Do internal controls influence innovativeness in firms? : a comparison between start-ups and established companies

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Do internal controls influence innovativeness in firms?

a comparison between start-ups and established companies

Bachelor thesis

Name: Lizzy Vermaas

Student number: 10913300

Institution: University of Amsterdam Program: BSc Economics & Business Specialization: Accountancy & Control Supervisor: Edo Roos Lindgreen Word count: 9780

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Statement of Originality

This document is written by Lizzy Vermaas who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is 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.

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Abstract

This research examines whether internal controls influence the innovative capabilities of firms based on two sub questions. Firstly, the influence of internal controls on innovation has been tested. Secondly, how this differs between startups and established firms is analyzed. Both sub questions are tested on three criteria of innovation: resources, initiative and organizational structure. Based on a literature review it can be concluded that internal controls negatively and positively influence all three criteria of innovation, therefore influences the innovative capabilities of a firm. This finding is supported by the difference in internal controls between startups and established firms and what their innovative capabilities are. This research contributes to previous literature by showing that the implementation of internal controls causes unexpected consequences.

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Samenvatting

Deze scriptie is een onderzoek naar de invloed van interne controles op innovatiemogelijkheden binnen bedrijven. De huidige markt verandert constant, hierdoor is het voor bedrijven van belang om constant te blijven innoveren om met de markt mee te bewegen. Interne controles zorgen voor zekerheid binnen een bedrijf, maar er is weinig onderzoek gedaan naar onvoorziene effecten die interne controles kunnen opleveren. Zo bleek uit een onderzoek dat innovatie niet effectief kan zijn als de corresponderende controlemechanismen niet juist geïmplementeerd zijn. Dit resulteerde in de volgende onderzoeksvraag: beïnvloeden interne controles de innovatieve mogelijkheden van bedrijven?

Het onderzoek is gebaseerd op bestaande literatuur en uitgevoerd aan de hand van twee deelvragen. Deze deelvragen zijn beantwoord met behulp van drie criteria voor innovatie: middelen, initiatief en organisatiestructuren. Het onderzoek wordt ondersteund door een vergelijking van interne controles binnen grote gevestigde bedrijven en start-ups en door te onderzoeken wat hiervan de invloed is op de innovatieve mogelijkheden van beide bedrijven.

Het onderzoek toont aan dat interne controles invloed hebben op de beschikbaarheid van bedrijfsmiddelen. Interne controles verbeteren de kwaliteit van de financiële verslaggeving, hierdoor kan er makkelijker geld worden geleend tegen een lager rentepercentage en dit bevorderd innovatie. Daarentegen heeft regulering op interne controles zoals de Sarbanes Oxley Act (SOX) een nadelig effect op financiële bronnen. Het blijkt dat bij gevestigde bedrijven de herverdeling van bronnen wordt beperkt door de interne controles wat nadelig is voor innovatie. Ten tweede worden de initiatieven van managers beïnvloedt door interne controles, enerzijds zorgt monitoren voor beter passende investeringsactiviteiten, anderzijds demotiveert het monitoren de innovatieve initiatieven van managers door onder andere de beperking in keuzevrijheid veroorzaakt door monitoren. Binnen gevestigde bedrijven worden werknemers meer gemonitord, onderzoek toont aan dat dit averechts werkt op werknemers die radicale innovatie initiatieven willen nemen. Ook de wettelijke gevolgen bij niet-naleving van SOX is een demotiverende factor voor managers om innovatieve projecten te ondernemen, wat alleen bij gevestigde bedrijven met een eigen vermogen boven de 75 miljoen zo is. Ten derde kunnen de interne controles beïnvloeden hoe een bedrijf innoveert, maar hoe een bedrijf innoveert kan ook de interne controles beïnvloeden. Gevestigde bedrijven vertrouwen in hun structuur door huidige prestaties, deze structuur, waarop de interne controles zijn ingesteld, ondersteunt alleen incrementele innovatie en niet radicale innovatie.

Dit onderzoek draagt bij aan de huidige literatuur door het in kaart brengen van een onvoorzien effect van interne controles, namelijk de invloed op innovatieve mogelijkheden van bedrijven.

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‘It seems that every aspect of business is in state of flux: technology, government regulation and global competition’ (Tushman & Nadler, 1986), this statement was made in 1986, but reflects the current economic environment perfectly. The high pace of change makes it difficult for companies to keep up, companies must continuously innovate products and processes to retain or gain a competitive position (Tushman & Nadler, 1986). The old view on competitive advantages, focused on cost advantages, has been replaced by the focus on continuous innovation as a result of the current dynamic economic environment (Porter, 1998). Companies are aware that innovation is the key to a competitive advantage in the economic markets, but to achieve a corporate environment focusing on and succeeding in innovation is a challenge.

Government regulation is one of the examples named by Tushman & Nadler (1986) that is in state of flux, affecting both companies and economic markets. Increased regulations for accountability caused internal controls to grow in importance and become part of public debates on auditing, resulting in a shift of focus from audit outcomes to auditing systems (Maijoor, 2000). In 2004 the Sarbanes-Oxley Act was released which emphasized the importance of internal controls through requiring the addition of an internal control report to the annual report, in which management state their responsibility for the quality of internal controls. Internal controls are a current and relevant topic, these controls are designed to provide reasonable assurance of the achievement of company objectives (COSO, 2013). However, internal controls also have negative effects, literature shows a relationship between innovation and the internal controls of a company, for example innovation will not be effective if the corresponding control mechanisms are not in place (Goodale, Kuratko, Hornsby, & Covin, 2011).

An important part of internal controls are the information technology (IT) controls, the Public Company Accounting Oversight Board (PCAOB) states in accounting standard 5 (2007) that IT controls can influence the effectiveness of other internal controls. Technological innovations made it possible to collect all kinds of data resulting in voluminous data sets, consisting of financial and non-financial information, known as ‘big data’ (Warren, Moffit, & Byrnes, 2015). IT controls are designed to ensure the quality of the data collected and created within the company, which is used by other internal controls and financial reporting (Klamm & Watson, 2009).

