Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get it Wrong?
Posted: 20 Aug 2011 Last revised: 23 Aug 2011
Date Written: August 1, 2011
The Sarbanes-Oxley Act (SOX) prohibits companies from outsourcing internal audit work to their external audit provider, likely under the assumption that involvement in the internal audit function creates "economic bonding" between the external auditor and client, resulting in less objective audits and, by extension, less reliable external financial statements. However, a competing argument posits that assisting with internal audit services creates opportunities for "knowledge spillover," resulting in a more informed and effective audit of the client's financial statements. Using proprietary data, we investigate whether companies that outsourced internal audit work to their external auditor pre-SOX had higher or lower risk of misleading or fraudulent external financial reporting. Examining this question is important both for evaluating the effects of this specific prohibition and for informing future deliberations on the effects of the broader set of non-audit services that are or could be offered by external auditors. 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. While improving external financial reporting quality is likely only one aspect of what SOX intended to accomplish through the prohibition of internal audit outsourcing, our results suggest that this provision of the law was not successful in this regard. Future deliberations by policy makers should include careful analysis of the possible unintended consequences of reducing coordination among the parties involved in corporate governance.
Keywords: Internal Audit Function, Outsourcing, Sarbanes-Oxley Act, Corporate Governance, Financial Reporting Quality, Accounting Risk
JEL Classification: M41, M43, M49, M55, G34, G38, K22
Suggested Citation: Suggested Citation