Ineffective internal controls | China Accounting Blog | Paul Gillis

Ineffective internal controls

An interesting academic paper presents some information about ineffective internal control disclosures of U.S. listed Chinese companies. Three professors at the University of Hong Kong, Raymond Reed Baker, Gary Biddle and Neale O’Connor, wrote the paper.

Sarbanes Oxley requires companies to certify the effectiveness of internal controls and to disclose any material weaknesses. Auditors are required to attest to the effectiveness of the controls annually.

The study compares U.S. listed Chinese firms with comparable U.S. firms. U.S. listed Chinese firms are broken down into two categories – cross-listed firms that also have a Chinese listing (which are all SOEs like PetroChina or China Life) and direct-listed firms, which are private companies like Baidu or Sina.

Not surprisingly, private, direct-listed firms from China have significantly more ineffective internal control disclosures than comparable U.S. firms. Certain internal control deficiencies have become commonplace among these companies, including deficiencies caused by a shortage of qualified accounting staff. The study was based on 2009 data, which precedes the major run of frauds and the subsequent SEC scrutiny that the companies faced. I expect if the study were conducted with 2012 data the rate of deficiency among Chinese firms would be even higher.

On the other hand, cross-listed Chinese firms (SOEs) had significantly lower rates of ineffective internal control deficiencies than their U.S. counterparts. The authors suggest that this could be the result of increased regulation of these companies (they are subject to CSRC regulation, while the direct listed firms are not), greater tendency to use Big Four auditors, age, and size. I would add that auditors might be hesitant to propose a deficiency on a major SOE.

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