The Effect of Internal Control Material Weaknesses on Executive Equity Incentives and Corporate Risk-Taking

In this study we examine how CEO equity incentives and firms' risk-taking behavior are influenced by material weaknesses in internal controls. We find that the disclosure of such material weaknesses is negatively associated with the vega and delta of CEO compensation, suggesting that firms with adverse SOX 404 opinions reduce equity incentives to discourage the CEO from taking excessive risks. Moreover, this association seems to be stronger for more severe company-level internal control weaknesses. In addition, we find that after controlling for the effect of equity incentives on risk-taking, firms receiving adverse SOX 404 opinions have less R&D and capital expenditure investment. Further remediation analysis shows that the boards not only make downward adjustments for CEO equity incentives and risky investments when internal controls are found to be ineffective, but also make upward adjustments when material weaknesses are remediated. Our study contributes to both the compensation and internal control literature by providing evidence that internal control quality plays a role in a board's decision to design CEO equity incentives as well as the level of a firm's risk-taking.