Disclosure on Internal Control Systems as Substitute of Alternative Governance Mechanisms

Abstract

The study addresses the issue of disclosure on internal control system (ICS) recommended by best practices in corporate governance in the light of the agency theory perspective. We posit that reporting on the characteristics of internal control systems is an alternative governance mechanism that management provide to investors when the other devices are not in place.

Analyzing the disclosure on internal control systems of 160 European firms listed in four different stock exchanges (London, Paris, Frankfurt and Milan) over a three-year period (2003 - 2005), we find empirical evidence that ICS disclosure is a substitute for the monitoring role played by the ownership structure, institutional ownership, the proportion of independent directors sitting on the board and the proportion of accounting expert members of the audit committee.

This study provides empirical support for Williamson's (1983) substitute hypothesis among different governance mechanisms and it offers insights to firms and practitioners on the relevance of disclosure on internal control systems as a monitoring mechanism for investors.

Keywords: Corporate governance, Monitoring package, Internal control systems, Disclosure, Ownership structure, Board of directors, Audit committee

JEL Classification: G18, G32, K22