Internal Control Disclosures, Monitoring, and the Cost of Debt

TLDR

The study explores how internal control disclosures influence debt costs, underscoring a gap in understanding the differential impact of monitoring on debt versus equity. The authors test whether a firm’s change in cost of debt is related to the disclosure of a material weakness in its initial Section 404 report. They analyze the role of credit rating agencies and banks, finding that the cost‑spread effect is stronger for firms lacking such monitoring. Disclosing a material weakness marginally raises a firm’s publicly traded debt credit spread, an effect amplified when the firm is not monitored and driven mainly by bank monitoring, supporting the view that banks serve as effective delegated monitors.

Abstract

ABSTRACT We test the relationship between the change in a firm's cost of debt and the disclosure of a material weakness in an initial Section 404 report. We find that, on average, a firm's credit spread on its publicly traded debt marginally increases if it discloses a material weakness. We also examine the impact of monitoring by credit rating agencies and/or banks on this result and find that the result is more pronounced for firms that are not monitored. Additional analysis indicates that the effect of bank monitoring appears to be the primary driver of these monitoring results. This finding is consistent with the argument that banks are effective delegated monitors for the debt market. The results of this study suggest the need for future research, particularly to test the differential effects of monitoring on the cost of debt compared to the cost of equity.