2017 3rd International Conference on Social Science and Management (ICSSM 2017)

ISBN: 978-1-60595-445-5

Does Internal Control in China State-owned Listed

Firms Improve Investment Efficiency?
Lin LIN
Finance and Accounting Research Center of Fujian Province Philosophy Social
Science Research Base, Fujian Jiangxia University, Fujian, China
Janelin31@163.com

Keywords: Internal Control, Evaluation Report, Material Weakness, Investment Efficiency.

Abstract: The main board firms listed on Shanghai and Shenzhen stock markets have been required
to implement the Basic Criteria of Enterprise Internal Control since the year of 2012. This paper
traces China state-owned listed firms the effects of internal control on investment efficiency from
the year of 2012 to 2014. We find that under different circumstances, the internal control material
weakness firms have the problem of inefficient investment, however, the under-investment and
over-investment problems are alleviated in the second year following the year of material weakness.
The above discovery shows that the implementing of the Basic Criteria of Enterprise Internal
Control by China state-owned listed firms has its positive effects.

Introduction
In China, state-owned listed firms cover many national economy fields and constitute the
majority of the capital market. In the year of 2008 and 2010, China Ministry of Finance coordinated
with other four ministries and commissions including Securities Regulatory Commission
promulgated the Basic Criteria of Enterprise Internal Control and the Application Guidelines of
Enterprise Internal Control, and required the A-share main board listed firms implementing the
both since the year of 2012. The basic purposes for the regulatory agencies advocating internal
control include assuring operating legally, assets safety, accounting information sincerity and
completeness, operating efficiency and effects, and promoting realizing strategy. Among the
purposes, assuring operating efficiency and effects is the critical prerequisite for firms achieving
sustainable development. Up to now, the Basic Criteria of Enterprise Internal Control has been
carried out in China for five years. How about the implementing effects? Whether the state-owned
listed firms advanced their operating efficiency and effects through the construction of internal
control? Investment efficiency represents the core ability of an entity’s value creating, and it is the
pivotal measurement of operating efficiency and effects. This paper will trace the effects of the
quality of internal control on investment efficiency from the year of 2012 to 2014, to evaluate the
outcome of constructing internal control system in China state-owned list firms.

1. Theory Analysis and Hypothesis Development

In the real business world, because of the existence of capital market frictions, firms investment
may deviate from the best level, sinking into under-investment or over-investment situations. The
main frictions include information asymmetry and agency problem [1]. Information asymmetry will
trigger adverse selecting and moral hazard. Agency problem has twofold manifestation, including
the agency problems between shareholders and managements, and between major shareholders and
minor shareholders. The first agency problem refers to that the managements have empire-building
desires, let the scale of investment exceed the optimal level to over-invest [2]. In China capital
market, because of the imperfection of power check and balance mechanism, the major
shareholders will tunnel the firms, causing the firms under-investment for fund shortage , or control
the decision power to require firms to invest in negative net present value projects, which leads to
over-investment.
Internal control is implemented jointly by the board of directors, the board of supervisors,
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managements and the staff, with the purposes of realizing a series control targets. Effective internal
control with its information and communication factor will help to solve the problem of information
asymmetry [3]. Effective internal control will also help to solve the agency problem. As a
supplement mechanism to remedy the contracts incompletion, internal control clearly differentiates
the responsibility and authority for all levels of departments and personnel, stipulates the check and
balance mechanism, creates an incentive and constraint equilibrium internal environment, provides
a solid safeguard to restrict the inappropriate behaviors of managements and major shareholders and
protects the interests of firms[4]. The effective internal control can curb the source of the inefficient
investment, and is the root mechanism to improve investment efficiency.
Weak internal control refers to having material weakness in the internal control system, which
will result in inefficient investment. However, the form of inefficient investment, including
over-investment and under-investment, is affected by the availability of funds. According to Biddle
et al. (2009), the firms with ample financial resources will be apt to over-invest, and the firms with
finance constraint will more likely to under-invest [5]. We formulate the first set of hypotheses:
H1a. Financially constrained China state-owned listed firms are more likely to under-invest in the
year of internal control material weaknesses (ICMWs).
H1b. Financially unconstrained China state-owned listed firms are more likely to over-invest in
the year of ICMWs.
The nineteenth clause of the Evaluation Guidelines of Enterprise Internal Control stipulates that
for identified ICMWs, firms should take countermeasures to control the risks within the tolerable
level. Hence, it is predictable that a responsible board of directors will abide by the requirement
organizing to rectify the ICMWs to improve the effectiveness of internal control. Then, the
inefficient investment problems will be remedied, which leads to the second set of hypotheses:
H2a. Financially constrained China state-owned listed firms will under-invest less in the years
following the year of ICMWs.
H2b. Financially unconstrained China state-owned listed firms will over-invest less in the years
following the year of ICMWs.

