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Internal control quality and information asymmetry in the secondary loan market

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Abstract

We examine the association between disclosure of internal control deficiencies (ICDs) and information asymmetry (IA) in the US secondary loan market. We also investigate which types of ICDs intensify or mitigate conditions of information asymmetry in the same market. Relying on loan syndication, loan credit rating, financial debt covenants and loan size, we further explore the effect of loan specific characteristics on the association between ICDs and IA. Consistent with our predictions, we find that while ICDs increase information asymmetry in the secondary loan market, the inimitable characteristics in the secondary loan market (e.g., syndication, loan credit rating, financial covenants, and loan size) help to mitigate such negative consequences of the disclosure of ICDs on the firm’s informational environment. We further find that disclosures of ICDs for firms in regulated industries help to mitigate the negative consequences of ICDs disclosures on IA.

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Notes

  1. The secondary loan market is the place where the initial loan is sold by the primary lender (lead arranger) to multiple lenders (multiple arrangers) after the close of the primary loan.

  2. LPC web page: http://www.loanpricing.com/analytics/pricing_service_volume1.html.

  3. An effective IC system is defined as a system that is free from material weaknesses, whereas an ineffective system is a system with one or more significant deficiencies. Quality of IC is disclosed under Sarbanes–Oxley Act 2002—IC related provisions to public registrants accompanying footnotes in various statutory filings such as: Item 9A of Form 10-K, Item 4 of Form 10-Q, and 8-K forms (Irving II 2006).

  4. Dhaliwal et al. (2011) examine the association between the disclosure of the firm’s credit spread and material weaknesses disclosed under section 404 in the secondary bond market, a public debt market.

  5. The Public Company Accounting Oversight Board (PCAOB) issued AS No. 2 (PCAOB 2004): “An Audit of Internal Control over Financial Reporting Performed in Conjunction with an Audit of Financial Statements”. AS No. 2 was issued following the issuance of SOX 2002—section 404 to assist auditors in issuing an opinion on the effectiveness of their public company clients’ internal control. It provides new detailed responsibilities and extensive procedures on both auditors and their clients (public firms). It further differentiates between the external auditors’ and management’s responsibilities regarding evaluating and reporting internal control material weaknesses.

  6. The PCAOB released Auditing Standard No. 5 (PCAOB 2007): “An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements-and Related Independence Rule and Conforming Amendments”—to amend the previously issued AS No. 2. AS No. 5 is issued to provide additional clarity, direct the external auditors’ focus on the most important matters in auditing the internal control over financial reporting, and further eliminate unnecessary audit work previously stipulated by AS No. 2.

  7. Prior to IC disclosures (section 302 and section 404) related to SOX 2002, disclosure of internal control was only required when changing auditors (Haron et al. 2010).

  8. On July 1, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was enacted and permanently exempted non-accelerated filers from section 404(b); however, non-accelerated filers are still required to comply with Section 404(a).

  9. Adverse selection is a situation where buyers and sellers have different information about the same product. Ivashina (2009) argue that adverse selection problem in the syndicated lending is due to the lead bank’s incentives to syndicate high risk loans. Also, a moral hazard problem exists because of the lead bank’s less rigorous monitoring incentives after selling high risk loans. Although the lead bank resells the loan after its closing, the lead bank still responsible for monitoring the borrower. When lead bank retain larger portion of the loan, the loan is less syndicated, the information asymmetry between lead bank and participants is expected to go down because participant bank will demand lower premium.

  10. Facility is a loan granted to a firm. A firm might have a number of facilities during one accounting period.

  11. We used the log transformation for key variables such as: Assets and Loan size.

  12. Wittenberg-Moerman (2008) claim that use of the bid-ask spread might be problematic because it includes an adverse selection component and a transitory component. The adverse selection component is the asymmetric information, and the transitory component is the inventory and order processing costs of market makers that can be measured by the number of market makers and could be endogenously associated with the IA. Information asymmetry is the adverse selection component in the bid-ask spread.

