“Regulators keep exempting more firms from complying with internal control audits because of the costs,” said Chan Lin, the C.A. Scupin Professor at the University of Kansas School of Business. “Not only is the cost high, but firms often don’t see the value. They assume that since management is conducting the internal control evaluation themselves, the auditor’s opinion doesn’t matter. That’s why it’s controversial.”
Lin’s article, titled “Does the Presence of an Internal Control Audit Affect Firm Operational Efficiency?”, explores how auditors’ evaluations and reports of Internal Control over Financial Reporting (ICFR) impact firm efficiency. While previous research suggests that strong controls are associated with economic benefits, this study reveals that small firms with ICFR audits demonstrate significantly higher overall efficiency than those relying only on management ICFR reports. The study, co-authored with Andrew Imdieke of the University of Notre Dame and Shan Zhou of the University of Sydney, appears in Contemporary Accounting Research.
The study analyzed firms with market values of $150 million or less from 2007 to 2019, comparing operational efficiency between those with ICFR audits and those without, while accounting for internal control quality and firm-specific factors. The findings show that improvements are reflected in areas like inventory turnover and corporate innovation.
“We examined the relationship between internal control audits and a firm’s operational efficiency,” Lin explained. “Our argument is that managers should rely on accurate numbers from the financial reporting system to make better operational decisions. If the internal financial reporting system produces high-quality information, management will make better decisions.”
The research identified two ways ICFR audits could enhance operational efficiency: auditors detect Internal Control Material Weaknesses (ICMWs) that might otherwise go unnoticed, and they provide managers with best practice recommendations during the ICFR evaluation process.
“We also found that the positive effect on operational efficiency is evident in the improvements in inventory turnover and innovation,” Lin added.
However, the study unexpectedly found that internal control audits could reduce the effectiveness of Selling, General, and Administrative (SG&A) expenses. “This might be partially due to the higher audit fees associated with internal control audits,” Lin noted.
In 2020, the SEC amended the definitions of “accelerated filer” and “large accelerated filer,” exempting more smaller issuers from complying with Section 404(b) of the Sarbanes-Oxley Act. This section requires public companies to assess the effectiveness of their internal controls over financial reporting. The new requirements exempt firms with a public float between $75 million and $700 million from internal control audits, as long as their revenues are below $100 million.
Despite these exemptions, Lin’s team found that firms previously subject to ICFR audits still benefited from improved operational efficiency. The removal of the mandate may prevent similar firms from realizing these benefits in the future.
“The lesson here is clear: internal audits have value,” Lin emphasized. “When regulators exempt more firms from internal control audits, they may inadvertently harm operational efficiency.”