Does Internal Control over Financial Reporting Reduce Cost of Capital?

• In Event: Auditing/International Accounting/FAR/Forensic and Investigative Accounting

Abstract

We address the cost-of-capital benefits of internal control reporting and auditing requirement under the Sarbanes-Oxley Act (SOX) of 2002 in the context of Seasoned Equity Offerings (SEOs) where the costs of raising equity capital can be directly measured and observed, and therefore are less likely to be subject to measurement errors. We find that internal control weaknesses (ICWs) are not directly related to underwriting fees, SEO announcement effects, and SEO underpricing, three primary components of issue costs, before the disclosure of ICWs. We also find that ICW issuers do not experience more negative announcement returns and greater underpricing but pay marginally higher underwriting fees than non-ICW issuers after the public disclosure of ICWs. Additional analyses show that managers play a dominating role in determining issue size before the disclosure of ICWs, but this dominance weakens after the public reporting of ICWs. The overall evidence suggests that internal control systems play a limited role in moderating the costs of raising equity capital and that public disclosure of ICWs conveys new information to underwriters about the uncertainty and risk of issuers in the equity issue market.

Authors

• Yonghong Jia, Governors State University

• Xinghua Gao, Wayne State University