Download This PaperThe Role of Internal Control Disclosure in Financial Reporting Precision and the Quality of Audited Financial Reports
36 Pages Posted: 4 May 2020 Last revised: 25 Mar 2024
Date Written: February 29, 2024
Abstract
We study the impact of internal control disclosure in a model in which a client company privately invests corporate resources in its internal control system that subsequently determines its financial reporting precision. Without internal control disclosure, the capital market cannot observe the precision and must price the client value based on its conjecture. With internal control disclosure requirement, the effectiveness of internal controls is disclosed, which reveals the precision to the market. Thus, internal control disclosure provides the client another channel to influence the market pricing. Contrary to the conventional wisdom, we find that the client tends to invest less in its internal control system with disclosure requirement. As a result of lower precision, internal control disclosure may lower the informativeness of audited financial reports, albeit ex-post communicating more information to the market. We also find that internal control disclosure reduces the client's ex-ante payoff when the auditor bears a high misstatement cost due to audit failure.
Keywords: Internal control; Misstatement cost; Audit quality
JEL Classification: M41, M48
Suggested Citation: Suggested Citation
Mingcherng Deng
City University of New York (CUNY) - Baruch College ( email )
One Bernard Baruch Way, Box B12-225
New York, NY 10010
United States