Internal control weaknesses, agency costs, and the value of cash holdings

Public accounting firms, as part of their audit of publicly traded corporations' financial statements, identify and disclose major weaknesses in these corporations' internal control over financial reporting. These internal control weaknesses are signals to outside stakeholders that current internal control systems are insufficient to constrain opportunistic behavior by managers of these corporations. I find that in the presence of these internal control weaknesses, shareholders discount the value of corporations' cash holdings due to expectations of increased agency costs at these corporations. Further, I find that shareholders do not discount cash holdings when other governance mechanisms are in place to constrain management behavior. My paper contributes to the understanding of how capital markets, in the absence of other shareholder protections, react to situations that signal high agency costs.