Submitted in part fulfilment of the requirement for the degree of Master of Science in International Financial Management

External Auditors Reliance on Internal Audit in Sri Lanka

By Dilukshan Manoharan

School of Management University of Surrey

September 2011

Word count: 18456

Dilukshan Manoharan

Abstract Auditing profession has reached new expectations in the dynamic world we operate in. Both external auditing and internal auditing has developed over last three decades individually and together. External auditors started to rely on internal auditors from 1975 when the auditing standards in the United States first accommodated this reliance. Since then many researchers have been done on the factors which influence the reliance decision and external influences which drives the external auditors to rely on internal auditors. Even though these researches over three decades have covered developed countries very few have been done in the developing countries. This research is done in the Sri Lankan external audit environment to study the external auditors reliance on internal auditors.

This research is a qualitative research using case study strategy. Primary data was collected using semi-structured interviews. Interviews were held with external auditors who work for a big four audit firm operating in Sri Lanka. External auditors were interviewed with answers and explanations derived from their experience. Qualitative data was analysed conceptually and with arguments by comparing and contrasting with prior literature.

Research objectives for this research was developed based on the prior literature and the auditing standards practiced in Sri Lanka and internationally. This research is an excellent start for Sri Lanka and other developing countries to further develop on this area of study. Findings from this study show that the Sri Lankan auditing environment does not vary significantly from that of developed countries. But the regulatory requirements and the auditing standard practiced influences the results obtain.

Declaration of Originality I hereby declare that this thesis has been composed by myself and has not been presented or accepted in any previous application for a degree. The work, of which this is a record, has been carried out by myself unless otherwise stated and where the work is mine, it reflects personal views and values. All quotations have been distinguished by quotation marks and all sources of information have been acknowledged by means of references including those of the internet. I agree that the University has the right to submit my work to the plagiarism detection sources for originality checks.

. Dilukshan Manoharan 9th September 2011

Table of Contents

Chapter 1: Introduction.......................................................................................................... 8
1.1 Background of the Dissertation................................................................................................ 9 1.2 Methodology of the Dissertation............................................................................................ 10 1.3 Structure of the Dissertation................................................................................................... 10

Chapter 2: Literature Review .............................................................................................. 12

2.1 Introduction............................................................................................................................ 12 2.2 Theoretical Aspects of Internal Audit and its Influence on Governance and Financial Reporting......................................................................................................................................12 2.3 Auditing Standards and Theoretical Framework regarding External Auditors Reliance on Internal Audit Function/ Internal Audit Function........................................................................ 14 2.4 Literature on External Auditors Reliance on Internal Audit..................................................17 2.5 External Auditors Reliance on Internal Auditors and the Impact of Audit fee and Partner Preference.....................................................................................................................................28 2.6 Sourcing arrangement of Internal Audit and its impact on Reliance Decision of External Auditors......................................................................................................................................31 2.7 External Auditors reliance on Internal Audit and the role of Corporate Governance and Audit Committees..................................................................................................................................33 2.8 Background of Accounting and Auditing in Sri Lanka..........................................................34 2.9 Research Questions and Objective......................................................................................... 35 2.10 Conclusion ............................................................................................................................ 37

Chapter 3: Methodology ...................................................................................................... 38

3.1 Introduction............................................................................................................................ 38 3.2 Research Methodology........................................................................................................... 38 3.3 Research Strategy................................................................................................................... 39 3.4 Data Collection Techniques................................................................................................... 39 3.4.1 Data Collection Method.................................................................................................. 39 3.4.2 Selection Method of Interviewees................................................................................... 40 3.4.3 The Semi-structured Interview process........................................................................... 41 3.5 Advantages of using Interviews and Qualitative data for Research.......................................43 3.6 Limitations and Overcoming the Limitations of this Methodology.......................................44 3.7 Data Analysis Techniques...................................................................................................... 45 3.8 Summary................................................................................................................................46

Chapter 4: Critical Analysis and Discussion ....................................................................... 48

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4.1 Introduction............................................................................................................................ 48 4.2 External auditors reliance decision and the relationship among competence, objectivity and work performance of the internal audit function.......................................................................... 48 4.3 Impact of independence on the reliance decision................................................................... 50 4.4 Impact of corporate governance and regulations on the reliance decision.............................51 4.5 Audit fee pressure and its influence on external auditors reliance decision.........................53 4.6 Sourcing arrangement of Internal Audit and its impact on Reliance Decision of External Auditors......................................................................................................................................55 4.7 External Auditors Reliance on Internal Auditors for Direct assistance..................................55 4.8 Summary................................................................................................................................56

Chapter 5: Conclusion ......................................................................................................... 57

5.1 Summary of Findings and Recommendations ........................................................................ 57 5.2 Contribution of this Dissertation............................................................................................ 58 5.3 Limitations of this research.................................................................................................... 58 5.4 Suggestion for Future Researches.......................................................................................... 59

References ........................................................................................................................... 60 Appendix A Ethical Approval .......................................................................................... 76 Appendix B List of Interviewees ...................................................................................... 77 Appendix C Sample of Interview Questions .................................................................... 78 Appendix D The 3 key Factors Competence, objectivity and work performance ........... 81

List of Abbreviations

AICPA ASA CAS CAATS CSR EU FSA IAS ICOFR ICASL IFRS IIA ISA LSE NED NYSE PCAOB SAS SLAuS SOX TOR UK USA US SEC

American Institute of Certified Public Accountants Australian Auditing Standard Canadian Auditing Standard Computer Aided Audit Tools Corporate Social Responsibility European Union Financial Service Authority International Accounting Standards Internal Control over Financial Reporting Institute of chartered Accountants of Sri Lanka International Financial Reporting Standards Institute of Internal Auditors International Standards on Auditing London Stock Exchange Independent Non-Executive Director New York Stock Exchange Public Company Auditing Oversight Board Statement on Auditing Standards Sri Lanka Auditing Standard Sarbanes-Oxley Act 2002 Terms of Reference United Kingdom United States of America United States Securities and Exchange Commission

Acknowledgement

I take this opportunity to thank the University of Surrey and its staff for providing the best educational service during my one year period in Surrey. Special thanks to my personnel tutor and Dissertation supervisor for giving advice and helping me during this year.

Special thanks to my previous Senior Audit colleague and lifelong friend Asanka Karunathilaka for his friendship and continuous support in developing me as an auditor and sharing his friendship.

My time here at the university wouldnt have been a reality without my parents support and love, thank you Amma and Appa.

I thank my uncle Mr.S.W.Kanagartnam for his continuous support to complete this degree.

Imagination is more important than Knowledge - (Albert Eienstein)

Chapter 1: Introduction
Events which occurred since the mid 1970s has significantly influenced towards the growth of internal auditing. This was first initialised in the United States and gradually other countries following the similar system quickly adopted. The foreign corrupt Practices act of 1977 in United States required and made mandatory effective internal accounting controls and effective internal control functions should be established by the public companies. This was initiated so that there was reasonable assurance that the company assets are safeguarded and the transactions are authorised and recorded properly. In highlight of this background companies in the United States established strong and effective internal audit departments or functions, increased their internal audit staff, and strengthened internal audit independence.

Beasley (2000) identified that the investments made in internal auditing have been effective and reaping benefit, as the companies with internal audit staffs have a lesser rate of financial statement fraud than companies without internal auditing function. Coram et al. (2008) argued that organisations having trained internal audit staffs are more likely to detect and self-report occurrence of fraud than those without internal auditing. In 1987 Treadway Commission recommended that the top management of the public companies should establish internal audit function and should implement an effective reporting relationship. 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 functions effectiveness and objectivity(Treadway Commission, 1987, p. 11).Another highlight in the report is to urge that the internal audit function should be staffed with adequate number of qualified auditing personnel appropriate to the size and the nature of the company.

Schneider (2009) discussed that New York Stock Exchange imposed a requirement in 2003 for all listed companies, where they must implement an effective internal audit function, in their organisation either in house or outsourced. This requirement was later approved by the Securities and Exchange Commission. A survey done by the Institute of Internal Auditors in 2003 revealed 20 percent of companies listed in the Fortune 1,000 did not implement an internal audit department. And 50 percent of the Fortune 1,000 companies

had plans to increase their audit staffs in order to be in compliance with Sarbanes-Oxley (Harrington 2004).

1.1 Background of the Dissertation

After the development of external and internal audit regulators identified that unnecessarily duplicated audit procedures done by both these auditors could be avoided and eventually time and resources also could be saved. Auditing Standard Executive Committee in 1975 published a separate auditing standard. Statement on Auditing Standards (SAS) No. 9 (AICPA 1975), which provides guidance for external auditors on reliance of internal audit function and the use of their work. In the year 1991 SAS No. 9 (AICPA 1975) was superseded by SAS No. 65 (AICPA 1991). This change was done after extensive researches done on the reliance decision by many such as Gibbs and Schroeder (1979); Milton (1979); Clark (1981a; 1981b); Brown (1983); Abdel-Khalik, et al. (1983); Schneider (1984); (1985a); (1985b); Margheim (1986); Messier and Schneider (1988). Similar standards on External auditors reliance on internal auditors were issued internationally. Where International Standards on Auditing (ISA) 610 , Sri Lanka Auditing Standard (SLAuS) 610, Australian Auditing standard (ASA) 610 and Canadian Auditing Standard (CAS) 610 outlines using the work of internal auditors by External auditors. Kaplan & Schultz (2006) argued that by increasing their investments in internal audit companies we able to reduce their external audit fees by substituting internal audit work. A Survey done in 2005 among 117 chief internal audit executives revealed that in 88 percent of their companies external auditors relied on internal audit in various capacities. It is also argued and proven in many instances relying on internal auditing can avoid unnecessarily duplicated audit procedures; it also can benefit external auditors because internal auditors have certain advantages. It is also argued internal auditors generally have more knowledge about the companys procedures, policies and business environment than the external auditors. External auditors reliance decision on internal auditors has been researched and studied in many developed countries especially mostly in the United States. But in a developing country like Sri Lanka this study has not been done before. Internal audit function and reliance over internal audit function is a developing phenomenon in Sri Lanka. As an
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external auditor who has worked for Sri Lanka for five years, this research will contribute towards the growth of auditing in Sri Lanka and the reliance decision. Further this research will contribute to the academics who are interested in this area of study, in order to develop the knowledge on how difference the developing countries accounting and auditing structure.

1.2 Methodology of the Dissertation

The methodology used was Qualitative, Case study strategy, where semi-structured interviews were used to collect primary data. Ten external auditors from one big four1 audit firm operating in Sri Lanka were interviewed. Interviews were conducted through the internet and interviews were recorded digitally.

1.3 Structure of the Dissertation

This Dissertation will be structured in the following way. Chapter 2: Literature Review, This chapter will give an overview of the context and the background of the research problem. Existing literature about External Auditor Reliance on Internal audit will be critically reviewed. Theoretical background and regulatory framework on External Auditor Reliance on Internal audit will be discussed and critically analysed. Research problem definition and aims and objectives will be discussed.

Chapter 3: Research Methodology, in this chapter research methodology which will be used to obtain the data to answer the research question will be justified. Data collection method and validity of data will be discussed in details.

Chapter 4: Analysis and Discussion, in this chapter results obtained from the interviews held with the external auditors will be presented and analysed. Results will be compared and contrasted with the prior literature. Statements made by the interviewees will be discussed and argued accordingly.

The Big 4 firms are Ernst & Young, Deloitte Touche Tohmatsu, Price Warehouse Coopers and KPMG.

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Chapter 5: Conclusion, brief overview and summary of finding will be presented in this final chapter. Contribution made by this research and limitations of this research will be presented. Future research opportunities and avenues will be listed.

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Chapter 2: Literature Review

2.1 Introduction
In this chapter Theoretical aspects of the External auditors reliance on Internal Audit will be discussed to introduce the background to the research problem. Prior Literature on External auditors reliance decision on internal auditors will be critically reviewed and discussed by comparing and contrasting various literatures. Problems and Gaps in the existing literature will be discussed and the research problem definition and aims and objectives will be presented in this chapter. Literature on External Auditors Reliance on Internal auditors was searched using various sources such as Journals, E-Journals and books. Mainly using the EBSCO database Business source complete search engine provided by the University of Surrey and Google Scholar was used to search related literature. Key words such as External Auditors, Internal Auditors, Reliance decision, Auditing standards on Internal audit, was used to search the databases.

