Whether the Quality of Internal Control Can
Influence the Quality of Accounting Information:
Evidence from China
Name: Zhao Kexin
Student number: 11392495
Thesis supervisor: Alexandros Sikalidis Date: 25-6-2017
Word count: 14,045
MSc Accountancy & Control, specialization [Accountancy] Faculty of Economics and Business, University of Amsterdam
Statement of Originality
This document is written by student [Kexin Zhao] who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document are original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Abstract
This study investigates whether the quality of internal control can influence the quality of accounting information. The level of discretionary accruals has been chosen as the index to evaluate the quality of accounting information. This paper has chosen the Chinese real estate industry as the studying objectives. This thesis formulates the regression models of the IC and ICI on DA. The result of the regression model suggests that the firms having higher quality of internal control system usually have less discretionary accruals, so that have the higher quality of accounting information. At the end, this study introduces some opinions on how to improve the quality of internal control system and prevent financial fraud from the perspectives of the five elements of internal control and the internal control information disclosure.
Abstract ... 3
1 Introduction ... 5
2 Literature review and hypothesis ... 8
2.1 Prior Literature ... 8
2.2 Prior literature for China ... 10
2.3 The overall review of previous literatures ... 13
2.4 Hypothesis ... 14
3 Research design ... 18
3.1 Data and simple selection ... 18
3.2 Measurement of internal control ... 19
3.2.1 The evaluation standard of internal control elements... 22
3.2.2 The evaluation standard of the disclosure of internal control information ... 26
3.3 Measurement of accounting info ... 29
4 Empirical models ... 34
5 Results ... 36
5.1 Descriptive Statistics and Univariate Analysis ... 36
5.2 The Relation between IC and discretionary accruals ... 37
5.3 The Relation between ICI and discretionary accruals ... 38
5.4 The Relation between IC, ICI and discretionary accruals ... 39
6 Optimal policies and suggestions ... 41
6.1 The improvement of the internal control elements ... 41
6.1.1 The improvement of internal environment ... 41
6.1.2 The improvement of the risk management ... 42
6.1.3 The improvement of internal control activities ... 43
6.1.4 The improvement on information and communication ... 44
6.1.5 The improvement of internal supervision ... 44
6.2 The improvement of the internal control information disclosure ... 45
6.2.1 Establish a more standardized internal control disclosure system ... 45
6.2.2 Enhance the level of external supervision... 45
7 Conclusion ... 47
1 Introduction
The quality of accounting information has aroused wide public concern for a long time. As an important information resource of enterprise, it can provide useful information to decision-making for both internal management and external investors. However, the current status of enterprise accounting information quality is worrisome. The numerous financial scandals, mostly misleading investors by whitewashing or modifying accounting information, hurt the credibility of accounting information. For example, the financial fraud event of TOSHIBA happened in 2015. TOSHIBA was one of the largest and oldest firms in Japan. Nevertheless, it is found that the TOSHIBA had made false fiscal revenues of more than 1 billion from 2010 to 2015. After that the exposure, the stock price slumped and the investors, even the whole economy of Japan had suffered huge losses. This kind of event reveals the adverse effect of fraud accounting information. At the same time, the exposure of these accounting frauds caused a certain degree of damage to the corporate image, and undermined the confidence of investor. Consequently, how to prevent the financial fraud and improve the quality of accounting information has been focused on intensively. However, the system and related norms of accounting information cannot fundamentally improve the low quality by themselves. Thus, this paper addresses the fundamental control activities within the enterprise. Although there are many factors affecting the quality of accounting information, internal control is the most effective one for its influencing and supervising power of the source of accounting information. It can influence the enterprise's operation process from inside to outside, and ensure the financial related information is objective and effective, so as to improve the reliability and usefulness of accounting information. Thus, many institutions and governments have formulated the related regulations about the internal control. In 1992, the COSO issued a programmatic document on internal control called “Internal Control－Integrated Framework”. This document defined the elements and the goal of internal control. After that, COSO issued documents about risk management to propose that it is necessary to concentrate the human resources of all sectors through
the enterprise on managing enterprise risks to avoid damage. In 2006, China's Shanghai and Shenzhen stock exchange made clear and explicit requirements about the internal control system, demanding the listed firms to constantly improve the internal control operation system, timely evaluate the internal control process, and gradually carry out independent audits of internal controls. The Chinese Ministry of Finance and the Securities Regulatory Commission jointly issued a notice, requiring listed companies to issue internal control information disclosure reports in 2012. In 2014, the standard of the disclosure of internal control self-assessment report was introduced, ensuring the development of internal control.
Most of the empirical analysis of internal control focuses on the quality of internal control disclosure, making the content is limited. This paper analyzes the influence of the quality of internal control elements and internal control information disclosure on the quality of accounting information, which can investigate the mechanism of the internal control more comprehensively.
In this paper, the combination of theoretical analysis and empirical analysis is adopted. Firstly, the related theories, such as the principal agent theory, asymmetric information theory, incomplete contract theory and signaling theory, are introduced to explain the relationship between the level of r control and the quality of accounting information, laying the foundation for further empirical research. After that, the establishment of the regression model of the index of the quality of internal control elements and the internal control disclosure on the quality of accounting information expands the content of empirical analysis. At the end of this study also puts forward some suggestions on how to improve the quality of internal control and accounting information from the perspective of cultural construction, humanistic thought, communication mechanism and supervision and management.
Most of the empirical analyses of internal control focused on the quality of internal control disclosure, which makes the content limited. This paper analyzes the influence of the quality of internal control elements and internal control information disclosure on
the quality of accounting information, which can investigate the mechanism of the internal control more comprehensively.
In this paper, a combination of theoretical analysis and empirical study is adopted. Firstly, the related theories, such as principal agent theory, asymmetric information theory, incomplete contract theory and signaling theory, are introduced to explain the relationship between the level of r control and the quality of accounting information, laying the foundation for further empirical research. After that, the establishment of the regression model about the index of the quality of internal control elements and the internal control disclosure on the quality of accounting information expands the content of empirical analysis. At the end of this study, I also put forward some suggestions on how to improve the quality of internal control and accounting information from the perspective of cultural construction, humanistic thought, communication mechanism and supervision & management.
