EXTERNAL AUDITOR'S EVALUATION OF INTERNAL AUDIT WORK: A CASCADED INFERENCE APPROACH

This dissertation is a theoretical examination of external auditor's evaluation of internal audit work using cascaded inference theory. The thesis consists of two major parts. The objective of the first part is to understand the relative importance of the three factors (objectivity, work performance, and competence) identified by auditing standards and by prior research, in determining the strength of the internal audit function of a client. In addition, the impact of evidence types--convergent (all positive) and conflicting (positive and negative)--is examined.; Results reveal that the importance of evidence relating to the three factors varies with the type of evidence (positive or negative) observed by the external auditor and is contingent on other factors, i.e., on the interrelationships among the factors.; Results also reveal that evidence of negative competence has a severe impact on the assessment of internal audit strength when there is positive evidence relating to work performance, but not when there is negative evidence relating to work performance. Results also indicate that auditors should focus more on looking for negative evidence relating to objectivity of the internal auditor. Collectively, this suggests that evidence evaluation is non-compensatory when either objectivity or competence is negative. Finally, results imply a compensatory processing strategy when all evidence is positive.; The second part of the project explored external auditor's evaluation of the internal audit report. Results suggest that the inferential value of the internal audit report is highly sensitive to changes in internal auditor reporting bias (defined as the propensity to lie when the internal auditor concludes material error), but relatively insensitive to changes in internal auditor reporting veracity (defined as the propensity to report the truth, when internal auditor concludes no material error). Results also reveal that such sensitivity is conditional on the risk of optimistic judgment, a measure of internal auditor competence, thus suggesting significant interaction between internal auditor objectivity and competence. Finally, analysis indicates that the quality of audit tests used by the internal auditor is critical in determining the value of the internal audit report.