Reputable inside directors and internal control effectiveness

The study investigates whether non-CEO inside directors with reputation incentives affect the effectiveness of a firm’s internal control over financial reporting. Internal control effectiveness is an important indicator of financial reporting quality. Using a large sample of 7,352 firm-year observations from 2004 to 2012, we find that firms with RIDs are less likely to report internal control weaknesses (ICWs). We also find that RIDs have a more pervasive impact on account-level ICWs than company-level ICWs. Empirical results also demonstrate that the association between RIDs and ICWs is more pronounced for firms with lower audit quality, higher CEO entrenchment, and higher cost of misreporting. These findings add to the few empirical studies examining the determinants of ICWs and have corporate governance policy implications for regulators by supporting the desirable role of inside directors in terms of efficient contracting.