The Effect of Voluntary Internal Control Audits on the Cost of Capital

Abstract:     
In this paper, we investigate whether companies that voluntarily comply with the provisions under Section 404(b) of the Sarbanes-Oxley Act of 2002 enjoy a lower cost of capital. While accelerated filers have been required to comply with Section 404(b) for several years, non-accelerated filer compliance has been (and, under the Dodd-Frank Act of 2010, will continue to be) voluntary. Using a sample of companies that voluntarily have their internal controls audited by an external auditor and a control group of companies that report on the strength of internal controls but do not have management’s internal control assertions audited, we first model the determinants of voluntary compliance. We find that companies issuing equity or debt and those with stronger monitoring mechanisms (i.e., Big 4 auditors and higher institutional ownership) are more likely to voluntarily comply with Section 404(b). Next, we test whether voluntary compliance companies enjoy a lower cost of capital relative to companies that do not comply with Section 404(b) and find that the cost of equity and the cost of debt capital are significantly lower for those companies choosing to have their internal controls audited. Our findings are important because they demonstrate an important benefit that small companies can derive from purchasing internal control audits.

Number of Pages in PDF File: 55

Keywords: Sarbanes-Oxley Act Section 404, internal control, cost of capital, voluntary audit, voluntary disclosure, non-accelerated filers

JEL Classification: M41

working papers series