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

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.