Previous audit research (Simunic 1 980, Rubin 1 988, Copley 1 989 and Hackenbrack and Knechel 1 997) uses, to limited success, some plausible surrogates for capturing auditor' s control risk assessment effects on audit fees and audit effort. Palmrose ( 1 989), O' Keefe et al ( 1 994), Hackenbrack and Knechel ( 1 994) use auditees' and auditors' assessments (obtained from surveys) of auditor reliance on internal control. These studies propose a significant negative effect of the rel iance on auditees' internal controls on audit
effortlhours. Only Palmrose ( 1 989) finds evidence of a significant relationship, while O'Keefe et al ( 1 994) and Hackenbrack and Knechel ( 1 997) find, contrary to expectations, that internal control reliance has no effect on audit hours.
In the absence of auditors' and auditees' direct assessments of the internal controls and their effects on audit production/effort, other plausible surrogates
are used in this study. 4 Based on recent research of the effects on corporate
4
The conceptual model for analysing audit risk as a part of audit production is presented in Figure 4. 1 and it denotes that, in conceptual terms, the existence of an internal audit department and the timeliness of auditor reporting are expected to have an effect on auditors' reliance on auditees' internal controls, the related auditors' assessments of control risk and the resulting audit effort.
The rationale behind the proposed significance of an internal audit department on audit production is the fact that an external auditor ordinarily has a c lose working relationship with auditee's internal auditors. From the perspective of the external auditor, the internal auditor is a component of the auditee's control environment. The work of the internal auditor in conducting tests of control is likely to influence the nature, timing and extent of external auditor's audit procedures. Where reliance is placed by external auditors on work and findings of internal auditors, the control risk is reduced which leads to reduction in audit effort. This relationship is also promulgated in New Zealand Auditing Standard AS-604: Considering the Work of lnternal Audit.
Therefore, it is plausible to expect that entities that have an internal audit function will incur less external audit effort. However, the existence of an internal audit department has not been frequently used in previous studies. Only Copley ( 1 989) examines the association between the internal audit function and audit fees in public sector, and he finds no significant relationship. Due to the information about the existence and function of internal audit departments not being publicly available and readily observable, this study does not use the existence of internal audit department as a measure of auditor's reliance on auditee's internal control structure.
Timeliness of an audit report is a result of efficiency of audit production and it is affected by auditee's characteristics. Audit timeliness or audit report lag (ARL) has been researched in several previous studies (Ashton et al 1 987, 1 988, Newton and Ashton 1 989, Bamber et al 1 993, Knechel and Payne 200 1 ). ARL has been found to be a function ofauditee business risk, complexity and occurrence of non-routine events (Ash ton et al 1 987), auditee industry, existence
governance on financial reporting and aUditing (Beasley 1 996, Beasley et al 1 999, Beasley et al 2000, Cohen and Hanno 2000, Cohen et al 2002), the effect of corporate governance on internal controls and audit production/effort is examined in this study. Corporate governance effectiveness is assessed through several board of directors characteristics and these are used to test H2-Hs.
Fama ( 1 980), Pfeffer ( 1 98 1 ) and Fama and Jensen ( 1 983) suggest that
characteristics of the board of directors, such as size and board composition are good proxies for board effectiveness. The board of directors characteristics tested in this study are: board size, CEO/director duality, multiple directorships, and the existence of audit committees.
of losses and a type of audit opinion (Ashton et al 1 988), auditee size and audit ftrm approach (i.e. structured vs. non-structured approach) (Newton and Ashton \ 989).
The conceptual model in this study (presented in Figure 4. 1 ) assumes that the ARL or audit report timeliness has an effect on audit production as part of the auditor's assessment of auditee' s internal controls effectiveness and the control risk. That is, although the ARL i s a symptom of audit production effectiveness, prior research has shown that it is highly dependent on client characteristics, of which one characteristic is the ability and effectiveness of the auditee (including auditee's information system) to produce fmancial information in a timely manner. New Zealand Auditing Standard AS-302 points out that one of the matters that auditors are to consider when engaging in audits are auditees' regulatory and reporting requirements which encompass reporting deadl ines.
For public sector entities in New Zealand, the audited financial statements are to be available within the maximum of five months of balance date. Historically, the long ARL in New Zealand public sector and a non-compliance with regulatory reporting requirements has been associated with entities not preparing financial statements for their audits in time. As a result in the 1 999/2000 year, the Auditor General reported that the auditors of public sector entities have been encouraged to put additional pressure on those responsible for preparing the financial statements in the public sector, and where such auditors are unsuccessful in obtaining financial statements, that the Parl iament is to be informed of the names of non-complying entities.
The Auditor General also ensured that auditors are prompt in completing audits (OAG Annual Report 1 999-2000). As a result ofthese efforts the number of audits and audit reports in arrears has been reduced from 1 ,038 in 1 988 to 646 in 1 999/2000, 395 in 2000/200 1 , and 372 in 2002/2003 (OAG Annual Reports \ 999-2003). Therefore, it is a plausible assumption, at least in this study's setting, that auditors do reflect on and assess auditee's information system's ability to produce financial statements in a timely manner and that ARL is at least partly a result of auditee's ability to produce financial statements in auditable form by the balance date. However, there is very little variation in the ARL for the public sector corporate entities under observation in this study. Any differences are largely industry related and thus captured by the industry variables included in the model.
The size of the board is measured by the number of directors on the board and it is denoted as TOT DIR. Whether the CEO is also a director on the board is measured by an indicator variable, CEO_DIR, that is equal to 1 if he/she i s a board member and 0 otherwise. This is consistent with previous research in board composition (Pound 1 988, Beattye and Zayack 1 994, Brickley, Coles and Jerrell 1 997, Cyert et al . 1 997, Core et al. 1 999, Cahan et al 2000, Adams and Mehran 2002). Busy directors are identified as those who have three or more directorships (Fama 1 980, Fama & Jensen 1 983, Core et al 1 999, Cahan et al 2000). BUSY _DIR is measured as a proportion of busy directors on the board.
The existence of an audit committee, as a subcommittee of the board, is denoted as ADT CMTE and is measured using an indicator variable equal to 1 if there is an audit committee or 0 otherwise (Bradbury 1 990, Cahan et al 2000, Xie et al 200 1 ).
Based on hypotheses (H2-HS) a positive relationship is expected between
TOT_DIR, BUSY_DIR and CEO_DIR and audit effort measured in actual audit hours AU_HRS (the dependent variable). A negative relationship is expected
between ADT CMTE and AU HRS. - -