A Comprehensive and Quantitative Internal Control Index: Construction, Validation, and Impact
64 Pages Posted: 16 Dec 2013 Last revised: 1 Jul 2017
Date Written: December 12, 2013
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: Suggested Citation