The Role of Internal Audit in the
Financial Statement Audit Process

Mario J. Maletta, Associate Professor, Northeastern University
Audrey A. Gramling, PricewaterhouseCoopers Faculty Fellow, Wake Forest University

For over a quarter of a century, the American Institute of Certified Public Accountants (AICPA) and the Institute of Internal Auditors (IIA) have recognized the unique and potentially significant role that an entity’s internal audit function can play in the external financial statement audit (see SAS No. 9 [AICPA 1975], SAS No. 65 [AICPA 1991], Specific Standard 550 [IIA 1995]). Also during this time period, the accounting academic community has conducted research investigating various aspects of the relationship between internal and external auditors. This research has been directed toward determining the extent and nature of internal audit contribution to the financial statement audit, and gaining a better understanding of the processes by which decisions to utilize the work of internal auditors are made. While evidence suggests that external auditors have not traditionally maximized their relationships with internal auditors, changes in the audit environment over the most recent decade have increased the potential for internal audit utilization and hence, underscored the importance of research in this area. Specifically, increases in competition have put downward pressures on audit fees, while at the same time, increases in the complexity of business organizations and concerns over litigation have increased the magnitude and required effectiveness of the external audit examination. These environmental changes have served to enhance the potential for internal audit contribution to the external financial statement audit and, accordingly, the need for a better understanding of internal/external auditor relations.

Our purpose here is to provide a relatively perfunctory review of academic research conducted during the last quarter of a century in the area of internal audit contribution to the financial statement audit and to highlight some of the major contributions. Our hope is that the delineation of some of the significant findings regarding the past and current role of internal auditors in the financial statement audit will: (1) provide the professional community with a greater understanding of the potential benefits of internal audit contribution to the audit process, (2) increase the communication and coordination between the two audit groups and, ultimately, (3) increase the efficiency and effectiveness of the internal auditors’ contribution. For discussion purposes, we have chosen to divide the literature into four subsections based on our view of the timing and nature of the studies performed. All of the studies relevant to each section are not addressed in this paper. A more complete discussion of the literature regarding the role of the internal audit function in the financial statement audit can be found in Gramling and Maletta (1999).

Internal Audit Objectivity, Competence and Quality of Work
Much of the initial research regarding internal audit functions investigated whether external auditors followed the directives set forth in official auditing pronouncements. The earliest research focused on external auditor assessment of the three internal audit factors originally identified in SAS No. 9: internal audit objectivity, competence and quality of work performed. In particular, these studies attempted to determine whether auditors actually considered these three factors when evaluating the overall quality of an internal audit function and, if so, the criteria that were included in the assessment of each individual factor. This literature was necessary as SAS No. 9 provided little, if any, guidance concerning how these dimensions of internal auditors should be evaluated.

In one of the important descriptive studies addressing this particular issue, Gibbs and Schroeder (1980) performed a series of surveys and experiments that led to the identification of ranked lists of criteria used by external auditors to evaluate the three internal audit factors. Their findings revealed that external auditors’ assessments of internal audit competence were principally a function of the internal auditors’ knowledge of company operations and the quantity and quality of the internal audit staff’s supervision. Internal auditor objectivity was determined to be a function of the independence of the internal audit department and the level to which the internal audit department reports. Finally, the primary factors considered by external auditors in evaluating the quality of the internal auditors’ work were management’s overall support for the internal audit function and their readiness to act on internal audit recommendations. The findings of this study, as well as others like it at the time, found their way into the practice community as they provided significant practical guidance to the profession at a time when, arguably, the official pronouncements did not.

The Extent of Internal Audit Contribution to the Financial Statement Audit
As the 1980s began, internal audit research shifted its focus away from external auditors’ assessments of the three internal audit factors toward questions regarding the extent of internal auditor utilization in the performance of the financial statement audit. At the time little, if any, information was available in either the practice or research communities regarding the extent and nature of internal audit activities related to the financial statement audit. One of the initial studies in this area was a survey conducted by Ward and Robertson (1980) involving internal and external auditor perceptions regarding the extent of external auditor reliance on internal auditors and the sufficiency of such reliance. The findings suggested some degree of internal audit reliance on most engagements. However, they also indicated that a majority of internal and external auditors did not believe that external auditors fully utilized the potential of the internal auditors in performing the external audit examination.

A subsequent time-series study by Wallace (1984) examined the impact of internal audit activities on external audit activities. Wallace (1984) found that from 1975 to 1981, there was an increase in the extent to which external auditors modified their audit programs as a result of internal audit activities. Similarly, she found increases in the utilization of internal auditors in the documentation and audit testing phases of the external audit. However, Wallace (1984) also found that, on average, only 5 percent of the total hours necessary for completing the audit were allocated to the internal audit function.

These studies were important as they provided evidence indicating that internal auditors had the potential to make a valuable contribution to the external audit examination. Yet, they also suggested that external auditors were not fully utilizing the valuable potential of their clients’ internal audit departments.

