Internal Control, Earnings Management And Audit Opinion

The famous British historian Arnold Toynbee says:"one country, and even a nation, its decline and fall from the internal, the external force is the final blow before the decline and fall." This sentence reveals the important role of Internal Control. The quality of Internal Control is essential for the listed company itself. High quality of Internal Control can improve the authenticity and reliability of financial information, can reduce the likelihood of earnings management, the company is more likely to get the standard unqualified audit opinion. Full disclosure of reliable Internal Control information can pass sound corporate governance information to investors and the public, so as to enhance the company’s corporate reputation and value.In December2001, the largest U.S. energy company Enron’s filed for bankruptcy protection. In June2002, the WorldCom’s accounting scandal erupted. These series of events completely blow to the American public and investors’ confidence in listed companies. In order to revive the American people’s confidence in capital markets, the United States enacted the famous "Sarbanes-Oxley Act" in July2002:The U.S. listed companies must disclose Internal Control self-assessment report and the Internal Control audit report which is attested by the auditor to the public. Since then, it laid a solid foundation for the regulations of the internal control information and the system construction. Also it shows that the America’s Internal Control information disclosure entered into the mandatory disclosure era.In the development process of China’s capital market, corporate scandals caused due to Internal Control deficiencies are not uncommon. The irregular oil trading approval of the China Aviation Oil Singapore branch, the Yili Group’s illegal misappropriation of funds...Internal Control system construction and the quality of the information become a hot topic of domestic scholars and the general public once again. In May2008, the Ministry of Finance, the Securities and Futures Commission, Insurance Regulatory Commission, the Audit Commission jointly issued the Basic Standards for Enterprise Internal Control". The listed companies must obey the basic specifications since July1,2009, and it encourages non-listed large and medium-sized enterprises to adopt it. The listed companies which meet the requirements should first evaluate its effectiveness of Internal Control, and then disclose Internal Control self-assessment report as required, also, they may engage intermediaries qualified with the Securities and Futures business to audit the effectiveness of internal control.This paper studies the impact of the quality of Internal Control on audit opinion. And on the premise that auditor’s independence is not threatened, it demonstrated that if audit fees are relatively abundant, auditors will expand the scope of the audit, then a more appropriate audit opinion will be issued. This paper collects Shanghai stock exchange A-share company data in2010, and carries empirical study on the relationship between Internal Control quality and earnings management, on the impact of Internal Control on audit opinion and the impact of auditor fees on audit opinion, which is under the premise that auditor’s independence is not compromised. It is hoped that this study can provide a reference for the Internal Control governance of listed companies in China, and provide empirical evidence to China’s regulators, so they will attach importance to the construction of the Internal Control system.This paper is divided into five chapters; each chapter is organized as follows:Chapter1, Introduction. This chapter firstly summarizes the research background and significance, and then describes the research ideas and research framework by a combination of charts and text.Chapter2, Literature review. This chapter reviews the literature and divides it into:(1) Internal control influences earnings quality;(2) Internal Control and risk identification affects the audit opinion;(3) Earnings quality has an impact on the audit opinion;(4) Audit fees affects the audit opinion;(5) Internal Control and audit fees together influence audit opinion. The literature review provides empirical evidence for further empirical analysis.Chapter3, Theoretical analysis and System assumptions. This chapter based on principal-agent theory, signaling theory and asymmetric information theory, this chapter analyses the Internal control’s inhibitory effect on earnings management, discusses the Internal Control’s influences on audit opinion, then proved that in the case of auditor is independent, more abundant the audit fee is, more likely auditors will expand audit procedures, it will help auditors to find earnings management, and then to issue Non-standard audit opinions. Analysis of system background ensures the rationality of research methodology, and these theoretical analyses support the empirical study in the following paper, so this chapter is the basis of this paper.Chapter4, Research Design. This chapter firstly discusses the sample selection and data sources, and then measures earnings management, and finally puts forward the empirical model and variable design.Chapter5, Empirical Analysis. This chapter firstly examines the relationship between Internal Control quality and earnings management. Mainly through empirical research,it finds that good internal controls can play a role in inhibition of earnings management. Then the chapter discusses the internal control’s impact on audit opinion. By regression analysis, we can see that the higher the quality of internal control is, the lower degree of earnings management will be, and more likely the auditors will issue a standard audit opinion. Finally, the factor of audit fees is added, on the premise of auditor’s independent, the increase of audit fees will lead auditors to expand the scope of the audit procedures, which increases the possibility of finding audition’s earnings management, then a more appropriate audit opinion will be issued.Chapter6, The conclusion of this paper, with the main innovation, policy Implications and Prospects. After reviewing the main conclusions of this paper, we explore the innovative point of this article, as well as to give the policy recommendations to the stakeholder groups. Meanwhile, we discuss the limitations of this study and outlook on future research of Internal Control.Through empirical research, the paper reaches the following conclusion:(1)The higher the quality of internal control is, the lower the degree of earnings management.The empirical conclusions proved that the higher the quality of internal control is, the higher the earnings quality will be, and the relationship between the two is significant. This conclusion is in accord with what we discussed in the theoretical analysis. Good internal control narrows manipulation range of earnings management, improves the quality of information disclosure of internal control, corrects the inappropriate accounting treatment and misstatements, and helps to improve earnings quality.(2)The higher the quality of Internal Control is, the smaller the probability of getting non-standard audit opinions.The higher the quality of internal control is, more likely the auditors will issue a standard audit opinion. This is consistent with our hypothesis. Companies with high quality of internal control have a stronger sense of anti-risk. If the Internal control of the entire enterprise is effective, enterprises will set up a risk control point in all aspects of the business to supervise all stages of their business processes, so, accounting firms can believe that their internal control is sound and effective. Therefore, the higher the quality of a company’s internal control is, the more likely a standard unqualified audit opinion it will get.(3)Under the premise of auditor’s independence is not compromised, the increasing of audit fees can make auditor expand the scope of the auditing, so as to identify earnings management, and company’s probability of getting a non-standard audit opinion will increase.When the auditors uphold an independent, objective attitude in auditing, they will be more likely to trust enterprises with higher quality of internal control and which establish a good risk control environment, and less the procedures the auditors will take. Under the condition of the shortage of time and manpower, or audit fees is not sufficient, auditors will reduce substantive tests largely, but take some simple control test. If auditors’misstatements or fraud are not found, the auditors will easily issue the standard unqualified audit opinions.