2. Research Design and Sample Selection

2.1 Research design
To test our two sets of hypotheses, on the basis of Biddle et al. (2009) and Cheng et al.(2013) [6],
our regression model is as follows:
Investmentt = α 0 + α1 × Deficiencyt + α 2 × Overfirmt −1 + α 3 × Deficiencyt × Overfirmt −1
+ ∑ bi × Characteri ,t −1 + ∑ ci × Opersitui ,t −1 + ∑ di × Govi ,t −1 + ∑ ei × Govi ,t −1 × Overfirmt −1 (1)
+ ∑ f i × Indui + ε t .
The dependent variable Investment is the total investment of a firm measured as the sum of
expenditures of capital, research and development, and acquisition scaled by the lagged total assets.
Deficiency is an indicator variable, which is set to one for firms that identified as having ICMWs in
one year and zero for none. To avoid the endogenous problem, we measure Investment in year t,
and all the control variables at the end of year t-1. As the hypotheses are conditional on the
availability of financial resources, we use a variable Overfirm. Prior studies suggest that cash-rich
and low-leverage firms are more likely to over-invest, high-leverage firms are more likely to
under-invest [5]. We rank each of our sample firms’ controllable cash balances (the sum of
monetary resources and trading financial assets) and negative leverage at the end of year t-1 into
two decile ranks, and then average the two ranks and divided by 10 so that it ranges from zero to
one to represent the very financial constraint to very financial ampleness situation. To examine the
effects of ICMWs on investment efficiency, we introduce the interaction item of Deficiency and
Overfirm.
We estimate Model (1) for the year of ICMWs to test hypotheses H1a and H1b, and focus on the
indicator variable Deficiency and its interaction with Overfirm. When Overfirm is close to zero,
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which means the firms are financially constrained, the firms are more likely to under-invest than
control firms do, then the coefficient on Deficiency is expected to be negative. When Overfirm is
close to one, the firms are financially unconstrained and more likely to over-invest than control
firms, then the sum of the coefficients on Deficiency and Deficiency*Overfirm is expected to be
positive. We estimate Model (1) for the years following the year of ICMWs to test H2a and H2b,
and also focus on the coefficients on Deficiency and Deficiency*Overfirm. As the above analysis, if
the boards of directors respond to the ICMWs and organize to rectify it, then the inefficient
investment situations will be eliminated, then the two coefficients will both be insignificant.
The control variables in Model (1) can be categorized into four groups: (1) the characteristics of a
firm (Character), including Logasset (the log of total assets book value at the end of year t-1), Age
(the years since listed on stock exchange). (2) the operation situations (Opersitu, all mesurements
are at the end of year t-1), including Pb (the ratio of market value to book value), Leverage (the
ratio of total debt to total assets), Loss (if net profit is less than zero, then 1, else 0), Cycle (the log
of operating cycle), Tangibility (the ratio of fixed assets to total assets), Dividend (the ratio of
accumulated dividend to retained profit for recent three years), Zscore (Altman Z score), Cfosale
(the ratio of net cash flow from operating to sale), Stdcfo, Stdsale, Stdinve (the standard error of cfo
(sale/Investment) scaled by average assets in recent three years); (3) corporate governance
mechanisms (GOV), including Firstshare (the share percentage of the first shareholder),
Sharebalance (the ratio of the sum of second to fifth shareholders share percentage to the first
shareholder share percentage), Manashare (the sum of the share percentage of all top managers),
Institutions (the sum of the share percentage of all institution investors) [7]; (4) industry effects
(Indu).
2.2 Sample selection
We choose the China state-owned firms that listed on Shanghai and Shenzhen stock exchange by
the end of 2010 as our study sample, to assure all the sample firms having list age longer than 3
years. For the reliability of the research conclusion, we exclude financial firms, ST and *ST firms
between 2012 and 2014, and the firms that involving acquisition and recombination during the three
years. For the convenience of judging the level of internal control according to the self-evaluation
reports, we also exclude the firms that never continually disclose self-evaluation reports between
2012 and 2014. The internal control related data are obtained from the internal control and risk
management database developed by Shenzhen Dibo Risk Management Technology Company. All
the data, including financial index, auditing opinion, corporate governance, violation of rules and
regulations, are obtained from Wind databases.
2.3 Descriptive statistics
Table 1. The Descriptive Statistics of Each Group Investment Dependent Variable.
Financially Constrained Financially Unconstrained
Year N Group
N Mean Median N Mean Median
ICMWs group 32 0.0356 0.0222 25 0.0829 0.0599
Year 2012 733
Control group 296 0.0631 0.0381 380 0.0653 0.0484
The first year ICMWs group 37 0.0309 0.0204 20 0.0832 0.0643
719
after 2012 Control group 283 0.0541 0.0386 379 0.0572 0.0407
The second ICMWs group 36 0.0310 0.0225 21 0.0439 0.0305
695
year after 2012 Control group 308 0.0503 0.0356 330 0.0502 0.0346
ICMWs group 29 0.0358 0.0241 27 0.0892 0.0873
Year 2013 733
Control group 299 0.0509 0.0339 378 0.0581 0.0404
The first year ICMWs group 27 0.0233 0.0126 29 0.0854 0.0763
697
after 2013 Control group 322 0.0505 0.0360 319 0.0478 0.0325
ICMWs group 36 0.0421 0.0345 23 0.0472 0.0508
Year 2014 733
Control group 328 0.0516 0.0360 346 0.0503 0.0333

