Internal Control over Financial Reporting and Resource Extraction: Evidence from China

Posted: 8 Feb 2021

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: October 2, 2020

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, because 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 consistent with internal controls curbing resource extraction on average. In particular, we document a negative association between internal control strength and resource extraction. We also find that the association between internal control strength and resource extraction is weaker in settings where we expect management to have fewer incentives to enforce these controls: within state-owned firms and within non-state-owned firms that have a powerful controlling shareholder. We interpret these results as suggesting that internal controls must both exist and be enforced by management for the controls to safeguard assets. Although the analyses are conducted using Chinese data, we expect the spirit of our findings to generalize to other settings — 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

Suggested Citation

Ge, Weili and Li, Zining and Liu, Qiliang and McVay, Sarah E., Internal Control over Financial Reporting and Resource Extraction: Evidence from China (October 2, 2020). Contemporary Accounting Research, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3748538

Weili Ge

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 (Contact Author)

University of Washington ( email )

Box 353200
Seattle, WA 98195-3200
United States

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