Internal Auditor Characteristics and the Cost of Debt Capital

Recent financial reporting scandals have prompted action by standard-setters to improve corporate governance. In the post-Sarbanes-Oxley era, the role of internal auditors in corporate governance is a subject of increasing public interest. Internal auditors serve as the first line of defense against information risk by monitoring managers’ decision-making. In this paper, we focus on the monitoring role of internal auditors and examine the relationship between internal auditor characteristics and the cost of debt. When an internal auditor is an effective monitor of the financial accounting process, creditors bear lower information risk and, therefore, impose lower costs to the firm. We posit that effective monitoring requires two components: expertise and activity. We find that the appointment of a new internal auditor for the firm is positively related to the cost of debt. This evidence is consistent with the view that, compared with internal auditors who have worked continuously at the firm for multiple years, newly appointed internal auditors have not had chances to develop firm- and/or industry-specific expertise due to time constraints or lack of experience; this lack, in turn, affects the debt pricing. In an additional test, we find evidence that the decrease in the cost of debt is greater when a legal expert, relative to a non-legal expert, is actively involved in board of director meetings than when the person is not actively involved in such meetings.