A Comprehensive and Quantitative Internal Control Index: Construction, Validation, and Impact

We use a new method to better measure internal control quality. Specifically, we construct an internal control index for all public firms in China, because the lack of internal control regulations during our sample period presents an interesting setting, in which the diversity of internal control quality is preserved. Two distinctive features set our index apart from the information currently available under SOX 404 in the U.S. First, it comprehensively evaluates a firm’s internal control, based on the COSO framework. Second, it quantitatively measures a firm’s internal control, using the analytic hierarchy process designed for analyzing complex decisions. We proceed to validate our index by confirming the known relation between internal control quality and earnings management. Further, we theorize that our internal control index has a positive impact on the earnings response coefficient, and find that better internal control indeed makes financial reporting more credible to investors.

Whether internal controls can effectively constrain earnings management, which is a hot topic in recent years. I investigate the impact of internal control on earnings quality based on a life cycle perspective using data of listed companies of China’s market from 2010-2013. The empirical findings indicate that high quality internal control can suppress accrual earnings management and real earnings management (except for discretionary expenses manipulating earnings management) effectively, whilst in different life cycle stages (LCSs), the relation between internal control quality and accounting earnings quality (accrual quality and real earnings quality) is different. For the accrual quality aspect, in mature LCS, internal control quality and accrual quality is positively correlated. In growth or decline LCS, the relation between internal quality and accrual quality is not significant. For the real earnings quality aspect, in decline LCS, high quality internal control can improve real earnings quality; in growth LCS or mature LCS, the relation is just the opposite.

INTRODUCTION In a sense, I began developing this presentation in 1993 when I first taught auditing and internal control for M.B.A.s at INSEAD (European Institute of Administration). In designing the course, I envisioned myself as the CEO of a multinational corporation (as many M.B.A.s view themselves), and asked how would I know whether I was getting the right information for decision making, that my assets were being protected, and that my people were complying with laws, regulations, and company policy--all on a worldwide basis? As I pondered these questions, it came to me that an answer to all of them is internal control. This revelation changed my thinking about internal control, changed the tone of the M.B.A. course, and also changed my teaching for majors,(1) I now believe that knowledge about internal control is an essential element that affects the welfare of management, corporate directors, shareholders, trading partners of an entity, auditors, and society at large--yet it is relatively unexplored by researchers. All major research methods are applicable, we have conceptual documents to guide our inquiries, and internal control quality is regulated directly or indirectly in many countries. In short, there is an outstanding opportunity for research in internal control for and auditing professors, and for Ph.D. students. There are substantial barriers, of course, and we must all work to overcome them. The rest of this paper explores research opportunities in internal control quality assurance beginning with a definition of internal control and the demand for internal control quality and quality assurance. This is followed by a discussion of barriers to research, and concludes with research questions and trends for the future. DEMAND FOR INTERNAL CONTROL QUALITY AND QUALITY ASSURANCE Because I am most familiar with them and because other groups around the world have conceptually similar definitions, I will use the Committee of Sponsoring Organizations of the Treadway Commission definition of internal control (COSO 1992) supplemented by that of Criteria of Control (CoCo, CICA 1995).(2) COSO defines internal control as: a process, effected by an entity's board of directors, management and other personnel designed to provide reasonable assurance regarding the achievement of objectives in the following categories: * effectiveness and efficiency of operations * reliability of financial information * compliance with the applicable laws and regulations (COSO 1992) (emphasis added) The COSO definition implicitly assumes a constant external environment. The Canadians' CoCo adds the risk of failure to maintain the organization's capacity to identify and exploit opportunities, and resilience or capacity to respond or adapt to unexpected risks and opportunities. Thus, CoCo assumes the external environment may change, and defines good internal control to include adaptability of the process to a changing external environment. The COSO/CoCo definitions have three distinguishing features. First, they are broad, much broader than traditional definitions of internal accounting control that are limited to reliability of data and protection of tangible assets. By including the efficiency and effectiveness of operations, compliance with laws and regulations, and responsiveness to external changes, the COSO/CoCo definitions can be interpreted to cover all of management's functions except choosing objectives, strategies to achieve objectives, and follow up of surprises identified. Second, the COSO/ CoCo definitions are about process, rather than about a static state. This means that internal control cannot be directly observed or verified. Third, internal control is about risk, or threats that an entity will not achieve its objectives. All decision makers want to optimize their risk/expected reward trade-off, thus leading to demand for internal control quality and quality assurance. …

