The Linear and Non-Linear Effects of Internal Control and Its Five Components on Corporate Innovation: Evidence from Chinese Firms Using the COSO Framework

Abstract

This study examines the impact of internal control and its five components on corporate innovation using the Committee of Sponsoring Organizations (COSO) framework with a sample of Chinese firms. The impact of the internal control system as a whole, as well as the impact of the five components of internal control individually (i.e. control environment, risk assessment, control activities, information & communication, and monitoring), are analyzed. Our results suggest that internal control, as an integrated system, has significant positive impact on firm innovation, as measured by patent applications. We document that the magnitude of impact on innovation varies across different subcategories (components) of internal control, with control environment, control activities, and information & communication components exhibiting stronger impacts on innovation than those of risk assessment and monitoring components. In addition, we find that a high level of control environment, control activities, and information & communication (risk assessment and monitoring) components have a stronger (weaker) impact on innovation compared to a low level.

Keywords:

• Internal control
• Innovation
• China
• Nonlinear effect
• COSO

Acknowledgment

We acknowledge the helpful comments from two anonymous reviewers and Yuan Ding. An early version of the paper was presented at the American Accounting Association conference in San Francisco, 2019. Liu acknowledges the financial support from the National Natural Science Foundation of China (No. 71702153).

Notes

1 While both indices are calculated by DIB, they cover different aspects of internal control. Most importantly, the DIB internal control disclosure index has five major components. In contrast, internal control aggregate index provides no explanation on the makeup of the index.

2 https://www.wipo.int/pressroom/en/articles/2017/article_0013.html (accessed April 10, 2019)

3 http://www.asiabriefing.com/store/book/internal-control-in-china-7214.html (accessed April 10, 2019)

4 To validate the DIB internal control index as a proxy of internal control quality, we study the impact of internal control (using LNICINDEX and its five components) on earnings management. Our findings suggest that when a firm has high-quality internal control, its accrual-based earnings management are less. The findings are consistent with studies using internal control weakness in the US (e.g., Doyle et al., 2007; Brown et al., 2014) and Ximen University internal control measures in China (Liu et al., 2013). The findings are available upon request.

5 The correlation coefficient between IC and LNICINDEX is 0.022. While it is statistically significant, it is economically small. The correlation coefficients between IC and each of the five components are 0.203, -0.115, 0.101, 0.028, and 0.001. With the exception of control environment (0.203), the IC does not capture the other four components of internal control. While both IC and INCINDEX are provided by the same company (DIB Ltd.) and both metrics measure internal control level, they capture different aspects of internal control. Based on our discussion with DIB’s representative, IC is based on a firm’s legal compliance, financial report quality, asset safety, operation, and business strategy. The exact details are not provided by DIB due to proprietary nature of metric. In contrast, INCINDEX is based on control environment, risk assessment, control activities, information and communication, and monitoring.

6 The findings using LNPATENTS are qualitatively the same. They are available upon request.

7 The results are available upon request.

8 Usually, sensitivity of management turnover to firm performance is positively related to corporate governance. In the channel analysis, we find TURNOVER (proxy for corporate governance) is negatively related to innovation. This finding echoes Ning et al.’s (2014) finding that top management turnover, as a result of strengthened corporate governance, has a negative effect on innovation investment and productivity. They argue that, in the effort to control agency costs and discipline managers, external corporate governance mechanisms such as stronger countervailing powers to secondary shareholders, stronger supervisory board rights, and greater independence of directors decrease time horizons of investment for the firm and impede innovation.

9 We thank an anonymous reviewer raising this point. The results are available upon request.

10 ABSDA has slight smaller number of observations at 15,507 instead of 15,531.

Additional information

Funding

This work was supported by National Natural Science Foundation of China [grant number 71702153].