Another quick changing aspect mentioned by Tushman & Nadler (1986) is the global competition, in the current economic market we experience the rise of ‘startup’ companies, these are relatively new and small companies which enter the market and become strong competitors within a short period. How startups manage to create a competitive advantage in the economic markets is very interesting, partly

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7 because Freeman & Engel (2007) found that as a startup grows their innovation will slow down, eventually resulting in the loss of their competitive advantage.

I have elaborated three topics: innovation, internal controls and the difference between established firms and startups, and shown why these are currently interesting and important. Due to the growing importance of and regulation on internal controls I am interested in the side effects of internal controls. I found different relations between internal controls and innovation (Chenhall & Moers, 2015; Goodale et al., 2011), which aroused my interest on what the total influence of internal controls are on innovation. To conduct thorough research on the influence of internal controls real world differences in design of internal controls between startups and established firms are examined and how this influences their innovative capabilities. The expectation is to find a difference in internal controls between startups and established firms and a relationship between the characteristics of internal controls and the innovativeness of a company. This has led to the following research question: ‘Do internal controls influence innovativeness within firms’. This question is answered by means of a literature review to compare startups and established firms and to answer of sub questions.

This subject is interesting and conducts to prior literature since most research on internal controls is very broad and this research focuses on the causality between internal controls and innovation. I believe that the addition to the research of comparing startups and established firms will make the subject even more interesting and could explain an aspect of the ability of startups to obtain a competitive advantage. My research will pay extra attention to IT controls, given the dependence on business information created by computerized systems. I think this research is necessary because of the mentioned importance of internal controls and innovation, companies want to have both good internal controls and effective innovations, to be aware of the relation between both factors is therefore important.

In this paragraph I have explained the importance of a few subjects, which led to the research question of my thesis. In the next paragraph I will explain theories which are important to be able to answer the research question and state criteria in order to test innovative capabilities. Paragraph three contains the analysis needed to answer the sub questions, followed by the conclusion and discussion in paragraph four and the references in paragraph five.

2. Theoretical framework

In the previous paragraph I have introduced the research question and explained the relevance of this question. In this paragraph the important terms will be defined to create a knowledge base for the analysis performed in paragraph three. First internal controls will be explained, combined with the COSO

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8 framework, IT controls and associated legislation. Secondly the concept of innovation will be explained, followed by the difference between startups and established firms and lastly additional important theories will be explained.

2.1 Internal controls

After scandals like Enron and Worldcom, where senior management overstated earnings creating fraudulent reports, the importance of internal controls have increased (Klamm & Wattson, 2009). Internal controls are designed to provide assurance on effective and efficient operating, reliable financial reporting and compliance with laws and regulations. The system also helps employees to understand the objectives of an organization and provide reasonable assurance on the timely recording of transactions. Internal controls have a preventive and a detective character (Christ, Emett, Summers, & Wood, 2012). Preventive controls are those to deter the problem before it occurs, for example through proper authorization processes. Detective controls discover problems after they occurred in order to solve it, for example through audits. The results from detective controls can be seen as information on the quality of preventive controls. Internal controls have a wide definition and companies have the freedom to design their own internal controls. This results in undefined boundaries of the internal control system, causing complications with defining what internal controls are (Stoel & Muhanna, 2011). In this research the updated framework from the Committee of Sponsoring Organizations of the Treadway Commission (COSO) will be used to define internal controls and provide an understanding of how internal controls function within an organization. This framework is very suitable since COSO designed the most commonly used framework to develop and assess internal controls (Klamm & Wattson, 2009).

Besides the wide definition of internal control, literature contains different sorts of control, for example management control systems, strategic control, financial control and information technology (IT) control. To avoid confusion it is important to know that management control systems, just like internal control systems, focus on the achievement of corporate objectives but management controls achieves this through behavior instead of instruments (Davila, Foster, & Oyon, 2009). Strategic controls, financial controls and IT controls are a subgroup of internal control (Hitt, Hoskisson, Johnson, & Moesel, 1996). Strategic controls are benefit-oriented, focused on sustainable innovation and long term performance and judge on the base of indices closely related to the purpose which requires information exchange between corporate and divisional managers (Liu, Li, Su, & Feng, 2007). Financial controls are aimed at the final outcome, therefore focused on achieving its short term goals, judging based on objective criteria like return on investment (Liu et al., 2007).

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9 2.1.1 The COSO framework

COSO (2013) describes internal control as a system that helps entities in achieving objectives and to sustain and improve the company’s performance. The designed framework is a tool to efficiently and effectively develop internal control. The goal is an internal control system that is able to adapt to the changing business environment of companies, assist with decision making and support governance of the organization. The framework is a cubicle which combines the three objectives, what the company wants to achieve, five components, which represents what is necessary to achieve the objectives, and the organizational structure of a company. Through this framework managers are able to see where companies need controls, how the controls should be designed and implemented and how controls help the company in achieving their objectives. The three sorts of objectives are operations objectives, reporting objectives and compliance objectives, respectively focused on the effectiveness and efficiency of operations, the reliability of financial reporting and the compliance with laws and regulations. The framework sets requirements to what makes an internal control system effective, internal control is seen as effective when the system reduces the risk of not achieving the objective to an acceptable level (COSO, 2013). These requirements are summarized as the presence and proper functioning of the components of the framework. These five components represent what is required to achieve the companies objectives, the components are the control environment, risk assessment, control activities, information and communication, and monitoring activities. Internal controls also require managerial judgement on the design, implementation and overall performance of the internal controls. These judgements can provide help with making decisions on internal controls, but they have to comply with laws and regulations.

2.1.2 IT controls

Over the years technological developments resulted in the ability to retrieve data from all kinds of activities and systems within companies. Companies rely heavily on data, for example the IT function plays a critical role in collecting, processing and storage of data used in financial statements or decision making. Concerns on the integrity, reliability and storage of these data have to be addressed prior to being able to rely on them (Dzuranin & Mălăescu, 2015; Stoel & Mulhanna, 2011). Accounting Standard 94 (AICPA, 2001) states that the use of information technology influences the fundament of companies and therefore information technology should be seen as part of internal control. ‘IT controls refer to the management, operational and technical safeguards or countermeasures prescribed for an information system to protect the confidentiality, integrity and availability of the system and its information’ (Stoel & Muhanna, 2011). So IT controls are mechanisms through which we can assess the quality of the retrieved data. Examples

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10 of IT controls are the controls related to software, program implementation and segregation of duties focused on access to electronic data and programs (Grant, Miller, & Alali, 2008).

