Do Internal Control Weaknesses and Their Related Adverse Outcomes Impact Municipal Debt Costs?

Abstract

This study investigates whether municipal bond prices reflect weaknesses in internal control and their related adverse outcomes (i.e., compliance with laws and regulations and questioned costs). Using hand-collected data from 866 official registration statements, our results suggest that adverse outcomes play an important role in explaining the underlying relationship between weaknesses in internal control and initial bond yields. Specifically, the municipal bond market penalizes governments with solely adverse outcomes, with a greater penalty if an adverse outcome is accompanied by a material weakness in internal control. Overall, our results provide compelling evidence that investors value the disclosure of internal control weaknesses/adverse outcomes in the Federal Audit Clearinghouse and that these disclosures have significant public policy implications.

Keywords: internal control weaknesses, material noncompliance with laws and regulations, questioned costs, municipal bonds