2.2 Theoretical Aspects of Internal Audit and its Influence on Governance and Financial Reporting
The Institute of Internal Auditors (IIA 1999) defines internal audit as: An independent, objective assurance and consulting activity designed to add value and improve an organizations operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.

International Standards on Auditing 610 defines Internal Auditors as Those individuals who perform the activities of the internal audit function. Internal auditors may belong to an internal audit department or equivalent function.

International Standards on Auditing 610 defines Internal Audit function as An appraisal activity established or provided as a service to the entity. Its functions include, amongst

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other things, examining, evaluating and monitoring the adequacy and effectiveness of internal control.

The above definitions illustrate that internal audit today is a service which is value-added assurance and consulting services through its role in monitoring, evaluating, and improving risk management, control, and governance process which are critical to preserving and enhancing stakeholders value (Bou-Raad 2000). This confirms that internal audit today is a different phenomenon compared to its initial service which was restricted to compliance assurance and safeguarding of assets of organisations. In the above definitions Assurance and Consulting means that internal audit becoming a proactive, consumer-focused activity concerned with the importance issues of control, risk management, and governance (Hass et al. 2006; Chapman and Anderson 2002). Munro and Stewart (2010) argues that definition laid by the Institute of Internal Auditors (IIA) clearly identifies that internal audit is both an assurance activity and a consulting activity which plays a key role in both risk management and corporate governance of organisations. McCollum (2006) explains that internal audit function has been redefined as a cornerstone on which effective corporate governance will be formulated. Arguments made by McCollum (2006) is been endorsed by the academician Rittenberg et al. (1999) by explaining that internal audit function is an integral part of corporate governance which also plays an important in assisting management and the board in achieving their objectives.

In todays corporate world internal audit plays a key role in supporting the management, audit committee, Board of directors, external auditors and other stakeholders (Ruud 2003). Internal audit report produced by the internal audit functions of the organisations has potential in complementing the existing governance disclosures made by organisations and in turn increases its stakeholders confidence in good governance and in the quality of the financial statements produced (Archambeault et al. 2008). Asare et al. (2008) discussed the negative role of internal auditors, where he argues internal auditors are sensitive to managements incentive to misreport financial information and, thus, they increase budgeted work hours when management has a high incentive to misreport. Internal audit function quality is linked to the moderation in the level of that if earnings management as measured in terms of abnormal accruals and the propensity to meet or beat analysts earnings forecasts (Prawitt et al. 2009). The role of internal audit function in corporate governance is well researched and documented in prior literature (Castanheira et al., 2010;
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Hirth, 2008; Jeffrey, 2008; Gramling and Hermanson, 2006; Gramling and Myers, 2006; Ramamoorthi, 2003).

2.3 Auditing Standards and Theoretical Framework regarding External Auditors Reliance on Internal Audit Function/ Internal Audit Function
The Sarbanes-Oxley Act (SOX) of 2002 significantly elevated the role of the internal audit function in USA (Gramling, Maletta, Schneider, and Church 2004). Section 302 of SOX requires the management to report on and certify to the effectiveness of its internal control structure and procedures with respect to the firms quarterly and annual reports. Section 404 of SOX requires management to document, evaluate and report on the effectiveness of internal control over financial reporting, and requires the external auditor to evaluate and opine on managements assessment of internal control. In order for the External auditor to rely on the work performed by the internal audit function the external audit must assess the quality of the internal audit function (AICPA 2003; PCAOB, 2007). It has been argued stronger the internal audit function the more extensively the external auditors will be able to use it (PCAOB, 2007). Auditing standards No.5 insist external auditors to use the principles based approach in determining when and to what extent they can use the work of others (PCAOB 2007). It is evident that even prior to SOX external auditors evaluated the strength of the Internal Audit function with the objective of assessing the strength of internal control structure of their client. SAS No 65 (AICPA 1991) prescribes the relationship between the external auditors and the internal auditors.

SAS No.65 (AICPA 1997, AU 322) discusses two approaches that external auditors can use to rely on a clients internal audit department. One approach is that where external auditors can use the clients internal auditors as assistants during the financial statement audit. The second approach is to rely on the work that was performed by the internal audit department during the year. According to the requirement of the SAS No. 65 AICPA (1991) before relying on the work performed by internal auditors, external auditors are required to evaluate the objectivity, competence, and work performed by internal auditors. Appropriately evaluating and relying on the internal audit function is critical as the inherent risk of the material misstatement in the financial statement increases or when the

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work of the internal auditor is more subjective and more susceptible to bias (AICPA 1991SAS No. 65).

Since a great amount of literature is written and tested in the United States regarding the internal auditors reliance decision SAS No.65 AICPA (1991) is discussed in the literature review. The equivalent standard internationally is IAS 610 and in Sri Lanka it is SLAuS 610 (ICASL 1999).The main difference in these standards versus the SAS No 65 (AICPA 1991) is that using internal auditors as assistance by external auditors is not allowed in IAS 610 and SLAuS 610 (ICASL 1999).

Using the existing auditing standards and regulatory requirements Schneider (2009) explained that external auditors reliance on internal auditing could be in three ways: which will be discusses below in more detail.

1. Relying on the internal audit function as part of the companys overall system of internal controls. 2. Relying on work already done in internal audits relating to testing of internal controls or testing of accounts, transactions or selected captions. 3. Relying on internal auditors to provide direct assistance to the external auditors.

External Auditors Reliance on Internal Audit as a part of Overall Control System

External auditors will have to test the design and operating effectiveness of the internal control system of their audit clients as this will directly affect the reliability of the companys financial information. When assessing the companys overall control environment. Auditing standards mandate the consideration of internal audit function. Statement on Auditing Standards (SAS) No. 65 The Auditors Consideration of the Internal Audit Function in an Audit of Financial Statements, states that:

[W]hen obtaining an understanding of internal control, the auditor should obtain an understanding of the internal audit function sufficient to identify those internal audit activities that are relevant to planning the audit (AICPA, 1991, AU 322.04).

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The above is evident in other standards such as ISA 610, SLAuS 610 etc. External auditors could identify relevant internal audit activities by obtaining the companys internal audit plan from the internal audit department or the Audit committee. This will ensure the external auditors to identify the nature, timing and extent of the internal audit work planned by the internal auditors. It is the responsibility of the External Auditors to identify and study how the internal audit function effectively contributes towards the overall control environment. They also should evaluate internal audits organisational status within the company and its ability to obtain unrestricted access to company documents and its personnel. This will ensure that the external auditor identifies that the internal audit function has an independence to effectively perform its work. Internal audit should report functionally to the audit committee and administratively to the companys Chief Executive Officer.

External Auditors Reliance on Work Performed by Internal Auditors

External auditors may decide to rely on the work that has been already performed independently by internal auditors. This could be for a single account balance or for collectively for certain account balances. SAS 65 (AICPA 1991) and other related standards clearly states that reliance decision is at the full discretion of the external auditors. They need not rely on the work performed by internal auditors if the external auditors decide that the internal audit activities are not relevant to their financial statement audit. This will help to express the true and fair view of those statements. On the other hand even though the work performed by internal auditors is identified as relevant still the external auditors should decide whether using the work of internal auditors is efficient and effective to perform their work. It should be noted that external auditors professional skepticism and experience for the independent judgement should be used when deciding the process described above.

External Auditors Reliance on Internal Auditors for Direct assistance

When using internal auditors as assistance the external auditors will specifically identify and request the internal auditors to perform specific external audit work. External auditors will plan the nature, timing and the extent of work or test to be performed.

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When direct assistance is provided, the auditor should assess the internal auditors competence and objectivity . . . and supervise, review, evaluate, and test the work performed by the internal auditors to the extent appropriate in the circumstances (AICPA, 1991, AU 322.27).

A survey done by (Taylor 1997) is evident that external auditors use senior internal auditors for junior work to be performed. There is a difference in the determinants of internal audit reliance decisions depending on whether the decision by external auditors relates to work that has been already performed against using the internal auditors as direct assistants (Maletta 1993 and Maletta & Kida 1993). The determinants such as inherent risk, internal control strength, and internal audit quality was texted in the prior researches done (Maletta 1993 and Maletta & Kida 1993).The research concluded as work already performed by internal auditors should be relied based upon internal control strength as it is a significant determinant of internal audit reliance, where as when internal auditors participate as direct assistants internal control strength does not affect the reliance decision (Maletta 1993 and Maletta & Kida 1993).

2.4 Literature on External Auditors Reliance on Internal Audit

In Early stages after the issue of SAS 9 (AICPA 1975) Gibbs and Schroeder (1979) studied the competency dimension of internal audit function where Clark (1981a; 1981b) studied the performance and objectivity dimension of reliability assessment which should be done by the external auditors before the reliance decision. The main drawback in their study was that these three dimensions were considered individually, this was also criticized by Milton (1979). Gibbs and Schroeder (1979) and Clark (1981a; 1981b) found the independence of the internal audit function is the most important factor for external auditors to rely on internal audit. Further Ward et al. (1980) found that external auditors rely on internal auditors more in regard with work performed by internal control than for direct assistance in performing audit procedures.

Brown (1983) initiated one of the pioneering studies on external auditors reliance on internal audit. During his time relying on internal auditors was covered by standard SAS 9 (AICPA 1975). Brown (1983) argued the guidelines were general and not easily
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implemented by the independent auditors. But as discussed earlier SAS 65 (AICPA 1991) superseded SAS 9 (AICPA 1975) and a comprehensive standard is in place now. Similarly ISA 610 is practised internationally. During this time there were less researches and empirical evidence available in this area of study. Also there were less empirical evidence and the four firms chosen by Brown (1983) from the Big Eight2 would have less experience on relying on internal audit work. Initially Brown (1983) found that two factors dominate the external auditors judgement (1) independence of the internal audit function and (2) satisfaction with the internal audit function during prior audits. The first factor identified has been a significant one even latter research found the same influencing factor but the second factor satisfaction with the internal audit function during the prior years is an arguable finding in contemporary context. As evident from the latter researches this factor was not given much prominence as the Internal Audit Function developed in a dynamic way year by year. New regulations and expectations were enforced to change the dimension of Internal Audit Function. Nevertheless its understanding that this was a significant finding by Brown (1983) since there were less empirical evidence available in this area of study during his time. Brown (1983) also identified that Work performance was the most important factor and then followed by objectivity and competence. Brown (1983) used the ANOVA (Analysis of variance) model which is a statistical model and has been used in prior auditing researches during his time. It is questionable whether this model has been used effectively since he argues the influencing factors have been considered in isolation. It is commendable that Brown (1983) identified that the future researches should consider this and ensures the influencing factors should not be analysed in isolation.

Abdel-Khalik, et al (1983) studied the factors influencing the external auditors judgment on internal audit function during the planning stage of the audit based on three EDP-audit techniques (Integrated test facility, Test data, and generalized audit software) and two organisational variables (the level to which the internal auditing department reports and internal auditors level of responsibility in reviewing changes in application programs). They reported that the independence of internal auditors as the most important factor that determines the reliance of external auditors on internal auditors work. This confirms the prior findings on reliance of internal audit by external auditors by Brown (1983). But in

The Big 8 firms until 1987 were Arthur Anderson, Arthur Young & Co, Coopers & Lybrand, Ernst & Whinney, Deloitte Haskins & Sells, Price Warehouse, Peat Marwick Mitchell & Co.; and Touche Ross & Co.
2

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contrast to Brown (1983) they found objectivity as the most important factor followed by work performance and competence. Even in their research they found no significant interaction among the three factors. Abdel-Khalik, et al (1983). This research was conducted based experiment in two different groups where external auditors were asked to prepare planning document for their clients based on the data of internal auditors given by the research group. Studying the factors influencing external auditors in relying on work of the internal audit function in a way of experiment is not so effective and rational, this is because the gravity of the natural practical problems faced by the external auditors will not be identified in this kind of experimental method. It should be noted that the use of Generalised Auditing Software by the internal auditors and how the external auditors response was an addition to the existing literature. It should be commended this was one of the first research to study on the use of internal auditors as assistants. But they did not examine much on the internal audit competence which could be a drawback.

Schneider (1984) identified work performance as the most important factor followed by competence and objectivity for external auditors reliance on internal auditors. Schneider (1985a) in his research identified the relationship between external auditors nature in evaluation of the internal audit function and their reliance decision during the planning of the audit. Outcome of the research was that auditors perceived competence and work performance to be almost equally important factor and the objectivity factor as less important but still a significant factor. Schneider (1985b) examined the degree of consensus among external auditors in evaluating the internal audit function. An additive, compensatory model was employed in an experiment atmosphere. Results indicated that the additive combination strategy seemed to fit the profile of evaluations of 15 of the 18 auditors participated. Out of the 15 auditors 9 of them rated work performance as the most significant factor and 8 out of those 9 identified the pattern which the study Schneider (1984) found. These studies were statistical and done in an experiment environment, which is questionable as discussed earlier.

