Internal control material weakness and CEO recruitment

Abstract

AbstractPrior research finds that internal control material weakness (ICMW) reduces the reliability of financial reporting numbers, imposes costs on firms and affects firm performance. Given these effects, we examine two research questions: Does the disclosure of ICMW hamper a firm's ability to hire high‐ability CEOs? Consequentially, does it also impact CEO contracting in terms of the compensation offered to newly hired CEOs? We provide three key findings. First, we find firms that disclose ICMW are more likely to appoint CEOs with lower managerial ability relative to firms that do not disclose ICMW. Second, we find ICMW firms offer lower compensation to new CEOs, suggesting that the pay offered is commensurate with the ability of the CEO recruited. However, the negative relation between ICMW and compensation is attenuated for individual CEOs with relatively higher abilities. Further analyses reveal that some high‐ability CEOs do take positions at ICMW firms, but these ICMW firms pay a premium to hire them, which contributes to greater dispersion and disparity in pay among the top‐five executives. Overall, our results point to ICMW imposing labor market consequences in terms of firm recruitment of high‐ability CEOs.