In our forthcoming Journal of Accounting Research paper entitled The Effect of SOX Internal Control Deficiencies on Firm Risk and Cost of Equity, we explore the relation between internal control quality and idiosyncratic and systematic risk, and the potential benefits of effective internal control in terms of cost of equity. Specifically, we investigate whether firms that disclose internal control deficiencies (ICDs) exhibit higher systematic risk, higher idiosyncratic risk, and higher cost of equity relative to firms with effective internal controls. Further, we investigate whether managements’ initial disclosures of ICDs and remediation of previously reported ICDs are related to changes in firms’ cost of equity.
We conduct both (1) cross-sectional tests to assess whether firms with ICDs present higher information risk to investors relative to firms having effective internal controls; and (2) inter-temporal tests to assess whether changes in the effectiveness of internal control yield changes in cost of equity consistent with changes in information risk. The results of our cross-sectional tests indicate that firms reporting ICDs exhibit significantly higher idiosyncratic risk, betas, and cost of equity relative to firms not reporting ICDs. These differences persist after controlling for other factors shown by prior research to be related to these risk measures. Our finding that differences in these risk measures pre-date the first disclosures of ICDs suggests that market participants’ assessment of non-diversifiable market risk (beta), idiosyncratic risk, and cost of equity incorporated expectations about internal control risks based on observable firm characteristics prior to firms’ initial revelation of control problems.
In an attempt to assess whether a causal relation may exist between internal control quality and firms’ cost of equity, we construct four sets of inter-temporal change analysis tests. The first inter-temporal test finds that ICD firms experience a statistically significant increase in market-adjusted cost of equity, averaging about 93 basis points, around the first disclosure of an ICD. In our second change analysis, we find that ICD firms that subsequently receive an unqualified SOX 404 opinion exhibit an average decrease in market-adjusted cost of equity of 151 basis points around the disclosure of the opinion. In contrast, for our third change test we find that ICD firms that subsequently receive adverse SOX 404 audit opinions, which indicate that internal control problems persist, exhibit a modest but insignificant increase in cost of equity around the SOX 404 opinion release. In our final inter-temporal change analysis, we find no significant cost of equity change for firms least likely to report an ICD, but a significant decrease in the average market-adjusted cost of equity of 116 basis points around the release of an unqualified SOX 404 opinion for firms most likely to report ICDs.
Collectively our cross-sectional and inter-temporal tests present consistent evidence that information risk as proxied by ineffective internal control is an important determinant of both idiosyncratic risk and systematic market risk that affects the market’s assessment of firms’ cost of equity. We document that firms with effective internal control or firms that remediate previously reported ICDs are rewarded with a significantly lower cost of equity.
The full paper is available for download here.