Internal governance and internal control material weaknesses

• Published date: 01 May 2024
• Author: Mai Dao,Trung Pham,Hongkang Xu
• Date: 01 May 2024
• DOI: http://doi.org/10.1111/corg.12548

ORIGINAL ARTICLE

Internal governance and internal control material weaknesses

Mai Dao

1

| Trung Pham

2

| Hongkang Xu

3

1

Department of Accounting, University of

Toledo, Toledo, Ohio, USA

2

Department of Accountancy, University of

Illinois Springfield, Springfield, Illinois, USA

3

Department of Accounting and Finance,

University of Massachusetts Dartmouth,

Dartmouth, Massachusetts, USA

Correspondence

Hongkang Xu, Department of Accounting and

Finance, University of Massachusetts

Dartmouth, Dartmouth, MA, USA.

Email: hxu5@umassd.edu

Funding information

This research does not receive any funding.

Abstract

Research Question/Issue: The objective of this study is to examine whether the

effectiveness of internal governance is associated with internal control material

weaknesses. We employ the concept of internal governance as the checks-

and-balances mechanism that subordinate executives apply to the chief executive

officer (CEO). We predict that with long horizons and long-term interests aligned

with firms' long-term growth, subordinate executives may have the incentive to sup-

port a high-quality internal control system, which is an important factor contributing

to firms' long-term success.

Research Findings/Insights: Using data on CEOs' and other highest paid executives'

age and compensation to measure the effectiveness of internal governance, we

empirically find consistent evidence that internal governance effectiveness is associ-

ated with higher internal control quality. In particular, we find that effective internal

governance is related to a lower likelihood of firms reporting internal control material

weaknesses, fewer material weaknesses in internal control (ICMWs), a lower chance

of firms disclosing internal control weaknesses for multiple years, and a lower proba-

bility of firms reporting entity-level and/or account-level material weaknesses in

internal control. We also show that among the two factors forming the internal gov-

ernance measure, only subordinate executives' horizon is associated with the proba-

bility of firms disclosing ICMWs. Our further analysis reveals that the probability of

reporting ICMWs is lower for growth firms with effective internal governance.

Theoretical/Academic Implications: Our findings contribute to the literature on

internal governance and internal control quality. The impact of the checks-

and-balances mechanism inherent in internal governance on firms' investment in the

internal control system and thus the probability of disclosing ICMWs has not

received sufficient attention from accounting researchers. While prior studies focus

on individual members of the management team, our finding implies that the quality

of the internal control system is a result of the joint effort of the whole management

team. Unlike the extant literature that captures only certain aspects of reporting qual-

ity and information disclosures, our study emphasizes the role of the horizon dimen-

sion of internal governance in enhancing the reliability of financial reporting

(measured as the quality of the internal control system).

Practitioner/Policy Implications: Our results shed light on the important role of sub-

ordinate executives in monitoring CEOs' short-term interests.

Received: 22 February 2022 Revised: 2 May 2023 Accepted: 7 June 2023

DOI: 10.1111/corg.12548

474 © 2023 John Wiley & Sons Ltd. Corp Govern Int Rev. 2024;32:474–499.wileyonlinelibrary.com/journal/corg

KEYWORDS

corporate governance, career horizons, CEO–subordinate pay ratio, internal control, internal

governance

1|INTRODUCTION

In this study, we examine the impact of internal governance on inter-

nal control material weaknesses (ICMWs). Developed by Acharya

et al. (2011), the concept of internal governance expresses the

checks-and-balances mechanism imposed on chief executive officers

(CEOs) by their subordinate managers

1

so that CEOs make investment

decisions to enhance their firms' long-term value. In other words, the

checks-and-balances mechanism applied by subordinate managers

curbs the CEO's myopic behavior, such as rent extraction, and forces

the CEO to focus on the firm's long-term value. To serve their self-

interest, CEOs may be incentivized to extract rents for their short-

term interest, which harms firms' long-term value. However, these

CEOs do not have complete freedom to pursue their own interest

because they must face various corporate governance mechanisms in

general and the internal governance of their firms in particular.

