The effect of internal control on earnings response coefficient

Abstract

PurposeThe purpose of this paper is to investigate the effect of internal control (IC) on earnings quality from the perspective of the capital market. Specifically, it examines the effect of IC on earnings response coefficients.Design/methodology/approachThis study uses the moderated regression analysis on a sample of 1,310 Chinese listed firms on the Shanghai Stock Exchange (SSE) from 2020 to 2022. It employed an earnings response coefficient model by Holthausen and Verrecchia (1988) and used the IC score produced by the index created by the Shenzhen Dibo Enterprise Risk Management Technology, i.e. DIB IC, and risk management database.FindingsThe study finds that the capital market placed lower earnings reliability on companies with high IC. This suggests that investors perceived negatively on the IC score of China listed companies, possibly due to their negative perception on the reason for implementation of high IC by those companies. A high IC score may raise suspicion amongst investors that the company has internal issues.Research limitations/implicationsThis study adds to the limited studies on less regulated internal governance mechanisms from the perspective of the capital market. The contradictory result suggests the need for more studies before deriving a solid conclusion.Originality/valueThis study focusses on the under research area of IC rather than the common board of directors and from the perspective of Chinese economies, limited studies of developed countries.