Voluntary Internal Control Audit Disclosure And The Cost Of Capital:Theoretical Analysis And Empirical Evidence

Enron’s outbreak makes the global capital markets clearly recognize that relying solely on the disclosure of corporate financial report and its audit can not achieve an effective supervision on the implementation of corporate contract, but internal control playing a role in the monitoring and optimizing the production process of corporate financial information causes great concern in capital markets. Internal control information disclosed by listed companies in the capital markets, which is the important basis for investors to determine the company’s internal control effectiveness, surplus reliability, violation possibility and their investment risk, and also the major reference for creditors to evaluate company’s information risk and probability of default. Five Chinese ministries including Ministry of Finance jointly issued The Basic Standard for Enterprise Internal Control and Implementing Guidelines for Enterprise Internal Control, which are effective for companies listed, both domestically and abroad, from January2011, and expanded to companies listed on the main board of the Shanghai Stock Exchange and Shenzhen Stock Exchange since2012. Previous to this, the internal control audit and its disclosure of listed companies in China is still in the voluntary phase. In recent years, a large number of listed companies to voluntarily disclose the internal control audit report issued by the auditors, giving rise to the theoretical discussion and empirical study about the motivations and economic consequences of their behaviors. The cost of capital is one of important perspectives to examine the economic consequences of information disclosure. The cost of capital is often viewed as a metric that captures how well information disclosure achieves its primary function of providing value-relevant information to users. The effective operation of capital markets can’t without information disclosure. Internal control information disclosure is an indispensable part of corporate information disclosure. The design and implementation of internal control of listed companies are being stored in their "black box", so the voluntary disclosure of internal control audit report is the signal from companies’ managements to release the internal control quality to the external stakeholders. Under our current institutional environment, to examine the economic consequences of internal control audit and its voluntary disclosure from a capital cost perspective, has a special theoretical value and practical significance, to empirically evaluate the internal control standards and their implementation effect, promote regulatory authorities to further improve the formulation of relevant policies, regulate internal control information disclosure, and strengthen the supervision of the capital market as well as protect the interests of external stakeholders.This dissertation uses a method of combining normative research and empirical research, and follows the four layers of Research Foundation-Mechanism Analysis-Empirical Test-Conclusions to undertake gradually the study after putting forward questions.Firstly, it combs relevant research literatures at domestic and abroad about information disclosure and cost of capital, as well as the internal control, followed by the use of the classical theory of contract economics and information economics, to analyze deeply the theoretical basis of the voluntary disclosure of internal control audit affecting the cost of capital, from the contract theory, principal-agent theory, asymmetric information theory, and signaling theory. And based on the classic theories, it derives the mechanism that voluntary disclosure of internal control audit report affects the cost of capital. Then, taking into account that different participants in the capital markets are different in access to information and ability to prevent risks, and have different extent of depending on and degree of concern about internal control governance mechanism. In the subsequent empirical test sections, according to difference in the financing channels of listed companies, based on the stock market, corporate bond market and bank credit markets, the dissertation examines the effects of listed company to voluntarily disclose internal control audit report on its capital cost of the different sources of financing respectively. In addition, taking account of our debt covenants often endogenous to the institutional environment for cost of debt capital, it also discuss effects of ownership type difference on the signaling of voluntary disclosure of internal control audit information from listed companies. Empirical study finds that:In the stage of voluntary internal control audit, both for the public markets (stock market and bond market) and private market (bank credit market), listed company by hiring an independent third party (CPA) to audit the effectiveness of internal control and its self-assessment, with the help of signaling function of voluntary internal control audit, can send the real situation of its effective internal control and reliable financial information to stakeholders in capital market, which contributes them to estimate more accurately the value and risk of the company, so as to lower the cost of capital for the listed company who disclosed voluntarily its internal control audit report. As a result, as a safeguard mechanism of effectively disclosing internal control information for Chinese enterprises, the audit of internal control, can make participants in capital market effectively identify the quality of internal control, and then to give differentiated treatment and capital pricing.Further studies grouped by the nature of ownership for the debt markets showed that, relative to the non-state-owned listed companies, state-owned listed companies’signaling intensity to voluntarily disclose internal control audit reports has been weakened. This is because of the implicit guarantee function provided by state-owned property makes the majority of investors in capital markets relax requirements for the quality of the information and internal control of state-owned listed companies when making investment decisions, which thereby weakens the signaling effect of listed companies to voluntarily disclose internal control audit report. This finding gains empirical supports both in primary market and secondary market of corporate bonds.The possible innovation of the dissertation is mainly reflected in the following three aspects:(1) Based on the main markets of Shanghai and Shenzhen A shares in China, and different from the existing literatures using the realized rate of return method to estimate the cost of equity capital, this dissertation uses financial analyst earnings forecast data and Easton’s (2004) PEG model to estimate ex-ante cost of equity capital, to test how the voluntary disclosure of internal control audit information affects cost of equity capital of public corporation, under the information disclosure environment in our capital market. The research perspective and methods, not only provide empirical evidence for the usefulness of Chinese financial analysts’ earnings forecasts, but also enrich and expand the existing related research from the research content and method.(2) According to the status quo of debt financing in Chinese listed companies, and considering the differences of different creditors in information collection and processing capabilities, the debt capital market is further divided into the public debt market (i.e., corporate bond markets between Exchanges) and private debt market (i.e., bank credit market), the dissertation builds econometric models respectively for the corporate bonds issued in public debt market and bank loans in private debt market, to test how voluntary disclosure of internal control audit information affects the cost of debt capital. Because the contract structure is endogenous in institutional constraints, under the transformation economic environment in China, the government still plays an important role in the allocation of social resources, and through the holding of state-owned enterprises turned to become participants in capital market. Therefore, the dissertation embeds above relationship into Chinese unique property rights system environment, to further investigate the effect of ownership type on signaling behavior result of internal control audit report, which has a special practical significance.(3) Corporate Bond Issuance Pilot Approach was officially released in2007, marking the formal sailing of corporate bond market in china. The development of corporate bond market contributes to the listed companies to enlarge financing channels, reduce financial risk dependent on bank loans, and make a positive contribution to playing a basic role of the market in the allocation of social resources. Vigorously developing corporate bonds is a hot issue in the current financial reform, and it is a strategic target of the development of Chinese bond market to improve the proportion of corporate bond financing in the direct financing. At present, related research on corporate bonds in China is in the initial stage, and still gives priority to qualitative analysis and lacks of quantitative research. There is less research on the pricing problem of the corporate bonds in the primary market and secondary market using a large sample empirical test. The theoretical analysis and empirical test based on Chinese corporate bond markets, is conductive to enriching the research on corporate bond literatures, enlarging theories of corporate bond pricing in China, and the accumulation of relevant empirical evidences based on Chinese institutional context.