Some evidence on the impact of internal audit on external audit fees

• Author: Sourour Hazami‐Ammar
• DOI: http://doi.org/10.1002/jcaf.22384
• Published date: 01 April 2019
• Date: 01 April 2019

BLIND PEER REVIEW

Some evidence on the impact of internal audit on

external audit fees

Data provided by the Institute of Internal Auditors are subject to restrictions

Sourour Hazami-Ammar

Institute of High Business Studies,

University of Sfax, Tunisia

Correspondence

Sourour Hazami-Ammar, Institute of High

Busimess Studies, Route Sidi Mansour Km

10 B.P. 1170 - 3018, Sfax, Tunisia.

Email: ammar_sourour@yahoo.fr

Abstract

We examine responses of 2,160 internal auditors to a global survey of the internal

auditing profession carried out by the Institute of Internal Auditors Research Foun-

dation from 2009 to 2013. We found that when the internal audit function's (IAF's)

quality is high, the external audit fees will be low. This result confirms the substitu-

tion effect. We also found that when internal audit hours work increase, audit fees

will be high; indicating a complementary effect between these variables. The inter-

nal auditor can be the external audit assistant and fully engaged in specific monitor-

ing and control tasks. Nevertheless, he also may be an independent partner of an

external audit and fully engaged in corporate governance. If the external auditor

apprehends that audit risk is low due to the quality of the IAF, he will require lower

fees. If the IAF's work devoted to external audit is high, a signal of a great firm

commitment in reinforcing corporate governance is transmitted. Such signal proves

the company's willingness to invest more in improving the external audit quality

and fees will be high.

KEYWORDS

audit fees, complementary/substitution effect, contribution, internal auditing function, quality

1|INTRODUCTION

Earlier, internal audit (IA) role focuses on compliance. Internal

auditors are expected to assess the extent to which internal

control procedures are being followed. Today, IA processes

encompasses also consulting role (Abdolmohammadi &

Burnaby, 2006; Roth, 2002; Sarens & De Beelde, 2006).

Assurance on financial statements characterizes the main con-

cern of the external audit (Mat Zain, Zaman, & Mohamed,

2015). External audit's role differs from that of IA. In order to

be the external audit's coordinator and partner, internal audit

function (IAF) must master these roles and go beyond them.

It must be able to perform a variety of other functions, mainly

risk assessments, control assurance and compliance. Working

together effectively may yield synergistic outcomes such

as higher quality audits and economic benefits (Gramling,

Maletta, Schneider, & Church, 2004; Sarens, 2009). Audit

firms often want to take up the challenge to be more cost-

efficient while looking to ensure audit quality because of the

instability of the law and the imprecision of accounting and

tax rules. Reducing audit fees while improving financial

reporting is the challenge these companies' face. In fact, pro-

fessional standards recognize the potential role that IAF may

perform for the external audit (SAS No. 65, AICPA, 1991;

ISA No. 610, MIA, 2000; PCAOB, 2007). IA's contribution

to financial audit can be made by internal auditors working

under the supervision of the external auditors as assistants.

Also, it may occur through maintaining an irreproachable

Received: 17 February 2019 Accepted: 23 March 2019

DOI: 10.1002/jcaf.22384

64 © 2019 Wiley Periodicals, Inc. wileyonlinelibrary.com/journal/jcaf J Corp Acct Fin. 2019;30:64–81.

quality by performing work during the year useful to the

external auditors (SAS No. 65, AICPA, 1997). However, the

quality of IAF is a key factor to which attention must be paid

by external auditors before any use of IA's work. In that, pro-

fessional auditing standards require that external auditors may

rely on the IAF if it is deemed to have sufficient objectivity

and competency ( Abbott, Parker, & Peters, 2012a) .

Both professional standards and prior studies (Burt,

2016; Chen, Sadique, Sirinidhi, & Veerarghavan, 2017; Ege,

2015) suggest that IA quality includes specific attributes of the

organization and parties performing IA activities (e.g., profes-

sional certification of IA staff). External auditors appreciate the

quality of IA through its competence and objectivity, and the

nature of the work performed. This paper contributes in a num-

ber of ways to prior research concerning the effect of gover-

nance mechanisms particularly the contribution of IA. First, we

analyze if firms with a higher level of IA assistance provided to

the external audit contributes to highlight the great commitment

of the firm in reinforcing corporate governance through an

improvement of external audit quality. When the IAF is used

as a volunteer, the idea is to analyze the impact of IA hours

worked for external audit on a possible increase of audit fees.

