Internal Control and Operational Efficiency

Transcription

1 Singapore Management University Institutional Knowledge at Singapore Management University Research Collection School Of Accountancy School of Accountancy Internal Control and Operational Efficiency Qiang Cheng Singapore Management University, Jae Bum Kim Singapore Management University, Beng Wee Goh Singapore Management University, Follow this and additional works at: Part of the Accounting Commons Citation Cheng, Qiang; Kim, Jae Bum; and Goh, Beng Wee. Internal Control and Operational Efficiency. (2013). Research Collection School Of Accountancy. Available at: This Working Paper is brought to you for free and open access by the School of Accountancy at Institutional Knowledge at Singapore Management University. It has been accepted for inclusion in Research Collection School Of Accountancy by an authorized administrator of Institutional Knowledge at Singapore Management University. For more information, please

2 Internal Control and Operational Efficiency Beng Wee Goh School of Accountancy Singapore Management University Jae B. Kim School of Accountancy Singapore Management University 2 April 2013 Key words: Internal control, operational efficiency, Sarbanes-Oxley Act JEL codes: G30, L20, M10, M41 We thank Chih-Ying Chen, Sunhwa Choi, Jimmy Lee, Yanju Liu, Dan Segal, Jean Seow, and Katherine Yuen for helpful comments. We also thank the School of Accountancy Research Center (SOAR) at Singapore Management University for financial support.

3 Abstract We examine whether effective internal control over financial reporting has implications beyond that of financial reporting to firm operational efficiency. We predict and find that operational efficiency, derived from frontier analysis, is significantly lower among firms disclosing material weaknesses in internal control relative to firms with effective control. This result exists even in the years leading up to the disclosure of material weaknesses, but disappears after remediation of the internal control problems, suggesting that the remediation of material weaknesses improves operational efficiency. Overall, our study extends the literature on the reporting effects of strong versus weak internal control, and helps inform the debate over the costs versus benefits of the internal control reporting requirements under the Sarbanes-Oxley Act of Key words: Internal control, operational efficiency, Sarbanes-Oxley Act JEL codes: G30, L20, M10, M41

4 Internal Control and Operational Efficiency 1. Introduction Section 404 of the Sarbanes-Oxley Act of 2002 (SOX 404) requires companies independent auditors to provide an opinion on their clients internal control over financial reporting (ICFR), in addition to the opinion on their clients financial statements (U.S. Congress 2002). However, SOX 404 has been subject to intense debate as critics maintain that the high costs of complying with it are not commensurate with its perceived benefits (Michaels 2003; DeFond and Francis 2005; Powell 2005; Romano 2005). While studies have documented the benefits of effective ICFR such as better financial reporting quality (Doyle et al 2007a; Ashbaugh-Skaife et al. 2008) and lower cost of debt and cost of equity (Beneish et al. 2008; Ashbaugh-Skaife et al. 2009; Dhaliwal et al. 2011; Kim et al. 2011), the high compliance costs of internal control reporting have led to the permanent exemption of non-accelerated filers from the compliance of SOX 404 under the Dodd-Frank Wall Street Reform and Consumer Protection Act in July These developments after the implementation of SOX 404 suggest that research examining the costs versus benefits of internal control reporting continues to be relevant and important to policy makers and researchers. In this study, we examine the effect of ICFR on firm operational efficiency. Because the intended objective of SOX 404 is to improve the reliability of firms financial reporting (PCAOB 2004; Donaldson 2005) and thus help external users make better decisions, whether effective ICFR has implications beyond that of financial reporting to firm internal operations is a prior unclear and an empirical question. However, recent studies suggest that ICFR has broader implications than financial reporting, particularly on firms investment efficiency (Cheng et al. 2013) and inventory management (Feng et al. 2012). Our examination on the link between ICFR 1

5 and operational efficiency is thus in line with this emerging literature. Our research question is also important because the Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992) explicitly states that one of the objectives of internal control is related to the effectiveness and efficiency of operation, 1 but hitherto there is little empirical evidence on the association between internal control and operational efficiency. We expect a positive association between internal control effectiveness and firm operational efficiency for the following reasons. First, ineffective ICFR leads to greater information risk, which increases agency problems and the likelihood of misappropriation by managers (Lambert et al. 2007). Given that operational efficiency is based on the relation between inputs and outputs, ineffective ICFR increases the likelihood that inputs available for production are diverted for managers personal consumption. This reduces the outputs generated for a given amount of inputs and adversely affects operational efficiency. Furthermore, ineffective ICFR in the form of inadequate physical security, inadequate segregation of duties, and inadequate documentation further allows the misappropriation of inputs by employees. Second, ineffective ICFR can result in erroneous internal management reports (Feng et al. 2009), and managers relying on such reports are more likely to make suboptimal operational decisions, leading to cost inefficiencies such as inventory obsolescence, increased inventory storage costs, idle capacity, and/or wastage of resources. Finally, ineffective ICFR relating to information technology not only further results in erroneous internal reports, but also reduces firms 1 The framework defines internal control as "the process designed, implemented and maintained to provide reasonable assurance about the achievement of an entity's objectives with regard to (b) effectiveness and efficiency of operation, (c) safeguarding of assets and (d) compliance with applicable laws and regulations. Furthermore, Statement of Auditing Standards No. 115, Communicating Internal Control Related Matters Identified in an Audit, defines internal control as a process effected by those charged with governance, management, and other personnel designed to provide reasonable assurance about the achievement of the entity's objectives with regard to the reliability of financial reporting, effectiveness and efficiency of operations, and compliance with applicable laws and regulations. 2

