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Transcript of Internal Audit Outsourcing Observations
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THE EFFECTS OF INTERNAL AUDIT OUTSOURCING ON EXTERNAL
AUDITOR’S INDEPENDENCE: THE NIGERIAN PERSPECTIVE
BY
OKPARA ENYINNA U.
BEING A RESEARCH PROPOSAL SUBMITTED TO THE SCHOOL OF
POSTGRADUATE STUDIES NIGERIAN DEFENCE ACADEMY (NDA)
KADUNA IN PURSUIT OF THE DOCTOR OF PHILOSOPHY (PhD) IN
ACCOUNTING
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CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND TO THE STUDY
There is no doubt that these are challenging times for the Accountancy profession
in view of the crisis of confidence arising from financial scandals rocking
corporate organizations across the world The challenges facing the Accountancy
profession is not made any better with the expansion in the mandate of statutory
auditors by the International Federation of Accountants (IFAC) to include the
detection of fraud (Abel AIG Asein 2007). The corporate scandals involving
Global Crossing, Enron, Adelphia, WorldCom, Johnson Mattheys Bank (JMB),
Bank of Credit and Commerce International (BCCI), Nomura Securities, H/H
Insurance in Australia, Parmalat (Italy) Satyam (India), and most recently the
Nigerian Banking sector; have placed a huge integrity burden on the job of the
external auditors as the buck of certifying the financial health of a corporate entity
stops on the external auditor’s table.(The Company and Allied Matters Act 1990).
These cases have nearly besmeared the image profile of the accountancy
profession. In the crisis that rocked the Nigerian banking sector in 2009, some
experts and public commentators laid the blame squarely on the door step of the
auditors. For instance, Mvendaga (2009) posited that the professional accountants
are supposed to lead in ethical practices but they have problem of incompetence.
They are also involved in criminal manipulation of figures for selfish interests.
They led the country into the current crisis. Similarly, Gafar (2009) observed that:
“External auditors should be liable for the recent developments that swept away
Chief Executives and Executive Directors of banks over alleged deep problems of
liquidity.”
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Walker D. (2002) toed the same line of thought when he asserted that the
accounting and auditing profession in particular have been under the searchlight as
these scandals appear to have exposed the weakness of the auditing profession in
protecting the investment interest of shareholders and other stakeholders. The rapid
failure and bankruptcy of Enron in particular, has led to severe criticism of
virtually all areas of financial reporting and auditing system considering the role
Arthur Andersen, the external auditors to Enron is thought to have played in the
whole saga. This situation has led many experts and professionals into casting
aspersion on the perceived independence of the external auditor. The general
thinking is that if the auditors were independent in fact and in appearance, their reports would not have attracted barrage of criticisms that has trailed the auditing
profession in recent times. Walker D. (2002 believes the auditing firm’s
responsibility is to ensure that corporate accounting follows the rules. According to
him “external auditors ought to investigate and discover. There is no excuse for
overlooking abuses. They must form independent, unbiased, and meaningful
opinions. Clearly the external auditing function has failed.” The point of view of
Walker brings to the fore the lingering and controversial issue of the independence
of the auditor while performing his statutory audit.
The independence of the external auditor has come under the search light in view
of the expanded role of the auditor who has included internal audit outsourcing
variously referred to as non audit services, management advisory services,
extended audit service etc. as part of services he renders to his clients. In particular,
it is common knowledge that a number of corporate entities now outsource their
internal audit functions to their external auditors particularly in Europe and
America. Barton (1996); Krishnan and Zhou (1997) confirmed that companies
such as First Bank System, Clark Equipment, Inland Steel and Unicom Corp in the
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United States have already outsourced their entire internal audit functions to their
own external auditors. The concern of many stakeholders with the provision of
additional services is the likelihood of the auditor losing his independence.
Auditor’s independence is very crucial to the reliability of the opinion that the
auditor expresses in financial statements
The view on the imperative of the auditor’s independence was also shared by Sori
and Karbhari (2006) who opined that auditors should not only be seen to be
independent in examining and attesting their clients’ financial statements, but be
able to independently report the financial position without their clients’
management interference as also noted by Fearnley and Benttie (2004), Stevenson
(2002), Krishnan (2005), Higson (2003), and Ghosh and Moon (2005). Nuhu
Ribadu (2007) lent credence to this when he said the external audit function in the
public sector should be handled by independent private sector professionals who
can bring a dispassionate eye to the work. The external auditor therefore need to
work under such conducive environment that he will not be influenced by any form
of externalities other than the issues thrown up in the process of executing his job.It is only under such circumstances that people will appreciate the independent
posture of the auditor.
The practice of outsourcing the internal audit function to the external audit firm has
raised fears by many parties of possible independence impairment. The fear stems
from the increased economic bond that exists when additional services are
provided to an audit client, as well as the long-held view that internal auditing is a
management function and, as such, is incompatible with the external audit
functions. After all, it is commonly said that he who pays the piper dictates the
tune.
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The Enron case has highlighted that the provision of internal audit services and
other management advisory services (MAS) by the external auditor can endanger
auditor independence. The fear and concern of regulatory authorities of possible
independence impairment has compelled a number of changes to be made to the
relevant international and US regulations, to build additional safeguards that will
ensure the independence of the auditor though he performs internal audit services
outsourced to him. Theoretical research explains the emergence of non-
independence and demonstrates that the provision of non audit services can
decrease independence. According to the economic model of DeAngelo, the
existence of client-specific quasi-rents impairs auditor independence. The provision of non audit services increases quasi-rents and thus, is a threat to
independence. Information asymmetries between auditor and client could lead to a
moral hazard risk, i.e. the auditor could give up independence from client's
management and accept payments for withholding detected errors and
irregularities. The client's management could also use internal audit functions to
legally compensate the auditor for giving away independence. The marriage of
external auditor with internal auditing functions, viewed traditionally as in-house
management functions has not gone without arguments on both sides of the divide
(IIA 1995)
Giving reasons for the acceptance of outsourced auditing jobs from client
companies: Jordan, Lowe, Geiger and Pany (1999), averred that global competition
and overcapacity have prompted many companies to downsize, reengineer,
restructure and implement substantial organizational changes. Therefore
outsourcing some of the companies’ services requirements becomes a cost saving
strategy. In its simplest form, outsourcing generally refers to the practice of
engaging outside individuals or organizations to provide services previously done
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within the company. These are non core functions such as data processing, taxation
and legal services as reported by Jordan Lowe, Marshall, Geiger and Pany (1999)
in Hodgson and Puschaver 1995; Petravick 1997. This trend has led to the
outsourcing of some or all of the company’s internal audit functions. “Accounting
Today” 1995a; 1995b, Pelfrey and Peacock 1995; Widener and Selto 1998; in D.
Jordan et al posited that banking and financial services companies were among the
first to outsource their internal audit functions. This practice of outsourcing
noncore service areas later spread to other industries and services including
retailing organizations. Krishnan and Zhou (1997) stated that more than 50 of the
Fortune 100 firms in the United States have outsourced a substantial part of their internal audit activities.
Another factor that may have necessitated external auditors engaging in outsourced
internal audit activities, according to (Elliot and Pallais 1997; Petravick 1997;
Schroeder and MacDonald 1997) as quoted in D. Jordan Lowe, Marshall A. Geiger
and Kurt Pany (1999), is the search for alternative ways to enhance present and
future income. The attraction of external audit firms to internal audit services is the
perception of internal services as additional sources for revenue growth. Kusel and
Gauntt (1997), PAR (1996b); Zhou (1998), reported that the big Certified Public
Accounting firms have created their own business units to market and deliver audit
outsourcing services. The Certified Public Accounting firms believe they can
provide more effective and efficient auditing services, hinging their argument on
the promise of better audit quality; more professional and experienced personnel;
improved specialization; a shift of liability to external organizations and a shift in
management focus to core business issues (Cheney 1995; Courtemanche 1991;
Institute of Internal Auditors (IIA) 1995; Verschoor 1992)
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This study therefore intends to contribute to existing literature on growing concern
for the independence of the auditor by examining from the Nigerian perspective
the issue of internal audit outsourcing to the external auditors of the company.
1.2 STATEMENT OF PROBLEM
Increasing business ties between Auditing firms and their audit clients, has raised
new questions regarding the nature of the auditor-client relationship (Jenkins and
Lowe 1999), reported in Gregory Jenkins & Kathy Krawczyk (2000). Significant
increases in consulting revenues generated by Certified Public Accounting firms in
the United States of America during the 1990s, led the Securities and Exchange
Commission (SEC) to believe that the increased economic dependence on these
services may potentially impair auditor independence. To bolster what the SEC
perceives as the profession’s weakening independence, it issued rules intended to
restrict firms’ ability to provide certain non audit services (NAS) to their audit
clients in the last decade.
No consensus exists about whether outsourcing of internal audit services to the
same external auditor of a corporate entity strengthens or weakens auditor
independence (Schroeder 2000). On the one hand, all of the Big 5 Certified Public
Accounting firms in the United States of America oppose the Security and
Exchange Commission’s efforts to limit extent of non audit services rendered by
external auditors, while many non-Big 5 Certified Public Accounting firms support
the SEC’s proposed rules. Goldwasser (1999) suggests the lack of consensus
within the accounting profession widens the debate on the desirability or otherwise
of the provision of non audit services by external auditors to their audit clients. He
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summarizes the debate by noting that some believe Non Audit Services create a
working relationship between the auditor and the client that is too close, while
others believe the provision of such non audit services as internal audit
outsourcing, investment advisers, regulatory filings, appraisal and valuation
services, bookkeeping asset valuation, corporate finance, treasury management,
management training, recruitment and selection, and personnel management
enhances the auditor’s knowledge of the client, thus increasing the auditor’s
objectivity and independence. The importance of the relationship between Non
Audit Services on one hand and auditor independence on the other, led the Security
and Exchange Commission to issue a letter to the American AccountingAssociation, inviting researchers to investigate differences between investors’ and
auditors’ views of how NAS influences auditor independence (Turner 1999).
