Does the Presence of an Internal Control Audit affect Firm Operational Efficiency?

This study examines whether auditors' evaluation and reporting of firms' internal control over financial reporting (ICFR) affects firm operational efficiency. Prior research indicates that the strength of internal controls is positively associated with economic benefits. However, notwithstanding the underlying strength of controls, whether the mere presence of an ICFR audit provides similar economic benefits is unclear. We predict and find that small firms with ICFR audits have significantly higher overall operational efficiency than small firms with only management ICFR reports, even after controlling for underlying internal control strength. We find this effect manifests through improvements in inventory turnover and innovation, and through increased relative product market share. Separately, we find ICFR audits are associated with lower efficiency in SG & A expenses. Cross-sectional analyses indicate that the mechanism by which ICFR audits affect overall operational efficiency is through auditor detection of internal control problems and through knowledge spillover from auditing other highly efficient firms in the audit office's metropolitan statistical area. These results provide additional evidence on the ongoing cost and benefit debate of ICFR audits for small firms.