Internal Control Weakness, Investment and Firm Valuation

Abstract

We propose reduced investment as a potential explanation for why firms with internal control weakness (ICW) exhibit lower valuation relative to non-ICW firms. We show that ICW firms significantly reduce investment around ICW disclosure and also have poor stock performance. Additional evidence shows that many of the investment reductions have been announced during the year before ICW disclosure. A possible explanation for investment reductions is the higher costs of financial friction associated with ICW. Consistent with this explanation, we show that ICW firms with credit ratings do not reduce their investment as much and have much better stock performance than ICW firms without credit ratings.

Keywords: Sarbanes-Oxley Act, Internal Control Weakness, Stock Performance, q theory of investments, Benchmark Adjusted Returns, Credit Ratings

JEL Classification: G12, G14, G30