Private lenders and borrowers’ internal control weaknesses

• Published date: 01 October 2021
• Author: Md Mahmudul Hasan
• Date: 01 October 2021
• DOI: http://doi.org/10.1002/jcaf.22517

Received: 24 June 202 1Accepted: 10 August 2021

DOI: 10.1002/jcaf.22517

RESEARCH ARTICLE

Private lenders and borrowers’ internal control weaknesses

Md Mahmudul Hasan

School of Accountancy, Strome College of

Business, Old Dominion University,

Norfolk, Virginia, USA

Correspondence

MdMahmudul Hasan, School of Accoun-

tancy,Strome College of Business, Old

DominionUniversity, Norfolk, Virginia,

USA.

Email:mmhasan@odu.edu

Abstract

This study examines whether the presence of private lenders is associated with

the effectiveness of borrowers’ internal controls. I provide evidence that the pres-

ence of private lenders is an important determinant of internal control weak-

nesses in borrower firms. To monitor loan contracts, lenders use borrowers’

financial information, reliability of which to a great extent depends on the effec-

tiveness of borrowers’ internal controls. I argue that lenders are likely to influ-

ence borrowers to maintain effective internal controls so that they can reliably

use borrowers’ financial reporting information. Using a battery of tests, I find

that the presence of private lenders has a significant negative association with

the probability of borrowers’ disclosing a material weakness in internal controls.

KEYWORDS

debt contracts, internal controls, private lenders

“The influence of banks and other private

lenders pervades public companies. From

the first day of a lending arrangement, loan

covenants and built-in contingency provisions

affect managerial decision making.”

- Frederick Tung, UCLA Review

1 INTRODUCTION

In the process of obtaining financial capital from debtors

and shareholders, firms enter into many contractual rela-

tionships with capital providers. Different parties to these

contracts have divergent interestscreating agency conflicts

and arising the need for monitoring mechanisms to alle-

viate these conflicts (Jensen & Meckling, 1976). Private

lenders (i.e., banks, insurance companies) work as dele-

gated monitors to ensure timely repayments and returns

on their loans (Diamond, 1984). To monitor loan contracts,

lenders use information from borrowers’ financial reports,

the reliability of which to a great extent depends on the

effectiveness of borrowers’ internal controls over financial

reporting. Lenders monitor borrowers’ financial reporting

information to ensure timely repayments and returns on

their loans and to assess current and likely future compli-

ance of debt covenants. Lenders are likely to influence bor-

rowers to maintain effective internal controls so that they

can trust the financial numbers reported by the borrow-

ers. This study examines whether the presence of private

lenders is associated with the effectiveness of borrowers’

internal controls.

Prior literature documents many negativeconsequences

of ineffective internal controls. For example, firms with

ineffective internal controls are associated with poor finan-

cial reporting quality, higher cost of equity, less accurate

management guidance, inefficient investment behavior,

and increased risk of financial reporting fraud by top man-

agers (Ashbaugh-Skaife et al., 2008; Cheng et al., 2013;

Donelson et al., 2017; Doyle et al., 2007a; Feng et al.,

2009; Järvinen & Myllymäki, 2016; Lenard et al., 2016;

Ogneva et al., 2007). Lenders rely on numbers from finan-

cial reports to assess the default risk and creditworthiness

of the borrowers. Effective internal controls in a firm may

ensure the reliability of the financial numbers reported and

J Corp Account Finance. 2021;32:71–83. © 2021 Wiley Periodicals LLC71wileyonlinelibrary.com/journal/jcaf