Margheim (1986) examined the extent that the external auditor adjust the nature and extend of audit procedures due to the reliance on internal auditors and if so whether any such reliance was related to the source reliability of the internal auditors which is defined by the three factors internal auditor competence, work performance and objectivity. His study identified that the external auditors reduced planned audit hours if the internal
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auditors had a high competence-work performance, and did not rely on internal auditors if they had low competence-work performance. Also found they did not change or adjust their tests in response to changes in the degree of internal auditors objectivity. This is complementing Schneider (1985) findings where he argues internal auditor competence and work performance were perceived as almost equally important in reliance decisions with objectivity less important although not trivial. The difference in Margheim (1986) study was that he examined by way of treating Competence and work performance as a single factor. Margheim (1986) treated these two factors as one single factor in order to avoid unrealistic combinations such as low competence of internal audit function and high work performance. This combination should be commended as the argument was clear and true because when the competence of the auditors were high you expect them to perform high but also one could argue against it depending on the weight age given and clearly defining the three factors more in their research papers. But it should be understood that these researches are based on criteria laid out SAS 9 during the time and revised standard in future.

Margheim (1986) uses experimental methodology in a hypothetical companys internal auditors in evaluating the accounts receivable internal control system and in evaluating the appropriateness of account balances. Margheim (1986) argues that the reason for the selection of accounts receivable is that it is a general importance to both external and internal auditors. Again using the experimental methodology and examining the three factors from choosing only one caption like accounts receivable is debatable, but also one would agree that there was no integrated Internal frame work such as COSO (1992) or Turnbull (2005) guidance for internal control during his time of research. Margheim (1986) found that external auditors did not react to internal auditor objectivity and did not find any significant interaction effects between competence-work performance and objectivity, this was surprising because earlier literature suggest otherwise. Brown (1983), Abdel-Khalik, et al (1983), and Schneider (1984, 1985). The reason for the difference may be due to the research designs used.

Messier and Schneider (1988) research on reliance decision was a hierarchical approach. Where hierarchy of attributes that enter into the decision process was developed based on prior research and with the assistance of Big eight audit managers. Interestingly contrary to earlier studies such as Brown (1983), Schneider (1984; 1985) and Margheim (1986) the
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conclusion of this research was that Competence of the internal auditors was the important factor followed by objectivity and work performance. After the SAS 9 (AIPA 1975) issuance and researchers done this was the first research to indicate that competence was the important factor compared to the other two factors. The key difference in this research work was rather unlike the previous researches where they used questionnaire, surveys and experiments Messier and Schneider (1988) uses Analytic Hierarchy process (AHP) (Saaty 1980) to assess which of these attributes were most important to a group of experienced external auditors as discussed above. The advantage in this methodology is that it is a composition approach where as previous studies have been decomposition approach (e.g. regression analysis, conjoint measurement). It should be identified the results found from this research was totally in contrast to prior literature even though the prior finding have been inbuilt in the hierarchy process as discussed earlier. This is a main drawback of this research and also the limitations of Analytic Hierarchy Process discussed by Jensen (1983) would be significant as these are discussed here as it is not relevant for our research.

Maletta (1993) concentrated his research on the decisions of external auditors to use internal auditors as assistants to perform audit work during the audit process. Maletta (1993) confirmed that external auditors decision comprised complex and rigid process when deciding whether or not to use the internal auditors as assistants. He also found that there is a strong relationship among competence, work performance, and objectivity in assessing the strength of the internal audit function for reliance purpose. Maletta (1993) interestingly concluded that when inherent risk is high external auditors considered the work performance of the internal auditors only if the objectivity was high. On the other hand when the inherent risk is low there was no interaction effects found between work performance and objectivity.

Competence was identified as the most important factor in all inherent risk conditions closely followed by objectivity and work performance. By this time now SAS 65 (AICPA 1991) superseded SAS 9 (AICPA 1975).After the study of Abdel-Khalik, et al (1983) the research of Maletta (1993) examines using internal auditors as assistants where as other prior researchers identified external auditors general evaluations of internal audit quality and their decisions to rely based on the prior work of the internal audit function. (Maletta and Kida 1992; Margheim 1986; Schneider 1984, 1985; Brown 1983; Clark, Gibbs, and Schroeder 1981; Gibbs and Schroeder 1980).Maletta (1993) argues lack of prior research
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on using internal auditors as assistants is surprising as the impact that it will have on the audit process and the future of the auditing profession. Today one could agree with him after the Sarbanes and Oxley act of 2002 and ICOFR requirements for public companies in the USA and other regulators requirements internationally on internal audit and corporate governance.

Another addition to the literature by Maletta (1993) was that he argues that the prior researches were only considering the three factors which influenced the external auditors which documented in SAS 9 & SAS 65 (AICPA 1975, 1990) rather he identifies a potential effects of audit risk factor such as related to inherent risk was not considered. Again it should be noted that SAS 65 (1991) did not provide a detail guidance on how the inherent risk should be assessed or either should be considered cohesively with internal audit objectivity, competence and work performed it was rather vague and ambiguous. Maletta (1993) studied the how the inherent risk impacts on the three factors such as objectivity, competence and work performed of internal auditors towards the reliance decision when external auditors use the internal auditors as direct assistants to perform certain tasks. Maletta (1993) further studied the impact of inherent risk on the complexity of the decision processes that auditors use to evaluate the three internal audit factors in making such judgements.

Under certain conditions auditors are relatively complex configural information processors (Brown and Solomon 1990). The evaluation was on the decision processes that auditors use when making decision on control risk assessments in cash disbursement area. They found that auditor judgements were significantly affected by specific interactions between information cues. This is where the result of their study indicates that auditors are not, as some of the previous research suggests, merely simple additive information processors. Brown and Solomon (1990) also argued these findings suggest that many auditors are able to react and process patterns of information when such reaction and processing make sense from an auditing perspective. It is a value addition to the thought process of how auditors decision process is linked to some of the psychological concepts studied over time, even though it is not directly linked to the research it is work discussing.

It is important and appropriate to discuss some theories on the relationship between the complexity of individuals decision processes and decision importance, as psychological
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research suggests that there may be relationship existing. This is directly related to the prior researches and future ones as External Auditors need to make judgemental decisions based on the level of risk involved. Christen-Szylanski (1978) found that when the benefits of a certain decision task increase, individuals use more analytical decision processes. Petty and Cacioppo (1984) found that information having a high personal relevance generated more intense, complex information processing on the part decision makers. Other Studies such as Murnigham and Leung 1976; Heslin, Blake and Rotton 1972; Bybee 1978) have provided evidence of similar tendencies. Hanno (1990) identified and argued that the more important the decision, the more complex and analytic decision process used by the decision maker (Beach and Mitchell 1978; Billings and Scherer 1988; Hagafbrs and Brehmer 1983). This is very important for this research as the prior researches because in an audit environment, auditors planning decisions increase in importance for situations in which there is a high likelihood of financial statement error or, in other words, a high level of inherent risk (Hanno 1990). Where we could rationalise that the audit-planning decisions made in high inherent risk situations should be greater importance than similar decisions made in low inherent risk. This was evident in the psychological researches discussed above and in the research and investigation done by Maletta (1993).

When discussing the inherent risk assessments by auditors it is important to discuss the concerns expressed by Cushing and Loebbecke (1983), where they argued auditors assessments of inherent risk and control design strength may not be entirely independent. This because the concern is that strong internal control systems may influence to reduce auditors assessments of inherent risk. This clearly shows that even though inherent risk is covered by separate auditing pronouncements, the concern is that the level of inherent risk may affect the function of the strength of the systems control. Strong internal controls may mitigate the effects of the high levels of the inherent risk and vice versa.

Whittington and Margheim (1993) examined the effects of inherent risk, materiality and subjective nature of the assertion under audit on external auditors reliance on internal auditors. This was a case study experiment among the Big six3 external audit managers. Again here it should be noted that using experimental study in a hypothetical company environment is not effective rather doesnt brings out the actual picture of the external

The Big 6 firms (1989-1998) were Arthur Anderson, Ernst Young, Coopers & Lybrand, Deloitte & Touche , Price Warehouse and KPMG.
3

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auditors reliance on internal auditors. This research used small samples around 10 or 11 observations for each case, which actually limits the generalisability of the result. Whittington and Margheim (1993) found at low materiality level the subjects felt that external auditors had an obligation to directly perform majority of the substantive work, but they were willing to let the internal auditors a large majority of the test of control work. This finding seems to be consistent with the survey Ward and Robertson (1979) that found external auditors relied on the internal auditors more extensively when performing test of control than for substantive test work.

Mills (1996) examined the effects of cognitive style on external auditors reliance decisions on internal auditors or internal audit function. Mills (1996) also examines the dimension of cognitive style, which is known as mobility-fixity, this is new to the auditing literature as this has not been previously researched in an auditing or accounting context. But also should be noted that Pincus (1990) studied the effects of field dependence/ field independence on an audit judgement and found that cognitive style did significantly affect auditors fairness and presentation decision. Similarly Bernadi (1994) studied and found that field dependence/ field independence did not significantly affect auditors fairness of presentation decision. This is one of the first researches to use field dependence/ field independence on an audit judgement where prior to this it was used by Cardy and Kehoe (1984) in raters accuracy in performance appraisal tasks and found it was significantly affected.

Using models based on Bayesian (cascaded) inference theory and analysed using numerical sensitivity Krishnamoorthy (2002) studied the factors that influences the external auditors in relying on the work of internal audit. Bayesian inference is a method of statistical inference in which the evidence is used to estimate the parameters and predictions in a probability method. All uncertainty is summarised by a posterior distribution which is a probability distribution for all uncertain quantities, given the data and model. The term Bayesian is derived from the application of the Bayes theorem to probabilities which have the interpretation as Bayesian probabilities. Krishnamoorthy (2002) argued there have been significant amount of prior academic research done on external auditors reliance decision on internal audit function but these results have been mixed and inconclusive. Krishnamoorthy (2002) studied the interaction and relationship these three factors (objectivity, work performance, and competence of the internal
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auditors) identified by the auditing standards and prior research in determining the strength of internal audit function.

His research was based on the interrelationship among these three factors and how they affect the assessment of external auditors on internal audit function. The use of Bayesian theory may be a questionable one in this research as they found evidence which had conflicting results as some of the evidence obtained was positive and others were negative but as he argued this is expected in auditing as human judgemental process is involved. Another Limitation is that the results of this research is arrived using model and parameter values which have been selected based on conditional independence and assumptions made as these are necessary in developing mathematical expression which is used in this research for Bayesian theory. Krishnamoorthy (2002) concluded that ranking the three factors Competence, Objectivity and work performance of internal auditors as some prior researches done is outdated as it is evident now that there is no single factor which will dominate in all condition of the reliance decision.

Vikram et al. (2010) models the interrelationships between the three key factors competence, work performance, and objectivity used by external auditors when evaluating the strength of the Internal Audit function (SAS 65 AICPA 1991; Messier and Schneider 1988; Krishnamoorthy 2002). The addition to the literature is that Vikram et al. (2010) explicitly models the And relationship between the internal audit function and the factors such as competence, work performance, and objectivity. This is an addition to the existing literature where earlier model by Krishnamoorthy (2002) failed to identify and model this relationship. This work provided a structural approach to gather and aggregate items of evidence pertaining to various internal Audit factors that will help the judgement of external auditors is assessing the reliability of the clients internal control system and determine the extent of reliance on the work of the internal auditors.

This model developed by Vikram et al. (2010) should be commended for the design and ease of use by the external auditors when evaluating internal audit function. Since it is presented in an evidential diagram external auditor could include or discard any items of evident related to specific internal audit factors in a structural way in varying situations. The finding of Vikram et al. (2010) contradicts with the results obtained in the prior researches as the results of Vikram et al. (2010) demonstrated the objectivity factor was
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not important as work performance and competence (Brown 1983; Schneider 1985a; Margheim 1986; Maletta 1993). Vikram et al. (2010) findings differ from prior work since they model the interrelationship between these three factors. According to their finding it was revealed the strength of the internal audit function was high when the three factors modelled had a strong or perfect relationship. This was satisfied even when there was positive or negative evidence about one of the factors as long as they had high levels of beliefs about the other two factors.But interestingly they also found that when objectivity is negative the belief dips to zero this is where the external auditors are certain that the objectivity of internal auditors has been defaulted or impaired. Vikram et al. (2010) also found the external auditors rely less on internal audit if the expectations on litigation and regulatory cost are high even when their evaluation on internal audit was strong. The use of belief function in this research by Vikram et al. (2010) is one main limitation as some would not agree on the outcome and findings based on the assumptions and model used. Finally commendable inclusion in the research was a detail Table was included on the three factors and determination criteria of those factors. This Table was used in this very research as well when interviews were held with external auditors. This table is presented in Appendix D of this research.

