Management Trade‐Offs of Internal Control and External Auditor Expertise

Managers of organizations establish control systems to reduce the agency costs inherent in those organizations. Control systems include both internal and external control mechanisms, some of which may be viewed as substitutes for each other. We develop a model of the demand for external auditor industry expertise and then examine whether managers substitute such expertise for certain closely related internal control mechanisms in their overall control systems. Using a sample of municipalities, we find evidence that managers who do not hire internal auditors or who hire accounting personnel with low levels of accounting expertise tend to hire external auditors with higher levels of industry expertise. We interpret this to be a conscious trade‐off on the part of the managers, which appears to be linked to the costs of hiring the internal mechanisms in question.