Quality of Internal Control Over Financial Reporting, Corporate Governance and Credit Ratings

Abstract:     
This paper examines the association between firm credit rating and quality of internal control over financial reporting, and whether corporate governance is plays a role in the association. Using a sample of firms disclosing internal control weaknesses during November 2003-July 2005, I find that internal control quality is negatively related to firm credit ratings and that firms disclosing internal control weaknesses are more likely to have lower credit ratings, speculative grade rating, smaller size, lower profitability, lower cash flows from operating activities, net losses in the current and prior fiscal year, higher income variability, and higher leverage than firms with no such disclosures. Additionally, I find that internal control weaknesses decrease the likelihood of a firm receiving an investment-grade debt rating, resulting in higher cost of debt financing, lower income, and lower overall attractiveness in capital markets. Finally, results suggest that the corporate governance strength, as proxied by Gompers (2003) G_SCORE, is positively related to internal control quality.

Number of Pages in PDF File: 63

Keywords: Internal control, Sarbanes-Oxley Act, Credit ratings, Corporate governance

JEL Classification: M41, M45, G32, G33, G34

Accepted Paper Series