Outsourcing became popular because it appeared to offer significant advantages to
both corporations and accounting firms. A company would benefit by reducing
internal audit costs and by obtaining access to the outsourcing firm’s broad range
of expertise that would otherwise be too expensive to maintain internally. Costs
would be reduced by eliminating overlapping positions and audit effort, and by
replacing fixed-cost with variable-cost employees. The expected benefits to
accounting firms were significant outsourcing fees and the ability to better balance
workloads, because much of the outsourcing work could be performed during the
off-peak summer season. Additionally, it was expected that the knowledge
obtained while performing internal audit activities would increase the efficiency
and effectiveness of the annual financial statement audit. For example, the
understanding of internal controls obtained while performing internal audit
services would enable the auditors to reduce the amount of work needed to
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document and test internal controls during the financial statement audit, as well as
enhance the auditor’s awareness of client-specific fraud risks.
Unfortunately, the purported benefits of outsourcing may have been overestimated.
Companies have not been able to reduce their internal audit costs as much as
expected, which correlates with a 1991 study that found that companies would not
realize cost savings unless accounting firms drastically lowered their hourly billing
rates or reduced the scope of audit programs.
Generally Accepted Auditing Practices (GAAP) requires auditors to be
independent in fact and in appearance. Auditors are independent in fact when theymaintain an attitude of judicial impartiality. On the other hand, auditors achieve
independence in appearance when third parties observe their behavior and have
confidence in that independence. The perception of the independence of the
external auditor becomes more challenging when he accepts internal audit
outsourced to him by his audit client.
This study therefore explores stakeholders’ perception of the independence of the
external auditor when performing internal audit functions for client organizations.
This research work will therefore provide a complete Nigerian perspective
understanding of perceptions regarding the independence of the external auditor
when rendering management advisory services or internal audit services
outsourced to him. The study intends to find out if the growing practice of
outsourcing internal audit services to external auditors does exist in Nigeria as is
the case in the United States of America in particular and other parts of the world.
Furthermore the study will also unravel the nature of the outsourcing. The fears
being raised by a number of stakeholders of the external auditor’s independence
impairment is premised on enhanced economic bond that results when additional
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services are provided to an audit client. Moreover, there is the long held view that
internal auditing is a management function (Swanger, Susan L., Eugene G. 2001).
More recently, high-profile reporting frauds such as the Enron debacle suggest that
outsourcing may not be as effective as a separate external auditor and an in-house
internal audit department at detecting and reporting fraudulent activity. As a result
of Enron, the Sarbanes-Oxley Act of 2002 now supercedes the voluntary self-
regulation of SEC auditors with the Public Company Accounting Oversight Board
(PCAOB). The implementation of the Sarbanes-Oxley Act will also forbid some
and limit many non audit services that a Certified Public Accounting firm can
provide to an SEC client.
Auditor independence may be a more salient issue when a client generates a
substantial amount of an office’s or practice area’s revenue (Wallman 1996). The
SEC issued ASR 250 in 1978, which required companies to disclose the NAS fees
and the audit fees paid to their auditing firms when those fees are material (i.e.,
exceeded a threshold of three percent of the total fees). Consequently, this study
contributes to the debate on the controversy of outsourcing internal audit functions
to an entity’s external auditors, by exploring the Nigerian perspective of the effect
internal audit outsourcing will have on auditor independence. This study
experimentally examines how the performance of internal audit functions
outsourced to a corporate entity’ influences the perceptions of auditor
independence held by various stakeholders
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1.3 OBJECTIVE OF STUDY
The collapse of Enron, and other corporate scandals that followed thereafter, most
of which were hinged on charges of accounting fraud, have undermined the U.S.
capital market system. The public is questioning the roles of all fiduciaries in the
financial reporting process, including management, boards of directors, audit
committees, and independent auditors. This increased scrutiny has seriously
challenged the accounting profession's reputation and led to the Sarbanes-Oxley
Act of 2002. The Sarbanes – Oxley Act which seeks to make financial statement
information more accurate and reliable, also proposed to create clearer guidelines
and restrictions for auditing firms and their clients regarding auditing and
consulting services. While the Act seeks to improve auditor independence by
limiting the scope of allowable non-audit services, there is little or no research
evidence in Nigeria that suggests: 1) the outsourcing of internal audit services to
external auditors exists. 2) Key stakeholders’ perceptions of the effects of internal
audit services on auditor independence, and 3) what specific non audit services
auditors should no longer perform for their audit clients 4) The extent and manner of the internal audit outsourcing as well as regulatory safeguards to curtail the
abuse of processes and procedure in the provision of non audit services.
The purpose of this study in more specific terms therefore is to provide a more
complete understanding from a Nigerian perspective of stakeholders’ perceptions
regarding auditor independence when the auditor performs outsourced internal
audit services. The primary issues being investigated are:
(1) Whether internal audit functions outsourcing to external auditors do
actually exist in Nigeria
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(2) To establish a strong basis for evaluating whether performing the
external audit and internal auditing services for the same entity
affects perceptions of independence,
(3) Ascertain whether there is staff separation that allows a different set
of staff handle the internal audit functions outsourced from those that
are involved in external audit job.
(4) Assess the extent to which separation between the Audit firm’s
internal and external audit personnel significantly affect perceptions
of independence when both services are performed by the same
accounting firm.
(5) Reveal whether the outsourcing of internal audit functions to the
external auditor is total or partial. This is against the backdrop of
surveys carried out by other researchers to the effect that some
organizations only outsourced part of the internal audit services while
retaining a certain percentage for its own staff.
6. Assess the extent to which external auditor’s engagement in internal
audit outsourcing influence the quality of financial report?
1.4 RESEARCH QUESTIONS
The effort of this research is aimed at resolving two investigation questions. The
first is to determine whether outsourcing a corporate entity’s internal audit
functions to another external audit firm other than the corporate entity’s external
auditor affects stakeholders’ perception of auditor independence and the reliability
of the financial statements. Petravick 1997; Verschoor 1992 admits that this type of
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outsourcing relationship is relatively common as companies at times would prefer
to outsource their internal audit functions to another external auditor other than the
one that performs their external audit. A typical example of this type of
arrangement is the retaining of Deloitte and Touche as external auditor to Morrison
Knudsen Corp. while its internal audit function is outsourced to Arthur Andersen
(Berton 1996). This arrangement may appear harmless and consequently not affect
stakeholders’ perception of the auditor’s independence. Therefore the research
questions are these:
1. To what extent does the outsourcing of internal audit function to another
external auditor affect stakeholders’ perception of auditor independence
and financial statement reliability?
2. To what extent does the outsourcing of a corporate entity’s internal audit
function to its own internal auditor affect stakeholders’ perception of
auditor independence and financial statement reliability?
3. Does an apparent management role on the part of the external auditor
performing the outsourced internal audit function of a client affect
stakeholders’ perception of auditor independence and financial statement
reliability?
4. What are the safeguards put in place by audit regulatory bodies such as
Institute of Chartered Accountants of Nigeria (ICAN) to assure
stakeholders of auditor independence in the case of outsourced internal
audit functions to external auditors?
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1.5 STATEMENT OF HYPOTHESES
In this part of the study we shall examine the topical issues that would lead us into
developing various hypotheses that will guide this investigation.
The existence of internal audit outsourcing to external auditors in America, Europe
and other parts of the world is beyond confirmation as studies had shown that not
only does it exist but that it is gaining popularity by the day. However, in Nigeria
the situation is different as not much has been heard or written about outsourcing
of internal audit functions to external auditors. This will therefore form the starting point of this study.
(Antle 1984) averred that the debate over whether external auditors should render
extended audit services to their audit clients is premised on the reasoning that
providing such services jeopardizes the auditor’s independence. However, the lack
of a clear definition of what auditor independence entails has contributed in no
small measure in sustaining the debate. Several authoritative and professional
bodies such as (AICPA 1997, Independence Standards Board 2000) as well as
academics (e.g., DeAngelo 1981, Magee and Tseng 1990, Penno and Watts 1991,
Dopuch et al.) have sought to define this term but without agreeing on a common
platform. In retrospect the accounting profession and Security and Exchange
Commission (SEC) regulators, developed rules describing what independence is or
is not, rather than give an exact definition
.
Despite the lack of a clear definition of auditor independence, what is evident and
paramount in all the proposition of both professional standards (AICPA Code of
Professional Conduct 1988) and regulators (SEC 2000f) is that auditors are
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required to be independent in fact and in appearance. Opinions differ as to which
is more important. Elliott (1992) argues that independence in fact is what
“matters,” and that independence in appearance should not be viewed as its equal.
The absence of independence in appearance is as dangerous as lack of
independence at all SEC (2000a,1) This is because investors’ confidence can only
be fostered when external auditors are truly independent of their audit clients but
are equally perceived to be independent by such investors.