6 effectiveness in monitoring the usage of resources. This, in turn, leads to wastage of resources and greater operational inefficiency. We empirically test for the relation between internal control effectiveness and firm operational efficiency using a sample of firms that reported internal control opinions under SOX 404 during the period 2004 to We define a firm as having ineffective internal control so long as it reported a material weakness in ICFR in a particular fiscal year. 2 A unique feature of our study is the use of frontier analysis Data Envelopment Analysis (DEA) to measure firm operational efficiency. DEA has been used extensively in operations research and management accounting research to evaluate organizations efficiency (see Callen 1991 for a review). An advantage of this technique is that it provides a specific measure of the overall firm-level operational efficiency that is based on the relation between inputs and outputs. Following Baik et al. (2013), we use sales revenue as the sole output variable and (1) net property, plant, and equipment, (2) cost of inventory, and (3) selling, general, and administrative expenses as the input variables. We detail the specific measurement of operational efficiency in Section 3. Consistent with our expectation, we find that firm operational efficiency is significantly lower in firms with material weaknesses relative to firms with effective internal control. The detrimental effect of ineffective ICFR on operational efficiency is present in the years leading up to the disclosure of material weaknesses, but disappears after remediation of the internal control problems. This latter result suggests that the remediation of material weaknesses in ICFR improves operational efficiency. We also conduct several sensitivity tests to ensure the 2 According to Auditing Standards No. 2 (PCAOB 2004), a material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected. A significant deficiency is a control deficiency, or combination of control deficiencies, that adversely affects the company s ability to initiate, authorize, record, process, or report external financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the company s annual or interim financial statements that is more than inconsequential will not be prevented or detected. 3

7 robustness of our results. For instance, we find that our results are not affected when we control for known determinants of material weaknesses and when we use the Heckman two-stage procedure to control for a potential self-selection of material weakness firms. To mitigate concerns of potential endogeneity, we use a propensity score matched sample based on the predicted probabilities of having a material weakness, a lagged variable for internal control effectiveness, and a change regression. The results remain the same. Finally, we obtain similar results using alternative measures of operational efficiency: (i) decile rank variable of efficiency, (ii) DEA measure based on seven input variables, and (iii) efficiency measure from the Stochastic Frontier Analysis (SFA). Overall, our results show that the effectiveness of ICFR is positively associated with firm operational efficiency. A related study by Feng et al. (2012) examines whether ineffective ICFR over inventory has implications for inventory management. The authors find that firms with ineffective ICFR over inventory have systematically lower inventory turnover and a higher likelihood and magnitude of inventory impairments. Our study differentiates from Feng et al. (2012) in two important ways. First, Feng et al. (2012) examine whether a specific type of material weaknesses in ICFR (i.e., inventory-related material weaknesses) has a significant adverse effect on inventory management, which is one aspect of firm operations. However, it is not clear whether the detrimental effects of ineffective ICFR extend to operational efficiency at the overall firm level. By examining the effectiveness of ICFR in general (i.e., all types of material weaknesses in ICFR) and using the technique of frontier analysis to generate an overall firm measure of operational efficiency, our study hence provides more comprehensive evidence on the link between internal control and operational efficiency. 4

8 Second, Feng et al. (2012) examine how inventory-related material weaknesses are associated with inventory turnover and inventory impairments, which are essentially financial ratios that proxy for operational efficiency. According to Baik et al. (2013, p2), frontier analysis provides an advantage over simple financial ratios by implicitly allowing for differential weightings among inputs, which should yield a more precise measure of operational efficiency compared to simple financial ratios. Even if a financial statement user constructed a non frontier-based measure using multiple inputs and outputs, an exogenous weighting scheme would need to be applied and that would likely result in the loss of information about operating decisions that firms make. The frontier analysis approach such as DEA can overcome such limitations of using simple financial ratios. In addition, SFA method, from which we derive an alternative measure of operational efficiency, distinguishes between random shocks (i.e., pure noise) and technical inefficiencies in the production function, while simple financial ratios cannot do so. Hence, frontier analysis technique provides us with a more comprehensive and conceptually appealing test on the link between internal control and operational efficiency. Our study makes several contributions. First, studies examining the reporting effects of ICFR have largely focused on its implications for financial reporting quality (Doyle et al. 2007a; Ashbaugh-Skaife et al. 2008; Beneish et al. 2008; Ogneva et al. 2007; Feng et al. 2009; Goh and Li 2011). Very few studies (e.g., Cheng et al. 2013; Feng et al. 2012) examine the implications of ICFR beyond financial reporting, especially how ICFR may benefit firms internal users. We extend this literature by documenting a positive link between ICFR effectiveness and firm operational efficiency. Second, our study is relevant and timely in light of the ongoing debate on the costs versus benefits of SOX 404 reporting. Opponents have argued that the costs of complying with SOX 5

