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Pre-Audit Information, Outsourcing and Perceived Auditor Independence
Derek K. Chan,
University of Hong Kong
ABSTRACT. Pae and Yoo (2001) show that asymmetric information about the internal control system (ICS) quality of a client when audit fees are negotiated results in an efficiency loss due to a suboptimal allocation of audit effort and ICS quality. The reason for this efficiency loss is the lack of an effective mechanism to regulate the supply of ICS quality by the client because the audit fee it pays does not reflect its ICS quality. I show that outsourcing the ICS to the client's external auditor will solve this asymmetric information problem. More importantly, I show that if the uncertainty about the pre-audit information (i.e., the client's ICS quality) is sufficiently high, this informational benefit becomes so significant that it makes outsourcing optimal, even if the auditor is a less cost-effective ICS provider, or the investors in the capital market discount the informativeness of the audited financial statements in response to the auditor independence concern.
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