Many financial statement users have given testimonies of a perception problem
with the provision of external audit services and internal audit services by the same
auditing firm and generally favored banning auditors from providing non-audit
services to their audit clients (Thornton 2003). Two Big Five firms in the United
States of America had recently divested themselves of their consulting practices
and acknowledged a perception problem with respect to the joint provision of audit
and non-audit services to the same client but testified that they were unaware of
any specific instances where the provision had resulted in an actual independence problem. The American Security and Exchange Commission (SEC) had come up
with proposals limiting the extent to which auditing firms could render non audit
services.
However, the American Institute of Certified Public Accountants (AICPA) and
three big firms opposed the SEC’s proposal to limit non-audit services, stating that
the joint provision of non-audit services (SEC 2000 b,c,d,e) neither impaired
independence in appearance nor in fact. They argued that the academic literature
did not support a perception problem, citing studies such as Kinney (1999), whose
review of 20 years of empirical evidence found virtually no evidence that investors
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share the scope of services concerns of regulators. Lowe and Pany 1995, 1996;
Swanger and Chewning (2001) and others who conducted similar studies found out
that staff separation within the audit firm appears to partly lessen stakeholders of
independence impairment. Allaying the fears on the external auditor’s
independence impairment, the AAA Financial Accounting Standards Committee’s
(2001, 381) review of studies on users’ perceptions of auditor independence has
this to say: “overall, these results are consistent with the notion that users believe
that there are positive synergies between auditing and consulting. Users perceive
the benefits of these positive synergies to exceed negative effects on independence
as long as consulting fees are not material to an individual office. There is someresearch evidence that large levels of consulting concern investors, however,
research is mixed as to what constitutes “large” levels of consulting.”
Based on this evidence, the FASC opposed the SEC’s (2000a) proposal to
proscribe a list of 10 non-audit services that auditors could provide to their audit
clients.
The SEC’s (2000f) Final Rule allowed auditors to continue providing non-audit
services that were not previously proscribed by accountants’ professional standards
but required additional auditor disclosures of non-audit services provided to their
clients. Two recent studies (Frankel et al. 2002, Wines (1994) found that
Australian companies purchasing non-audit services from their audit clients have
increased levels of impaired appearance of independence.
The Sarbanes-Oxley Act (2002) proscribed a list of non-audit services essentially
identical to the services the SEC proposed to ban in 2000 to help restore investor
confidence in the reliability of financial information. The present research
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therefore expects that a significant portion of stakeholders perceive that non-audit
services impair auditor independence.
The position of this hypothesis is based on the following reasons. First, while the
current literature and studies do not state emphatically whether a perception
problem exits, the profession, regulators, and legislators have taken action as if
there is a perception problem. Furthermore all studies to the best of our knowledge
that examined the issue of perception problem were carried out before the recent
highly publicized collapses of large publicly traded entities such as Enron,
World.com. It is believed that these recent events may have changed perceptionsthat influenced legislative decisions. Thirdly, previous studies have generally
addressed the question of the appearance of independence indirectly, using
between-subjects manipulations of independent variables in quasi-experimental
settings (e.g., Lowe 1992, 1994; Lowe and Pany 1995, Geiger et al. 2002). This
study intends to obtain stakeholders’ perceptions of auditor independence directly
and to provide empirical evidence supporting or contradicting regulatory and
legislative action in proscribing non-audit services, where such exists in Nigeria.
Studies and surveys of various stakeholder groups conducted including members
of the bar and bench (Lowe 1992, 1994; Andersen et al. 1993), on the way auditors
perceive themselves revealed that auditors perceive themselves to be more
independent of their clients than do others.
Two theories compete to explain observed differences in perceptions of auditor
independence. On the one hand is the complex mental model theory, which
explains that differences in users’ and preparers’ perceptions of auditor
independence may arise from information asymmetry. This occurs when the
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observer’s perceptions are not fully informed or when the observer does not
rationally process the information (cognitive bias). Shockley 1981, Eagly and
Chaiken 1993) assert chartered accountants may have more complex mental
models of independence than those outside the profession. This is probably why
they perceive themselves to be independent of their clients.
However, auditors’ perceptions of their own independence could be biased even
though sometimes without any intent as self-serving bias typically enters
unconsciously and unintentionally at the stage of making rather than reporting
judgments. Bazerman et al. (1997) argue that bias frequently occurs withoutintent. How difficult it might be for the auditor to be able to issue an unbiased
report after his self-interests had been mortgaged with management? It is therefore
a natural expectation founded on ethical egocentrism that auditors will be less
likely to perceive non-audit services to impair auditor independence than will other
stakeholders. It is however expected and this is consistent with prior research on
perceived independence, that users of auditor’s financial statements perceive a
greater impairment of auditor independence from the provision of extended audit
services than would professional accountants.
The above assumption is important since the user primacy principle requires users’
interests to supersede the profession’s interests. User primacy calls for a systematic
bias in financial reporting in favor of those users of financial statements who are in
disadvantageous positions regarding the production and consumption of financial
information (Beaver and Demski 1974, Cyert and Ijiri 1974, Gaa 1986).
User primacy is a foundational theory for the FASB’s Statement of Financial
Accounting Concepts No. 1 (1990) and the AICPA Professional Code of Conduct
(1988) which requires its members to put users’ interests ahead of their own when
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the two conflict. Thus the profession should understand the interests of the
stakeholder groups whom they serve. Moreover, since all stakeholders are
generally not auditors, the accounting profession should attempt to understand the
perceptions of others outside their own group.
The Sarbanes-Oxley Act (2002) prohibits auditors from providing some specified
non-audit services to their audit clients, closely following the SEC originally
proposed ban (2000a), which its Final Rule (2000f) later rejected. Recent evidence
(e.g., Lowe 1992, 1994; Lowe and Pany 1995; Reinstein and Lander 2001; Geiger
et al. 2002; Thornton 2003) suggests that certain non-audit services auditors provide to their audit clients influence stakeholders’ perceptions of auditor
independence, yet considerable debate continues as to what types of services
potentially do so (Kinney 1999; FASC 2001).
The user primacy principle states that financial statement users’ interests should
take precedence over preparers’ interests in the standard setting process (Gaa
1986). However, Dopuch and Sunder (1980) call the user primacy principle
ineffective in guiding regulatory efforts, claiming that financial statement users
lack the economic or political power to enforce their preferences (i.e., Watts and
Zimmerman’s Positive Accounting Theory 1978, 1979) and that financial
statement users’ preferences lack homogeneity.
Since little empirical evidence exists on what types of audit services impair
stakeholders’ perceptions of auditor independence, we explore the degree of
homogeneity in stakeholders’ perceptions of how internal audit services outsourced
to the company’s external auditors impair auditor independence. This study posits
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that stakeholders’ perceptions of internal audit outsourced to external auditors,
impairing auditor independence will differ within stakeholder groups.
The issue of homogeneity is important to determine if the regulatory Act
proscribed services of most concern to stakeholders, if the Act proscribed services
of least concern to stakeholders, and if services were left off the list. This research
question provides evidence on whether legislation can adequately address the
concerns of stakeholders when they do not share common concerns.
Extended audit services may include investment banking, strategic management planning, human resource planning, computer hardware and software installation
internal audit outsourcing, risk assessment and business performance management.
An extensive debate is raging in the literature about the compatibility of consulting
and audit service. In line with this, several empirical surveys were conducted in
order to find how third parties, auditors and firms view this issue. The results are,
however, inconclusive, suggesting that the effect of extended audit services on
perceptions of audit independence is complex and other factors such as cultural
differences of the subjects may also be a significant factor in the way internal audit
services are viewed in the context of auditor independence. Shockley, believed that
collateral services create a working relationship between the auditor and the client
that is too close and that the provision of management advisory services negatively
affected audit independence.
Therefore this study hypothesis as follows:
In view of the above topical issues discussed, the following hypotheses have been
formulated to guide the course of this investigation.
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H1 Stakeholders perceive that there is no outsourcing of internal audit
functions to external auditors in Nigeria
H2: Stakeholders perceive auditors’ independence to be impaired when
auditors provide internal audit services to their audit clients
H3: There are no differences between preparer and user stakeholder
groups’ perceptions of the effects of internally outsourced audit
services on auditor independence.
H4: There is no significant relationship between separation of internal
audit staff and perception of auditor independence impairment.
H5 There is no significant relationship between perception of internalaudit outsourcing and incompatibility with external audit functions
H6: There is no significant relationship between auditor independence and
quality of audit report
1.6 SIGNIFICANCE OF STUDY:
This study is very significant in many ways and to many groups. The ever rising
number of financial scandals and the consequent collapse of businesses with
attendant job losses, make the evaluative study an important tool in assessing the
level of perception of auditor’s independence. The study has the potential of
motivating auditors and other users of financial statements to see the imperative for
the independence of the auditor. The study will enable client organizationsappreciate the array of challenges the auditor has to grapple with in his effort to
produce an unbiased report that will be acceptable to all interested parties. The
outcome of the study will encourage audit firms, management of client
organizations, directors of companies to further assist the auditor by complying
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with relevant Statement of Accounting Standards (SAS), as well as with
International Financial Reporting Standards (IFRS). This study will provide
relevant literature on internal audit outsourcing, auditor independence, non audit
functions. Consequently, the study will make contribution to the controversial
debate of auditor independence. Furthermore, the study will provide an updated
and Nigerian environmental specific information on internal audit outsourcing as
there are no existing Nigerian evidence of internal audit outsourcing. In the same
vein, the study will serve as input to regulators and other stakeholders to establish
policies that will guard against auditor independence impairment especially in the
Nigerian setting since empirical study on this topic is virtually nonexistent. Theoutcome of this study will add to the push in the international harmonization of
opinions. This study will also provide new insight for research students and serve
as a basis for further study on internal audit outsourcing to external auditors in
Nigeria.