9 404 outweigh the benefits for the compliant companies, especially for small firms (Financial Executives International 2004, 2007; SEC 2009). 3 Subsequently, non-accelerated filers are permanently exempted from SOX 404 compliance under the Dodd-Frank Act. To the extent that greater operational efficiency translates into higher profitability (Greene and Segal 2004; Baik et al. 2013), our results suggest that the greater operational efficiency achieved through having effective ICFR may help offset the high compliance costs of SOX 404. Finally, our study sheds some light on the existing research that documents a negative market reaction to the disclosure of internal control weaknesses (Hammersley et al. 2008; Beneish et al. 2008). These studies attribute the negative market reaction to investor concerns over the disclosing firm s financial reporting reliability. Our results suggest that the negative market reaction could also be in part due to investor concerns that internal control weaknesses, if unremediated, would harm the firm s operational efficiency and future profitability. The remainder of our paper proceeds as follows. In the next section, we discuss the related literature and develop our hypothesis. Section 3 describes the data and our research methodology. We present and discuss the results in Section 4. Section 5 reports additional analyses and sensitivity tests and Section 6 concludes. 2. Related Literature and Hypothesis Development In an attempt to restore investor confidence in firms financial reporting, the Sarbanes- Oxley Act of 2002 requires firms to assess and disclose, and auditors to certify, the effectiveness of ICFR (SEC 2002, 2003). Presumably, regulators hope that these requirements can improve the quality of internal control and enhance the reliability of financial reporting. To shed light on 3 For instance, in July 2004, the Financial Executives International surveyed 224 public firms about the direct costs of complying with Section 404 of SOX. The survey finds that the average first-year cost estimate is almost $3 million for approximately 26,000 hours of internal work and 5,000 hours of external work, plus additional audit fees of $823,200, or an increase of 53% in audit fees. 6

10 whether the internal control requirements achieve these objectives, studies have focused on how the effectiveness of ICFR is related to financial reporting quality. For instance, Doyle et al. (2007a) and Ashbaugh-Skaife et al. (2008) show that effective ICFR can enhance financial reporting quality, proxied by accruals quality and the size of abnormal accruals. Beneish et al. (2008) and Ashbaugh-Skaife et al. (2009) find that effective ICFR results in reduced information risk, which can lower a firm s cost of equity. However, Ogneva et al. (2007) fail to find a significant relation between internal control weaknesses and cost of equity after controlling for primitive firm characteristics and analyst forecast bias. Recent studies further document that material weaknesses in ICFR are associated with a higher cost of debt (Dhaliwal et al. 2011; Kim et al. 2011). Although the above studies have largely focused on the impact of effective ICFR on financial reporting quality, there is an emerging literature examining the implications of ICFR beyond financial reporting. For example, Feng et al. (2009) examine the relation between internal control quality and management guidance accuracy and find a positive relation, consistent with ineffective internal controls causing errors in internal management reports. Cheng et al. (2013) examine the investment behavior of a sample of firms that disclosed internal control weaknesses under the Sarbanes-Oxley Act. They find that prior to the disclosure, these firms under-invest (over-invest) when they are financially constrained (unconstrained). However, after the disclosure, these firms investment efficiency improves significantly. Their results are consistent with ineffective ICFR having a significant adverse impact on investment efficiency. Feng et al. (2012) investigate whether ineffective internal control over inventory has implications for inventory management. The authors argue that inventory-related material weaknesses in internal controls can result in suboptimal order quantities, leading to higher 7

11 inventory levels and higher holding costs. In addition, inaccurate inventory tracking and internal valuation processes can lead to mismanagement of inventory, resulting in larger and more frequent inventory impairments as out-of-date or obsolete product loses market value. Consistent with their expectations, they find that firms with ineffective ICFR over inventory have systematically lower inventory turnover and a higher likelihood and magnitude of inventory impairments. Their study hence provides insights on how material weaknesses in ICFR over inventory can have significant adverse effects on inventory management, which is one aspect of firm operations. It is, however, not clear whether the effects of material weaknesses in general extend to operational efficiency at the overall firm level. In this study, we extend the literature on the broader implications of internal control by examining the relation between ICFR effectiveness and firm operational efficiency. Because the intended objective of SOX 404 is to improve ICFR and hence the reliability of firms financial reporting for external users, whether effective ICFR has implications beyond that of financial reporting and benefits firms internal users is a prior unclear. However, we argue that effective ICFR can have a positive effect on firm operational efficiency for the following reasons. First, studies have shown that firms with effective ICFR have better financial reporting quality (Doyle et al. 2007a; Ashbaugh-Skaife et al. 2008). To the extent that reliable financial reporting reduces information asymmetry between insiders and outsiders (Lambert et al. 2007), effective internal control enables better monitoring of managers and mitigates agency problems. As such, one can expect managers misappropriation of firm assets to be more constrained among firms with effective internal control. 4 Supporting this argument, Ashbaugh-Skaife et al. (2013) find that the profitability of insider trading, a proxy for managerial rent extraction, is 4 Similarly, Ashbaugh-Skaife et al. (2009) assert that ineffective internal control over information and assets within the firm can adversely affect firms real decisions including the appropriation of firm assets by management, thus reducing the expected value of cash flows to investors. 8

