Is the type of outsourced internal audit function provider associated with audit efficiency? Empirical evidence from Oman

Published date01 November 2019
DOIhttp://doi.org/10.1111/ijau.12170
Date01 November 2019
ORIGINAL ARTICLE
Is the type of outsourced internal audit function provider
associated with audit efficiency? Empirical evidence
from Oman
Saeed Rabea Baatwah
1,2
| Abood Mohammad Al-Ebel
3
| Muneer Rajab Amrah
4
1
Department of Accounting, College of
Business Administration, Shaqra University,
Shaqra, Saudi Arabia
2
Department of Accounting, College of
Administrative Sciences, Seiyun University,
Seiyun, Yemen
3
Department of Accounting, Faculty of
Administrative Sciences, Hadhramout
University, Fuwwah, Yemen
4
Department of Accounting, College of
Business Administration, Seiyun University,
Seiyun, Yemen
Correspondence
Saeed Rabea Baatwah, Department of
Accounting, College of Business
Administration, Shaqra University, Shaqra,
Saudi Arabia.
Email: sbaatwah@yahoo.com; sbaatwah@su.
edu.sa
Abstract
The main aim of this study is to provide empirical evidence examining how outsourced
internal audit function (IAF) providers are associated with audit efficiency, and how such
providers interact with high-quality external auditors. We use a sample of 711 observa-
tions for companies listed on the Muscat Security Market during the period 20052014.
Based on pooled regression, we find that audit efficiency is significantly improved when
the IAF provider is from a Big4 audit firm, whereas a non-Big4 audit firm IAF provider is
associated with reduced audit efficiency. Furthermore, we find evidence suggesting sig-
nificant interaction between the external auditor and IAF in relation to audit efficiency if
the outsourced IAF provider is from a Big4 audit firm. In additional analysis, we con-
struct a new measure for audit efficiency, dividing the IAF providers into Big4, second
tier, and other non-Big4, and consider the time of connection between such providers
and their clients. We still observe that Big4, as an outsourced IAF provider, is more sig-
nificantly associated with audit efficiency than other types of IAF provider. This paper is
important because there is currently little evidence concerning the type of outsourced
IAF provider; it contains useful information for auditors, companies, and regulators.
KEYWORDS
audit efficiency, audit fees, audit report lag, Big4, non-Big4, outsourced IAF
1|INTRODUCTION
Since the worldwide corporate scandals of the 1990s and 2000s, the
internal audit function (IAF) has attracted considerable attention from
a large number of stakeholders who realize that it is vital for promot-
ing internal control quality and, consequently, the quality of financial
reporting. For example, the SarbanesOxley Act 2002 (SOX) in
section 404 expanded the activities of the IAF for USA public compa-
nies. The audit standards regulatory authorities (e.g., International
Federation of Accountants International Standard on Auditing (ISA)
610; Public Company Accounting Oversight Board (PCAOB) Auditing
Standard No. 5) also encourage external auditors to use the work of
internal auditors when testing the internal control and financial
reports of a client. Accordingly, various capital market authorities have
required listed companies to establish an IAF; for example, the Omani
Capital Market Authority (CMA) in 2002, the New York Stock
Exchange in 2006, and the Malaysian Securities Commission in 2008.
Nevertheless, though regulators, standard setters, and prior empirical
research have recognized the importance of having an IAF, there is no
agreement concerning whether this function should be performed by
an internal or external provider (in-house or outsourced). This paper
focuses on this issue and provides empirical evidence concerning how
external providers of the IAF affect audit efficiency. Note that our
focus is on sourcing the IAF to an external audit firm that is not the
external auditor for the company. This is because in the Omani bylaws,
the external auditors of listed companies are not allowed to provide
internal audit services to their clients.
Received: 3 September 2018 Revised: 1 July 2019 Accepted: 14 July 2019
DOI: 10.1111/ijau.12170
Int J Audit.
wileyonlinelibrary.com/journal/ijau
© 2019 John Wiley & Sons Ltd
2019; :424443.
23
424
The main objective of the current study is to investigate the asso-
ciation between outsourcing the IAF and audit efficiency. Specifically,
we examine whether outsourcing the IAF to either Big4 audit firms or
non-Big4 audit firms contributes to audit efficiency, and how out-
sourcing the IAF to either type of external provider (Big4 or non-Big4)
interacts with a high-quality external auditor, such as a Big4 audit
firm. Audit efficiency is crucial in minimizing the audit cost,
accomplishing the audit task in less time, and sustaining profitability
(Bamber, Bamber, & Schoderbek, 1993; Pincus, Bernardi, & Ludwig,
1999). This dynamic suggests that auditors should employ methods to
minimize the nature, time, and audit procedures. Several external
auditing standards setters (e.g., International Federation of Accoun-
tants, PCAOB; Institute of Internal Auditors [IIA]) have therefore pro-
posed ways of achieving audit efficiency, including considering the
work of the internal auditor. For example, ISA 610 recognizes the use-
fulness of some aspects of the IAF in determining the nature, time,
and audit procedures of the external audit. PCAOB Auditing Standard
No. 5 allows the external auditor to rely on relevant work performed
independently by internal auditing, as long as the IAF is deemed to be
of acceptable quality. However, a full understanding concerning the
role of the IAF in terms of audit efficiency and audit quality is not yet
available, as the empirical evidence concerning this role is an emerging
literature (e.g., Abbott, Daugherty, Parker, & Peters, 2016; Gros,
Koch, & Wallek, 2017; Johl, Johl, Subramaniam, & Cooper, 2013;
Prawitt, Sharp, & Wood, 2012; Prawitt, Smith, & Wood, 2009).
