The effects of internal audit outsourcing on financial statement users' confidence in their protection from fraudulent financial reporting

The purpose of this study is to examine whether outsourcing the internal audit function enhances users' confidence in their protection from fraudulent financial reporting. Using source credibility theory, this study proposes that Big Five audit firms will be perceived as more competent and more objective than in-house internal audit departments and thus more likely to deter or detect and report fraudulent financial reporting. A between-subjects field experiment is performed in which the internal audit arrangement is the only independent variable. This arrangement is manipulated at four levels: (1) insourcing with the internal audit department reporting to senior management (2) insourcing with the internal audit department reporting to the audit committee (3) outsourcing to the same Big Five firm that performs the external financial statement audit and (4) outsourcing to a Big Five firm different from the firm that performs the external financial statement audit. Dependent variables measure lenders' perceptions of the likelihood that fraud will be deterred, the likelihood that a committed fraud will be detected, and the likelihood that a detected fraud will be reported. This study finds that bank lenders perceive a greater likelihood that fraud will be deterred when the internal audit function is outsourced to a Big Five firm than when it is performed by an internal audit department that reports to senior management. Lenders also perceive a greater likelihood that a detected fraud will be reported by a Big Five firm than by an internal audit department that reports to senior management. These findings hold whether the company outsources the internal audit to the same firm that performs the external audit or to a different Big Five firm. Findings from this study suggest that to maximize user confidence in their financial reports, companies should either outsource their internal audit functions or structure insourced internal audit departments to report to the audit committee.