Does Ineffective Internal Control over Financial Reporting affect a Firm’s Operations? Evidence from Firms’ Inventory Management

We investigate whether ineffective internal control over financial reporting has implications for firm operations by examining the association between inventoryrelated material weaknesses in internal control over financial reporting and firms’ inventory management. We find that firms with inventory-related material weaknesses have systematically lower inventory turnover ratios and are more likely to report inventory impairments relative to firms with effective internal control over financial reporting. We also find that inventory turnover rates increase for firms that remediate material weaknesses related to inventory tracking. Remediating firms also experience increases in sales, gross profit, and operating cash flows. Finally, we assess the generalizability of our findings by examining all material weaknesses in internal control over financial reporting, regardless of type, and provide evidence that firms’ returns on assets are associated with both their existence and remediation. Collectively, our findings support the general hypothesis that internal control over financial reporting has an economically significant effect on firm operations. We appreciate comments from two anonymous reviewers, Bin Ke (editor), John Harry Evans III, Ed deHaan, Lynn Hanna, Jim Irving, Glen Schmidt, and workshop participants at the 2012 AAA Annual Meeting, Arizona State University, the 2011 University of Alberta Research Conference, Georgia State University, University of Pittsburgh, The University of Tennessee, the 2012 Western Region AAA Meeting, and the 2012 Yale Summer Accounting Conference. We thank Michelle Frank, Sehan Kim, Sara Toynbee, Amy Yurko, and Xiao Xiao for their research assistance. An earlier version of this paper was circulated under the title ‘‘Ineffective Internal Control over Financial Reporting and Firm Operations.’’ Editor’s note: Accepted by Bin Ke. Submitted: December 2012 Accepted: August 2014 Published Online: September 2014