If this relationship is empirically validated, then the more help

given by the IAF, the higher the external audit fees would

be. Second, we test if firms with higher IAF quality contribute

to the reduction of external audit fees. The context in which

companies are setting themselves in searching better corporate

governance means that the idea of the contribution of IA to the

reduction of audit fees can only be timely. This research is

becoming more and more alarming in the current area, as there

is a multiplication of recommendations which recognize IAFs

as a driving mechanism for the development of internal control.

Third, we consider that the contribution of IAF lead to higher

external audit fees. This contribution is a combination between

IAF quality and IAF assistance. The present study enriches pre-

vious research in the area by examining the link between both

IA help and IA quality on audit fees within a developed and

mature market, that is, the French context. We contribute to a

better comprehension of the relationship between the external

and the internal auditing and follow up on studies already con-

ducted in the European context (e.g., Arena & Azzone, 2009;

Italian context; Arena & Jeppesen, 2010; Danish context) as

well as in the American context (Abbott et al., 2012a; Abbott,

Parker, & Peters, 2012b; Messier Jr., Reynolds, Simon, &

Wood, 2011; Prawitt, Sharp, & Wood, 2011).

When we study the relationship between IA and audit

fees, we rely on both the substitution and complementary

approaches. Faced with the challenge of competitiveness

through the reduction of costs, the decrease in external

audit fees can be achieved. It is mainly when the contribu-

tion of IA to external audit is likely to reduce the work

done by the external auditor. Burt (2016) contends that IA

may be able to obtain more and better quality information

about control system weaknesses than would be the exter-

nal audit. He suggests that the use of the IA during the

external audit could increase audit quality by obtaining bet-

ter quality information, while also potentially decreasing

the external audit fees. The substitution effect assumes that

the implementation of effective governance mechanisms

will limit the external auditors' control effort and reduces

audit fees. Also, the complementary effect has been consid-

ered by the literature. Companies express their desire to

develop complementary governance mechanisms in order

to reduce agency costs between managers and shareholders.

Therefore, they are likely to invest in greater levels of IAFs

to discipline managers, and they are ready to pay more for

the external audit (Goodwin-Stewart & Kent, 2006; Hay,

Knechel, & Ling, 2008).

Research that has examined the relationship between the

contribution of IA and external audit fees is not abundant

and are nonexistent in the French context. The study by

Felix, Gramling, and Maletta (2001) is pioneering. It exam-

ines this relationship in the American context and finds that

IA is a significant determinant of audit fees and the relation-

ship is greatly influenced by the quality of the IAF. Prawitt

et al. (2011) find that IAF contribution is negatively associ-

ated with external audit fees of U.S. companies. However,

they did not find that the external auditors' willingness to

rely on the IAF varied with the quality of the IAF.

Like Pizzini et al. (Pizzini, Lin, & Ziegenfuss, 2015),

Prawitt et al. (2011) and Messier Jr. et al. (2011); we use the

responses of 2,160 internal auditors to a global survey car-

ried out by the IIA's Global Audit Information Network

(GAIN).

1

Unlike Mohamed, Mat Zain, Subramaniam, and

Wan Yusoff (2012), assessment of the IAF's contribution to

financial reporting quality is based on objective questions such

as number of hours worked by IA for external audit or the

money spent on the IAF by the organization. In this research,

we study the direct effect of the quality of IA and its contribu-

tion to the audit of financial statements in the French context.

Thus, in this paper, we are using an index based on IAF attri-

butes prescribed in ISA No. 610. Prior literature has used

other proxies, such as the existence of IAF (Hay et al., 2008),

direct assistance provided by internal auditors (Abbott et al.,

2012a) and the consideration of IAF as a training ground

(Messier Jr. et al., 2011).

Today, the importance of the IAF goes hand in hand with

the search for the reliability and transparency of financial

reporting, as well as the improvement of the company's perfor-

mance. According to the opinion of the external auditor, IAF

may contribute to risk identification resulting from fraud or

errors. While exchange is possible, thisrequires an understand-

ing of the nature of IAF, its status within the organization, and

the activities it has implemented (ISA No. 315). The external

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