The Impact Of Internal Control On The Cost Of Equity

Internal control is an important part of corporate governance system, in order to perfect capital market and improve the governance level of listed companies; the regulators released a series of standards and guides towards internal control, which turned the voluntary disclosure to mandate disclosure. These rules provide specific guidance for the promotion of internal control quality of listed companies on the one hand, and make market participants more informed on the other hand.According to the principal-agent theory and signaling theory, effective internal control will decrease accounting mistakes and reduce agent cost, and then improve the accrual quality and management efficiency, these are signals transmit to the market which will affect the valuation and decision process of investors, and move forward to influence the cost of equity. This paper empirically analyses the relationship between internal control efficiency and cost of equity.This paper chooses listed companies of SME board in2011as sample; analyzes the impact of mandated disclosure of internal control deficiencies (ICD) during internal control self-assess activities of Shenzhen Stock Exchange on cost of equity. The paper determines the quality of internal control and the type of ICD from archival analysis, and according to the frame of Basic Rules of Corporate Internal Control, the paper labeled the ICD as the five aspects of internal environment, risk assessment, control activity, information and communication, internal monitoring. This paper reflects the quality of internal control from the amount and type of ICD.This paper examines the impact on the cost of equity from the aspects of existence and disclosure of ICD.The results show that the cost of equity is higher for those companies with more ICDs, and among different types of ICDs, deficiencies of control activity and internal monitoring are more predictive for the cost of capital. It implies that companies with these two types of deficiencies are more likely to show poor accrual quality or ineffective management, and learned by the market before disclosure. For the study of disclosure effect, generally, after the disclosure of ICD, the market reaction are more intense for those disclose more deficiencies, as for the concern of ICD types, the reaction to deficiencies of internal environment and information&communication are more pronounced.There are several implications of this paper: as for the listed companies, they can lower down the cost of equity through effective internal control, as for the regulators, the mandated disclosure could decrease the information asymmetry between companies and investors, and alleviate agency problems.