Mismatched SOX

When a public company’s external audit firm also assists with internal auditing, the risk of fraud actually falls.

By CHRYSTAL HOUSTON

Illustration by Todd DavidsonToward the end of their relationship, Enron was paying nearly $50 million each year to then-Big Five accounting firm Arthur Andersen for services that included both internal and external auditing. Did the risk of losing such a large client lead Andersen to collaborate with Enron in the enormous accounting fraud that eventually brought down both companies?

Yes, say the analysts who recommended splitting up internal and external audit functions in public companies to prevent similar frauds in the future.

Created soon after the Enron scandal, the Sarbanes–Oxley Act (SOX) prohibited external audit firms of public companies from having any involvement in the internal audit function. But new research from Nathan Sharp, assistant professor of accounting at Mays Business School, suggests that this strategy may have been a mistake.

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

The reason is simple. When a single firm is involved in both audits, it’s harder for fraud to go undetected because greater communication occurs between both audit teams. The internal audit team offers insights into the company that an independent external audit team might miss.

This sharing of information is less likely when the teams are from competing firms or when the internal audit function is kept entirely in-house, Sharp says. Much debate surrounds this topic, Sharp says. He and his colleagues are not suggesting that SOX be changed. However, if you talk to public accounting firms, the opinions are clear: It is just good sense to make it easier to share information between internal and external audit teams if you want to create the most thorough financial snapshot of a company.

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