Internal Control and Internal Capital Allocation: Evidence from Internal Capital Markets of Multi-Segment Firms

Abstract

We investigate the impact of internal control over financial reporting on management decisions in directing corporate resources to alternative investment projects in multi-segment firms. Results from cross-sectional and inter-temporal analyses indicate that internal control weaknesses (ICWs) are associated with distortionary internal capital allocations. The adverse impact on internal capital markets is more pronounced for firms with company-level ICWs. Our analyses also show that firms with weak existing governance mechanisms benefit more from maintaining effective internal control. We further document that the negative impact of ICWs on firms’ internal capital transfers manifests in a lower excess value of diversification.

Keywords: Internal Control over Financial Reporting; Internal Capital Allocation; Internal Capital Market; Diversification

JEL Classification: M41, M48, G32