1.7 SCOPE OF STUDY
The problem of auditor’s independence impairment concern is a global one.
However, while a lot of studies have been carried out in other climes to establish
the existence and the extent of practice of this new growing phenomenon, little or
nothing has been done to examine the Nigerian perspective. Therefore while
drawing inferences from other countries; the focus is the Nigerian dimension of
internal audit outsourcing to external auditors. The purpose of this approach is to
enable the study situate appropriately established cases of outsourcing of internal
audit function in Nigeria. This approach will then provide an opportunity for
comparison with practices in other clime. The scope of this study therefore covers
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the outsourcing of internal audit services to external auditors of the client
organizations. However, for logistics reason, this study would be restricted to
companies located in Lagos, Nigeria. The reason for the choice of Lagos is not far
fetched. Lagos is the economic and corporate capital of Nigeria and therefore
represents all the major geographical, socio-economic and political dimension of
the country. In view of the strategic importance of Lagos, the findings of the study
will be applicable to other audit firms and client organizations situated outside
Lagos.
1.10 JUSTIFICATION FOR THE STUDY:
The practice of internal audit outsourcing is very much on the increase and
stakeholders are becoming worried of the possibility of independence impairment
when the same external auditor who reports on an entity’s financial statements
performs internal audit functions for that There have been an increasing number of
financial scandals in many corporate organizations all over the world. The case of
Enron is still fresh in the minds of lot of people. In Nigeria in particular, the
banking sector has been hardest hit in recent times in terms of corporate scandals.
The matter is made worse by the fact that these banks have been audited by
reputable Accounting Firms who attested to the good financial health of the banks
Furthermore external auditors that have been auditing some of these organizations
have come under the hammer for its failure to give early warning signals regarding
the financial health of the affected firms and save shareholders the agony of losing
their life investments. The findings of this study will assist in restoring the
confidence of investors and other stakeholders on the neutrality of the auditor
while attesting to financial reports of a corporate entity.
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CHAPTER TWO
REVIEW OF RELATED LITERATURE
2.0 INTRODUCTION
This chapter provides the theoretical literature and empirical findings on the
subject area of internal audit outsourcing to external auditors. The concepts of
auditor’s independence internal audit outsourcing to the external auditors have
been well explained. The theoretical framework upon which this study is anchored
has been based on the stakeholder theory and the contract theory. Arguments for
and in favour of internal audit outsourcing to external auditor have been
extensively reviewed.
2.1 THEORETICAL FRAMEWORK
The theoretical framework of this study is hinged on two theoretical concepts
namely: the stakeholders’ and the contract theory.
2.1.1 Stakeholder Theory
The argument for stakeholder theory is based upon the assertion that maximizing
wealth for shareholders fails to maximize wealth for society and all its members
and that only a concern for managing all stakeholder interests achieves this (David
Crowther and Shahla Seifi 2011).
Stakeholder theory states that all stakeholders must be considered in decision
making process of the organization. Stakeholder theory states that there are three
reasons why this should happen: The first reason is because it is morally and
ethically right to do so, as doing so would benefit the shareholders. Secondly, it is
a reflection of what actually happens in an organization, and lastly, it is supported
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by research from Cooper et al (2001) into large firms. The research shows that
majority of the firms are concerned with a range of stakeholders in their decision
making process according to David Crowther and Shahla Seifi (2011)
In understanding the fundamentals of this study, it is logical to define one of the
major concepts of this research. Just as it is common with all social science
concepts, there are several definitions of what constitute stakeholders. Stakeholders
may consist of those groups without whose support the organization cease to exist;
or any group or individual who can affect or be affected by the achievement of the
organization’s objectives (David Crowther and Shahla Seifi 2011). The implication
of the above definition is that a number of people with diverse interest in a
business entity quality as stakeholders. Attempting to group them we have the
following classes: managers, employees, customers, investors, shareholders,
suppliers.
In a more generic sense, the stakeholders list might include groups such as:
government, local community and the society at large. David Crowther and Shahla
Seifi posits that while it normal to consider the stakeholder groups, separately, it is
not out of place for one person to belong to more than one stakeholder group. A
typical example to this is where an individual is a customer of an organization and
at the same time a shareholder. The customer will be concerned that the company
operates with a high degree of ethical standard and would also expect the managers
of the company to maximize his investment
Stakeholders could further be classified into internal and external stakeholders.
Internal stakeholders are those found within the organization such as employees
and managers. The external stakeholders include suppliers or customers who are
not generally considered to be part of the organization.
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One fundamental aspect of the stakeholder theory is that it attempts to identify
numerous different factions within a society to whom an organization may have
some responsibility. However, the criticism of this approach is that, despite some
attempts, it fails to specifically identify these factions (Argenti, 1993). David
Crowther and Sahla Seifi stated Sternberg (1997) suggestion to the effect that
Freeman’s (1984) second definition of stakeholder which is now the more
commonly used, has increased the number of stakeholders to include virtually
everything whether alive or not.
However, attempts have been made by stakeholder theorists to provide framework
by which the relevant stakeholders of an organization can be identified. Clarkson
(1995), in David Crowther and Sahla Seifi (2011), suggest that a stakeholder is
relevant if he has invested in the organization and are therefore subject to some
risk from that organization’s activities. He separated these into two groups: the
voluntary stakeholders who choose to deal with an organization, and the
involuntary stakeholders, who do not chose to enter into nor can they withdraw
from a relationship with the organization. Mitchel, Agle and Wood (1997)developed a framework for identifying and ranking stakeholders in terms of their
power, legitimacy and urgency. If a shareholder is powerful, legitimate and urgent,
its needs will require immediate attention and given primacy.
Irrespective of which model is used, it is not controversial to suggest that there are
some generic stakeholder groups that will be relevant to all organizations. Clarkson
(1995) posits that the voluntary stakeholders include shareholders, investors,
employees, managers. This list might also include government, regulators, analysts
and creditors of the organization. This study is adopting the voluntary
stakeholders’ model as being appropriate for this investigation. It is the voluntary
stakeholders who have invested financial resources in the organization that would
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be affected in one way or the other if the independence of the auditor is perceived
to have been impaired.
The second theoretical framework upon which this study is premised is the
contract theory.
2.1.2 The contract theory
In economics, contract theory studies how economic actors can and do construct
contractual arrangements, generally in the presence of information asymmetry.
Because of its connections with both agency and incentives, contract theory is
often categorized within a field known as Law and economics. The practical
application of the contract theory is based upon the design of optimal schemes of
managerial compensation. In the field of economics, the first formal treatment of
this topic was given by Kenneth Arrow in the 1960s. (Wikipedia on- line)
The external auditor is therefore in a contractual relationship with the shareholders
of the corporate entity even though he might not know the shareholders
individually. The auditor is also fully aware that the attestation he is engaged in to
carry out goes beyond the interest of the management with whom he deals directly.
The contractual relationship of the auditor with the company imposes both
statutory and common law duties. The Nigerian Law Reform Commission in its
‘Report of the Nigerian Company, 2008’ articulates these duties as follows:
(Chikwendu 2009). Auditors must inform themselves of any special duties
imposed on them by the Articles. A standard practice in the microeconomics of
contract theory is to represent the behaviour of a decision maker under certain
numerical utility structures, and then apply an optimization algorithm to identify
optimal decisions. Such a procedure has been used in the contract theory
framework to several typical situations, labeled moral hazard, adverse selection
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and signaling. The spirit of these models lies in finding theoretical ways to
motivate agents to take appropriate actions that will promote the overall welfare of
all stakeholders.
The corporation should be viewed as nothing more (or less) than a set of
contractual arrangements among the various claimants to the products and earnings
generated by the business. The group of claimants includes not only shareholders,
but also creditors, employee managers, the local communities in which the firm
operates, suppliers, and, of course, customers. In the case of banks, these claimants
also include the regulators in their roles as insurers of deposits and lenders of last
resort and in their capacity as agents of other claimants. It is only the a satisfactory
audit report that can resolve any conflict between the various contending
stakeholders.
As Hart (1989, pp. 1757, 1764) observes, every business organization, including
the corporation, “represents nothing more than a particular ‘standard form’
contract.” The very justification for having different types of business
organizations is to permit investors, entrepreneurs, and other participants in the
corporate enterprise to select the organizational design they prefer from a menu of
standard form contracts. In line with the contract theory, the Board of Directors of
the various banks are in contract relationship with their employers who are the
shareholders. The contract agreement requires them to act in the best interest of the
other contracting parties upon the fulfillment of the terms and conditions set
therein. The contractual relationship between the auditor and the shareholders
imposes a duty on the external auditor. This is why the auditor is expected to
exercise the degree of professional care and skill appropriate to the circumstances
which is expected of an auditor. (Adeniyi, 2008). Claims for negligence will
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generally arise if the auditor has failed to discover a defalcation or fraud and the
company suffers loss in the process. Whether the contracting parties have lived up
to the terms of their contract will be determined in the course of this study
2.2 THE AUDIT FUNCTION
It is pertinent at this point to begin a review of issues associated with the
independence of the auditor by understanding what functions the external auditor is
expected to perform in order to satisfy the minimum requirement of his
responsibilities.