  13. Remediation can be captured by SOX section 404 unqualified opinion (Ashbaugh-Skaife et al. 2008; Goh 2009), or by the difference in internal control disclosure in year t + 1 or t − 1 and the indicator variable in year t as suggested by (Feng et al. 2009), or remediation actions by the management (Ashbaugh-Skaife et al. 2008). Following Feng et al. (2009), we identify firms that took remediation actions to correct their internal control deficiencies. We only include firms that took serious steps to correct their internal control deficiencies. For example, in period t − 1, a firm might disclose internal control deficiencies related to competency of their human resources, merger and acquisition and foreign-related issues. In period t, the same firm might disclose internal control deficiencies related to only merger and acquisition. In this latter case, the firm partially remediated their internal control deficiencies and we consider this case “remediation”. Alternatively, in period t, the firm might disclose effective internal control system and in this case, the firm fully remediated their internal control deficiencies and we considered this case “remediation”. Although there could be some firms in the process of remediating their internal control deficiencies that include such statements in their financial statements to outsiders, such disclosed intent to correct ICDs was not recognized as remediation.

  14. The Big-6 audit firms include: Deloitte, KPMG, Ernst & Young, PricewaterhouseCoopers, BDO Seidman and Grant Thornton.

  15. In categorizing the internal control deficiencies as either company level (CL) or account-specific (AS), we classified weaknesses in internal control related to any accounts such as: inventory, accounts receivables, loan receivables, gain or loss recognition issues, liabilities, reserves, tax expense, depreciation, depletion or amortization issues, and financial derivatives as account-specific (AS) weaknesses in internal control. With the same token, we classified weaknesses in internal control related to company level issues such as: acquisition, merger, disposal or reorganization issues deferred, stock-based or executive compensation issues, intercompany issues, foreign, related party, consolidation, affiliated and/or subsidies issues as company-level (CL) weaknesses in internal control. We then manually coded firms with CL with 1 and firms with AS with zero.

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Acknowledgments

We thank the editor and two anonymous reviewers for their constructive comments. We also thank Carolyn Norman, Benson Wier, Jong Eun Lee, Manu Gupta, Ivo Jansen, and participants of the 2012 American Accounting Association Mid-Atlantic conference for their helpful comments.

Author information

Authors and Affiliations

  1. Earl G. Graves School of Business and Management, Morgan State University, McMechen Commerce Building, 1700 E. Cold Spring Lane, Baltimore, MD, 21251, USA

    Dina F. El-Mahdy

  2. School of Business, Virginia Commonwealth University, Snead Hall, 301 W. Main Street, Box 844000, Richmond, VA, 23284-4000, USA

    Myung Seok Park

Authors
  1. Dina F. El-Mahdy
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Correspondence to Dina F. El-Mahdy.

Appendix

Appendix

Variable definitions and measurement

Variable

Symbol

Definition and measurement

Information asymmetry

IA

Natural log of the difference between the average annual bid and ask spread of the traded facility

Internal control deficiencies

ICDs

An indicator variable equals 1 if the firm disclosed Internal Control Deficiencies, zero otherwise

Internal control material weaknesses

ICMWs

An indicator variable = 1 if the firm disclosed ICMWs under section 302 or section 404, zero otherwise

Company level disclosure

CL

An indicator variable equal 1 if the disclosed IC weaknesses on the company level, zero if it is Account Specific (AS)

Remediation

REM

An indicator variable = 1 if the firm remediated part or all the disclosed IC weaknesses from year t − 1 to year t, zero otherwise

Internal control deficiencies under SOX 302

ICDs_302

An indicator variable equals 1 if the firm disclosed Internal Control Deficiencies under SOX 302, zero otherwise

Internal control deficiencies under SOX 404

ICDs_404

An indicator variable equals 1 if the firm disclosed Internal Control Deficiencies under SOX 404, zero otherwise

Return on asset

ROA

Return on Asset is Income before Extraordinary items/lagged total assets

Total assets

ASSETS

Natural log of total assets (Compustat data item # 6)