12 larger for firms with material weaknesses in ICFR. Given that operational efficiency is based on the relation between inputs and outputs, ineffective ICFR can increase the likelihood that inputs available for production are diverted for managers personal consumption, reducing the outputs generated for a given initial amount of inputs. Furthermore, material weaknesses in the form of inadequate physical security allow the misappropriation of inputs by employees, and inadequate segregation of duties or inadequate documentation, policies or other means of justifying account balances allow for the alteration of recorded amounts by employees, all of which have a detrimental effect on the input-output relationship. Consider the following material weaknesses disclosed by MGP Ingredients Inc. in the 10-K for the fiscal year ending December 31, The lack of proper control over the physical security of inputs can lead to wastage and pilferage, hence resulting in higher input costs. In addition, MGP s material weaknesses relating to the controls over the purchase and maintenance of materials and supplies can result in inputs not being procured at the lowest possible costs (hence increasing input costs) or inputs being procured at a more inferior quality (hence leading to lower sales), both of which result in lower operational efficiency for the firm. Physical security over maintenance materials, electrical materials and chemicals at the Atchison, Kansas facility is not adequate to ensure that items removed from the facilities are documented in accordance with Company policy. This could result in unauthorized or undocumented removal of such materials. As a result, financial statement presentation of such items could be affected, particularly our interim statements in connection with which we do not perform physical inventories at period end.all modules of our computerized purchasing and maintenance system are accessible to various employees with access to the system, which includes purchasing, receiving, maintenance and administrative employees. Unlimited access to a system of this type could allow an individual to establish fictitious vendors, purchase items for other than business use and cover up errors that occur within the system. Invoices are not consistently reviewed and approved by someone other than individuals placing the order with the vendor. Further, our personnel have sometimes failed to use or maintain required requisition forms in the purchase of maintenance, electrical and chemical type items. These practices could result in unauthorized and undocumented purchases. 9

13 Second, ineffective ICFR can affect firm operational efficiency by resulting in erroneous internal management reports and untimely financial reporting information. Consistent with this notion, Feng et al. (2009) find that material weaknesses in internal control affect the financial inputs to management guidance and they document less accurate guidance among firms reporting ineffective internal controls. 5 The authors further assert that..beyond issuing guidance, the internal management reports are also the basis for managers to make many day-to-day operational decisions. Hence, our findings on the effect of internal control quality on management guidance have potential implications for other management decisions based on internal reports... We argue that erroneous internal management reports can have implications for firm operational efficiency because managers rely on sales forecast, a form of internal reports, to make decisions on the next period production units. Over-forecasting of sales due to erroneous internal reports can result in overprovision of productive inputs and consequently increased costs in the form of inventory obsolescence, storage, idle capacity, redundant manpower, and wastage of resources. On the other hand, under-forecasting of sales can result in under-provision of productive inputs that may eventually lead to increased costs in the form of rushed overtime work to produce the inventory or last minute sourcing of potentially more expensive raw 5 To illustrate how ineffective internal controls can lead to erroneous internal reports, Feng et al. (2009) provide the example of a material weakness disclosed by Dana Corp. in the 10-K for the fiscal year ending December 31, Specifically, Dana Corp. disclosed that Our financial and accounting organization was not adequate to support our financial accounting and reporting needs. Specifically, lines of communication between our operations and accounting and finance personnel were not adequate to raise issues to the appropriate level of accounting personnel and we did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of GAAP commensurate with our financial reporting requirements. This control deficiency resulted in ineffective controls over the accurate and complete recording of certain customer contract pricing changes and asset sale contracts (both within and outside of the Commercial Vehicle business unit) to ensure they were accounted for in accordance with GAAP. 10