The auditor has a duty to provide a professional opinion on the relationship
between the assertions in the financial statements and those embodied in the
statement of accounting principles. The auditor’s job, according to Chikwendu
(2009), is to state whether the financial statement tells it as it is. Where an auditor
tells it as it is, in accordance with the principles as contained in Companies and
Allied Matters Act (CAMA), Banking and other financial institutions Act (BOFIA)
and Statement of Accounting Standards (SAS), he has done his job and this will go
a long way in safeguarding the interest of investors and create room as well for the
improvement in the management of the organization. The duty of reporting
objectively as it is enshrined in the statute books are examined below:
Auditors’ Duties Under Companies and Allied Matters Act (CAMA)
Under CAMA, the auditors must report:
1. Whether they have obtained all the information and explanations which
to the best of their knowledge and belief were necessary for the purpose
of the audit
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2. Whether in their opinion, proper books of accounts have been kept by the
company, so far as it appears from their examination of those books, and
proper returns adequate for the purposes of their audit have been received
from the branches not visited by them.
3. (i) Whether the company’s balance sheet and profit and loss account
dealt with by the
report are in agreement with the books of accounts and returns.
(ii) Whether in the opinion and to the best of their information and
according to the explanations given to them, the said statements give the
information required by this Act in the manner so required and gives a true
and fair view.
(a) In the case of the balance sheet; of the state of the company’s
affairs at the end of its year and
(b)In the case of the profit and loss account; of the profit and loss for
its year, or as the case may be given a true and fair view thereof
subject to the non-disclosure of any matters (to be indicated in the
report) which, by virtue of Part I of the Second Schedule of this Act,
are not required to be disclosed
Auditor’s duties under Common law and Equity:
Apart from the statutory duties outlined above, auditors also have common law
imposed duties. The Nigeria Law Reform Commission in its ‘Report of the
Nigerian Company, 2008 articulates these duties as follows (Chikwendu, 2009).
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Auditors must inform themselves of any special duties imposed on them by the
Articles; they must check the cash in hand and the balance at the bank; they must
satisfy themselves that the securities of the company exist and are in safe custody
and (for the purpose of the statutory report) they must ascertain the true financial
position of the company. The statement ‘Auditors must be watchdogs..” refers to
the last mentioned duty. They must examine the company’s books, and if there is
anything to arouse their suspicion, they must make full investigation. They are
under no duty to take stocks nor are they concerned with the policy of the company
nor whether it be well or ill managed; the duty of an auditor is not to confine
himself merely to the task of verifying the arithmetical accuracy of the balancesheet, but to inquire into its substantial accuracy
Auditors’ duties under Banks and Other Financial Institutions Act (BOFIA)
Under section 29 (7), an auditor must immediately report to the CBN if he is
satisfied that there has been a contradiction of the Act, or that an offence under any
other law has been committed by the bank or any other person, or loss have been
incurred in the bank which substantially reduce its capital funds or any irregularity
which jeopardizes the interest of depositors, creditors of the bank, or any other
irregularity has occurred, or he is unable to confirm that the claims of depositors or
creditors are covered by the assets of the bank.
2.3 AUDITOR INDEPENDENCE: CONCEPTUAL DEFINITION
Auditor independence is commonly referred to as the cornerstone of the auditing
profession. This is premised on the fact that it is the foundation of the public’s trust
in the auditing function of attesting to the true and fair view of an entity’s financial
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reports. In the last decade starting from 2000, a number of high profile accounting
scandals have cast the accounting profession into the limelight, negatively
affecting the public perception of auditor independence. This is why it imperative
at this time to understand and appreciate what auditor independence entails.
According to Wikipedia online Auditor independence refers to the independence
of the internal auditor or of the external auditor from parties that may have a
financial interest in the business being audited. Independence requires integrity and
an objective approach to the audit process. The concept requires the auditor to
carry out his or her work freely and in an objective manner. The independence of
the auditor is therefore a generic term which applies to any one handling auditing
functions whether internally or as an external attestator. There is often the
misconception that whenever auditor independence is mentioned, one is tempted to
think of the external auditor.
Independence of the internal auditor therefore means independence from parties
whose interests might be jeopardized by the results of an audit. Specific internal
management issues which the internal audit department is expected to address
include: risk management, internal controls problems, and poor corporate
governance. The Charter of Audit and the reporting to an Audit Committee
generally provides independence from management. Furthermore the code of
ethics of the organization and that of the Internal Audit profession helps give
guidance on independence from suppliers, clients, third parties.
Independence of the external auditor means independence from parties that have
an interest in the results published in financial statements of an entity. The support
from and relation to the Audit Committee of the client company, the contract and
the contractual reference to public accounting standards/codes generally provides
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independence from management, the code of ethics of the Public Accountant
profession) helps give guidance on independence form suppliers, clients, third
parties.
The purpose of an audit is to enhance the credibility of financial statements by
providing written reasonable assurance from an independent source that they
present a true and fair view in accordance with an accounting standard. (Wikipedia
online 2011). This objective will not be realized if users of the audit report believe
that the auditor may have been influenced by other parties, especially company
managers and directors or by other conflicting interests such as when the auditor
owns shares in the company to be audited. In addition to technical competence,
auditor independence is the most important factor in establishing the credibility of
the audit opinion.
There are two important aspects to independence which must be distinguished
from each other: independence in fact (real independence) and independence in
appearance (perceived independence). These two forms auditor independence are
essential to achieve the goals of independence.
Real independence refers to the actual independence of the auditor, also known as
independence of mind. More specifically, real independence concerns the state of
mind of an auditor, and how the auditor acts or deals with a specific situation. An
auditor who is independent 'in fact' has the ability to make independent decisions
even if there is a perceived lack of independence present, or if the auditor is placedin a compromising position by company executives. The inability to measure and
observe the auditor’s mental attitude and personal integrity makes the
determination of whether the auditor is truly independent difficult. Similarly, an
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auditor’s objectivity must be beyond question, but how can this be guaranteed and
measured? This is why perceived independence is of such importance.
It is essential that the auditor not only acts independently, but appears independent
too. If an auditor is in fact independent, but one or more factors suggest otherwise,
this could potentially lead to the public concluding that the audit report does not
represent a true and fair view. Independence in appearances also reduces the
opportunity for an auditor to act otherwise than independently, which subsequently
adds credibility to the audit report.
2.3.1 Types of Auditor independence
It can be identified that there are three ways in which the independence of the
auditor manifests. These are listed below but in no way in any order of importance.
• Programming independence
• Investigative independence
• Reporting independence
Programming independence essentially protects the auditor’s ability to select the
most appropriate strategy when conducting an audit. Auditors must be free to
approach a piece of work in whatever manner they deem fit. The auditor’s
programming independence must create room for his ability to adapt his methods
to suite the growing and challenging needs of the organization. Furthermore, the
auditing profession is a dynamic one, with new techniques constantly being
developed and upgraded which the auditor may decide to use. The auditor must
ensure that whatever strategy or methods which he intends to implement cannot be
inhibited in any way.
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Investigative Independence The auditor must have unlimited access to company’s
information, so as to be able to select and implement strategies that would ensure
his investigative independence. Just a programming independence protects
auditors’ ability to select appropriate strategies, investigative independence
protects the auditor’s ability to implement the strategies in whatever manner they
consider necessary. Consequently any queries regarding a company’s business and
accounting treatment which the auditor might raise must be answered by the
company. The collection of audit evidence is an essential process, and cannot be
restricted in any way by the client company.
Reporting independence ensures that the auditor is able to choose to reveal to the
public any information they believe should be disclosed. If company directors have
been misleading shareholders by falsifying accounting information, they will strive
to prevent the auditors from reporting this. It is in situations like this when auditor
independence is most likely to be compromised. In effect, reporting independence
enables the auditor to report in an unmistakable manner his findings which reveals
the true state of affairs of the company. Reporting independence of the auditor also
empowers him to quality his report if the circumstances he met on ground warrant
so.
2.4 NON AUDIT SERVICES.
(Wallman 1996) comments that Companies currently demand a broad range of
NAS which Certified Public Accounting firms are responding to. These wide
ranges of non audit services include such varied services as investment banking,
strategic management planning, human resource planning, computer hardware and
software installation, and internal audit outsourcing services [AICPA 1997; Berton
1995]. Growth in the revenues earned from these services has been significant.
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NAS fees have grown from about $3.5 billion in 1990, to $15.7 billion in 1999 –
an increase of over 460 percent (Antle 2000). The AICPA has also identified new
opportunities for auditors to expand traditional assurance service offerings. These
services include risk assessment, business performance management, electronic
commerce, and healthcare performance measurement among others [Elliott and
Pallais 1997; Telborg 1996]. Notwithstanding the profession’s efforts, the growth
in assurance fees has not kept pace with the growth in NAS revenues. Fees from
assurance services increased from $6.5 billion in 1990 to $9.2 billion in 1999 – a
42 percent increase (Antle 2000). In summary non audit services are those services
other than attestation and assessment of the reliability of an organization financialstatements. This in effect means that internal audit outsourcing is just one out
many non audit services that an audit firm can render to an audit client. In this
study non audit services, management advisory services, and internal audit
outsourcing would be used interchangeably.