Prior empirical studies on the relationship of internal and external auditors are predominantly in the context of developed economies. It is noted that the implications have been under researched in the developing countries. Interestingly Haniffa and Cooke (2002) suggest that as environmental factors influence audit practice, the techniques and approaches prescribed for the use in developed economies may not apply to a similar extent in countries with socio-economic settings that are different. This argument is also supported by Ritchie and Khorwat (2007). Haron (2004) identified internal auditors competence and scope of work was the main factors that the external auditors considered in making reliance decision. Carey (2006); Felix (2001) argued that another factor which influences the reliance decision is the level of inherent risk that an audit client entails. Carey (2006) also argued that the for high risk clients, external auditors use of internal audit work may reduce inherent risk because internal auditors possess a greater awareness of client operations than external auditors. Spraakman (1997) argued that the Internal Auditors possess superior authority of access to organisational information than external auditors.

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Internal audit effectiveness as measured by managements acceptance and implementation of internal audit findings and recommendations may impact on external auditors reliance on internal auditors work. Mihret and Woldeyohatmis, (2008); Mibret and Yismaw, (2007); Roth, (2000) put forward that the extent of internal audit effectiveness exhibits variation across organisations the level of external auditors reliance on internal audit work may also vary accordingly. Higher level of acceptance of internal audit recommendations by the management may lead to higher level of external auditor reliance than a situation where internal audit is less effective. The variations in empirical research results on factors that determine external auditors reliance on internal audit may raise interest to explore associations between these factors and audit market characteristics, as mentioned earlier the Socio-Economic environments in developed economies and the developing ones like Sri Lanka should be taken into consideration. Differences also may be observed in the level of external auditors reliance on internal audit work among external audit markets when different levels of competition for clients prevail in external audit market. This is the argument that the external auditors level of reliance on internal audit work varies depending on the level of competition that exists in the external audit service market.

As most of the Literature on this topic is based on the developed world studies on developing countries may contribute additional evidence and new insights into the literature. One such evidence is that of Al-Twaijry et al. (2004) on Saudi Arabia, which indicates that the extent of external auditors' reliance on internal audit work was associated with external auditors' perceptions of internal audit's objectivity, competence and work experience. Mihret et al. (2011) identified in Ethiopia external auditors perceptions of internal auditors work performance are significantly associated with external auditors level of reliance on internal audit work. This also suggests that strengthening internal audit could help improve internal-external audit linkages. This research focused on the External auditors ' perceptions of internal audit practices in Ethiopian state-owned enterprises do not differ from external auditors 'perceptions of internal audit practices in Ethiopian private companies.

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2.5 External Auditors Reliance on Internal Auditors and the Impact of Audit fee and Partner Preference
It has been argued and even empirical evidence proves in many circumstances that external auditors reliance on internal audit has reduced the external audit fees and eventually has reduced the total cost of auditing for companies. It is also argued that this benefits both the External auditors and its clients, since the external auditors could compete well in the market to win audit proposals and also the clients could benefit by needing to pay less for the service they obtained. Some academics also argue the margin is that total audit cost either internal or external and this will not affect the total impact. But it is important to have the balance between both internal auditing and external auditing today, as discussed earlier both are mandatory by the regulators and need to be in place to achieve the high standards in corporate governance. According to prior research done by Felix (2001) and Al-Twaijry (2004) external Auditors Reliance on Internal Auditors work is beneficial for Organisations. Felix (2001) also found that the contribution of internal auditors to financial statement audit as a significant external audit fee determinant supported by Spraakman, (1997). This will benefit both the client and the External auditors have an incentive to seek greater extent of external auditors reliance on internal audit work.

According to the previous Literatures such as Krisnamoorthy (2001), (2002); Morrill and Morrill (2003); Mihret (2010) and James and Mula (2010) argued that the external auditors reliance on internal audit work could produce a significant cost saving through reduction of external audit time and resources. External auditors assess Internal Audit work to determine the extent of their reliance on internal audit, which is done at the planning stage of the Audit. In the early stage of the reliance decisions itself the external auditors identified the reliance as a cost benefit method, as Brown (1983) argues that initially after the issue of SAS 9 in 1975 external auditors were mainly interested on cost reduction by the use of internal auditors work. Ward et al. (1980) also in early stages commented on the cost saving factor where external auditors could save cost and reduce audit fees to be attractive in the market by relying on the internal auditors. Morrill and Morrill (2003) identified the intention to reduce external audit costs in a bid to reduce audit fees and maintain the competitiveness in the audit service market motivates external auditors decision to rely on external auditors work. He also argues that the external auditors level

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of reliance on internal audit work is associated with their perception of internal audit practice of clients.

Felix et al (2001) concluded in his research that internal audit has a direct relationship with external audit fee and rather it contributes towards the determinant of the external audit fee. Felix et al. (2001) also states that the greater the contribution of the internal auditors to the financial statement audit, the lower the audit fee. Felix et al. (2001) further mentioned that the internal audit contribution is influence by internal audit quality. Inherent risk increases, the effect of internal audit availability on contribution diminishes, while the effect of coordination on contribution increases (Felix et al. 2001). Overall findings of Felix et al. (2001) reveals that the contribution made by internal audit could lower the external audit fees, and in order to influence the contribution made by internal audit clients could invest further in internal audit quality, managing availability, and facilitating coordination between the internal and external auditors.

Recent researches indicated that at planning stage auditors do reduce planned audit hours in response to clients fee pressure (Bierstaker and Wright 1999: Houston 1999). But also argued that without the understanding the mechanisms through which auditors make these hours reductions, it will be difficult to assess whether such reductions in planned audit hours will affect negatively on audit effectiveness. Gramling (1999) focused in his research whether and to what extent, client fee pressure and related partner preferences affect audit mangers reliance decision. Before researches such as Ashton and Ashton (1988); Anderson and Maletta (1999) suggested that the order in which information about the internal audit department is received may affect the reliance decision of external auditors on internal auditors. Further according to Gramling (1999) in the case of fee pressure applied by clients external auditors may reduce the planned audit hours and pressure to rely on internal audit is indirectly enforced on external auditors. This will cause concern over the independence of auditor and the effectiveness of audit and in order to overcome this issue auditors have viable mechanisms through which planned audit hours can be reduced. Gramling (1999) argued that mechanism used by external auditors is to rely on internal audit function.

Recent survey research indicates that key reason auditors rely on the work of internal auditors to lower the audit cost. This Reliance on internal auditors is an outcome as
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response to fee pressure and to the competitiveness of the market place (Felix et al. 1998). Reliance on clients internal audit department should result in less external audit work being performed and also lower the audit fees, this intern might affect the effectiveness of the audit work (Felix et al. 1999). They also argue that if an internal audit department is compromised of quality internal auditors with objective and competent there is no reason that they cannot contribute effectively to the financial statement audit. But if the quality of the internal auditors is compromised then the question on audit effectiveness arises. SAS 65 (AICPA 1991) and SLAuS 610 (ICASL 2009) cautions external auditors on relying on work performed by internal auditors who do not satisfy the required or sufficient level of objectivity and competence. Trompeter (1994); (POB 1993) argues any individual partner may emphasise audit efficiency and profitability because of the concern on audit firms short term profitability. On the other hand because of a focus on the extent of litigation faced by audit firms, a partner may explicitly emphasise the need of the audit quality, and professional skepticism. Gramling (1999) suggested by his experimental investigation that the audit mangers rely to a greater extent on the internal audit work when the client explicitly emphasises the need for reduced or low audit fees, than when their client explicitly emphasis a preference for audit quality. This has increased reliance even though the internal audit department is characterised as being of low-to-moderate quality. Gramling (1999) findings also proved that the partner preferences influence audit managers reliance decision. However, the results did not provide any evidence of an interactive effect between client fee pressure and partner preference on audit managers reliance decisions.

Bierstaker and Wright (1999); Gibbins and Newton (1994) discussed that audit managers are not pressurised by client fee or engagement partner preference on an individual basis, rather both of these factors would co-exist on any one engagement. This discussion pays way to further discussion to whether these two factors have an interactive effect on audit managers reliance decision (Gramling 1999). In his study he further questioned whether the audit managers rely on internal audit work to a greater extent when client fee pressure is combined with a partner emphasising on efficiency than when the client fee pressure is combined with a partner emphasis on audit quality or professional skepticism. Gramling (1999) also noted that concern for audit quality and audit independence emphasized by the observers and the auditing profession with relevant standards. But the argument he kept forward was interesting issue and question, whether an audit partner who emphasises audit
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quality or professional skepticism would be able to limit the influence of a client who exerts a high level of fee pressure. On the other hand Gibbins and Newton (1994) suggested that an interactive effect may exist, but the experimental research does not support such effect. Bierstaker and Wright (1999) found in their result that there was no interactive effect among those two factors on auditors budgeted audit hours. But

Bierstaker and Wright (1999) found an interactive effect of these two factors on planned tests, the nature of the interaction does not indicate that auditors who encounter both higher client fee pressure and partner preference responded to a greater degree than did auditors who were subject to just one form of pressure. Interestingly Bierstaker and Wright (1999) did not include a condition in which audit partner emphasises audit quality or professional skepticism in their experimental design that they have used. And their study does not allow for examination of whether an explicit partner emphasis on audit quality or professional skepticism. The main limitation in Gramling (1999); Bierstaker and Wright (1999) as the prior researches they used an experimental research to identify the effects they reported.

2.6 Sourcing arrangement of Internal Audit and its impact on Reliance Decision of External Auditors
Companies have also outsourced their internal audit facilities to experts such as the Public Accountants and chartered Accountants. Many researchers have studied the impact and effectiveness of in-house and outsourced internal audit functions in organisations. A survey done by Wallace & Kreutzfeldt (1991) on external auditors revealed that the total external audit hours increases by ten percentages on average with no internal audit functions involved in audits. This result was an outcome from 26 companies which indentified that the reliance in internal auditing had an impact of ten percentage reduction in the average external audit fee (Wallace 1984).

A survey conducted by the Institute of Internal Audit (IIA) indicates that as of 2002, 54 percent of the surveyed companies used third party or outsourced some or all of their internal auditing work performed within the entity (IIA 2002). But interestingly by contrast, an earlier study in 1995 conducted by the IIA indicated only about 30 percent of organisations used third parties to perform internal audit work (Rittenberg and Covaleski 1997) . In prior literature where researches such as Alhawat and Lowe (2004); Caplan and Emby (2005) discussed and identified differences between in-house and outsourced
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internal audit service providers. Caplan and Emby (2005) found that out-sourced and inhouse internal audit functions provided similar type of quality and equally competent work when in the context of control evaluation. Alhawat and Lowe (2004) interestingly found that both type of internal auditors advocate managements position when selling or purchasing a new department or division but the outsourced internal auditors advocates managements position to a lesser degree compared to the in-house internal auditors. The reason for these findings could be linked to the management power where in-house internal auditors are considered to work under the organisations management in certain circumstances but the outsourced internak auditors tend to have more independency in working environment. Lowe et al (1999); Swanger and Chewning (2001) examined how the external audit report users change their behaviour based on whether the external auditors relied on an in-house or outsourced internal audit function. Financial analyst and Loan granters do not differentiate between external auditor reports that are based on external auditors reliance on work performed by an in-house versus outsourced internal audit function (Lowe et al 1999; Swanger and Chewning 2001). James (2003) in his research examined how the users of financial information change their behaviour depending on the sourcing arrangement of the internal audit function. He found that lending officers do not differentiate their decision on granting loan on the basis of internal audit function sourcing arrangement when relevant financial statements are based primarily on the work performed by the internal audit function.

