The Research Of Internal Control Weaknesses

On 28 June 2008,the Ministry of Finance(MOF),the China Securities Regulatory Commission(CSRC),the National Audit Office(NAO),the China Banking Regulatory Commission(CBRC),and the China Insurance Regulatory Commission(CIRC)jointly released a circular on the release of The Basic Standard for Enterprise Internal Control(The Basic Standard).The Basic Standard for Enterprise Internal Control requires Chinese enterprises to assess and disclose effectiveness of their internal controls.On 26 April 2010,relevant government regulatory agencies further issued the Application Guidelines for Enterprise Internal Control,Guidelines for Assessment of Enterprise Internal Control and Guidelines for Audit of Enterprise Internal Control(collectively the"Implementation Guidelines")as the detailed guidelines for Implementing The Basic Standard.This signifies that the China regulators are finally mandating this compliance requirement.The Implementation Guidelines are effective for companies listed both domestically and abroad from 1 January 2011,and are effective for companies listed on the main board of the Shanghai Stock Exchange and Shenzhen Stock Exchange from 1 January 2012.External auditors are also required to opine on the effectiveness of their client's system of internal control and issue a"qualified opinion" in presence of even a single material weakness.I examine whether such internal control weakness disclosures benefit listed enterprises or convey any new information to the equity markets.This issue is important because increasing disclosure requirements without any attendant effect on valuation would impose unnecessary deadweight costs on the shareholders of a company.This paper first studies whether enterprises with internal control weaknesses are more likely to have negative earnings surprises(the differences between actual earnings and expected earnings).If so,internal control weaknesses provide warning about potential future financial statement problems and disclosures of these weaknesses help analysts and investors know more about enterprises'performance.This paper also studies if internal control disclosures have any effects on the share price.If so,reports on internal control systems provide markets with useful information.In order to study whether internal control weaknesses have any effects on the difference between actual earnings and expected ones,I present the following hypothesis:Enterprises with internal control weaknesses are more likely to have negative earnings surprises.To testing the hypotheses,I take advantage of descriptive analysis and logistic regression model.In order to study whether the disclosures of internal control weaknesses have any effects on share price,I present the following hypothesis:Disclosure of internal control weaknesses will negatively affect the stock price.To testing the hypotheses,I take advantage of descriptive analysis,simple hypothesis testing,and multi-linear regression model.By studying 300 companies listed in the major China exchanges,I find that internal control weaknesses lead to more significant negative earnings surprise and the disclosures of these weaknesses are associated with a negative stock price reaction.Therefore,the disclosure of internal control system encourage enterprises perform in line with the expectation,and provide valuation-relevant information.