2.5 NON AUDIT SERVICES AND AUDITOR INDEPENDENCE
Previous research studies had shown the impact of Non Audit Services on auditor
independence to be uncertain. These collateral services create a working
relationship between the auditor and the client that is too close (Goldwasser 1999,
Sutton 1997). As Wallman (1996) stated, auditor independence may be adversely
affected by the provision of Non Audit Service if those services are perceived as
escalating the economic bond between auditors and their clients. Economic theory
suggests that the separation of firm ownership from the control of decisions held
by management leads to the presence of asymmetric information, creating the need
for mechanisms to monitor a firm’s financial reporting process. A commonly used
external monitoring mechanism is the firm’s hiring of an independent auditor to
opine on the firm’s financial statements (cf., DeAngelo1981). Part of the value of
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this mechanism is dependent upon the auditor’s perceived independence.1 As SEC
Chairman Arthur Levitt stated “(W)ithout confidence in an auditor’s objectivity
and fairness, how can an investor know whether to trust the numbers?” (Schroeder
2000). Shockley (1981) and Knapp (1985) report evidence of NAS’s adverse
effects on perceived auditor independence. Shockley (1981) examined whether
providing management advisory services (MAS) influences perceptions of auditor
independence. He found that Auditing firms providing MAS were perceived as
having a higher risk of losing independence than those firms not providing such
services. Knapp (1985) examined whether management’s ability to affect a dispute
resolution process is influenced by the purchase of MAS from its auditing firm. Hefound that management was perceived as more likely to obtain its preferred
resolution when the audit firm provided MAS than when the audit firm did not
provide MAS. A second and opposing view holds that the provision of NAS
enhances the auditor’s knowledge of the client, thus increasing the auditor’s
objectivity and independence (Goldwasser 1999, Wallman 1996). DeAngelo
(1981) argues that increased revenues generated by auditors from NAS lead to
greater reputational capital. The desire to maintain this reputational capital will
lessen the auditors’ willingness to acquiesce to their clients (cf., Haynes, Jenkins,
and Nutt 1998). Goldman and Barlev (1974) also suggest that the provision of
NAS increases the auditor’s independence because these services enhance the
auditor’s “uniqueness” to the client. This distinctiveness in turn increases the
auditor’s ability to resist management pressure and thus, maintain their
independence.
Evidence of this positive relationship is reported by Schulte (1965) and Lowe,
Geiger, and Pany (1999). Schulte (1965) investigated whether the provision of
MAS affects confidence in auditor independence. He found that the majority of the
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respondents believed that MAS did not impair independence. Lowe et al. (1999)
studied the implications of various internal audit outsourcing arrangements. They
found that the highest ratings of auditor independence and financial statement
reliability occurred when the company’s external auditor used separate staff
members to perform the internal auditing services.
Non-experimental evidence of the positive relationship is reported in a survey of
investors conducted by Penn, Schoen, and Berland [2000]. By an overwhelming
four-to-one margin, surveyed investors believe that audits are “better” when the
auditors know more about a company (as might be the case when auditors provide
NAS). In addition, 59 percent of the investors believed that, if the SEC rules areimplemented, audit quality might suffer because auditors will be less
knowledgeable about their clients’ business.
A final view holds that the provision of NAS has no effect on perceptions of
auditor independence. In their reviews of prior studies of auditor independence,
Kinney (1999) found no substantial evidence that investors are concerned about
NAS, while Wallman (1996) encountered little evidence that the performance of
these services impairs independence in fact . Similarly, Palmrose (1999) found that
less than one-percent of the lawsuits against auditors between 1960 and 1998
included an allegation involving the provision of NAS. McKinley, Pany and
Reckers (1985) examined whether the provision of MAS by external audit firms
affects the decisions and perceptions of bank loan officers. They found that the
performance of MAS did not significantly affect loan decisions, financial statement
reliability perceptions, or auditor independence perceptions.
The SEC recently issued rules to restrict firms’ ability to provide NAS for their
audit clients as a means of bolstering what it perceives as the profession’s
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declining independence. Notwithstanding the SEC’s concerns, there is a lack of
consensus about the impact of NAS on perceptions of auditor independence among
members of the accounting profession and the investing public. Given the debate
surrounding NAS and the SEC’s call for research on auditor independence, further
investigation seems warranted.
2.6 NON AUDIT SERVICES AND AUDITOR INDEPENDENCE: THE
ACCOUNTANTS’ AND INVESTORS PERSPECTIVE
Much of the prior research related to NAS (and MAS) and auditor independence
has examined the perceptions of investment officers, loan officers, and financial
analysts. However, there is a dearth of research investigating the perceptions of members of the accounting profession. Shockley (1981) examined whether the
provision of MAS significantly influenced perceptions of auditor independence
held by Big international and local auditing firms. He found that regional/local
partners weighed MAS more heavily in their independence assessments than did
Big auditing firms – indicating that regional/local partners viewed the provision of
MAS as increasing the likelihood of a loss of independence. Shockley suggests that
this difference might result because the segregation of MAS and audit is less
distinct in smaller firms. While companies are demanding more NAS, all segments
of the CPA profession are not sharing in this growth. In fact, Big 5 CPA firms and
non-Big 5 CPA firms generate substantially different proportions of their total
revenues from NAS. Accounting Today reported that for 2000, the Big 5 CPA
firms generated approximately 52 percent of their total revenues from NAS, while
the remaining Top-100 accounting service providers earned just 25 percent of their
revenues from these services (Accounting Today, 2000). In addition, the Big 5
CPA firms dominate the NAS market, earning over 92 percent of total NAS
revenues generated by the Top-100 accounting service providers. Given the Big 5
CPA firms’ greater reliance on NAS revenues, there may be a difference between
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Big 5 and non-Big 5 CPA firms with respect to their perceptions of how NAS
influences auditor independence. There is also a lack of research focused on
investors’ views of auditor independence. Wallman (1996) stressed that the
public’s (i.e., investors) perception of auditor independence has been of highest
importance to regulators for some time now. Even more recently, the SEC has
renewed the call for researchers to investigate how NAS influences investors’
views of auditor independence (Turner 1999). Pany and Reckers (1984) is one of
the few prior studies to investigate investors’ views. They compared investors’ and
chartered financial analysts’ evaluations of a CPA firm’s audit independence when
that firm also provided NAS. Pany and Reckers found that the views of investorsand analysts did not differ in any significant way. The similarity of responses led
them to conclude that “the ‘Independent to who?’ question may not be as
intractable as might be feared” (1984, 96). To address the SEC’s call for research,
the current study examines investors’ perceptions of auditor independence. In
addition, the study also investigates perceptions of professional CPAs from both
non-Big 5 firms and Big 5 firms. The lack of consensus regarding independence
regulations within the profession, as described by Schroeder (2000), suggests that
the opinions of professional CPAs may vary more than previously thought.
2.7 INTERNAL AUDIT OUTSOURCING
The outsourcing of internal auditing is just one aspect of a larger trend of
outsourcing that has characterized a number of organizations. In fact outsourcing
of internal auditing functions and other non auditing services appears to be the in-
thing. Scott McNealy, CEO of Microsystems in Rittenberg 1997 confirmed this
when he stated that “every company is racing to outsource non-core areas.” The
rationale for outsourcing is simple i.e. the outsourcing provider has identified the
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service area as a core competency and has positioned the firm to provide better
services at the same cost as the client is currently incurring, or alternatively the
same services at lower costs. (Rittenberg 1997). It is not only internal audit
services that are outsourced. Corporate entities have outsourced a variety of
functions ranging from accounting to human resources as well as pension fund
management. Many observers however, do not query the rationale for some of the
outsourcing. The observers argue that companies outsource services that are not a
core competency area. A typical case in point is the contracting of pension assets to
outside investment companies because such organizations do not have investing as
core area of operation.
The American Institute of Certified Public Accountants AICPA through its over
sight board had portrayed the challenging circumstance of the Auditing profession
when it said that the auditing profession is at a critical juncture and must re-
examine its role in providing public services or lose its ability to self regulate. The
Public Oversight Board stated further that members of the profession providing
auditing and other attestation services should be independent in fact andappearance (POB 1995). The major worry here is that Chartered Accounting firms
involved in internal audit outsourcing may have the potential of compromising the
independence and objectivity of the auditor. It has been reported that in the United
States, Pelfrey and Peacock 1995, reports that researches conducted in recent times
confirms that about half of the internal audit outsourcing in the United States are
performed by the company’s external auditors.
The former Chief Accountant of the United States Security and Exchange
Commission (SEC), Michael Sutton in reacting to this development posited that
external auditors offering these internal audit services to their audit clients are too
closely assigned with traditional management functions and activities. Such
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emerging services raise doubts about auditor independence (Public Accounting
Report 1996d). According to Sutton: How can the auditor be independent in
attesting to management’s assertions regarding internal controls when (a)
management in part, is relying on the external auditor’s work (performed on an
outsourced basis) to develop its assessment of internal controls, and (b) the
external auditor would in part, be attesting to the quality of his own work as quoted
in Rittenberg and Covaleski 1997)
The Institute of Internal Auditors gave impetus to the likely problem that would
arise when an external auditor takes up internal audit functions outsourced to him
by stating that a clear conflict of interest exist when the same Accounting firm that
performs external audit also has primary responsibility for the internal audit. The
Institute of Internal Auditors further asserts that under this arrangement, the
external auditor becomes an indirect advocate of management assertions.
Consequently external auditors may have a tendency to serve corporate
management rather than shareholders and investors (Cheney 1995, 1996). The
assertion of the Institute of Internal Auditors has been re-enforced by a number of other commentators. Researchers are of the opinion that auditors might be
abdicating their role of protecting investors and instead are becoming client
advocates (Haynes et al 1998; Shah 1996; Schuetze 1994; Sporkin 1993). The
United States regulatory authorities have put in place a number of measures they
hope will ameliorate the dangers inherent in the likelihood of external auditors’
compromise of his independence in the event of taking up internal audit functions
outsourced to him. For instance, the formation of the Independent Standards Board
(ISB) was aimed at creating independence standards that assure public confidence
in the integrity of the audit.
