Research On The Governance Effect Of Mandatory Internal Control Audits

Compared with the mature capital markets of developed countries,the practice of building an internal control audit system in China started relatively late.In 2012,the Ministry of Finance and the Securities Regulatory Commission issued "The Notice on the Implementation of the Corporate Internal Control Standard System of Main Board Listed Companies in Batches by Classification in 2012"(Hereinafter referred to as The Notice in Batches by Classification).The notice required all the listed companies on the main board to carry out the construction of internal control system in different batches since 2012.This marks that the internal control audit has entered the mandatory implementation stage,which provides a perfect quasi-natural experimental environment for this paper.Although internal control audit and financial statement audit are some of the important tasks of auditors,existing literature about the governance role of audit is almost limited to financial statement audits,the evidence from to the governance effect of internal control audits is very little.The research methods that existing research on the economic consequences of internal control audits used make the research results have a certain endogeneity.Meanwhile,the existing literature research on mandatory internal control audits(MICAs)has a single perspective,and there is a lack of systematic research on how mandatory internal control audit promotes the realization of internal control objectives.In summary,the limitations of previous research in research methods and perspectives make this paper have certain practical and theoretical significance.Internal control aims to provide reasonable assurance for the effectiveness and efficiency of business operations,the reliability of financial reports and compliance with applicable laws and regulations.The notice requires companies to hire a third-party audit institution to audit the effectiveness of the design and operation of the internal control,and issue the internal control audit reports,which will help firms to identify internal control problems to improve,promote the enterprise to establish an effective internal control system and achieve the internal control objectives.Therefore,from the perspective of the three basic objectives of internal control(operating objectives,financial reporting objectives,and compliance objectives),this article constructs an integrated framework for the external governance effects of MICAs.We use the implementation of The Notice in Batches by Classification as a natural experiment and adopt DID empirical methods to test the governance effect of MICAs on three internal control objectives.Based on the theory of principal-agent theory,information asymmetry theory,audit demand theory,and reputation mechanisms theory,this article assumes that MICAs achieve governance effect mainly through the authentication,supervision,and information function of the internal control audit,reflecting in promoting the realization of internal control objectives.China’s internal control regulatory system experiences the transition from induced change stage(voluntary disclosure)to mandatory change stage(mandatory disclosure),the double constraints from the regulation party and the capital market can further promote the realization of the governance effect of internal control audits.As an important market supervision system,MICAs can exert governance effect through authentication(to alleviate agency problems),supervision(to improve the design and operation level of the company’s internal control),sending signals(to reduce the degree of information asymmetry),and other ways to promote the realization of the three objectives of internal control.This paper studies the governance effect of MICAs by testing the relationship between the three objectives of internal control,and according to the existing literature to choose inefficient investment,real earnings management,and tax avoidance as the main indicators to test the realization of the three objectives of internal control.First,we use inefficient investment to measure the efficiency and effectiveness of operations,examine the role of MICAs play in achieving operating objectives.In the additional test,we also use operating performance as alternative indicators of the level of operating goals to ensure the robustness of the conclusion.Secondly,we employ the real earnings management of enterprises to measure the reliability of corporate financial reporting information and examine whether MICAs benefit the realization of financial reporting goals.Finally,considering that compliance with national tax regulations goes through all aspects of enterprise production and operation,which is a very important part of achieving compliance objectives,we choose tax avoidance behavior to test the effect of the implementation of MICAs on the realization of compliance goals.In the additional test,we also use corporate litigation risk and corporate violation as alternative indicators of the level of compliance goals to ensure the robustness of the conclusion.It shows that after the implementation of MICAs,firms’ inefficient investment levels,real earnings management,and tax avoidance levels have declined.This verifies the MICAs’ external governance effects from the perspectives of internal control operating objectives,financial reporting objectives,and compliance objectives.We also find that the better institutional environment of the registered place reinforces the governance effect of MICAs.Furthermore,the information transparency of firms reinforces the governance effect of MICAs on firms’ inefficient investment levels.The agency costs of firms weaken the governance effect of MICAs on firms’ real earnings management,and the financial constraints of firms weaken the governance effect of MICAs on firms’ tax avoidance levels.We utilize the practice of implementing MICAs in phases from 2012 as a natural experiment and systematically examine the governance effects of the implementation of the MICAs from the perspective of the three basic goals of internal control.Our research enriches the literature related to the study of the governance effects of MICAs systems in the institutional context of the Chinese capital market,and provides new evidence to further our understanding of how internal control audits can have a governance effect.This paper also provides reference for policy-making departments to further improve China’s internal control specification system.