The COSO framework is not sufficient enough to be a good framework for the development and assessment of IT controls, this resulted in the rise of the Control Objectives for Information and related Technology (COBIT) framework. The COBIT framework describes IT controls that a company can use to provide reasonable assurance on the achievement of business goals and to improve internal controls (Kerr & Murthy, 2008). This framework states that when designing or assessing IT controls, the focus has to be on the security, availability, processing integrity, confidentiality and privacy of data (Coe, 2005).

2.1.3 Regulations

Important regulations which affect internal controls, and therefore could affect this research, should be taken into consideration. The Sarbanes-Oxley (SOX) act was implemented in 2002, where section 302 and 404 relate to internal controls. The goal of SOX was to restore public trust in the capital market after scandals like Enron. Section 404 of this regulation made it obligatory for management to evaluate and conduct audits on the effectiveness of internal controls over financial reporting and to report on these results, disclosing positive assertions or disclosing material weaknesses in internal controls. In addition, management has to put out a statement in which they take the responsibility for designing and maintaining good internal controls, use a framework to check on the controls and report on material weaknesses if found (Stoel & Muhanna, 2011). The purpose of SOX is to create awareness on internal control systems and improve the quality of the systems. Another requirement of section 404 is the opinion of an independent auditor, the auditor has to check and report on management assessment of internal controls (Klamm & Watson, 2011; Stoel & Muhanna, 2011). The opinions of the external auditor and management on internal controls have to be included in the annual report (Beneish, Billings, & Hodder, 2008). Literature also points out that the 404 requirement is only applicable to companies which have at least 75 million dollar in public equity float. Another important section of SOX is section 302, this section requires managers to ensure that weaknesses and deficiencies have been reported to the audit committee and to disclose material weaknesses and material changes in internal controls to the financial reporting (Beneish et al., 2008).

2.2 Innovation

Innovation is the result of a process which starts with an idea, leads to an invention and when implemented is called innovation (Freeman & Engel, 2007). Innovation is very risky and uncertain due to

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11 the high probability of failure, unpredictability of future contingencies, the idiosyncratic character, labor intensity and to succeed all incentives within a company must be aligned (Freeman & Engel, 2007; Holstrom, 1989). Holstrom (1989) states that these factors are critical because of the influence on the ability to monitor innovation within the principle-agent framework. It is important to determine which factors influence the ability to innovate, to be able to conduct new research on innovation. Innovation can be both radical or incremental. Radical innovation is a fundamental change to input, output or processes and requires long term thorough strategic planning and huge research and development investments (Liu et al., 2007). Incremental innovation is the continuous improvement of current technology and processes used, these are much less risky and require less research and development investment. A lot of different determinants of innovative activity are pointed out in current literature, this research will focus on the following three determinants.

First, an important part to be able to innovate is the availability of resources. The availability of money in specific, since innovating activities require a lot of funding, but funding is hard to obtain due to the risks and information asymmetry which occur alongside innovation (Brown, Fazarri, & Petersen, 2009; Hall, 2002). Especially the level of investment in research and development is a critical input to innovation (Brown et al., 2009; Santos, Basso, Kimura, & Kayo, 2013).

Second, initiative is considered as a determinant of innovation (Berglund, 2007). Managers make decisions within the company whether or not to invest in certain opportunities, depending on their willingness to spend their time and accept the risks. The outcome of these projects are mostly uncertain (Berglund, 2007). This risk should be considered with the knowledge of the agency theory, where incentives of managers and stakeholders can differ and monitoring managers is very difficult.

Third, organizational structures influence the ability to innovate. The structure of the company sets drivers and barriers to employees, when strict controls are implemented on chosen objectives managers are restricted to these. The structure of a company determines the freedom of managers to perform innovative activities (Perez-Freije & Enkel, 2006).

2.3 Startups and established firms

It is important to have a clear understanding of the differences encountered between startups and established firms in order to conduct this comparison. Startups are defined as relatively small and new companies, which undergo rapid and constant development and growth (Freeman & Engel, 2007). These startups usually have less brand awareness, capital, organizational structure and business processes than

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12 established firms, but still manage to be a big competitor to those firms (Freeman & Engel, 2007). Startups can also be defined as entrepreneurships, which is defined as the creation of a new business which contains financial risks and profit uncertainty (Davila et al., 2009; Freeman & Engel, 2007; Shane & Venkataraman, 2000). Established firms, also referred to as corporations, are those which are existing for a longer period already and are relatively big, these firms have a lot of resources, like financing and knowledge, at their disposal. Due to their large and old aspect they have created great overall structure and business processes (Freeman & Engel, 2007). In this paper established firms are assumed to have an equity float larger than 75 million and therefore need to report on internal controls.

An important difference to acknowledge is the structure of ownership, most established corporations have a separation between ownership and control, which means that the managers who run the company and make the decisions are different from the owners or stakeholders of the firm. On the contrary, the managers in startups are also the owners, but ownership and control might separate in the long term as a result of development.

2.4 Additional theories

Separation of ownership and control is very common within companies. Here the company shareholders are the owners of the companies receiving profit from the company while managers are controlling the company, receiving a fixed salary. A common problem arising when a company separates ownership and control is the principle-agent problem, where the incentives of managers, the agent, differ from the incentives of stakeholders, the principal, causing a suboptimal value to the principal (Masulis, Wang, & Xie, 2009). Agents might focus on short term investments because their success will be rewarded soon while long term investments might yield higher profits, but managers will only be rewarded when these investments turn out to be profitable in the long run. The delays in the assessed success might cause another organizational level to be rewarded for the investment. The difference in incentives can be explained in multiple ways, for example managers could experience a high bonus when their investment or innovation produces high earnings, but the financial consequences of a bad investment are smaller for managers then for shareholders. Another example to consider is that some decisions of the managers are optimal to them, but not optimal to shareholders (Goodale et al., 2011; Masulis et al., 2009). When the owners do not have all information available at the time of decision making there is information asymmetry. This asymmetry results in the inability of the owner to assess whether this is the best investment to the company, this limitation is called adverse selection (Masulis et al., 2009).

