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Do Management Training Grounds Reduce Internal Auditor Objectivity and External Auditor Reliance? The Influence of Family Firms

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Abstract

We test competing theoretical perspectives of family firm governance in two separate studies by investigating whether family firm control moderates the detrimental effect of a management training ground (MTG) on internal auditor objectivity and on the external auditor’s decision to rely on the internal audit function (IAF). In Study 1, we assess the objectivity of internal auditors working under an IAF that serves as a MTG or non-MTG and located in a family or non-family firm. A key result of Study 1 is the mitigating role of family firm control, as we find that the objectivity of internal auditors is reduced when the IAF serves as a MTG but only in non-family firms. When the IAF is located in a family-controlled firm, the objectivity of internal auditors is unaffected by the opportunity to be promoted into management positions outside of the IAF. In Study 2, we utilize a controlled laboratory experiment with experienced Big 4 auditors as participants and examine their decision to rely on an IAF when it serves as a MTG. Our analyses indicate that external auditors reduce their reliance on non-family firm IAFs that are also MTGs and their decision is fully mediated by the perceived objectivity of non-family firm internal auditors. In contrast, external auditors’ reliance on family firm IAFs and their perceptions of internal auditor objectivity are unaffected under a MTG regime. The results of Studies 1 and 2 provide support for the alignment perspective of family firms.

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Notes

  1. The internal audit function typically performs financial and operational audits, and may also conduct performance, environmental and information technology audits (https://www.accountingedu.org/internal-auditing.html).

  2. Carcello et al. (2018, p. 121) note that “33% of global companies (both public and private) and 64% of Fortune 500 companies reportedly use their IAF as a MTG.”

  3. Objectivity is one of the four principles of code of ethics that governs the behavior of individuals and organizations in the conduct of internal auditing (https://na.theiia.org/standards-guidance/mandatory-guidance/Pages/Code-of-Ethics.aspx).

  4. This is not a trivial inquiry, as family-controlled firms represent a dominant component of international economies (Le Breton-Miller and Miller 2009; Hope et al. 2012), constituting over 66% of firms located in East Asia, 44% of big companies in Western Europe and 33% and 46% of S&P 500 and 1500 index corporations, respectively (Cheng 2014).

  5. The International Professional Practices Framework (IPPF) represents the conceptual framework organizing mandatory and recommended authoritative guidance communicated by the Institute of Internal Auditors (IIA).

  6. Abbott et al. (2016, p. 8) note that: “…independence is often framed as objectivity or as the means to protect against bias or undue influence of others…”

  7. Objectivity “requires that internal auditors do not subordinate their judgment on audit matters to others” (IIA 2016, Sec. 1100) and “avoid any conflict of interest” (IIA 2016, Sec 1120).

  8. The IIA (2016, Sec. 1120) defines a conflict of interest as “a situation in which an internal auditor, who is in a position of trust, has a competing professional or personal interest.”

  9. The findings of Ahlawat and Lowe (2004, p. 156) suggest that “maintaining a truly objective view” may be impossible when internal auditors face economic pressure.

  10. A potential limitation of the Rose et al. (2013) and Hoos et al. (2018) experimental studies is that the internal auditor participants were not identified as actually working under an IAF serving as a MTG.

  11. In 2004, The Economist (2004) estimated that family firms owned up to 95% of Mexican firms and 43% of the value of firms listed on the Mexican exchange market were controlled by just one family. Our focus on Mexico also contributes to filling an extant gap in the literature as very few academic studies refer to Mexican family firms, perhaps because of the difficulty in gaining access to information about their ownership and control structures (Aguilo and Aguilo 2012).

  12. Mexican internal auditors follow International Standards on Auditing (IAS) and International Standards for the Professional Practice of Internal Auditing (IPPF) per discussions with CAEs from participating firms.

  13. On average, participants spent 20–25 min to complete the task.

  14. A total of 81 internal auditors participated in a pilot test of the case material. The pilot test was conducted at a plenary session held by the Mexican Institute of Internal Audit. Feedback from the pilot test was used in modifying the final case material to minimize any ambiguous and/or unclear information. We verified that the pilot test participants were excluded from the final sample.

  15. After collecting data, we coded participants’ Proposed Solution on the bipolar scale of: − 3 (Strongly propose Solution 1), − 2 (Moderately propose Solution 1), − 1 (Slightly propose for Solution 1), 0 (Indifferent), + 1 (Slightly propose Solution 2), + 2 (Moderately propose Solution 2), and + 3 (Strongly propose Solution 2). A similar approach was used by Peters et al. (2006) and Weller et al. (2013).

  16. In the absence of the demographic variables, a regression of Proposed Solution on Family Firm, MTG, and the interaction term (MTG x FF) produces similar results to those presented in Table 3. The participating internal auditors’ Proposed Solution is influenced by the MTG variable (p = 0.008) and significantly affected by the interaction term (p = 0.030).

  17. We include the Years of Firm Experience variable as a control variable in the logistic regression analysis because it is the only demographic variable that is significantly associated with the Proposed Solution variable (Table 3).

  18. A Chi-square test (un-tabulated) indicates that the internal auditors’ choice of Solution 1 versus Solution 2 differs significantly (p = .056) across the four MTG and Family Firm contexts.

  19. ISA 610 requires the external auditor to evaluate the objectivity and competence of the IAF and whether it “applies a systematic and disciplined approach.” To reduce the potential for cross-national differences in interpretation of “systematic and disciplined” (O’Donnell and Prather-Kinsey 2010), we employ the more general term “due professional care” to capture the audit work approach of the IAF.

