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External auditors’ reliance on internal audit works Corporate Governance perspective in Enugu Nigeria.

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CHAPTER ONE

INTRODUCTION

1.1       BACKGROUND OF STUDY                                               

The Institute of Internal Auditors as contained in the work of Robertson (1996), defined Internal Auditing as “an independent appraisal function within an organization to examine and evaluate its activities as a service to the organization”. The appraisal part of the Internal Auditor’s function places him/her in a position to ensure that established policies and procedures are complied with.  External audit, on the other hand, is the independent examination of, and expression of opinion on, the financial   statements of an enterprise by an appointed auditor in pursuance of that appointment and in compliance with any relevant law and regulation. . Principally, the external auditor forms and expresses an independent opinion as to whether accounts give a true and fair view of the state of affairs at the balance sheet date and of the profit or loss for the period (sec 358(1) of CAMA 1990). External Auditors are professionally qualified accountants who are involved in public practice. They are described as chartered; qualified; certified or registered Accountants who are engaged by the owners of a company to represent their interest.  Corporate governance is a set of policies, regulations and laws affecting the way a corporation is directed, administered and controlled.  It involves company managements setting the company’s objectives (such that, inter alia, the company will meet its accountability obligations) and establishing and maintaining systems of control designed to ensure the objectives are met (Cadbury committee, 1992).

 

Events since the mid-1970s have contributed to the growth of internal auditing. The Foreign Corrupt Practices Act of (1977) mandated public companies to establish and maintain effective internal accounting controls to provide reasonable assurance that assets are safeguarded and that transactions are properly authorized and recorded. According to Section 357(1) of the Companies and Allied Matters Act (1990), every company shall at each annual general meeting appoint an auditor or auditors to audit the financial statements of the company, and to hold office until the conclusion of the next annual general meeting. This in all sense spells the critical and legitimate role of auditors in ensuring corporate survival

 

To accomplish this, many companies established internal audit functions, increased internal audit staffing, and strengthened internal audit independence. Beasley, (2000) show that these investments in internal auditing have been effective, as companies with internal audit staff are less prone to financial fraud than companies without internal auditing. Also, Coram, (2008) found that organizations with internal audit staff are more likely than those without internal auditing to detect and self-report occurrences of fraud.

 

In 1987, a report by the Tread way Commission recommended that public companies establish an internal audit function to be fully supported by top management and have effective reporting relationships. This means that “the internal auditors’ qualifications, staff, status within the company, reporting lines, and relationship with the audit committee of the board of directors must be adequate to ensure the internal audit function’s effectiveness and objectivity “. The report (Tread way commission) urged that the internal audit function be “staffed with an adequate number of qualified personnel appropriate to the size and the nature of the company’’.

 

The increased capability and scope of internal audit work may enable external auditors to rely increasingly on internal audit’s work in conducting the external audits (Fowzia, 2009). Relying on internal auditing can avoid unnecessarily duplicating audit procedures. It also can benefit external auditors because internal auditors have certain advantages. The internal auditors generally have more knowledge about the company’s procedures, policies, and business environment than do the external auditors (Mihret and Yismaw, 2007). This could provide external auditors with useful information that will lead to possibility to reduce audit risk. They also assist management in the effective discharge of their responsibilities by furnishing them with analysis, appraisal, recommendations and pertinent commentary in the activities reviewed (Mihret et al, 2007) emphasized.   External auditors therefore, may take advantage of relying on internal auditing without neglecting the need to maintain the reality of independence as defined for external auditors.

 

However, coordination between internal and external audit, has received considerable attention especially over the last decade due to the understanding that robust corporate governance systems which help minimize the devastating impact of corporate collapse (Rusak and Johnson, 2007).  The Blue Ribbon Committee (1999) report presents audit committees of  boards, internal audit and external audit as a three-legged-stool of corporate governance that help ensure reliability of financial reports. The use of financial information by boards of directors on behalf of shareholders and involvement of internal and external audit in enhancing the utility of this information which is provided and also used by the management provides an integrated picture of the linkages that exist among the four components of corporate governance (i.e. management, auditors, shareholders and audit committees). Internal and external audit help enhance audit committee effectiveness by serving as a resource to boards of directors   (Dezoort, 2002). Internal audit (IA) is a crucial resource in the corporate governance system as it provides services to the other three components of corporate governance (Gramling, 2004) and (Dezlort, 2002).