Subordinate managers, who are generally younger than CEOs,

have a longer horizon, and their interest is more closely aligned with

firms' long-term value for several reasons. First, these subordinates

wish to gain more benefits within their firms when they become the

next CEOs (Acharya et al., 2011). Second, human capital is relatively

more important for these younger subordinates because their future

pay and reputation in the labor market depend on their firms' perfor-

mance (Fama, 1980). In other words, the opportunity costs due to cor-

porate failures are higher for these longer horizon subordinates. Last,

the loss (relative to their total wealth) that subordinates may have to

suffer from corporate underperformance can be greater than that of a

CEO because they have more remaining years of employment

(Q. Cheng et al., 2016). Thus, these managers are expected to restrain

CEOs from taking actions that harm firms in the long run. When CEOs

make investment decisions for the long-run value of their firms, we

expect firms with more effective internal governance to be less likely

to engage in accounting gimmicks to temporarily boost profits

(Acharya et al., 2011). In light of this argument, this study scrutinizes

how and to what extent pressure from lower level members of the

management team can constrain CEOs' self-interested behavior by

increasing the quality of internal control over financial reporting.

CEOs have the discretion to invest in their firms' internal control

systems to improve financial reporting quality and enhance firms'

operational effectiveness and efficiency (Committee of Sponsoring

Organizations of the Treadway Commission [COSO], 2013). However,

CEOs might not have the incentive to invest in internal control sys-

tems for at least two reasons. First, an improvement in internal control

might limit the CEO's decision to manipulate financial information

(Balsam et al., 2014) and make rent-extracting activities more difficult

to adopt (Ashbaugh-Skaife et al., 2013; Lambert et al., 2007). Second,

investing in internal control might be costly for the firm as a whole

(Charles Rivers Associates, 2005; Ge & McVay, 2005). Thus, CEOs

might be incentivized to act myopically and in a self-interest maximiz-

ing manner by not investing sufficiently in their firms' internal control

systems. However, internal control weaknesses, if detected, might

negatively affect the firm's value, such as by causing lenders to

demand a higher interest rate or ask for loan collaterals (Costello &

Wittenberg-Moerman, 2011). With a longer horizon, subordinate

managers are more likely to support a stronger internal control system

because they are more interested in the firm's long-term success.

Therefore, the CEO's myopic behavior may discourage subordinate

executives from directing their effort toward the firm. To motivate

subordinates to increase effort directed toward the firm's current cash

flow, the CEO should consider the firm's long-term value by increasing

investment in the internal control system. Taken together, we expect

that the checks-and-balances mechanism between the CEO and sub-

ordinates may motivate the CEO to improve the firm's internal con-

trols and reduce the control system's material weaknesses. Our

prediction regarding the improvement in the internal control quality

for firms with effective internal governance also results from the

belief that subordinate executives may become more involved in

firms' operations and decision-making processes because of their

potential to become the next CEO. With firm-specific knowledge and

skills, subordinate executives may help the CEO identify where and

how to improve the internal control system and thus enhance the

quality of internal controls.

We test the association between internal governance effective-

ness and internal control material weaknesses using data for the

2004–2018 period. Consistent with Q. Cheng et al. (2016), we per-

ceive internal governance effectiveness as subordinate executives'

desire and ability to monitor the CEO. We therefore define internal

governance effectiveness as the sum of the standardized values of

subordinate executives' years to retirement (i.e., subordinates' hori-

zon) and the ratio of top subordinate executives' average compensa-

tion to CEOs' compensation (i.e., subordinates' pay ratio). We find

that the likelihood of firms reporting material weaknesses in internal

control is lower when firms have effective internal governance. When

we decompose the internal governance measure into subordinate

executives' horizon and pay ratio, we find that among the two mea-

sures, only subordinate executives' horizon is associated with the like-

lihood of firms reporting ICMWs. Furthermore, we find that internal

governance effectiveness and subordinates' horizons are associated

with fewer material weaknesses in internal controls, a lower probabil-

ity of firms reporting internal control material weaknesses for multiple

years, and a lower likelihood of firms disclosing entity-level and/or

account-level material weaknesses. In the sensitivity tests, we use

alternative measures of internal governance and find robust evidence

consistent with our main results that effective internal governance is

associated with higher internal control quality. We also address

potential endogeneity problems by rerunning our main tests with the

DAO ET AL.475