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13 Another theory is conservative accounting, conservatism is the early recognition of losses and the late recognition of earnings. The difference in timing is caused by the higher degree of verification required for the earnings than costs causing a difference between the actual cash flows and earnings on the financial statement, called accruals (Goh & Li, 2011). The lower the accruals are, the more reliable the financial statements are, since lower accruals reflect the actual cash flows more accurate (Doyle, Ge, & McVay, 2007).

3. Analysis

In the previous paragraph the theoretical framework that applies to this research is shown. The theoretical framework shows how internal controls work and what the determinants of innovation are, which are the two main subjects of this research. Also, additional important theories for this research have been explained. In this paragraph the analysis of the sub questions has been carried out in order to gain an understanding of the relationships between different factors to be able to answer the research question in the end of this research. The determinants discussed in the theoretical framework will be used to test the relationship between internal controls and innovation in order to answer the sub questions.

3.1 How do internal controls influence innovative capabilities of companies?

First the influence of internal controls on the availability of financial resources will be discussed. Second the influence of internal controls on the innovation initiative of managers is discussed. Third the influence of internal controls and organizational structures on innovation are discussed.

3.1.1. Resources

Financial constraints should be considered, these are circumstances where companies might be unable to obtain financial resources for their innovation projects (Crisostomo, Lopez-Iturriaga, & Vallelado, 2011). There are multiple ways through which internal controls could influence financial constraints to a company, one of these is the reliability of financial reporting. Obtaining a loan at a bank will be much easier when the financial statements of companies are transparent and reliable. For example the separation of functions or authorization restrictions through internal controls improve the quality of information and therefore the financial statements. Another influence on this reliability is the relationship between internal control quality and accruals quality. Research shows that effective internal controls are able to prevent intentionally biased accruals in earnings management, through control mechanisms like segregation of duties (Ashbaugh-Skaife, Collins, Kinney, & Lafond, 2008; Doyle et al., 2007; Iliev, 2010). By

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14 means of controls on training and policy, effective internal controls are also able to prevent unintentional errors.. Accruals are assessed as high quality when estimated accruals are realized as cash flows, when there are estimation errors in the accounting numbers, accruals are estimated as low quality, resulting in lower financial reporting quality and reliability (Goh & Li, 2011). Intentional earnings management through accruals can lead to fraudulent reporting charges as happened to Enron (Goh & Li, 2011). Research has shown that accrual quality increases after the remediation of detected weaknesses in internal control systems (Ashbaugh-Skaife et al., 2008; Doyle et al., 2007). Thus effective internal controls improve the quality of accruals and therefore improving quality and reliability of financial reporting, making it easier and less costly to obtain capital.

Another effect of weak internal controls is the hinder of timely recognition of losses, because these are not able to prevent low quality accruals, therefore lowering conservatism (Goh & Li, 2011). Strong internal controls form an environment aware of the possibilities of conservatism, leading to higher conservatism (Goh & Li, 2011; Iliev, 2010). A higher level of conservatism leads to a higher bias in the financial reporting, therefore influencing the reliability of financial reporting. This bias is described as asymmetric reporting, which can influence the market value of a company and increase the equity costs of capital (Guay & Verrecchia, 2007; Suijs, 2008). But, the reporting of low earnings and high costs in a timely manner results in a full disclosure of information, therefore lowering the asymmetric information problem (Guay & Verrecchia, 2007). Therefore internal controls increase companies trustworthiness which lowers the cost of capital.

Information asymmetry in financial markets is another constrain of financial resources, causing implications on the independence for investing and other financial decisions (Crisostomo, Lopez-Iturriaga, & Vallelado, 2011). This information asymmetry is between managers and lenders, where the lenders do not have all the information on how the manager will spend the money, therefore they experience increased risk in lending this money. This increased risk results in investors requiring a higher rate of return to compensate the risk. The internal control system has a direct influence on the information asymmetry problem, this is where IT controls have an important role. Because of the use of computerized systems most business information is created on computers, to ensure the reliability of information IT controls have to be designed and implemented. Effective IT controls protect the companies data through access controls and segregation of duties, this limits the ability of employees to alter the information in systems, resulting in reliable information therefore lowering the information asymmetry (Grant, Miller, & Alali, 2008). This reliability increases trust of investors therefore loosening financing constraints and reducing financing costs.

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15 Also the influence of internal control regulations on the financial resources of a company should be taken into account. The rise of regulations like SOX have great influence on the internal controls and financial constraints of companies. Because of SOX the focus on internal controls within companies has grown, improving quality of these controls, hence improving financial reporting quality. But there are also unpleasant consequences: the attestation of a managerial report filed by outside auditors to comply with section 404 caused an increase in audit fees of millions and negative average earnings (Iliev, 2010). Ilievs research (2010) shows that audit reports of firms which did not have to comply with SOX 404 had 30 percent lower audit fees than those who had to comply. Another consequence of SOX to consider is the market response on a section 302 or 404 weakness disclosure. When a firm has a section 302 weakness disclosure they tend to have a negative market response. This response is found in research showing that abnormal returns declined by 1.8 percent and a great increase of equity costs after a weakness announcement (Beneish et al., 2008). This response can be explained by the negative reconsideration of a company’s forecast and the abnormal increase in cost of capital caused by the experienced increase of risk after a 302 disclosure (Beneish et al., 2008). The implementation of SOX has resulted in grown awareness of companies on their internal controls, through this awareness the quality and effectivity of internal controls improved the reliability of financial reporting.

Summarized, internal controls improve the quality of financial reporting by lowering the information asymmetry and improving accruals quality. Higher financial reporting quality results in lower cost of capital due to lowered risks for investors. The implementation of SOX has improved awareness of the quality of internal controls but is very costly, it is arguable that the costs of SOX are higher than the profits, especially for small firms.