14 materials. In both cases, cost inefficiency arises because higher input costs are incurred for a given amount of outputs (i.e., sales). 6 Finally, material weaknesses relating to information technology (IT) can impair a firm s ability to capture, process and record raw transactional data corresponding to economic events, further resulting in erroneous internal management reports. In addition, these weaknesses can reduce the effectiveness in monitoring the usage of resources, which can lead to wastage of resources. Consistent with this line of reasoning, studies have documented that IT investments are associated with greater capacity utilization and inventory turnover (Barua et al. 1995), lower production costs, overhead costs and costs of goods (Mitra and Chaya 1996), and improved labor and administrative productivity (Yao et al. 2010), all of which lead to higher operational efficiency. The following example from TRC Companies in the 10-K for the fiscal year ending June 30, 2005 illustrates how material weaknesses relating to IT can affect the monitoring of purchases and expenditures, which translates into higher input costs and lower operational efficiency. The Company did not adequately design controls to maintain appropriate segregation of duties in its manual and computer-based business processes which could affect the Company s purchasing controls, the limits on the delegation of authority for expenditures, and the proper review of manual journal entries. Based on the above discussions, we expect that the benefits of effective ICFR to extend beyond that of enhancing financial reporting reliability to improving firm operational efficiency. Hence, we state our hypothesis in the alternative form as follows: 6 Foamex International Inc. disclosed in its 10-K filing for the fiscal year ending December 31, 2005 material weaknesses in its ICFR related to accounting for labor and overhead variances to standard costs, which should be included in its work in process and finished goods inventories. If managers rely on erroneous (especially underestimated) inventory costs to determine the selling price, this can result in a lower sales achieved for a given amount of input costs and harm the firm operational efficiency. 11

15 H1: Firm operational efficiency is lower among firms with ineffective internal control over financial reporting. To test this hypothesis, we first examine the association between the effectiveness of ICFR and firm operational efficiency, including control variables for known determinants of operational efficiency and internal control quality. As mentioned earlier, we consider a firm to have ineffective internal control so long as the firm reports a material weakness in ICFR in a particular fiscal year. In addition, we conduct a two-stage regression analysis which includes the inverse Mills ratio in the second stage regression to control for the self-selection of internal control quality. To provide further evidence on the link between operational efficiency and ineffective ICFR, we also examine whether operational efficiency improves upon the remediation of material weaknesses. 3. Research design 3.1 Sample selection Panel A of Table 1 summarizes the sample selection procedure for our empirical tests. Using Audit Analytics, we first identify a sample of 32,897 firm-year observations (6,593 unique firms) with a SOX 404 disclosure for the period We delete 13,158 firm-year observations that are from financial industries, 178 firm-year observations with missing data to measure firm efficiency, and 2,139 firm-year observations with missing data on firm characteristics. We are left with 17,422 firm-year observations representing 3,907 unique firms. Over the period 2004 to 2011, 8.10% of the observations have ineffective ICFR. Panel B of Table 1 shows the sample distribution of firm-year observations with ineffective ICFR over time. There is a declining trend in the proportion of firm-year observations with ineffective ICFR, ranging from 17.77% in 2004 to 4.08% in

16 3.2 Measuring operational efficiency As mentioned earlier, we use DEA to create a measure of firm operational efficiency (EFFICIENCY). DEA has been used to measure efficiency across multiple disciplines. For example, Murthi et al. (1996) use DEA to assess marketing efficiency, and Leverty and Grace (2012) use DEA to examine the relative efficiency of insurance companies. It is a nonparametric method of measuring operational efficiency of decision-making units (DMUs) by creating an efficient frontier of production based on an optimization programming to maximize a ratio of outputs to inputs. This approach produces an ordinal ranking by measuring the relative efficiency of a DMU compared to those DMUs located on the efficient frontier (i.e., these DMUs produce the maximum level of outputs given the level of inputs or use the minimum level of inputs given the level of outputs). After solving an optimization programming for each DMU within an estimation group (e.g., industry group), DEA analysis standardizes efficiency scores so that the most (least) efficient DMUs are assigned a value of one (zero) (see Cooper et al for details). The advantage of DEA is that one does not need to impose a specific functional form for the relationship between outputs and inputs or assign a priori factor weightings on inputs since the optimal weightings are derived from the data (Cooper et al. 2000). 7 Because efficiency measures are derived based on the relation between inputs and outputs, it is critical to choose inputs and outputs that adequately describe a firm s production function. Prior research uses sales revenue as the sole output variable because it is a primary source of earnings and cash flows generated from firms operating activities (Verma 1993; Thore et al. 1994; Demerjian et al. 2012). Even with several intermediate outputs, sales revenue is usually the ultimate goal of these intermediate outputs. Input variables used in prior studies 7 However, such mechanical approach to deriving the optimal factor weightings is criticized as it does not involve any value judgments on different outputs (e.g., Stone 2002). 13

17 typically include net property, plant, and equipment, operating leases, R&D, purchased goodwill, other intangible assets, cost of inventory, and selling, general, and administrative expenses. In this study, we follow Baik et al. (2013) and use three input variables: (i) net property, plant and equipment (PP&E), (ii) cost of goods sold (COGS), and (iii) selling, general, and administrative costs (SG&A). Net PP&E, measured at the beginning of the current fiscal year, represents a firm s primary capital that is utilized to generate revenue (Demerjian et al. 2012). The other two variables represent operating expenses incurred during core business activities, measured over the current fiscal year (Thore et al. 1994; Demerjian et al. 2012). According to Baik et al. (2013), these three input variables are key determinants of sales revenue and thus adequately reflect firms production function in a parsimonious way. Following Demerjian et al. (2012), we estimate EFFICIENCY by industry according to Fama and French (1997) to increase the comparability of business models and cost structures among peer firms (see Appendix A for details). 3.3 Regression model To test the relation between ICFR effectiveness and firm operational efficiency, we estimate the following pooled cross-sectional regression: EFFICIENCY it = α + βmwic it + ψefficiency_controls it + γic_controls it + IND_FE + ε it (1) where EFFICIENCY refers to our measure of operational efficiency, MWIC is an indicator variable for ineffective internal control equal to one if a firm reports a material weakness in ICFR and zero otherwise, EFFICIENCY_CONTROLS refers to a vector of controls for the determinants of operational efficiency, IC_CONTROLS refers to a vector of controls for the determinants of internal control effectiveness, and IND_FE refers to industry fixed-effects. 14

