Internal Governance and Internal Control Material Weaknesses

Abstract

Research Question/Issue: The objective of this study is to examine whether the effectiveness of internal governance is associated with internal control material weaknesses. We employ the concept of internal governance as the checks-and-balances mechanism that subordinate executives apply to the chief executive officer (CEO). We predict that with long horizons and long-term interests aligned with firms’ long-term growth, subordinate executives may have the incentive to support a high-quality internal control system, which is an important factor contributing to firms’ long-term success.

Research Findings/Insights: Using data on CEOs’ and other highest-paid executives’ age and compensation to measure the effectiveness of internal governance, we empirically find consistent evidence that internal governance effectiveness is associated with higher internal control quality. In particular, we find that effective internal governance is related to a lower likelihood of firms reporting internal control material weaknesses, fewer material weaknesses in internal control (ICMWs), a lower chance of firms disclosing internal control weaknesses for multiple years, and a lower probability of firms reporting entity-level and/or account-level material weaknesses in internal control. We also show that among the two factors forming the internal governance measure, only subordinate executives’ horizon is associated with the probability of firms disclosing ICMWs. Our further analysis reveals that the probability of reporting ICMWs is lower for growth firms with effective internal governance.

Theoretical/Academic Implications: Our findings contribute to the literature on internal governance and internal control quality. The impact of the checks-and-balances mechanism inherent in internal governance on firms’ investment in the internal control system and thus the probability of disclosing ICMWs has not received sufficient attention from accounting researchers. While prior studies focus on individual members of the management team, our finding implies that the quality of the internal control system is a result of the joint effort of the whole management team. Unlike the extant literature that captures only certain aspects of reporting quality and information disclosures, our study emphasizes the role of the horizon dimension of internal governance in enhancing the reliability of financial reporting (measured as the quality of the internal control system).

Practitioner/Policy Implications: Our results shed light on the important role of subordinate executives in monitoring CEOs’ short-term interests.

Keywords: internal governance, corporate governance, internal control, CEO-subordinate pay ratio, career horizons, checks and balances.

JEL Classification: M41, M42, M52.