Practice of outsourcing internal audit has become increasingly prevalent, with internal auditor services are provided by specialist and traditional accounting firms (Ernst & Young 2006); (Glover et al, 2008). These changes in the internal audit are likely to impact external auditors reliance decision (Munro and Stewart 2010). Interestingly Munro and Stewart (2010) argued that three decades of research has been done in exploring external auditors reliance on the work internal audit but most of these researches were conducted when the internal audit had a narrow focus and was only offered in-house, where organisations had their own internal audit departments. They further argued that both the provision of consulting services by the internal audit function and the sourcing arrangement of internal audit have the potential to impact internal audit objectivity. Munro and Stewart (2010) based on an experimental design studied whether these two factors have an impact on the external auditors reliance decision.

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Glover et al, (2008) discussed that the outsourcing of internal audit increased mostly after the importance of section 404 of the Sarbanes-Oxley Act 2002. Glover et al, (2008) investigated whether external auditors are sensitive to differences in internal audit sourcing arrangements by examining the external auditors reliance decision on the work of outsourced versus in-house internal auditors. Further in-house and outsourced internal auditors have different motives and incentives as a result of the differences in the institutional structures such as nature and relationship with management, economic independence, legal liability, etc (Glover et al, 2008). Glover et al, (2008) results indicated that external auditors relied on in-house versus outsourced internal auditors work equally when the inherent risk is low, but significantly more likely to rely on the outsourced than in-house internal auditors when the inherent risk is high. They also found that external auditors relied more on internal auditors work for objective tasks than subjective tasks when inherent risk is high and not when inherent risk is low. Interestingly Glover et al, (2008) could not find any evidence of interaction between sourcing arrangement and the subjectivity of the task performed by the internal audit function. Further outsourcing internal audit was found to have an indirect effect on the reliance decision by means of differences in perceived objectivity and direct effect on reliance even taking into account the external auditors assessment of internal audit function objectivity and competence and attempting to hold work performed constant (Glover et al, 2008). Glover et al, (2008) research was conducted based on attribution theory. Attribution theory proposes that evaluators assess a sources incentive to bias their message when evaluating the sources message (Glover et al, 2008). Attribution is a concept used in social psychology referring to how individuals explain causes of behaviour and events. This theory was first proposed by Fritz Heider who was an Austrian psychologist in his book The Psychology of interpersonal relations (1958) and later this theory was developed by Harold Kelley and Bernard Weiner.

2.7 External Auditors reliance on Internal Audit and the role of Corporate Governance and Audit Committees
Cohen, Gaynor, Krishnamoorthy, and Wright (2007) suggested link between governance quality, including the audit committee, and the internal audit function this was also examined by Vikram et al. (2010). Vikram et al. (2010) found that even though the external auditors had positive belief in all three factors such as competence, objectivity and
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work performance they did not consider the internal audit function to be effective if they have no prior knowledge or negative knowledge about the quality of corporate governance of the organisation.The Blue Ribbon Committee (1999) report presents that the audit committees of boards, internal audit and external audit as three legged stool of Good corporate governance the help ensure reliability of financial reports. According to DeZoort et al. 2002 Internal and external audit helps to enhance the audit committee effectiveness by serving as the resource to board of directors.

2.8 Background of Accounting and Auditing in Sri Lanka

The Institute of Chartered Accountants in Sri Lanka (ICASL) is the main governing body of the Accounting and Auditing profession in Sri Lanka. It has been enacted under the parliament Act No. 23 of 1959. During that time the financial reporting requirements were based on the British system. In 1970, the ICASL has issued its first accounting standard. Subsequent to that collapse of several financial institutions during late 1980s and early 1990s has warned the government to regularize the financial reporting process. As a result of that Sri Lanka Accounting and Auditing Standard Act No. 15 of 1995 has been enforced by the government with the support of the accounting profession and business community. This Act identifies some enterprises as Specified Business Enterprises (SBEs) and governs the preparation, presentation and audit of those entities. The Act also established the Sri Lanka Accounting and Auditing Standards Monitoring Board (SLAASMB) which monitors the accounting and auditing arrangements and practices. Act is administered by the SLAASMB and all the SBEs are required to prepare and present financial statement based on the Sri Lanka Accounting Standards. As a result of the above changes Sri Lankan accounting practices developed to an international level. Currently ICASL has more than 4200 members and more than 30000 registered students. The Institute is a member of the International Federation of Accountants (IFAC), The Confederation of Asian and Pacific Accountants (CAPA) and a Founder member of the South Asian Federation of the Accountants (SAFA).The Institute has issued Sri Lanka Accounting Standards (SLAS), Sri Lanka Auditing Standards (SLAuS), Sri Lanka Auditing Practice Statements (SLAPS) and Code of Ethics for Professional Accountants based on international standards.Apart from the ICASL, The Association of Sri Lanka Accounting Technicians (AAT) is operating as the next local professional body for the
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development of the Accounting profession in Sri Lanka. Other than the above two (2) professional bodies the Association of Certified Chartered Accountants (ACCA) is operating as the main international body. Apart from the above professional bodies there universities, offering well reputed Accounting degrees in Sri Lanka. University of Colombo, University of Sri Jayewardenepre and University of Kelaniya are among them. Auditing practices of Sri Lanka has also been developed with accounting practices. According to Sri Lanka

Accounting and Auditing Standards Act, auditors are required to certify that the audit has been conducted in accordance with SLAuS and that the financial statements have been prepared and presented in accordance with SLAS. Based on the 1972 constitution public sector institutions are to be audited by the Auditor Generals Department under the laws relating to local authorities and state corporations. Currently there are three audit firms out of Big Four audit firms operating in Sri Lanka, which are independent member firms of the Big Four audit firms in the world. They are KPMG Ford, Rhodes, Thornton & Co., Pricewaterhouse Coopers and Ernst & Young. Apart from those firms, there are around 200 registered firms and members with practicing rights who is operating as small to medium scale professional service providers.

2.9 Research Questions and Objective

As discussed above it is clear external auditors reliance on internal audit is a well researched topic in the western world especially in United States and United Kingdom. But this area has not been studied much in the developing countries. Developing country like Sri Lanka has been involved in significant contribution towards the profession of Accounting and Auditing. In Sri Lanka Institute of chartered Accountants is the national professional accounting body of Sri Lanka established by Act of parliament. No 23 of 1959. Institute is a member of the International Federation of Accountants (IFAC) and the International Accounting standards committee (IASC). It is also member of the Confederation of Asian and Pacific Accountants (CAPA). Chartered accountants are the only professionals who has the right to perform auditing in Sri Lanka according to the above act. Sri Lanka is well known for running Business Process outsourcing companies specialised in Accounting and Auditing. In the last three years post war period in Sri Lanka
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many foreign investors have shown interest, but Sri Lankan regulatory frameworks such as Data protection, corporate governance and internal audit has not developed to the high international standards even though it has developed over the years. Extending the

research in this area here will be adding to the literature how the reliance decision is influenced in a developing country.

As discussed above prior literature has concentrated mostly studying the three factors (Objectivity, work performance and competence) and the relationship among these three influences the reliance decision of external auditors on internal auditors. External auditors reliance decision and the impact on audit fee and partner preference also were studied separately by many academicians. Role of internal audit perceived in corporate governance and audit committee responses also were studied which included the communication among internal and external auditor and the reliance decision. Further sourcing

arrangements of internal audit and how they influence on the reliance decision of external auditors were researched in detail as well.. In these research external auditors reliance decision on internal auditors in Sri Lankan context will be researched. All factors which influenced the reliance decision of the external auditors which identified in prior researches will be tested in Sri Lankan external audit environment.

The Aim of this research will be External auditors reliance on internal auditors or internal audit function in Sri Lankan perspective, following research objectives will be expected to be achieved in the research.

1. To identify how the reliance of external auditors on internal audit function in Sri Lanka is influenced by the three factors (Objectivity, work performance and competence) and the relationship among these factors identified by auditing standards and prior research.

2. In order to identify how the external factors identified by prior academics influences the external auditors reliance decision on internal auditors in the Sri Lankan phenomena.

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3. Establish whether the difference in regulatory requirements among institutions for Internal Audit function in Sri Lanka influences the reliance decision of the external auditors.

2.10 Conclusion
Prior Literature on external auditors reliance decision was reviewed critically. Theoretical frameworks of reliance decision of external auditors were presented. The findings by the prior researches show that there are no major differences between researches done during a given period on reliance decision. But over the last three decade external auditors reliance decision has changed over the period. This is mainly because of the regulatory changes which happened over the last three decades especially in United States. Even though the three factors competence, objectivity and work performance have varied on importance among external auditors over the periods the contemporary researches prove that all three factors are equally considered and no one factor will dominate in all conditions.

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Chapter 3: Methodology

3.1 Introduction
In this Chapter Research Methodology used in the research will be discussed in detail. Various methods are used by students to conduct business research. Brief description about different methodologies and data collection will be discussed and the relevant methods for this research will be discussed in detail. Detailed data collection technique used in this research and data analysis techniques used will be explored in this chapter. Also arguments for choosing the methodology will be presented in detail. This will be also demonstrated by justifying the research methodology used to obtain data to answer the research questions and to achieve the research objectives.

3.2 Research Methodology

Any given Business research methodology could be categorised into two which is quantitative and qualitative methodology. This categorisation of methodology is mainly based on the data collection and analysis techniques used. Quantitative research is where data is collected and analysed based on meanings which are derived from numbers. The data collected will consist of numerical and standardised data. Quantitative research analysis is mostly conducted through the use of diagrams and statistical analysis. Qualitative research is based on meanings express through words and discussions documented in prior literature. In qualitative research data is collected as non-standardised data requiring classifications into categories. Analysis is done through the use of conceptualisation and arguments. This research regarding the External auditors reliance on internal audit in Sri Lankan perspective will be done based the qualitative methodology. Prior literature and researches in this area of study were mostly based on the quantitative approach. So one main reason choosing qualitative method for this research was to identify and answer the research questions in a different perspective and also this is one of the pioneering researches done in Sri Lanka on this field of study. Using qualitative methodology was perceived to be helpful as it uses conceptualisation and arguments to analyse the data so that future researches could benefit from this.
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3.3 Research Strategy

In business researches today various research strategies are used which use both qualitative and quantitative methodology. Those various business research strategies are experiment, survey, case study, action research, grounded theory, ethnography and archival research. Some of these research strategies belong to deductive approach and inductive approach, and it should be noted that neither of these strategies are superior or inferior to any other (Saunders 2009). Research strategy chosen will guide the research questions and the objectives. Using certain strategies within another strategy also recommended for example it is possible to use survey strategy as a part of a case study (Saunders 2009).

In this research we will be using Case study strategy to achieve our research questions and objectives. According to Robson (2002) case study is defines as a strategy for doing research which involves an empirical investigation of a particular contemporary phenomenon within its real life context using multiple source of evidence. According to Morris and Wood (1991) case study will be an ideal strategy when it comes to a particular interest that the researcher would like to gain a rich understanding of the context of research and processes which are being enacted. In this research the Reliance decision of External auditors on internal auditors will be studied in the context of Sri Lanka, which confirms that features identified by Morris and Wood (1991) is satisfied by this research and the chosen research strategy which case study is well suited to achieve my identified research questions and objectives. In this research as mention by Saunders (2009) Triangulation is used where multiple sources are used to achieve the research question and objective. Where qualitative data collected by the way of semi-structured interviews is compared and contrasted with the existing literature available on external auditors reliance on internal auditors. A big four auditing firm operating in Sri Lanka will be used in this case study approach.

3.4 Data Collection Techniques

3.4.1 Data Collection Method To study the case of Sri Lankan external auditors reliance decision, primary Qualitative data will be collected from Semi-structured interviews held with the external auditors.
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According to the degree of structuring, interviews are divided into three categories; they are structured interviews, semi-structured interviews and unstructured interviews (Fontana & Frey 2005). In a structured interview set of predefined questions and the questions are expected to be asked in the same order for all respondents or interviewees. This standardisation is intended to reduce the effects of the instrument and the interviewer on the research results obtained. Structured interviews are similar in nature to surveys, except that they are administered orally rather than in black and white. Unstructured interviews also known as informant interview is used to explore in depth a general area in which the interviewer is interested or expected to explore. For this reasons unstructured interview is also known as in-depth interviews. There will be no predetermined list of questions or guide to work in this type of interview. Interviewee has the opportunity to comment and express freely about events, behaviour and beliefs on the research topic area. Due to this nature this type of interview is also known as non-directive. It has been labelled as informant interview as it is the interviewees perceptions that guide the conduct of the interview. Finally the Semi-structured interviews are more flexible compared to the structured interviews but streamlined than the unstructured interviews.. In semi-structured interviews agenda for interview or rather an interview guide is presented to the potential interviewees. This guide will contain both closed-ended and open-ended questions. During the interviewee process the interviewer has certain flexibility where the sequence of the questions could be manipulated based the responses from interviewee. Also further probing questions could be asked based on the response of the interviewee. This will be done based on the experience and new insights discussed by the interviewee regarding the research topic. 3.4.2 Selection Method of Interviewees

Ten Experienced external auditors were selected to be interviewed from one of the Big four Audit firm operating in Sri Lanka. All the auditors had worked in the external audit department for at least 5 years or more and are professionally qualified Chartered Accountants from Institute of Chartered Accountants of Sri Lanka (ICASL). Partner of the Big four firm operating in Sri Lanka was approached and requested to identify Ten External Auditors who had experience in various industries and exposure. Prior working

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relationship with the Partner was used to gain access in to the organisation. The interviewees were randomly selected by the partner.

