The Analysis Of Factors Related To Reporting Internal Control Deficiencies For Limited Companies

Internal control is very significant for the sustainable development of a company. The function of internal control system is to combine a variety of economic factors (such as funds, equipment, personnel, etc.), so that these factors could take the most advantages of their potentials. In addition, an effective internal control system plays the role of barrier for the enterprise to avoid risk. Notwithstanding the importance of internal control, not until the year of2002the detailed information of internal control is acquired by the corporate outside investors. As a result of the outbreaks of U.S. Enron, WorldCom and other company’s financial scandal, the community pays more and more attention to improve the quality of internal control and financial reporting information. Consequently, in July2002the U.S. Congress passed the Sarbanes-Oxley Act (SOX), which coerced the corporate management to evaluate its internal control, and requested to audit the self-assessment by the external audit agencies. In2008and2010China issue the basic norms of internal control and three supporting guidelines respectively. By now China has developed a complete system of internal control. The Chinese system not only asks for the evaluation of internal control by management, but also shows clear definition and disclosure of internal control deficiencies. The Internal control information, especially the information about the disclosure of internal control deficiencies is vital for investors to make investment decisions, also, is very meaningful for enterprises to improve their internal control system. This dissertation aims at studying the influencing factors of internal control weaknesses in the perspective of internal governance and external audit.This paper is composed by two parts:the theoretical research and the empirical study. In the first place, this paper shows the definition of internal control weakness in the theoretical analysis. According to the internal control evaluation guidelines in China, there are three kinds of internal control weakness: material deficiencies, significant deficiencies and general deficiencies. Material deficiency is one deficiency or the combination of several deficiencies that could cause severe deviation from the control objectives. Significant deficiency is one or more deficiencies that may cause deviation from the control objectives, but its severity and economic consequences is less than significant deficiencies. In addition to material and significant deficiencies, other deficiencies are described as general deficiencies. As can be shown from the literal meaning, the criteria for the classification of control deficiencies provides greater discretion for enterprise, which may cause the consequences of unreliable control information. Therefore, this paper does not distinguish between material deficiencies, significant deficiencies and general deficiencies. In addition, I think only those companies which need to report the information on control deficiencies have internal control deficiencies. Thence in this article Shanghai Stock Exchange A-share companies of existing control deficiencies in2008-2010is selected as a sample to study influencing factors on disclosure of internal control. If one company meets any of the following conditions, it is considered as our sample in this paper:(1) the company has disclosed control deficiencies in its annual report or internal control self-assessment report;(2) the company or its directors, supervisors, management experienced the punishment by China Securities Regulatory Commission or the Stock Exchange;(3) the financial restatement is occurred in the company;(4) the company’s financial statement was issued as non-standard by audit opinion.Second, in the theoretical analysis, the basis of theoretical analysis and empirical research------asymmetric information theory and principal-agent theory are listed in this paper. In modern society, many investors employ professional managers to run the company for them. Therefore a kind of contract relationship is formed between investors and managers. Managers acquire more information of the company than the investors, and their interests function is different, so the managers will make use of the information acquired to achieve his utility maximization in despite of investors’interests. In this condition, investors must strengthen the supervision on the managers in order to obtain enough and reliable information. Internal control deficiency is one kind of negative information, which is a sign of bad management. In order to avoid the punishment from the investors, managers may have the motivation to conceal the control weaknesses and make a false report. To deal with this situation, investors would request to establish specialized department on the one hand, such as the independent director system, audit committee and so on, to supervise managers. On the other hand, investors would hire external auditors to audit the internal control information. By doing these, more pressure is expected on managers to drive them to report true internal control information.On the basis of the theoretical explanations, this paper puts forward six assumptions:(1) the larger scale of the audit committee, the greater possibility of internal control deficiencies disclosed;(2) the more audit committee meetings, the greater possibility of internal control deficiencies disclosed;(3) the higher proportion of independent directors, the greater possibility of internal control deficiencies disclosed;(4) the company that employs external auditor to audit its internal control has a higher possibility to report internal control deficiencies:(5) the scale of the external audit agencies has an influence on internal control deficiencies disclosed;(6)the company that changes its external audit institution is more likely to disclose internal control deficiencies.In the empirical research section, the paper chooses following explanatory variables according to the previous assumptions:the scale of the audit committee, frequency of board meetings, the proportion of independent directors, internal control auditing or not, the scale of external audit agencies, changing external audit agencies or not. In addition, the paper selects financing, ST and year as the control variables. Through descriptive statistics, logistic regression and sensitivity analysis, we gain the following results:the assumptions of one, two, four, five and six all pass the empirical test. The third assumption, which is the proportion of independent directors, does not pass the test, and the paper gives the reason in the following paragraph.According to the conclusions of empirical analysis, the paper puts forward four-point policy recommendations:(1) our country should develop a rule-oriented standard on internal control deficiencies identified;(2) the relevant departments should strengthen the external auditing on internal control to improve the quality of the internal control auditing report;(3) the company should strengthen its internal governance, for example, the competence of the audit committee, the independence of the board etc.;(4) the relevant departments should strengthen the regulatory for these companies, which have financing planning or experience the special treatment, because they have less motivation to report the deficiencies.The innovation of this paper is reflected on the following two points:(1) large quantities of previous studies imply an assumption:those companies who report internal control deficiencies exists internal control deficiencies, those companies do not report internal control deficiencies exist none internal control deficiencies. However, the existing of internal control deficiencies is a premise of reporting the internal control deficiencies. So the previous assumption would have influence on the study results. In order to exclude the impact of the assumption, the paper selects those companies which have the internal control deficiencies as the sample;(2) the paper clearly indicates the details of the internal control deficiencies by descriptive statistical analysis, which is very meaningful for the company to correct its internal control deficiencies. The paper also has two shortcomings:(1) four conditions are selected as the measurement of internal control deficiencies existed, in the practical business, some companies may experience the deficiencies otherwise the four conditions. So the paper excludes this kind of companies, which may lead to invalidity and inaccuracy:(2) the paper does not develop research in other characters of the audit committee, such as its competence and etc.