The surpluses of this paper are arranged as follows: Section 2 reviews prior literatures, both world-widely and in China, and develops the hypothesis. Section 3 describes the design of the research method. Section 4 introduce empirical model to future research. Section 5 discusses the empirical results and discussions, Section 6 provides improvement opinion of internal control system and Section 7 presents the conclusions of the study.
2 Literature review and hypothesis
2.1 Prior Literature
Internal control existing within the enterprise is a series of adopted control activities to achieve the business objectives of the enterprises. In 1980, FASB issued Announcement No. 2, "Accounting Information Quality Features", which discusses the characteristics and structure of accounting information extensively and adequately. In the announcement, the comparability of accounting information was addressed. It was considered that the comparability of accounting information included the comparability of time (i.e. longitudinal comparability) and the comparability of industry (i.e. lateral comparability). Therefore, it is necessary to unify accounting systems and accounting methods of which companies are not allowed to change. In July 2006, the FASB and IASB jointly issued the "Financial Report Conceptual Framework: Financial Report Objectives and the Quality Characteristics of Decision Making Useful Financial Reporting Information" (preliminary comments), which reassigned the relevance and reliability of accounting information.
The existing literature is more concerned with the economic consequences of the SOX act. Most of the research results have a positive attitude towards the role of internal control, suggesting that internal control has a good impetus to the enterprises. However, there are few scholars and experts who do not approve this opinion; they think the internal control doesn’t have obvious effect on the business performance of enterprises. Ge and MCvay (2005) examined the relationship between the internal control and earnings account. Using 261 simple firms which disclosed at least one material weakness after the implementation of SOX, they found the firms having low quality internal control usually had poor quality accounting information. They also pointed out that the most common accounting significant flaws usually occurred in liquidity accruals, such as accounts receivable and investment income accounts. Bedard (2006) suggested that the internal control requirements of the Sarbanes-Oxley Act raised the quality of accounting
earnings by researching the impact of internal control deficiencies on total surplus and liquidity surplus.
Chan (2007) argued that the firms having more disclosure on the inadequacy of internal control system were more likely to have earnings management. The research results of Dolye (2007) showed that the establishment and improvement of the internal control system had a positive effect on the improvement of accounting information quality. By investigating 705 US companies in 2002 and 2005, he found that the accounting information of enterprises with imperfect internal control system was difficult to be guaranteed, and it was more likely to have financial fraud in this kind of firms. In the same year, Doyle concluded that the quality of internal control and the quality of accounting information were positively correlated. In other words, the better the quality of internal control performed, the higher the quality of accounting information was.
In 1998, Germany established the Law on Accounting Information Control and Transparency. Brown (2008) examined whether this law raised the quality of accounting earnings in German listed companies and found that these companies increased the timeliness of loss recognition and reduced earnings management after 1998, suggesting that a consummate internal control system can improve the quality of earnings.
AshbaughSkaife, Collins and Kinney (2009) suggested that the implementation of internal control of enterprises would increase the cost burden on enterprises, but would be even more significant in improving the quality of accounting status. Hermanson (2010) investigated the domestic demand for internal control by questionnaire survey. Through the interviews with the users of the balance sheet, income statement and cash flow statement, he stated the internal control was conducive to the operation and management of enterprises and had inhibitory effect on financial scandals. Therefore, strengthening the construction of the internal control system was beneficial to improve the quality of accounting information.
internal control deficiencies and the quality of earnings management. The outcome revealed that even if the internal control deficiencies were revised in a timely manner, the problem which was correlated with the abnormal earnings would still exist after two years.
Aloke Ghoshk and Yong Gyu Lee (2013) studied the relationship between the internal control flaws and the quality of financial reporting before and after the Sarbanes-Oxley Act. They concluded that the quality of financial statement was lower in the period of non-compulsory disclosure of internal control information. Compared the quality of internal control and the quality of accounting information between 928 Korean firms, Kwangwuk Oh and Wooseok Choi (2014) found that firms implementing stricter IFCR regulation usually had less discretionary accruals, which leaded to higher quality of accounting information.
Although many studies found that the internal control has positive effect on the quality of accounting information, some scholars hold the opposite view. Cohen (2002) proposed that after the establishment of the internal control system, the true earnings management increased, revealing the fact that under the internal control system, the firms used more concealed true earning management, instead of disclosure management. Based on the empirical evidence, Cohen argued the internal control system could not considerably improve the quality of accounting information.
Bartov (2009) studied the impact of internal controls on earnings quality by examining the quarterly data of 6186 companies from 1987 to 2006. The results indicated that the number of companies breaking the analysts’ expectations on earnings decreased after the implementation of the internal control system. The reason was that internal control would weaken the accuracy of predicted future earning by analysts. He also argued that the real earnings management had increased.
2.2 Prior literature for China
established late in China, the available data about the economic consequences of the implementation is limited. Consequently, most of the Chinese studies focused on the disclosures of internal control deficiencies and their effect on the quality of accounting information.
Tang Yuhua (2003) carried out a comprehensive and systematic statistical analysis on the relationship between the internal accounting control and the accounting information quality of Chinese listed firms by questionnaire survey and interview, expounding the mutual influence relationship between the level of internal control and the quality of accounting information. Qiang Peidong (2003) argued that the enhancement of internal control system was conducive to improve the objectivity and effectiveness of accounting information. Through comparing the proportion of corporate shares and internal directors of simple firms having financial scandals, Liu Liguo (2003) examined whether the corporate governance had impact on the quality of accounting information. He concluded that the proportion of internal directors, the size of the board of supervisors and the quality of accounting information were inversely related.
Based on the investigation about internal control reports of Shanghai firms, Yang Youhong and Wangwei (2008) stated that the firms disclosing more internal control information tended to have higher quality of accounting information. Zhang et al(2010) adopted the data of A Shares in Shanghai stock market from 2006 and 2008, at which the assessment of internal control is not mandatory in China. Empirical outcome revealed that the firms performing the assessment of internal control had better quality of accruals management. Qi et al (2010) focused on accounting earnings conservatism, accrual quality and relevance financial information value to explore the impact of internal control on accounting information, conducting the conclusion that firms with internal control deficiencies have lower accruals quality and accounting earnings conservatism. However, there was no significant difference in the relevance of financial information. This paper did not analyze the relationship between the accounting earnings conservatism, accrual quality and financial information value relevance, raised the
problem about whether these three perspectives form the quality of accounting information directly affect the effectiveness of research results.
