Toward the end of their relationship, Enron was paying nearly $50 million each year to Arthur Andersen for services, including both internal and external audit functions. Did the risk of losing such a large client lead to the ethical compromises that Andersen was willing to make in colluding in the enormous fraud scandal that eventually brought down both firms?

Nathan Sharp
Sharp

Yes, said analysts, who recommended internal and external audit functions in public companies be split between firms to prevent economic bonding and cooperation in fraud. Created soon after, the Sarbanes-Oxley Act prohibited external audit firms of public companies from having any involvement in the internal audit function. However, research from Nathan Sharp, assistant professor of accounting, suggests this move may have been a mistake.

Sharp and colleagues investigated companies in the pre-SOX era to determine if companies that outsourced or co-sourced internal audit work to their external auditor had a higher risk of misleading or fraudulent external financial reporting. The result? This relationship actually lowered accounting risk.

The reason is simple. When a single firm is involved in both audits, it’s harder for fraud to go undetected, as there is greater communication between both audit teams. Knowledge spillover occurs because the internal audit team provides insights into the company that an external audit team might miss. This information sharing is less likely to happen when the teams are from competing firms or when the internal audit function is kept entirely in-house.

There is much debate about this topic says Sharp, and he and his colleagues are not suggesting SOX be changed. However, if you talk to public accounting firms, the opinions are clear: It’s good sense to make it easier to share information between internal and external audit teams to create the most complete financial snapshot of a company.

Sharp’s article, “Internal Audit Outsourcing and the Risk of Misleading or Fraudulent Financial Reporting: Did Sarbanes-Oxley Get It Wrong?” coauthored with Doug Prawitt and David Wood, is currently under review at Contemporary Accounting Review.