In a recent study, published in the European Accounting Review (EAR), Yining Chen, Baohua Liu and I study the impact of internal control (IC) on corporate innovation. Per the Committee of Sponsoring Organizations (COSO), IC has five components (i.e., control environment, risk assessment, control activities, information & communication, and monitoring). Surprisingly, with a few exceptions, studies on IC seldom examine how these five components individually impact corporate policies and activities. The literature on IC primarily uses IC weakness measure (“yes” or “no” in IC weakness). Hence, the information content of IC weakness is much less than a continuous measure of an IC index and its five components.
We focus on the impact of the internal control system as a whole, as well as the impact of the five components of internal control individually on corporate innovation because innovation plays an important role in a firm’s success and a country’s economic development (Devece, Peris-Ortiz, & Rueda-Armengot, 2016; Galindo & Mendez, 2014; Kirchhoff, Linton, & Walsh, 2013). Innovation gives firms from advanced economies, not only an edge to penetrate markets but also better connections and opportunities to develop markets (Henderson, 2017).
Conceptually, we contend that internal control is a double-edged sword to a firm’s innovation endeavor. Despite the firms’ good intent to ensure the safety and effective management of investment, internal control can present tension and rigidity constraining the freedom of creativity for innovation. Hence, we expect a nonlinear impact of internal control on innovation, i.e., the impact of a low level of internal control differs from that of a high level on innovation.
Leveraging from the unique IC data in China during 2007 to 2016, we document that both the aggregated-level internal control and its five individual components have a positive impact on innovation. The magnitudes of the impact, however, differ across the individual components. We find that the control environment, control activities, and information & communication components exhibit stronger impact on innovation than risk assessment and monitoring components do. These results are robust for different measures of innovation and after accounting for endogeneity. Most importantly, after establishing the impact of internal control on innovation, we incorporate a nonlinear element in our empirical models to document that the magnitude of a low level of internal control is indeed different from that of a high level of internal control on innovation. Specifically, we show that a high level of control environment, control activities, and information & communication (risk assessment and monitoring) components have a stronger (weaker) impact on innovation compared to a low level. This new finding extends the conceptual framework of internal control and innovation outlined in Li et al. (2019).
Our findings have two major managerial implications. First, we conclude that a good internal control positively contributes to more innovation. Correspondingly, firms should actively engage in improving the quality of internal control and practices in conjunction with their innovation endeavors. Second, internal control, as an integrated system, has different components. While these components, on their own, are important to a firm, their impact on innovation may be different. Our findings suggest that macro-level components of a firm’s internal control in terms of control environment, control activities, and information & communication are more important to innovation than other components such as risk assessment and monitoring to innovation. For that reason, firms need to closely evaluate specific components of internal control in setting their innovation promoting corporate policies. In any case, controls ought to be flexible, relevant, and linked to current organizational objectives. By and large, the results of our study provide a practical implication to firms seeking to foster innovation with stronger internal control. While firms can expect that strengthened internal control in respect of control environment, control activities, and information & communication can lead to a better managed and more successful innovation endeavor, cautions should be taken to raise the level of risk assessment and monitoring. Overly rigid risk assessment and stringent monitoring can deter innovative attempts and constrain the freedom of creativity.
Discover more about our study at https://doi/abs/10.1080/09638180.2020.1776626
To cite this article: Kam C. Chan, Yining Chen, and Baohua Liu (2020). The Linear and Non-Linear Effects of Internal Control and its Five Components on Corporate Innovation: Evidence from Chinese Firms using the COSO Framework, European Accounting Review