Fang et al (2011) stated that although the internal control had the objective to guarantee the quality of financial reports, there was no empirical evidence about whether it could suppress earnings management. Therefore, they constructed the models of Accrued Income and Real Earnings to conduct empirical examination about the influence of internal control on the earnings management. They found that the high-class internal control can inhibit the Accrued Income management and real earnings management. However, Fan et al (2013) stated the opposite pinion. In their paper, high-quality internal control could reduce accrual earnings management, but it did not improve the control over real earnings management.
Xu et al (2013) found that the deficiencies in the system of internal control might cause unintentional missing and misplaced information in the process of confirmation and measurement and inefficient suppression of management or employee fraud. Tong et al (2013) claimed that the limitation of earnings management could constraint the information asymmetry caused by agency problems, especially about limitation of the real earnings management. On the other hand, as an evaluation index of the performance of management, the quality of earnings can reveal whether the management team fulfills their responsibilities. Consequently, the earnings quality can influence the establishment and operation of internal control.
Chen (2013) found that there were more difficulty detected accounting misstatements in the firms with poor quality internal control system, resulting auditors to perform more audit tests and lower the timeliness of financial reports. Fang et al (2013) argued that the higher the quality of internal control, the higher the persistence of earnings by constructing an empirical model of internal control and earnings persistence.
Unlike prior papers, some Chinese scholars and experts have different views about the impact of internal control on the quality of accounting information. Zhang et al (2008) chose the A-share non-financial listed companies in China as the research objective and
found the improvement of internal control did not increase the quality of earnings significantly. Chen (2011) found that only part of the control elements could influence the quality of the information, while the other elements did not affect the quality of accounting information by investigating the COSO reports.
From the above researches, we can find that the Chinese articles about the influence of internal control on the quality of accounting information researched only one or several aspects of the accounting information, without an overall theoretical analysis and discussion.
2.3 The overall review of previous literatures
Internal control and accounting information have been deeply analyzed and studied in the existing research literatures. The scholars and experts have put forward the key control measures for the construction and effective implementation of the internal control system. However, some shortcomings are also reflected in the existing studies, which are summarized as follows:
Most of the relevant research focus is on the constituent elements and system of internal control, but there are few research about the internal control mechanism, and the specific measures to enhance the effectiveness of internal control are lack of feasibility. The causing of such pitfall is that the researches are focused on empirical research rather than theoretical analyses and discussions.
Most existing papers which examine the relationship between the internal control and the quality of accounting information are narrowed on the analysis of single factor. From the internal control perspective, most scholars choose the five interrelated components of internal control or the internal control disclosure evaluation criteria rather than the combination of these two indexes. In this situation, the assessment of the level of internal control cannot objectively and truly reflect the circumstance of internal control environment. To address this problem, this thesis will combine the two indexes to judge the quality of internal control. From
the accounting information perspective, the existing aspects includes the earnings management, earnings sustainability, accounting information timeliness, accounting conservatism, value relevance and other research aspects. These research angles can represent the quality of accounting information to a certain extent, but it is difficult to evaluate the quality of accounting information from the whole because of the lack of theoretical analysis of the overall accounting information quality.
The researches about the improvement of internal control in existing papers are not deep enough. Most improvement advices are based on the construction of the concept, without the consideration about the working environment, communication mechanism, human resource and supervision mechanism.
2.4 Hypothesis
Before proposing the hypothesis, the theories about how the internal control system influence the quality of accounting information should be introduced. To examine this impact of internal control on the quality of accounting information, there are two questions need to be discussed: What the impact is and what degree of impact is.
According to Wan Yunlei(2015), the impact of internal control on the quality of accounting information can be analyzed form different elements of internal control system., including the internal environment, risk assessment, control activities, information and communication and the internal oversight.
First impact is the assimilation of the internal environment. Based on the allocation of authority, the management should separate the related working positions, forming a system that different positions can constrain and monitor each other. This kind of organizational structure is beneficial to mutual supervision, thus preventing the risk of financial fraud and guaranteeing the objectivity of the accounting information. Company capacity, including the ability of actual controller and employee competence, also has significant impact on the quality of accounting information. Enterprise managers should be competent, communicative and coordinated, so that different departments can work
with each other smoothly. Only by cooperation and mutual supervision can firms provide real and effective accounting information.
Next influence is the strengthening effect of risk assessment. Firms will face various risk factors, including the external risks and internal uncertainties during the operation. A firm should be able to take a series of measures to reduce related risks, aiming at preventing the significant fluctuation of operation and reduce the uncertainty of earnings. If the firm's risk assessment processes is neither timely nor unreasonable, the firm is likely to suffer from operating losses. Under these circumstances, management may carry out earnings management in order to cover up business problems that may hurt their careers, reducing the quality of accounting information. In other words, effective risk assessment can prevent the earnings management and improve the reliability of accounting information.
Thirdly, the assurance effects of control activities. Control activities are specific operation procedures of internal control system, mostly revealing at institutional level and basic business level of firms. In the accounting information generation process, according to the existing accounting system, management should implement the corresponding accounting treatment and authorize the major accounting matters, thereby reducing the risks brought by private accounting because of personal objectives. Through series of control activities, firms can achieve the mutual restraint in internal control system, can make the business activities proceed smoothly, and assure the accounting information can be created objectively and effectively, which can effective lowering the possibility of financial frauds.
Furthermore, the communication and information of internal control system has restriction effect to accounting information. The information and communication segment is the procedure that the firm collects and processes the information in a timely way and transfers it between the internal organizations, so that the information can be effectively communicated within the different departments. As owners and managers have different understanding degree of information, managers may whitewash
accounting information for their own interests. To prevent the manipulation of financial information, firms should establish effective information and communication system, which can makes firms operate in a more transparent information environment. Meantime, this kind of mechanism allows information to be transmitted among each department without delay, so that employees can clearly define their own duties and responsibilities. In this way, firms can prevent employees from negligence at work and reduce the possibility of accounting manipulation.