3.4.3 The Semi-structured Interview process The selected ten external auditors were interviewed using electronic interview technique. Morgan and Symon (2004) used the term electronic interviews to refer to interviews held both in real time using the internet and organisations intranets as well as that are in effect undertaken off-line. This is sub-divided into asynchronous and synchronous where the categorisation is based real time (synchronous) or off-line (asynchronous) interviews. Asynchronous interviews could be done using internet technologies such as email, internet forums and blogs, synchronous interviews could be done using chat rooms such as Messenger, VoIP softwares and Skype. This interview used in this research was a synchronous which is in real time. Interview was held over Skype and reordered using sound recorder which is available in Windows 7 and a freeware MP3 Skype Recorder. Debates on suitability of internet and internet mediated communication for synchronous interviewing has been reviewed by Mann and Stewart (2000). Some researches argued

that interviewing participants using online techniques such as using the web conferencing or chat rooms are unlikely to achieve the same level on interactivity and spontaneous communication that is obtained with face-to-face interviewing. This is mainly because of the direct body language impacting on interviews and non verbal communication which could be observed. This research is based on Sri Lankan external auditors done from United Kingdom the limitation in direct travelling to conduct the interview should be understood. On the other hand Sweet (2001) suggested that relative anonymity of online interviews facilitates more open and honest responses, in particular with regard to sensitive questions where participants have adopted pseudonyms. Neither gender nor age and ethnicity had adverse effect on the interviewees as their experience in the firm was only considered to be important in context of this research. Permission was obtained from both the Partner of the Participating Big Four Audit firm and the interviewees to record the interviews. During the interview written notes were also taken on key points and statements made by the interviewees. All the interviews were held in English and in case of clarifications Sinhala and Tamil languages also were used when
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needed. Recording the interview was helpful as the interviewer was able to concentrate in listening and questioning the interviewee. It is understood that it is ethical to allow the interviewee to maintain control over the recorder so that they could decide not to record the interview at any given time but this viable since the interviewee was over Skype. Contextual data such as the date and time of the interview, information about the participant such as designation, experience and qualification was also recorded. On average each interview lasted forty five minutes. Prior to the interview an agenda with relevant themes of the area to be questioned were circulated among the participants with the purpose of the research. They were also asked to refresh their knowledge on standards ISA 610 and SLAuS 610 (ICASL 2009) and regulatory requirements on Sri Lankan Public companies and financial institutions. Themes were derived from the knowledge gained from prior literature during the literature review process. At the start of the interview an introduction and brief background of the research was communicated to the interviewees. This was done to built credibility and confidence among the interviewee to understand the research questions and objectives and divulge the genuine information needed. Also the themes presented to the interviewees proved to be helpful in reducing the anxieties and to actively participate in the interview with genuine interest in the research as it will contribute towards addition to the existing literature. Open questions were asked from the participants and followed with probing questions accordingly from their answers. Long questions and those made up of two or more questions were avoided since these will not help to obtain response to each aspect that was interested to explore as explained by Robson (2002). Interviewees were asked to demonstrate and explain practical situations where they were deciding to rely on internal auditors. This approach was key participant experience which is known as Critical incident technique, in which they were asked to describe in detail a critical incident or number of incidents that they experience in relying on internal auditors. A Critical incident is defined as an activity or event where the consequences were clear that the participant has definite idea regarding the effect (Keaveney 1995). At the end of each interview the interviewer summarised by explaining the understanding obtained from the interviewee. This will ensure the interviewee to evaluate the adequacy of the interpretation and correct where necessary (Healey and Rawlinson 1994). This could be a powerful way to avoid bias or incomplete interpretation, this also will help to explore and

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probe the interviewees responses further. A sample of questions asked from the external auditors is attached in Appendix C.

3.5 Advantages of using Interviews and Qualitative data for Research

It has been found that managers are more likely to be interviewed, rather than complete a questionnaire; this is especially where the topic of the interview is interesting and relevant to their current work (Saunders et al. 2009). This is mainly interview gives them an opportunity to reflect on events without needing to write anything. Especially subjects in this research External Auditors are very busy professionals who will be more reluctant to fill in questionnaires in detail. Another key factor which was considered is to understand the relationship among the research objectives as one cohesive unit to identify the external auditors reliance on internal audit in Sri Lanka; this could be well achieved using interviews. Healey (1991) identified that the interviewer has more control over who answers the questions in comparison with a questionnaire, which may be passed from one to another. Easterby-Smith et al. (2008) and Jankowicz, A.D. (2005) argued that interview will be the most advantageous approach to attempt to obtain data in the following circumstances: 1) Where there is large number of questions to be answered, 2) Where the questions are either complex or open-ended and 3) Where the order and logic of questioning may need to be varied. These findings are well suiting this research as most of the questions are open-ended and varied rather than a logic order.

The research approach will be a semi-structured interview as most questions need to be varied according to the external auditors experience and industry exposure. Another key advantage in using interviews is that the external auditors will be more comfortable in discussing the questions openly with the interviewer as I was one time an external auditor worked for a Big four for five years, until a year ago. Another advantage in semistructured interviews is that the questions could be modified according to the participants and also according to their responses given. Some respondent might not be interested in answering certain questions and some might prefer to answer that area as their expertise varies. Some also identifies this as a disadvantage of semi-structured interviews as the generalisation is not eminent, but according to our understanding this is a classical method to achieve the identified objectives successfully as this is almost the first time this area is
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been researched in a country like Sri Lanka. And this reason itself encourages us to use the semi-structured interview methods as we could identify the variations and influencing factors in a detail cohesive view. Interestingly Bryman (1988) argued that within case study a wide range of different people and activities are invariably examined so that in contrast to survey samples is not so acute as it appears at the first glance. This single case could involve a study in a large organisation with sites across the country or even around the world. In contrast to this Bryman (1988) identifies that many research projects adopting a survey strategy use samples restricted to one particular locality. A well-completed and rigorous case study is more likely to be useful in other contexts than one that lacks such rigour. Saunders et al. (2009). Generalisabilty of qualitative research or a case study is related to significance of this type of research to theoretical propositions (Bryman (1998) and Yin (2003). Where we are able to relate our research findings to existing theory and will be in a position to demonstrate that our findings have broader significance than the case or cases that form the basis of our work (Marshall and Rossman 1999).

3.6 Limitations and Overcoming the Limitations of this Methodology

It has been discussed in many researches that the lack of standardisation in interview may lead to concern about reliability. Relation to qualitative research reliability is concerned with whether alternative researches would reveal similar information Easterby-Smith et al. (2008) and Silverman (2007). The main concern about reliability in the interview is that of bias. This could be divided into two namley interviewer bias and interviewee bias. It has been argued that tone or the non verbal behaviour of the interviewer creates bias in the way that interviewees respond to the question being asked Saunders et al. (2009). This is because I as an external auditor could attempt to impose my own beliefs and frame of reference through the questions that I ask. I have discussed the questions more openly as this is the first time such a study in the context of Sri Lankan auditing environment is done and this would encourage further research in depth and also could contribute towards the growth of the auditing profession in Sri Lanka. Since this is an audio Interview through Skype non verbal behaviours will not influence or affect the interview. Easterby-Smith et al. (2008) also argues that one could also demonstrate bias in the way that responses are interpreted. The other main concern is that developing the trust of the interviewee, or perhaps where the interviewers credibility seem to be lacking, the information or response
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given by the external auditors may be limited, creating doubts about the validity and reliability.

The other concern is that interviewee may choose not to reveal and discuss certain topic which interviewer would like to explore, because this may lead to probing question s that would intrude on sensitive information that they do not wish or not empowered to discuss with the interviewer Saunders et al. (2009). Healey and Rawlinson (1994) also argued that assurance from the interviewer that confidential information is not being sought should make the interviewees more relaxed and open about the information that they willing to discuss. Combined with assurance about anonymity, Should increase the level of confidence in trustworthy towards the interviewer and reduce possible interviewee or response bias. This was overcome by, when permission was sorted from the Partner from the Big Four firm which subjects are from, the partner clearly demonstrated there will be no restriction on any information to be divulged except for any Individual client information and their anonymity to be maintained. This was strictly taken into consideration when questions were asked and interviewees only mentioned the industry and size of their clients. Marshall and Rossman (1999) argued that the responses obtained through the non-standardised research methods are not necessarily intended to be repeatable since they reflect reality at the time they were collected, and which may be subjected to change. This is the reason subjects selected were identified from auditors who had at least five years of experience so that they have a good knowledge in the prevailing culture and also could foresee the future of external auditors reliance on internal auditors with great potential.

3.7 Data Analysis Techniques

Qualitative Research is more interested in the depth of the data rather than breadth and it requires the researcher to play an active role in collecting the data Wimmeer and Dominik (1997). Marshall and Rossman (2006) discussed that data analysis as one of the issue that should be considered at the time of formulating a proposal to undertake a qualitative research. Kvale (1996) discussed the process of anglicising qualitative data is likely to begin at the same time as the data is collected and as well as continue afterwards. These golden rules were taken into consideration when the data was analysed qualitatively. The
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process of transcription is an important part in analysing the qualitative data obtained through interviews. It was important to write down the key experience shared by the auditors and also to make note of the tone of voice used so that the participants non-verbal communication was understood well in analysing the data. In order to save time the entire interviews were not transcribed fully. Recordings of the interviews were played back twice and listened while short notes were taken. A mind map was created by differentiating the topics covered by individual objective set in the research. Data Analysis in qualitative research was proactive as the interactive nature of the data collection and analysis allowed to recognise important themes, patterns and relationships as the interviews were done. This was helpful to re-categorise the existing data to see whether themes, patterns and relationships were present in both existing literature and interviews held prior. As Strauss and Corbin (2008) pointed out in the research we were able to adjust the future data collection to see whether data exist in cases where we intend to conduct our research. Analysis were done using conceptual and argument techniques and compared and contrasted with the existing literature.

3.8 Summary
The methodology used was Qualitative, Case study strategy, where semi-structured interviews were used to collect primary data. This methodology is favoured as most of the prior researches conducted were based on surveys, questionnaires, and experimental methods. As discussed above these methods did not prove to reflect the actual intension of the external auditors. Frey and Oishi (1995) defines interviews as a purposeful conversation in which one person asks prepared questions (interviewer) and another answers them (respondent) This type of data collection supports toe research to obtain information and understand a particular field of topic to be researched using qualitative methodology. Interviews can be categorised as structured (closed interview style) or unstructured/semi-structured (open interview style). Wimmeer and Dominik (1997) discussed that open-ended question in semi-structured interviews allows the interviewer to probe deeper into the initial responses of those respondents to gain more detailed answers to the question asked. As Explained in the previous chapter Critical Literature Review was done prior to identifying the research questions and objectives. Understanding the theory
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on the Reliance of External Auditors on Internal Auditors was important for this research and also the prior literature was useful in deriving at the research objectives and questions. Based on this the case study strategy was chosen to study the Sri Lankan case regarding external auditors reliance on internal auditors through semi-structured interviews. by collecting primary qualitative data

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Chapter 4: Critical Analysis and Discussion

4.1 Introduction
In this Chapter critical analysis and discussion of the data collected through interviews will be presented. Interviews recorded were played again and listened where summary of the key points that emerged from the interviews were documented. This summary will compress long statements into briefer statements in which the main sense of what has been said or observed is rephrased in few words (Kvale 1996). Statements or quotations made by external auditors during the interview process will be quoted within double quotation marks. Data obtained from the interviews will be critically analysed and discussed by comparing and contrasting with the existing literature and the theoretical framework of External auditors reliance on internal auditors.

