Does Ineffective Internal Control over Financial Reporting affect a Firm's Operations? Evidence from Firms' Inventory Management

Abstract

We investigate whether ineffective internal control over financial reporting has implications for firm operations by examining the association between inventory-related material weaknesses in internal control over financial reporting and firms' inventory management. We find that firms with inventory-related material weaknesses have systematically lower inventory turnover ratios and are more likely to report inventory impairments relative to firms with effective internal control over financial reporting. We also find that inventory turnover rates increase for firms that remediate material weaknesses related to inventory tracking. Remediating firms also experience increases in sales, gross profit, and operating cash flows. Finally, we assess the generalizability of our findings by examining all material weaknesses in internal control over financial reporting, regardless of type, and provide evidence that firms' returns on assets are associated with both their existence and remediation. Collectively, our findings support the general hypothesis that internal control over financial reporting has an economically significant effect on firm operations.

Accounting-based downside risk, cost of capital, and the macroeconomy

“…SIZE is also significantly positively associated with earnings, consistent with prior research and the notion that big firms have competitive advantages (e.g., Hall and Weiss 1967;Fiegenbaum and Karnani 1991;Feng et al 2015). In addition, the average adjusted R 2 is 41.8 %, demonstrating that there is a significant portion of earnings that is unexplained, which indicates a source of risk in firms' fundamentals.…”

“…To specify our model and ensure that the estimated EDR-subsequentperformance links are not biased or inconsistent due to potential omission of firm fundamental characteristic or risk variables, we identify k control variables for Eq. (4), denoted as CONTROLS1 kit , following prior research on profit margins (e.g., Hall and Weiss 1967;Hurdle 1974;Connolly and Hirschey 1984;Feng et al 2015) and implied sources for downside risk (e.g., Miller and Reuler 1996;Driouchi and Bennett 2010). Specifically, CONTROLS1 kit includes the following variables measured at fiscal year-end t: book-to-market ratio, BM; market value of equity, MVE; ROA; LEVERAGE; cash holdings, CASH; changes in cash holdings, DCASH; research and development investment intensity, Invest_RD; capital investment intensity, Invest_CAPX; operating options, OO; return volatility, SIGMA; and year dummies.…”

“…We include SIZE following the intuition of Hall and Weiss (1967), Fiegenbaum and Karnani (1991), and Feng et al (2015). We include ROA volatility (STD_ROA) and prior-period ROA to account for their possible effects on earnings predictability (e.g., Watts and Leftwich 1977;Dechow 1994;Minton et al 2002;Dichev and Tang 2009).…”

Information systems and internal control: evidence from China

“…We categorize these ICW as information system weaknesses (ISW) and non-information-system weaknesses (NISW). Feng et al [15] show that firms with ICW have worse performance than firms without ICW, but do not test whether the effects on performance vary across different types of ICW. In this paper, we examine whether and when ISW have a stronger adverse impact on firm performance than NISW.…”

Supervision of financial reporting through the prism of the regulatory framework and practice in the Republic of Serbia

“…Altamuro and Beatty (2010) have examined the internal control provisions mandated by the Federal Depository Insurance Corporation Improvement Act during the early 1990s to investigate how internal control regulation affects financial reportingstudy examines both the validity of specific accounts and the quality of financial reporting. Feng, Li, McVay and Skaife (2015) have investigated whether ineffective internal control over financial reporting has implications for firm operations by examining the association between inventory-related material weaknesses in internal control over financial reporting and firms' inventory management. Bardhan, Lin and Wu (2015) have studied the relationship between family firm characteristics and the quality of internal control over financial reporting, relative to non-family firms using a relatively large sample of S&P 500 firms.…”