The Impact Of Internal Control Effectiveness On Stock Price Crash Risk

Stock price crash can harm the corporate value of listed companies,causing the loss of investors.Stock price crash also has negative impacts on industries and securities markets.Therefore,how to avoid stock price crash is a hot topic in both academic and business communities.Internal control is an important component of risk management and draws increasing attention from worldwide market regulators.In theory,effective internal controls could decrease stock price crash risk,but literature on consequences of internal control is mostly limited to annual reports reliability,lacking of the logic extension to capital markets.Considering the current research gap,this paper links internal control effectiveness(ICE)and stock price crash risk(SPCR).First,this paper establishes a theoretical framework considerring the inherent logical relathionship between ICE and SPCR.Then,the being and causality of the ICE-SPCR relationship is explored.Finally,this paper pays attention to China's internal control reform and wonders whether the regulation(C-SOX)can influnence ICE and SPCR.To be more specific,the main contents of this study include:First,this study establishes the theoretical framework of how internal control effectiveness affects stock price crash.Based on principle-agent theory,efficient market theory,information asymmetry theory and incomplete contract theory,document and normative analysis methods are employed to construct the integrated framework.The framework describes the dynamic processes and mechanism of how internal control effectiveness influnces stock price crash risk,locating the key role of transparency in the relationship between internal control effectiveness and stock price crash risk.The integrated framework is the theoretical basis of the whole study and also provides logic references for follow-up studies.Second,this study isolates the different impacts of internal control deficiencie s existence and internal control deficiencies disclosure on stock price crash risk.The formation of stock price crash can disassemble into two stages which are the hoarding of bad news and the release of bad news.Existed literature always observe the joint effect of the existence and disclosure of internal control deficiencies,ignoring the situation of“existed but not disclosed”.In reality,hiding internal control deficiencies from the public is a pervasive phenomenon in China.Listed companies naturally regard internal control deficiencies as typical bad news.In order to avoid the possible negative consequences,managers have incentives not to disclose internal control deficiencies,deteriorating the information asymmetry between investors and listed companies,which is on the contrary to aspiration of regulators.Selecting listed companies as samples,this study adopts OLS and difference-in-difference regression methods to testify the beingness and causality of the relationship between internal control effectiveness and stock price crash risk.Results show that the disclosure of internal control deficiencies leads to scant fluctuation of stock price crash risk,but the existence of internal control deficiencies is positively correlated to stock price crash risk,indicating that the disclosure strategy of internal control deficiencies has a weak influence on stock price crash risk while maintaining healthy internal controls is the effective way to restrain stock price crash risk.The findings are of great practical value to help companies to correctly understand the functions of internal control,especially under the background that internal control is an important topic during the 18^th and 19^thNational Congress of the Communist Party of China.Third,this study explores the mechanism of how internal control effectiviness affects stock price crash risk.Based upon the integrated framework,this study adopts document,normative and mathematical analysis methods to locate transparency as the key channel in the relationship between internal control effectiveness and stock price crash risk.Selecting listed companies as samples and following the procedures of mediating effect test,this study finds that effective internal controls can enhance transparency to achieve keeping stock price crash risk at a relatively low level.The findings are beneficial for stakeholders to establish a systematic cognition on how internal control effectiveness affects stock price crash risk.Fourth,this study discusses the institutional environment effect of internal control effectiveness and stock price crash risk.In recent years,China has been contiguously pushing the entire establishment and refinement of the internal control system.Regulatory and service departments in China,including China Securities Regulatory Commission,China Ministry of Finance,China State-owned Assets Supervision and Administration Commission,Shanghai Stock Market and Shenzhen Stock Market,successively published several internal-control-related regulations and guidance,requiring enterprises to take measures to ensure and maintain the effectiveness of internal controls.Sepecifically,the measures contain mandatory disclosure of internal control self-evaluation reports and internal control audit reports which convey the information of effectiveness and deficiencies,making the external institutional environment changed.Considering the internal control regulation comes into effect in batches,this study conducts time-varing difference-in-difference tests among listed companies instead of classic difference-in-difference mothodlogy,and finds that companies experience a decline in stock price crash risk with an increase in internal control effectiveness and an enhancement in transparency during the regulation reform.This study extends the extant literature focusing on policy effect of internal control regulations by observing the economic consequences in the capital market,providing new evidence in the perspective of stock price crash.This study also strengthens the theoretical applicability of the integrated framework on internal control effectiveness and stock price crash risk by taking both internal mechanism and external environment into account.This study is of great value in both academic and practical angles.This study excavates and enriches the theoretical connotation of internal control effectiviness by distinguishing the existence and disclosure of internal control deficiencies,brodens and deepens the literature on internal control effectiv eness consequences by expanding the logic chain to the capital market,replenishes and develops the causality-based and mechanism-based research on internal control effectiviness affecting stock price crash risk by exploring the processes and channels of h ow internal control effectiviness affecs stock price crash risk,provides evidence and perspectives on stock price crash formation theory from the view of the developing country and unmature market by combining the research with the special background of China.Enterprises can benefit from this study in correctly recognizing and understanding the functions of internal control and internal control deficiencies.Findings of this study also help listed companies to conduct stock price crash risk management.Moreover,this study contributes to steady and healthy development of capital markets by adding evidence on the cost-benefit tradeoff of internal control regulations.