4.2 External auditors reliance decision and the relationship among competence, objectivity and work performance of the internal audit function
During the interviews regarding the relationship between internal auditors competence and the nature, timing and extent of external auditors audit procedures, a senior external auditor mentioned Depending on the internal auditors competency level, the external auditors in Sri Lanka adjust the nature, timing and extent of audit procedures performed after discussion with the audit partner. When further explanation was requested the external auditor shared an experience where they had to increase the audit procedures performed on reliance on fixed asset verification during the year since the internal auditors competency was low. When the clients internal audit competency was low during the initial years external auditors increased the nature, timing and extent of the audit procedures. In subsequent years when they identified that the client had a better or high level of competence with more qualified and skilled audit staff external auditors reduced the nature, timing and extent of the procedures performed in identified financial statement caption during the reliance process. Senior external auditor further stated It has been evident that the work performed by the internal auditors was at a higher level when the competency of the internal audit function was high and the work performed was low, when the competency of the internal audit function is low. This is complementing the prior
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findings by Margheim (1986) and Schneider (1985) where they concluded there was a similar relationship between the nature and audit procedures performed by external auditors and the competency of the internal audit function.

Margheim (1986) also treated the competence and work performance as one single factor and the explanation given by the senior auditor explains the reason of this combination is vital and not to contradict with the fundamental rationalisation of the relationship between competence and work performance of the internal audit function. Interview with the external auditor on relationship between objectivity and the two factors such as competence and work performance of internal audit function, one stated that The objectivity ensures the competence and work performance is achieved in an overall internal control system. External auditors argument is that there is a strong relationship between these three factors and also they complement each other during the evaluation process of the internal audit function during reliance decision. This is complementing the findings of Maletta (1993) and Krishnamoorthy (2002) where they report the similar relationship but contradicts with the findings of Margheim (1986).

When interviewed and discussed on the risk assessment and the reliance decision and external audit manager stated that High inherent risk is linked to more audit procedures by nature, timing and extent, and when it comes to reliance competence and objectivity should be high in order to rely on the work performed by internal auditors. According to further explanation from the auditor it is the high competence and objectivity of the internal auditor that will ensure high level of work performance by internal auditors. This argument is complementing the findings of Maletta (1993) where he found that when inherent risk was high external auditors relied on the work of internal auditors only if the objectivity was high. But there was no direct evidence on the competence level and the work performance when the inherent risk was high; rather competence was the important factor in all inherent risk conditions. But from the mangers explanation it is evident that both competence and objectivity should be at higher level in order to rely on the work of the internal auditors. The relationship between all three factors is confirmed once again.

The interviews regarding substantive and control testing in reliance decision revealed that there was no much different in Sri Lankan auditing environment compared to other developed countries and prior literature. One senior external auditor stated Using external
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auditors work in test of control is more preferred than in substantive work. Further he explained that the main reason for this preference is that external auditors feel comfortable in using the control testing by internal auditors as its more transparent compared to substantive work. This is because today the big four audit firms use more sophisticated sampling methods and also external auditors consider that manipulation of sampling in substantive work is higher than in control testing. This finding in Sri Lanka also

complements the prior findings by Ward and Robertson (1979) and Whittington and Margheim (1993) as they concluded the same where external auditors preferred letting the internal auditors perform more control testing rather than substantive work and eventually this helped the external auditors reliance on internal auditors.

When questioned individually on the three factors such as competence, objectivity and work performed the explanation given by external auditors did not vary significantly with the prior literature as this is standardised or rather structuralise by the relevant auditing standards used internationally on using the work of internal auditors by external auditors to perform their financial statement audit. These findings are evident that no single factor dominates others in all conditions.

4.3 Impact of independence on the reliance decision

According to a senior external auditor who had experience in evaluating the reliance decision of the internal audit in Sri Lankan perspective stated that Independence of the internal audit is an important factor which influenced his decision in deciding whether to rely on internal audit or not. He also stressed that independence is an essential factor which is expected to be fulfilled by the corporate governance requirements and also the regulatory bodies. This independence factor was discussed long before by Gibbs and Schroeder (1979); Clark (1981a; 1981b); Brown (1983) and Abdel-Khalik, et al. (1983) in their researches respectively. When discussed further about the prior year experience on the nature of the internal audit functions and whether it was an influencing factor in the reliance decision, the senior auditor argued that prior year experience would be used only if there are no major changes in the nature of the internal audit function. He further stated that in the last five years he has witnessed various structural changes in the internal audit departments in Sri Lanka where many listed firms have started to increase their staff
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strength and invest more in internal audit function. According to the auditor this is mainly due to two reasons which one of it is the increased pressure from the regulatory bodies and the other is foreign investors willingness to invest in Sri Lanka in the post war period, expecting high quality of effective internal controls and corporate governance practises in the listed companies. Interestingly the senior auditor explained this development has encouraged them to rely on internal auditors as the departments are effective and stronger than ever before. Discussion with this senior external auditor revealed that the effectiveness and importance given to internal audit function by their clients was a significant factor in the reliance decision. When questioned about the three dimensions such as competence, objectivity and work performance of the internal audit and the most important factor out of these three, he explained in his experience all three factors were equally important when evaluating the internal audit function for reliance purpose. He mentioned that no single factor could be prioritised than the other.

According to a senior audit manager who had experience in also working with another big four which operates in Sri Lanka stated Audit procedures we use in the big four and the tools such as Computer Aided Audit Tools (CAATS) significantly influences the reliance decision on substantive procedures performed by internal audit function. When further clarifying this statement he explained that certain audit procedures performed using CAATS by the external auditors restricts them in relying on the internal audit workings as the requirements of the work performed are different, especially when it comes to the substantive work. He also explained that his experience in confirming Information technology controls had similar problems with certain clients as these tools conflict among the external and internal auditors. This was an interesting finding in the research as there were no such prior researches commenting on the tools used by external auditors and the reliance decision.

4.4 Impact of corporate governance and regulations on the reliance decision

When questioned from an external audit manager who had experienced in auditing Banking and other Financial Institutions in Sri Lanka stated During the last decade corporate governance rules have become more important towards the Listed companies and Financial institutions, and this has increased the effectiveness of internal audit and this
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leads to reliance decision of external auditors. Further discussing on this subject he explained that the Colombo Stock Exchange has made it mandatory for the listed companies in Sri Lanka to be in compliance with the Corporate Governance Code which was jointly issued by the Institute of chartered accountants of Sri Lanka and the Securities and Exchange Commission of Sri Lanka effectively from April 1, 2008. He also explained due to this reason all listed companies invested on establishing an internal audit function, which eventually strengthened the internal control function in listed companies. When asked about how this regulation has influenced the external auditors reliance decision on internal auditors, he explained that before this the listed companies had a vague and ineffective internal audit function. But after the regulations were imposed qualified internal auditors were recruited to make the internal audit departments effective. This further encouraged the external auditors to rely on internal audit.

The senior auditor confirmed that competence, objectivity and work performed, all three factors were equally important when reliance decision was made, and he experienced that reliance was more effective after the regulatory changes compared with the past. This confirms that the recent regulatory changes in Sri Lanka influenced the reliance decision of the external auditors. When explaining on Banking and financial institutions he mentioned During the year 2007 The Governor of the Central Bank of Sri Lanka has issued direction to amend the Banking Act No.30 of 1988 relating to corporate governance requirements to regulate the banking sector with strong internal audit functions. When the Manager explained in detail it was revealed that the banks in Sri Lanka did not have an effective internal audit function before 2007 and the external auditors reliance on the internal audit function was less effective. But after 2007 amendments to regulatory requirements, banks have strengthened their internal audit functions. As a result of that the reliance decisions of the external auditors increased to a greater extend. Again all three factors namely competence, objectivity and work performed equally contributed towards the reliance decision. When discussed about the same matter with another senior external auditor he explained that in the banking sector after 2007 amendments to the regulation, work performance was the most important factor which influenced the reliance decision. As he stated Bank supervision department of Central Bank in Sri Lanka reviews the internal audit departments of banks once a year by reviewing the work performed by internal auditors. These reviews encouraged the external auditors to rely based on the work performed by internal auditors. According to prior research Brown (1983); Schneider
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(1984); (1985a); (1985b); and Margheim (1986) also identified work performance of the internal auditors as the most important factor influencing the reliance decision of the external auditors.

When discussion with Senior Manager on the Litigation and regulatory cost for external auditors in Sri Lanka the manager mentioned The cost of litigations and regulatory is not a major threat on reliance decision, but the Sri Lanka Accounting and Auditing Standards Monitoring Board (SLAASMB) in recent years has followed many recent scandals and imposed strict fines on auditors who have not discharged their duties. Further when clarifying on this matter manager explained that if the litigation or legal cost is high the reliance on internal audit function was minimum or none even if the client had a strong and effective internal control function. This finding in Sri Lanka was complementing the findings by Vikram et al. (2010). Senior manager who discussed on the audit committees role and the reliance decision explained that effective communication among external auditors and the clients audit committees positively influenced the reliance decision. This is mainly because audit committees who followed the internal audit reports and findings discussed the important matters in the meetings with the external auditors.

4.5 Audit fee pressure and its influence on external auditors reliance decision
During the interviews held to collect data external auditors were inquired on the reliance decision of external auditors and its impact on the audit fee. Audit Senior Manager who had a very good experience in the reliance decision and the audit fee structure stated Increasing audit fees has brought concerns in the board rooms and among the shareholders and interestingly he also stated Directors and shareholders require effective and efficient internal controls and audits than ever before. This is a conflicting goal or expectation from the board and shareholders he explained further. It is a known fact that after introduction of the Sarbanes and Oxley (SOX) Act 2002 in The United States and the introduction Internal Control over Financial Reporting internal audit work increased and external auditors also needed to certify the work of the internal auditors. This showed a great increase in related audit fees and SOX 404 working required by the act. This nature of regulatory requirement is not in force in Sri Lanka but it should be understood that the
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cost of auditing will be high when both the internal and external audit is at high level to meet the expectations. When further asked about the reliance decision and how this directly impacts the audit fees he stated that Reliance on internal auditors do help to reduce the planned work hours and nature and timing of certain audit procedures. This was evident that there is a relationship between reliance decision and audit fees, where the reliance tends to reduce the external audit fees, prior findings by Felix (2001) and AlTwaijry (2004) also confirms the same.

When discussed about the reduction of planned audit hours based on the reliance on internal audit and the its impact on audit effectiveness, manager replied saying External auditors will never compromise on audit effectiveness even when the audit fee is reduced or reliance on internal auditors is agreed in engagement. Further clarifying on the partner preference the manager stated Partners give importance to audit quality and effectiveness by strictly following the required standards and professional skeptism. He also stated that Client fee pressure doesnt influence the partners preference or the reliance decision on the internal auditors. This evident that even though in Sri Lanka reliance decision on internal auditors reduces the audit cost it is not driven by the client fee pressure. External auditors give preference to the quality and the effectiveness of the audit. Partner preference is also based on the audit quality and its effectiveness rather than client fee pressure. This finding in Sri Lnaka complements the finding by Gramling (1999) where he didnt find any interactive effect between client fee pressure and partner preference on audit managers reliance decisions. But Gramling (1999) argued that clients fee pressure had an effect on mangers reliance decision as this is not the same in Sri Lanka as explained above by the manager.

When questioned about the relevant auditing standards which is been used in Sri Lanka regarding the external auditors reliance decision on internal auditors. Senior Manager stated In Sri Lanka SLAuS 610 (ICASL 2009) is used and in the case of subsidiaries which have their parent companies outside Sri Lanka will be reported in accordance with ISA 610 and for the companies listed in United States SAS 65 (AICPA 1991) will be considered. He also explained that the main difference in SAS 65 (AICPA 1991) is that it allows the external auditors to use internal auditors as direct assistance and other standard doesnt incorporate this. This difference is clearly discussed in the literature review chapter under the theoretical and auditing standards in reliance decision section.
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4.6 Sourcing arrangement of Internal Audit and its impact on Reliance Decision of External Auditors
The interviews also consisted questions on sourcing arrangement of the internal auditors and its impact on external auditors reliance decision. One manager stated that In Sri Lanka some companies have outsourced their internal audit departments to professional internal auditors such as Chartered accountancy firms. When further inquired how this directly impacts on the reliance decision, he explained that outsourcing the internal audit by the clients has increased the reliance on internal audit because these professional internal auditors are independent from the management. He said that due to this independence nature reliance on internal audit was high in clients who have out sourced their internal audit departments. The other argument in the sourcing arrangement is that regulations have restricted audit firms to conduct both internal and external audit in one organisation. This has increased the independence of the internal audit function and positively influences the reliance decision.

