Does Internal Control Quality over Financial Reporting Affect Firms' Investment Decisions?

This study examines whether internal control quality over financial reporting affects firms’ investment decisions. A good internal control over financial reporting is an effective internal monitoring mechanism for financial information quality and provides an environment that supports investment, productive activities and reduces opportunistic behavior by management. Theoretical work by Lambert et al. (2007) demonstrates that the quality of a firm’s accounting information system, including its internal control, has an effect on the manager’s real investment decisions. Overall, better internal control leads to more reliable financial reporting useful for investors in monitoring managerial investment decisions by reducing agency problems (e.g., adverse selection and moral hazard). I refer to this as the stewardship role of internal controls over financial reporting. Alternatively, poor internal control systems increase potential measurement errors or manager’s ability to manage earnings, which results in lower quality financial reporting. Material weaknesses are viewed as the more severity of the internal control problems, which reflects severe information asymmetries between managers and shareholders, and thus reduce the ability of shareholders to monitor manager’s investing decisions. This study hypothesizes that firms reporting material weaknesses in internal controls make suboptimal investment decisions preceding material weakness disclosure. A material weakness disclosure is likely to affect past investments directly, since ex ante accounting erroneous in financial reports reduces the ability of shareholders to monitor managerial actions. These cause managers to make inefficient investment decisions, including passing up investment opportunities with positive NPV (under-investment) and undertaking projects with negative NPV (over-investment). 表 C011 共2頁第 1 頁 Using sample from Audit Analytics database, I measure inefficient investment by the deviations from expected investment using a parsimonious investment model which predicts expected investment as a function of growth opportunities then use residuals from this model as a proxy for inefficient investment (Biddle et al. 2008; Richardson 2006). In addition, prior research (Beneish et al. 2008; Hammersley et al. 2008) suggested that material weaknesses of a severely negative abnormal return to the announcing firm is more severe and more concerning to investors. Thus, I use the firms’ abnormal returns at the disclosure of material weaknesses as a proxy for the severity of the weakness, which measured the investors’ perceives of concern on the effect of the material internal control weakness on the announcing firms. My study provides the first evidence that a firm’s internal control influences its real economic costs such as inefficient investment decisions within a material weakness disclosure.

Project ID:PF9803-0075
External Project ID:NSC98-2410-H182-001