3.1.2 Initiative

The importance of financial resources have been explained but these resources are scarce, therefore the board, stakeholders and investors are engaged in determining the optimal way to spend resources. Optimal investments or innovations could be missed due to the agency problem and information asymmetry within companies. There are two ways in which agency problems can affect innovation, first innovation requires a lot of work that deviates from the regular business activities, these activities are difficult to monitor compared to standard activities, reducing the ability to monitor the input of managers. Therefore internal controls might not be optimal in these situations, controls do not limit innovation in this case but are not able to support optimization of innovation. Second, the differences in incentive between principal and agent as a result of different payoffs is considered, causing the agent to be less

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16 likely to use the resources in the most efficient way for the owner (Hu, 2003). These difference in incentives can be explained through the career concerns of managers, afraid of the consequences of risks managers avoid them, even though these risky opportunities could be increasing the firm value (John, Litov, & Young, 2008). They argue that managers might use resources to diversify the risk of the company, lowering their own risk but also lowering the expected benefits of the company. These agency costs and conservative attitude towards risk can be lowered through the monitoring function of the internal control system, effective monitoring can provide owners with more information on the efforts of managers, this monitoring will drift managers from unproductive activities and conservatism (Hu, 2003; John et al., 2008). Monitoring will decrease the information asymmetry and can improve resource utilization, which is beneficial for innovation.

However, negative effects of the internal controls on innovative capabilities should also be considered. The implementation of SOX tilted monitoring to being more objective and switch the responsibility of monitoring to outsiders, this reduced the subjective decision making of managers and therefore reducing the innovative capabilities of companies (Shadab, 2007). Missed innovative opportunities due to SOX and grown monitoring should be seen as foregone benefits. Another negative effect of high quality internal controls is that these discourage managers to approve risky but promising innovative projects. This emerges from the obligatory extensive control requirements to innovative projects (Bargeron, Lehn, & Zutter, 2009). The criminal liabilities and penalties, if not in compliance with SOX, have put high pressure on managers to comply with the regulations. The pressure to comply with SOX and the great consequences if management does not comply can be used by managers to justify their lowered innovation efforts. Research shows that one out of ten persons believes that their job is at risk if the firm does not comply with SOX (Kim, Robles, Cho, Lee, & Kim, 2008). The influence of financial controls should also be considered, these controls encourage managers to set up financial objectives within their department. These financial controls can be unfavorable to high risk innovation initiatives when the controls are focused on short term performance, since employees tend to focus on short term performance due to the rewarding structure (Liu et al., 2007). This creates risk-averse behavior, while risk taking is a supportive of innovative capabilities. On the other hand, strategic controls focus on evaluation of performance resulting in rewarding on overall performance instead of short term financial performance. With the knowledge of management that their strategic behavior is understood and will be rewarded for overall performance instead of short term, managers are willing to take risks and long term projects (Liu et al., 2007). Thus, the chosen controls influence the behavior of managers and their attitudes toward risks.

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17 Even if managers accept the risk and decide to invest in risky projects, innovation requires an effective control over the risks of innovations which checks, modifies and optimizes the innovation project in order to be a success. Even though management has a lot of experience in financial and other risks, the management of innovation risk is complicated to them (Liu et al., 2007).

Summarizing, monitoring has both positive and negative influences on the initiatives of managers regarding innovation. Monitoring can reduce the agency problems resulting in managers using resources and taking risks in the most profitable way for the company. On the other hand, SOX puts a lot of pressure on managers, out of fear not to comply with SOX managers might stay away from innovative activities. The way controls are designed, financial or strategic objectives for example, determine the incentives of managers and therefore might influence innovation in a positive or negative way.

3.1.3 Organizational structure

Companies operate in fast changing industries, internal controls need to be able to suit the changing environment, this requires an environment supporting creativity to innovate and discipline to be effective (Perez-Freije & Enkel, 2006). When designing an internal control system managers have to focus on the barriers and drivers of innovation in order to foster creativity and therefore innovation. But, only good internal control systems are not enough to support innovation, the innovative control systems have to be accepted by the users in order to be fully effective. Designing internal controls based on the environment is in agreement with the contingency theory, which states that there is no best way to organize a company but management has to find the most suitable organizational structure (Perez-Freije & Enkel, 2006).

In contrast to what has just been discussed, different literature shows that how companies implement innovative activities depends on the internal controls implemented instead of the other way around. Liu et al. (2007) researched the relationship between the internal controls companies have and the way they innovate. They found that financial controls, which focus mostly on short-term financial objectives, result in incremental innovation. Because radical innovation requires a long time to show benefits and the financial controls are focused on benefits in the short-term. In contrary, strategic controls focus on development instead of improvement, which allows judgement on performance in a qualitative way instead of a financial way, changing the fundament of rewarding. Thus, if a company focusses on strategic controls they promote long term radical innovation (Liu et al., 2007).

Nonetheless, the internal controls within a company can also have a positive influence of innovation. For example the situation that a corporate environment is in place that drives innovative activities but there is lack of internal control. In this situation there will be a dozen of interesting and

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18 profitable opportunities, but all the opportunities are non-related and will not result in superior innovation performance in the long run (Goodale et al., 2011). Another argument mentioned on how internal controls are favorable for innovation is that innovation might not be fully effective or efficient when the matching control mechanisms are not in place. Controls help innovation to be focused, productive and strategically relevant (Goodale et al., 2011).

The dynamic environment of IT has significant implications for the internal control environment. The main internal controls have been evolving over decades under a relatively stable environment, resulting in a standard design and techniques to resolve material weaknesses found in the internal control (Cannon & Growe, 2004). This standard design kept IT employees from involvement to solve the material weaknesses. But the dynamic characteristic of technologies resulted in a life cycle of months instead of decades, therefore current internal control systems have not evolved as well as companies were used to. The short cycle leads to a lack of techniques within the internal control and little knowledge on the technology to solve material weaknesses. To be able to solve material weaknesses in the current dynamic environment the assistance of IT personnel is required, this need has to be acknowledged by companies in order to maintain the effectiveness of internal controls. Besides the causal effect of the implementation of new technologies on material weaknesses in internal control, some implementations might even require new internal controls to be developed to be able to manage all the new risks. The PCAOB emphasizes in practice alert 11 (2013) and 15 (2017) this importance of changing controls which are used to gather and archive data and to provide the required disclosure. The PCAOB alerts firms on the fact that the use of and changes in the information systems determine how internal controls should be designed. If controls are not adequately and effectively adjusted after a change in alliances for example, the risk of material weaknesses will increase.

