The Effects of Employer and Client Identification on Internal and External Auditors' Evaluations of Internal Control Deficiencies

Abstract

SUMMARY The Public Company Accounting Oversight Board's (PCAOB) Auditing Standard No. 5 (AS5) encourages external auditors to rely on internal auditors to increase the efficiency of lower-risk internal control evaluations (PCAOB 2007). We use post-SOX experimental data to compare the levels and effects of employer (client) identification on the control evaluations of internal (external) auditors. First, we find that internal auditors perceive a greater level of identification with the evaluated firm than do external auditors. We also find some evidence that, ceteris paribus, internal auditors are less lenient than external auditors when evaluating internal control deficiencies (i.e., tend to support management's preferred position to a lesser extent). Further, while we support Bamber and Iyer's (2007) results by finding that higher levels of external auditor client identification are associated with more lenient control evaluations, we demonstrate an opposite effect for internal auditors—higher levels of internal auditor employer identification are associated with less lenient control evaluations. Our results are important because we are the first to capture the relative levels of identification between internal and external auditors, as well as the first to compare directly internal and external auditor leniency, both of which are important in light of AS5. That is, we provide initial evidence that external auditors' increased reliance on internal auditors' work, while increasing audit efficiency, also could improve audit quality by resulting in less lenient internal control evaluations, due, at least in part, to the effects of employer and client identification. Data Availability: Contact the first author.

How Client Identification and Client Commitment Uniquely Influence Auditor Objectivity

“…Prior studies in the accounting literature find that client identification impairs external auditor objectivity (Bamber and Iyer 2007;Stefaniak et al 2012;Svanberg and Ö hman 2015). Consistent with this literature, we predict that client identification will be negatively associated with auditor objectivity.…”

“…Confirming previous research (Bamber and Iyer 2007;Stefaniak, Houston, and Cornell 2012;Svanberg and Ö hman 2015), we find that client identification impairs auditor objectivity. Extending prior research, this is the first study to evaluate the impact of client commitment on auditor objectivity.…”

Social Identification and Differences in External and Internal Auditor Objectivity

“…External auditors must develop and maintain client relationships to ensure that clients do not become dissatisfied and seek replacements; however, they also must provide objective, high-quality audits with appropriate evaluations of the firm, including its internal controls (Stefaniak et al 2012). Prior accounting research shows that external auditors' desire to maintain client relationships can affect their objectivity (Carcello et al 2000;Blay 2005;Carey and Simnett 2006) and can cause them to acquiesce to client-preferred accounting positions (Bamber and Iyer 2007).…”

“…For example, since SOX, internal auditors are more likely to form informal partnerships with management (Bou-Raad 2000), and likely do not have the same level of employment relationship risk in that they have longer-term employment horizons with the organization, which yields less risk that their employers will seek a replacement if they are dissatisfied with the internal auditors' decisions (Balkaran 2008). Moreover, internal auditors' employers typically are the internal auditor's primary income source; accordingly, internal auditors are more likely to be concerned with the organization's long-term sustainability because the costs associated with seeking and securing new employment are high (Stefaniak et al 2012). …”

“…As external auditors continue to be encouraged to reduce redundant audit procedures, in part by relying on internal auditors for low-risk control evaluations (PCAOB 2007), scrutiny of internal auditors' objectivity and the overall effect of this audit process evolution will continue. Stefaniak et al (2012; hereafter SHC) examined how internal and external auditors may be susceptible to unique objectivity differences. Prior research in accounting and psychology indicates that individuals' objectivity and judgments are affected by the extent to which they are ''attached'' to a particular group, such as an employer or audit client.…”