Discussion

This study examines the effects of perceived auditor litigation risk and internal audit source (in-house vs. outsourced) on auditor reliance decisions in an integrated audit environment under various levels of account risk of material misstatement. The results suggest that external auditors exhibit prospective rationality cognition. Auditors who perceive lower litigation risk increased planned reliance on the work of internal auditors while auditors who perceive higher litigation risk decreased their planned reliance to increase the defensibility of their actions. However, those who perceive lower litigation risk were also influenced by the internal audit source. Lower litigation risk auditors indicated a significantly greater willingness to rely on outsourced internal auditors than in-house internal auditors. Further analyses indicated that the results are consistent with source credibility theory as outsourced internal auditors were perceived as significantly more competent and more objective than in-house internal auditors. The results also found that external auditor reliance decisions are sensitive to account risk as more reliance was placed on the work of internal auditors in an account with a low risk of material misstatement than in an account with a high risk.

Before discussing the implications of this study's results, several limitations should be noted. As with any experimental study, there were limits to the realism of the case. The participants were given limited information about the internal audit department and did not interact with the internal auditors described in any manner. In practice, personal reactions to the internal auditors may also impact the reliance decision. In addition, all participants were from one Big 4 public accounting firm. Participants from other Big 4 firms may evaluate internal auditors differently however the use of only firm allows the study to control for firm effects on auditors' perceived litigation risk. Finally, this study only examined two types of account risk and auditor evaluations may be different for other levels of account risk.

The findings of this study will be of interest to audit firms as they consider their current practices for internal auditor evaluations. Given the increased audit work associated with an integrated audit, opportunities to appropriately place reliance on the work already performed by competent and objective internal auditors can benefit the audit firm as reliance frees resources to perform other audit tasks. These results will also be of interest to management of public companies. If decreased audit fees can result from increased external auditor reliance on work of internal auditors and the results show auditors more willing to rely on outsourced internal auditors, then outsourcing the internal audit function to another Big 4 firm may be a cost effective decision for public companies.

The fact that external auditors react in the expected direction to account risk factors in an integrated audit is relevant to standards setters. External auditors placed more reliance on the work performed in a low risk account compared to a high-risk account. The extent of reliance, however, is still an issue. For the high-risk account, the extent of reliance was appropriately low for all conditions but for the low risk account, the extent of reliance was moderate, at best. This result may support the suggestion of DeZoort, Houston, and Peters (2001) that there is some threshold to the extent of reliance external auditors will place on the work of internal auditors. However, it is not clear whether the mean response levels obtained are "appropriate" in that there is no measure of actual audit effectiveness for the work of the internal auditors.

The results of this study present opportunities for future research. An examination of the effect of other types of outsourced internal audit providers (e.g., Non Big-4 Firms, Protiviti) or other sourcing arrangements (e.g., partial outsourcing, only Section 404 testing) on the reliance decision could be performed. Because auditor perceived litigation risk has an influence on the reliance decision, future research is needed to determine if judicial decision makers increase auditor liability when reliance is placed on the work of internal auditors during an apparent audit failure.