Management's Role in the Corporate Governance of Smaller Publicly Traded Companies: Internal Control Assessment and Earnings Quality

• In Event: Auditing I

Abstract

This study is motivated by the current gap in literature on the role of management in the corporate governance process focusing on internal controls. Management is one of five internal actors in corporate governance, as suggested by the corporate governance mosaic (Cohen et al. 2004). Yet in smaller companies, many of these actors are absent or less effective—thus placing additional burden on management in its corporate governance role. Further, internal controls are key to corporate governance, and establishing and maintaining effective internal control is one of management’s major governance roles. In the U.S., that role has been mandated by Congress in an effort to ensure fair and honest business dealings and financial reporting. Yet, due to their nature, and more restricted resources, smaller companies may be less able to establish and maintain effective controls. As such, in this study we first test whether small companies (less than $75 million in market capitalization) are, in fact, more likely to have ineffective internal controls than the large companies. Second, we analyze the relationship between management’s assessment of internal control effectiveness and the earnings quality of small companies. We use two different measures of earnings quality in the analysis. The results show that small firms are significantly more likely than are larger firms to have ineffective internal controls. Further, we find that firms which have ineffective internal controls, as assessed by management, have lower quality of earnings than the small firms with effective controls.

Authors

• Larry R Davis, University of St Thomas - Minneapolis

• Alexey Lyubimov, Concordia University

• Gregory M Trompeter, University of Central Florida