How Does the Heterogeneity of Internal Control Weakness Affect R&D Investment?

ABSTRACT

Internal control of nonfinancial reporting has received attention in the Committee of Sponsoring Organizations of the Treadway Commission’s new Internal Control-Integrated Framework. This paper explores the effect of internal control weakness (ICW) in financial reporting and nonfinancial reporting on R&D investment. Our results show that ICWs in financial and nonfinancial reporting inhibits R&D investment, and this effect comes mainly from ICWs in nonfinancial reporting. The impact of ICW in nonfinancial reporting on R&D investment is more serious at technology-intensive companies than labor- or capital-intensive companies. The influence of heterogeneous ICW on investment in corporate innovation has time lag effect and takes at least two paths of impact: weakening of executive compensation incentives and internal cash flow oversight. These results suggest that the ICW in nonfinancial reporting play a more important role in the allocation of resources for technological innovation.

KEY WORDS:

• financial reporting
• innovation
• internal control
• nonfinancial reporting

Acknowledgments

We gratefully acknowledge financial support from the National Natural Science Foundation of China (No. 71472047; 71872078; 71828201; 71872046), the Humanities and Social Science Foundation of the Ministry of Education of China (17YJA630001), Jiangsu Provincial “333 Project” Research Program (No. BRA2018071), and the Postgraduate Research & Practice Innovation Program of Jiangsu Province (No. KYCX18_1371).

Notes

1. A-shares are ordinary shares issued by chinese companies for chinese institutions, organizations or individuals to subscribe and trade in RMB. A-share-listed company is simply a listed company that issues RMB ordinary shares.

2. Dibo database is a famous database specially disclosing internal control information of Chinese-listed companies.

3. CSMAR is the first chinese and the largest professional high-tech company engaged in design and development of accurate financial and economic information databases. CSMAR database covers a wide range of areas, complete time zones, and rich indicators, serving more than 1,000 universities and financial institutions.

4. Firm Internal Control Basic Norms was designated by the China Ministry of Finance, the China Securities Regulatory Commision, the China Audit Commission, the China Banking Regulatory Commission, and the China Insurance Regulatory Commission in accordance with relevant Chinese laws and regulations. The purpose is to strengthen and standardize internal control of enterprises, improve business management and risk prevention, and promote companies sustainable development.

5. Internal Control Audit Guidelines was enacted by the China Ministry of Finance, the China Securities Regulatory Commission, the China Audit Commission, the China Banking Regulatory Commission, and the China Insurance Regulatory Commission. The purpose is to promote the establishment, implementation, and evaluation of internal control, the internal auditing behavior of accounting firms.

6. The PCAOB protects investors by overseeing the audits of public companies, other issuers, and broker-dealers. A US private-sector nonprofit created by Congress, the PCAOB.

Additional information

Funding

This work was supported by the National Natural Science Foundation of China: [Grant Number 71872046].