The Monitoring Role of Internal Controls: Evidence from Excess Value of Diversification

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

Abstract

We investigate how the development of internal control systems in multi-segment firms affects the well-documented diversification discount. Because internal controls play an important role in mitigating agency conflicts and reducing information asymmetry, they are hypothesized to impact the value of diversified firms by influencing the efficiency of firms’ real decisions. In support of this hypothesis we find that (1) internal control weaknesses (ICWs) are negatively related to the cross-sectional variation in excess value of diversification; (2) multi-segment firms with persistent ICWs and firms with deteriorating internal control systems demonstrate lower levels of excess value while firms with improved internal controls reverse the value loss from diversification; and (3) ICWs are associated with misallocation of capital resources and inefficiency of internal capital transfers as well as lower levels of accounting performance. The overall evidence is consistent with the monitoring role of internal control systems and strongly supports the SEC’s proposition that internal controls affect firms’ real decisions.

Authors

• Ranjan D'Mello, Wayne State University

• Xinghua Gao, Wayne State University

• Yonghong Jia, Governors State University