On the Importance of Internal Control Systems in the Capital Allocation Decision: Evidence from SOX

Abstract:     
I examine the effect of information frictions across corporate hierarchies on internal capital allocation decisions, using the Sarbanes-Oxley Act (SOX) as a quasi-natural experiment. SOX requires firms to enhance their internal control procedures in order to improve the reliability of financial reporting across corporate hierarchies. I find that after SOX, the capital allocation decision in conglomerate firms is more sensitive to performance as reported by the business segments. The effects are most pronounced in conglomerates that are prone to information problems within the organization, such as conglomerates with more segments and conglomerates that restated their earnings in the past, and least pronounced in conglomerates that still suffer from material weaknesses in their internal controls after SOX. In addition, I find that conglomerates’ productivity and market value relative to stand-alone firms increase after SOX. My results support the argument that inefficiencies in the capital allocation process are partly due to information frictions across corporate hierarchies. My findings also shed light on the importance of SOX on the efficiency of capital allocation decisions in large firms.

Number of Pages in PDF File: 48

Keywords: Internal Capital Allocation, Internal Capital Markets, Internal Control Systems, Asymmetric Information, Agency Conflicts, Sarbanes-Oxley Act

JEL Classification: D22, D82, G30, G31, G34, G38

working papers series