Reputed Inside Directors and Internal Control Effectiveness

The proposed research aims to provide systematic evidence on the impact of non-CEO inside directors on a company’s internal control over financial reporting. Internal control over financial reporting is “a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP” (PCAOB 2007). Internal control effectiveness is an important indicator of financial reporting quality and has become a topical issue after a number of accounting scandals and the subsequent passage of the Sarbanes-Oxley Act (SOX) of 2002.

Inside directors are firm managers that sit on the board of directors. There are two conflicting views on the role of inside directors. Conventional agency theory suggests that inside directors are dependent on the CEO for their continued employment, compensation, and private benefits. In contrast, efficient contracting theory suggests that if properly motivated, non-CEO inside directors can use their valuable firm-specific information to improve the communication between firm management and outside investors and the monitoring of CEOs. Given the above conflicting views, the proposed research intends to provide evidence on two interrelated issues: (1) whether and how reputed non-CEO inside directors (RIDs) affect the existence of internal control weaknesses (ICWs); (2) whether the effect of RIDs is conditioned upon the type of ICWs, i.e., company-level versus account-level ICWs.

The proposed research hopes to contribute to the literature in several ways. First, the proposed research will add to the studies examining the determinants of internal control effectiveness. As the reputation concern is an implicit incentive for board directors to effectively perform their duties, it is worthwhile to investigate whether and how RIDs can affect a company’s internal controls. Second, although theoretical research has explored the role of inside directors from several perspectives, there is sparse empirical evidence. The propose research thus contributes to the growing literature by providing new evidence in this area. Third, the proposed research will have policy implications for regulators. The governance reforms mandated by the SOX recommend greater outside representation on the board, but pay little attention to the value of inside directors. In this sense, the proposed research sheds light on the future governance reforms.