The motivation for this study is therefore as follows. First, in
recent years, there has been a trend to outsource IAF activities to
external providers (Abdolmohammadi, 2013; Mubako, 2019; Stew-
art & Subramaniam, 2010), a trend that is expected to increase
(CBOK, 2006). This trend is justified in several ways, such as cost sav-
ings (Glover, Prawitt, & Wood, 2008; Mubako, 2019), recent regula-
tory initiatives related to the work of the internal auditor
(Abdolmohammadi, 2013), maintaining IAF objectivity (Ahlawat &
Lowe, 2004), and access to specialized internal auditing resources
(Mubako, 2019). Although the IAF can be provided by both public
accounting and specialist firms (Stewart & Subramaniam, 2010) and
quality differences are anticipated (Munro & Stewart, 2010), little is
known about how the type of external provider is associated with
aspects of the audit and financial reporting. To the best of our knowl-
edge, Prawitt et al. (2012) is the only study that provides insight into
this issue. However, it uses US companies and pre-SOX data where
external auditors were allowed to provide the IAF to their clients.
Therefore, we conduct this research by using data other than from
the USA in an era where external auditors are not allowed to provide
the IAF to their audit client.
Second, recent IAF literature has confirmed that external auditors
rely on the work of the internal auditor (e.g., Desai, Gerard, &
Tripathy, 2011; Glover et al., 2008). However, this literature does not
provide conclusive evidence that external auditors prefer to rely on
IAF work when the provider is external. One possible explanation
could be that this literature fails to differentiate between the type of
external provider in which external IAF providers, particularly large
accounting firms, can offer high-quality services (Caplan &
Kirschenheiter, 2000; Munro & Stewart, 2010). Therefore, we extend
this literature by providing evidence concerning how external auditors
such as Big4 audit firms interact with outsourced IAF providers (Big4
or non-Big4) in terms of audit efficiency.
Third, in recentyears, IAF practice has evolved and attracteda large
number of stakeholders from emerging countries. Beisland, Mersland,
and Strøm (2015)observed that 45% of 70 sampled emerging countries
have established an IAF and prefer to use it as a control mechanism
over other corporate governance (CG) mechanisms. Sarens and
Abdolmohammadi (2011) reported that emerging countries prefer to
apply US IAF best practices than those of other developed countries.
Accordingly, empirical research has emerged to cover some aspects of
IAF in, for example,Malaysia (e.g., Abdullah, Ismail, & Smith, 2018; Johl
et al., 2013; Mat Zain, Zaman, & Mohamed, 2015), China and Taiwan
(Leung & Cooper, 2009), Egypt (e.g., Ebaid, 2011), Jordan (e.g., Al-
Sukker, Ross, Abdel-Qader, & Al-Akra, 2018), and Saudi Arabia
(e.g., Alzeban, 2015; Alzeban & Gwilliam, 2014). However, although
outsourcingIAF is the predominant practice inthese countries, the evi-
dence from this literature is based on the traditional form of IAF; that
is, in-house. Hence, it is essential to expand our understanding of cur-
rent IAF practicesin an emerging country, such as Oman.
Fourth, to our knowledge, there is little research concerning audit
efficiency in Gulf Cooperation Countries (GCCs), particularly in Oman.
In this setting,companies and auditors have to focuson audit efficiency
to meet regulatory requirements. For example, companies should dis-
close their annual reports to the public within 2 months, and external
auditors are prohibited from providing most types of nonaudit service
or having a relationship with their clients for a period of more than
4 years (CMA,2007, 2009a, 2009b).
1
As a result of these requirements,
auditors can facepressure from companies to finalize the audit process
and audit reportwithin the required timeframe.At the same time, they
lose effective ways to enhance their efficiency that previously attained
from long tenure andthe provision of nonaudit services (Lee,Mande, &
Son, 2009). Our study provides insights for companies, auditors, and
regulators to gain a deeper understanding of how audit efficiency can
be maintainedunder the current regulatory requirements.
Finally, the GCCs, and Oman in particular, have experienced major
reforms in relation to IAF; for example, the requirement for the estab-
lishment of an internal audit department for listed companies (CMA,
2002). However, this region suffers from a shortage of skilled staff
with the required expertise (Barclay Simpson, 2015; UAE Internal
Auditors Association, 2016) and from difficulties in preserving IAF
objectivity (Al-Akra, Abdel-Qader, & Billah, 2016). Therefore, compa-
nies are motivated to outsource all or some of the IAF activities to
overcome these constraints (PWC, 2016). Although the IAF has
1
In articles 5 and 7, the CG code issued in 2002 explicitly banned the external auditor
providing the IAF and other nonaudit services to clients. However, the code did not specify
what type of other nonaudit services are prohibited. Therefore, the CMA issued Circular
No. E/12/2009) that clarifies 13 types of nonaudit service permitted after audit committee
(AC) approval: divestiture advisory, investigations, anti-money laundering and terrorist
financing, process improving services, capital adequacy and regulatory reporting
requirements, corporate risk management, CG, regulatory assistance services, enterprise
resource planning controls integration, information technology security, vendor-initiated due
diligence, nonexecutive search, and taxation.
BAATWAH ET AL.425

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