A Research On Relationship Between The Quality Of Internal Control And The Financial Risk

Economic globalization raises the uncertainty of business environment, whichmakes enterprises face greater risks than before. How to improve the ability ofenterprises to cope with risks, to enable them to develop sustainably in the fierce marketcompetition is an urgent and valuable topic. The case of bankruptcy of Enron andLehman Brothers in the United States, domestic cases such as the SanLu Group whichwas sued as a result of the tainted milk scandal, tidal waves of enterprises bankruptciesin Wenzhou, Zhejiang province and the bankruptcy rumors of the Greentown Group dueto funding strand breaks reflect the fact that, in addition to the impact of severe externaleconomic situation, enterprise internal control also have many defects, which exacerbatethe risk of the enterprise. And operating risks, compliance risks, and many other riskswill eventually be reflected by the financial results of the enterprise. This paper deeplystudies the inherent relationship between financial risks and the internal control qualityas the starting point of this paper.Firstly, this paper sums up the related literatures on the internal control quality andfinancial risk. The current studies mostly focus on separated analysis on these two fields,and there are very few scholars discussing the correlation between these two. Then thispaper discusses the internal control theory and analyses the causes of financial risk.Combining five elements of internal control proposed by COSO Committee and thespecific situation of capital market in china, this paper proposes a quality evaluationindex system of internal control of listed companies in China.Through the quality evaluation index system of internal control, we could quantifythe internal control quality of sample enterprises. On the other hand, we use the“Z-score” as a surrogate marker of enterprise financial risk. The empirical analysisindicates that there is a correlation among internal control quality, control environment,risk assessment, control activities, information and communication, supervision andfinancial risk, but the degree of correlation is different. There is a significant correlationamong the internal control, internal control environment, risk-assessment, supervisionand financial risk. Besides, the empirical test also shows that internal control quality isaffected significantly by control environment, ownership structure, and managementposition setting. We also found the characteristics of enterprises that have internal control deficiencies: highly concentrated shareholding structure, the major shareholders’control of the board, and the excessive executive duties of chairman of the board.Therefore, the irrational corporate governance structure, failed mechanism of the checksand balances, major shareholders and executive overriding the internal control systemusually result in the fact that many important decisions are made by controllingshareholder arbitrarily.Furthermore, this paper does a cases comparison analysis to discuss the correlationbetween internal control quality and financial risk after empirical test to improve thereliability and robustness of the conclusion. The conclusion of case analysis alsosupports the result of empirical test.The main innovation points lie in:(1) to analysis the financial risk from the pointof view of the internal control quality. The result of empirical test indicates that internalcontrol quality significantly affects the financial risk. A perfect control system helps tosuppress the financial risk;(2) to use the method of case comparative analysis to discussthe different characteristics of internal control between two companies that havedifferent financial risk levels.