In additional, the internal supervision has oversighting effect. Through internal supervision, firms can inspect the performance of management and employees, and rectify the irrational operation of enterprises in a timely manner. Meanwhile, internal supervision and other factors of internal control system are complementary, meaning that the internal supervision can ensure the effective implementation of other elements, and can significantly promote the quality of accounting information.
The last impact is the normative function of information disclosure. Internal control information disclosure is the feedback of the implementation of internal control; it can make the enterprise stakeholders grasp the operational information of enterprise. The disclosure of internal control information can not only meet the needs of information users, but also transmit the signal of firms’ operational condition to the outside world. Therefore, it can help firms improve the control status and increase the reliability and compliance of disclosed accounting information. Furthermore, the internal information disclosure can suppress earnings management, effectively protect the quality and accuracy of financial accounting information, and provide real and effective information for internal and external stakeholders.
According to the above analysis, both optimization of internal control and construction of information feedback mechanism have a positive impact on the quality of accounting information. Therefore, it can be assumed that there is a positive correlation between internal control and the quality of accounting information. As this paper mainly studies the design and implementation of internal control and the impact of information
disclosure on the quality of accounting information, it establishes comprehensive indicators of internal control factors, rather than analyzing each factors separately. Therefore, the following hypotheses have been proposed:
H1: The firms having higher quality internal control system have less earnings management, so that higher quality accounting information.
H2: The firms having higher quality internal control information disclosure have less earnings management, so that higher quality accounting information.
H3: The firms having higher quality internal control system and information disclosure have less earnings management, so that higher quality accounting information
3 Research design
3.1 Data and simple selection
This paper focuses on the relationship between the level of internal control and the quality of accounting information, thus the data should be organized to reveal these two aspects.
Due to the late development of China's internal control structure, the related literatures and examinations are limited. Furthermore, China has a considerably different economic environment, especially in terms of regulation and institutional weakness. Therefore, this investigation will focus on Chinese firms. Since 2011, Chinese regulatory authorities have made strict demands on the self-evaluation of internal control system and the third party external audit to listed companies. In 2012, the listed companies were required to gradually implement the standardized system of information disclosure process, so that the disclosure of internal control information was transferred into the mandatory disclosure era. Taking availability of relevant information into consideration, this study uses data from 2012 to 2014 as simple data.
The reason for paying attention on the real estate industry is that real estate is a major pillar industry and has played a crucial role in Chinese. Since the implementation of the real estate market reform in 1998, the Chinese real estate industry has entered a period of rapid, sustained and stable development, and its contribution to economic growth has been increasing. From 1998 to 2007, the total real estate investment in fixed assets has raised rose from 3614.23 billion Yuan to 25288.8 billion Yuan, with an average annual increase of 24.14%; the total value of the real estate industry increased from 3434.50 billion Yuan in 1998 rose to 11854.3 billion Yuan in 2007, an average annual increase of 14.76%, which is even higher than the average annual GDP growth rate of 12.8%. Furthermore, the real estate industry witnesses obvious spin-off effects, as it is in the middle link of the national economic chain. It can promote the development of building materials industry, metallurgy industry, machinery manufacturing industry, and other
industries through forward effect, and can, by the backward effect, promote the decoration industry, household appliances industry, finance and insurance industry. Another major reason is that the rapid growth of real estate industry has triggered a panic over the real estate bubble, which means that the real estate price is much higher than its practical prices with the rising price and increased speculative capital. Based on the proportion of real estate industry in China, once the real estate bubble is created and collapses, the economics of both China and the whole world will fluctuate, causing huge economical damage. To avoid this situation, the quality of accounting information which can help outsider world better know the financial performance of firms becomes more and more important.
On the basis of the analysis above, this article selects the real estate industry from 2012 to 2014 as the research object. As the Shenzhen has more stringent and explicit requirements than the Shanghai Stock Exchange, the real estate company listed on the Shenzhen stock exchange became the subject of study, and filter the data according to the following criteria:
Since the quality of accounting information needs to be calculated from last year's data, the listed companies that lack data about the quality of internal control and accounting information are excluded.
Excluding listed companies that issue AR shares and AH shares at the same time. Eliminating the firms that have huge distinction with the overall sample data. After the screening process, the sample size is 131. The data is mainly collected from the Resset database, the Shenzhen Stock Exchange website and the annual report, the internal control evaluation report and the audit report published by Cnif Website.
3.2 Measurement of internal control
Internal control system is not the only factor which can influence the quality of accounting information. Thus, if we want to evaluate the level of internal control for the
relationship between them, we should first analyze how the internal control affects the quality of accounting information. There are several theories in past examinations. First one is the principal-agent theory. After the separation of enterprise ownership and management power, the principal-agent theory emerged as the times require, as the management authority of the enterprise was entrusted to the managers. Based upon the assumption of economic man, the owners of firms pay more attention to maximizing the benefit of the company so as to realize the accumulation of their own wealth. Therefore, theory is more concerned with the sustainability of the company. In contrast, the managers pay more importance to the working environment and the rewards, since they exercise responsibility to the enterprise just because of the remuneration. That is the reason why they are likely to adopt radical development strategy and management measures, exaggerate or whitewash the firms’ operational performance, and make the accounting treatments which are misleading but beneficial to themselves, improving their outstanding achievement. This kind of "moral hazard" will have adverse impact on the management and development of the firms, which is the cause of the conflicts of interests between the owners and the managers. Moreover, there is a principal-agent relationship between managers and employees, as managers refine the business activities and divide them at different levels, giving the employees chances to take the actions that are beneficial themselves but will damage the interests of the firms.
Internal control can be the tool to reduce these risks. The firm owners can supervise the behavior of managers and managers can control the employees at all levels through it. Thus, the internal control can prevent the earnings management of managers and can control the misbehavior of the employees, so as to ensure the quality of accounting information.
Another approach is the information asymmetry theory. Managers can obtain more information as controllers and owners of firms not directly involved in enterprise management activities cannot fully grasp the information. Besides, because the compensation of executives is correlated with their performance, they tend to just disclose information which can improve the evaluation of their performance to the
owners, which hurt the transparent of the business activities and eventually lead to asymmetric information between the owners and managers. That will also increase the possibility of adverse selection and moral hazard.