18 Appendix B includes the detailed definition of all variables. All p-values are computed using the standard errors adjusted for firm-clustering and year-clustering (Petersen 2009). We select EFFICIENCY_CONTROLS that are documented in Demerjian et al. (2012) to be associated with firm operational efficiency. First, managers of larger firms with more market share will be more effective than others in negotiating terms with suppliers and customers, holding their ability constant. Hence, we include the log of total assets (LOGTA) to control for firm size and the percentage of revenues earned by a firm within its Fama and French (1997) industry (MKTSHARE) to control for market share. Second, we control for free cash flow (FCF) because managers in firms with greater positive free cash flows are able to pursue positive net present value projects more effectively. Third, we control for firm age (LOGAGE) because the life cycle of the firm can affect management s opportunity set of possible projects as well as the required start-up costs of investments. Finally, operating in multiple industries requires a broader knowledge set and reduces the amount of attention management pays to any single industry, hence reducing managers ability to efficiently allocate capital. We control for firm diversification using the Herfindahl index for business segment concentration (CONCENTRATION) and an indicator variable signifying foreign operations (FOREIGN). We also include IC_CONTROLS, a vector of control variables for the determinants of internal control effectiveness, because prior studies suggest that firms with material weaknesses are likely to be systematically different from firms with effective internal control (Ashbaugh- Skaife et al. 2007; Doyle et al. 2007b). Specifically, firms with ineffective internal control tend to be smaller, poorer performing, more complex, undergoing rapid growth, involved in mergers and acquisitions or restructuring, operating in a more litigious industry, audited by Big N auditors, and involved in an auditor change. Hence, IC_CONTROLS includes the amount of 15

19 inventory relative to total assets (INVENTORY) and the number of operating segments (SEGMENTS). It also includes indicator variables signifying loss-making firms (LOSS), firms involved in mergers and acquisitions (MERGER) or restructuring (RESTRUCTURE), firms operating in a litigious industry (LITIGATION), firms experiencing rapid sales growth (EXTREME_GROWTH), firms audited by a Big 4 auditor (BIG4), and firms that have changed auditors in the fiscal year (AUD_CHANGE). 4. Empirical results 4.1 Descriptive statistics Panel A of Table 2 presents the descriptive statistics on EFFICIENCY and other firm characteristics by ICFR effectiveness. The mean EFFICIENCY for firms with ineffective internal control (0.314) is significantly smaller than for firms with effective internal control (0.337). 8 This result provides preliminary evidence on the positive association between ICFR effectiveness and operational efficiency. Among the determinants of operational efficiency, we find that firms with ineffective internal control are smaller (LOGTA), younger (LOGAGE), have lower market share within their industries (MKTSHARE), lower free cash flows (FCF), and are less likely to have foreign operations (FOREIGN). For the determinants of ICFR effectiveness, we find that firms with ineffective internal control are more likely to be loss making (LOSS), undergoing restructuring (RESTRUCTURE), operating in a litigious industry (LITIGATION), experiencing extreme sales growth (EXTREME_GROWTH), audited by a Big 4 auditor (BIG4), and involved in an auditor change (AUD_CHANGE). These results are generally consistent with prior studies. 8 Compared to other studies using a large sample, these average efficiency scores are lower than that of 0.57 in Demerjian et al. (2012), and that of 0.79 in Baik et al. (2013). However, these studies use the data from a much longer period than our study. 16

20 In Panel B of Table 2, we present correlations among firm operational efficiency, ICFR effectiveness, and control variables. Pearson product moment correlations are presented in the upper-right, and Spearman rank order correlations in the lower-left portion of the table. As predicted, the correlation between EFFICIENCY and MWIC is negative and significant. Most of the control variables for the determinants of operational efficiency and internal control effectiveness are significantly correlated with EFFICIENCY. Variance inflation factors (untabulated) suggest that our multivariate analyses are not subject to multicollinearity concerns. 4.2 ICFR effectiveness and firm operational efficiency Table 3 presents the regression results on the association between ICFR effectiveness and firm operational efficiency. In Column (1), we present the result controlling only for the determinants of operational efficiency. We find that the coefficient on MWIC is negative and significant (p < 0.001), indicating that operational efficiency is lower for firms with ineffective internal control. The coefficient estimates on the operational efficiency determinants suggest that operational efficiency is higher for larger firms (LOGTA), firms with more free cash flows (FCF), and firms with foreign operations (FOREIGN). Operational efficiency is lower for firms with greater market share within the industry they operate in (MKTSHARE). Column (2) shows the result after further including the determinants of internal control effectiveness. The coefficient on MWIC continues to be negative and significant (p = 0.003). Column (2) also indicates that operational efficiency is lower for firms that have poorer performance (LOSS) and firms that undergo restructuring (RESTRUCTURE), but higher for firms that have more inventories (INVENTORY), firms that are involved in mergers and acquisitions (MERGER), and firms that experience high sales growth (EXTREME_GROWTH). 17

