Internal control quality and relationship-specific investments by suppliers and customers

This paper investigates the association between the quality of internal control over financial reporting (ICOFR) and relationship-specific investments by suppliers/customers. I find a significant negative association between the disclosure of a material weakness (MW) in ICOFR and changes in the relationship-specific investments of suppliers/customers. Relationship-specific investments of suppliers/customers have a stronger negative association with inventory-related MW. The negative association between MW disclosures and the relationship-specific investments of suppliers/customers is stronger when economic dependence between the firms and the suppliers/customers is more important and when the suppliers/customers have greater bargaining power. Also, suppliers/customers significantly increase their relationship-specific investments following the remediation of ineffective ICOFR. Overall, my findings show that a firm's quality of ICOFR affects the relationship-specific investment decisions of suppliers/customers.