Internal Control Weakness and Investment Efficiency: Evidence from Korea

The Committee of Sponsoring Organizations of the Treadway Commission (hereafter COSO) Internal Control Integrated Framework states that adequate internal control helps firms to achieve effective and efficient operations. To empirically validate this argument, I test the relation between weakness in internal control over financial reporting (hereafter ICW) and investment. Prior literature finds that firms tend to over-invest when they have enough financing capacity and under-invest when they lack financial resources and this inefficient investment behavior is exacerbated as information asymmetry grows. As firms reporting ICW have a lower quality of financial information and weaker corporate governance, I predict that ICW firms invest less efficiently than other firms. From 7,434 firm-year observations from Korea, I find that, on average, ICW firms are associated with over-investment but not with under-investment. The finding is different from Cheng et al. (2013) which report both over- and under-investment of ICW firms in the U.S. To further investigate why over-(under-) investment is (not) observed for ICW firms in Korea, I compare the external financing activities of ICW firms with benchmark firms. On the contrary to the prediction that capital providers will allocate less capital to firms with high information asymmetry and low accounting quality, ICW firms finance as much capital as other benchmark firms. This finding warns investors to carefully allocate capital to ICW firms and underlines the importance of monitoring the investment decision of ICW firms. This paper finds evidence that effective internal control facilitates efficient decision making as the COSO states. It also reveals that ICW firms raise as much external capital as other firms, which explains why over-investment is observed while under-investment is not observed. The findings of this paper show that investors and regulators should be more cautious on the allocation of capital to ICW firms and increase monitoring level to those firms.