Internal Control Disclosures, Monitoring, and the Cost of Debt

We test the relationship between the change in a firm's cost of debt and the disclosure of a material weakness in an initial Section 404 report. We find that, on average, a firm's credit spread on its publicly traded debt marginally increases if it discloses a material weakness. We also examine the impact of monitoring by credit rating agencies and/or banks on this result and find that the result is more pronounced for firms that are not monitored. Additional analysis indicates that the effect of bank monitoring appears to be the primary driver of these monitoring results. This finding is consistent with the argument that banks are effective delegated monitors for the debt market. The results of this study suggest the need for future research, particularly to test the differential effects of monitoring on the cost of debt compared to the cost of equity.