PurposeThe purpose of this paper is to emphasize the relationship between managerial ability, earnings management, internal control quality and audit fees to establish whether or not there is a significant relationship between the variables of managerial ability, earnings management, internal control quality and the audit fees.Design/methodology/approachThe study sample includes 190 listed companies on the Tehran Stock Exchange during 2009–2016. Research hypotheses were tested using the statistical methods of multivariable linear regression and data envelopment analysis pattern.FindingsThe obtained results indicate that there is a significant and direct relationship between managerial ability and internal control quality as well as real earnings management and internal control quality. Based on the results obtained from the second hypothesis, the authors could claim that there is an inverse and significant relationship managerial ability and audit fees. The third hypothesis also revealed that in companies with lower audit fees, there is a stronger relationship between managerial ability and internal control quality. The results of related tests show no significant relationship between accrual-based earnings management and internal control quality.Originality/valueThis paper is the first study in Iran whose main focus is on the relationship between managerial ability, earnings management, internal control quality and audit fees.

This paper establishes the evaluation index system of the quality of internal control of commercial banks.Then the paper combined with the improved adding calculated by entropy method within the accrual cash flow model of quality control index, the presence of internal control and the level of accounting conservatism were considered.This paper aims at figuring the relationship between the ability to internal control and accounting conservatism of listed commercial banks through the study, the representative of the financial field of the enterprises to strengthen internal control system to establish and improve the theoretical basis of information disclosure quality.

Digital transformation has become a new engine driving the development of enterprises. Based on the data of Chinese A-share listed manufacturing enterprises from 2008 to 2020, this paper measured the intensity of enterprise digital transformation with the help of machine learning method, and empirically investigated the impact mechanism of digital transformation on the quality of enterprise's internal control. It is found that digital transformation can significantly improve the quality of internal control. Mechanism analysis shows that digital transformation has a positive impact on the quality of internal control mainly by reducing agency costs and increasing the shareholding ratio of institutional investors. The results of heterogeneity analysis indicate that the promotion effect of digital transformation on the quality of internal control is more significant in enterprises with small scale and strong manager's ability. Digitization improves the total factor productivity of enterprises by promoting the quality of internal control.

With increasing market competition and the arrival of technological innovation, the automobile-manufacturing industry faces great changes. In this situation, the quality of internal control becomes an important part that affects the growth and development of enterprises. According to the theories of internal control and enterprise growth, this paper selects data of Chinese listed-companies in the automobile manufacturing industry to analyse the relationship between the internal control index and enterprise growth. Further, it verifies the research conclusion using multiple regression analysis that the improvement of internal control quality can play a positive role in promoting the growth of automobile manufacturing enterprises.

Based on a sample of Chinese A-share listed firms on the Shenzhen Stock Exchange and the Shanghai Stock Exchange between 2007 and 2012, we examine the effect of product market competition on the internal control quality of Chinese listed firms and the difference in this effect between state owned firms and non-state owned firms. Using the internal control index constructed by Chen et al. (2013) as the proxy for internal control quality, we find that product market competition has a significant effect on the internal control quality of Chinese listed firms: the more intense the product market competition is, the higher the internal control quality will be. However, the effect is only significant for non-state owned firms, not for state owned firms. In addition, we find that high quality internal control can improve product market competition advantage, providing support for our main findings. Overall, our study extends the literature on internal control and product market competition, provides evidence on whether internal control can help firms realise their development strategies, and offers advice to related government departments and firms on improving internal control quality.

PurposeThis paper aims to investigate the association between internal audit function (IAF) characteristics and internal control quality.Design/methodology/approachUsing data gathered from 59 chief audit executives from Tunisian listed companies, this paper uses a regression model to examine research hypothesis related to the association between IAF characteristics and internal control quality.FindingsThe findings of the current study reveal that internal control quality is significantly and positively associated with IAF competence, internal audit quality control assurance level, follow-up process and audit committee’s involvement in reviewing the internal audit program and results.Practical implicationsThe findings have significant implications for IAF wishing to enhance their effectiveness, by recognizing the impact of the IAF’s characteristics on internal control quality. The findings of this study also have significant implications for regulatory bodies who are concerned with the internal control quality, managers and audit committees who determine IAF investment, oversight IAF activities and assess internal auditors’ performance.Originality/valueThis study helps fill a gap in the extant literature where existing empirical evidence of how the IAF characteristics influences the quality of the financial reporting process in emerging markets is scant.

