Internal Control Quality and Investment Efficiency

Abstract

We investigate whether the quality of internal control over financial reporting (ICOFR) has implications for the quality of internal control over fixed assets by examining the relation between material weaknesses (MWs) and investment efficiency. After excluding restating firms and controlling for externally reported earnings quality and the potential endogeneity of material weakness disclosure, we find that managers in firms with weak ICOFR are more likely to make inefficient investments. This relation is stronger when investment-specific MWs are related to capital expenditure and property, plant, and equipment. We further show a significantly negative relation between future cash flows and investments made by firms with weak ICOFR. Overall, our findings are distinct from prior studies in that they are independent of financial reporting quality and suggest that weak ICOFR implies that internal controls over fixed assets failed as well.