head or direct interviews were
not available. Interviewer and interviewee bias could influence the discussion and results
59
obtained. Some argue that auditors use judgmental decision based on professional skepticm
and the research results obtained could vary due to individual perceptions.
5.4 Suggestion for Future Researches
Prior Literature has not concentrated much on the tools and techniques such as CAATS
used by external auditors and how that influences the reliance decision. Because in this
research there was an argument and suggestion made that there is a relationship between
the tools used by external auditors in performing substantive procedures and reliance
decision on internal auditors work. Future researches should concentrate on this area in
future as it is evident auditing profession is moving in a rapid phase with the developing
technologies especially with automated controls. Future researches on this area of study
should concentrate on using practical and actual evidence as used in this research rather
than experimental method. More researches in similar reliance decision should be done in
developing countries as they play a big part in the world economy in cost reduction and
cost saving programmes.
60
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Appendix A – Ethical Approval
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Appendix B – List of Interviewees
Serial No.
Date and Time Designation No. of years in experience
Qualification Comments
1 July 05, 8.30 a.m. Senior Audit Manager
12 ACA, FCMA
2 August 05, 9.00 a.m.
Senior Audit Manager
9 ACA, FCMA Financial Services expert
3 July 07, 8.30 a.m. Senior Audit Manager
8 ACA
4 August 08, 4.00 p.m.
Senior Audit Manager
8 ACA, CIMA
5 August 10, 3.00 p.m.
Audit Manager
7 ACA IT specialist
6 August 03, 3.30 p.m.
Audit Manager
7 ACA
7 August 04, 8.30 a.m.
Audit Manager
7 ACA
8 August 04, 3.30 p.m.
Audit Senior 5 ACA, Finalist SOX experienced
9 August 05, 4.00 p.m.
Audit Senior 5 ACA, Finalist
10 August 09, 4.00 p.m.
Audit Senior 5 ACA, Finalist
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Appendix C – Sample of Interview Questions
1. Research background and Interview
• Give a brief Introduction on the research Objectives and Questions to the participants.
• Agreeing on confidentiality and research ethics. • Discussion on Participants Qualification, Experience and Industry Exposure
on external audit.
2. Reliance on Internal Audit decision prior to the acceptance of an Audit Engagement
• Does the strong internal audit function influence the decision to audit a client?
• Does the reliance decision on internal audit will impact significantly on the audit fee?
• How does this help to compete in the audit market by reducing the audit fee?
• Does the reliance decision impact on the planned hours and impact on the audit effectiveness?
3. Reliance on Internal Audit decision prior to commencing of an Audit Engagement
• Does the reliance decision considered during planning stage of the audit? (Planning discussion with the client and among the audit team, better to include or have this in mind)
• Do the Auditors have the opportunity to document include internal audit work during the audit process?
• Would you consider any specific areas of internal during the audit process?
4. Reliance on Internal Audit based on auditing standards
• How the relevant standards (SLAuS 610 and ISA 610) considered when the reliance decision is materialised?
• Will the internal audit reliance scope of the firm be limited to the minimal requirements of the above standards or will cover wider range?
• How factors such as Competence, Objectivity and work performance of internal audit function is assessed?
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• Discussion on the relationship among these three factors Competence, Objectivity and work performance with practical experience faced by the external auditors
5. Regulatory requirements on Internal audit function and the impact on reliance decision
• How do the Regulatory bodies in Sri Lanka perceive and enforce the role of internal audit functions in Public Companies and Financial Institutions?
• Are there any impacts on the scope of the internal audit due to the regulatory bodies?
• How does this difference enforcement of regulatory bodies help the external auditors in the reliance decision?
• Risk of regulatory and litigation cost and how it impacts on reliance decision?
• Explain the differences with examples and experience obtained during audit process?
6. Role of Corporate Governance requirements towards Internal Audit function
in Sri Lanka and its influence on reliance decision
• Does the Corporate Governance in Sri Lanka enforce strong internal audit practise?
• Do the corporate governance requirements differ based on Company size, Legal status and reporting requirements?
• Does the above difference between industries influence the changes in internal audit function and the external auditors’ reliance decision?
7. Communication among External auditors and Audit committee on internal auditors function and the impact on reliance decision
• How often the Audit committee and External auditors communicate on internal audit issues?
• What mode of communication is preferred; email, meetings, conference calls etc?
• Does the Audit committee report significant findings by internal auditors on time to external auditors?
• Does the scope of Internal Audit communicated clearly to the external auditors?
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8. External auditors using internal auditors to directly assist in conducting audit procedures
• Does the external auditor in Sri Lanka use internal auditors as direct assistance in performing audit procedures?
• If yes or No reasons for this decision on reliance?
9. External Auditors reliance based on Internal Audit Function whether it is In-house or Out source
• How does the sourcing arrangement of internal audit influence the reliance decision of external auditors?
• Explanations with practical experience?
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Appendix D – The 3 key Factors Competence, objectivity and work performance Factors Definition Evidence Description of Evidence Competence Competence has
been defined as the educational level and professional experience of the internal auditor and other such factors.
1. Evidence concerning auditor qualifications and training.
2. Evidence of audit planning and supervision.
3. Evidence of auditor tacit knowledge.
1. Auditor qualification and training:
• Educational background
• Certification • In-house training
program • Support for continuing
education 2. Audit planning and supervision:
• System of defined responsibilities
• Review of procedures and working papers
• Planning of work 3. Tacit knowledge:
• Experience or knowledge about the company
• Experience or knowledge about auditing the company
Work Performance
Work performance has been defined as internal control and risk assessment, and substantive procedures performed by the internal auditor.
1. Evidence of internal audit effort.
2. Evidence of execution of internal audit plan.
3. Evidence of thoroughness and quality of internal audit reporting.
1. Internal audit effort: • Time spent on audits • Number of items
examined • Sampling techniques
used • EDP audit techniques
used 2. Execution of internal audit plan:
• Number of areas audited
• Number of audits completed versus number of audits planned
3. Thoroughness and quality of internal audit reporting:
• Completeness of audit programs and working papers
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• Quantity and quality of working papers documentation
4. Quality of corporate governance:
• Minutes of audit committee meetings
• Documentation of communication between IAF and audit committee
• Verification of directors’ independence
• Education and experience of audit committee members
Objectivity Objectivity has been defined as the organizational status of the internal auditor and organizational policies affecting the independence of the internal auditor.
1. Evidence of managerial reporting relationship.
2. Evidence of breadth and scope of investigatory scope.
3. Evidence of Recommendation implementation.
1.Managerial reporting relationship:
• Level to which IA reports
• Level to which IA report’s findings
2. Breadth and scope: • Ability to investigate
any area • Freedom from
conflicting duties 3. Recommendation implementation:
• Disposition of recommendations
• IA’s access to audit committee
4. Quality of corporate governance:
• Minutes of audit committee meetings
• Documentation of communication between IAF and audit committee
• Verification of directors’ independence
• Education and experience of audit committee members
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Source: Vikram et al. (2010)