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 According to Overfirm value bigger or smaller than the median, we divide the sample firms into
two groups, financially constrained and financially unconstrained. Then, according to whether
identified as having ICMWs, we further differentiate ICMWs group and control group. Table 1
presents the descriptive statistics of the dependent variable Investment of all groups. We can see
that in the year of 2012, under the financially constrained (unconstrained) circumstance, the
investment expenditure mean of ICMWs group is lower (higher) than the control firms, which
initially verifies H1a and H1b. In the first and second year after 2012, take the ICMWs firms in
2012 as test samples, exclude the firms that haven’t ICMWs in 2012 but have in 2013 (2014), the
remained firms as control firms. The statistics data demonstrate that, in the first year after 2012, the
inefficient investment problems still exist, which never verifies H2a and H2b. However, in the
second year after 2012, under the financially unconstrained circumstance, the over-investment
problem seems disappeared, which seems to support H2b.

3. Empirical Results
Table 2 presents the results from estimating Model (1) for the year of 2012, 2013 and 2014
respectively. The lowest adjusted R2 of all the estimates is 22%, and the highest is 47%. The P value
of F statistics of all estimates is 0.0000, which shows the fitting effects of all regressions are
relatively good. The VIFs of all the varibles are below 4, which suggest that there never exists
serious multicollinearity. We adopt the heteroscedasticity robust standard errors for all the estimates
to overcome the problem of heteroscedasticity.
Table 2. Investment Efficiency Estimate Results for the Year of 2012 to 2014.
Predi Year 2012 (A) Year 2013 (B) Year 2014 (C)
Variables cted Coefficie t-Value Coefficie t-Value Coefficie t-Value
sign nt nt nt
Constant ? 0.222** 2.17 -0.035 -0.6 -0.033 -0.67
Deficiency (1) - -0.063** -2.34 -0.039** -2.21 -0.030** -2.52
Overfirm ? -0.067 -1.01 0.053 1.23 0.032 1.02
Deficiency*Overfirm(2) + 0.113** 2.19 0.082*** 2.73 0.067** 2.88
(1)+(2) + 0.050* 3.21(f-v) 0.043*** 7.20(f-v) 0.037 7.97(f-v)
Firstshare ? -0.096** -2.39 -0.032** -2.64 -0.016** -2.43
Firstshare*Overfirm - 0.121 1.12 -0.050 -0.67 0.007 0.10
Sharebalance + -0.038 -1.32 -0.008 -0.45 0.002 0.17
Sharebalance*Overfirm - 0.053 1.12 0.014 0.51 -0.007 -0.37
Manashare + -0.425 -0.58 -1.297 -1.18 -1.427 -1.02
Manashare*Overfirm - 1.145 0.86 2.182 1.11 2.204 0.98
Institutions + 0.057** 2.49 0.043** 2.57 0.036* 1.94
Institutions*Overfirm - -0.055 -0.94 -0.027 -0.62 -0.044 -0.93
Logasset + -0.003 -0.82 0.003 1.17 0.001 0.37
Age + -0.001 -1.34 -0.001 -0.48 -0.001 -0.70
Pb + -0.003 -1.52 0.002 1.51 0.001 0.61
Leverage ? -0.031 -0.57 -0.041 -1.44 -0.018 -1.76
Loss - 0.022 0.74 -0.026*** -3.72 -0.001 -0.10
Cycle - -0.007** -2.34 -0.004* -1.90 -0.022** 2.53
Tangibillity + -0.063 -1.44 -0.050** -2.47 0.009 0.83
Dividend - 0.001 0.15 -0.002 -1.28 -0.009** -2.06
Zscore + 0.001 0.60 0.001 0.29 -0.001 -0.26
Cfosale + 0.004 1.40 0.004 0.80 0.003 0.94
Stdcfo ? -0.148 -1.24 -0.035 -0.58 -0.052 -0.94
Stdsale ? 0.025 0.91 0.013 1.11 -0.003 -0.16
Stdinve + 0.705*** 3.61 1.65*** 5.61 1.718*** 7.37
Observations 733 733 733
Adjusted-R2 0.2209 0.4756 0.4606

