Internal control quality and relationship‐specific investments by suppliers and customers

• DOI: http://doi.org/10.1111/jbfa.12396
• Published date: 01 October 2019
• Date: 01 October 2019
• Author: Shu‐Miao Lai

DOI: 10.1111/jbfa.12396

Internal control quality and relationship-specific

investments by suppliers and customers

Shu-Miao Lai

National TaiwanOcean University, Taiwan,

Republic of China

Correspondence

Shu-MiaoLai, National TaiwanOcean University,

2Pei-Ning Road, Keelung, Taiwan,Republic of

China.

Email:r89341026@ntu.edu.tw

Fundinginformation

Ministryof Science and Technology (former

NationalScience Council) (NSC 101 2410-H-424

-013).

Abstract

This paper investigates the association between the quality of

internal control over financial reporting (ICOFR) and relationship-

specific investments by suppliers/customers. I find a significant

negative association between the disclosure of a material weak-

ness (MW) in ICOFR and changes in the relationship-specific

investments of suppliers/customers. Relationship-specific invest-

ments of suppliers/customers have a stronger negative associa-

tion with inventory-related MW. The negative association between

MW disclosures and the relationship-specific investments of sup-

pliers/customers is stronger when economic dependence between

the firms and the suppliers/customers is more important and when

the suppliers/customers have greater bargaining power. Also, sup-

pliers/customers significantly increase their relationship-specific

investments following the remediation of ineffective ICOFR. Over-

all, my findings show that a firm’s quality of ICOFR affects the

relationship-specific investment decisions of suppliers/customers.

KEYWORDS

customers, internal control weaknesses, relationship-specific invest-

ments, section 404 reporting, suppliers

1INTRODUCTION

In response to a wave of accounting scandals, the US Congress passed the Sarbanes–Oxley Act (SOX) in July 2002.

Section 404 of SOX requires all public firms to assess the effectiveness of their internal control over financial report-

ing (ICOFR) and to provide periodic auditor-attested evaluations of internal control effectiveness. Specifically, audi-

tors are required to issue an adverse opinion on the ICOFR when material weaknesses (MW) exist (Public Company

Accounting Oversight Board [PCAOB]Standard No. 2 and No. 5).1The fundamental reason for this requirement is that

1Under Section 404 of SOX,MW is the key concept in evaluating the effectiveness of internal controls. PCAOB defines a MW as a significant deficiency or a

combinationof significant deficiencies that result in more than a remote likelihood that a material misstatement on the annual or interim financial statements

willnot be prevented or detected (PCAOB Auditing Standard No 2, 2004). Section 404 requires external auditors to report MWs in their reports if one or more

MWs existin a company’s ICOFR. On 24 May 2007, the PCAOB adopted Auditing Standard No. 5, which replaces the term ‘more than a remote likelihood’

with‘reasonably possible’ when defining MWs in internal controls. Auditing Standard No. 2 was in effect during my sample period.

J Bus Fin Acc. 2019;46:1097–1122. wileyonlinelibrary.com/journal/jbfa c

2019 John Wiley & Sons Ltd 1097

1098 LAI

ineffective ICOFR leads to low-quality financial reporting, which, in turn, affects the quality of the information used by

firms’ stakeholders such as managers, tradingpartners, investors and creditors to make decisions.

Iuse the disclosure of the Section 404 report to examine whether, and if so, how, a firms’ quality of ICOFR (measured

by the disclosure of MW in ICOFR) affects relationship-specific investmentsby the firms’ suppliers/customers. Suppli-

ers/customers dealing with a firm in the product marketsoften undertake relationship-specific investments. Because

such specialized investments have design characteristics that are specific to a particular firm, their value to suppli-

ers/customers depends on the future prospects of the business relationship (Raman & Shahrur, 2008; Williamson,

1975). Accordingly,the perception of a firm’s financial condition can either motivate or dissuade suppliers/customers

from undertaking relationship-specific investments.

