Management Control Systems and Boundaries of the Firm: Why do Firms Outsource Internal Auditing Activities?

Internal auditing (IA) has been an important part of the internal management control system (MCS) of many firms. Nonetheless, growing numbers of firms have, in recent years, outsourced some or all of the internal audit function to third-party providers such as large public accounting firms. Articles in the professional literature suggest that these firms are focusing resources on core competencies and seeking to minimize noncore support costs. If that is generally the case, then one could question why any industrial firms retain IA functions since, as some observers argue, few would regard IA as creating competitive advantages. This study uses organizational relations from transaction cost economics (TCE) to model, describe, and explain the level of outsourcing of the IA portion of the MCS. The study uses a survey questionnaire and archival sources to obtain qualitative and quantitative data from a random sample of 600 publicly traded firms (stratified by industry) from the Compustat industrial files (33 percent overall, 14 percent usable response rate). Quantitative data are analyzed using multiple regression analysis, and qualitative data are analyzed using qualitative database software (ATLAS.ti). Composite measures of asset specificity and frequency and their interaction are significantly associated with outsourced IA as hypothesized in a regression model that explains 53 percent of the variation in outsourced IA. Other TCE variables, which measure uncertainty, do not significantly explain outsourced IA. Qualitative data reinforced the importance of asset specificity and indicated that other TCE variables may be associated with outsourcing IA, identifying opportunities for future research.