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 3.1 Testing of investment efficiency by year
Colume A, B, C of Table 2 presents the estimate results for the year of 2012, 2013 and 2014. The
coefficients on Defficiency are all significantly negative, which suggests that under the financially
constrained situation, ICMWs firms invest significantly less than control firms, which lends strong
support to H1a. Meanwhile, the Wald tests show that the sum of the coefficients on Defficiency and
Defficiency*Overfirm are all significantly positive, which lends support to H1b, means that under
financially unconstrained situation, ICMWs firms invest significantly more than control firms. The
above results show that under different financial circumstances, ICMWs negatively affects
investment efficiency.
With respect to corporate governance variables, Column A shows the coefficient on Firstshare is
significantly negative, the interaction of Firstshare and Overfirm is not significant, which suggests
that the first shareholder implements tunneling behavior aggravating the under-investment of
financially constrained firms. The coefficient on Sharebalance is not significant, shows the second
to fifth shareholders can not have the check and balance effects on the first shareholder. The
coefficients on Manashare and Manashare*Overfirm are not significant too, implies that the
management stock incentive mechanism in China has not exert its expectant effects. The coefficient
on Institutions is significant positive, but Institutions*Overfirm is not significant, which shows the
involving of institutions is helpful to alleviate the problem of under-investment.
3.2 Testing of investment efficiency in following years
The column A (B) of Table 3 presents the estimate results of the first (second) year after 2012.
The coefficient on Deficiency is significantly negative in the first year and not significant in the
second year, which lends part support for H2a, implies that in the first year after 2012 the
under-investment still exists, but in the second year the problem is alleviated. Meanwhile, the sum
of the coefficients on Deficiency and Deficiency*Overfirm are significantly positive in the first year
and not significant in the second year, which also lends similar part support for H2b. As analysed
above, the effective internal control is the root mechanism to handle the problem of inefficient
investment. Hence, we can infer that after two years rectifying ICMWs, the investment efficiency
has been improved to some extent.
Table 3. Investment Efficiency Estimate Results for Following Years.
The first year after The second year after The first year after 2013
Predict 2012 (A) 2012 (B) (C)
Variables
ed sign Coeffici t-Value Coefficie t-Value Coefficient t-Value
ent nt
Constant ? -0.038 -0.65 -0.104** -2.03 -0.106** -2.33
Deficiency (1) - -0.041* -1.86 -0.021 -1.56 -0.043*** -3.01
Overfirm ? 0.018 0.40 -0.044 -1.33 0.050 -1.54
Deficiency*Overfirm(2) + 0.076** 2.82 0.011 0.43 0.080*** 3.03
(1)+(2) + 0.035* 3.29(f-v) -0.010 0.38 0.037** 6.28(f-v)
Observations 719 695 697
Adjusted-R2 0.4734 0.5231 0.5287
The “f-v” in Table 2 is the abbreviation of f-Value. The***, **, and * denote statistical
significance at 1%, 5%, and 10% levels respectively, based on two-tailed tests.

4. Robustness Tests
To promote the robustness of the estimates, we changed the measure of some variables. Such as,
we use the internal control quality index developed by Shenzhen Dibo and rank it into decile rank,
take the firms at the lowest decile as the ICMWs firms, the other firms as control firms, and
replicate the regressions on model (1). The major estimate results remain unchanged, that is, the
support for the first set hypotheses is confirmed, and the second set of hypotheses is also partly
supported.
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Conclusion
This paper traces China state-owned listed firms the effects of internal control on investment
efficiency from the year of 2012 to 2014. We find that in the year of ICMWs, under the financially
constrained circumstance, ICMWs firms have the problem of under-investment; under the
financially unconstrained circumstance, ICMWs firms have the problem of over-investment;
although the inefficient investment situations of ICMWs firms have not been mitigated in the first
year following the ICMWs year, the under-investment and over-investment problems are alleviated
in the second following year. The above discovery shows that the implementing of the Basic
Criteria of Enterprise Internal Control by China state-owned listed firms has its positive effects,
that is, after two years rectifying, under different financial circumstances, the investment efficiency
has been improved to some extent, which is an encouragement for both regulatory agencies and
firms.

Acknowledgement
This research was financially supported by the major projects (2014JDZ036, 2015JDZ049) of
Fujian Province Philosophy Social Science Research Base, the young and middle-aged teachers
educational research project (JAS150619) of the Education Department of Fujian Province and the
young research project (JXS2013002) of Fujian Jiangxia University.

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