The Process of Determining the Role of Internal Audit
In the mid-1980s, a number of studies refocused the research on the three internal audit factors discussed in the professional external auditing standards: objectivity, competence and quality of work performed. Instead of examining external auditors’ assessments of these factors in isolation, these studies used the earlier research findings to investigate the process by which external auditors combined and weighted the three internal audit factors in making decisions to actually use the internal audit function in performing the financial statement audit. One of the primary purposes of this stream of research was to determine which factors were most critical in external auditors’ decisions to utilize the internal auditors. The logic was that if certain factors could be identified as being of greater importance than others, then internal audit departments could focus on improving those qualities and, thus, increase their contribution to the external financial statement audit.

The first of these studies was performed by Brown (1983), with a series of subsequent studies performed by Abdelkhalik et al. (1983), Schneider (1984, 1985) and Margheim (1986). This research followed a similar approach to that of earlier work in that external auditors were given a description of a client and, in some cases, a particular area of the external audit. They were then provided with one or more internal audit profiles and asked to determine how and/or to what extent they would use the internal auditors in performing the external financial statement audit. The results of these studies were mixed, as no specific internal audit factor was systematically found to be most important across this series of studies. Further, the extent of internal audit reliance varied widely across auditors and across studies. These findings suggested that external auditors’ decisions to rely on internal auditors were situationally determined and were likely to be more than just a function of internal audit quality or, more specifically, the competence, objectivity and work quality of the internal auditors. Instead, these studies suggested that additional environmental audit factors might play a critical role in the extent and nature of internal audit contribution to the financial statement audit.

Environmental Audit Factors and the Role of Internal Auditors
At the same time that academic research was suggesting that the use of internal auditors in the performance of the financial statement audit was not simply a function of internal audit factors, the AICPA began drafting a new, more comprehensive pronouncement addressing internal audit reliance (SAS No. 65, AICPA 1991). These events inspired a series of additional internal audit studies that attempted to identify factors from the audit environment which could be significant in determining the extent to which internal auditors contribute to the financial statement audit. These studies included experimental work performed by Maletta (1993), Maletta and Kida (1993) and Gramling (1999). In particular, Maletta (1993) and Maletta and Kida (1993) investigated the role of various audit risk factors (i.e., inherent risk, control risk) on the extent and nature of internal audit reliance by external auditors. Gramling (1999) examined the effect of fee pressure on external auditors’ decision to rely on internal audit work.

Maletta (1993) revealed that external auditors’ decisions to use internal auditors as assistants in performing the audit were a function of the level of inherent risk associated with the area being audited, as well as the quality of the internal auditors. In fact, the findings of the study indicated that the process by which external auditors evaluate the quality of the internal auditors increased in complexity as the level of inherent risk increased.

Maletta and Kida (1993) examined the extent to which external auditors reduced the extent of planned external audit work due to the work of the internal audit function. Their findings indicated that the magnitude of the reduction of planned audit work was a function of both inherent and control risk factors, as well as factors associated with the competence, objectivity and work quality of the internal auditors. The study also revealed that external auditors reduced their work by up to 28 percent depending on the risk conditions and the quality of the internal auditors.

Gramling (1999) investigated whether downward pressures on audit fees could potentially affect the role of internal audit in the financial statement audit. Her results indicate that external audit managers encountering clients who explicitly impose a high level of fee pressure rely on the work of the client’s internal auditor to a greater extent than audit managers encountering clients who do not explicitly state such a preference.

Overall, the importance of these studies is that they revealed that decisions to use internal auditors in the financial statement audit are not simple, nor are they merely a function of factors specific to the internal auditors. Instead, these studies indicated that environmental audit factors are considered in external auditors’ decisions to rely on internal audit functions.

Conclusion
Our discussion highlights a number of findings from academic research over the last 25 years. First, the objectivity, competence and work quality of a client’s internal audit function are important factors used by external auditors in assessing overall internal audit quality. Second, these same factors play a significant role in determining the extent to which the internal audit function will contribute to the completion of the financial statement audit. Third, in addition to factors specific to the internal auditors, external auditors are significantly affected by audit risk factors and client fee pressures when determining the extent to which they will rely on the work of internal auditors in performing the audit examination.

While these findings provide a basis on which researchers and practitioners can build an understanding of internal audit’s potential for contribution to the financial statement audit process, it is important to consider how the changing audit environment will influence the evolving role of internal auditors in this process. Current changes include new risk-based approaches to financial statement auditing currently being adopted by many audit firms (e.g., Bell et al. 1997) and increasing complexity of business organizations and environments in the global economy. These changes suggest the need for future research and greater understanding of the potential role of internal audit in the financial statement process. It is our hope that researchers and practitioners will work together to determine how to best increase the efficiency and effectiveness with which the internal and external auditors coordinate their efforts to complete the financial statement audit.

REFERENCES

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Gramling, A. A. 1999. External auditors’ reliance on internal auditors: The importance of client fee pressure in this reliance decision. Working paper, Wake Forest University.

———, and M. J. Maletta. 1999. The evolving role of the internal audit function in the financial statement audit. Working paper, Wake Forest University.

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———, and T. Kida. 1993. The effect of risk factors on auditors’ configural information processing. The Accounting Review (68): 681–691.

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Wallace, W. A. 1984. A Time Series Analysis of the Effect of Internal Audit Activities on External Audit Fees. Altamonte Springs, FL: IIA.

Ward, D. D., and J. C. Robertson. 1980. Reliance on internal auditors. Journal of Accountancy (150, 4): 62–74.

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