The practice of outsourcing the internal audit function to the external audit firm has raised fears by many parties such as the SEC of possible independence impairment. The fear stems from the increased economic bond that exists when additional services are provided to an audit client, as well as the long‐held view that internal auditing is a management function and, as such, is incompatible with the external audit function. This paper reports the results of a two‐phase study of the perceptions of financial analysts regarding external auditor independence when a CPA firm performs both external and internal auditing services.

In phase 1, analysts' perceptions of auditor independence are greater when the client employs its own internal audit staff or outsources to a different CPA firm than when the external auditor also performs internal audit functions. Phase 2 results show that analysts' perceptions of auditor independence are higher when the internal audit services are provided by the staff of a different division of the CPA firm compared to a nostaff separation treatment. Perceptions do not differ between full and partial outsourcing treatments, which conflicts with the recent SEC rule limiting the extent of outsourcing arrangements.

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