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However, the American Institute of Certified Public Accountants (AICPA) has a
divergent view and posits that independence related concerns have been
exaggerated and that guidelines have been implemented to prevent firms carrying
out internal audit outsourcing activities from performing management functions
(Car-michael 1998; Rittenberg and Covaleski 1997). To address the independence
concerns posed by outsourcing, the AICPA Professional Ethics Executive
Committee recently issued an interpretation under rule 101 on Extended Audit
Services. This interpretation provides fairly explicit guidance on the committee's
position as to the types of internal audit activities that would and would not impair
an external auditor's independence.
The AICPA has therefore set parameters as to when and how such internal control
related services would be allowable under professional standards and still maintain
the external auditor’s independence (Sutton 1997. The AICPA interpreted its Rule
of Conduct 101, Extended Audit services thus: “Independence would not be
considered to be impaired if the member or his firm does not act or does not appear
to act in a capacity equivalent to a member of client management or as an
employee “(AICPA 1997a) In essence, the interpretation concludes that such
services would not of themselves impair auditor’s independence if the
responsibility of providing the external auditor with considerable knowledge about
the client, its key operations and its industry (AICPA 1997b). The greater the
external auditors’ insight into the client, the more likely it is that the business
transactions will be understood and key audit risks identified. External Auditors
armed with greater knowledge and insights of their client would be more apt to
discover errors and fraud and thereby perform a high quality audit.
2.8 INTERNAL AUDIT OUTSOURCING AND FRAUD DETECTION
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The external auditor, as well as the internal auditor, by auditing standards requires
only reasonable and not absolute, assurance of detecting corporate fraud by
remaining alert to conditions where fraud is most likely to occur. Realistically,
however, external auditors may not be as effective at detecting fraud as full-time,
in-house internal auditors. (George R. Aldhizer III, James D. Cashell, Dale R.
Martin)
As far back as 1987, the Tread way Commission in the United States encouraged
corporations to expand their existing full-time, in-house internal audit departments
or begin the formation of an internal audit department if none existed in order to
increase the likelihood of detecting and reporting material frauds on a timely basis.
This underscores the importance attached to the internal audit department in an
organization. Recent fraud studies support the Tread way Commission’s
recommendations. For example, a survey carried out in 1998, by KPMG of top
executives within 5,000 of the largest U.S. publicly held companies, not-for-profit
groups, and local governments. Respondents consistently rated internal auditors
among the entities most likely to detect fraud within their organizations, while
external auditors were among the least likely. According to the survey, key factors
in detecting fraud included customer and employee notification and anonymous
letters. These factors might not be effective if someone such as a full-time internal
auditor were not immediately available to receive such communications. This point
is especially critical if a firm plans to perform internal audit services only on a
part-time basis (George R. Aldhizer III, James D. Cashell, Dale R. Martin).
It was rightly predicted by researchers opposed to the outsourcing of internal audit
to the external auditor that internal audit outsourcing is a ticking time bomb
waiting to explode. It was only a matter of time before an external auditor that also
provided internal audit outsourcing services was entangled with a potentially
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significant reporting fraud. By wearing “both hats” at Enron for almost five years,
Andersen could be held to a higher standard of fraud detection and, thus, subject to
significantly higher damages than otherwise. (The June 2002 guilty verdict in the
government’s obstruction of justice case against Andersen means that the firm will
probably be unable to pay significant damage awards to Enron investors.) This
case, however, is not very clear, because Andersen stopped providing internal audit
services for Enron in the late 1990s, and it may never be known exactly how much
internal audit outsourcing contributed to Enron’s collapse. Conceivably, however,
Andersen’s internal auditors may have been more accepting of the special purpose
entities (SPE) and their inadequate disclosures if they knew that the SPEs and their disclosures had been approved by Andersen’s external auditors.
2.9 POTENTIAL SOLUTIONS TO INTERNAL AUDIT OUTSOURCING
Possible solutions to enhance the public’s confidence in auditors and to reduce
their exposure to litigation include increasing internal audit fraud training budgets
and promoting internal audit co sourcing services.
Increase spending on internal audit fraud training. Recent fraud studies
indicate that internal audit departments spend a very small portion of their budgets
on fraud prevention and detection training. This may be due, in part, to corporate
managers who do not fully appreciate the value-added benefits of internal audit
fraud training. To help prevent and detect fraudulent financial reporting, corporate
managers should significantly increase their internal audit fraud training budgets.
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The Enron crisis should have alerted shareholders and managers to the value-added
benefits of internal audit fraud training. This training should more than pay for
itself by helping to ensure the long-term viability of the company.
Promote co sourcing services. Unlike outsourcing, co sourcing relies on a strong
in-house internal audit department as the primary resource and usually uses
external service providers for no routine services when special capabilities are
needed (e.g. special need IT audits, environmental audits, derivative reviews,
contract audits, and enterprise-wide risk management services). This allocation of
audit tasks creates a synergy that incorporates the strengths of an in-house audit
function with the benefits of access to the broad spectrum of capabilities available
from an external accounting firm. Co sourcing allows an internal audit department
to pursue value-added services that it could not provide because of a lack of time
or capabilities. Furthermore, co sourcing should appeal to large firms because, like
outsourcing, it generates an attractive new revenue base. Finally, co sourcing could
save the company money because routine audit work may be less costly if provided
by internal auditors (e.g., extensions of year-end financial statement auditing
procedures).
The above approaches would not apply to relatively small privately held
companies that normally cannot justify the cost of at least one full-time in-house
internal auditor. These companies might be able to justify having an accounting
firm provide internal audit services on a part-time basis.
2.10 POTENTIAL BENEFITS OF OUTSOURCING
The knowledge obtained by the external auditor while performing internal audit
activities can increase the efficiency of the annual independent financial statement
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audit. For example, the internal control knowledge obtained while performing
internal audit services should reduce the amount of work needed to document
internal controls, access control risk, and design tests of controls. It should also
enhance the auditor's awareness of specific client related risks. This would help in
planning an effective and efficient substantive audit program and should assist with
detecting fraudulent financial reporting. Outsourcing also has another benefit of
creating a potentially large new source of revenue. In addition, since much of the
outsourcing work could be performed during the off-peak season, external audit
firms should be able to better balance their workloads across the entire year. There
is no way the benefits of internal audit outsourcing can be spoken of withoutmentioning the financial benefit which is the main driving force that entices the
external auditors in the first place.
For companies, outsourcing the internal audit function offers potential cost
benefits. Internal audit outsourcing may reduce overlapping positions and audit
effort by creating more flexibility in increasing and decreasing workloads.
Additionally, outsourcing allows a company to replace "fixed" cost employees
with "variable" fees for services. Finally, a wide range of expertise is available
from large firms that would be too expensive for a company to maintain internally.
Unfortunately, the purported benefits of outsourcing may have been overestimated.
Companies have not been able to reduce their internal audit costs as much as
expected, which correlates with a 1991 study that found that companies would not
realize cost savings unless accounting firms drastically lowered their hourly billing
rates or reduce the scope of audit programs.
The high-profile reporting frauds such as the Enron debacle suggest that
outsourcing may not be as effective as a separate external auditor and an in-house
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internal audit department at detecting and reporting fraudulent activity. As a result
of Enron, the Sarbanes-Oxley Act of 2002 now supersedes the voluntary self-
regulation of SEC auditors with the Public Company Accounting Oversight Board
(PCAOB). The implementation of the Sarbanes-Oxley Act will also forbid some
and limit many non audit services that an auditing firm can provide to a client.
2.11 WHAT INFLUENCES AUDITOR INDEPENDENCE
Research has found a number of factors which influence independence of the
auditor. These factors which will be discussed in turns include: tenure of audit
firms in a given corporate entity; size of audit firm; level of competition in the
audit services market; size of audit fees received by audit firms; provision of
managerial advisory services by audit firms to the audit clients; and existence of
audit committee. (Adeyemi SB, Okpala Okwy 2011)
Size of Audit Firm
Larger audit firms are often considered have a higher auditor independence than
smaller firms. This is because the bigger audit firms are able to resist pressure from
management due to the high reputation the firm’s size has built over the years. Abu
Baker and Ahmad, 2009 in their empirical study demonstrated that there is a
positive relationship between audit firm size and auditor independence. They
argued that certain characteristics inherent in small audit practices may increase the
danger of impairment of independence. A typical example is where there existthe tendency towards a more personalized mode of service and close relationship
with client. However, it should not be assumed that firms act independently
because the use of large audit firm is no guarantee of its ability to resist pressures
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from clients. The case of Arthur Andersen in the Enron scandal confirmed this
much. (Adeyemi SB and Okpala Okwy 2011).
Level of Competition
Shockley 1981 has identified competition as the most important single
environmental or external factor affecting auditor independence. In a highly
competitive environment firms are often faced with a great temptation to
compromise independence. In order to avoid losing its client to another rival firm,
the auditing firm may find it difficult remaining independent since t. Shockley,
1981 proved that the high level of competition in the audit firm has resulted in lessauditor independence. However, another researcher Gul (1989) holds a contrary
opinion. He argued that the existence of competition caused auditors to be more
independent and create a favourable image in order to maintain their clients.
