Reputable Inside Directors and Internal Control Effectiveness

Abstract

Internal control effectiveness is an important indicator of financial reporting quality. This study investigates whether reputable inside directors impact a firm’s internal control over financial reporting. Using a large sample of Standard & Poor’s 1500 firms from 2004 to 2012, we find that firms with reputable inside directors are less likely to have reported and likely internal control weaknesses and the association is more pronounced when (1) firms have higher needs for monitoring; (2) firms have higher costs of misreporting; (3) the reputable inside directors have higher reputational concerns; and (4) the reputable inside directors have no connections with the chief executive officers. We also find that the likelihood of remediating internal control weaknesses is significantly increased when new reputable inside directors join a firm. These findings enrich prior empirical studies examining the determinants of internal control weaknesses and have corporate governance policy implications for regulators by supporting the desirable role of inside directors.