21 Given prior findings that firms with material weaknesses are systematically different from other firms (Ashbaugh-Skaife et al. 2007; Doyle et al. 2007b), we further control for the possibility of self-selection into the MWIC group by employing the Heckman (1979) two-stage procedure. In the first stage, we estimate a probit regression of the likelihood of having a MWIC on the determinants (i.e., IC_CONTROLS) and the result is presented in Appendix C. 9 From this regression, we calculate the inverse Mills ratio LAMBDA and replace IC_CONTROLS in Equation (1) with LAMBDA. The result, presented in Column (3), shows that the coefficient on MWIC remains negative and significant (p = 0.02). 4.3 Firm operational efficiency over time Our main findings are consistent with the conjecture that ineffective internal control contributes to lower operational efficiency. According to Doyle et al. (2007a), material weaknesses, on average, should have existed several years prior to their disclosure under SOX 404. Hence, our result of the positive association between ICFR effectiveness and operational efficiency should also hold for years before material weakness disclosure. Furthermore, if ineffective internal control impairs operational efficiency, then the reduced operational efficiency associated with ineffective internal control should disappear once firms remediate their internal control problems. As such, we expect no significant difference in operational efficiency between material weakness firms that remediate their internal control problems and firms with effective internal control. To test these conjectures, we add fiscal years to our sample of firms with SOX 404 disclosures during the period and introduce indicator variables that capture the pre-disclosure and post-remediation periods. 9 Consistent with prior studies, we find that the presence of a material weakness in ICFR is significantly negatively related with firm size (LOGTA) and age (LOGAGE) but positively related with poor performance (LOSS), the complexity of firm operations (FOREIGN and SEGMENTS), the magnitude of inventory (INVENTORY), rapid growth (EXTREM_GROWTH), audit quality (BIG4), and the occurrence of auditor change (AUD_CHANGE). 18

22 Including the data from fiscal years 2002 and 2003, we augment our main sample to 22,890 firm-year observations. We replace MWIC in Equation (1) with PRE and POST. PRE is an indicator variable set to one for firm-years before the disclosure of material weakness in ICFR, and zero otherwise. If ineffective internal control reduces operational efficiency even before the material weaknesses are disclosed during the period, we expect a negative and significant association between PRE and EFFICIENCY. The indicator variable POST is set to one for firm-years after the disclosure of remediation of previous material weaknesses, zero otherwise. 10 If the remediation of material weaknesses improves operation efficiency, we will not expect significantly different operational efficiency between material weakness firms that resolve their internal control problems and firms with clean opinions. As such, we predict the coefficient on POST to be insignificant. Table 4 displays the results on the temporal variation in operational efficiency. The coefficients on PRE variable in Columns (1) and (2) are negative and significant, suggesting that the operational efficiency of the firms with material weaknesses is lower compared with firms with no material weaknesses in the years leading up to the fiscal year of the adverse SOX 404 opinion. In contrast, the insignificant coefficients on POST indicate that the lower operational efficiency associated with ineffective internal control disappears once the material weaknesses are remediated. Taken together, these results suggest that the detrimental effect of ineffective ICFR on operational efficiency is present in the years leading up to the disclosure of material weaknesses, but disappears after remediation of the internal control problems, providing further support to H1. 5. Additional analyses 10 Following Ashbaugh et al. (2013), POST is equal to one for fiscal years if the firm discloses a material weakness for fiscal-year 2004 and a clean opinion for fiscal-year

23 5.1 Propensity score matched sample Our tests above are based on pooled cross-sectional regressions. In this sub-section, we examine the robustness of our results using a propensity score matched sample (LaLonde 1986). Specifically, we create a matched control sample of non-mwic firms, based on the predicted probabilities from the probit regression in Appendix C. This matching process identifies control firms with similar predicted probabilities (thus incorporating the combined effect of the predictive variables) of having a MWIC as the test firms within the same industry-year group based on the propensity score. Following this procedure, we have a combined sample of 2,822 observations, consisting of 1,411 MWIC firm-years and 1,411 non-mwic firm-years. Untabulated results show that the mean operational efficiency for the group of MWIC (mean = 0.314) remains significantly lower compared to that of non-mwic group (mean = 0.324) at the 1% significance level. Hence, our main findings in Table 3 are robust to using a matched-pair rather than a pooled sample research design. 5.2 Lagged variable for internal control effectiveness It is possible that firms with lower operational efficiency have poorer financial performance (Baik et al. 2013), which in turn increases the likelihood of internal control problems (Ashbaugh-Skaife et al. 2007; Doyle et al. 2007b). Using a lagged variable of internal control effectiveness will mitigate this concern and be consistent with our expectation that internal control effectiveness affects operational efficiency, rather than vice versa. Hence, we reestimate Equation (1) using a lagged variable for internal control effectiveness and the results are presented in Table 5. We find that the coefficient on MWIC continues to be negative and significant. 5.3 Change analysis 20

