Internal Control Weaknesses Criteria And Adjustment:Implications And Consequences

At the beginning of the 21st century,several severe financial fraud cases occurred around the world,such as the Enron,WorldCom Events in the United States,and Yin Guangxia,China Aviation Oil Affairs in China.These cases exposed the widespread internal control weaknesses in the listed companies,and reflected the ineff-icient internal control systems under the flourishing appearance.These significant financial fraudulence behaviors which have been revealed and those more which are potentially existed exert a great negative impact on the capital market.In order to increase the credibility of financial reporting under this background,following the Section 404 of the 2002 Sarbanes-Oxley Act(SOX),Chinese regulators j ointly issued the Basic Standard of Enterprise Internal Control and supplementary guidelines in 2008 and 2010 respectively.These regulations require that Chinese public companies self-evaluate the effectiveness of their IC and disclose their self-evaluation report along with the annual report.Moreover,companies are required to disclose the audit report on management IC self-evaluation.These rules reflect that our country pays more attention to the internal control system construction in the listed companies recently.However,it becomes an important question in both academy and practice field that how to implement those regulations eff-icientlyThe design and execution of Internal Control in the listed companies have been a black box for a long time.Since the 2011 annual report,some Chinese listed companies began to disclose their criteria under which management believes a material weakness,a significant deficiency,or a control deficiency exists in financial reporting-related internal control.A typical example could be a company stating that a material weakness is deemed to exist if the impact of the weakness on earnings is no less than 5%of current-period pretax income.However,the regulations leave management a lot of discretion in deciding the materiality criteria.This setting provides us an opportunity to research the internal control evaluation system in the listed companies,to comprehend management's tolerance toward internal control weaknesses,and to examine the effect of internal control-related criteria on financial report reliability.Therefore,I hand-collected the internal control weaknesses criteria disclosed by each listed companies from 2011 to 2014,and explore the implications and consequences of the materiality criteria's first-time decision and subsequent adjustmentFirstly,we introduce the overall circumstances of the internal control weaknesses criteria's first-time decision and subsequent adjustment set by each listed companies from 2011 to 2014 Statistics show that,there are more and more companies disclosed the internal control self-assessment report,internal control audit report,and internal control weaknesses criteria.Among them,the increase of internal control weaknesses criteria is the most significant.From 2011 to 2014,the proportion of companies which disclosed that metrics rises from 5.15%to 81.49%,which means that management think more highly of the public disclosure of internal control information.Moreover,there are about 5.80%observations changing their internal control weaknesses criteria which means that the materiality metrics remain stable generally once they were set.However,there are also some companies adjusting them in subsequent periods.This part tries to give readers preliminary and overall understanding of a "New Thing" in the capital market—the internal control weaknesses criteria Secondly,we examine the considerations of Chinese listed companies'first-time decisions on materiality criteria of internal control weaknesses.The results show that when companies committed fraud in the prior year but remain undetected,the management is more likely to choose revenue rather than pretax income as the first-time benchmark.In contrast,there is no significant association between an existing and detected fraud and the selection of revenue as the benchmark.Moreover,companies using revenue as the base are more likely to select a higher percentage rate if they committed fraud in the prior year but remain undetected.For companies using the most common base(i.e.,pretax income),we do not find a similar pattern Collectively,these findings support our hypothesis that managers with existing but undetected misconducts allow room for themselves by manipulating IC-related materiality metrics,once given the opportunity to do soThirdly,we examine the implications of Chinese listed companies' first-time decisions on materiality criteria of internal control weaknesses.The results show that there is a significant and positive association between the first-time revenue-based materiality threshold and subsequent incidence of corporate fraud.In contrast,we do not find a significant association between the first-time pretax income-based materiality and subsequent fraud incidence.These findings are consistent with the notion that deviant and loose internal control materiality metrics leave room for the management to engage in misconducts.On one hand,deviant and loose materiality metrics convey top-management's tolerance for internal control weaknesses,and such an attitude likely induces the incidence of fraud;on the other hand,materiality criteria,once set,form a legitimate and fundamental corporate internal control policy,which provides an opportunity for the incidence of misconducts.Fourthly,we examine the determinants of Chinese listed companies' subsequent adjustments on materiality criteria of internal control weaknesses,especially studying the materiality criteria change characteristics following the top management turnover.The results show that,the internal control weaknesses criteria tend to be loosened in the incoming management's first full year of her tenure,which means that all other things equal,it is less demanding for the incoming management to identify and disclose an internal control weakness.Our evidence is more consistent with the incoming management shirking the accountability,rather than maximizing shareholder's interests.Moreover,we distinguish the demission reasons of the prior management and the succession origins of the incoming management.The results show that the above findings mainly occur when the prior management leave office in a normal way and the incoming management succeed from interior of the company.Finally,we examine the consequences of Chinese listed companies' subsequent adjustments on materiality criteria of internal control weaknesses,especially studying the influence on financial report reliability.The results show that,the management-loosened internal control weaknesses criteria are positively and significantly associated with subsequent higher possibility of fraud and financial restatement,which means that the increase in internal control weaknesses criteria has a negative impact on the financial report reliability.Meanwhile,as an efficient internal control mechanism,the accounting expertise of independent directors significantly restrain the effect of loosening internal control weaknesses criteria on the financial report reliability.Our evidence implies that,if management doesn't apply the discretion in the internal control system reasonably,instead turning it into a tool for exerting opportunism incentives,the financial report reliability will be damaged seriously.This paper focus on a particular stage which is the early implementation of the Basic Standard of Enterprise Internal Control and supplementary guidelines,and examine the implications and consequences of the internal control weaknesses criteria's first-time decision and subsequent adj ustment systematically and comprehensively.We try to provide evidence for the establishment and supervision of the internal control-related regulations in Chinese capital market,and for the better understanding of investors and other stakeholders on publicly disclosed internal control information.And also,we hope to make some vital contributions tointernal control-related literatureThe academic contributions of this paper is as follows:(1)Existing literature about the internal control weaknesses criteria are basically all analytical researches.This paper is the first to study the internal control weaknesses criteria of Chinese listed companies empirically and systematically in a large sample.(2)We collect the systematically data which is hardly to observe in foreign countries,and provide better understanding on how the management identify and assess internal control weaknesses.(3)Most of previous studies about materiality focus on materiality judgment from the auditor's perspective.As the internal control weaknesses criteria provide a more direct measure of management materiality decision,our study extends the few researches that focus on materiality from the management's perspective.(4)As the attitude element of the fraud triangle has received the least amount of attention in the accounting literature,we use a unique data and provide evidence on management tolerance and opportunism for corporate fraud.(5)Compared to most studies which pay more attention to the accounting performance following the management turnover,our study explores its impact on another important situation,i.e.the internal controlThe results of this paper have vital referential significance for the investors,rule makers,regulators,management and related intermediaries.(1)We provide suggestions to investors for how to better understand and apply publicly disclosed internal control information.(2)The rule makers should further standardize the disclosure format of internal control self-assessment report.(3)The regulators should strengthen the punishment of illegal behaviors on internal control information disclosure.(4)Management of listed companies should complement the entire procedure of internal control self-assessment.(5)Related intermediaries should enhance their independence and supervision function during the internal control auditing.