Senior external auditor shared his experience stating Our client had an in-house internal audit function in the past and last year outsourced the entire internal audit function to another big four this immediately impacted on our reliance decision. He further explained saying that the outsourced internal audit function had effective scope of internal auditing combined with effective procedures to encourage the reliance decision of external auditors.

4.7 External Auditors Reliance on Internal Auditors for Direct assistance

External auditors were inquired on this area briefly and as expected the external auditors mentioned that none of them had prior experience in using internal auditors as direct assistants in performing any of the audit work or participated as a team member. This reliance was clearly discussed in the literature review that neither ISA 610 nor SLAuS 610 covers or permits the use of the internal auditors to directly assist the external auditors. This was clearly identified in the literature review as the key difference in the Auditing standard SAS 65 which is followed in the United States and ISA 610 internationally. But a
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senior external auditor explained that one of his clients was a subsidiary of listed company in United States.

4.8 Summary
In this chapter qualitative data obtained through semi-structured interviews with external auditors was discussed and analysed. External auditors statements were compared and analysed with prior literature obtained through literature review. The results from this discussion and analysis proves that external auditors reliance decision on internal auditors in Sri Lanka does not vary significantly from the prior findings in other developed countries. But it should be noted that discussion revealed that internal auditing in Sri Lanka is still an emerging function and the reliance on internal function was at a lower level when compared to developed countries. But it is encouraging that Sri Lankan internal audit function has gradually developed in the last five years mainly due to the regulatory requirements and pressure from shareholders. Thus it will increase the reliance decision in future.

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Chapter 5: Conclusion

5.1 Summary of Findings and Recommendations

The findings from this research on External Auditors reliance decision on internal auditors in the Sri Lankan Case it is evident that the three factors such as Competence, work performance and objectivity which are used to assess the internal auditors or internal audit function has a significant and equally complementing relationship between all three factors, and no single factor will dominate the other factors at any given condition. It is evident from this research that in Sri Lanka reliance on internal auditors does reduce the external audit fee thus eventually it reduces the total cost of auditing. But it is also evident that client fee pressure does not directly influence the partners preference or the managers reliance decision on internal audit. This research shows that communication between external auditors and audit committees were a significant influence in external auditors reliance decision on internal auditors in Sri Lanka. Effective communication among external auditors and audit committees resulted in high and confident reliance over the internal auditors by external auditors.

This research identifies that sourcing arrangement of the internal audit has an impact on the reliance decision of external auditors. It is evident that the external auditors reliance increased when the clients outsourced their internal audit functions to independent internal audit consultants or professional audit firms. In this research it was evident that the reliance decision of external auditors defers from companies in Sri Lanka as the internal audit functions are different in accordance with industry specific regulatory requirements. This research in Sri Lanka ensure that using internal auditors as direct assistants to perform external auditors work is not accommodated in the International standards ISA 610 or in SLAuS 610 (ICASL 1999). Using internal auditors as direct assistance has been practised in the United States for decades and after the Sarbanes and Oxley Act 2002 it has increased further. Developed countries and other developing countries should consider this option to incorporate in their standards. Prior Literature reviewed for this research indicated that the external auditors from the United States have benefited from using internal auditors as direct assistance.

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As summarised in the findings the results obtained from Sri Lanka has not significantly varied from the prior literature. Even though the internal audit function and the reliance decision in Sri Lanka has not developed to that extent of the developed nations.

5.2 Contribution of this Dissertation

This is one of the pioneering researches conducted in the case of Sri Lankan external auditing environment. This research explains the external auditors reliance decision in Sri Lankan perspective and how it is linked with the regulatory environment. This research was done using Semi structured interviews conducted with the external auditors, and the explanations and arguments obtained were more practical and actual experience of the external auditors from Sri Lanka. Prior literature on reliance of external auditors decision was evaluated mostly based on experiments conducted with external auditors in hypothetical situation. This research develops a clear structural ground situation to future researches that could be done in Sri Lanka and other developing countries on this area of study

5.3 Limitations of this research

This research was done based on a case study using a selected Big four audit firms external audit staff in Sri Lanka. Findings from this research will not be fully reflecting the views of all Sri Lankan external auditors. As Bryman (1988) stated since the research was done in one organisation with selected interviewees generalisation of the entire external auditors population in Sri Lanka is not possible from this research. Since the interviewees were randomly selected by the Partner who is the head of Audit in the organisation, this random interviewees selection method was not verified or rather could not be verified. The interviews selected may or may not be expressing the views of the Partner involved and thus it might not reflect the actual views or experience face by the external auditors in Sri Lanka. Interviews held by Skype which was only voice

conversation where as the benefits attainable from head to head or direct interviews were not available. Interviewer and interviewee bias could influence the discussion and results

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obtained. Some argue that auditors use judgmental decision based on professional skepticm and the research results obtained could vary due to individual perceptions.

5.4 Suggestion for Future Researches

Prior Literature has not concentrated much on the tools and techniques such as CAATS used by external auditors and how that influences the reliance decision. Because in this research there was an argument and suggestion made that there is a relationship between the tools used by external auditors in performing substantive procedures and reliance decision on internal auditors work. Future researches should concentrate on this area in future as it is evident auditing profession is moving in a rapid phase with the developing technologies especially with automated controls. Future researches on this area of study should concentrate on using practical and actual evidence as used in this research rather than experimental method. More researches in similar reliance decision should be done in developing countries as they play a big part in the world economy in cost reduction and cost saving programmes.

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145) Whittington, R. (1989). 'New study on using internal auditor's work', Journal of Accountancy (May): 123-124, 126, 128. 146) William R. Edge, Alan A. Farley. (1991) External Auditor Evaluation of the Internal Audit Function, Accounting & Finance, 31 (1), pp. 69-83.

147) Wimmer, Roger D. & Joseph.R.Dominick (1997) Mass Media Research: An Introduction, Belmont, MA: Wadsworth.

148) Wyatt, E. (2011) Accounting Board to Seek Comments on Rotating Auditors, The New York Times, Available at:http://www.nytimes.com/2011/08/17/business/accounting-board-considersmeasure-to-rotate-auditors.html?_r=3&smid=fb-share (Accessed 20 August 2011). 149) Yin, R.K. (2003) Case study research: Design and Methods (3rd edn). Beverly hills, CA: Sage.

150) Zhang, Y. Wildmuth (2006) Unstructured Interviews, B. M. Available at:http://www.ischool.utexas.edu/~yanz/Unstructured_interviews.pdf (Accessed 22 August 2011).

151) Wallace, W. (1984a). A time series analysis of the effect of internal audit activities on external audit fees, Altamonte Springs, Florida: Institute of Internal Auditors. 152) Wallace, W. (1984b). Enhancing your relationship with internal auditors. The CPA Journal, (December), 46-53.

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Appendix A Ethical Approval

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Appendix B List of Interviewees

Serial Date and Time No. 1 2 July 05, 8.30 a.m. August 05, 9.00 a.m. July 07, 8.30 a.m. August 08, 4.00 p.m. August 10, 3.00 p.m. August 03, 3.30 p.m. August 04, 8.30 a.m. August 04, 3.30 p.m. August 05, 4.00 p.m. August 09, 4.00 p.m.

Designation

Senior Audit Manager Senior Audit Manager Senior Audit Manager Senior Audit Manager Audit Manager Audit Manager Audit Manager Audit Senior Audit Senior Audit Senior

No. of years in experience 12 9

Qualification

Comments

ACA, FCMA ACA, FCMA Financial Services expert

3 4 5 6 7 8 9 10

8 8 7 7 7 5 5 5

ACA ACA, CIMA ACA ACA ACA ACA, Finalist SOX experienced ACA, Finalist ACA, Finalist IT specialist

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Appendix C Sample of Interview Questions

1. Research background and Interview Give a brief Introduction on the research Objectives and Questions to the participants. Agreeing on confidentiality and research ethics. Discussion on Participants Qualification, Experience and Industry Exposure on external audit.

2. Reliance on Internal Audit decision prior to the acceptance of an Audit Engagement Does the strong internal audit function influence the decision to audit a client? Does the reliance decision on internal audit will impact significantly on the audit fee? How does this help to compete in the audit market by reducing the audit fee? Does the reliance decision impact on the planned hours and impact on the audit effectiveness?

3. Reliance on Internal Audit decision prior to commencing of an Audit Engagement Does the reliance decision considered during planning stage of the audit? (Planning discussion with the client and among the audit team, better to include or have this in mind) Do the Auditors have the opportunity to document include internal audit work during the audit process? Would you consider any specific areas of internal during the audit process?

4. Reliance on Internal Audit based on auditing standards How the relevant standards (SLAuS 610 and ISA 610) considered when the reliance decision is materialised? Will the internal audit reliance scope of the firm be limited to the minimal requirements of the above standards or will cover wider range? How factors such as Competence, Objectivity and work performance of internal audit function is assessed?

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Discussion on the relationship among these three factors Competence, Objectivity and work performance with practical experience faced by the external auditors

5. Regulatory requirements on Internal audit function and the impact on reliance decision How do the Regulatory bodies in Sri Lanka perceive and enforce the role of internal audit functions in Public Companies and Financial Institutions? Are there any impacts on the scope of the internal audit due to the regulatory bodies? How does this difference enforcement of regulatory bodies help the external auditors in the reliance decision? Risk of regulatory and litigation cost and how it impacts on reliance decision? Explain the differences with examples and experience obtained during audit process?

6. Role of Corporate Governance requirements towards Internal Audit function in Sri Lanka and its influence on reliance decision Does the Corporate Governance in Sri Lanka enforce strong internal audit practise? Do the corporate governance requirements differ based on Company size, Legal status and reporting requirements? Does the above difference between industries influence the changes in internal audit function and the external auditors reliance decision?

7. Communication among External auditors and Audit committee on internal auditors function and the impact on reliance decision How often the Audit committee and External auditors communicate on internal audit issues? What mode of communication is preferred; email, meetings, conference calls etc? Does the Audit committee report significant findings by internal auditors on time to external auditors? Does the scope of Internal Audit communicated clearly to the external auditors?

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8. External auditors using internal auditors to directly assist in conducting audit procedures Does the external auditor in Sri Lanka use internal auditors as direct assistance in performing audit procedures? If yes or No reasons for this decision on reliance?

9. External Auditors reliance based on Internal Audit Function whether it is Inhouse or Out source How does the sourcing arrangement of internal audit influence the reliance decision of external auditors? Explanations with practical experience?

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Appendix D The 3 key Factors Competence, objectivity and work performance

Factors Competence Definition Competence has been defined as the educational level and professional experience of the internal auditor and other such factors. Evidence 1. Evidence concerning auditor qualifications and training. 2. Evidence of audit planning and supervision. 3. Evidence of auditor tacit knowledge. Description of Evidence 1. Auditor qualification and training: Educational background Certification In-house training program Support for continuing education 2. Audit planning and supervision: System of defined responsibilities Review of procedures and working papers Planning of work 3. Tacit knowledge: Experience or knowledge about the company Experience or knowledge about auditing the company

Work Work Performance performance has been defined as internal control and risk assessment, and substantive procedures performed by the internal auditor.

1. Evidence of 1. Internal audit effort: internal audit Time spent on audits effort. Number of items 2. Evidence of examined Sampling techniques execution of internal audit used plan. EDP audit techniques 3. Evidence of used thoroughness and 2. Execution of internal audit quality of plan: Number of areas internal audit audited reporting. Number of audits completed versus number of audits planned 3. Thoroughness and quality of internal audit reporting: Completeness of audit programs and working papers
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Objectivity

Objectivity has been defined as the organizational status of the internal auditor and organizational policies affecting the independence of the internal auditor.

Quantity and quality of working papers documentation 4. Quality of corporate governance: Minutes of audit committee meetings Documentation of communication between IAF and audit committee Verification of directors independence Education and experience of audit committee members 1. Evidence of 1.Managerial reporting managerial relationship: reporting Level to which IA relationship. reports 2. Evidence of Level to which IA breadth and reports findings scope of 2. Breadth and scope: investigatory Ability to investigate scope. any area 3. Evidence of Freedom from Recommendation conflicting duties implementation. 3. Recommendation implementation: Disposition of recommendations IAs access to audit committee 4. Quality of corporate governance: Minutes of audit committee meetings Documentation of communication between IAF and audit committee Verification of directors independence Education and experience of audit committee members

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Source: Vikram et al. (2010)

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