Internal control can effectively restrain the accounting manipulation and limit the management authority, through the establishment of more transparent communication and oversight mechanisms, so that employees will carry out their duties, and minimize the likelihood of moral hazard.
Besides, the incomplete contract theory also has impact. Under the modern enterprise system, there are various contractual relations. Through the establishment of these relationships, the division of labor among the owner, the managers and the employees at all levels of the enterprise has appeared. The Contractual relationship is created to ensure both parties of the contract perform their duties and obligations so as to meet the needs of all parties to the contract. However, as the contract is incomplete, each side of the contract may breach the contract for their own needs to gain more benefits. The existence of implicit contract will lead to greater probability of moral hazard, since managers and employees may transfer optimum but false business information to maximize their own interests, resulting in damage for firms.
The building of internal control system can promote the communication between owners and managers, helping to get a balance between their own demands. If the latter’s needs can be satisfied, their motivation to manipulate the earnings will decrease, increasing the quality of accounting information significantly.
Another theory is the signaling theory. Because of the information asymmetry, the enterprise can exhibit the management superiority and excellent benefit level of enterprise by delivering its own information as a signal to the public. Compared with the firm with poor operating conditions, well-run firms are more willing to disclose business information to attract more investors and financial capitals, forming a sharp contrast. Once this signaling effect makes impact, it will lead firms disclosing information to make more efforts to build their own enterprise organizational systems, improve the internal
control system, ensure the quality of accounting information, and maintain a good image of the establishment of the enterprise.
In this paper, two angles are taken into account for evaluating the quality of internal control: the five elements of internal control and the disclosure of internal control information. In this way, we can examine the correlation relationship and impact between variables more comprehensive, so that we get the opportunity to discuss the optimization of internal control based on different perspectives.
3.2.1 The evaluation standard of internal control elements
Internal control in the COSO report is consisted of five major elements, namely risk assessment, control activities, information and communication, and internal oversight. To evaluate the quality of them, they will be graded according to certain standards.
Internal environment
The internal environment is the foundation for the whole internal control system to exert its effectiveness, since it determines the enterprise management model and management philosophy. It involves a number of sub factors, such as corporate governance hierarchy, enterprise capabilities, corporate culture, human resources policy, development strategy and social responsibility performance. Corporate governance structure is the fundamental framework of the company operation. The company should streamline the company's corporate governance hierarchy and ensure that the governance mechanism is aligned with the overall development goals of the company to ensure the effectiveness of the internal control organization. The enterprise culture is the foundation of the enterprise. It can enhance the cohesive force of the enterprise and enable the enterprise organization member to carry on the unified goal, which eventually will contributing the strength for the enterprise development together. Meantime, the human resources policy should ensure the full embodiment of enterprise capability, encouraging employees to give full play to their personal abilities. The fulfillment of social responsibility shows that the firms not only take the economic man role, but also
take the social man role.
As the internal environment includes many factors, the indicator of it should also involve the related factors. The internal environment indicators mainly include: the proportion of independent directors, whether owner is the CEO or not , executive holdings, employee training system, the incentive and restraint system, the fulfillment of social responsibility, the corporate culture and so on.
Independent directors can maintain the efficiency of the firm and are not controlled by the shareholders of the company or other interested parties, ensuring the implementation of related affairs of firm is not for pursuing personal interests. In the concrete evaluation, the proportion of the independent director less than 1/3, the value of the variable is 0, the ratio is 1/3, the value is 1, and the value is 2 if the ratio is more than 1/3.
Within the board of directors, the chairman and vice chairman play the role of decision making. In the contrast, the general manager is the core of the management and is responsible for the specific affairs of the firm. As the duties of chairman and general manager are separated from each other, when the chairman or vice president act as general manager, the variable is 0, conversely, it is 1.
Risk assessment
Risk assessment is a process of identifying and analyzing the risk factors faced by firms. This process includes three parts: risk identification, risk analysis and risk response. Firms should have a timely identification of risks, analyze the identified risk factors objectively and prudently, and then select risk response strategies based on the outcome of analysis, including avoidance, reduction and acceptance of risks.
The evaluation of risk assessment includes whether the firm set up the enterprise strategic target, whether the firm analyzes the internal and external risks, and whether the firm can propose solution of risk. Risk is an inevitable factor in enterprise management. However, firms can prevent the adverse consequences of risk factors by adequate
policies. Therefore, the high quality internal control reflects the proper knowledge and timely response of risks.
Control activities
Control activities are embodied in the institutional level and business level. Generally speaking, the control activities at the institutional level mainly involve the basic system of enterprise management, which are the guiding principle of the daily operation of enterprises and the implementation of the main business activities of enterprises. At the business level, the control activities ensure the orderly operation of the enterprise through controlling the specific business activities of the enterprise, including accounting activities control, financial safety control and budget management control, etc. The objective of accounting activities control is ensuring the standardization of accounting information, making the accounting activities strictly comply with the requirements of the accounting system. Financial security control is the effective control of enterprise property and material. Through the inventory management and the feedback mechanism, the property and material can be effectively regulated and used to improve the efficiency of business operation. Budget management control is the budget activity for the future activities of an enterprise, which can ensure the rationality of the budget and control the budget in an effective range during the implementation of the project.
The internal control activities include the separation of business duties, the control of enterprise accounting and the authorization examination and approval process. As it is difficult to evaluate whether the firm has arranged the above-mentioned control activities in the annual reports and internal control reports, whether the listed companies establish clear business processes and set up the key control points becomes the assessed standard of internal control activities. If the answer is yes, the variable is 1, conversely, the variable is 0.
Information and communication
including the external information, such as the policies, laws and regulations, and the economic situation faced by the enterprises, and the internal information such as the production and operation and the management level of enterprises. In order to ensure usefulness of information, enterprises should set up efficient information processing mechanism and information sharing mechanism, broadening information collection channels, selecting useful information from enterprises, and ensuring the efficiency of information transmission. Enterprises should also maintain the enterprise information system timely, insuring that the information system is effective at all times and providing efficient information for management decisions. Communication is the way to transfer information, and a necessary link of enterprise management decision. A complete system can make the grass-roots level employees participate in the process of business decisions, improving the effectiveness of decision-making.
The information and communication index is selected and the number of board meetings. In general, the more the number of board meetings of listed companies, the better the information and communication links of listed companies, and the better the internal control is.
