Pages: 13

Chapter 1 introduces the empirical findings from U.S. and China’s studies on the effect of internal control on corporate behaviours and decisions and unveils that China’s studies simply follow the U.S.’s research paradigm based on financial-reporting (FR)-oriented internal control, that is, “Internal control over FR → Quality of accounting information → Agency cost and information asymmetry and related consequences”, without noticing that China adopts operation and management (OM)-oriented rather than FR-oriented internal control. Given the different orientations of internal control between China and U.S., this chapter raises the research question—whether internal control in China plays a role of trimming rather than hyper-correcting in corporate financial activities, which respectively correspond to OM-oriented and FR-oriented internal control. Finally, this chapter clarifies the research design and framework of isolating trimming hypothesis and hyper-correction hypothesis and discusses this research’s incremental contributions to existing internal control literature.

Pages: 20

Chapter 2 reviews existing literature on internal control. Firstly, this chapter summarises the international literature which adopts quantitative research methodology. The statistics show that the upsurge of internal control studies in the U.S. began around 2007 and mainly focuses on two major themes: determinants and economic consequences. Secondly, this chapter introduces the internal control studies in China which adopt both qualitative and quantitative research methodology. The statistics show that the quantitative studies emerged after the publication of the Standard in 2008. These studies also mainly focus on the two major themes-determinants and economic consequences. However, unlike studies conducted in the U.S., studies in China predominantly support the benefits of internal control with ignoring its costs. Finally, with a review and comparative analysis of studies conducted in and outside China, this chapter introduces the research opportunities.

Pages: 15

Chapter 3 develops two theoretical hypotheses respectively corresponding to the FR-oriented and OM-oriented internal control. Firstly, this chapter introduces the evolution in orientations of internal control in both the U.S. and China. Secondly, building on existing theories and internal control practices, this chapter discusses the differences in the impacts of internal control on corporate behaviours and firm value under different orientations, that is, FR orientation and OM orientation. Finally, based on the previous discussion, this chapter presents the two theoretical hypotheses, that is, the hyper-correction hypothesis and the trimming hypothesis, and introduces the strategy of empirically isolating these two hypotheses from each other.

Pages: 19

Chapter 4 examines whether internal control plays a hyper-correcting or trimming role in corporate financial activities from the perspective of corporate cash policies. The empirical results show that firms with higher internal control quality (hereinafter, ICQ) hold more cash. Further analysis show that when holding extra cash, firms with higher ICQ are more likely to increase investment expenditure, M&A and R&D expenditure, and cash dividends in the next year, suggesting that firms with higher ICQ reserve a large amount of cash, not to avoid excessive risk (reducing all expenses as much as possible), but to meet their investment and profit distribution needs for the next period. Finally, stock market investors value the cash held by firms with higher ICQ more, indicating that these firms’ cash holding behaviour is in line with shareholders’ interests and firm value. In short, this chapter uses corporate cash policy to provide empirical evidence supporting the trimming role of internal control.

Pages: 16

Chapter 5 examines whether internal control plays a hyper-correcting or trimming role in corporate investment activities from the perspective of M&A. The empirical results show that firms with higher ICQ have higher M&A frequency and tendency. Further analysis show that the higher the ICQ of the acquirer, the smaller the increase in bankruptcy risk in the year of and three years after the completion of the M&A transactions, and the better the M&A performance, suggesting that a high level of internal control enhances a firm’s integration capability after the M&A, thereby improving M&A performance. In summary, these findings suggest that although firms with higher ICQ carry out more M&A activities than their counterparts, they can effectively keep the risks within their tolerance, which brings a better integration effect and better M&A performance. Therefore, the trimming role of internal control is verified.

Pages: 25

Chapter 6 examines whether internal control plays a hyper-correcting or trimming role in corporate profit allocation from the perspective of corporate tax avoidance. Corporate tax avoidance activities can be divided into two categories with distinct risk and value effects: prudent tax planning and aggressive tax avoidance, which are respectively in the lower and higher distributions of tax avoidance. Using the quantile regression model, empirical results show that in the lower (higher) quantile of the tax avoidance distribution, ICQ is significantly positively (negatively) correlated with the level of tax avoidance. This finding suggests that internal control neither leads to excessive risk aversion (measured as a higher level of prudent tax planning) nor to excessive risk-taking (measured as a lower level of aggressive tax avoidance), but instead controls the risk of tax avoidance within a rational level consistent with firm value, supporting the trimming role of internal control.

Pages: 17

Chapter 7 examines the relationship between internal control and corporate development strategy in order to investigate whether it is the OM orientation that results in all findings in Chapters 4 to 6 support the trimming role of internal control. The empirical results show that the positive relationship between ICQ and the value of diversification strategy only exists in non-SOEs. Further analysis confirms that the different effects of ICQ on the value of diversification strategy between SOEs and non-SOEs result from that internal control plays different roles in the choice of diversification strategies by firms with different types of ownership. Overall, this chapter takes the diversification strategy as an example and verifies the role of internal control in promoting the realisation of corporate development strategies, which justifies that the difference in the orientations of internal control between China and U.S. leads to the different impacts of their internal controls on corporate financial activities.

Pages: 3

Chapter 8 summarises the background and process of developing two competing theoretical hypotheses, that is, the hyper-correction hypothesis and the trimming hypothesis, and the empirical findings from cash holdings, M&A activities, tax avoidance, and diversification strategy, and concludes that the OM orientation of internal control determines (in contrast to FR orientation in U.S.) that internal control in China plays a trimming role (in contrast to hyper-correcting role found in U.S.) in corporate financial activities. Then, this chapter identifies several limitations of the previous empirical analyses and calls for more deeper studies on the real effects of internal control on corporate operation and management instead of only financial reporting issues and their variances among different countries or periods.

Pages: 7

Chapter 9 introduces recent progress in empirical research on economics consequences of internal control after 2016 when the period of empirical analyses in Chapter 4 to Chapter 7 ends. Generally, the focus of empirical studies both in and outside China has switched from the effect of internal control and related reforms on accounting information quality, corporate governance, auditing behaviours, stock market reactions, and the direct implementation costs of internal control to the firm’s operation and management activities. Based on the previous research trend and pattern, this chapter finally discusses four specific promising research directions for further empirical studies on internal control.