Purpose This study aims to investigate the relationship between the prior audit experience of Chief Financial Officers (CFOs) and corporate internal control quality, specifically how the professional background enhances their expertise in internal control. This expertise may enhance their effectiveness in overseeing and maintaining robust internal control systems. Design/methodology/approach Using a sample of Chinese A-share listed firms from 2012 to 2020, this study examines the association between former-auditor CFOs and internal control quality. To ensure the robustness of this study’s conclusion, the authors use a Difference-in-Differences design, propensity score matching, entropy balancing, instrumental variable estimation and alternative fixed-effects specifications. Findings This study found that CFOs with prior audit experience are associated with improved internal control quality. This association is more pronounced when the CFO has senior-level audit experience, more recent tenure at an accounting firm, prior experience at an international Big 4 or a domestic Top 10 accounting firm or when the firm operates in a highly digitalized environment. Aligned with the COSO Framework (2013), path analysis reveals two key channels: improved risk assessment and strengthened internal supervision. Furthermore, former-auditor CFOs contribute to more reliable financial reporting, greater accounting conservatism and reduced corporate default risk. Originality/value These findings expand the literature on the benefits of accounting firm experience and clarify the underlying mechanisms. Additionally, this study provides a plausible explanation for the increasing preference for appointing CFOs with audit experience.

Credit rating is a primary determinant of firm cost of debt capital, capital structure, and hence the range of acceptable investment opportunities. Scant research has been conducted thus far on the relation between internal controls and cost of capital, particularly after the 2002 Sarbanes–Oxley Act. However, academic researchers argue that credit ratings may be affected by internal governance mechanisms instituted by firms and that the quality of internal controls is a potential driver of cost of equity capital. This paper examines whether firm credit ratings is associated with the quality of internal control over financial reporting. Using a sample of firms disclosing internal control weaknesses during November 2003–July 2005, I find that firms with low internal control quality are more likely to have lower credit ratings, speculative-grade rating, smaller size, lower profitability, lower cash flows from operating activities, net losses in the current and prior fiscal year, higher income variability and higher leverage than firms compared to firms with high-quality controls. Further, lower quality controls decrease the likelihood of a firm receiving an investment-grade debt rating; hence, resulting in higher cost of debt financing, lower income and lower overall attractiveness in capital markets for these firms. Finally, results also suggest that corporate governance strength is positively related to internal control quality. Study results should be useful to a wide range of academic and business readers, because it suggests the increasing importance of firm internal controls in financing decisions and cost of capital determination, of investment in proper internal controls and of exploring the various possibilities from instituting high-quality internal controls. Additionally, regulators are advised to take into consideration the potential effect of legislation on firm credit ratings and internal control quality.

We address whether SOX 404(b) internal control audits under two auditing standards regimes and SOX 404(a) management assessments are associated with improved internal control system quality, an important and largely unstudied potential benefit. In 2013, the PCAOB disclosed that 15 percent of inspected control audits were ineffective, suggesting that the current control auditing standard may not be sufficient to induce implementation of high-quality control systems. We use an indirect measure of internal control system quality—future unaudited accruals quality—to proxy for internal control quality because sustained internal control improvements should be exhibited in future quarterly financial reports unaltered by contemporaneous financial statement audits. We find that internal control audits initially provided internal control quality benefits. After the 2007 auditing standards change, internal control quality deteriorated for ICFR audited versus unaudited firms. Finally, we find limited evidence that management assessments affect internal control quality. Results indicate that recent PCAOB concerns may have merit. Data Availability: Data are publicly available from the sources identified in the text.

52 SFPM working group on DBT internal quality control

Reasonable assurance of the reliability of financial report is one of the main objectives of internal control. Thus, high-quality internal control should help to improve the quality of corporate's financial report theoretically. In this paper, we examine the effect of internal control on earnings management, which was measured by real activity earnings management. Besides, we further test the moderating effect of ownership structure on the association between internal control quality and earnings management. The results indicate that higher quality of internal control can restrain real activity earnings management. Specially, this restrain function is more obvious in un-stated firms compared to state-owned firms. And the restrain function cannot be found in companies exist separation of corporate controlling right from the right to control cash flow.

As an important measure of enterprise governance, internal control can enhance the organizational rationality of the enterprise, ensure that the enterprise consciously assumes social responsibility for the protection of the natural environment and resources, and promote the sustainable development of the national economy. Using data from China’s A-share heavy pollution industry listed companies from 2009 to 2018, this study explored the relationships among internal control quality, enterprise environmental protection investment, and financial performance. The results show that the quality of internal control has a significant positive impact on enterprise environmental protection investment and financial performance. Enterprise environmental protection investment has a significant positive impact on financial performance and plays a partial intermediary role in the positive impact of internal control quality on financial performance. While expanding the theory of resource-based concepts, this study clarified the positive impact of corporate environmental management and practical behavior on corporate value and provides a theoretical basis for companies to actively implement environmental protection responsibilities, strengthen internal environmental management capabilities, and enhance corporate value. At the same time, it also provides a basis for the government to issue relevant environmental protection policies, strengthen enterprise internal control construction guidelines, and encourage third-party organizations to evaluate the effectiveness of enterprise internal control.