Internal supervision
Internal supervision is a comprehensive inspection of the daily operation of the whole internal control system, and feedback to all types of defects and rectification, while supervising the internal control staff to perform their duties.
To evaluate the internal supervision, there are four quantitative indexes: Whether the board of supervisors has independent opinions, the types of audit opinions of financial statements, whether the firms have received penalties by the regulatory authorities and whether the auditing firm is “big 4”. Among them, the board of supervisors plays a supervisory role of the internal management. It presents independent opinions on the annual matters of the enterprise, which shows that the board of supervisors participates in the management process. And then, the selection of the "Big 4" auditing firms shows the level of operating ability of firms. And the “Big 4” auditing firms can assure the
quality of accounting information.
In view of the above analysis, the evaluation criteria of five elements of internal control are shown in table below:
Table 1: Five elements of internal control
3.2.2 The evaluation standard of the disclosure of internal control
information
The disclosure of internal control information is the feedback of the implementation of internal control system. Through it, owners of firms can monitor the situation of internal control, managers can modify the flaws of internal control system and investors and other capital providers can get an over assessment of the operation of the firms.
As the internal control information is an important information resource of listed firms, the quality of it can affect the realization of enterprise management and strategic objectives, and play a certain role in restricting the quality of enterprise financial accounting information. The disclosure of internal control information, usually including the self-assessment report and the audit report, means the behavior that the board of directors or managers of listed firms issue internal control report based on the efficiency and effect of the internal control system to the public on a regular basis.
The internal control information disclosure reveals the entrusting liability viewpoints and useful viewpoints of policy-making. The manager is authorized by the enterprise owner to supervise the business matters of the firms, and the latter will investigate the performance of the former by clear disclosure of information, which is also the wat of managers to remove their fiduciary duties. Meantime, through the disclosure of the internal control information, the external investors and other capital providers can understand the situation of internal control, helping them make proper investing decisions. Therefore, the overall goal of internal control information disclosure is to realize the protection of investors' interests.
Since the enterprises must comply with the related law first, the design of the internal control should ensure the fulfillment of the legal requirements ,continuously improve the mistakes and loopholes in the operation and management, and strictly avoid the occurrence of various irregularities in the enterprise due to the lack of internal control. The disclosure of internal control information help enterprise message about its legitimacy, and it can make the enterprise exposed to public supervision, guarantying the lawful operation of the enterprise. The enterprise will also get benefit from the enhancement of corporate image. Therefore, the internal control information disclosure itself is the reflection of the abidance of laws.
Internal accounting control is the backbone of the whole internal control system. The stakeholders and other stakeholders are mostly concerned about the reliability of the financial statements provided by firms. Thus, one of the mainly objectives of the internal
control is ensure the efficiency of the financial report. The information disclosure of internal control can form a balance mechanism which can reduce the possibility of earnings management and promote the managers to improve the quality of financial reports. Internal control information disclosure can also show the operational efficiency. No matter the internal managers or outside investors, the major concern of them is whether they can obtain more profits through the operation of the enterprise. Thus, the objective of the disclosure of internal control information is to provide information about the efficiency and effectiveness of the operation.
Another purpose of internal control system is exhibit the sustainability of the operating strategy. The aim of enterprise strategic planning is to anticipate the future operation and management, and to ensure the expectation can be achieved. The external investors focus on the actual operation of the enterprise and predict the future development , so as to make a dependable investment decision. Consequently, the disclosure of internal control information should include the formation conditions operating strategy, the operating performance of the firm and the achievement of the operating strategy, providing useful information to investors and guiding them to make appropriate expectations.
Based on the above analysis, the overall objective of the internal control is to protect the benefits of investors. Through the implementation of the overall goal, the internal control system should assure the legitimacy and the efficiency of operation, the reliability of financial reports, and the sustainability of strategy.
The evaluation of the disclosure of internal control information mainly bases on the listed company's defects of internal control according to the self-evaluation reports and the internal control audit opinions. On the basis of the self-evaluation report, we can draw a rough assessment about the level of the internal control of firms. However, relying solely on the internal control self-evaluation report to assess the quality of information disclosure is not sufficient. Thus, the internal control audit reports should be included in the construction of indicators, since it is more objective. The Shenzhen
Stock Exchange's rating of listed companies' information disclosure is also a supplement to the construction of disclosure indicators, cos it can reflect the specific level of enterprise internal information disclosure.
Table 2: The explicit evaluation indexes of internal control information
3.3 Measurement of accounting info
Accounting information is the information produced during the firms’ operating and management course and processed by the specific accounting system and procedure, becoming useful to external investors and other capital providers. The quality of it cannot be described by tangible characteristics, as it is an intangible concept. Therefore, the description of the quality of accounting information needs to be described by abstract standards, such as relevance, reliability, authenticity, etc. Accounting information can be seen as commercial product. Under this perspective, it should follow the standard of the commercial product, to achieve the customer satisfaction. Based on this, the quality of it can be described as the satisfaction degree of the related parties to the virtual accounting information. Radically speaking, the quality of accounting information can be defined as the level of effectiveness of decision-making. That means, if the accounting information is useful for decision-making, then the quality of it is high, otherwise, the quality of accounting information is inadequate.
different requirements for the quality of accounting information at the same time, and the requirements of accounting information in different periods are not the same. FASB lists the framework of the quality of accounting information, which uses the "reliability" and "relevance" characteristics as the basis quality characteristics and considers "decision-making usefulness" as the most important feature criteria. The ASB considers comprehensibility, relevance, reliability, and comparability as four important essential features, and details all the features. The ASB divides this quality into three parts: the part associated with information content is needed to be relevance and reliability; the part related to the statements is required to be comparable and understandable; and the part associated with the information quality constraint should be efficiency and timeliness. The requirements of quality of accounting information in China are shown below: The fundamental requirements
The fundamental requirements of the quality of accounting information in China include two aspects: relevance and reliability.
