Internal Control and Operational Efficiency

Abstract

In this study, we examine whether and how internal control over financial reporting affects firm operational efficiency. We find that operational efficiency, derived from the frontier analysis, is significantly lower among firms with material weaknesses in internal control relative to firms without such weaknesses. We document some evidence suggesting that effective internal control leads to greater operational efficiency through reducing the likelihood of misappropriation of corporate resources and through enhancing the quality of internal reports for decision making. We also document that smaller firms benefit more from having effective internal control in terms of operational efficiency. In addition, we find that the market appears to understand the effect of ineffective internal control on operational efficiency: within firms with internal control material weakness, those with more negative market reaction experience a larger deterioration in operational efficiency. Lastly, we find that the firms that remediate their material weaknesses subsequently experience an improvement in operating performance and stock returns, and this effect is mainly driven by the improvement in operational efficiency. Overall, our study extends the literature by presenting systematic evidence on the effects of effective internal control on operational efficiency and firm performance.

Keywords: Internal control, operational efficiency, Sarbanes-Oxley Act

JEL Classification: G30, L20, M10, M41