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Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get It Wrong?

47 Pages Posted: 29 Jan 2009 Last revised: 5 Feb 2015

Douglas F. Prawitt

Brigham Young University

Nathan Y. Sharp

Texas A&M University - Department of Accounting

David A. Wood

Brigham Young University - School of Accountancy

Multiple version iconThere are 2 versions of this paper

Date Written: 2012

Abstract

The Sarbanes-Oxley Act (SOX) prohibits companies from outsourcing internal audit work to their external audit provider. Competing predictions on the effects of this prohibition stem from two academic arguments relating to the provision of nonaudit services by the external auditor: knowledge spillover and economic bonding. Using proprietary data, we investigate whether companies that outsourced internal audit work to their external auditor pre-SOX had a higher risk of misleading or fraudulent external financial reporting (accounting risk). Consistent with the knowledge spillover argument, our results indicate that prior to SOX, outsourcing internal audit work to the external auditor is associated with lower accounting risk as compared to keeping the internal audit function (IAF) entirely in-house or outsourcing the work of the IAF to a third party other than the external auditor. The magnitude of the relation is significant, as outsourcing to the external auditor is associated with a 23 percent reduction in accounting risk relative to firms that kept the IAF in-house.

Keywords: Internal Audit Function, Outsourcing, Sarbanes-Oxley Act, Corporate Governance, Financial Reporting Quality, and Accounting Risk

JEL Classification: M41, M43, M49, M55, G34, G38, K22

Suggested Citation

Prawitt, Douglas F. and Sharp, Nathan Y. and Wood, David A., Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get It Wrong? (2012). Contemporary Accounting Research, Vol. 29, No. 4, 2012. Available at SSRN: https://ssrn.com/abstract=1333710 or http://dx.doi.org/10.2139/ssrn.1333710

Douglas F. Prawitt

Brigham Young University ( email )

Provo, UT 84602
United States
801-422-2351 (Phone)

Nathan Y. Sharp

Texas A&M University - Department of Accounting ( email )

4353 TAMU
College Station, TX 77843-4353
United States
979-845-0338 (Phone)

David A. Wood (Contact Author)

Brigham Young University - School of Accountancy ( email )

518 TNRB
Brigham Young University
Provo, UT 84602
United States
801-422-8642 (Phone)
801-422-0621 (Fax)

HOME PAGE: http://marriottschool.byu.edu/employee/employee.cfm?emp=daw44

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