AUDITING, DIRECTORSHIPS AND THE DEMAND FOR MONITORING

Three monitoring mechanisms used for corporate governance are external auditing, internal auditing, and directorships. We consider the three mechanisms as endogenous to the firm and that each firm has an optimal set of monitoring mechanisms the specific mix of which is conditioned by the firm's production-investment attributes. Production-investment attributes are proxied by the degree to which firm value is determined by growth options versus assets-in-place. Empirical predictions are then made and tested concerning the total demand for monitoring from all three mechanisms, and substitutions or tradeoffs between 1) auditing and directorships and 2) external and internal auditing. The results support the hypotheses that overall monitoring expenditures decrease as the firm has relatively more assets-in-place, that relatively more auditing (compared to directorships) occurs for firms with greater assets-in-place, and that relatively more internal auditing (compared to external auditing) also occurs for firms with greater assets-in-place. Predictions are also made and tested concerning the general effect of firm size on the demand for auditing and directorships. The study helps to better understand the economic rationale for each monitoring mechanism and the role it plays in the efficient corporate governance of the firm.