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Quality of internal control over financial reporting, corporate governance and credit ratings

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Abstract

Credit rating is a primary determinant of firm cost of debt capital, capital structure, and hence the range of acceptable investment opportunities. Scant research has been conducted thus far on the relation between internal controls and cost of capital, particularly after the 2002 Sarbanes–Oxley Act. However, academic researchers argue that credit ratings may be affected by internal governance mechanisms instituted by firms and that the quality of internal controls is a potential driver of cost of equity capital. This paper examines whether firm credit ratings is associated with the quality of internal control over financial reporting. Using a sample of firms disclosing internal control weaknesses during November 2003–July 2005, I find that firms with low internal control quality are more likely to have lower credit ratings, speculative-grade rating, smaller size, lower profitability, lower cash flows from operating activities, net losses in the current and prior fiscal year, higher income variability and higher leverage than firms compared to firms with high-quality controls. Further, lower quality controls decrease the likelihood of a firm receiving an investment-grade debt rating; hence, resulting in higher cost of debt financing, lower income and lower overall attractiveness in capital markets for these firms. Finally, results also suggest that corporate governance strength is positively related to internal control quality. Study results should be useful to a wide range of academic and business readers, because it suggests the increasing importance of firm internal controls in financing decisions and cost of capital determination, of investment in proper internal controls and of exploring the various possibilities from instituting high-quality internal controls. Additionally, regulators are advised to take into consideration the potential effect of legislation on firm credit ratings and internal control quality.

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  • In addition to analysing Model Y for the entire sample, I also test the relation within each of the two groups, ICW firms and non-ICW firms, separately. All three versions of Model Y are significant, albeit at different explanatory powers, measured by the adjusted R 2 (0.61, 0.50 and 0.45n, respectively). The results show an interesting conclusion: the relation between G_SCORE and RATING is positive for both groups, but is only significant for ICW firms. This may be due to rating agencies not placing governance on the top of the firm evaluation criteria if the firm exhibited no history of internal control deficiencies. Further, after including G_SCORE in the model, ROA, CVNI and LEVER in the sample group and INDUSTRY, LOSS and OPCASH in the control group entirely lose significance. In particular, the loss of significance for LEVER in the sample group is interesting because it is a primary driver for credit rating scores. This may be due to rating firms giving leverage a lower priority in well-governed firms, which increases the rating agency's confidence in the firm's stream of future cash flow. Additionally, the loss of significance for the set of variables representing firm risk (LOSS, OPCASH and CVNI) may suggest the lack of concern on the part of rating agencies for these measures when the firm being evaluated for credit worthiness has no internal control problems.

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Elbannan, M. Quality of internal control over financial reporting, corporate governance and credit ratings. Int J Discl Gov 6, 127–149 (2009). https://doi.org/10.1057/jdg.2008.32

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