Audit Firm’s Tenure
An audit firm’s tenure, which is the length of time an auditing firm has been
rendering audit services to a client company, has been mentioned as having an
influence on the risk of losing an auditor’s independence. A long association
between a company and an accounting firm may lead to such close identification of
the accounting firm with the interests of its client’s management that truly
independent action by the accounting firm becomes difficult pointed out that
complacency, lack of innovation, less rigorous audit procedures and a learned
confidence in the client may arise after a long association.(Adeyemi SB & Okpala
Okwy 2011)
The United States Congressional Subcommittee on Reports, Accounting and
Management considered that the above dangers are serious enough to recommend
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the mandatory rotation of auditors as a possible remedy. Rotation ensures that the
auditor remains independent since tenure will be limited and any vested interest
will no longer be relevant. Nevertheless, this suggestion has been opposed, in
studies conducted by Shockley, 1981, tenure was not found to have a significant
impact on perception on independence.
Size of Audit Fees Received by Audit Firm
Large size of audit fees is normally associated with a higher risk of losing the
auditor’s independence. The IFAC’s Code of ethics for professional Accountants
suggests that client size (measured from size of fees) could raise doubts as toindependence. In Malaysia, the MIS By Law (Section B-1.98 on Professional
Independence) has emphasized that “if the total fees (arising from assurance and
non-assurance services) generated by one assurance client or its related entities
exceed 15% of the firm’s total fees in each year over two consecutive financial
periods, financial dependency shall be considered to exist, in which case, a self-
interest threat to independence is created. In such event, the only course of action
is to refuse to perform or withdraw from the assurance engagement.”
Most empirical studies conducted on size of audit fees do not look at the factor
above, instead they inter-relate it with other factors. For example, Shockley, 1981
suggests that the adverse effects of Management Advisory Services, the size of the
audit firm and competitive on a third party’s audit independence actually arise
because of the link of these variables to audit fees. Nevertheless, there is a study
that proves otherwise. Gul, 1989 proved that each independence related variable
namely Management Advisory Services, competition and audit firm size, after
audit independence in its own right. He also found size of audit fees to be an
important determinant of audit fee (measured as a percentage of office revenues to
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the audit firm), though do not show any significant impact on audit independence,
have influenced respondents to feel less confidence in the auditor’s independence.
[
Audit Committees
An audit committee is a selected number of members of a company’s board of
directors whose responsibilities include helping the auditors remain independent of
management. For that reason, there is much support to suggest a positive
relationship between audit committees and auditor independence.
According to SOX section 301, the audit committee carries out its responsibility
over the financial reporting process by(i) Appointing, overseeing and compensating the independent and
compensating the independent auditor;
(ii) Establishing procedures for handling complaints about accounting,
auditing and internal control; and
(iii) Establishing procedures for the submission of concerns about
questionable accounting and auditing matters.
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CHAPTER THREE
3.0 RESEARCH METHODOLOGY
3.1 Introduction
This chapter explains the procedure used for the purpose of carrying out the
research. The methodology that will be used for the research is explained in this
section, and it explains the steps and methods that will be used in the study. The
section provides details of the research design, population and sample, methods of
data collection, methods of data analysis and justification of the methods used were
discussed, the section ended with a summary of the section.
3.2 POPULATION AND SAMPLE SIZE
The study is on Nigerian evidence of impact of internal audit outsourcing to
external auditors of client organizations. The population of this study is in two
categories namely auditing firms across Nigeria and users of financial information.
Esan and Okafor (1995) described a sample as a subset of a population selected to
meet specific objectives. It results in the reduction of the amount of data to becollected by considering only data from a subgroup rather than all possible
elements. This makes economic sense and decreases the time spent on the study.
Sampling is useful when it is impracticable, impossible or extremely expensive to
collect data from all potential units of analysis covered by the research problem. A
sample consisting of respondents in Lagos would be considered a good
representative of the respondent groups for this study, since the ultimate test of a
sample design is how well it represents the characteristics of the population it
purports to represent (Emory and Cooper, 2003).
The sample drawn for the study includes the following number chosen from the
sample of the respondents.
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In all four hundred and ten respondents were targeted as sample from the
stakeholders groups. These are made up as follows:
GROUP NO SAMPLED NUMBER
Auditors 350
Shareholders 350
Brokers 100
Analyst 80
Regulators 80
Directors 80
Academics 80
Others 80
Total 1200
The choice of this sample size was guided by literature on the maximum and
minimum practical sample sizes for statistical testing. Descombe (2003) suggested
that a sample size of not less than thirty (30) subjects per group category for any
statistical test.
To test our hypotheses, this study will conduct and collect survey data from
targeted preparers of financial statements and user stakeholders’ groups in various
cities across Nigeria. Specifically five major metropolitan cities will be used for
this study. They are: Lagos, Abuja, Port Harcourt, Kano and Enugu. The listed
cities chosen for this research have often been refered to as the economic bases of
the nation. The preparer stakeholder groups include auditors and non-audit
accountants working for reputable accounting firms, and other professional
accountants in various industries. The user stakeholder group includes chief
executives of various corporate entities including banks, stock broking firms,
telecommunications and government parastatals and agencies. To reduce non-
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response bias, the author will administer the surveys to targeted stakeholders
attending professional meetings. Some of such gatherings is the Annual
Conferences of the Institute of Chartered Accountants of Nigeria (ICAN);
Association of National Accountants of Nigeria; Chartered Institute of Bankers of
Nigeria (CIBN) and Chartered Institute of Taxation of Nigeria (CITN) The
companies that would be targeted for this investigation would come majorly from
the over three hundred public companies quoted at the Nigerian Stock Exchange
(NSE). The total number of subjects from the various target groups would be
worked out as the study progresses.
3.3 SURVEY INSTRUMENT
To examine the research hypotheses, a survey instrument consisting of questions to
be constructed will be administered, along with questions taken from a survey on
stakeholders’ perceptions of auditor independence. Hutchinson (?) indicates that
the survey method of data collection is appropriate for understanding preferential
characteristics of respondents. Data from the prior survey would be used as proxy
for a pretest of stakeholders’ perceptions of auditor independence. The study will
pre-test the survey instrument on six local Audit practitioners, six national
Chartered Accounting practitioners, six accounting and business professors, and
six local Financial Executives Institute chapter members.
The study will obtain stakeholders’ perceptions of the effects of internal auditoutsourcing services on auditor independence, to determine if they were
statistically greater than zero. A subset of participants, as described above, will
then be used to test for differences in stakeholder groups’ perceptions of auditor
independence. In additional analysis, a logistic regression model will be used to
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include the full sample of participants. The main dependent variable would be a
dichotomous measure of auditor independence with the provision of non-audit
services (coded 1 if perceived independent, 0 if otherwise). Independent variables
with theoretical interest include profession membership (Eagley and Chaiken 1993,
Bazerman et al. 1997), current occupation (Shockley 1981), and experience
(Reckers and Stagliano 1981, Farmer et al. 1987). Gender and years of experience
are included as control variables.
The survey instrument will also include other dependent measures. We would
further test for differences in stakeholder groups’ perceptions of (1) the financial
power consulting engagements give clients over their auditors (Farmer et al. 1987,
Trompeter 1994), (2) large accounting firms' independence in appearance and fact
(3) consulting services’ effect on audit quality 4) the importance of proposed
actions in achieving auditor independence
Stakeholders would be asked to identify client-contracted services that would tend
to compromise the auditor’s independence and judgment. The survey would
include services that are: banned under professional standards at the time of the
survey (asset valuation, corporate finance, treasury management, accountancy
outsourcing, legal services, actuarial services, management training, recruitment
and selection, and personnel management The study will further examine
stakeholders’ perceptions of the importance of these services in assuring
independence to determine if adequate stakeholder consensus exists to proscribe
specific non-audit services.
The questionnaire used as instrument of survey also will include other dependent
measures. The study will test for differences in stakeholders’ groups perceptions of
the financial power internal audit outsourcing engagements give clients over their
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auditors; large accounting firms independence in appearance and fact, consulting
services effect on audit quality; importance of intended action for achieving auditor
independence, auditors credibility arising from reputation.
3.4 VALIDATION OF INSTRUMENT
The research instrument would be subjected to content validity. Content validity is
the extent to which the test adequately covers the areas, syllabus or same segment
designed to be tested (Kerlinger, 1973). To ensure content validity of the
instrument to be applied for the study, a first draft of the questionnaire based on the
suggested recommendations, revisions would be made. The revised copy would be
given to Doctorate students in accounting and other professional colleagues in
accounting. Their useful recommendations would be incorporated into the final
draft of the questionnaire. The various recommendations actually helped in
reducing the length of the survey instrument.
3.5 STATISTICAL TOOL/ANALYTIC PROCEDUREAnalysis means the ordering, categorizing and summarizing of data to obtain
answer to research hypothesis. The purpose of this analysis is to put data collected
into manageable and intelligible form so that the relation of research problem can
be studied and tested. The primary data were analysed using descriptive and
inferential statistics (t-Tests). The descriptive method described the demography of
respondents using frequency and percentages. Also, regression analysis would be
employed to analyse the secondary data. Inferential statistics would then be
performed at a 0.05 level of significance using SPSS version 17.0. A logistic
regression model would be used to include the full sample of participants. The
main dependent variable would be a dichotomous measure of auditor independence
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with the provision of internal audit services coded 1 if perceived independent, 0 of
otherwise. Independent variables with theoretical interest include professional
membership (Eagley and Chalken 1993, Bazerman et al 1997, present occupation
(Shockley 1081 and experience (Reckers and Stagliano 1981 Farmer et al 1987)
Gender and years of experience will be included as control variables.
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