Internal Control Quality, Disclosure and Cost of Equity Capital: The Case of an Unregulated Market

Abstract

This paper examines the direct effect of internal control quality (ICQ) on cost of equity capital and whether ICQ has a moderating effect on the association between voluntary disclosure and cost of equity capital in an emerging market (Egypt). ICQ is measured using a survey of external auditors. A content analysis approach is used to proxy for the level of voluntary disclosure in annual reports. Finally, the Capital Asset Pricing Model framework is used to estimate cost of equity capital. Based on a sample of 512 firm‐year observations over the period 2007–2014, we find that ICQ is negatively and significantly associated with cost of equity capital, indicating that better controls reduce cost of equity capital as predicted by theory. In addition, ICQ moderates the association between voluntary disclosure and cost of equity capital since this association is only negative and significant for companies characterized by high ICQ. These findings remain stable after controlling for endogeneity concerns and political instability. Our study contributes to the internal control literature by focusing on an emergent unregulated market with respect to internal control disclosure and documents that ICQ plays an important role in reducing cost of equity capital (either directly or indirectly) by increasing the value relevance of voluntary disclosure among investors on the Egyptian stock exchange.