A Comprehensive and Quantitative Internal Control Index: Construction, Validation, and Impact

64 Pages Posted: 16 Dec 2013 Last revised: 1 Jul 2017

See all articles by Hanwen Chen

Hanwen Chen

University of International Business and Economics

Wang Dong

Zhejiang University - School of Management

Hongling Han

Zhejiang University - School of Management

Nan Zhou

University of Cincinnati - Lindner College of Business

Date Written: December 12, 2013

Abstract

We use a new method to better measure internal control quality. Specifically, we construct an internal control index for all public firms in China, because the lack of internal control regulations during our sample period presents an interesting setting, in which the diversity of internal control quality is preserved. Two distinctive features set our index apart from the information currently available under SOX 404 in the U.S. First, it comprehensively evaluates a firm’s internal control, based on the COSO framework. Second, it quantitatively measures a firm’s internal control, using the analytic hierarchy process (AHP) designed for analyzing complex decisions. We proceed to validate our index by confirming the known relation between internal control quality and earnings management. Further, we theorize that our internal control index has a positive impact on the earnings response coefficient (ERC), and find that better internal control indeed makes financial reporting more credible to investors.

Keywords: Internal Control Index; COSO; Analytic Hierarchy Process (AHP); Earnings Quality; Earnings Response Coefficient (ERC)

JEL Classification: M42; C44

Suggested Citation

Chen, Hanwen and Dong, Wang and Han, Hongling and Zhou, Nan, A Comprehensive and Quantitative Internal Control Index: Construction, Validation, and Impact (December 12, 2013). Review of Quantitative Finance and Accounting, August 2017, Vol. 49, No. 2, pp. 337-377. Available at SSRN: https://ssrn.com/abstract=2368000 or http://dx.doi.org/10.2139/ssrn.2368000

Hanwen Chen

University of International Business and Economics ( email )

10# Huixin East Street,Chaoyang District
Beijing, Beijing 100029
China

Wang Dong

Zhejiang University - School of Management ( email )

Hangzhou, Zhejiang Province 310058
China

Hongling Han (Contact Author)

Zhejiang University - School of Management ( email )

Room701-07, School of Management,
Zhejiang University
Hangzhou, Zhejiang Province 310058
China
+86-571-88206830 (Phone)
+86-571-88206867 (Fax)

Nan Zhou

University of Cincinnati - Lindner College of Business ( email )

P.O. Box 210211
Cincinnati, OH 45221-0211
United States

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