Co-operation of internal and external audit under client pressure – Some empirical evidence on the independence of external auditors

Abstract

The role of internal audit has become more essential in organizations during the last decades. At the same time, the external audit services have faced competitive biddings and they have been pressured to lower their audit fees. The International Standards on Auditing give a possibility for external auditors to use the work of an internal audit function as part of the external audit, and thus lower the external audit fees. However, the sole responsibility of a statutory audit is still on the external auditor and this responsibility is not lowered by using the work of the internal audit function. In other words, external auditors need to maintain their independence and their professional judgment cannot be influenced by this pressure.

This study aims to investigate if external auditors rely too much on the internal audit under the fee pressure, and if this is a threat to the external audit independence. This is studied by discussing how the parties contribute according to the principal-agent-theory, and studying how the previous research has seen the co-operation. Previous research has introduced the substitution theory. The theory assumes that when one type of governance mechanism (internal audit) substitutes another (external audit) the fees of the other reduce. External auditors appreciate the availability, the effective communication and the high quality of the internal audit, and thus reward it by lower audit fees. However, previous research has shown that under pressure the external auditors do not consider these factors as relevant as in normal circumstances.

The empirical analysis was conducted by making five theme interviews with external audit managers from Luxembourg and Finland to gain in-depth knowledge. The objectives were to see if they feel their independence is endangered, if the external auditors have experienced these situations, and if the fee pressure changes the co-operation of the parties in the future.

The results suggest that the external auditors see this matter differently and their personal attitude affects their opinion. None of the interviewees stated that the independence would be endangered, but three of the interviewees stated it lowers the overall audit quality. Two of the interviewees stated that they do not see the subject neither as independence or an audit quality issue. However, the interviewees have experienced these situations and the fee pressure affects them at least at some level. All of them saw the co-operation increasing due to the fee pressure. This could eventually lead to more efficient overall audit and enhanced monitoring for the principal in the principal-agent relationship if the quality of internal audit increases, and the co-operation becomes more efficient.