Even though investing in new technologies to support innovation is very attractive, the risks of new technologies are often not fully understood (Cannon & Growe, 2004). The research on whether or not to invest in a certain new technology lacks consideration of additional control risks, while these risks arise quickly but take time to be discovered. For example investment in technologies, this caused the rise of big data and IT within companies resulting in a lot of information, which is very useful for companies but brings, for example, a lot of privacy risks. The rise of IT has improved the speed and efficiency of firm innovation and provided extra information for financial reporting and decision making. But, the information risks accompanying the development was not considered until later on (Kerr & Murthy, 2013). When the risks were acknowledged, IT controls were implemented to assess the quality and reliability of internal controls. Even though IT controls are financially beneficial due to the security these controls

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19 provide and the contribution to full depletion of the value-adding potential of IT investments they provide, they are often seen as a big cost item (Stoel & Muhanna, 2011). The rise of IT controls is an example of how the internal control system is able to change to fit the environment and implement controls when needed in order to make full use of the potential benefits of investments and innovations.

Another important characteristic of control is if controls are centralized within the company. If controls are decentralized the mechanisms are chosen and directed at operational level, there will be organizational routines, like specific work tasks, reducing the risks which originate from outcome based incentives (Goodale et al., 2011). Designing and implementing controls in a decentralized way is ought to promote long-term innovation within a firm. The responsibility for a certain activity is assigned to the individual decision maker. The decentralization of control grants power to managers, therefore attracting radical innovators therefore increasing the probability of investing in entrepreneurial opportunities of the highest perceived value.

Summed up, the implemented internal controls can influence the way a company innovates but on the other hand a firm can design internal controls which fit their innovative strategy. Even though internal controls might obstruct innovative activities, they are profitable to companies by limiting opportunities to a few optimal innovative opportunities, instead of many sub optimal opportunities. Decentralization of control results in more suitable controls within departments, which are more flexible and more supportive of innovation. The flexibility of controls and structures are important for the company in order to fit the constantly changing environment, keeping internal controls optimal and ensure that these do not limit the innovative opportunities.

3.2 How do internal controls influence the innovative capabilities of startups and established firms? In this paragraph an analysis is conducted on the internal controls of startups and established firms and how these influence the innovative capabilities of firms. This analysis is performed based on the three criteria of innovation. First the influence of internal controls at startups and established firms on resources is discussed, second the influence of internal controls on innovative initiatives is discussed and third the influence of organizational structures within startups and established firms on innovation will be discussed.

3.2.1 Resources

Resources are a critical factor to innovation, how internal controls cause a difference in resources between startups and established firms has to be determined. Incremental innovations require the input

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20 of the same resources over a longer period of time resulting in a continuous innovation of current projects (Stringer, 2000). On the other hand, radical innovations require a suitable growth strategy and the ability to reallocate a lot of resources fast enough in order to deplete radical innovation opportunities.

Startups are known to have less capital, less knowledge and less employees than established firms (Freeman & Engel, 2007). Another difference is that smaller and younger firms are more likely to disclose internal control weaknesses compared to other firms (Ashbaugh-Skaife, Collins, & Kinney, 2007). Therefore the quality of financial reporting will be lower at small firms, which can contribute to financial constraints experienced by startups (McCahery & Vermeulen, 2014). A factor partly relieving financial constraints on startups is the rise of venture capitalists, since these capitalists are willing to invest in new and risky firms. The high cost of capital experienced by startups is only partly relieved through venture capitalists (Hall, 2002). But venture capitalist want more than just being the outside investor, they want to add value through services which help shape strategies, provide technical advice and attract key personnel (Hellman, 1998). This results in more internal control and especially more monitoring since these capitalists take a chair on the board of the company (Gompers & Lerner, 2001).

Even though established firms are known to have a wide variety of resources, most of them are not able to perform radical innovation. Internal controls are installed to ensure the effective allocation and managing of resources, but research shows problems within established firms to reallocate resources in a timely manner. The current structure and current focus of the company causes rigidity within resources and is therefore not available in a timely manner to use for radical innovation projects (Freeman & Engel, 2007; Gilbert, 2005). This shows that the presence of resources within a firm is not enough, they have to be available and flexible. The internal control system limits this flexibility through setting requirements before resources can be used. Yet, without these internal controls managers have free access to the resources, which might cause inefficient allocation of resources (Gao & Jia, 2016). Therefore firms should focus on a implementing controls that safeguard resources without causing rigidity in the reallocation of resources to promote innovation.

As previously discussed, the costs of internal control strongly increased after the implementation of SOX, especially through the obligation of section 404. Since startups have looser internal controls and

less clear segregation of duties the implementation of section 404 would be more costly to startups than to established firms (Goa, Wu, & Zimmerman, 2008). But the regulation has postponed compliance with section 404 for companies with an equity float below 75 million dollars. This makes internal controls more costly for established firms than for startups, which has a positive influence on the financial resources of startups. This exception had a few unexpected negative consequences due to the size of equity float

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21 determining whether or not firms have to comply with section 404 firms might change their behavior (Gao et al., 2008). Some firms might not be willing to invest or innovate, since they believe the future growth benefits will not outweigh the compliance costs. Another possibility is that companies might change their equity values, for example through bad news disclosure to decline stock value, to keep the equity float under 75 million. This has a negative influence on the quality of financial reporting, which can increase the financial constraints and negatively influence innovation.

Summarizing, internal controls are effective and efficient in the allocation of resources within firms. But internal controls do have negative effects on resources, the rigidity of resource allocation restrains established firms to perform radical innovations. Another influence on available resources are regulations on internal controls, these influence financial resources negatively which cause a decline in overall innovativeness. But, these regulations on internal controls have less influence on startup resources, since SOX section 404 does not apply to them.

3.2.2 Initiative

The second criteria of innovation is initiative taking, the manager has to be willing to spend time on innovation and accept the risks associated with innovation. Managers of established firms are focused on the fostering of continuous improvement of existing products and services, thus on incremental innovation, and all resources are allocated to these activities (Chang, Huo-TsanChang, Hui-RuChi, Ming-HueiChen, & Li-LingDeng, 2012). Due to the separation of ownership and control within established firms, owners create rewards based on the performance of managers to align their incentives. The managerial rewards are based on the maintaining and improving of the established system, therefore pushing managers to support incremental rather than radical innovation. Also, internal controls are designed to ensure that current operational activities will lead to the desired outcomes of the owners (Birkinshaw et al., 2007). Literature shows no significant relation between the implementation of financial or strategic controls and specific firms.

