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

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