Causes and Effects of Internal Control Outcomes

Causes and Effects of Internal Control Outcomes
-Final Thesis-

Universiteit Maastricht
Faculty of Economics and Business Administration
Maastricht, February 21th, 2008
Martina Kratz
ID: 239232
Master International Business – Concentration Finance
Supervisor: Robin Braun

Abstract

Since the implementation of the Sarbanes-Oxley Act in 2002, the topic of internal control systems never came to rest. The current subprime crisis is just one example of internal control failures and their negative consequences. Other severe cases, where internal control failures lead to earnings management, fraud and misstatements of financial reports, are Enron,
WorldCom or Global Crossing. This paper analyses causes and effects of internal control outcomes. Corporate governance structures might influence the effectiveness of internal controls systems. This proposition is tested with regressions on a US dataset for the period of
2005 until 2007. A positive relation between corporate governance structures and internal control outcomes is found. By paying attention on well functioning governance mechanisms, organizations are able to optimize their internal control results. In contrast to optimal control structures stand failures of internal controls. Failures of internal controls can lead to a stock price drop after the announcement day because investors lose confidence in the company and withdraw their funds. This hypothesis is tested with the use of event studies of 100 US companies in the period of 2005 till 2007 and can be supported in the short-run. The assumption of a continuing poor stock price movement after the event day can be rejected.

1

Table of Contents

1. Introduction

3

2. Literature Review

5

2.1. Historical background

5

2.2. Earnings management

8

2.3. Internal controls

10

2.4. Contribution to the empirical body of research, expectations and hypothesis

11

3. Data and Methodology

13

3.1. Sample construction to test for internal control outcomes

13

3.2.

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