Market-to-book ratio

MTB

Natural log of the ratio of the firm’s market value to book value of common equity, computed as (share price times the number of shares outstanding (Compustat data item #25*Compustat data item #199) divided by (Compustat data item # 60)

Discretionary accruals

DA

We measure the discretionary accruals using the correct model of the Modified Jones Model as in Dechow et al. (1995)

Regulated industry

REG

An indicator variable = 1 if the firm is in regulated industry such as financial or utility industry (SIC codes 6000–6999 and 4900–4999), zero otherwise

Liquidity

LQ

Natural log of the volume of stock traded to proxy for liquidity

Losses firms

LOSS

An indicator variable = 1 if the firm had losses over the last 2 years (Compustat data item # 172)

Auditor dismissal

AUD_D

An indicator variable = 1 if the firm dismissed the auditor, zero otherwise

Auditor resignation

AUD_R

An indicator variable = 1 if the auditor resigned, zero otherwise

Big-6 4 audit firms

BIG_6

An indicator variable = 1 if the financial statements are audited by one of the top 6 audit firms, zero otherwise

Credit rating categories

RATING_CAT

A continuous number from 1 to 3 indicating the rating categories with 1 being the highest rating category and 3 being the lowest rating category

Short revolvers loans

S_REVOLVERS

An indicator variable = 1 if it is a short term revolver loan such as 364-Day Facility, and 0 otherwise

Long revolvers loans

L_REVOLVERS

An indicator variable = 1 if it is a long term revolver loan such as Revolver/Line >= 1 Year, and 0 otherwise

Bank lenders

BANK_LENDERS

An indicator variable = 1 if the identity of the lender is a bank (Term Loan A “TLA”), and 0 otherwise

Institutional lenders

INSTIT_LENDERS

An indicator variable = 1 if the identity of the lender is an institutional lender (Term Loan B, C, and D), and 0 otherwise

Capital expenditure loans

CAP

An indicator variable = 1 if the loan purpose is to cover capital expenditures, and 0 otherwise

Corporate-purpose loans

CORP

An indicator variable = 1 if the loan purpose is to cover corporate expenditures, and 0 otherwise

Commercial paper back up loans

CP_BACKUP

An indicator variable = 1 if it is a loan commitment with a bank “the bank will provide liquidity if the loan failed”, and 0 otherwise

Debt repay loans

DEBT

An indicator variable = 1 if the loan purpose is to repay debt, and 0 otherwise

Takeover loans

TAKEOVER

An indicator variable = 1 if the loan purpose is takeover, and 0 otherwise

Other loans

OTHER_LOANS

An indicator variable = 1 if the loan purpose is any other reason than the ones listed above, and 0 otherwise

Secured

SECURED

An indicator variable = 1 if the loan is secured with collateral, and 0 otherwise

Sponsored

SPONSORED

An indicator variable = 1 if the loan is for private equity related-transactions, and 0 otherwise

Credit rating availability

RATING

An indicator variable = 1 if the loan is rated by a credit rating agency, and 0 otherwise

Syndication

SYND

A continuous number indicating number of lenders

Maturity

MATURITY

A continuous number indicating the maturity of a loan or the length of time until the loan is due

Loan size

LOAN_SIZE

Natural log of the loan value in dollar amount

Debt covenants

COVEN

An indicator variable = 1 if covenants exist, and 0 otherwise

Sox 404

SOX 404

An indicator variable = 1 if the reporting period underlying SOX 404 period, zero otherwise

Standard industry classification

IND

Eight indicator variables to represent the eight industries shown in Table 1 for the sample firms. The SIC two digits codes are used to categorize the industries

Year-effect

SOX_Y

Three indicator variables to proxy for the 4 years of the sample period (2002, 2003, 2004, and 2004) due to the passage of SOX 2002

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El-Mahdy, D.F., Park, M.S. Internal control quality and information asymmetry in the secondary loan market. Rev Quant Finan Acc 43, 683–720 (2014). https://doi.org/10.1007/s11156-013-0389-1

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