Internal Controls in Family-Owned Firms

Abstract

This study investigates the relationship between family ownership and material weaknesses in internal controls over financial reporting. Recent Sarbanes-Oxley (SOX) regulation and mandatory disclosure of family relations among block shareholders and directors in Israel offer an ultimate setting for exploring this relationship. The findings reveal that (i) family ownership is significantly associated with less material weaknesses in internal controls, (ii) material weaknesses in internal controls are associated with lower earnings quality in family-owned firms than in non-family-owned firms, and (iii) investors find weaknesses in internal controls to be more serious in their potential to lessen future performance in family-owned firms than in non-family-owned firms. The contribution of the study is threefold. First, the findings expand our understanding of how ownership structure influences financial reporting procedures. Second, they suggest that family-owned firms use internal controls as a mechanism to enhance earnings quality. Third, they extend the literature on the implications of the SOX legislation by highlighting the joint effect of family ownership and effective internal controls in achieving high-quality financial reports.