 

Literature also indicates that external auditors’ reliance on internal audit work could produce a significant cost saving through reduction of external audit time (Wallace, 1984) and (Haron, Ramsi and Ismail 2006). External auditors assess IA work to determine the extent of their reliance on internal audit. Such reliance is also considered as an area where internal audit adds value through reduced audit fees (Krishnamoorthy, 2001and 2002), (Morrill and Morrill, 2003), (Mihret, James & Mula 2010).  The intention to reduce external audit costs in a bid to reduce audit fees and maintain competitiveness in the audit service market motivates external auditors’ decisions to rely on internal audit work (Morrill et al 2003).  Studies focusing on audit mechanisms as a component of corporate governance in developing countries are relatively limited.  Fan and Wong (2004) indicate the corporate governance role of external audit in emerging economies based on empirical evidence from East Asian countries. Nevertheless, the linkages between internal and external audit mechanisms in developing countries and the implication of the linkage for corporate governance in such settings are generally under-researched (Fan et al, 2004). Thus, testing internal – external audit reliance in diverse setting would yield useful insights of academic and practical value of corporate governance.

 

1.2    STATEMENT OF RESEARCH PROBLEM

The United States of America Department of Justice indicted the Chartered Public accounting firm of Arthur Anderson, Enron’s external auditors as being culpable in the collapse of Enron Corporation in 2001 (Meyer, 2009).  There were other instances of corporate failures and fraud all over the world due to inappropriate accounting and corporate irregularities. For instance, the WorldCom Communications failure in (2002), (Meyer 2009), the corporate governance failure at Satyam Computers in India, where the role of the auditors were questioned on how such a magnitude of financial fraud could have gone unnoticed  (Shruti,  2009).  The failures of AWA and HIH were both significant corporate failures within Australian financial and corporate history.  Deloitte Haskins and Sells, AWA’s auditors were found negligent and damages were awarded (George & Malane, 2010).  In Nigeria, Cadbury Nigeria Plc, Intercontinental Bank Plc, Union Bank Plc, Oceanic Bank Plc, FinBank Plc, Bank PHB Plc, Afribank Plc and Spring Bank Plc had their Chief Executive Officers and Chief Accounting Officers sacked on issues bothering on imprudent financial management and lack of corporate governance  (Uba, 2011).

 

Studies revealed that, in all the cases that have occurred around the world, accountants and auditors were known to be deeply involved. They cover up their greed by presenting false financial impressions about their organizations (Gilman (2003) (as cited in Uba, 2011).  These failures brought severe criticisms to the accounting profession thus, eroding investors’ confidence on the external auditors’ work (Meyer, 2009).  As a result of this, the government of various countries and professional accounting bodies rose up to the challenge by enacting laws and reforms that will restore investors and public confidence in the profession. These include the passage of the Sarbanes-Oxley act in America in 2002,  (Meyer, 2009) and the Public Accounting Oversight Board which recommend that external auditors should ‘rely on the work of others’ in order to reduce cost associated with the compliance with Sarbanes –Oxley Act also came into being (Cohn, 2011).

 

Bierstaker (2009) (as cited in Cohn, 2011) conducted a study on the external auditors’ reliance on internal audit works in Australia.  Haron, Chambers, Ramsi and Ismail (2004) in a study conducted in Malaysia agreed that external auditors should rely on the work of internal auditors because, it results in cost saving.  Desalegn and Mengistu, (2011) carried out a research on this topic in Ethiopia where the two external audit markets were studied.    Felix, Gramling and Maletta, (2001) found that internal audit contribution serves as a determinant of external audit fees determinant.

However, all the empirical studies as reflected above were all done outside Nigeria. No study of this nature to the best of the researcher’s knowledge was done in Nigeria. It therefore, becomes imperative to explore the Nigerian situation that is, whether the external auditors in Nigeria rely in the works of the internal auditor.

 

  • OBJECTIVES OF THE STUDY

The objective of this study was to find out if external auditors in Nigeria rely on the works of the internal auditor; using some manufacturing and audit firms in Enugu metropolis as cases of study. The specific objectives were to:

  1. Ascertain the extent to which the external auditors rely on internal audit work.
  2. Examine the extent, to which the quality of internal audit work affects external audit work,
  3. Assess the effect of internal audit work on the time spent by the external auditor during his work and
  4. Ascertain the effect of external audit reliance on internal audit on fraud and corporate failures.

 

1.4       RESEARCH QUESTIONS

Based on the statement of problem and objectives of the study, the following research questions guide discussions on this work.

  1. To what extent does external auditor rely on internal audit work?
  2. To what extent does quality of internal audit affect external audit work?
  3. How does reliance on internal audit work affect the time spent by the external auditor during his work?
  4. How does reliance on internal audit works by the external auditor affect fraud and corporate failures?

1.5       STATEMENT OF RESEARCH HYPOTHESES

In order to achieve the stated objectives and answer the research questions, the following hypotheses have been formulated for this research. They are deliberately stated only in their null (Ho) or negative form and served as fulcrum of the study:

  1. The external auditor does not significantly rely on internal audit work.
  2. The quality of internal audit work does not significantly affect the quality of external audit work.

Reliance on internal audit work has no effe

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