Product market competition on the effectiveness of internal control^*

This paper investigates the impact of product market competition on a firm’s internal control system, which is an important corporate control mechanism. We measure the effectiveness of a firm’s internal control system based on the material weakness disclosure under Section 404 of the Sarbanes-Oxley Act (SOX). Using several measures to capture different dimensions of product market competition, we find that firms operating in competitive markets are more likely to have material weakness under Section 404 of the SOX; further, they are more inclined to disclose multiple internal control weaknesses. These results are robust after controlling for both internal and external governance mechanisms. The results indicate that market competition reduces the effectiveness of internal controls over financial reporting and hampers the quality of a firm’s information environment.