The effect of internal audit outsourcing on financial analysts' perceptions of external auditor independence

The practice of outsourcing the internal audit function to the external aud it firm has raised fears by many parties such as the SEC of possible indepe ndence impairment. The fear stems from the increased economic bond that exi sts when additional services are provided to an audit client, as well as th e long-held view that internal auditing is a management function and, as su ch, is incompatible with the external audit function. This paper reports th e results of a two-phase study of the perceptions of financial analysts reg arding external auditor independence when a CPA firm performs both external and internal auditing services. In phase 1, analysts' perceptions of auditor independence are greater when the client employs its own internal audit staff or outsources to a differen t CPA firm than when the external auditor also performs internal audit func tions. Phase 2 results show that analysts' perceptions of auditor independe nce are higher when the internal audit services are provided by the staff o f a different division of the CPA firm compared to a no-staff separation tr eatment. Perceptions do not differ between full and partial outsourcing tre atments, which conflicts with the recent SEC rule limiting the extent of ou tsourcing arrangements.