Plenty of surveys and studies have tracked the dollars companies are spending to meet the internal control reporting requirements of Sarbanes-Oxley—but less is said or known about any positive effect improved controls might have on a company’s bottom line.
Now Corporate America might finally get some answers. A quartet of academics has scrutinized equity capital costs before and after disclosures of internal control problems, attempting to peg dollar amounts to reported deficiencies. While the technique still doesn’t create a bottom-line figure, observers say, it does wrap some hard numbers around marketplace assumptions.
In their report, “The Effect of Internal Control Deficiencies on Firm Risk and Cost of Equity Capital,” the four authors say that companies reporting internal control deficiencies have an increased risk of misstating their financials, which causes the cost of equity to increase by about 1 percent. For a company with a market capitalization of $1 billion, a 1 percent increase in capital cost would be equivalent to a $10 million movement.
Kinney
The study’s assessment of equity cost is based on data from Value Line, a research firm, and tracks expected return before and after companies announced news on internal controls, says William Kinney, a co-author of the study and professor at the University of Texas at Austin. The expected return derives from changes in share price and expected future earnings.
“This gives some indication that internal controls are valuable to a company,” Kinney explains. “The market in an overall way is agreeing with that.”
Schacht
Kurt Schacht, managing director with the Certified Financial Analysts’ Centre for Financial Market Integrity, says the study confirms what the market has sensed. “More honest and transparent financial reporting, achieved by stronger controls over such reporting, will reduce specific risk and the cost of capital for companies,” he says. “Investors do not want accounting and disclosure risk. They absolutely value efforts to reduce or eliminate that risk.”
Michael Tankersley, a lawyer with the firm Bracewell & Giuliani, is quick to note that the quality of internal controls “is not a direct cost to anyone,” but rather diffused throughout a company’s stock price. Still, he adds, the study supports “common sense conclusions. Companies with problems in their internal controls will be downgraded by the market. It stands to reason.”
The study also says that the market rewards corrections and pleasant surprises. When an auditor confirms that a company has corrected an internal control deficiency, the cost of equity capital drops by 131 basis points, or 1.31 percent. For the $1 billion company, that’s a $13.1 million decrease in the cost of equity. When a company is expected to report an internal control problem but instead gets a clean audit opinion, the cost of equity capital drops by 58.3 basis points, or 0.58 percent, equivalent to a $5.8 million decrease.
Kinney and his co-authors—Hollis Ashbaugh-Skaife of the University of Wisconsin at Madison, Daniel Collins of the University of Iowa, and Ryan LaFond of MIT’s Sloan School of Management—say the study creates a statistical link between internal control deficiencies, the risk of misstatement, and the ultimate cost of raising equity.
“Our study provides evidence that internal control risk matters to investors and that firms reporting strong internal controls or firms that correct prior internal control problems benefit from lower costs of equity capital beyond that predicted by other internal control risk factors,” they wrote.
EXCERPT
The excerpt below is from "The Effect of Internal Control Deficiencies on Firm Risk and Cost of Equity Capital," published in April 2006 by the University of Wisconsin-Madison's Hollis Ashbaugh-Skaife, the University of Iowa's Daniel W. Collins, the University of Texas' William R. Kinney, Jr., and the MIT Sloan School of Management's Ryan LaFond:
We use initial ICD [internal control deficiencies] disclosures provided by management and auditors’ opinions under SOX 404, along with the determinants of ICD disclosures, to structure change analysis tests designed to investigate whether initial ICD disclosures are related to predictable changes in firms’ cost of capital. Our change analysis reveals that ICD firms experience a statistically significant increase in market-adjusted cost of capital, averaging about 93 basis points, around the first disclosure of an ICD. Moreover, we find that ICD firms with the lowest probability of reporting internal control problems exhibit a greater cost of capital change (125 basis points on average) relative to those ICD firms with the highest likelihood of reporting control problems based on observable firm characteristics (49 basis points on average). This result is consistent with the market incorporating incomplete adjustments for internal control risks into firms’ cost of capital assessments prior to the revelation of which firms have ICDs, and then updating these risk assessments after ICDs are revealed …
In general, our findings indicate that firms that disclose an internal control problem experience a significant increase in market-adjusted cost of capital and firms that subsequently improve their internal control systems as evidenced by receiving an unqualified SOX 404 audit opinion exhibit a decrease their market-adjusted cost of capital. Our study provides evidence that internal control risk matters to investors and that firms reporting strong internal controls or firms that correct prior internal control problems benefit from lower costs of equity capital beyond that predicted by other internal control risk factors.
Source
Effect Of Internal Control Deficiencies On Firm Risk And Cost Of Capital (April 2006)
Capital Costs
One question for auditors and risk managers is how much the cost of equity really matters. Randy Marshall, managing director with the financial risk solutions practice of Protiviti, says companies generally aren’t as concerned about the cost of equity as they are about their debt ratings. “When looking for benefits of good internal controls, I’d zero in on the impact companies have on their capital structure and the cost of debt,” he says.
Marshall
Marshall says the rating agency Moody’s helped the market assess the significance of adverse internal control reports when it established “A” and “B” labels for such disclosures. An “A” report is viewed as isolated, not pervasive, and not likely to impact ratings, where a “B” report is considered a more serious concern regarding management’s ability and credibility. Companies in the B category are more likely to get a downgrade in their debt rating, and companies pay close attention to those changes, Marshall explains.
James Tholey, managing director with Accume Partners, said the Moody’s A and B assessments helped set the tone for how the market reacts to adverse internal control reports. In the first year of internal control reporting in 2005, with as many as 15 percent of all companies reporting problems, the market was “nonchalant,” he says.
As companies improve their controls and fewer report problems, the consequence will be more noticeable. “That noise is going to go away, and if you’re the only one still reporting problems the market will react,” he says.
Tholey agrees the cost of debt is at least as serious a concern for companies as the cost of equity. “Bankers are starting to put the heat on even private companies with poor controls,” he says, as are bond holders for private companies with public debt.
Tholey
Tholey is circumspect about whether the study gives hard data that helps establish the Holy Grail of identifying a cost/benefit relationship for Sarbanes-Oxley compliance. “The cost-benefit relationship is still arguable,” he says; the market is still reflecting on the “manifold benefits,” like better information for decision-making, better accountability, and so forth.
Sanjay Anand, chairman of the Sarbanes-Oxley Institute, says he welcomes more industry-specific or country-specific analysis. “The biggest thing that is missing for me from such broad-sweeping studies is that they tend to over-generalize,” he says. “Nevertheless, it is a good start in the quantification of an otherwise qualitative hypothesis.”
Tankersley
Tankersley at Bracewell & Giuliani believes the better evidence of internal control improvements so far is still anecdotal rather than statistical. He cites the example of a personal friend who serves on the board of a public company, where the CEO was annoyed by the $1 million the company spent on SOX compliance in its first year.
“Their internal control review found a glitch in their pricing software that would have caused them to overstate revenues by about $2 million,” a certain recipe for restatement, Tankersley recounts. His friend, meanwhile, “has seen a remarkable turnaround in the CEO’s attitude about the 404 process since they made that discovery.”
Tankersley says SOX compliance also has created a culture that can’t be measured in numbers, but that surely will boost companies in the long term. “It has conveyed to employees that controls are important,” he explains. “That has an uplifting effect on the effort to produce accurate reports and to not go along with efforts to game the system.”
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