Internal Information Quality and Capital Allocation within Conglomerates

Abstract

Theoretical research on internal capital markets suggests an important role for internal information quality in the capital allocation process within conglomerates. Direct empirical evidence, however, has been sparse, largely because informational frictions inside firms are difficult for researchers to observe and measure. We leverage public reporting on internal control effectiveness mandated by the Sarbanes-Oxley Act of 2002 and recent developments in the accounting literature to provide evidence that the quality of the internal information environment is positively associated with the efficiency of internal capital allocation. We find that firms with internal control weaknesses allocate internal capital less efficiently than firms without weaknesses, and that allocation efficiency improves following the remediation of control weaknesses, to a level similar to firms without weaknesses. We document similar results using other recently developed proxies for internal information quality, suggesting that our inferences are not confined to internal control issues, but rather are related to internal information quality more generally. We also show that internal information quality plays a particularly important role for firms with diverse operations and during periods of economic expansion, when misallocation due to agency and information frictions tends to otherwise be more severe.