Are Material Weaknesses in Internal Controls Associated with Poor M&A Decisions? Evidence from Goodwill Impairment

Abstract

SUMMARY This paper examines the effect of the quality of a firm's internal control over financial reporting (ICFR) on the quality of corporate M&A decisions. We use material weaknesses in internal control (ICMWs) from SOX 404 audits as a proxy for the quality of a firm's ICFR and use future goodwill impairment to proxy for the quality of managers' M&A decisions. We find that goodwill recognized from acquisitions in years concurrent with ICMWs has a greater rate of impairment in subsequent years than goodwill recognized from acquisitions in years without ICMWs, thereby establishing a link between ICMW and goodwill impairment. We further show that disclosure and remediation of ICMWs appear to improve valuations of subsequent acquisitions. Our study contributes to the literature on internal controls by documenting unanticipated benefits of SOX 404 audits on managerial performance, and to the goodwill literature by identifying ICMWs as a determinant of goodwill impairment.