Research has shown that managers who do want to take risk in order to provide radical innovation, do have certain needs which might explain why established firms find difficulty in performing radical innovations (Stringer, 2000; Watts, 2001). Managers that aim at radical innovation prefer to have power, the ability to influence others and work without organizational boundaries. They are also known to be stubborn but very driven. In large established firms managers are subject to the control and constant monitoring top level management, which is the opposite of their needs, therefore driving away radical

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22 innovators (Stringer, 2000). The managers of established firms are seen as reluctant to experiment in unknown territory therefore risk averse (Chang et al., 2012).

Startups are the opposite, the lack of hard structures and controls gives innovators the freedom to perform radical innovations and attracts those kind of employees. Note that startups are mostly build around one ground breaking radical concept, thus the whole existence of the startup is the result of radical innovators putting their ideas into actions. Another reason for the ability of startups to perform radical innovation is that these firms do not have a separation of ownership and control. Therefore managers will not be rewarded based on specific objectives and the monitoring of the objectives through internal control (Stringer, 2000). The profit of not rewarding on certain objectives is the managerial focus drifting from short-term objectives to long term, therefore managers might choose radical innovation because they have less to lose than with objective based rewarding.

But, we should consider the role of venture capitalists within startups. Radical innovation, especially within startups, requires money from external parties which feel comfortable in investing in risky projects (Gilbert 2005; McCahery & Vermeulen, 2014). These venture capitalist initiate new business structures, implement controls, allocate the resources and monitor the startups. This could cause a restriction on freedom which radical innovation requires and could have an adverse effect on radical innovators.

In short, the controls within startups give more power and freedom to employees which attract radical innovators who want to take risks. The heavy controlling and monitoring within established firms and the lack of power in departments do not attract radical innovators and therefore limit the possibility to radical innovation within established firms, putting the focus on incremental innovation. The influence of growing monitoring and other controls caused by financing through venture capital should be considered, since these might have an adverse effect on radical innovators.

3.2.3 Organizational structure

Established firms are known for their well-defined but complex structures. These firms believe that this is what gives them their competitive advantage, but do not see the long term potential of new technology because the lack of knowledge on changed competition (Freeman & Engel, 2007). Startups are known to be young and small, they lack structures and controls but are therefore simple and flexible.

The internal controls within established firms are designed to preserve the current operational environment, resulting in efficient and effective allocation of resources, ensuring that company objectives are achieved and that the financial reporting of these firms is reliable (Stringer, 2000). This results in a

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23 very stable and continuous incremental innovation within these firms, supported by systematic mechanisms within the company. If established firms wish to perform radical innovation, these structures nurturing incremental innovation could be the rigidities to radical innovation (Chang et al., 2012). When these firms want to perform radical innovations they have to move to industries where the usual systematic approaches will not be of use and must adapt their controls and structures to the new environment (Chang et al., 2012). Established firms have created their current competitive advantage through their current systems and structures which resulted in the focus on incremental innovation and the matching structures and controls within established firms. This focus does bring risks to the firms, when startups do focus on radical innovation in a successful way, established firms might lose their competitive advantage (Birkinshaw et al., 2007). An example of an established firm losing their competitive advantage is Nokia, who was a market leader with their cellphones until smartphones became available on the market. The investments in research and development in smartphones were risky. Nokia decided to focus on their current product and therefore missing out on the development of, turning out in the end, much better phones. A firm like IBM did manage to perform incremental innovation, the firm started with a time clock to record the working times of employees in 1889 but kept up with the technological environment resulting in the development of the first computer in 1964. Now they focus on block chain, a current new and complex technology which has not proven to be successful yet, showing that they keep focusing on incremental innovation to maintain their competitive advantage. So they did retain their competitive advantage over time but in different economic markets.

Startups are developed around one particular breakthrough concept, thus startups are immediate radical innovators (Stringer, 2000). Startups experience certain benefits of being relatively small, for example the possibility of coordinating and controlling through informal management and social norms instead of rigid internal controls (Davila, 2009). This lack of need for strong and complex internal controls makes startups very flexible and adaptive. Another benefit of being relatively small is that close collaboration and coordination on projects is much easier, which is supports the effectivity of innovation (Lee & Xia, 2006). The adaptability and flexibility makes startups more responsive to the unpredictable nature of the current economy. In order for startups to maintain this flexibility, the internal control should be limited to bookkeeping under the traditional view of management (Davila et al., 2009). Research has shown that after startups become successful through their radical innovation, they experience the same problems that once gave them their competitive advantage (Freeman & Engel, 2007). Over time business structures and controls have been implemented and the firm wants to hold on to their current business

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24 operations, since these have brought them their success. In the end, startups could therefore lose their ability to perform radical innovations.

But, internal controls can also be encourage radical innovation if they are focused on the right objectives. When internal controls are implemented in a way where they signal if a company should change strategy due to changes in the environment, firms could be able to change their structures, objectives and controls in time to be a first mover in radical innovations (Davila et al., 2009). This would solve the problem that occurs within firms where they continue with the predetermined strategy, which would cause the inability to respond to the market. However, until now firms have not been able to implement controls in such a way. Another profitable function of internal controls is that it supports innovation in some way. The freedom to be creative and take initiative to innovate has to be accompanied by control as a disciplinary function to move from an idea to a valuable innovation (Davila et al., 2009).

Technology is the key driver of innovation in the current markets, therefore the importance of effective implementation within firms is high. The internal control framework within firms has to adapt to new technologies, especially information technology, in order to remain effective and efficient (Cannon & Growe, 2004). The design of current internal control systems does require the input of both operational and IT experts in order to design a good internal control system. For both established and startups IT could provide a lot of information on their current performance and possibilities to improve. Due to IT controls managers are ensured that they can rely on the given information. For the adoption of IT established firms seem to be in favor, while startups might suffer from tight IT budgets and the lack of expert IT employees, established firms have plenty resources and employees (Lee & Xia, 2006). For the adoption of new technologies in general, established firms might face the problem of having experts on both technological and operational aspects which do not collaborate their knowledge, resulting in suboptimal internal controls. Startups might face the problem of lacking knowledge on how to design internal controls throughout the entire firm, but the importance of internal control within these firms is much lower. Therefore internal controls might obstruct the adoption of new technologies, due to the inability to match internal controls in a way that the controls remain able to ensure on the achievement on companies objectives.

