When Does Internal Control Over Financial Reporting Curb Resource Extraction? Evidence from China

56 Pages Posted: 18 Dec 2015 Last revised: 29 Mar 2019

See all articles by Weili Ge

Weili Ge

University of Washington - Michael G. Foster School of Business

Zining Li

Loyola Marymount University - College of Business Administration

Qiliang Liu

Wuhan University - School of Economics and Management

Sarah E. McVay

University of Washington

Date Written: March 30, 2018

Abstract

We examine whether the strength of internal control over financial reporting (internal control) reduces the expropriation of resources from the firm by managers and controlling shareholders. Although we have ample evidence from prior literature that internal controls reduce errors in financial reports, it is less clear that they can curb resource extraction, as management may fail to enforce these controls. Exploiting the setting of China where we have a rich internal control dataset and established measures of resource extraction, we provide evidence that internal controls curb resource extraction on average. However, we also find that internal controls are less effective in curbing resource extraction within state-owned firms and within non-state owned firms that have a powerful controlling shareholder, suggesting that internal controls are less effective in these instances. Taken together, we conclude that internal controls must both exist and be enforced by management in order to achieve the intended goal of safeguarding assets. Although the analysis is conducted with Chinese data, the spirit of our findings should generalize to other settings. In particular, our findings suggest that management can “window dress” internal control procedures while still engaging in undesirable behavior.

Keywords: Internal control over financial reporting; regulation; resource extraction; window dressing; agency costs.

JEL Classification: M4

Suggested Citation

Ge, Weili and Li, Zining and Liu, Qiliang and McVay, Sarah E., When Does Internal Control Over Financial Reporting Curb Resource Extraction? Evidence from China (March 30, 2018). Available at SSRN: https://ssrn.com/abstract=2704663 or http://dx.doi.org/10.2139/ssrn.2704663

Weili Ge (Contact Author)

University of Washington - Michael G. Foster School of Business ( email )

Box 353200
Seattle, WA 98195-3200
United States

Zining Li

Loyola Marymount University - College of Business Administration ( email )

Los Angeles, CA 90045
United States

Qiliang Liu

Wuhan University - School of Economics and Management ( email )

Wu Han, Hu-Bai 430072
China

Sarah E. McVay

University of Washington ( email )

Box 353200
Seattle, WA 98195-3200
United States

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