Relevance represents the degree to which the provision of accounting information corresponds to the user's demand for accounting information, including the timeliness of accounting information, the predictive value of it and feedback value. Predictive value refers to the role played by accounting information for the users in predicting the future. Currently accounting information cannot fully represent the real accounting information in the future, thus the prediction of the future will inevitably deviate from the specific environment. However, the current information must be closely related to the future accounting information, and the predictive value can be represented by the degree of correlation between them. The feedback value refers to the extent to which users can draw on a lesson through the past accounting information. Timeliness restricts the delayed time of accounting information, and the information is valid only if it is provided to the users within the specified time. Once the information is not delivered in a timely manner, the information will lose its timeliness and become information that is not related to the needs of the information user.
Reliability requires accounting information can effectively reflect the operation and outcome of accounting objects, that is, accounting information cannot be tampered for personal benefits and should be consistent with the economic phenomenon. The reliability, including the, integrity, verifiability and fairness, emphasizes the objective reflection of accounting information rather than subjective assumptions. Integrity demands the accounting information can reflect the business activities of firm completely and enable information users to know the operating conditions of the firms comprehensively and make proper decisions. Verifiable demand the same accounting data are processed or checked by different accounting personnel to obtain the same or similar outcome, which can reduce the possibility of arbitrary tampering. Fairness requires that accounting information should be generated under objective conditions, not be influenced by personnel desire.
The enhanced requirements.
The enhanced requirements include comparable, materiality and Understandability. Comparable requires the accounting information for different accounting entities and different periods should have similar characteristics, thus can be compared horizontal and vertical. Through the comparison, the information users can understand the development of firms’ operating conditions, facilitating the adjustment of the business and strategic plan. The materiality demands different business matters be accounted separately, according to the degree of importance. By this way, the accounting information will pay more attention on the matters that are more concerned by managers and investors. Understandability is based on the requirements of the information user, requiring the format and the expression of the provided accounting information should be understandable to information users.
When measure the quality of accounting information, prior literatures usually focus on the relevance and reliability of the accounting information (Sheng Jin,2014). As the data used to evaluate the relevance is lacking in China market, this paper mainly considers the reliability of the accounting information. There are three common measure methods.
First of all, this article uses the evaluation results published by authoritative department directly (Wang, 2006). Cai Jifu (2006) established the quality index of accounting information. And the last one is selecting the quality of earnings to measure the quality of accounting information (Healy. 1985; DeAngelo. 1988). The authoritative institutions information disclosure evaluation index is more focused on the level of disclosure, leading the inspection of accounting information is not complete. Furthermore, it is difficult to exercise the second method in current environment. As in previous financial frauds, the earnings management behavior was the main factor reason, using the earnings quality to measure the quality of accounting information is more reasonable. Therefore, this paper adopts the third method.
The evaluation of the quality of earnings involves the concept of earnings management. Earnings management, as its name suggests, is the management of accounting earnings according to the loophole of the enterprise accounting standards. From this point of view, the earnings quality is measured by the extent of management of earnings, which is negatively related to earnings quality.
There are different ways to measure the quality of the earnings (Zhang, 2010). Firstly, the market affects evaluation method, which main index is earnings response coefficient. As an important component of accounting information, earnings information should meet the requirements of accounting information quality, which means it should ensure the reliability and usefulness of information, and maximize the decision-making efficiency. Therefore, under this method, if earnings information is beneficial to external investors in decision-making, the quality of earnings is high; on the contrary, the quality of earnings is poor. The second one is accrual evaluation method. The principle of accrual basis is the foundation of modern accounting measurement. Under this principle, accounting earnings are divided into two parts: accruals and net cash flows from operating activities. Former are part of the gains that have been recognized but not realized based on the accrual basis, and latter represents the actual income realized by the enterprise. Accrued profits include the discretionary accruals and non-discretionary accruals. The discretionary accruals is easily manipulated by the management, as this part
of accruals can be influenced by the different accounting treatments, but the non-discretionary accruals cannot be controlled because of the limitation of the accounting treatments. Consequently, the greater the proportion of discretionary accruals, the lower the quality of earnings, and then the lower the quality of accounting information is.
Compared the market effect evaluation method and the accrual evaluation method, the former mainly measures the contribution of earnings information to external investment decisions, and the latter more concerns about the composition of accruals. Thus, this paper uses the second method which is more appropriate for internal control. To measure the non-discretionary accruals, this paper adopts the modified Jones-model which is used by DeFond and Subramanyam (1998). The formulation is shown below:
𝑇𝐴𝑖,𝑡 𝐴𝑖,𝑡−1 = 𝛼1( 1 𝐴𝑖,𝑡−1) + 𝛼2( ∆𝑅𝐸𝑉𝑖.𝑡 𝐴𝑖,𝑡−1)) + 𝛼3( 𝑃𝑃𝐸𝑖,𝑡 𝐴𝑖,𝑡−1) + 𝜀𝑖.𝑡 (1) 𝑁𝐷𝐴𝑖.𝑡 𝐴𝑖.𝑡−1 = 𝑎1( 1 𝐴𝑖,𝑡−1) + 𝑎2(∆𝑅𝐸𝑉𝑖,𝑡− ∆𝑅𝐸𝐶𝑖,𝑡 𝐴𝑖,𝑡−𝑎) + 𝑎3( 𝑃𝑃𝐸𝑖,𝑡 𝐴𝑖,𝑡−1) (2) 𝐷𝐴𝑖,𝑡 = 𝑇𝐴𝑖,𝑡 𝐴𝑖,𝑡−1− 𝑁𝐷𝐴𝑖,𝑡/𝐴𝑖,𝑡−1 (3) Where,
TA= The total amount of the total profit of the company A= The total assets of the company
REV= Revenues of company
PPE= Gross property plant and equipment NDA= Estimated nondiscretionary accruals REC= Net receivables of company
4 Empirical models
To realize the relationship between the internal control and the earnings management, this study estimates the following regression model:
|𝐷𝐴| = 𝑦0+ 𝑦1𝐼𝐶 + 𝑦2𝑀𝐵 + 𝑦3𝐿𝐸𝑉𝐸𝑅𝐴𝐺𝐸 + 𝑦4𝐵𝐼𝐺4 + 𝑦5𝐿𝑂𝑆𝑆 + 𝑦6𝐹𝐼𝑅𝑀𝑆𝐼𝑍𝐸 + 𝑦7𝐴𝐷𝐽_𝑅𝑂𝐴 + 𝜀 (1) |𝐷𝐴| = 𝑦0+ 𝑦1𝐼𝐶𝐼 + 𝑦2𝑀𝐵 + 𝑦3𝐿𝐸𝑉𝐸𝑅𝐴𝐺𝐸 + 𝑦4𝐵𝐼𝐺4 + 𝑦5𝐿𝑂𝑆𝑆 + 𝑦6𝐹𝐼𝑅𝑀𝑆𝐼𝑍𝐸 + 𝑦7𝐴𝐷𝐽_𝑅𝑂𝐴 + 𝜀 (2) |𝐷𝐴| = 𝑦0+ 𝑦1𝐼𝐶 + 𝑦2𝐼𝐶𝐼 + 𝑦3𝑀𝐵 + 𝑦4𝐿𝐸𝑉𝐸𝑅𝐴𝐺𝐸 + 𝑦5𝐵𝐼𝐺4 + 𝑦6𝐿𝑂𝑆𝑆 + 𝑦7𝐹𝐼𝑅𝑀𝑆𝐼𝑍𝐸 + 𝑦8𝐴𝐷𝐽𝑅𝑂𝐴+ 𝜀 (3) Where,
DA= discretionary accruals
IC= the score of the elements of the internal control system using the above index ICI= the score of the internal control information disclosure using the above index
MB= market-to-book equity ratio, measured as MVE/BVE, where BVE is the book value of equity;
Leverage= long-term debt scaled by total assets;
Big4= an indicator variable if the firm is audited by a Big 4 auditor Loss= an indicator variable if the firm has reported loss
Firmsize= natural logarithm of the market value of equity
ADJ_ROA= industry-adjusted ROA, where ROA is measured as income before extraordinary items, scaled by lagged total assets;
this paper introduces some control variables. First one is the firm size. As according to previous literatures, the firm size has impact on the opportunity of earnings management. Larger firms are more likely to manipulate earnings. The reason is that they are more likely to be focused, and if these firms want to convert these concerns into investment, they need to have better performance. And the market-to-book equity ratio is included, because it can explain the opportunity of growth. The forms having more growth opportunity will have more incentives to have better financial performance, so as have more willing s to manipulate the earnings. Another control variable is leverage.
The level of leverage has obvious impact on the possibility of earnings management, sinceasset-liability ratio can reflect the solvency and operating capacity of listed firms, which is a significant index of the performance and ability of managers. Too high asset-liability ratio will increase the cost of capital, which give managers incentives to manipulate earnings. Therefore, external investors will use them to do investment decisions. The market-to-book equity can also reveal the growth opportunity of firms, which is the reason why it is include as a control variable.
Moreover, considering that the degree of the earnings management may be influenced by the different audit firms, this paper includes an indicator control variable, Big4. The Big4 auditing firms have much stricter auditing standard to the financial reports of enterprise, leading less possibility of fraud financial reports. If the firm uses the Big4 as auditing firms, the amount of this index is 1, otherwise, it is 0. The last control variable is also an indicator variable, LOSS, since the situation of operation has obvious impact on the extent of the earnings management. If the firm reported loss, it is 0, conversely, it is 1. The Equation (1) can demonstrate the relationship between the internal control system and the degree of earnings management, which can justify whether the H1 can pass. The objective of the Equation (2) is to judge the reliability of H2. H3 is verified by the Equation (3)
5 Results
5.1 Descriptive Statistics and Univariate Analysis
The table 3 reports the descriptive statistics for the variables in the regression model. The median values of discretionary accruals (DA) calculated by the modified Jones model and the quality of internal control elements(IC) are 0.414 and 31, respectively, which are less than their mean, indicating they are right-skewed. The median of the quality of the internal control information disclosure (ICI) is 8 which is bigger than its mean (7.626). Therefore, it is left-skewed.
For the control variables, the median (mean) of industry-adjusted intensity (ADJ_ROA) and the market-to-book equity ratio (MB) are 0.4827(0.856) and 3.6192(7.008), indicating the former is right-skewed and the latter is left-skewed. The median of leverage measured by the long-term debt scaled by total assets is 6.766, and the mean is 6.432. The median (mean) of the Firmsize which is the natural logarithm of the market value of equity is 1.0126(1.676). The percentage of firms reporting loss is 8%. And 5% percentage firm uses the big-4 audit firms.
Descriptive Statistics
N Minimum Maximum Mean Std. Deviation Median
DA 131 .00428 2.69 .726 .722 0.414 ICI 131 6.0 9.0 7.626 .8973 8.000 IC 131 21.0 62.0 31.550 6.9980 31.0 ADJ_ROA 131 -9.5285 14.838 .8562 3.7681 .4827 MB 131 -29.4074 172.49 7.008 16.7651 3.6192 Loss 131 0 1 .08 .278 .00 Leverage 131 1.252 12.018 6.432 1.805 6.766 Big4 131 0 1 .05 .21 .00 Firmsize 130 .1784 18.0666 1.676 2.369 1.0126 Valid N (listwise) 130
Table 4 presents Pearson correlation coefficients for selected variables. As we can see, both the IC and ICI are negatively correlated with the DA. This outcome indicates that the firms having higher quality internal control system and disclosure of internal control disclosure have less possibility of earnings management, so that the higher quality of accounting information.
Coefficientsa
Model Unstandardized Coefficients Standardized Coefficients t Sig. B Std. Error Beta 1 (Constant) 6.387 .291 21.918 .000 ICI -.755 .030 -.940 -25.309 .000 ADJ_ROA -.007 .007 -.036 -1.003 .318 MB -.001 .003 -.034 -.562 .575 Loss -.078 .094 -.030 -.821 .413 Leverage .018 .021 .046 .892 .374 Big4 -.177 .125 -.047 -1.418 .159 Firmsize .005 .025 .016 .194 .847
Table 4: Pearson correlation coefficients for selected variables
5.2 The Relation between IC and discretionary accruals
Table 5 reports the results of the regression analyses between the IC and DA. As we can see, there is a significantly negative relation between the IC and the magnitude of earnings management, as the estimated coefficient is -0.33 and the p<0.05. Thus, the higher quality of the internal control system, the higher quality of the accounting information, we can accept the H1. However, the adjusted R square is 0.223, meaning that change in IC just can explain 23% of the change in DA.
