On the Importance of Internal Control Systems in the Capital Allocation Decision

The following post comes to us from David De Angelis of the Department of Finance at Cornell University.

In the paper, On the Importance of Internal Control Systems in the Capital Allocation Decision: Evidence from SOX, which was recently made publicly available on SSRN, I investigate the effects of information problems across corporate hierarchies on internal capital allocation decisions by using the Sarbanes-Oxley Act (SOX) as a quasi-natural experiment of a shock to the level of information frictions across corporate hierarchies. SOX requires firms to enhance their internal control systems in order to improve the reliability of financial reporting across corporate hierarchies.

I find that after SOX the capital allocation decision is more sensitive to performance as reported by the business segments. The changes in sensitivity of investment to performance are more pronounced for conglomerates that are more prone to information problems across corporate hierarchies, such as conglomerates with more segments and conglomerates that restated their earnings in the past. Moreover, in the post-SOX era, firms do not rely on past performance in their capital allocation decision when auditors report material weaknesses in their internal controls. The productivity advantage of conglomerates over stand-alone firms increases after SOX. In addition, conglomerates and segments that are more affected by SOX exhibit a larger increase in future profitability after SOX. Furthermore, the excess value of conglomerate firms relative to stand-alone firms increases (i.e., the conglomerate discount decreases). These changes in the internal capital allocation process are not associated with economic activities, financial constraints, or tensions between the management and shareholders.

My findings support the idea that after an increase in the reliability of internal financial reporting, top executives rely more on information reported by the division managers. By improving the within-firm information system, stronger internal controls lead firms to adopt more efficient capital allocations and, thus, firm productivity increases after SOX.

The results of this paper suggest that inefficiencies in the capital allocation process are partly due to information frictions across corporate hierarchies. It thus confirms predictions from a wide range of models that use within-firm frictions to explain inefficiencies in internal capital markets (e.g., Harris and Raviv, 1996; Scharfstein and Stein, 2000).

In addition, this study clarifies the impact of SOX—revealing the consequences of SOX for conglomerate firms from a new perspective and providing additional explanations for why large firms benefit more from SOX than do small firms (see, e.g., Chhaochharia and Grinstein, 2007). Larger firms are more likely to have multiple divisions and, thus, are more prone to information problems within the organization. By mitigating information problems, the implementation of SOX leads firms to make better investment decisions and thus increases their productivity. These findings also shed light on the importance of internal control systems in the efficiency of corporate decisions (Jensen, 1993).

The full paper is available for download here.

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