In short, internal controls cause rigidity within firms, especially established firms due to their extensive internal controls compared to startups. These controls safeguard the maintaining and innovating of the factors that created current success, but keeps them from radical innovations which might be necessary to retain their competitive advantage. Startups are built around the radical innovation they are carrying out, therefore able to perform the radical innovation. The use of technology is key to

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25 innovation, the internal control system does not seem to influence the adoption of technology in a significant way. IT controls only ensure the quality of information provided by IT which is a positive influence while the inability to adapt the systems to new technologies might keep managers from adopting new technologies which is negative.

4. Conclusion and discussion

In this thesis research has been conducted on the influence of internal controls on innovative capabilities of firms, supported by a comparison between startups and established firms. The research question is answered by means of a literature review on two sub questions. These sub questions are tested on three criteria of innovation: resources, initiative and organizational structure. This research adds to current literature on internal controls, until now this focused mainly on the influence on financial reporting and information quality, this research shows how these might cause unintended consequences on innovative capabilities. In this paragraph the findings on the three criteria of innovations are discussed, followed by the answer on the research question and finally a discussion on the implications of this research.

First we analyzed resources, this gave the following insights in the relationship between internal controls and available resources. Internal controls safeguard information and increase accruals’ quality, therefore increasing financial reporting quality. In addition, internal controls provide more information on operational activities reducing the information asymmetry. Higher quality of financial reporting and less information asymmetry improves the knowledge of outside investors and therefore lowers cost of capital. The influence of high quality internal controls on conservatism should be taken into consideration, since this might cause lower quality financial reporting. The comparison showed that investors are very important to startups due to having less resources, the importance for high quality controls is therefore much higher to attract investors. Instead literature shows that startups lack formal controls and gain financing through venture capitalists, which accept the risk in return for certain rights within the firm. On the other hand established firms have plenty resources, most of which are assigned to operational activities and incremental innovation. Established firms cope with rigidity to reallocate their resources, partly caused by internal controls, limiting these firms to perform radical innovations. The implementation of SOX increased internal control awareness which improves financial reporting quality. But there are also negative influences, for example section 404 is very costly for established firms which has a negative influence on innovation. Since startups are not public yet, the regulation does not apply to them, but could at some point be a reason to limit innovation to remain under the 75 million limit of section 404.

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26 Second initiative is discussed, the analysis showed a few relationships between internal controls and innovating initiative. The monitoring function of internal controls has the greatest influence on investment initiatives. A positive effect of monitoring is the decrease of the agency problem, especially within established firms, because monitoring provides principals with more information on the agents and resources. This increases efficiency in allocating resources and gives the possibility to influences the efforts of managers. A negative effect is the adverse reaction of radical innovators on monitoring, therefore lowering radical innovation. Monitoring is low within startups, but the use of venture capital increases monitoring and might restrict radical innovators. The implementation of SOX has increased risk-adversity within established firms, managers are afraid of the inability to comply with SOX when performing radical innovation, therefore relaxing their efforts. The focus of controls have influence on the behavior of managers, financial controls focus on short term efforts and managers will be rewarded for this effort, thriving them to incremental innovation. There is no evidence of startups or established firms using one specific sort of control, this depends on strategic decisions.

Third the influence of corporate structures are discussed. In the analysis a two-way causal relation was found, on the one hand design of internal controls determines how a company innovates, for example with strategic controls. On the other hand the chosen innovative strategy of a firm can determine how internal controls are designed and implemented. The restrictive characteristic of control does positively influence firms as these prevent from many irrelevant investment opportunities which would not optimize firm value. The analysis has shown the importance of the flexibility of internal controls, the markets and technologies are in constant flux and internal controls must be up to date to provide reliable information to use for financial reporting and investment decisions. The believe of companies in their current competitive advantage creates rigidity in their structures and puts their focus on incremental innovations, making radical innovations impossible. Startups are built around one breakthrough idea, therefore radical innovation is possible, but startups risk to believe in their competitive advantage in the future, resulting in the same rigidity problems as established firms experience now. The influence of IT controls on innovation is rather small, IT controls do improve the reliability of information which is used in other internal controls, improving their quality, but there is no direct relation between innovation and IT controls.

As a result of this analysis and the comparison between startups and established firms, enough information is available to answer the research question. The analysis has shown that internal controls do have a big influence on the innovative capabilities of firms, especially the difference between incremental and radical innovations is highly dependent on the controls implemented within firms. This influence of

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27 controls is emphasized by the difference in internal controls between startups and established firms and how these influence their innovative capabilities. Regulations on internal controls like SOX improve the benefits of internal controls, but imply a lot of restraints and costs which negatively influences innovation. This research shows that when implementing internal controls all possible consequences of these controls have to be considered, an advantage of monitoring on one place can disadvantage innovative capabilities. Therefore internal controls do influence the innovative capabilities of firms, both in a positive and in a negative way.

The limitations of this research should be considered. The biggest limitation is the single use of existing literature as evidence for this research, future research could increase significance through the use of data-analysis. Also, this research took the broad concept of startups and established firms but all startups and established firms are different, they focus on different innovations and implemented different controls. This research lacks the documentation of what internal controls startups and established firms have implemented, which is important to be able to compare. Not only firms differ, there are many different industries with different characteristics and therefore the influence of internal controls on innovation can be different. Future research should focus on specific industries and firms with the same characteristics to be able to compare the influence of their internal controls on innovation. Another limitation is the use of only three criteria for innovation, there could be other criteria of innovation which are influenced by internal controls. In contrast to expected, the influence of IT controls on innovation is relatively small, further research could focus on finding how IT controls do influence certain criteria of innovation. A lot of relationships found in this research are indirect, therefore it should be considered how strong these relationships are. This research lacks measurement of how significant the influence of certain internal controls are on innovation, this could be achieved through data-analysis and improve the quality of future research. The initiative for innovation is a criteria which is difficult to measure, therefore the response of employees on certain controls is often very speculative and therefore not very reliable.

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28 5. References

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Do internal controls influence innovativeness in firms? : a comparison between start-ups and established companies

Do internal controls influence innovativeness in firms?

Table of Contents

2.1

2.2

2.3