  20. SAS 128 was developed using ISA 610 as its base and converges with the language and requirements of ISA 610 (AICPA 2014), resulting in substantively similar standards. We cite the language of ISA 610 because Mexican external auditors follow IAASB regulations.

  21. Discussions with partners from participating Big 4 offices indicated that Mexican external auditors follow substantially the same audit practices as their U.S. counterparts, receive training identical to Big 4 auditors in the U.S., and often conduct audits conjointly with American auditors. Furthermore, audits in Mexico are subject to The International Forum of Independent Audit Regulators as well as Public Company Accounting Oversight Board inspections for clients whose securities are registered on exchanges in the United States.

  22. The head of the IAF administratively reports to management and functionally reports to the audit committee.

  23. The percentage of time allocated between financial and operational audits represents the average time reported by participants from Study 1 and the pilot test. Prior research also finds that internal auditors, on average, spend between 27 and 33% of time on financial audits (Goodwin 2004; Prawitt et al. 2009).

  24. A total of 60 external auditors from one of the Big 4 firms, averaging approximately 5.19 years of auditing experience, participated in a pilot test of the experimental materials. Based on the pilot test results, we concluded that the experimental manipulations were effective. We also used feedback from the pilot test to modify the final case instrument. Firm management verified that the pilot test participants were excluded from the final sample.

  25. Chong et al. (2009) report that the average ownership concentration in Mexican family firms is 64%. We set the percentage in the case to be consistent with this level. In Study 1, we find that the level of ownership concentration for family firms in our sample is, on average, 62%.

  26. Of the 76 external auditor participants, 62 (82%) chose Solution 2, with a mean of 2.74 (Sx = .51). In Study 1, 70% of the internal auditor participants chose Solution 2, with a mean of 2.52 (Sx = .59). The Proposed Solution mean for the external auditor participants (\(\bar{X}\) = 1.83, Sx = 2.00) is significantly higher or more conservative (t = 2.32, p = 0.021) than the mean for the internal auditor participants (\(\bar{X}\) = 1.12, Sx = 2.22).

  27. To test for randomization of the experimental treatments, we evaluated the distribution of the MTG and Family Firm treatment conditions across firm, rank, and external auditor experience. Chi-square analyses and one-way ANOVA tests were performed on the 76 usable observations. The results indicate that the reported demographic variables do not differ significantly across manipulated conditions (all p > .05), suggesting successful randomization of treatments among participants.

  28. We also perform ANCOVA using Reliance as the dependent variable, MTG and Family Firm as the independent variables and External Audit Experience and Firm Experience as covariates. The results of ANCOVA are essentially identical to those reported in Panel B of Table 6. We find a significant main effect for MTG (p = .011), an insignificant main effect of Family Firm (p = .994) and an insignificant interaction effect (p = .371).

  29. Results of hypotheses testing using a subsample of 52 audit seniors and managers are identical to those of the final sample of 76 audit juniors, seniors and managers.

  30. For robustness, we also perform tests with the orthogonal contrast weights for Reliance based on the entrenchment (cell A = 1, cell B = 1, cell C = 1, cell D = − 3) and) alignment (cell A = 1, cell B = 1, cell C = − 3, cell D = 1) perspectives and find similar results to those reported in Panel C of Table 6. Contrast tests for the alignment perspective are significant (F1,72 = 4.077, p = .047) while the residual between-cell variance is not significant. Results of contrast tests for the entrenchment perspective are not significant.

  31. For more information on moderated-mediation analysis and multiple mediator models, see Preacher et al. (2007) and Preacher and Hayes (2008). For the moderated mediation analysis, we used Model 5 (Hayes 2013).

  32. Our sample size of 76 may not be large enough for the sampling distribution of the indirect effect to be normal. The Sobel test assumes that the sampling distribution of the indirect effect or the product-of-coefficients is normal. This assumption is released when the sample size is not large enough (Preacher and Hayes 2008).

  33. A bias-corrected confidence interval is preferred to an ordinary confidence interval as the latter can be asymmetrical or skewed relative to a normal distribution, causing the distance between the upper confidence limit and the point estimate be different from the distance between the lower confidence limit and the point estimate. The bias-corrected confidence interval corrects this problem. For more information, see Efron and Tibshirani (1998) as well as Hogg and Tanis (2001).

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Acknowledgment

We would like to express our appreciation to the seminar participants at the University of Central Florida, University of Nevada-Las Vegas, Marquette University and Instituto Tecnológico Autónomo de México. We appreciate the insightful comments of Vicky Arnold, Erin Hamilton, William Messier, Mark Peecher, Elizabeth Poziemski, Robin Roberts, Sherron Roberts, Aaron Saiewitz, Jason Smith, Greg Trompeter, Ken Trotman, and the research assistance of Ken Dalton. We would also like to thank the Mexican Institute of Internal Auditors and the Instituto Tecnológico Autónomo de México, in particular Jose Luis Rivas and Sylvia Meljem, for their assistance and support.

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  1. Department of Accounting, University of Nevada – Las Vegas, Las Vegas, NV, USA

    Ikseon Suh

  2. Department of Accounting, University of Kansas, Lawrence, KS, USA

    Adi Masli & John T. Sweeney

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  1. Ikseon Suh
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  2. Adi Masli
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Correspondence to Ikseon Suh.

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Suh, I., Masli, A. & Sweeney, J.T. Do Management Training Grounds Reduce Internal Auditor Objectivity and External Auditor Reliance? The Influence of Family Firms. J Bus Ethics 173, 205–227 (2021). https://doi.org/10.1007/s10551-020-04507-3

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