Internal Control Quality and Information Asymmetry in the Secondary Loan Market
Dina El-Mahdy
Chapter 7 Summary and Conclusion
Limited research examines the impact of the quality of financial reporting on the secondary loan market (Ball, Bushman, and Vasvari 2008; Yu 2007; Gaul and Uysal, 2009; Moerman, 2008). To the best of my knowledge, examining the association between the disclosures of Internal Control quality on information asymmetry in the secondary loan market has been missing from this line of research. The main purpose of my study is to void the missing link in prior literature by testing the association between the disclosure of IC effectiveness and information asymmetry in the secondary loan market. An effective internal control system is an indication on the creditworthiness of the business environment and quality of financial reporting. Likewise, the presence of Internal Control Deficiencies is a sign that information provided to management for the decision-making process contains errors and that assets are not protected. Considering that assets are the collateral in any loan agreement, if these assets are not protected, then collateral will be viewed by creditors as overvalued assets. Therefore, to the extent that assets are not protected in a firm, creditors must account for the high risk associated with their investment in such firms by increasing the cost of borrowing. Likewise, credit rating agencies might lower the credit rating of such risky firms.
The primary objective of this study is tri-fold. First, it examines the association between the disclosure of the IC quality as a proxy for the firmrsquo;s informational environment, and information asymmetry in the secondary loan market. Second, it identifies which types of IC weaknesses exacerbate conditions of information asymmetry in the secondary loan market. Third, it investigates whether firms that remediate or take corrective actions to address IC weaknesses lead to a reduction in information asymmetry in the market. Moreover, this study examines the effect of the loan specific characteristics in the secondary loan market on the association between internal control deficiencies and information asymmetry.
To the best of my knowledge, my study is the first to integrate the quality of IC and information asymmetry in the secondary loan market into one paradigm. My study extends numerous research on the association between the quality of accounting information and information asymmetry or cost of capital. For example, my study differs from and extends the study by Beneish, Billings and Hodder (2008). It also extends research on audit quality (DeAngelo, 1981, Teoh and Wong, 1993, Krishnan, 2005) because I compare two SOX 2002 provisions, section 302 is unaudited disclosure of ICDs and section 404 is audited disclosure of ICMWs. My work extends the study made by Moerman (2008), which finds that timely loss recognition, as a measure of financial reporting quality, decreases information asymmetry in the secondary loan market. Furthermore, my study extends research by Ashbaugh-Skaife, Collins, Kinney, and Lafond (2009), which argues that firms that failed to remediate their Internal Control Deficiencies (ICDs) receive an adverse SOX 404 opinion for the period after the ICDs disclosure, and consequently, experienced a higher cost of equity capital. Moreover, my study contributes to resolving the mixed evidence on the association between disclosure of material weaknesses and cost of capital.
To test my hypothesized relationships, I focus on four main predictions: the association between IC disclosure and information asymmetry, types of ICDs and information asymmetry, IC remediation and information asymmetry, and the effect of the loan-specific characteristics on the association between ICDs and information asymmetry. I based my prediction on the premise that the disclosure of ineffective ICs affects past, present and future financial reporting (Irving, 2006) because the internal control system is providing information to internal managers and market-wide participants for decision making for purposes such as buying and selling decisions, ratings by credit agencies, loan decisions, and rating firm creditworthiness.
The descriptive statistics of firms with ICDs reveal that firms with reported ICDs are generally small, poorer performers, financially weaker, and with higher market risk. These results are documented by multiple studies (Bryan and Lilien, 2005; Ge and McVay, 2005; Doyle, Ge and McVay 2007 a,b; Ashbaugh-Skaife, Collins, and Kinney, 2007, Ashbaugh-Skaife, Collins, Kinney, and LaFond, 2008). I also found strong evidence to support the claim that firms that disclose ICDs have significant positive association with IAs. The positive significant association between information asymmetry and ICDs suggests that the quality of accounting information matters in the secondary loan market. Additionally, on average, firms with ICDs are experiencing higher means and medians of IAs than firms with effective IC systems. In other words, effective IC systems serve the same function that other proxies of the quality of accounting information do, such as fill the role of timely loss recognition the secondary loan market (Moerman, 2008.)
Theoretically, proponents of section 302 might argue that it results in incremental value because it discloses Internal Control Deficiencies (ICD) which includes both material weaknesses and significant deficiencies. Nevertheless, I argue in my hypothesis development section and suggest, based on the results of my statistical analyses, that disclosing significant deficiencies causes variability in stakeholdersrsquo; beliefs in two ways. First, stakeholders might perceive a reported significant deficiency as bad news as it might become a material weakness in the future. Second, stakeholders might also perceive a significan
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