During the current market crisis, it has become fashionable to argue for a revamping of the current regulatory structure. Those suggestions are frequently coupled with comments about the need for additional regulation and more authority for regulatory agencies such as the Securities and Exchange Commission. Even former SEC Chairman Christopher Cox, hardly a champion of increased regulation, called on Congress to give the SEC additional regulatory authority as discussed here.

The Sarbanes Oxley Act, passed in the wake of huge corporate scandals such as Enron, Worldcom, Global Crossing and others, as well as the demise of accounting giant Arthur Anderson, contains a number of restrictions on outside auditors to ensure independence. In this regard, the Act requires that the audit committee be responsible for the hiring, supervision and retention of the outside auditors and, in addition, imposes a number of other restrictions regarding the outside auditors. These include a requirement that the audit committee pre-approve all services purchased from the outside auditors, limits on the services which can be provided by those auditors and audit partner rotation requirements.

One of the services which SOX precludes issuer from purchasing is internal auditing services. Specifically, the outside audit firm cannot also serve as the internal auditors. The purpose of this and the other limitations in the Act is to ensure in substance, as well as appearance, the independence of the outside auditors. Underlying these restrictions, in part, is the notion that the outside auditor should not have to review or audit their own work, a situation which could arise if the outside auditors also serve as the internal auditors.

The results of a recent study calls into question the ban on the outside auditors serving as the internal auditors. According to CFO.com, a study by three professors has concluded that the “knowledge of a company that an external auditor gained from internal auditing lowered the chances of publishing misleading or fraudulent financial results … .” These findings seem to call into question at least part of the predicate for the restrictions on services outside auditors can provide to an issuer under SOX. At the same time, the results of the study are preliminary, produced from limited data and subject to peer review. Even if these results are confirmed, it seems unlikely in the current environment that the SOX restrictions will be repealed.

Other conclusions of these professors may however, have a more practical impact. In an earlier paper this same team of researchers concluded that issuers may achieve efficiencies and reduce fees paid to outside auditors if they have a high quality internal auditing function on which the outside auditors can rely. Douglas F. Prawitt, Nathan Y. Sharp, and David A. Wood, “Does Internal Audit Quality Affect the External Audit Fee?” The results of this study may suggest to issuers that an investment in the internal audit function is worthwhile, not only to achieve better controls but also economies in audit fees. It may also suggest that audit committees should carefully consider this question when discussing fees with the outside audit firm.

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