The Role of Internal Control Disclosure in Financial Reporting Precision and the Quality of Audited Financial Reports

Abstract

We study the impact of internal control disclosure in a model in which a client company privately invests corporate resources in its internal control system that subsequently determines its financial reporting precision. Without internal control disclosure, the capital market cannot observe the precision and must price the client value based on its conjecture. With internal control disclosure requirements, the effectiveness of internal controls is disclosed, which reveals the precision to the market. Thus, internal control disclosure provides the client with another channel to influence the market pricing. Contrary to the conventional wisdom, we find that the client tends to invest less in its internal control system with disclosure requirements. As a result of lower precision, internal control disclosure may lower the informativeness of audited financial reports, albeit ex-post communicating more information to the market. We also find that internal control disclosure reduces the client’s ex-ante payoff when the auditor bears a high misstatement cost due to audit failure.JEL Classification: M41, M48