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

22



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.

23



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

24



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.

25



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

26



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 online)

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

27

http://en.wikipedia.org/wiki/Economics

http://en.wikipedia.org/wiki/Asymmetric_information

http://en.wikipedia.org/wiki/Agency_(law)

http://en.wikipedia.org/wiki/Law_and_economics

http://en.wikipedia.org/w/index.php?title=Managerial_compensation&action=edit&redlink=1

http://en.wikipedia.org/wiki/Kenneth_Arrow

http://en.wikipedia.org/wiki/Moral_hazard

http://en.wikipedia.org/wiki/Adverse_selection

http://en.wikipedia.org/wiki/Economics

http://en.wikipedia.org/wiki/Asymmetric_information

http://en.wikipedia.org/wiki/Agency_(law)

http://en.wikipedia.org/wiki/Law_and_economics

http://en.wikipedia.org/w/index.php?title=Managerial_compensation&action=edit&redlink=1

http://en.wikipedia.org/wiki/Kenneth_Arrow

http://en.wikipedia.org/wiki/Moral_hazard

http://en.wikipedia.org/wiki/Adverse_selection



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

28

http://en.wikipedia.org/wiki/Signalling

http://en.wikipedia.org/wiki/Signalling



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

29



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).

30



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

31

http://en.wikipedia.org/wiki/Auditing

http://en.wikipedia.org/wiki/Auditing



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

32

http://en.wikipedia.org/wiki/Accounting_scandals


http://en.wikipedia.org/wiki/Independence

http://en.wikipedia.org/wiki/Internal_auditor

http://en.wikipedia.org/wiki/External_auditor

http://en.wikipedia.org/wiki/Integrity

http://en.wikipedia.org/wiki/Objective_approach

http://en.wikipedia.org/wiki/Auditor

http://en.wikipedia.org/wiki/Risk_management

http://en.wikipedia.org/wiki/Internal_control

http://en.wikipedia.org/wiki/Governance

http://en.wikipedia.org/w/index.php?title=Charter_of_Audit&action=edit&redlink=1

http://en.wikipedia.org/wiki/Audit_Committee

http://en.wikipedia.org/wiki/Management

http://en.wikipedia.org/wiki/Code_of_ethics


http://en.wikipedia.org/wiki/Financial_statements




http://en.wikipedia.org/wiki/Independence

http://en.wikipedia.org/wiki/Internal_auditor

http://en.wikipedia.org/wiki/External_auditor

http://en.wikipedia.org/wiki/Integrity

http://en.wikipedia.org/wiki/Objective_approach

http://en.wikipedia.org/wiki/Auditor

http://en.wikipedia.org/wiki/Risk_management

http://en.wikipedia.org/wiki/Internal_control

http://en.wikipedia.org/wiki/Governance

http://en.wikipedia.org/w/index.php?title=Charter_of_Audit&action=edit&redlink=1









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

33




http://en.wikipedia.org/wiki/Mental_health









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.

34



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.

35



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

36



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

37



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

38



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

39



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

40



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

41



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.

45



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

48



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

49



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

50



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-

53



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

54



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

55



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

56



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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Documents

Internal Audit Outsourcing Observations