24 To mitigate the concern that omitted correlated variables are driving our results, we utilize a change regression specification for our main analyses as an additional sensitivity test. In particular, we regress the change in EFFICIENCY (ΔEFFICIENCY) on changes in the status of internal control (REMED and NONREMED) and the changes in control variables. Here we assume that those omitted correlated variables which can cause endogeneity are stable over time and thus will cancel out by taking a change of variable. REMED (NONREMED) is an indicator variable that equals one if the material weakness firms (do not) remediate their internal control problems in the subsequent year, and zero otherwise. The results, reported in Table 6, show that the coefficient on REMED is positive and significant but the coefficient on NONREMED is negative and not significant. These results show that an improvement in the effectiveness of internal control is associated with an improvement in operational efficiency, confirming the over-time findings in Section 4.3 and providing further support to H Using decile rank of firm efficiency To make the efficiency score more comparable across time and industry and to mitigate the influence of extreme observations, we re-estimate Equation (1) using the decile rank of EFFICIENCY by year and industry (RANK_EFFICIENCY). The results are reported in Panel A of Table 7. Column (1) shows the results when we control for operational efficiency determinants, and Columns (2) and (3) show the results when we further include internal control determinants and the inverse Mills ratio LAMBDA, respectively. Although all control variables are included in the empirical specifications, we report only the coefficient and significance level for our main variable of interest, MWIC, for brevity (this applies to the subsequent two sections as well). In all the three specifications, the coefficient on MWIC continues to be negative and significant. 21

25 5.5 Measuring firm efficiency based on seven inputs In our main tests, we follow Baik et al. (2013) and measure operational efficiency using three input variables: (i) net property, plant and equipment (PP&E), (ii) cost of goods sold (COGS), and (iii) selling, general, and administrative costs (SG&A). As another sensitivity check, we follow Demerjian et al. (2012) and further include the following four input variables in estimating EFFICIENCY: (i) capitalized operating leases, (ii) capitalized research and development (R&D) costs, (iii) purchased goodwill, and (iv) other intangibles. Panel B of Table 7 reports the regression results. The coefficient on MWIC continues to be negative and significant in all specifications, with or without controlling for internal control determinants and the inverse Mills ratio. 5.6 Measuring firm efficiency based on Stochastic Frontier Analysis As mentioned earlier, the DEA operational efficiency measure is derived using a non parametric approach. We examine the sensitivity of our results using an alternative measure of operational efficiency derived from Stochastic Frontier Analysis (SFA), a parametric approach to model the relationship between outputs and inputs. The advantage of using a parametric method such as SFA is to allow random shocks in the production process in measuring efficiency. However, unlike DEA, SFA model has disadvantages; for example, one should specify a specific functional form for the relation between inputs and outputs and distributional assumption on the random error term, which could be arbitrary (e.g., Stone 2002). Following Baik et al. (2013), we use the same three inputs which are used for DEA measure and estimate a SFA model for each industry group (see Appendix A for details). Panel C of Table 7 reports the regression results. Again, we find that the coefficient on MWIC remains negative and significant in all specifications, consistent with our earlier findings. 22

26 6. Conclusion In this study, we examine whether effective ICFR has implications beyond that of financial reporting to firm operational efficiency. We predict a positive association between internal control effectiveness and operational efficiency because ineffective ICFR can lead to greater information risk, which increases agency problems and the likelihood of misappropriation by managers. In addition, inadequate physical security, inadequate segregation of duties, and inadequate documentation further allow the misappropriation of inputs by employees. Furthermore, ineffective ICFR results in erroneous internal management reports (Feng et al. 2009), and managers relying on such reports are more likely to make suboptimal operational decisions Finally, ineffective ICFR relating to information technology not only further results in erroneous internal reports, but also reduces firms effectiveness in monitoring the usage of resources and leads to inefficient use and wastage of resources. Using a sample of firms that reported internal control opinions under SOX 404 during the period and the frontier analysis method to measure operational efficiency, we find that operational efficiency is significantly lower in firms disclosing material weaknesses in internal control relative to firms with effective control. This result holds even in the years leading up to the disclosure of material weaknesses, but disappears after remediation of the internal control problems, suggesting that the remediation of material weaknesses in ICFR improves operational efficiency. Our results are robust to a battery of sensitivity checks, such as controlling for known determinants of material weaknesses, using the Heckman two-stage procedure to control potential self-selection of material weakness firms, using a propensity score matched sample based on the predicted probabilities of having a material weakness, using a 23