Extant research suggests that a firm’s suppliers/customers use accounting performance to assess the firm’s long-

term financial viability and the risk of making relationship-specific investments (Bowen, DuCharme, & Shores, 1995;

Hui, Klasa, & Yeung,2012; Raman & Shahrur, 2008; Titman, 1984). Several studies indicate that the quality of ICOFR

affects the quality of accounting information (Ashbaugh-Skaife, Collins, Kinney, & LaFond,2008; Doyle, Ge, & McVay,

2007a). More important, the quality of ICOFR affects the efficiency of investment and operation decisions within a

firm (Cheng, Dhaliwal, & Zhang, 2013; COSO, 2006; Feng, Li, McVay, & Skaife, 2015; Kinney,2000). Although these

findings suggest that a firm’s quality of ICOFR can affect its suppliers’/customers’ perception of potential revenuesof

undertaking relationship-specific investments, the literaturehas yet to investigate this topic. This study fills that gap.

I hypothesize that ineffective ICOFR is negatively associated with a change in relationship-specific investmentsby

suppliers/customers. Ineffective ICOFR can reflect a decrease in expectedfuture cash flows (operating performance)

and/oran increase in information uncertainty (Beneish, Billings, & Hodder, 2008; Feng etal., 2015; Hammersley, Myers,

& Shakespeare, 2008; Ogneva, Subramanyam, &Raghunandan, 2007). As such, the disclosure of a MW in ICOFR can

damage a firm’s reputation, thereby leading suppliers/customersto reduce relationship-specific investments.

Totest this hypothesis, I examine a sample of firms that disclosed internal control reports under Section 404 from

2004 to 2009 in the Audit Analytics database. I take firms with adverse Section 404 reports as a measure of firms

with a MW in ICOFR (MW firms) and control firms with clean Section 404 reports (non-MW firms). I use the approach

of Fee and Thomas (2004), Hertzel, Li, Officer, and Rodgers (2008), Pandit, Wasley, and Zach (2011), and Raman

and Shahrur (2008) to identify firms’ major suppliers/customers with Section 404reports. Following previous studies

(e.g., Fee, Hadlock, & Thomas, 2006; Kale & Shahrur,2007; Raman & Shahrur, 2008), I use the research and develop-

ment (R&D) intensity of suppliers/customersto measure the importance of the trading partners’ relationship-specific

investments.

After correcting for the self-selection bias by using the Heckman two-stage approach and propensity score match-

ing model, I come to severalmain conclusions. First, I find a significant negative association between the disclosure of a

MW in ICOFR and changes in the relationship-specific investmentof suppliers/customers. That is, suppliers/customers

significantly shrink their relationship-specific investments in a firm after the disclosure of a MW in ICOFR. This find-

ing is consistent with the notion that a firm’s quality of ICOFR affects its suppliers’/customers’ relationship-specific

investmentdecisions and thus shows that the quality of ICOFR plays an important role in the supply chain relationship.

Second, suppliers’/customers’ R&D intensity has a stronger negative association with inventory-level MW. Feng

et al. (2015) suggest that inventory-related MW can cause poor inventory management, which results in a mismatch

between inventory supply and demand, thereby leading to poorer operatingperformance. Their findings suggest that

inventory-relatedMW has a direct effect on inputs demand (outputs supply) for suppliers (customers), thereby leading

to the change in suppliers’ (customers’) relationship-specific investments for the MW firm. Because the disclosure of

a MW in ICOFR provides information about a MW firm’s lower operating performance, inventory-related MW has a

stronger negative association with suppliers’/customers’relationship-specific investments.

Third, the negative association between changes in suppliers’/customers’R&D intensity and the disclosure of a MW

in ICOFR is stronger when the economic links between MW firms and the supplier/customer are more important.

Specifically, firm’s disclosure of internal control problems affects the suppliers’/customers’R&D intensity only if the

MW firm is important to the supplier/customerand if the supplier/customer has greater bargaining power.