Keywords

internal audit outsourcing, financial reporting quality, audit quality, accounting risk

Abstract

The Sarbanes-Oxley Act of 2002 (SOX) represents a far-reaching legislative attempt to improve the quality of financial reporting in the United States in response to the major accounting frauds of the late 1990s and early 2000s (Klein 2003). A significant change imposed by SOX was to prohibit the outsourcing of internal audit services to firms’ external auditors.1 Competing academic arguments suggest that this ban will either improve or worsen financial reporting quality. The knowledge spillover argument suggests that by both performing the external audit and providing nonaudit services, auditors improve overall audit quality through a deeper understanding of the client (e.g., Simunic 1984; Plitch 2002). The economic bonding argument suggests that overall audit quality is compromised when the external auditor provides nonaudit services, essentially because the external auditor is unwilling to stand up to aggressive or abusive accounting practices for fear of losing a lucrative client engagement (e.g., Simunic 1984; Moore 2002; Lindberg and Beck 2004). Given the competing predictions for how outsourcing may affect audit quality, and thus financial reporting quality, we examine whether outsourcing internal audit services to the external auditor pre-SOX is associated with higher or lower accounting risk, where accounting risk is defined as the risk that clients’ financial statements contain misleading or fraudulently reported numbers.

Original Publication Citation

Prawitt, D. F., N. Y. Sharp, and D. A. Wood. 2012. Internal audit outsourcing and the risk of misleading or fraudulent financial reporting: Did Sarbanes-Oxley get it wrong? Contemporary Accounting Research, 29 (4): 1109-1136. DOI: 10.1111/j.1911-3846.2012.01141.x.

Document Type

Peer-Reviewed Article

Publication Date

2012

Publisher

Contemporary Accounting Research

Language

English

College

Marriott School of Business

Department

Accountancy

University Standing at Time of Publication

Full Professor

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