Internal control effectiveness is an important indicator of financial reporting quality. This study investigates whether reputable inside directors impact a firm’s internal control over financial reporting. Using a large sample of Standard & Poor’s 1500 firms from 2004 to 2012, we find that firms with reputable inside directors are less likely to have reported and likely internal control weaknesses and the association is more pronounced when (1) firms have higher needs for monitoring; (2) firms have higher costs of misreporting; (3) the reputable inside directors have higher reputational concerns; and (4) the reputable inside directors have no connections with the chief executive officers. We also find that the likelihood of remediating internal control weaknesses is significantly increased when new reputable inside directors join a firm. These findings enrich prior empirical studies examining the determinants of internal control weaknesses and have corporate governance policy implications for regulators by supporting the desirable role of inside directors.
ABSTRACT
The rise of index funds, or passive investing, in recent decades has caused heated debates over the efficacy of passive investors’ stewardship role in corporate governance. Our study adds to this emerging line of literature by examining whether passive investors enhance the quality of financial statement audits, a key aspect of corporate governance mechanisms. We follow [Appel, I. R., Gormley, T. A., & Keim, D. B. (2016). Passive investors, not passive owners. Journal of Financial Economics, 121(1), 111–141. https://doi.org/10.1016/j.jfineco.2016.03.003] we exploit the yearly Russell index reassignment, which provides us with an ideal setting to study the causal relation between passive institutional investors (i.e., index trackers) and firms’ audit quality. Examining firms closely surrounding the Russell 1000/2000 cutoff line, we find that higher passive ownership leads to higher audit quality proxied by audit fees. To investigate the channel through which passive investors influence audit-related governance issues, our evidence from auditor ratification voting records suggests that passive investors do ‘voice’ their opinion on low-quality audits. Such effort also leads to a higher likelihood of auditor turnover in the following year. In the cross-sectional analysis, we also find that the positive effect of passive investors on audit quality is more pronounced in firms with higher agency costs. Thus, our study supports the view that passive investors play an active role in improving corporate governance.
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